Morality is class morality
Although its value has been poo-poohed over the years, the concept of morality has not been so easily disposed of. Noted historian Paul Johnson declares that morals are at the heart of the current financial crisis in a philosophical sense. Writing in Forbes Magazine, Johnson says:
The financial crisis, detonated by greed and recklessness on Wall Street and in the City of London, is for the West a deep, self-inflicted wound. The beneficiary won’t be Russia, which, with its fragile, energy-based economy, is likely to suffer more than we shall; it will be India and China. They will move into any power vacuum left by the collapse of Western self-confidence. If we seriously wish to repair the damage, we need to accept that this is fundamentally a moral crisis, not a financial one. It is the product of the self-indulgence and complacency born of our ultraliberal societies, which have substituted such pseudo-religions as political correctness and saving the planet for genuine distinctions between right and wrong and the cultivation of real virtues.
But the importance of morality goes beyond being a figure of speech or a nod to piety, Karl Okamoto, at the Drexel School of Law, believes that we need to incentivize morality in transactions by making changes to regulation, otherwise our financial system will continue to be subverted. Okamoto writes we are in this mess because we have failed to control “moral hazard”.
The assertion of this Article is that the root cause of the current financial crisis is systemic moral hazard. Systemic moral hazard poses a unique challenge in crafting a regulatory response. The challenge lies in that the best response to systemic moral hazard is “preventive prediction.” It is inherently difficult to reward individuals for producing preventive prediction. Therefore markets fail to produce it at optimal levels, and thus prevent systemic moral hazard and the kind of crisis we are facing.
The difficulty in valuing preventive prediction is seen when we model how risk managers make decisions regarding the prevention of excessive risk. The model reveals that the balance is easily tipped in favor of risk-taking that leads to systemic failure and broad social harm. The model also reveals how regulation might work to reset the balance to one that is superior for society. We achieve this by imposing two requirements on all asset managers in the market: we require them to put their own money at risk in their trading decisions, and we require them to use “best practices” in managing risk. These prescriptions arise out of a regulatory strategy that accepts the need to balance the benefits of risk-taking in financial markets (and the consequent inevitability of some financial failure) with the desire to avoid excessive risk-taking and the costs of systemic collapse. It is a strategy that focuses on those instances where we cannot trust ourselves to be prudent.
In the both the Johnson and Okamoto senses the practical problem is how to ensure people act under incentives which are aligned with the desired outcomes. It is easy for people in actual positions of power or influence to pursue a separate agenda and serve those goals instead of the stated ones. In the case of financial transactions, the natural temptation is to put your pocket-book ahead of those of the investors. Hence, Okamoto recommends that all asset managers be required to “put their own money at risk in their trading decisions”. This concept is familiar to everyone, even Joe the Plumber, in the expression “put your money where your mouth is.”
In the Western morality that Paul Johnson criticizes, “a farcical coalition of fashionably liberal academics on the make, assorted eco-crackpots and media wiseacres” pursue their fantasies with other people’s money and other people’s futures. It’s Okamoto’s moral hazard situation in another setting where well-to-do social activists instead of asset managers take risks with things that have merely been entrusted to them, presumably because they are the Great and the Good. Johnson tells the following story: “I had to laugh when a Chinese visitor recently said to me: ‘I see you’re going back to the windmill in Britain. We Chinese cannot afford that.’” Al Gore can afford a windmill. The question is whether the average working stiff can.
ABC News describes how Hugo Chavez is making friends with Hollywood’s “A List”. He’s invited a number of well known entertainment figures to view his revolution. “Venezuelan President Hugo Chavez’s list of Hollywood buddies is getting larger. The latest A-list acquaintance is an intriguing friendship that’s sprung up with Oscar-winning actor Sean Penn — in a trend critics say is aimed at improving the left-wing leader’s international reputation. … Other high-profile visits have been made by actors Kevin Spacey, Danny Glover and Tim Robbins, all of whom have been vocal critics of President Bush, Chavez’s so-called nemesis. Last year, supermodel Naomi Campbell got a one-on-one with the man for a magazine interview, during which she called him a “rebel angel” and he playfully invited her to touch his muscles. “ A poor Venezuelan might not be able to afford the luxury of a Hugo Chavez, but Hollywood can. And guess who wins?
