The single best explanation for why we had a terrifying financial crisis 10 years ago goes back to how easy it seems to be to take risks when it’s someone else’s money.
It’s a problem often called moral hazard, a term that was talked about a lot just after the financial crisis but not as much lately. Now, 10 years out from the worst days of the financial crisis, it’s important to stress once again that this is a chronic problem. And it’s not something easily fixed with a batch of regulations.
To get the idea, just imagine what would happen if you had to decide how much risk to take while fully aware that somebody else would bear the losses if things don’t pan out. Sounds a little like “heads I win, tails you lose.”
Lots of Americans during and after the financial crisis hated the idea of the federal government propping up private financial firms, and this was one reason why. These companies wounded themselves by taking risks in housing and mortgage finance and if the taxpayers saved them, the argument went, they would just try it again.
The government had to really step up its support after the investment bank Lehman Brothers collapsed 10 years ago this weekend, precipitating the scariest week of the crisis.
Maybe the federal government got this one at least partly right by dodging moral hazard and letting Lehman tip over. Yet a version of the moral hazard problem existed in spades at Lehman, and it proved fatal — to the company. And it was happening all along the housing finance chain.
In the mortgage origination business, it wasn’t the mortgage banker’s money. So what mattered was not whether it was a good mortgage but whether the deal closed.
If the mortgage-backed securities put together by investment banks later turned out to have been backed by some slices of the worst mortgages, the bankers who packaged and sold the deal still kept their bonuses.
If enough deals went south that the investment bank’s customers fled — or worse, like Lehman Brothers the company got caught with too many assets it couldn’t unload — then the unsuspecting shareholders were hammered.
A lot of firms put effort into managing risk, of course, including investors buying mortgages only if the originator promised to take back bad loans. But there was a lot of heads I win, tails you lose going on.
Remember, this is not a problem unique to financial services or to that era. Any company’s owners, for example, can’t really know if the insiders are shooting for bonuses and promotions using shareholder money that they would never risk if it were their own dollars.
Part of what makes this a persistent problem is the way a lot of American business is structured, in big publicly held corporations. Except maybe for company founder CEOs who never sell a share, nobody who works at one of these organizations could fairly be considered a business owner with a lot at risk.
It’s up to management to put in place rules and make sure they are followed, but the incentives for the boss aren’t that much different from a rookie banker trying to close a mortgage loan. A good example of that coming out of the financial crisis is the story of Angelo Mozilo, co-founder of a 2000s-era market share leader in mortgages called Countrywide Financial.
A popular product for Countrywide back then was something called an “option pay” mortgage. As it sounds, the borrower essentially got to decide how much to pay every month.
One problem is that the homeowner often didn’t pay enough to even cover the interest due and thus the mortgage balance only got bigger. As the housing market grew even hotter, bad became worse as option-pay borrowers were getting approved with little or no documentation, including just saying what their income was without providing so much as one pay stub.
Mozilo realized a train wreck could lie ahead. He said so, too — in e-mails to his colleagues.
He owned about 2 percent of Countrywide during this period, but that included shares he could get through his stock options. Mozilo then converted options to stock and sold nearly $140 million worth, according to a complaint later brought by the Securities and Exchange Commission.
He had let his company’s owners take the risk.
Mozilo must have felt right at home visiting the big investment banks at the other end of the mortgage-finance pipeline. By the time the crash hit, they had long since abandoned the old Wall Street model of partnerships and become modern, publicly held firms.
Former Lehman Brothers partner Peter Solomon told the commission that investigated the causes of the financial crisis that at one time he and his Lehman partners all sat together in one big room. They weren’t especially chummy, but because they were all on the hook together they had to watch each other carefully.
During the boom, publicly held Lehman Brothers Holdings, Inc., had a balance sheet so leveraged that it had just $1 of tangible equity to cushion any losses for every $40 it had invested.
No real partner in the business would have allowed that to happen.
The week after Lehman fell, traders, bond sales reps and investment bankers in Midtown Manhattan were lining up on their lunch breaks to withdraw money from their accounts at Citibank and Chase. They knew how bad it was.
The Financial Times’ John Authers wrote this month that he saw this happening right in front of him and decided to write nothing, judging that the last thing the world needed that week was news that a bank run seemed to be happening in the heart of the New York financial district.
But here’s another example of just how common the moral hazard problem is. Those bankers could have been withdrawing money made by packaging up and selling the worst of the toxic mortgage securities. Yet by getting their accounts under $100,000, then the limit of Federal Deposit Insurance Corp. insurance, they wouldn’t have to worry about Citigroup not making it out of the crisis alive.
It was still their money in the bank, it just wasn’t their risk. It was ours.