18 March 2010

Selling skills caused the recent US recession ...


Provocative title, no? But it's really not so far-fetched considering credit rationing theory ...

Ignorance of credit rationing theory caused the recent US recession, I assert.   In my professional life, when I say the word "theory" in the presence of other professionals the reaction is often the same: they roll their eyes, make some vague statement about "ivory tower types", and continue the conversation while completely ignoring whatever I said in connection with the dreaded word: theory. These are people, by the way, who scoff at the stupidity of Wall Street quantitative trading strategies while--in the same breath--talk about "alphas" and "betas" on stocks; alluding to the not-very-well-accepted theory, the Capital Asset Pricing Model. And these are the people who--because they choose to ignore what theories like the CAPM actually say (and don't say)--make mistakes.  Nonetheless, I will once again use the dreaded word discussing the relationship between credit rationing theory and the mortgage loan crisis, which many reasonably believe is the proximate cause of the recent US economic recession. It seems once again that ignoring theory led people to make mistakes ...

The basic idea underlying
credit rationing theory is lenders intentionally limit credit supply such that loan demand exceeds loan supply. This seems strange from a Microeconomics 201 perspective because we expect prices (and, so, interest rates) to adjust to equilibrate loan supply and demand. So why would lenders intentionally limit supply when they could just increase interest rates, make the loans, and generate additional profit? The theory suggests lenders cannot simply increase interest rates to make it profitable to increase loan supply because (1) increasing rates above a certain level attract borrowers that are too risky (i.e., increased rates will not compensate for increased risk, so the marginal expected profit is negative) and (2) lenders are often unable to estimate such risks a priori due to information asymmetries. So here's the proposition:
Lenders systematically bought mortgages--with interest rates at levels representing rates well in excess of historical interest rate spreads over costs of funds--where the expected profit was negative due to excessive credit default risk; thus leading to widespread mortgage defaults, the related credit crunch feedback cycle, and the recent US recession.
Having run the proposition by some professionals who gave me the usual eye-rolling response, along with statements similar to "Well, that's just obvious.". When asked the question, Well then, why did the lenders systematically--pretty much across the entire economy--buy the mortgages? To this they answered, "They were just plain stupid." Hmmm. I know quite a few people in the mortgage lending industry and I wouldn't characterize any of them as stupid. Moreover, it seems patently ridiculous to suggest mortgage lending professionals were systematically stupid across the entire industry. So, contrary to their belief the proposition is not exactly obvious, and I don't think they were plain stupid; they understood Microeconomics 201 but, unfortunately, not credit rationing theory.

In any case I thought it best to make the proposition more provocative by making more of a story of it and do my best to avoid any mention of the word theory. Here goes ...

Mortgage broker selling skills caused the recent US recession, I assert.  Consider the following highly simplified representation of the mortgage lending process in the US over about the last 15 years or so:

Many mortgage loans, and perhaps most sub-prime mortgage loans, have been originated by mortgage brokers. That is to say, mortgage brokers somehow find potential borrowers, obtain information on the proposed borrowers' credit and property values, and then "sell" the proposed mortgage loans to mortgage lenders, usually banks and other types of financial institutions. The loans are then bundled together in the form of securities ("mortgage-backed securities", MBSs) with presumably well-understood credit risks, and then sold by investment banks to investors. The loans underlying the MBSs are then serviced, again most often by banks and other financial institutions involved in mortgage lending.

So, what exactly is the relationship between mortgage broker selling skills and the recent US recession? I will first state the proposition in dramatic terms, then present the argument after:

The excellent selling skills of mortgage brokers, in conjunction with the incentives provided to them to exercise the skills, caused the recent US credit crunch and recession.
The proposition might seem a bit of a stretch but systematic micro-motives often result in macro-behaviors (i.e., pervasive incentives provided to individuals have large scale economic effects; see Schelling's book of a similar title), so it's really not so unreasonable. Let me explain.  Here's what mortgage loan brokers do (or at least it is what they did before the credit crunch):

  ::  speak and meet with prospective borrowers;
  ::  obtain prospective borrowers' credit and property value information;
  :: determine whether borrowers "qualify" (i.e., meet lender underwriting standards);
  ::  negotiate contracts so borrowers qualify and broker fees are maximized; and
  ::  sell the qualified contracts and related information to lenders.

Notice selling skills factor prominently in both activities shown in bold: Negotiating terms with borrowers in a way that ensures they meet mortgage lender underwriting standards while, at the same time, maximizing the broker's fees for originating the loans often requires considerable selling skills. To see this, consider the following annotated graph:


The graph summarizes certain problematic selling activities of mortgage brokers in the context of two factors addressed in credit rationing theory: credit default risk and interest rate. It also shows the main prediction of credit rationing theory: Lenders generally set a fixed interest rate for borrowers of observably-acceptable credit risk (usually around 3.0% over funds cost in mortgage lending) so as not to attract unacceptable credit risk borrowers. The problematic selling activities:
Interest rate up-selling -- Convincing prospective borrowers that they represent higher credit risks than they actually are, thus justifying higher than expected interest rates. (Mortgage broker: "Hey, I'm doing my best for you guys, but lenders are requiring a higher rate to compensate for the risk; you guys have some late payments on your credit history ... ." Late payments on a credit history can be pure gold for a mortgage broker with good selling skills.)
Credit risk up-selling -- Convincing loan underwriters employed by mortgage lenders that proposed mortgage contracts being offered for sale to the lenders have acceptable credit default risk (given acceptable collateral risk), even when they perhaps represent unacceptable risk. (This is how mortgage brokers can "help their customers": by misrepresenting facts and circumstances relevant to a mortgage lender's assessment of a borrower's credit risk, and "getting them loans".)
It turns out neither selling activity is easy. Mortgage lenders were, in my experience, reasonably diligent in credit risk analysis and loan underwriting. It often took brokers considerable skill to convince borrowers they had to pay a higher interest rate because they were a higher credit risks than they actually were, while at the same time convincing lenders that borrowers were lower credit risks than they were. That, as they say, is why mortgage brokers "got paid the big bucks".  But, of course, enquiring minds naturally want answers to questions about this idea of "up-selling":
Why were both borrowers and lenders willing to accept such "up-selling"?  They accept it largely unknowingly because of bi-lateral information asymmetry: In general, borrowers don't actually know what lenders think and say to mortgage brokers (even on average; many borrowers are quite naive when it comes to common lending practices), and mortgage brokers can withhold relevant credit risk information from lenders (e.g., the mortgage broker might realize a two income household will lose one income forthwith because of a new child and maternity leave, but choose not to disclose this to the lender since it might suggest higher, unacceptable credit default risk). 
Why, exactly would mortgage brokers up-sell borrower credit risk to lenders?  Two reasons: Strong monetary incentives and a decision horizon that is too short for a mortgage broker's reputation to matter. The basic monetary incentives are related to origination fees, which generally range from .5% to 2.0% (though there are perhaps additional fees as well). So that's between $500 and $2,000 on a hypothetical $100,000 mortgage. 
Why, exactly, would mortgage brokers up-sell interest rates?  Among other factors commonly listed in adverts for sales positions like being an Aggressive, Self-Starting, Team Player, the prominent reason brokers up-sell interest rates is very strong monetary incentives. To give one a rough idea of the incentives, consider a $100,000 mortgage loan offered by a broker to a lender at an annual interest rate of ...
... with daily interest compounding. It turns out that at the height of the US mortgage lending boom in about 2003, a certain mortgage lender/securitiser in the Western US would pay a mortgage broker an additional $250 for the daily interest compounding provision (as opposed to monthly or quarterly compounding) and an additional $2,000 for the .50% above the lender's normal interest rate spread.
So, adding a basic 1.0% origination fee of $1,000 to the additional 2,250 fees for daily interest compounding and the up-sold-by-.5% interest rate, the broker receives $3,250 on a $100,000 mortgage. One could easily say monetary incentives for credit risk and interest rate up-selling are "strong". (Kaaaa Ching. "Money talks ... and it's persuasive." Elvis Costello.)
Why, exactly, is interest rate up-selling a bad thing?  Two reasons: Interest rates in excess of normal interest rate spreads (about 3.0%-3.5%) tend to attract higher-than-normal-risk borrowers since normal-risk borrowers can, and on average do, borrower at normal rates. Higher interest rates, holding all else equal, make it more likely borrowers will default on loans if--for whatever reason--their incomes decrease. (I recall having an interesting discussion in the mid-1980s with David Cates, a highly-regarded bank industry consultant, where he mentioned that rapid loan growth and increased interest rate spreads were the two primary predictors of credit quality problems in banks. It seems the half-life of knowledge in the lending industry is quite short or ... perhaps there is systematic ignorance of credit rationing theory.)
But wait. Isn't it a little unreasonable to pin the whole mortgage loan crisis on the mortgage brokers? Weren't others in the mortgage lending industry, and investors, equally at fault? It's true that factors leading to the US mortgage loan crisis were systematic. So, mortgage broker behavior selling skills and activities alone did not cause the problems: In any exchange there is a buyer and seller and both have an obligation to themselves, and perhaps others, not to do anything stupid. Lenders, investment bankers, and investors all had the obligation to properly value and price the mortgage contracts and related securities to account for the expected risk. Moreover, the lenders, investment bankers, and investors each played a non-trivial role in providing the mortgage brokers with the strong monetary incentives for up-selling.

Nonetheless ...
Without mortgage brokers' on-average-excellent selling skills that allowed them to strategically and convincingly misrepresent credit risk factors to both borrowers and lenders, they would not have been able to sell many billions of US dollars worth of improperly priced mortgage loans with excessive credit risk, which essentially caused a near-collapse of the US credit markets and represented the proximate cause of the recent US recession.
I believe we can now reasonably say, quod erat demonstrandum: Notwithstanding mortgage brokers' excellent selling skills, had lenders and investors not ignored credit rationing theory they would not have made critical errors that led to the recent US credit crunch and recession. :)

MMc
São Paulo
 
Postscript: The term "credit risk up-selling" is not one I've actually heard in practice; I've just defined it here as a convenient nominalisation of a mortgage broker over-selling the expected credit risk associated with a mortgage loan. Also, I've personally known 5 commercial mortgage loan brokers who were highly ethical when dealing with matters discussed above. None I knew would misrepresent credit default risk to lenders, or jack-up interest rates to borrowers, since they were more interested in developing long-term relationships with both lenders and borrowers. MMc

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