This is the reason for the underlying unease with the “redistributive” financial system proposed by Barack Obama, which was highlighted by a comparison in tax plans between the two financial candidates by Harvard economist Greg Mankiw. At one level, the problem is not the numbers, it’s the principle of putting someone else, besides yourself, in control of who gets what. Why? The moral hazard problem of course.
Some people of course, have no problems leaving their fates to others. Recently a 52 year old man in El Paso jumped to his death from a highway overpass leaving a note “asking for Barack Obama to help his family”. Tigerhawk asks whether the man from El Paso should expect help before or after any assistance to Obama’s uncle and aunt who are living in a run down dump not far from Harvard. Nobody is under any obligation to his help his relatives — except a moral one — but how certain are we that asset managers and politicians will do what they promised? Many sectors we had counted on to lead society are now marching to a drummer of their own. If so, maybe the right watchword for the times isn’t ‘Hope’ or ‘Change’ but ‘remember who your’re working for’. That would be the government, right?
While I don’t disagree with much of your post Wretchard, I take issue with the characterization of the current crisis as a moral one. The Western economies since the beginning of the Early Modern Era have been characterized by speculative bubbles. The Tulip Craze, the South Seas Bubble, the Louisiana Bubble (in France), the Telegraph and Railroad bubbles, the telephone bubbles, the oil bubbles too numerous to mention, all point to speculative frenzy and then crash.
What makes this crisis bad is that it coincided with an energy spike. Which was far more pervasive since it takes money out of circulation and transfers it to a non-productive set of states minimally involved in the global economy.
Moreover, the politics of redistributive Welfare States all rested on good times, to avoid hard decisions of impoverishing Peter to pay Paul. In fact, a global depression brings the Welfare State crashing down, since the policy of various goodies distributed to favored groups degenerates quickly into brute struggles over who gets what pie slices.
The farcical group of NGOs and so on get replaced by brutal struggles between elitists and populists. Whoever can hold the middle wins. And the middle is not always one that is occupied by nice people, either.
Don’t worry, President Obama will give lower interest rates to people with good morals; taking the troops out of Iraq will pay for that.
It would have taken some kind of moral courage for any prominent politician to try guide the US or UK economy into a soft landing 10 or more years ago, rather than allowing it to whirl onwards into this train-wreck.
It would have meant saying things too many people would not want to hear, and doing things which, while right and good, would be likely to end a political career at the next election, or sooner.
The two big drivers on the financial crises as far as I can tell were
1.)
a.loans given to people in the USA who couldn’t afford to repay.
b.European loans to institutions who couldn’t afford to repay.
2.)Banks in the US & EU over leveraged. Traditionally ratio of loans to assets are 12-1. (Eastern banks were not over exposed to toxic mortgages/loans & they kept their ratios down to historical levels.)In the US and the EU banks over the last decade were lending out at over 30-1. Thus the immense expansion of liquidity. (That’s why everywhere you looked in the last decade, neighborhoods just seemed to float on money.)
To cure the problem
1.)ya gotta stop giving loans to people who can’t afford to repay them.
2.) Return banks to normal lending ratios.
In the USA — Acorn needs to be defunded, the community reinvestment act should be rescinded, a lot of regulatory laws in the US tightened up. Fanny & Freddie should be restored to their original intent.
Dear Wretchard,
When a ‘broker’ (regardless of what he calls himself) suffers no consequence if the product he’s selling goes ‘south’, this generally results in the broker being fired, or avoided by the investor.
A rating agency (or a mortgage insurance company) that brands an instrument “AAA”, without financial consequence to itself, should be ‘disenfranchised’ if the “AAA” instrument goes into default.
The market by definition must deliver financial consequence — and that means in both directions, gain and loss.
Why is this such a mystery?
Such ‘brokers’ always strive to invent ‘innovative’ new verbiage that obfuscates financial consequence.
“Fast” money swift traders look to high-concept icon pneumonics to substitute for laborious analysis of financial consequence.
The folks who learn to do this work for real have a bona fide significant opportunity there.
Triple AAA debt with higher premiums than U.S. Treasuries will require due diligence comparable to 4-to-1 tax incentive financing proposals without a competent tax opinion.
Losses are healthy for the economy, government regulation is not.
