Sunday, November 30, 2008

"Safe As Houses:" A Psychoeconomic Reflection

There's a relationship between economics and psychology.  A lot of human behavior often has an economic motivation, although it's often concealed, sometimes from the person doing the behaving.  I address that in a question in the Q and A archive on my website,, where I see psychoeconomic issues figuring powerfully, if without acknowledgement, in the marital issues of a questioner.  Similarly, a lot of economics looks to me like a branch of psychology, because it's about human nature, what people believe and how we behave.  

The current economic crisis is a psychoeconomic case study worth our reflection, because I think we are looking at a case of the removal of trust from human relationships, and the elevation of greed in the absence of context to a dominant position in our national economic life.  For these two psychoeconomic dynamics, we are paying the price. 

There is a spectrum of trust in economic relationships. 

Let's think about credit, which is at the center of this crisis.  If I ask you for a loan, and you give it to me at a rate of interest that I can pay, you can accept, and we can agree on, we have a relationship in that loan.  You have evaluated my ability to repay.  I want to keep my reputation as credit-worthy.  We will both have probably assessed the risk that I might not be able to pay back the note, and found it worth taking.  Probably I will pay you back.  If I can't you can live with it.  Maybe I put something up for collateral.     

Now, if we think about a traditional home mortgage, a bank is making a significant multi-year commitment to a borrower who promises to pay back the note, and in whom the bank has a reasonable basis for trusting that he will.  We are moving up the spectrum of trust from person-to-person relationship to person-to-institution relationships.  But it is still between the borrower and the lender, for the duration of the loan.  It is a relationship of trust that is direct and effectively interpersonal, albeit at one remove.  Having made the loan, the bank still carries it.  Someone, or some group, at the bank decided to make that loan, and they are probably going to be around.  Their own reputation among their colleagues at the bank depends in part on the performance of that loan.  The well being of all the depositors and investors in the bank even depends, in some small way, on the performance of that loan.  There is a long-term relationship among the people involved in that loan.  

Then we have Fannie and Freddie, buying mortgages from banks in order to stimulate the mortgage market.  It seems to have been an idea that worked, for many years, as long as banks made loans for sale to federal agencies by the same standards that they would apply if they had to hold the mortgages themselves.  The relationship of trust between borrower and lender was effectively maintained, albeit at another remove when it was passed onto the federal agency.  It became part of the relationship between the federal agencies and the banks that made mortgages.  The line of financial relationship was longer, it was extended, but it hadn't snapped.  It remained intact.  

The bubble in the mortgage market removed that financial relationship between borrower and lender, because lenders could sell mortgages for quick profit immediately after closing the deal, and borrowers could apply for mortgages that they couldn't repay with the expectation that they could always refinance later, when their homes would be even more valuable. Under such circumstances, the incentive in the mortgage market was just to make and sell as many mortgages as one could.  There was no longer a relationship of trust; it was gone.  In it's place was greed:  the greed of unqualified home buyers to purchase homes they couldn't really afford, and the greed of the mortgage seller for a quick profit.  

Now we come to the interesting term "securitization."  This involves bundling mortgages together into financial investment instruments purchased by investors and insured against default by insurers such as AIG.  The economic rationale in bundling mortgages into securities was that most mortgages would be repaid even though some would fail, and the majority of successful notes would compensate for the small minority of failures within the security.  This worked well as long as the original mortgages were based on relationships of trust.  It was based on expected ratios of home mortgage payoff to failure that were typical of mortgages made in the traditional, fixed rate, long-term, more or less interpersonal way.  But such ratio estimates did not apply to the new short-term adjustable make-and-flip mortgages which were comprising an increasingly large proportion of the mortgage market.  Similarly, the security insurer (such as AIG) made its insurance against default on the basis of an expected rate of failure that characterized securities with much more fundamental validity than these new instruments.  My impression is that default insurance hardly ever had to be paid, because the instruments rarely defaulted; they were, as the saying goes, "safe as houses."  This expectation was seemingly borne out by the bestowing of triple A rating on the securitized mortgage instruments.  This is another example of greed for gain in the absence of relationships of trust; with the statistics involved in bundling the mortgages together, and a belief--astonishing in financial professionals--that the values of housing stock would always move upward without correction, substituting for relationships of trust in the mortgages themselves.  

So the psychoeconomic line from an economy based on relationships and trust to an economy based on greed without relationship or trust was crossed when the relationship between borrower and lender was effectively nullified.  The borrower no longer had an obligation to pay off the note as made,, based on the assumption that housing value would continue to increase and new mortgages at favorable terms would always be available whenever the note came due.  The lender no longer had an obligation to hold the note for the loan, because it would be instantly flipped into a securitized bundle.  When houses and mortgages could be bought and flipped, there was no foundation of relationships and trust to support the economy any longer, and it wasn't a matter of whether the system would collapse, but of how long it could keep going until it did.     

Another dynamic of greed fueling the bubble was the existence of large amounts of investor wealth, both in the U.S..A. and internationally, looking for opportunities for high rates of return.  With the bestowal of triple A rating, and in the presence of default insurance, the elements of an economic "perfect storm" all came together.  

Reflecting on the unrealistic thinking that went into creating this mess, I'm reminded of the story of Mulla Nasrudin, the Sufi wise-fool star of hundreds of jokes and tales, who was observed by his friend one day, pouring yogurt into a lake.  When his friend asked him what he was doing, Nasrudin said, "I'm making yogurt."  "But you can't make yogurt that way, Nasrudin!" exclaimed his friend.  "Yes," replied Nasrudin, "but just suppose it takes!"  (See, "The Exploits of the Incomparable Mulla Nasrudin and The Subtleties of the Inimitable Mulla Nasrudin," a double book, by Idries Shah, available at I.S.H.K. Book Service,




No comments: