CAPITALISM IN THE ABSENCE OF REGULATION:

The Root of the Financial Crisis: A dearth of knowledge at the nexus of decisions (Arnold Kling, December 2009, Policy Review)

To understand the problems inherent in securitization, imagine that you are a bank executive faced with two alternative routes for obtaining mortgage loans — a direct route and an indirect route. In the direct route, your loans are originated by your own staff. You establish standards, policies, and procedures for loan origination. You choose the markets in which you would like to originate loans, and you will probably focus on communities where you know the local economy. You hire and train personnel to follow internal guidelines. Your compensation policies incorporate incentives for them to accept or reject applicants in accordance with company policy. Once the loan has been made, if the borrower misses a payment, your staff follows company procedures for contacting the borrower and resolving the problem.

In the indirect route, loans are originated by persons unknown to you, following guidelines established by someone else. The loans may come from communities with which you are totally unfamiliar. The originators may very well be paid on commission, which they can receive only if they close a loan — never if they reject an applicant. If the loan gets into trouble, you will have no control over how the delinquency is handled.

No sane bank executive would choose the indirect route over the direct route. In economic jargon, the “agency costs” of the indirect route are prohibitive. The originators of mortgages in the indirect route are operating under incentives that are contrary to the bank’s interest. The misalignment of incentives between the bank and those acting as its agents in the indirect route will force banks to incur additional costs to monitor and review the work of the originators. Even with most diligent efforts, the bank is likely to incur higher losses from defaults as originators squeeze bad loans through the cracks of its monitoring systems.

It is surprising, then, that as of 2008, nearly three-fourths of mortgage debt in the United States originated by use of the indirect method. To reach this point required a combination of Wall Street ingenuity and regulatory anomalies.

Some of the ingenuity involved finding an intermediary to bear the risk of mortgage loan defaults. For example, gnma securities are guaranteed by the government, with the default risk on the mortgages ultimately borne by fha. As we will see, the concept of guaranteed securities spread to other types of mortgages, although the quality of the guarantees became suspect during the crisis period in 2008. Without the guarantees — or the apparent guarantees — indirect lending would not have been possible. Even with guarantees, there was nothing cost-effective about indirect lending. The main cost advantages of securitization came from accounting and regulatory anomalies. [...]

In hindsight, it seems that the regulators had the tools but lacked the knowledge to prevent the 2008 financial crisis. Had policymakers determined that the housing bubble posed risk, they could have warned banks and the gses to limit their risk exposure starting in, say, 2005. Had policymakers understood the way that bank capital requirements were distorting the mortgage market away from direct lending and toward securitization, they could have adjusted those capital requirements. Had regulators understood the extent to which the gses were trading off safety and soundness in order to meet affordable housing goals, they could have required the gses to change behavior, either by buying fewer risky loans or by raising more capital. Had regulators understood the way that rating agencies were mislabeling mortgage securities, they could have issued rules to banks requiring them to treat mortgage securities as riskier than their ratings signified.

The failure to regulate in time was not due to lack of tools. Nor was it due to lack of will. The failure to prevent the crisis was due to the lack of knowledge among key policymakers: There was a discrepancy between knowledge and power.

Wait, it was all supposed to be the fault of undeserving coloreds and their Democrat enablers....

Posted by Orrin Judd at January 2, 2010 6:22 AM