The Financial Crisis and the Principal Agent Problem

Christopher Joye discusses the "far-reaching flaw sitting in the foundations of the US credit creation system"

Dismantle and Start Again, by Christopher Joye, Commentary, Business Spectator....The problem is a simple one: the vast bulk of all home loans in the US(around 70 per cent) are funded not using the balance-sheets of large transnational banks, and in turn the regionally diversified deposits of their customers, but via the far more complex, unstable and sometimes conflicted process of “securitisation”.

In contrast to the rest of the world – where securitisation, if it exists at all, has been a small yet valuable part of the housing finance mix – the process completely dominates home loan funding in the US.....

When a mortgage is securitised, the lender that originates the loan does not keep it on their balance-sheet and hold it to maturity – the whole point of this exercise is to take assets “off balance sheet” and sell them to third-party investors, thus enabling the lender to recycle the original capital and embark on a new round of financing.

Indeed, most regulators around the world have noted approvingly over the years that securitisation allows lenders to alleviate balance-sheet stresses and share some of their risks with third-parties, such as pension funds, who in turn get exposure to typically low volatility “mortgage-backed securities” that yield higher returns than conventional cash instruments. The very low risk and robust long-term performance of securitised home loans in Australia has been testament to the merits of this diversification process for consumers, lenders and investors.

Trouble nevertheless arises when you create artificially strong incentives, as US governments repeatedly did, to predicate your entire housing finance edifice on securitised forms of funding to the detriment of the traditional deposit-taking market. Over and above stunting the growth of a nationally-integrated banking sector, synthetic incentives that instill securitisation as the preferred source of funding expose the overall financial system to a number of potentially destabilising conflicts. The most obvious of these is that the organisations that source new home loans and which are responsible for assessing their credit risk are removed from the institutions that ultimately own the assets and hence bear that risk. We have, therefore, a classic principal-agent problem....

Mark Thoma provided a similar analysis of the principal agent problem in a post last year, but also argues that "the mis-pricing of risk and the failure of securitization to distribute risks across the financial system" contributed to the financial crisis.

Fannie and Freddie Did Not Cause This Crisis, by Mark Thoma, Seeking Alpha.... With respect to the agency issues, there is a long chain between the home buyer, the mortgage broker, and, ultimately, the sliced and diced complex securities that nobody fully understands. Let's take one step in the chain, that of a bank or mortgage broker, either one.

Suppose they are paid a fee, i.e. by the number of mortgages that pass through their hands each month (as, essentially, they were). The more mortgages they can push through, the higher their income. They are required to meet certain guidelines as they do this, but so long as their income depends upon the number of mortgages passing through their hands and not what happens to the mortgages later on - so long as it is a fee-based system - they have every incentive to push the guidelines as hard as they can and to find a way around them whenever possible.If mortgage brokers had done their job and only made loans to people who could pay them back (i.e. with "reasonable" levels of default), we wouldn't have a financial crisis. So right away, in nearly the first step of the chain, we have to ask what went wrong, why they were willing to take so many questionable loans.

The problem is what economists call an agency issue. The brokers had no stake in the outcome once the mortgages left their hands. The same with banks, all they had to do was process the mortgages, package them up, then sell them and collect their fee.

Think about the incentives here. Suppose you are a mortgage broker and you begin to suspect that the bubble will pop soon, that all this lucrative business might end. To protect the business, should you get worried and start checking mortgages more carefully to make sure that things don't get further out of hand? No, you should accelerate what you are doing, write even more mortgages - nothing you can do can stop the bubble from popping, you are just one of many, many brokers far down the chain - so why not collect as many fees as possible before the gravy train ends? What if everyone thinks this way, and they all rush to sell as many of these things as they can? Mania.

A solution to this is to give each person in the chain a stake in the future outcome of the mortgage. If mortgage brokers' income had been connected to a financial instrument that pays off according to the future performance of the mortgages they write, would they have behaved differently? Probably...

Ah, you say, but as you go up the chain why didn't people refuse to take the financial paper, why didn't they conclude it was too risky? The risky mortgages don't have to be stopped at the bottom, this is a linked chain, so why weren't they stopped higher up in the chain where the stakes are higher? ..... The mis-pricing and mal-distribution of risk played a key role here ....

The people at the top of this complex chain did not fully understand the risks the were assuming when they took on the subprime business, or, rather, when they took on the complex securities derived from the subprime business. When the bubble popped, it shouldn't have been a big problem if the risk assessment models they relied upon had been correct, and if securitization had distributed the risk as promised. .....

(I)f the risks had been distributed fairly evenly, it's much less likely that we'd be in this mess (the losses of $2T(rillion) - an intentionally high-balled number - are only 1/30th of global financial assets). It wasn't the mis-prediction of the level of risk that was the biggest problem, the losses could have been absorbed, it was the (unintended) concentration of risk through the failure of securitization that was the most problematic.

Fundamentally, then, it was the agency problems and the failure of risk prediction and distribution models that allowed the bubble to inflate and then cause big problems after it popped....

The unexpected losses alone might not have caused a crisis had the losses been widely distributed, but, the losses were concentrated and hidden in ways that created widespread fear and threatened the entire system. Getting rid of that fear is not going to be easy.