What’s wrong with the following picture by Paul Willen, Senior Economist and Policy Advisor, Federal Reserve Bank of Boston?
Lehman apparently conducted stress tests of mortgages inhouse. Under a meltdown-worst case scenario, the investment bank reached an outcome on subprime mortgage deals where lenders could end up foreclosing on one-third of the loans in the pool.
“The analysis underscores investors’ knowledge about the sensitivity of subprime loans to adverse movements in housing prices, and it refutes the idea that investors did not or could not determine how risky these loans were,” Willen wrote in his research report.
It appears there that Mr. Willen is using the term “investors” as applying to a very narrow category with direct access to the data and the ability and time to crunch it all (whether or not in a meaningful way). It seems to us that most investors, pension funds and the like, relied upon the Wall Street bankers’ representations about the market and were certainly not apprised of the fact that the mortgage-backed securities were commingled loans ranging from truly AAA to pure junk yet all stamp together as AAA. The bubble was due to a lack of disseminated information that the bubble was not sustainable.
Had investors known the full circuit of the securities and why the Wall Street banks were shelling out billions to local mortgage bankers, etc., those investors would not have purchased securities, even rated AAA, with any intention to hold them.
The vast majority of such investors and also house buyers had no idea that no-doc loans, for instance, were being made because the lenders (Wall Street banks and investment banks) thought they could get away with it because they had no skin in the game but were bundling the junk in with the good and selling it off at a fee and were also purchasing and selling Credit Default Swaps as supposed hedges against the whole system collapsing.
We understand the point Mr. Willen is making and don’t disagree with it. We simply feel that the distinction among the various levels of investors should be made for clarity sake going forward.
It is not as if the Wall Street bankers did not know that they, the bankers, were stealthily adding the junk in with the good and getting it rated AAA. They knew.
So why do we bring this up? Well, the regulatory climate at the time represented a clear moral hazard, and we here at PropertyPak™, as insurance brokers, are concerned with such issues for the sake of our clients.
Here’s the introduction on the Wikipedia for Moral Hazard (which is a fairly good intro):
In economic theory, a moral hazard is a situation where a party will have a tendency to take risks because the costs that could incur will not be felt by the party taking the risk. A moral hazard may occur where the actions of one party may change to the detriment of another after a transaction has taken place. For example, persons with insurance against automobile theft may be less cautious about locking their car, because the negative consequences of vehicle theft are now (partially) the responsibility of the insurance company. A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party isolated from risk behaves differently from how it would if it were fully exposed to the risk. Another more complex example would be the Euro debt crisis, in which the troika of relief funds (aka the ECB, the IMF, and the EC) for heavily indebted nations like Greece are waiting as long as possible to act. The risks of a money run, and the consequential market crash in Europe is by far not as detrimental to these institutions as to the indebted nations themselves.
Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions.
Economists explain moral hazard as a special case of information asymmetry, a situation in which one party in a transaction has more information than another. In particular, moral hazard may occur if a party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.
Moral hazard also arises in a principal–agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.
So, you can readily see how moral hazard applies here to what the Wall Street bankers did. This is something we all need to keep in mind as we decide 1) which public policies we will or will not support and 2) where, etc., we will or won’t invest.
Something to keep in mind here is that due-diligence is extremely important, but due-diligence would only have run into a brick wall when attempting to get information on the loans that were bundled.
Too many buyers were buying based upon the rating agencies’ AAA ratings for the Mortgage-Backed Securities sellers to concern themselves with the lone holdout demanding enough data upon which to make a sound and independent determination as to the creditworthiness of the applicable home buyers or the overall sustainability of the economy.