A Remarkable Question

by on December 11, 2008 at 7:10 am in Economics | Permalink

Our colleague, Richard Wagner, a leading light in the public choice revolution, wrote the following remarkable question for the 2005-2006 graduate political economy preliminary exam at George Mason.

Joseph Schumpeter claimed that capitalism would give way to socialism largely for ideological reasons. This does not seem to have happened, at least directly. But might it be happening indirectly? Consider, for instance, a significant change that has occurred in the economic organization of debtor-creditor contracts. Not too long ago, lenders held their loans in their portfolios. They would lose if the borrower defaulted, which gave the lender a strong incentive to monitor the borrower, particularly for large loans. Now, lenders split their loans into numerous small pieces and disperse them throughout the economy. (For instance, many people who hold mutual funds and retirement accounts will find that they are holding small pieces of large loans made by commercial banks.) The burden of non-performing loans is thus dispersed throughout the economy rather than residing with the original lender. Does this development weaken the incentive of lenders to monitor borrowers and thereby weaken overall economic performance? That is, can market transactions generate institutional arrangements that impair the market economy? However you address this topic, do so clearly and cogently.

I am sorry to say that none of the students got the answer right.  Of course, very few of their teachers, here or elsewhere, got the answer right, either.  Kudos to Dick for his prescience.

I thank David Levy for the pointer.

1 nelsonal December 11, 2008 at 7:28 am

So essentially concentrated ownership is a public good and there are lots of diversified free riders?

2 dearieme December 11, 2008 at 7:34 am

offenders -> of lenders.

P.S. “However you address this topic, do so clearly and cogently.”
Shouldn’t it be unnecessary to say that?

3 Brian December 11, 2008 at 8:13 am

Yes.

4 datacharmer December 11, 2008 at 8:35 am

Alex, two points are in order here:

Does this development weaken the incentive offenders to monitor borrowers and thereby weaken overall economic performance?

Yes, but why would that not be reflected in the price? If I’m buying part of a loan from you, weakening your incentive to monitor it in the first place, wouldn’t I be offering a lower price for it than if your incentives were perfectly aligned? Shouldn’t I be able to realise that the asset I’m buying has a higher probability of default and thus change my bid price accordingly (or choose not to bid)? Furthermore, loans these days are not awarded on the basis of personal knowledge (Good ol’ Bill’s farm is doing OK, let’s lend him some money), they are screened and monitored on the basis of credit-worthiness information that will generally be available to all financial companies willing to request it – so there’s nothing that the issuer of the loan knows that cannot, in principle, be found out by whoever is purchasing the loan. Yes, they own only a small part of the loan so it may not be worth the hassle of monitoring the loan, but that’s a point that’s well known ex ante and should affect the decision of whether to buy the CDO (or whatever) from the primary issuer in the first place.

Of course the whole point here is that this information regarding weakened incentives was not taken into account by the buyers’ of these securities, hence the current mess. But if it was not taken into account by the buyers, it sure as hell wasn’t (and couldn’t really be expected to be) taken into account by governments and regulators operating with even less information. Perfect information is not some natural state of the world, and complaining about the lack of it in the abstract is akin to complaining about how the existence of gravity greatly reduces our freedom of movement.

In terms of answering Richard’s question, yes capitalism can produce scary outcomes but this is just a manifestation of the high risk/ high average return paradigm. If society lacks the stomach for such variations it can well move in a more socialist, low risk/ low average return direction, perhaps even all the way to communism (no risk at all, nice and steady decline)

And by the by, CDOs and CDSs would not even be the example that first came to my mind if you want to ask the question Richard is asking. How about employing someone when you can’t monitor their effort and even their output perfectly? Corporations are creations of the free market, and they ‘weaken incentives and overall economic performance’ considerably. Compared to the labour market, the whole securitisation business and its effect on incentives is truly minimal.

5 nelsonal December 11, 2008 at 9:48 am

So does this mean that the government should begin subsidizing Gordon Gecko types? Greed for lack of a better word, is good, indeed.

6 asiequqnq December 11, 2008 at 10:24 am

How can you grade a question like this right or wrong? There is only the well thought out answer or one that isn’t.

7 Chris December 11, 2008 at 11:36 am

If the entity buying the risk knows that they will not be responsible for the risk (either through selling it again or through bailout) then yes, they will not monitor the borrowers, as they have no exposure. It falls to the final holder of the security to properly monitor the borrowers and to bear the risk of the securities that they have purchased. And 3rd party intervention (either through bailout or by making money available cheaper than the market rate) disrupts this market.

