There’s no place like a home. For most of a decade, that belief fueled a boom in home mortgages and mortgage-backed securities. It looked like a win-win-win-win proposition for borrowers, mortgage brokers, bankers, and investors alike. It offered the ultimate proof that private greed produces public good.
Until it didn’t.
“We still wanted to believe it was true that acting in your own self-interest would produce good results,” says Greg Hallman, senior lecturer in the finance department at the McCombs School of Business. “But in this case, that idea clearly led to a horrible outcome.”
David Spence, associate professor of law, politics, and regulation at McCombs, explains how the market’s invisible hand got caught in the machinery. “It was a situation in which individual players, at each stage of the chain, were responding almost entirely to incentives that allowed them to make a lot of money, but which collectively were disastrous for the system. Nobody was looking out for the entire system.”
At each individual level of the system, the incentives appeared to make sense, says Hallman, but the overall system did not produce a common-good outcome. The mortgage boom was driven by investors, who were seeking higher returns than they could get from Treasury bills. They found those returns in subprime loans, on which marginal homebuyers paid high interest rates.
Along the pipeline between homebuyers and investors, other players tapped in, too. Mortgage brokers earned fees for arranging the loans and banks for making them. Securities houses bought up the loans and repackaged them as mortgage-backed securities. Other financial firms insured the mortgage-backed securities with exotic derivatives like credit default swaps.
The system’s fatal flaw, says Hallman, was that self-interest was not restrained by risk. Lenders didn’t risk their own money when they made subprime loans, because they knew they could quickly sell the loans to a group of investors.
“When the lender had the loan on their books, we could count on them working towards their own self-interest, and it would lead them to write safe loans,” says Hallman. “When they pulled the loans off their books, their self-interest was not to be as careful anymore.
While banks were shoveling mortgage loans off their books, many were simultaneously investing large sums in mortgage-backed securities. Those holdings were often hidden from shareholders and regulators, because they were made by off-the-books affiliates called structured investment vehicles.
Again, says Hallman, a crucial check on self-interest was missing. “We count on the markets to monitor companies. But the market can’t monitor a company if it doesn’t know what’s in the company.”
A major lesson from the mortgage meltdown, both professors agree, is that self-interest is like the devil in the Rolling Stones song: It’s in need of some restraint.
New laws will attempt to create a new system of checks and balances. The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in July, creates a 16-member council to oversee the entire financial system. Says Spence, “On Wall Street, everybody’s world is their own little part of the chain. Nobody, regulators included, was looking at the whole system. That’s what this package is trying to cure.”
Alongside detailed new regulations, Hallman recommends two simple changes to the financial system: Make banks show all their investments on their books and make lenders put their own money at risk. Instead of selling off mortgage loans, banks should hold on to parts of them, using them as collateral for European-style securities called covered bonds.
“People can always game rules,” says Hallman, “but you can’t game having your own money at risk.”