Agree with Charles that the structural deficiencies of the 2008 debacle/catastrophe/crisis/meltdown are clear and require fixing (something to watch for), but I also agree with the thesis of moral hazard as the foundation for redistributive policies.
As for Chavez and the Hollywood A-list, boy, the hits just keep on comin’, don’t they. Last time I looked USGS expected San Andreas to open up wide with 95% probability within a decade.
Colo. public employee pension fund plunges $10B
California pensions were hit harder. Hopefully the government unions that are all democratic will fry the people like barney frank who fiddle with institutions like freddie and fannie.
But for these unions to do so they’ll need to know something about how money works.
Will they get it? beats me.
The democratic party typically screws hardest the very people who support them the most. Blacks & unions.
In fact I would further add that watching the Congressional and prosecutorial response to the financial dysfunction would constitute one active component of a Conservative rebuttal position.
The immorality at the heart of this crisis is not greed. It is the notion that certain segments of society, evil by definition (capitalists, the rich, in reality every individual who has earned any property) OWES certain other groups (primarily the poor, who are dubbed disadvantaged) that property. That’s what “affordable housing” is all about. That’s what Messrs. Frank and Dodd and yes, Bush, kept pushing in the full knowledge that doing so would bankrupt our financial institutions. It’s called Communism unless you missed my point and it is the total inversion of morality.
Another being to vote accordingly in those Congressional races critical to achieving a filibuster-proof Senate as per Michael Barone’s recent article.
The people who pushed making loans easier and easier to get thought they were doing something morally right. They would have viewed it as a moral hazard not to make such loans.
But, of course, even they now pretty much say that things went too far. Barney Frank said the other day “Sure I wish that we had regulated Fannie and Freddy more but I would also like to eat more and not get fat. And after all, the Republicans had control of Congress, so they could have done it.” The head of ACORN said last week “Sure, we advocated low interest loans but how were we to know that the financial institutions would use them as they did?”
So the moral hazard was that you were not supposed to use the low interest loans meant for poor people to buy a couple of extra houses and sell them after a few years for a 20% markup. And you were not supposed to do that over and over again.
The problem with Morality is that there are so many different flavors of it. One man’s morality is another man’s opportunity.
And as Canada Bill Jones famously said “It is morally wrong to let suckers keep their money.”
One man’s morality is another man’s opportunity. – RWE
That’s why I make a distinction between the players that game the system by finding the loopholes – heinous but not illegal – and the oversight agencies, such as Arthur Anderson, SEC, and the F/F oversight agency. They are the first line of defense and must be held to a higher standard.
Slade:
Note also that the heinous derivatives created by the financial industry for their own profitable purposes kept the money coming so that those non-poor people using “poor people” style financial instruments to become real estate magnates did not prevent the real intended recipients of Fannie and Freddy and Barney and Acorn’s efforts from getting loans either.
This was like the USSR, where farmers found it more profitable to feed their personally owned cows bread rather than grain, because the government paid premiums to encourage the production of grain (to encourage people to plant it in their private plots) and heavily subsidized the price for bread (to prevent revolution). As you allude, people will always figure out a way to take advantage of government and industry stupidity or miscalculation. Is this immoral?
G.R.Langworth: “A rating agency (or a mortgage insurance company) that brands an instrument “AAA”, without financial consequence to itself, should be ‘disenfranchised’ if the “AAA” instrument goes into default.”
A rating, at its heart, is a statement about the estimated probability of default.
One way to hold ratings agencies to account, would be to keep track of the actual probability that an issue rated AAA (or equivalent) goes into default within 3 years of having a AAA rating. If a rating agency has X% of its AAA-rated issues go into default, then its AAA rating gets redefined as “junk”, and ALL issues it rated are now “junk” rated. The people the rating agency rates will thus have a powerful incentive to scream if they see the agency give a good rating to issues that they know are too risky for the rating given.
Morals are well and good.
But, how do you impose them on people with little oversight such as Barney “Fannie” Frank, Chuck “Indymac liquidator” Schumer, and George “There is another Jew, arrest him” Soros?
The idea of “moral” markets seems very silly to me, as if the current situation is due to a lack of morality (oooo, the devil made me do it.) These bad loans were made because they could be gotten away with. Responsibility was passed on, up, over, whereever…there was very little (immediate) risk involved. It was almost implicit that any danger would be to someone else, (maybe that Uncle Sugar had it covered.) Lo and behold…
It seems that complex, organic, almost living systems, such as markets, are subject to recurring, large scale bitch-slaps which determine, in the main, how they actually perform (how much wealth was wiped out in this last one…..trillions?)
