Swept under the rug

Risk is an unavoidable part of our economy. Without risk-taking, none of the conveniences of the modern world would have come to market. The problem is that government encourages some risks and discourages others based on political factors unrelated to inherent riskiness, and one risk that the government has consistently encouraged is lending to a homebuyer. This encouragement obviously causes companies to act differently than they would have otherwise, but is the government-induced mortgage lending good or bad for the economy?

To encourage home ownership, the government passed regulations mandating that banks make loans that look bad on paper. Incentives were put in place to lower the banks’ risk if someone defaulted on the mortgage (an indirect way of subsidizing the mortgage), but this just shuffled the risk around rather than actually lowering it. Attempts at hiding these risks caused the government to set up more and more elaborate mechanisms to grease the mortgage market, and financial intermediaries responded to these incentives by treating risky mortgages as if they were far less risky than they really were. The bankers didn’t know where the risk went, but it wasn’t with their bank.

On the surface, the risk of lending to homebuyers appears low. Homeowners will do whatever they can to avoid getting thrown out of their homes, so there really isn’t as much risk in a mortgage as there would be in a similar-scale commercial investment. The problem is that the banks already knew this and had been treating people accordingly, but the government wanted more mortgages written. The rails were greased, and a derailment became inevitable.

While home prices were rising, the risks being swept under the rug didn’t matter very much. Once a bubble started to form, more homes were being purchased by speculators and landlords than people who actually intended to live in them. Speculators and landlords do not have the same aversion to foreclosure, so banks required 20% down payments and other assurances that the loans would be repaid. This assurance was always some variation on “prices are going up, so even if I default you can seize the house and sell it at a profit.” As long as speculators and landlords were a relatively small fraction of homebuyers, these assurances were sufficient.

Meanwhile as the bubble inflated, homeowners cashed out their equity to improve their lifestyles. When people they ran out of equity, they stopped spending. This decrease in consumer spending set off ripples through the economy, and it turned out that just about everyone who lost a job as a result of the slowdown happened to own a house. A shock to the real estate system causes house prices to stop rising. In fact, the amount that people were willing to pay dropped below where owners were willing to sell.

This inability to agree on a price has happened in the past, and the usual result is for home sales to freeze until inflation causes home values to catch up with the prices that sellers demand. This time, however, the fraction of speculators in the market wasn’t so small. Speculators didn’t want to have houses, they wanted to sell houses. A clearance sale ensued, lowering prices and making millions of legitimate homeowners upside-down on their mortgages. Suddenly a vast number of homes had zero or negative equity, consumer spending skidded to a halt, and the real estate market got even worse.

All of that risk that had been swept under the rug came out at once.

Shifting risk around the economy is just as important as shifting money around the economy, but risk is harder to understand and easier to ignore. The government moves money around the economy all the time. It’s a very inefficient process, but people at least understand the principles involved. When the government moves risk around the economy, it does just as inefficient a job but voters tend not to notice. When a spending project like the Bridge to Nowhere is discovered, people get outraged at the politicians (rather than, say, the construction workers). When a risk-sharing project like Freddie or HAMP blows up, politicians take advantage of the confusion and lay blame on the people who specialize in taking calculated risks. Sure, the incentive schemes of bankers are imperfect. These imperfections led to some of the problems of their companies, but the severe distortions of the mortgage market induced by the government are much more directly linked to the problem and responsible for far more of the risk that ended up knocking the economy to its knees.

No amount of punishing banks for doing what the government told them to do is going to fix the underlying problems, because the government is still telling the banks to do precisely the same things that led to the current housing crisis. As a consequence of the government’s risk-shifting, money is being shifted from responsible people (renters and prudent homeowners) to rescue irresponsible homebuyers. The current loan modification program is comically inefficient; it would actually be cheaper for the federal government to buy the distressed home outright and give it to the homebuyer. This isn’t working, so the government will need to try something else. Either the government is going to unwind its subsidies on home buying and cause a lot of short-term pain, or the government is going to come up with an even more elaborate shell game to sweep the risks under another rug.

The government’s fixation on increasing home ownership has led to increasingly complex and risky schemes to get banks to play along. It was inevitable that greasing the rails for so long would lead to a derailment. It is clear that this particular case of risk-shifting has damaged the economy, and it will continue to cause occasional disasters until the government gives up on this obsession.

Why do banks pay these bonuses anyway?

With all the flak that financial companies get for paying bonuses, one might wonder why the companies do it at all. The short answer is that they are legally obligated to honor the contracts they’ve written. But this just begs the question, why would companies sign these contracts in the first place? The answer is that bonuses are the most efficient way to rent an investment banker’s best judgment in order to increase the bank’s profitability.

What makes a bonus better than a salary or a commission? Different pay schemes attract different kinds of people, and the people who make the best investment bankers are the type who would be motivated by bonuses. To see why this is the case, we need a bit of background.

Due to a combination of upbringing, skill, experience, personality and responsibilities, different people have different levels of discomfort with financial risks. The technical term for this discomfort is risk aversion, and generally the risk that bothers someone is the risk that is outside of his or her control (if the person really wants something, there is no “risk” that he or she won’t put forth effort). The more one’s earning swing with these uncontrollable outside forces, the more he or she expects as a base salary to compensate for the uncertainty.

Compensation schemes can be split into four broad categories based on how risk averse the person is: entrepreneur, pure commission, salary + bonus, and pure salary. Of course the real world is a bit more complicated (for example, franchising is somewhere between entrepreneur and pure commission).

Entrepreneur. People who have really low risk aversion and high self-confidence will often become entrepreneurs. They put forth their best effort and compulsively micromanage all of the factors under their control, but acknowledge that there is a lot of uncertainty out there. This is a high-risk/high-reward endeavor.

Pure Commission. People with a little more risk aversion or a little less self-confidence want the thrill and sense of accomplishment that comes with entrepreneurial success, but without the possibility of financial ruin hanging over their heads. An employer thinks this is probably a real go-getter and is willing to bankroll the effort. The employer, however, wants to make sure he or she gets maximum effort by paying on commission. Now both the employer and employee do well if things go well, and if it turns out that the market really stinks this year, the employer bears the loss. For this insurance, the employer keeps a big cut of the profits.

Salary + Bonus. The next group is okay with ups and downs, but needs a safety net due to responsibilities, personality or other needs. A lean year means no vacation and no eating out, but at least it doesn’t mean losing the house. Since the employer is agreeing to pay a decent wage even if everything goes wrong, financial incentives are important to get maximum effort. The implied insurance is costly in the sense that even if there is a fantastic year, the employee only gets a small fraction of what he or she won for the company.

Pure salary. The last group values stability over thrills. They are so hesitant to stomach ups and downs, that it is easier for the company to just pay a flat wage and monitor him or her closely.

If this seems similar to investment decisions, that’s because it is. The person is investing effort and expecting a payoff in money.

Now put yourself in the shoes of a bank trying to hire investment bankers. Wild risk-taking will make the bank unstable, so something safe like a pure salary would be best. Since there is no financial incentive for success, the bank needs to monitor a salaried employee very carefully. Close monitoring implies that the company knows what would be “right” in each trade, and this is so subjective that it would lead to endless lawsuits. Pure salary is infeasible. The next step up the ladder is salary + bonus. Bank and banker can agree on what the investment is worth at the end of the year (and if they don’t agree then plenty of accounting firms will be happy to investigate the matter for a fee), so the bonus is based on this output.

In the rarified air of the ivory tower, this is the optimal incentive scheme. The reality is that no incentive plan is perfect; people can and do game the system. Another serious problem is what happens at the low end of the output spectrum. Big risks have huge potential payoffs, but if they don’t pay off the bonus doesn’t go negative. High rewards for success and low penalties for failure create a culture of excessive risk-taking even if that isn’t what the bank wanted.

The problem is not that people take risks. Without risk-taking, none of the conveniences of the modern world would have come to market. In a well-functioning market, a bank that took bad risks would go out of business, go through bankruptcy, get seized by the FDIC (which at least ensures that depositors get their money back), or otherwise get punished. The industry would learn from those mistakes, and everyone (except for a few unlucky bondholders) would be better off.

When the government bails out banks beyond the scope of FDIC insurance, a situation similar to the salary + bonus effect emerges. Banks get to keep huge profits if they make winning bets, and they get bailed out if the bets don’t pay off. This leads to excessive risk-taking.

If people are furious at banks for using a less-than-perfect contracts for investment bankers, maybe they should take a closer look at the incentives that government is setting up for the banks. The government has a choice in how it deals with bank failures: it can let ineffective institutions die off or it can prop them up and let them continue to damage the economy. On the other hand, banks have little choice in how they pay their bankers: using something other than bonuses would actually make things worse.

Not-So-Gigantic Shift

A number of people who dislike President Obama seem to be of the impression that the Democratic Party is imploding, and that public outrage will cause virtually every competitive seat to go Republican in November. When such groups gather (in person or on a website’s comment area), the ideas are echoed and take on the appearance of certainty.

Large swings have happened before, but in cases like the "Republican Revolution" of 1994 there was a leader and a positive agenda. Historically the balance of power shifts more gradually because voters, for some reason, give incumbents a LOT of slack when it comes to poor performance. Mayor Ray Nagin, having botched New Orleans’ evacuation for Hurricane Katrina (which was entirely a city function) and having made repeated stupid comments about chocolate cities and knowing the mind of God, was re-elected.

That said, even an incremental change in the US Senate can cause huge shifts in the legislation passed by that body. A net increase of two or three seats would give the Republicans significant leverage in toning down the majority’s agenda. A net increase of four seats could halt that agenda in its tracks. The current wave of Democratic resignations seems designed to get the most vulnerable incumbents off of the ballot. Conservative impatience with Republicans may also lead to strong third-party candidates that will only split the anti-Democrat vote.

A majority of Americans may be dissatisfied with President Obama’s leadership, but simply assuming that this will translate into a sea change in Congress is foolish. People who want to see an end to the President’s brand of "bipartisanship" and "transparency" need to take action to make competitive seats go Republican in November.