The Huffington Post has an interesting article about Long Beach Mortgage. In interviews:
[F]ormer employees say the company encouraged the sales force to churn out as many loans as possible with lavish commissions and bonuses. And it didn’t matter if the loans went bad because Long Beach Mortgage bundled them and sold most of them quickly to investors.
There are two preliminary moral hazard problems. First, obviously the sales force does not have the incentive to screen out “bad loans” given the incentive contract offered. Second, as mortgages can be bundled and traded, the managers do not have the incentive to give the sales force the incentive to screen our bad loans. They want to maximize raw volume rather than quality-adjusted sales.
This leaves “the market” as the potential monitor. A large group of owners of securities faces a free-rider problem in monitoring so no-one monitors. The price of the bundled security reflects the mix of good and bad loans in the market. An individual issuer of mortgages has the incentive to screen out bad loans if this is reflected in the price of the security they sell. But if no-one is monitoring, no-one will notice the extra benefits from screening, the price will not improve and there is no incentive to invest in making just good loans.
Finally when everything does tank, if banks sell mortgages and the banks are too big to fail, they get bailed out by taxpayers. One final bit of moral hazard to make sure there is no incentive to monitor the monitor to monitor the mortgage sale.
If the grand coalition of lenders, borrowers and taxpayers can form, they can design a better mechanism. In fact, a system with less liquidity gives better incentives to monitor – if the owners of Long Beach Mortgage cannot sell mortgages they have better incentives to design good incentives for their salesmen. It doesn’t seem impossible to make things a bit better. But without the taxpayers in the coalition, there is no reason for the remaining sub-coalition to design the socially optimal mechanism. If a bunch of people are playing poker but they can dump their losses on an innocent bystander, why will they ever stop playing?
So, what do Olympia Snowe and Ben Nelson think about financial reform? The median Senator responds to the median voter in their state. Wise people of Maine and Nebraska over to you, again. And people of Connecticut, if you can get Joe Lieberman to be a bit more predictable, that would be great.
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December 22, 2009 at 10:15 pm
Paul
I’m not entirely clear on the thesis here. Do you mean that absolutely no-one monitors, or that there is a sub-optimal level of monitoring? It seems to me that the monitors are paid for doing the monitoring by a reduction in the risk of their assets. Presumably prices adjust after the monitoring has been done, which gets the information out to the other holders of securities, but those holders didn’t get to take part in the arbitrage. Am I missing something?
December 23, 2009 at 7:29 am
sandeep
I’m not claiming the incentive to monitor is zero. I am claiming there is a free-rider problem so the level of monitoring is inefficient. This is part of the classic Grossman-Stiglitz thesis.
June 23, 2010 at 2:53 pm
steve
The above thought is smart and doesn’t require any further addition. It’s perfect thought from my side.
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Steve