And, I think the attempt to give access to home ownership to an increasing number of people was an attempt at “moralizing” financial markets. How twisted and distorted that became.
Question: is acting in self-interest greedy? If not, why not? If so, is that bad?
RWE
Agreed about the derivatives. As I have said before, I see these instruments as pure plays on market movement, which makes them Vegas crap shoots, as opposed to plays on assets, management, and capital. Others see a role for them. I really don’t appreciate their functionality.
Is this immoral?
Ha! I don’t know if you were being serious, but at the very least it’s not a play I would make since not one of those drinks I had in Las Vegas was ever free. In that light, they must come under the “R word.” My opinion.
Economics is the study of applied morality.
Banks have traditionally used five criteria for underwriting a loan – the “Five C’s”:
The last “C” is clearly a moral assessment. Lenders have known for centuries that character is an excellent predictor of the likelihood of being repaid. J. P. Morgan once had the following exchange:
The problem, of course, is that it can seem “unfair” to lend money to people on the basis of something as fuzzy as character. Who are we to judge someone’s lifestyle; I mean, if I want to smoke a little weed or do a little blow, why should that interfere with my God-given right to own my own home? Who do you think you are? How can you be so judgmental? Are you some kind of puritan?
Moreover, in a culture that values consumption and image more than production and reality, character loses its meaning. It’s not important that you be successful, only that you look successful. Do you want a blue suit? Step under the blue light.
From this perspective, the financial crisis was baked from the following recipe:
But don’t worry. It may not be good for you, but it tastes great!
L3
L3; G-R-O-A-N!!!!!!!
BTW; google up “Iowahawk” and hit the lucky button. He will have you in stitches.
You too, Slade and everybody else. One of the best paradies I have seen in a while.
lc,
I largely agree with your analysis. However, I have to push back on the silliness of moral markets.
The reason morality is essential to the proper functioning of markets is that all markets operate, to a greater or lesser degree, on trust. Trust is needed to keep transaction costs low. But trust involves making a judgment about future behavior under circumstances that are unknown.
I lend you $1,000,000 for one year at 6% interest. I’m expecting to earn $60,000, but I borrowed most of the money from depositors, and I will have to pay them 3%, and I have fixed costs that add up to 1%. That means I will only make $20,000. If I have to keep $1 of equity for every $10 of loans, this isn’t so bad; I earn $20,000 on an equity investment of $100,000, or 20%.
But how do I know you will repay it, even if you have the money? Sure, I could sue you if you don’t, but it will cost me $40,000 in legal expenses to chase you down through the courts, plus I have to keep paying my depositors. If you don’t pay me back as promised, I lose money.
So I must have a high level of trust in you, that you’ll do what you say you’ll do. And the best way for me to make this assessment is to look at your history of following through on past promises. If you have always paid back your loans, I have a good reason to trust you.
But the habit of honoring commitments is a moral habit; it is a pattern of action that is the external sign of an internal commitment to honesty. If you have past instances of violating commitments – unpaid loans, going AWOL, multiple divorces, skipped child support payments, felonious behavior – isn’t this a warning sign? But in a culture that says these things are Jim Dandy, how do I legitimately use these signs to guide my decisions?
For markets to be efficient, transaction costs must be low. Immoral behavior increases transaction costs. Hence, far from “moral markets” being very silly or oxymoronic, it seems to me that moral markets are the only kind that function properly over the long run.
So, to your question,
I would respond, “It depends.”
Acting in your self-interest is not necessarily greedy, but acting greedy is most certainly not in your self-interest.
Cheers.
L3
Dave,
It’s a pleasure to provide you with groanable content.
Iowahawk is a genius.
L3
lc,
The last sentence of my post #21 didn’t quite say what I intended. Hopefully, this is better:
Acting in your short-term self-interest may be greedy, but acting greedy is most certainly not in your long-term self-interest.
What I wrote was illogical. And that was a bug, not a feature.
