Rules, Risk, and the Dodd-Frank: They Earned It

Whenever I see a parent who has a toddler at the end of a leash, my first reaction is one of horror. But my girlfriend always reminds me that nobody just gets the leash. No parent arbitrarily decides putting their kid at the end of a tether would be a good idea; they do it because, at least once, their toddler tried to run out into the street. Though the Chamber of Commerce seems to be horrified by the proliferation of regulation under the Dodd-Frank Act, it’s precisely the same situation. The financial services industry earned the leash.

I try to steer away from political topics on the blog. They tend to divide people more than they bring them together and often provide more heat than light. A post by the formerly mainstream, now free-market-fundamentalist Chamber of Commerce has inspired me to break that proscription, however, because it goes directly to the issues of ethic, risk, and compliance.

The page, http://www.chamberpost.com/2011/01/dodd-frank-unleashes-a-tsunami-of-regulation-a-visual.html, features a very well-done graphic on the number and scope of rules and regulations mandated by the Dodd-Frank act. The contention is clearly that the overwhelming profusion of regulatory activity is going to damage U.S. competitiveness as a provider of capital market services.

What it missing from the discussion is a review of why Dodd-Frank was enacted in the first place; the capital markets have proved, over and over, utterly incapable of regulating themselves. The fact is that there were trillions of dollars of real value lost in the financial meltdown of 2007/2008, and no one has gone to jail, and almost no one lost their job, and all the bankers and bond traders and rating agency executives got to keep the billions of dollars in bonuses they made in the run up to 2007. So the scoreline reads Wall Street 3-0 Main Street.

We have laws for a reason. In a world with both limited resources that must be competed for and the unlimited right to stockpile those resources, some people will do things that may not be illegal but that are unethical. In some spheres of life the social pressure against doing the unethical countervails the reward. Additionally, some people are just decent and won’t exploit others on principal. But as the rewards grow into the millions and billions, like they do in the capital markets, internal and external non-legal pressures fail and we get collusion, insider-dealing, and revolving-door quid-pro-quo deals.

Furthermore, risk is hard. All the academic research suggests that people are not wired to understand risk well, especially when it occurs at the far ends of the bell curve (we tend to overestimate rare risks and underestimate common risks). Without incentives to understand it correctly (i.e. that the companies themselves will be left holding the bag in case of failure), it gets ignored and/or externalised.

And that’s precisely what happened in the subprime, derivatives, and insurance scandals of the last half of the decade. And, as above, what essentially resulted was a huge wealth transfer from the investors and taxpayers to the financial services companies. Through both the bonuses that happened in the run-up and the the bail-out in the aftermath, the capital markets firms internalised return but externalised risk.

So while the infographic on the COC website might make Dodd-Frank seem like an overreaction, remember what it is reacting to. There is absolutely no reason, given the evidence of recent and/or past history, to think that the capital markets can overcome the human tendencies for greed and risk ignorance. In the long run, prudent regulation makes the capital markets more competitive by increasing stability and transparency. And that’s what really want out of Wall Street, not seven figure bonuses.

The Ethics Of, and Response To, "Strategic Default" (part 3 of 3)

Part 3: How lenders should handle the situation

So, if strategic default is clearly unethical, financially irresponsible and certainly legally questionable, how are the banks to respond? In the days before the sub-prime meltdown, this would have been an easy question. Since banks were assumed to have the superior ethical standing, they could afford to take a hard-line approach to defaulters and quickly use whatever legal and financial means at their disposal. Now, however, the ethical presumption lies with the borrowers, so the lenders have to be very careful about how they respond.

We will need to approach this issue sensitively and creatively. I have to admit that my first reaction upon hearing about this trend was neither sensitive nor particularly creative. Given the ethical in-defensibility and dire consequences of strategic default, it’s an understandable reaction. Lenders are going to have to resist the urge to play hardball with these borrowers, however. For one thing, it probably won’t work. Since debtors prison hasn’t existed for two hundred years, the borrowers already know that the worst that can happen is that their credit will be ruined; they’ve already worked that into the cost benefit analysis.

The first step will be to draw a profile of who the strategic defaulters are. Since no one bank is likely to have enough data to draw solid conclusions from, there will need to be inter-bank or, preferably, industry-wide cooperation. I’m assuming, since I don’t have access to that sort of data, that a statistical picture of the strategic defaulter is possible and that a predictive model could be constructed. Again, this would have to be an industry effort to aggregate enough data to make meaningful predictions.

