Question

The Big Short:  Role Play

In 1965 Ed and Carla Langenberg took out a 20-year mortgage from Preble State Bank to purchase their first (and only) home.  The down payment was 20%.

Here were the risks:

Ed and Carla:  

• If they failed to make their loan payments they would lose the house.  
• When the bank sold the home to recoup their loan the first 20% of loss, if any, was borne by Ed and Carla.
• Preble State Bank intended to hold the mortgage for up to 20 years.  Which means…

1. If Ed didn’t pay, they lost money.
2. Which means they looked at his work history.
3. They had to decide they trusted him to pay it back.

In The Big Short…

• Borrowers obtained loans without effectively confirming their income.
• 0% down payments were common.
• Banks expected to write the mortgage, collect a fee, then sell the mortgage but retain servicing income.  Which means…

1. If the borrower didn’t pay, investors lost money.
2. If there was a loss, given no down payment, investors lost money.

• Incremental federal government deficits (above a $300 billion “norm”) from 2009-2012 total about $3.9 trillion or about $12,200 for every man, woman and child or $48,800 for a family of four.  At 1% = $488 interest payments per family annually, at 2% = $976 per year.

https://datalab.usaspending.gov/americas-finance-guide/deficit/trends/

QUESTIONS (There isn’t a “right or wrong” on this…)

1. What are the benefits, and costs, to society of securitization of home loans?

2. Compare and contrast the incentives for moral hazard in the modern, securitized system with prior practices in the 1960’s from the standpoint of:

1. Borrowers
2. Banks
3. United States (society) as a whole

3. Discuss whether you believe this, or a similar situation, can be prevented in the future without resorting to a police state or massive killing off of imperfect people (which has been attempted multiple times this century)?  

[Hint:  Your answer cannot be a variant of “people should” because that never happens]

4. What specific legislative or regulatory actions would you recommend to discourage excessive moral hazard?  

Answer 1

Securitisation of home loans is selling the securitised product ie the borrowers obligation is sold or pledged to a trust along with a variety of similar loans.

The Benefits and cost of securitisation of home loans to the society can be depicted as follows:

Securitisation benfits the economy as a whole by bringing financial markets and capital markets together. Financial Assets are created which are traditionally refinanced on on-balance sheet.
Further financial assets are converted into capital market commodities and the agency and intermediary costs are reduced considerably.
It undoubtedly increases the power of the capital markets.
However there are also potential risks and cost of the capital market- financial market connectivity. Marketable assets bought by securitisation have stretched credit creation. It tends to sustain borrowers longer in conomic expansion and expose them more in contractions. Therefore it has magnified the volatility of financial assets prices.

The incentives for moral hazard in the modern, securitized system with prior practices in the 1960’s from the standpoint of various parties can be noted as follows:

Borrowers
Borrowers who earlier took loans without having a considerable ability/ credit appetite and subsequently defaulted has reduced. With the onset of parties like the factor the borrower tend to think twice before taking any such loan which is beyond his repayment appetite. Borrowers now obtain loans only after effectively confirming their income and paying an agreed downpayment and against a collateral.

Banks
Banks which earlier followed a poor mechanism of credit evaluatio now tend to follow stringh mechanism of credit evaluation. DUe to increase transparency this has been possible.

United States (society) as a whole
Overall there has been a drastic shift in the entire society as compare dto the 1960s. Earlier where the investors lost money due to moral hazards, now due to revised mechanism in the securitisation process, and induction of various parties like the factor there is better risk management and possibly lower level of risk.

Such similar situations can be difinitely prevented in the future without resorting to a police state or massive killing in the followiinng way:

Maintenance of high diligence from the very initial stage when loan is sanctioned like credit evaluation, covering risk through collateral or involvement of a surety.

Also risk can be managed using concept of factor and mutual settlement.

Enetring into a valid agreemnt with parties which claerly bifurcates and defines the terms and conditions as well as risk and responsibilities.

Actions which can be taken to discourage excessive moral hazards are:

Fast track resolution process for companies which fall into such hazards with well defined limits for completion of resolution process.

Clarity in laws and regulations governing such matters is of utmost importance. Coincident laws can be straemlined to provide for better clarity in the governing process.