L3
Okamoto raises an excellent point – and about the only shot the securities industry and the Corporatists have at avoiding Gov’t regulators come in and “manage” the situation with reams of chickenshit “do’s and don’ts”. The public has lost faith that the deregulated fatcats can be self-policing after 7 major scandals since dereg started and trillions in money lost.
Right now, the system is set up to reward the money-makers. Their prestige in their peer group is defined by the money they make and perks..Powerful incentives. And those that break trust but still end up with tens of millions are still defined as winners even if they have to pay a piddling fine or even do a few months in the pen as a price for getting, and remaining, fabulously rich.
Ivan Boesky and Michael Milliken of the 80s scams have their own philanthropic Foundations and 90% of the wealth they gained by slight of hand. They kibbitz with the elite of Wall Street.
Fast Andy Fastow and his crooked family of Enron shame served minimal sentences, retained most their gains, got their US and Israeli passports back, and are again raking it in as International Hedge Fund associates and are again welcome in the highest social circles.
Meanwhile, investors get the usual caveat emptor message from “freedom-loving means free Markets!” ideologues, pennies on the dollar class action lawsuits, or told the offending banker or broker was “reprimanded” in closed to the public “arbitration” sessions attended to by a phalanx of the offending tycoon’s lawyers.
It will be interesting to see Dubya’s Pardon List.
Their only shot at avoiding the public sending tens of thousands of new “regulators” to new desks and new offices set up on their own property and sitting in on and monitoring meetings, deliberations and looking at any transaction – is to be as hard ass as some other professional associations are on the “ethically challenged” .
Of course the next big reality check coming is we are about out of phony “bubbles” that mask the reality that we are being killed on ideological notions like “free trade is great” which are undermined by trillion-dollar trade deficits and by the fact that the American Worker cannot outcompete the 3 dollar an hour Chinese or Indian worker of similar brains and skill level – if they are being paid 28 bucks and hour. Maybe if their pays are more “levellized”. The Chinese wage rising to 6 dollars and the American one falling to 10.50 an hour..Or the Indian IT engineer getting 28K while the American one falls to 40K.
Nor can 2 billion modern high tech jobs be created for 4 billion “excess job seekers” of the overpopulated 3rd Worlders in Asia, Africa, LA, the Muslim world – in which trade magically balances out and labor differentials magically adjust to parity without killing jobs or compensation in the developed world. That is what is different about the Japanese model that beat us to a pulp in the 80s. The Japs ended taking industries and jobs when they achieved wage parity for their much smaller excess, or then-underemployed workforce (21-24 million)
No more “exciting new high tech jobs coming Asians lack the IQ to do” stories will be spun out of Wall Street and America’s political elites bootlicking to the Corporatists. As justification for “Our American glory – free trade”. No more pretense that China eating our lunch didn’t matter at all because we are now in some magical new economic era of being “post-industrial, post service-sector” where we build McMansions for one another on magical new money and can borrow endlessly for “rich rewarding new Fed Gov’t jobs in “security against the 20,000 ‘Evildoers’”. No more tales of how we will somehow keep manufacturing jobs in new dream fields – Nanotech! Green Energy Solution Components! – somehow here in America when all the other stuff has gone overseas.
And the other “hope” being pushed is some cant about how America will flourish because glorious free markets and free trade and Americans are Freedom-Lovers!! somehow germinates this “creativity” no other country can match!! (But ask them to explaain their business model on how a new game or frozen yogurt on a stick or a line of hip-hop clothing zippers to be made in China will compensate for loss of 60 million skilled and college white collar jobs threatened by free trade and race to the bottom labor price? The “creativity and innovation is the answer!!” people get more than a little flummoxed. “You know..it’s all the stuff yet to be made that makes free trade the wonder that it is!!” And then the usual lectures about how the protectionism that grew the American, Japanese, European job base and economy will – under their ideology – cost us jobs if we don’t let them get outsourced…)
“It will be interesting to see Dubya’s Pardon List.”
Yes, if there’s one person on it with a Jewish-sounding name C-fudd will have more talking points to spew out his ass for the next few years. Judging from his recent posts he’s more Boshevist than the Jooos bwahaha.
L3 – Thanks for the info. Your posts are very interesting and informative (as some others here are also) on a subject about which I know very little. You are also often pleasantly humorous, which is a VERY good thing. Thank God for humor (…is humor “moral”?)