Once the picture of the likely defaulter is developed, banks would need to develop individual ways of dealing with them. The most effective way will be to proactively approach the borrowers that fit the profile and offer them some kind of pre-emptive workout plan. It will be harder for the borrowers to default if they feel they’ve been treated fairly by their banks. It would be a way of building brand loyalty and it would skew the cost benefit analysis toward keeping their homes. While it will cost the lenders in the short run, given the fall in value in some real estate markets, the cost of foreclosure and disposition of the defaulted properties will likely even out. Beyond that, should the effects of strategic default become systemic, the losses would be far greater. Dealing with this problem is going to require foresight and a long-term view of these assets and the market as a whole.

Once these proactive workout plans are offered, there will be several further practical steps required to adequately address this problem. First, so that strategic defaulters do not get lumped into the category of those who merely borrowed beyond their means or were victims of the economic downturn, additional means testing would have to be added to work-out planning by the banks. This adds a further burden to non-strategic defaulters, but this is one further consequence of the strategic defaulters’ actions (in other words, the banks can’t be blamed for this…blame the people walking away from their homes).

Second, government regulators and legislators should be brought into the conversation. This sort of activity by individuals borders on fraud and theft and while it may not be universally popular, the systemic danger of strategic default becoming widespread and having a serious impact on the functioning of the lending ecosystem transcends short-term popularity.

Finally, a coordinated publicity campaign about the dangers of strategic default to the society at large and its ethical indefensibility should be undertaken. If the presumption of ethical activity could be more neutral (i.e., neither with the banks nor with individuals), the peer pressure that used to exist that kept people from walking away from their homes could be revived. While it’d require careful execution, I think the intuitive reaction of most people to strategic default is negative, so merely pointing out the possible dire consequences of such defaults might be enough to turn public option strongly against it.

It goes without saying that all three responses would have to be cautious, careful, and sensitively planned and executed. Banks and other mortgage lenders have fallen into the same category as lawyers and politicians in terms of public esteem and ethical estimation. Because of the possibility of systemic consequences such as the possible disruption of the entire mortgage ecosystem (which would have ripple effects in real estate, building, tax revenues, and ever other system that depends on a functioning lending system), I don’t think it should be ignored. The challenge will be convincing the public, regulators, and government officials that the concern of the banks isn’t merely with coughing short-term gains out of already struggling homeowners. By offering proactive help to borrowers who could fall into strategic default, lenders could demonstrate that they are working in the best interest of not only their customers but the economic wellbeing of the entire home owning ecosystem.

The Ethics Of, and Response To, "Strategic Default" (part 2)

Part 2: The Ethical and Systemic Consequences of Strategic Default

For this reason, mortgage lenders should be very cautious in their approach to dealing with this trend. Additionally, there is reason to think that there could be systemic effects should this trend become widespread. If strategic default were to go to 2 million, the risk profile of mortgage lending in the US would change so significantly that it could result in much higher interest rates for all borrowers or, in an extreme case, could see lenders exiting the business for lower-risk places for their capital.

To see why I think there could be systemic effects from strategic default, it’s necessary to understand the risk sharing profile of home lending. There are several kinds of risk involved in making a loan, market, default, and financial. Market risk is the possibility that the property being bought by the homeowner will decrease, rather than increase in value (or, perhaps, even just fall short of the cost of capital, in this case the interest rate of the home loan). Default risk is possibility that the borrower might not repay the loan. Finally, financial risk is the possibility that money the bank uses to lend to the homeowner will become more expensive than loan itself (i.e. the bank’s cost of capital exceeds the interest rate on the loan.)

As in most financial transactions, the holder of the risk gets the rewards for that risk. In the case of mortgage lending, if the house goes up in value, the homeowner gets to keep difference (minus taxes, etc.). If the loan gets repaid, the bank (or holder of the loan in the secondary market) gets compensated for the default risk by interest payments. The same goes for financial risk. If the opportunity cost of the loan was lower than that of other investments, it’s a good investment.

The major problem with strategic defaults, from both ethical and financial perspectives, is that they transfer the market risk from the party who gets the benefit if the risk comes good (the homeowner) to a party who gets gets no benefit and in fact sees nothing but downside risk (the lender). Since the lender isn’t expecting the downside market risk when making the loan, that risk isn’t priced into the loan. The lenders would want either to share in the upside risk (by sharing in the profits of a sale if the market went up) or price the market risk into the into the interest rate (by raising it considerably). But since neither of these scenarios was taken into account went the loans were made, I’d argue that transferring risk to a party that isn’t compensated for it is unethical.

