Platt Perspective on Business and Technology

Considering a cost-benefits analysis of economic regulatory rules – 6

Posted in in the News, macroeconomics, outsourcing and globalization by Timothy Platt on April 27, 2012

This is my sixth installment in a series on the cost-benefits analysis of economic regulatory rules (see Macroeconomics and Business, postings 64, 66, 69, 70 and 72 for parts 1-5.)

So far in this series I have been discussing the complex of issues that constitute regulatory oversight and its economics through a series of case studies. I am going to focus on and expand upon one of them in this installment as a specific starting point for discussing some fundamental principles. The case study I will use here is a discussion of the regulatory failure of the home mortgage and banking industries that so strongly contributed to our still recent Great Recession (see Part 2 of this series for my opening notes related to that.) The fundamental principles I will discuss, using this case study as a working validating example are at least loosely outlined as:

• The absolute levels of potential risk and benefit are not as important as the symmetrical distribution of risk and benefit as shared – ideally, at least, equally by all involved stakeholders.
• And the real risk of instability and crisis comes from risk and benefits distribution asymmetry.

But first the case study:

• Bank loan officers and their managers, who packaged and offered home loans leading up to the Great Recession received compensation that correlated directly with the volume of loans they closed on and completed – and regardless of the creditworthiness of the would-be home owners who took on these loan obligations or their likelihood of being able to meet the terms of these loans in paying them off.
• So as at least initially noted in Part 2 of this series, bank officers, and in fact these banks themselves saw direct gain from making these mortgage loans and regardless of risk. They faced the benefits. Now who faced the risk involved in all of this?
• One obvious answer is the homeowners who bought their homes through these loans and particularly the holders of higher risk mortgages whose finances were such that they were much more likely to go into default than to be able to make their payments, through the full payoff of the loan due.
• But as I noted in Part 2 of this series, the list of participants in this system who faced significant risk was a lot larger than just the pool of homeowners who had bought into toxic, high risk mortgages that they would be unlikely to be able to pay off. This also very significantly included investors who bought into investment funds and other investment instruments without knowing what risk they faced. And as noted in Part 2, these toxic home mortgages, just waiting to explode into foreclosure were folded into and hidden within complex financial derivatives that were opaque as to their full contents, but that were graded as of high quality and low risk by accreditation firms such as Moody’s and Standard and Poor’s .
• One group faced potential gains that they were in fact certain to be able to cash in upon and regardless of outcome for the individual mortgage loans they sold, and regardless of the overall impact of their loan offering practices as a whole. And another set of participants assumed all of the risk – including some of the largest pension funds in the country as well as myriad individual investors.

This asymmetry in the distribution of potential risks and benefits led to risk taking that with time was essentially guaranteed to lead to large-scale financial failure. All of the incentives to take risk, and even enormous risk were on one side of the table. And for senior executives who oversaw and managed these systems and who were supposed to provide oversight and internal controls for these banks and lending institutions – they were all personally protected from any adverse consequences of their actions, or from their failure to act from their contractual agreements with those banks – they were all protected by golden parachutes that in effect indemnified them against personal loss and that in fact guaranteed gigantic payoffs.

• Note: this is not about absolute levels of risk and benefit. What I propose here is all about risk distribution and the tamping down of risk-taking that equitable distribution of risk and benefits would encourage and support.

I am going to propose a set of possible regulatory actions in my next series installment that would serve to level the risk/benefits playing field. And I will discuss them in terms of short and long-term time frames in determining risk, and risk perception, and for acting upon them. Meanwhile, you can find this and related postings at Macroeconomics and Business and also at Outsourcing and Globalization.

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