Your point about morality within markets is well taken…it (morality/honesty) seems a key feature to a well functioning market, and it seems (as pointed out by slade) that some of the oversight mechanisms meant to ensure honest activity failed bigtime in the current situation.
Could it be said that self-interest is a function of common sense (or vice/versa)? I am thinking of the Russian farmers in the above post (RWE #13).
I still have to ask though, even though morality is essential to the proper functioning of markets, are they therefore “moral”…I guess I have a picture of markets as a system or mechanism much like “evolution” (which may be a bogus analogy as evolution is more a process than a thing.); or, like those futures markets used to predict the probability of some not-too-distant future occurance? This is sort of like the aborted attempt at predicting future occurances of terrorist activities through a market like system. It seems that in this instance the market is neither moral or immoral, although many wanted to portray it as immoral. (Although integrity within the system is key to the system’s utility here too.)
An interesting point from Taleb’s “Black Swan” about Benoit Mandlebrot – why would a brilliant, established scientist like Mandlebrot, who should have better things to do with his life, “take an interest in such a vulgar topic as finance?” M.’s answer “Data, a gold mine of data.” Markets are where the rubber meets the road, or as Taleb infers, where representation meets reality (if properly understood).
Agree with your viewpoint re: self-interest/greedy. It seems in a well functioning market greed would, in the long run, be “failed” out. (and Barney Frank still gets reelected means what?????)
Thanks.
Leo Linbeck:
Relative to the 5 “C’s” I am convinced that part of the mortgage problem derived from the fact that the mortgage broker industry became in many ways an industry in its own right. Even today after, the crash, you hear “Get Your Credit Report” commercials at least every 15 min on TV and radio and the edges of our internet pages are crowded with mortgage offers and credit report ads.
Here in Florida it was said that during the height of the mortgage craze a few years ago that poor service in bars and restaurants was due to the waitresses and bartenders having gone off to become mortgage brokers.
I not only got numerous telemarketing phone calls offering refinancing, but Well Fargo sent me two express mail packages with all of the paperwork filled out and ready to sign.
A large and presumably profitable industry developed that was eager to reap the fees associated with loans. Way back when, I never got the impression that the banks gave a rat’s rump about the loan fees; they were focused on the long term viability of the deal. That clearly is not true with the credit/mortgage/loan application industry.
P.S., I grew up hearing “Turn on the blue light the man wants a blue suit” as a warning on certain people’s business practices.
I believe one important aspect of “character” is a proven ability to save ove the period when one is earning in early mid life. There are people who hardly save but borrow and then use the money that they should have saved to pay off the loan. So such a person has a high credit rating but at the age over 55 that person is a bad risk for a mortgage.
There is too much reliance on metrics over judgement.
Aren’t we making this too complicated? Isn’t the moral hazard: If you don’t make your mortage payments – you lose your home? If you lend to too many people who don’t make their payments – you go bankrupt?
The government reshaped this common sense morality by forcing banks to make loans. And by setting up a government-company or a company-government called FannieMaeFreddyMac that didn’t face the moral hazard of you make to many bad loans you go bankrupt.
The banks responded by making those loans-under-duress into hot potato instruments. Who would end up holding it? And now the government further reshapes morality by preventing big elite companies from going out of business. In the end government has almost destroyed credit.
And liberals call this de-regulation.
Having thought about this topic for a day, I have only one word to say:
“Transparency”
lc,
I think your fundamental point is right – “markets” are neither moral nor immoral. In fact, only human action is moral or immoral.
That being said, there are certainly ways to design markets that reward moral behavior, and punish immoral behavior. Maybe that’s really what we’re talking about when we refer to moral markets.
Well-functioning markets tend to “moral” in this sense. The key requirements of a well-functioning (and therefore “moral”) market are:
In short, markets require rules that distinguish between good and bad actions; in other words, morality. Our unwillingness to “impose our views on others,” why laudable in certain contexts, will undermine free enterprise in the long run, and make us all poorer.
The question, then, is not whether to impose morality. It is which morality to impose, because impose them we must. Moral relativism and political correctness destroy markets, and with them prosperity.
Cheers.
L3
RWE,
Sounds like you were a tempting target for mortgage hucksters. You must have great credit.
Interesting. I’ve heard the Florida (esp. South Florida) was Ground Zero of mortgage meltdown. Your stories certainly support that.