8 Bernard Yomtov December 11, 2008 at 12:14 pm

Yes, but why would that not be reflected in the price? If I’m buying part of a loan from you, weakening your incentive to monitor it in the first place, wouldn’t I be offering a lower price for it than if your incentives were perfectly aligned?

Yes, but that destroys value. It meas that some sound loans will not be made, precisely because they cannot be sold at their actual value. Lemons.

Two other issues arise.

One is the built-in conflict among holders of pieces of the loan if renegotiation becomes necessary. Loans are forced into default/foreclosure that might be renegotiated to the aggregate benefit of the lenders, but because the benefits are unevenly distributed no renogiation can take place.

The other is that when buyers rely on the coarse categories used by ratings agencies to judge creditworthiness, which runs on a continuum, sellers will inevitably game the system.

Not that I would have thought of all this in 2006.

9 mk December 11, 2008 at 12:38 pm

As an addendum: related issues with instituting novel markets may pose a challenge to imposition of a CO2 cap-and-trade system. It might be related to what happened in Europe, where the initial carbon permits were trading at absurdly low prices.

Or the problem in Europe could have just been too much supply.

10 liberalarts December 11, 2008 at 1:49 pm

The answer: no.

Clear and cogent reason: If lenders split securities up and they make loans into that system that are unwise, then a profit opportunity will emerge for other more careful lenders who could deliver better returns to investors via lower default rates. Dividing the mortgages up merely helps manage risk in the long run.

11 meter December 11, 2008 at 3:31 pm

“Furthermore, loans these days are not awarded on the basis of personal knowledge (Good ol’ Bill’s farm is doing OK, let’s lend him some money), they are screened and monitored on the basis of credit-worthiness information that will generally be available to all financial companies willing to request it – so there’s nothing that the issuer of the loan knows that cannot, in principle, be found out by whoever is purchasing the loan. ”

The credit-worthiness information you speak of: turns out that “information” was all garbage.

12 surge December 11, 2008 at 5:57 pm

MBSs are priced in the market. If that price does not reflect the cost of increased default resulting from the reduced incentives on the part of the originator to maintain a certain standard of underwriting then it is an arbitrage opportunity for the bank. This was certainly the case in the past, partly facilitated by the rating agencies. But otherwise if the market price of the MBS is set so that it reflects a higher default risk then by definition there is no impairment.

13 Will December 11, 2008 at 6:04 pm

Adam Smith asked this same question (and unlike Richard’s students and most economists today) got the answer right several centuries ago. Check out the last 10 pages of Chapter II Book II of The Wealth of Nations.

14 traderjohn December 11, 2008 at 8:58 pm

Historical note:
This securitization started in the 80s in the aftermath of the 1982 international bank crisis. Governments increased regulation on bank holdings of loans to developing countries. Banks got them of the books by securitizing.

15 StreetWalker December 11, 2008 at 10:07 pm

@Bill C

the ratings agencies were obscuring (lying about?) the quality of the mortgages behind the securities

No, I’m afraid it’s actually worse than that. If you look at the emails submitted to the House Oversight Committee in October, you’ll see a real doozy from 2001. There a quant asks to see the underlying loan info before rating a structured deal.

The managing director writes back with clear direction: “Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don’t have it and can’t provide it. Nevertheless we MUST produce a credit estimate. †¦ It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.”

That’s right – no data in the first place, and the people doing ratings were told to shut up and rate anyway, no one cares how. The agencies didn’t and don’t collect their own data, they rely on “representations & warranties” from the issuer.

But as highlighted above, if the issuer doesn’t have the underlying data, how does anyone know it’s the truth? Ah, trust! I trust my long-time business partners! Read it and weep.

16 J Thomas December 12, 2008 at 4:50 am

Will, if you believe that Adam Smith got the right answer several centuries ago, then the natural question arises:

How come nobody noticed for several centuries?

17 Neal December 12, 2008 at 10:19 am

If you answer “no” based on theory, then shouldn’t you double-check the theory because the “yes” actually happened?

18 Mike D December 12, 2008 at 5:31 pm

In the traditional lemons model, the pooling equilibrium is efficient.

But suppose that, responding to the demands of the lemon-owners, I invent a device for current used-car owners to diagnose whether their cars are lemons or peaches. My apparently productive profit-seeking will end up driving us to the inefficient separating equilibrium.

I’m sure there’s a parallel example you could rig up for financial markets.

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