Bubble Psychology and Complicity in Financial Fraud
Matt Yglesias does write about things other than monetary policy and zoning regulation. Today, he’s got a post up about the relationship of fraud to credit bubbles:
Federal Reserve governor Jeremy Stein has a learned talk out today about the need to take an “institutional view” of credit market dynamics. There are a lot of stylized models out there in which credit intermediation institutions basically don’t exist, and the volume of credit is simply determined by fluctuations in household and firm preferences. He argues that you have to think about the way the institutions actually function and the incentives facing actors within them.
Specifically, he notes “three factors that can contribute to overheating” in credit markets.
One is “financial innovation.” The second is “changes in regulation … new loopholes … exploited by variants on already existing instruments.” The third is “a change in the economic environment that alters the risk-taking incentives … a prolonged period of low interest rates … ‘reach for yield.'”
And fair enough. But here’s some evidence that’s emerged from litigation between Dexia, a large Belgian bank that lost a ton of money buying mortgage-backed securities from JPMorgan and also from two banks that JPMorgan has since acquired:
According to the court documents, an analysis for JPMorgan in September 2006 found that “nearly half of the sample pool” — or 214 loans — were “defective,” meaning they did not meet the underwriting standards. The borrowers’ incomes, the firms found, were dangerously low relative to the size of their mortgages. Another troubling report in 2006 discovered that thousands of borrowers had already fallen behind on their payments.
But JPMorgan at times dismissed the critical assessments or altered them, the documents show. Certain JPMorgan employees, including the bankers who assembled the mortgages and the due diligence managers, had the power to ignore or veto bad reviews. […]
In other words: JPMorgan – and other banks in the mortgage derivatives business – had powerful incentives to commit what looks like fraud (though Yglesias is careful to note that he isn’t equipped to speak to the question of legal liability).
The thing to remember, though, is that the incentives for doing this sort of thing exist on both sides of the desk in any transaction. You would think that a buyer of a security would want full disclosure of all the risks, and the seller would want to hide potentially damaging information. And relative to some market benchmark, that’s generally true – a less-scrupulous seller will try to get away with disclosing less than his competitors, a more conservative buyer to get more information than her competitors. But the benchmark itself moves, and both sides are complicit in moving it during bubbles – because in bubbles, market participants are more worried about missing out on profit opportunities than with incurring losses.
At the height of the bubble, if you brought a piece of paper to market with a high percentage of no-doc “liar” loans in the portfolio, the market would demand a higher interest rate because of the higher risk that these loans would go bad. But eventually the rate would be high enough that investors convinced themselves they were being compensated for that risk – and they wanted to convince themselves, because they needed the yield.
(Actually, that’s not strictly true – at the very height of the bubble, perversely some of these deals would have been priced tighter than some other deals, because certain issues that were included on common “short” lists or that were included in indices had a more liquid credit-swap market associated with the paper, and that greater perceived liquidity – which appeared to reduce market risk – drove yields down to levels that did not reflect the underlying credit risk. But that’s a wrinkle that cuts against a story that in general is correct.)
Ratings agencies benchmarked the quality of their work against each other. In a raging bull market, a single agency could grab market share by lowering standards, and the others would have to follow suit. The effect was observable within institutions as well, as the risk management departments of institutions couldn’t get away with demanding tougher risk assessments than competitors, and legal departments couldn’t get away with taking a more conservative view of proper disclosure. And everyone in the market, buyers and sellers, is subject to the same pressures.
There were, of course, plenty of instances of out and out fraud. But “consensual” fraud, where all parties know that there’s more being left out than said, was vastly more common – indeed, was almost ubiquitous.
[I]t’s clear that in economic terms we were dealing with a marketplace in which major vendors were concealing materially relevant information. The ability to get away with that kind of thing is a factor that can easily lead to overheating. After all, the actual creditworthiness of potential borrowers is a major constraint on the expansion of credit. If intermediaries believe they can get away with misstating the creditworthiness of borrowers (either through direct fraud or by covering up fraud on the part of the borrowers) then there’s going to be a lending boom.
None of this is to undermine the stuff Stein does say, but there continues to be a big blind spot in the economics world to this stuff, even though there’s more and more lawyering around it every day.
The lawyering is actually pretty important to restraining this kind of behavior. The prospect of a prison term concentrates the mind wonderfully – at least for a while. People will still commit out-and-out fraud, but the prevalence may go down, and, to the extent that a new bubble still emerges eventually, it might take just a little bit longer to get going. But, as I say, “consensual” fraud is a much bigger phenomenon than clear-cut lawbreaking. To the extent that buyers succeed in suing sellers over this kind of thing, that’ll make sellers more cautious next time – but it’ll make buyers more complacent, and more willing to encourage sellers to tell them what they want to hear. So I’m not sure, in the end, lawsuits will do much to restrain the biggest driver of misinformation.
Similarly, an agency designed to protect the consumer in these transactions could do real good (if properly staffed) inasmuch as it might compensate for the massive information asymmetry between consumers and financial professionals. But the kinds of transactions Yglesias is talking about take place between “big boys,” where even if there are information asymmetries (and there always are), there’s no suggestion that they should be regulated away (nor is it obvious how they could be). And anyway, inasmuch as much of the fraud that takes place at that level is “consensual,” regulation would have the same effect as a legal regime tilted more towards buyers: it would encourage greater vigilance by sellers, but laxer vigilance by buyers, and it’s hard to know what the net effect would be.
So the key word is “ability.” In any bull market, the willingness of intermediaries to “conceal materially relevant information” goes up, and so does the willingness of risk-takers to let that information be concealed. It’s very hard to regulate away that behavior – doing so would be tantamount to regulating away bubble psychology. But how possible it is to conceal this kind of information is a function not only of the regulatory environment (which also gets laxer during bubbles – bubble psychology works on regulators, too) but of the nature of the products themselves. Credit securitization provided multiple opportunities to inaccurately represent risk, each of which was seized by somebody, and which collectively resulted in a much more substantial mis-representation than would have been the case with simpler products.
I’d be interested to know whether there’s any academic literature addressing this question of opacity/complexity and its relationship to bubbles.