You know, one way to think about the mortgage mess is that a long-lived product (up to 30 years) was sold by people who had a very short time horizon (get rich quick). This is not necessarily a problem; the insurance industry has done this for centuries. But there were three important differences between mortgages and insurance:
1. Insurance is regulated at the state level. This prevents a single insurer from co-opting a single regulator. Insurance regulators must compete to attract insurers, and insurers must compete within different states. It also means a failure in a single state is very unlikely to spread to other states. Mortgages evolved into a national system, dominated by Wall Street, and regulated nationally.
2. Regulations strictly enforced capital requirements. You have to keep sufficient reserves, or you can’t write policies. Them’s the rules of the game, and if you don’t like them, you just don’t play. There may be lots of arguments about the right amount of reserves, but there are rarely arguments about the right amount of equity. This is a good example of intelligent regulation.
3. Insurance is a liability to the insurer, but mortgages are assets to the lender. This is important because when you stop paying premiums, you stop getting coverage. When the cash flow goes away, so does the liability. This means that underwriters to not have to predict the future with precision. Lenders, on the other hand, need to know that, over the life of the loan, the cash flow will be there. This is much harder to do, and moral hazard is a much greater risk.
This last one is probably the most important. Because the industry was rewarded on short-term results, and because the mortgages had a “long tail” so to speak, everyone kept looking for a way to financially engineer away the tail, so they could “lock in” profits and pay everyone handsome bonuses. And it worked for a while.
Problem was, the tail didn’t go away. It turned into a bullwhip.
Ouch.
L3
“Transparency” – Mark
Just a footnote, a persistent ambiguity in vocabulary is failure to distinguish between mickey-mouse “do and don’t” (much of SOX) and the kind of code that would lead to true transparency. I am guilty of not being precise. And it’s a crucial distinction because I expect what will emerge from the hoo-haw to “do something” will be more of the former and very little of the latter.
Again, something to watch. (Read an article last week that Charles “Tax This” Rangel is too powerful to fail.)
Leo:
It is clear to me that “a long-lived product (up to 30 years) was sold by people who had a very short time horizon (get rich quick)” is the essence of the problem. That certainly applies to the ones who bought houses just to flip in a couple of years. It probably even applies to many who bought them to live in, figuring that something would turn up when the rates inevitably ballooned – they figured they could always refinance the appreciated house at some point in the future and pocket the difference.
I was flabbergasted to hear that people were getting interest only loans – but this makes perfect sense if all you are going to do is flip a piece of property – or just use it as low cost rent and then walk off when the time comes to pay the piper.
I am afraid I count as one of those evil people who see the issue now as how do we punish the idiots and crooks strongly enough to make clear our displeasure. It is not just a matter of Social Justice, to coin a phrase, but also to serve as an object lesson to people who are not naturally so venal or dumb. Many thousands of people are asking themselves now “Okay, why should I continue to pay my mortgage, even though I can well afford to do so? If I prostitute myself though self-destitution, why is that either a social stigma or financial burden?” Maybe that is the essence of the moral argument.
P.S.: You can use that phrase “if I prostitute myself though self-destitution” if you like at no charge. Just give me credit. Has a nice ring to it, don’t you think?
“The financial crisis, detonated by greed and recklessness on Wall Street “
That first sentence couldn’t be further from the truth.
The financial crisis was sparked by altruism – the principle that we should strive for others’ benefit, not our own.
Few really achieve that of course, but it’s the foundation behind Democrat redistribution policies and promotion of regulations and institutions that put large numbers of people into homes that they can’t afford. The rest of society is now paying for them. That’s not greed. It’s not even selfishness. It’s selflessness.
Selflessness is fine between family members, maybe among friends, but disastrous in financial systems and government.
Long time lurker, first time poster.
Elfman, I must disagree with your assessment. This crisis has nothing to do with altruism. I would not call it generosity to take other people’s money for a ‘good cause.’ If Jim holds a gun to Bill’s head and takes his money to give to Bob that is not altruism. In fact, if Jim does so because he expects Bob to support his rise in power and influence then the proper word to use is thuggery.
This, in a nutshell, is what leftists (read Democrats) do with our tax system, and with the CRA pressure on banks to lend to unqualified borrowers. It was nothing more than an attempt to buy people’s votes. I wouldn’t call that selflessness.