Economy

[JohnnyV13]

There have been a lot of excellent posts, but I think people have missed some key elements.

Basically, this economic downturn resulted from the system rewarding people for behavior that damaged the economy as a whole. When the behavioral pressures get too out of wack, we get into a downward spiral until adjustments are made. To put in specific terms:


The mortgage industry changed drastically over the last 25 years. Debt in general has become more "marketable", consequently, you rarely see the company that sells the home loan actually HOLDING that loan. Instead we have a system where one company specializes in selling mortages (retail mortgage lender), in between we have mortgage brokers who sell those instruments to larger financial institutions like banks, insurance companies and investment funds.

THe problems is, this fractioning of debt has created some counter productive incentives for individuals and corporations. Since the retail mortgage lender is going to sell that loan to someone else, there is little interest in actual ability to repay. The retail lender will get paid an immediate fee depending on the size of the loan. Consequently, that company's immediate interest is to sell as large a loan as possible, as long as they can somewhat justify the loan recipient's ability to pay. In fact, if the seller fudges the numbers or exaggerates the financial stability of the recipient, that's even better to maximize their fee.

The mortgage broker, meanwhile, takes a percentage to distribute these finance instruments in large blocks to larger financial institutions. Essentially, they find small gaps between what it takes to purchase those instruments and what they can sell those intruments for to make a profit. Again, they have little incentive to ensure the loan repcipient's ability to ACTUALLY pay those loans, as long as they can make the numbers look like they fit a risk model. (The risk model sets the price for the value of the loans).

The large institutions then hold those loans. Financial houses can include these loans in funds they sell to investors. They can also "hedge" the risk of these loans with OTC derivatives (which are the "bets" on whether or not those loans will actually be repaid). The problem is, these institutionas are WAY removed from the street-level loan.

Because the way mortgages are bought and sold has changed over the last 25 years, the historical risk data with respect to loan default has been out of wack. These newer loans are more risky than the historical data suggests because the people who sold the loans didn't have the same incentives to verify their abiilty to be repaid. Subprime mortgages are relatively new animals (before lenders wouldnt make such risky loans), and their risk models aren't supported by long historical data. Apparently, those risk models weren't accurate.

The end result is that we have way more than predicted defaults on loans. The credit markets are in a panic because they don't know the true value of the debt they have on their books. Consequently, these lending institutions don't want to issue more credit, which has caused a chain reaction in the economy.

Now, many believe we shouldnt' "bail out" the financial markets. They think the market should 'self correct" (which is basically a darwinian process in which institutions that can't fix themselves die off). One of the problems with "self correction" is that companies don't exactly work on a darwinian model. In some instances, top executives make MORE money by making decisions which ruin the companies for whom they work.

Lets take, for example, the CEO of countrywide (a large mortgage lender). In 2006, countrywide's CEO made 100million because of stock options at the height of the housing bubble. Even IF that CEO foresaw the underlying problems, he would actually harm his own income to prevent it. In 2008, he lost his job, but made 80 million in severance pay. In three years, he made over 180 million. What does he care if his company is now in ruins? IF CEOs receive such lavish rewards for making decisions which result in short term profit but long term disaster, we create a recipie for repeated corporate stupidity (but individual genious).

The reason a Darwinian model doesn't exactly work with companies is because the top decision makers can sometimes make MORE money by allowing their company to destroy itself. The "self correct" model works on the assumption that organizations that behave in a "healthy" manner will survive the current crisis, and continue their "healthY' behavior in the future (thus we will eliminate poorly run companies from the market). But, with this CEO compensation model, the incentives actually will favor self destructive corporate behavior so that there is no guarentee the executives who run these companies will contintue their policies in the future.

Project current market conditions and we notice even more disturbing realities. We now have loyal CEOs valiantly volunteering to take 1 dollar salaries OR we fire the current "rats" that got us into this mess (after they've already cashed in on their risky behavior). After the market recovers, the CEOs and top execs will make a new mint when stocks shoot up (on their stock options) even without any kind of extraordinary performance.

This reality actually ENCOURAGES a "boom-bust" model of corporate management, because the top decision makers actually profit maximize even though this behavior clearly HARMS their companies (and the nation as a whole). Consequently, CEOs are encouraged to IGNORE business models that get out of wack, rather than try to fix them.