What is to blame for the mortgage crisis?

By Jon Hainer

Good question.
As a student of economics, I was taught to be very careful when designing incentives to affect any element of human behavior because you tend to get more of the behavior that you actually reward. This is often not the same thing as the behavior that you intended to reward. Unfortunately in real life, there is no professor standing on the sidelines ringing a bell and intoning “beware the incentives” at the crucial moment.
Two dozen years ago, I was involved in one of the first securitizations of retail automotive receivables cutely called CARS for collateralized automotive receivables. (Loans grouped to provide the security for a bond are said to be “securitized”). It was perhaps the very first securitization effort that targeted “B” and “C” borrowers (car buyers). “A” borrowers were the people with good credit and/or large down payments. The transaction involved multiple originators (automobile dealerships), a loan broker, a loan servicing company, and an investment bank. My commercial bank provided the funding to accumulate the loans into a large enough pool to be efficiently securitized.
Auto dealers had difficulty selling cars to people with uneven or bad credit histories because few lenders wanted to hold such loans. By gathering these loans into pools and securitizing them, we provided funding for an under-served market. CARS helped struggling borrowers to finance the cars they needed to get to work and promoted the sales of cars for auto dealers. It transferred risk to those who were willing to bear those higher risks in exchange for stellar returns and an absence of paperwork. Everyone benefited.
Can you hear a bell ringing? Perhaps you can if you have been paying attention to the mortgage crisis of the last year or two.
With CARS we created some perverse incentives. The auto dealer did not have to be as careful as it once was in arranging financing for marginal buyers because it no longer had a meaningful stake in whether the loan was repaid. The loan broker did not worry because it would only be holding the loans for a matter of days. The loan servicing company did not worry because its fees were paid from the very first dollars coming from borrower payments into the loan pool. The commercial banker did not worry because the exposure was short term and hedged. The investment banker (think bond salesman) did not worry because it never owned the loans but rather packaged them for the end-buyers. The end-buyers made the relatively subtle error of assuming that things were staying the same, and that they were buying into a pool of collateralized loans underwritten to very exacting specifications – high risk, but high return and carefully scrutinized. They should have worried.
The truth was that no one was carefully watching. By changing the system from a one-step process (borrower and lender) to a five-step process, lines became blurred, responsibilities vague, and self-interest paramount. Borrowers promised more than they could deliver. Auto dealers generated worse and worse quality loans because that meant they could sell more and more cars. The rest of us just passed on whatever came through the pipeline blithely unconcerned because we were not bearing the ultimate risk. The system did not reward being careful; it rewarded volume with large short-term profits. So we generated fleets of loans. Before long, however, there were too many defaults and too many repossessed cars gathering dust in a lot in the desert. Does any of this sound familiar?
The underwrite-to-hold model (traditional lending) is successful precisely because it requires the financial entity generating a loan to depend upon its repayment. The underwrite-to-sell model (securitization) is not only successful, but superior in many ways because, if everything is done right, everyone benefits. But with underwrite-to-sell, moral hazard is built-in. Without very careful financial engineering, perverse incentives will undermine even those with the noblest of motives, much less the characters (like me and you) who operate out of strict self-interest.
As the current mortgage crisis developed, it looked quite familiar to those who remembered the ill-fated CARS. The moral hazard of the underwrite-to-sell system wreaked its havoc as it is wont to do. To solve the current financial crisis, we have to realign the system’s incentives so that all participants are rewarded for success at every stage and all are punished for failure at any stage. It is easier said than done; but in the end, it is just a question of creating proper incentives. Economics 101.