Even more concerning than the losses to banks is the possibility of strategic defaults becoming widespread. While I’m not one to prophesy doom for the worlds most resilient financial system, strategic defaults could have a severely destabilizing effect on the mortgage lending market if their prevalence rises. Without structural changes in the way home loans apportion risk and reward, mortgage lending would become a very unattractive business indeed.

This could play out in a number of ways. Risk-averse investors/lenders could leave the market. The process and qualifications for the getting a home loan could be much more stringent, pushing housing prices down. The most likely scenario would be a wholesale rise in interest rates to account for increased default risk. Here’s where the strategic defaulters would be forcing us into a “tragedy of the common” situation, thereby doubling their ethical . The short-term individual gains of the defaulters would cause a structural change in the way interest rates are calculated. This would result in everyone paying higher interest rates for their loans.

In short, from an ethical perspective, the strategic defaulter is a triple loser. First, they break a contract made in good faith. Second, they cause others to become unable to get home loans as banks tighten their lending standards. Third, as the price of strategic defaults gets priced into the interest rates charged on home loans, they cause many people who are ethically untainted pay the price of their default.

This raises the question, of course, if there are ethically defensible reasons for breaking a contract like a home loan. While this may controversial in some cases, it’s pretty clear that there are situations when a borrower shouldn’t be held ethically (or financially, for that matter) liable for walking away from a loan. If the loan was made under fradulent pretenses (by the lender, that is), for example, a borrower shouldn’t be held to the contract. Similalry, if undue or inappropriate pressure or misinformation was used to get a borrower to take out the loan, I think we’d say they should be released from responsibility. Also, the ethical approbrium we would level at someone who has lost a job or has seen their ability to pay a loan decreased through either macro- or micro-economic circumstances would be diminished. Thus, there are clearly cases when it’s not ethically questionable to default on a home loan and banks should be clear about dilineating the different classes of borrowers when dealing with the default.

That said, under no traditional ethical framework would strategic default be approved of. Clearly, all foundational ethical systems have “no stealing” and “no lying” dicta which preclude strategic default. Virtue ethics, in which one asks if this is something a virtuous person would do, is (as always) a little less definite on this question, but it’s hard to imagine a person walking away from a contract for purely economic gain being considered a paragon of virtue. A deontological approach, especisally that of Kant’s Categorical Imperitive, would clearly make strategic default unethical. In Kant’s approach, we try to imagine a world in which everyone acted in the way we are examining. If it becomes impossible, than Kant would say it’s unethical. Obviously, if everyone defaulted on a loan that lost value, no one would make loans any more, which would make taking out loans impossible. Finally, under a pragmatic/utilitarian ethical framework, which looks at the action in terms of how well it works out for the everyone, strategic default would be considered unethical because, due to the “tragedy of the commons” effect, far more finanical pain is caused by the defaulters than is gained by them.

Tomorrow, part 3: Playing Heavy and/or Creative Solutions: What Should the Banks Do?

The Ethics Of, and Response To, "Strategic Default" (part I)

My reflections on this topic ended up being far too long for a single blog post, so I’ve divided it into three for easier reading. I’ll post them over the next three days).

Part I: Strategic Default: What is it, and why would anyone consider doing it?

Banks, once the paradigm case of fiduciary responsibility, have taken quite a reputational hit in the past half-decade. Where once the banker was the very stereotype of responsible, conservative financial management, whom you’d trust with your money more than you’d trust yourself, many people now see banks as just one more institution interested in nothing more than taking your money from you. While this is a broad generalization, it’s not without some basis in fact. Mortgage lenders and mortgage brokers, particularly, played a substantial role in the current financial crisis. However, an emerging trend called “strategic default,” where homeowners who are capable of repaying loans walk away from their homes because of a drop in investment value, takes unfair advantage of this perception and could possibly endanger the entire home loan ecosystem. Because of the recent reputation of dirty-dealing in lending, though, banks need to very careful in how they analyze and respond to this trend.

Strategic default, as it has come to be known, is when a homeowner who has the means to pay his or her mortgage stops paying their mortgage and allows the bank to foreclose. For example, let’s say a family took out a $400,000 loan in 2005 to buy a house at the peak of the market. They were able to pay the loan at the time and it is still within their means to do so. But let’s further assume that the value of the house, should they sell it today, would be $250,000 (a drop that would be entirely likely in some parts of California). The “strategic” defaulter, seeing that they have $-150,000 in equity, decides that letting the bank have the house and taking the 7 to 10 year hit on his or her credit is worth the $150,000. They know it would probably be 7 to 10 years before they recover the original value of the house, to say nothing of the thousands payed in interest.

Looked at from a purely financial point of view, it’s easy to see their point. Let’s look at the math. In May 2005, the average interest rate for a 30 year fixed rate mortgage was 5.75. Let’s use the following assumptions:

House price: $420,000

Down payment (5%): $20,000

PMI: .5%

Taxes: 1.25%

Current value: $250,000

Rate of return for the next 10 years: 4%

A homeowner would be likely to analyse his or her cost benefit analysis as follows:

The value of the house at the end of the period: $370,000

Total payments: $418,000

Investment value $-48,000

It should be pointed out that this isn’t a very sophisticated way of doing a cost benefit analysis, but I think it is pretty close to the intuitive way people think about their housing investment. A good CBA would consider the pre-2010 payments sunk costs, take into consideration the value of housing for that period, and would include transaction and opportunity costs, etc. But still, I suspect it’s this sort of analysis that leads people to walk away from their homes. They think that for the $418,000 of payments they will have made, a $48,000 loss is a pretty bad return. And who could blame them for thinking that? But a mortgage is not just a financial, but a legal and ethical transaction, as well.

While there has likely always been a small percentage of homeowners who default on their loans for investment reasons, this number has remained small for few reasons. First, since the early 90s, the real estate market has almost always been a good investment. Over that period, there was never a period where the overall market dropped ( see graph for illustration of this phenomenon). Second, homeownership has traditionally held an exalted place in the American psyche and there has always been a good deal of social pressure to own a home among the middle and upper classes. Finally, in a another manifestation of social pressure, anyone who walked away from a home for purely financial reasons would be ostracized as a thief or, at the very least, a deadbeat.

The 20-40% market drop, in some places more, removed the investment incentive. While this has happened before, however, and there was not a wholesale abandonment of homes. The primary difference is that the fallen reputation of banks has provided a sort of excuse for people who would otherwise have been ashamed to walk away from their homes. The assumption of superior ethical standing has moved from the lenders to the borrowers. Now a person who is foreclosed upon is seen as a victim rather than a perpetrator, regardless of the actual circumstances of th default.

(Tomorrow: Risk and Consequences)

Introduction to Financial Crisis

In doing some research on the emerging trend of “strategic default” from an ethical perspective, I came across two programs, one audio, one video, on the banking crisis. While not strictly concerned with business ethics, these programs do a nice job in explaining the mistakes of human cognition/decision making that led to the crisis. Ultimately, I think, these perceptual shortcomings, combined with or magnified by unreflective profit-seeking, were to blame for the crisis, not a wholesale breakdown in ethics (or even a one-sided breakdown, which side you blame depending on your political/economic commitments).

For a very fun, non-technical introduction, you can’t do better than This American Life‘s episode, co-produced by the people responsible for the Planet Money blog, “The Giant Pool of Money“. It looks at the crisis from the perspectives of several players in the mortgage production chain (borrower, mortgage broker, banker) and describes how an excess of global capital helped drive the market frenzy for securitized mortgage obligations of various sorts. There is a follow-up program that is worth listening to, as well, “The Return to the Giant Pool of Money“.

For a more technical, yet still very accessible, introduction to the crisis, I suggest watching a brief talk given by Andrew Lo, who is the Director of the MIT Sloane School’s Laboratory for Financial Engineering. Titled Are Mathematical Models the Cause for Financial Crisis in the Global Economy?, he spends most of the talk providing the best introduction to the actual process of securitization that I’ve seen (and I’m someone who spent a good deal of my time actually working with the rating agencies, investment banks, and capital markets experts in putting these securities together). While I don’t think Lo actually answers the question adequately (the answer, in my opinion, is “no, the models didn’t cause the crisis, but the use of dodgy, short-term data and blind reliance on the models did”), the entire 50 minute talk is well worth your time if you want to get a high-level technical introduction to how securitization works and how it magnified the housing bubble and debt crisis.

I’m interested to hear from anyone who has other sources to help people understand the financial crisis. Part of what caused the bubble was that actors all along the mortgage production chain didn’t look carefully enough at the parts of the process they weren’t involved in. This led to a blind faith that “if the investment banks say the bonds are good, they must be good” and “if Countrywide thought this was a good loan, it must be a good loan”, etc. (I was actually guilty of the first one, looking back). If everyone had understood what other parts of the chain were doing, we might have seen the developing crisis much earlier than we did and been able to mitigate some of the worst effects.

Also, as I mentioned above, I’m working on an ethical analysis of “strategic default” and if anyone has any perspectives they’d like to share on it (pro, con, or otherwise), I’d be really interested to hear them.