Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  Pecunia Non Olet

  Most of us do not work for money alone. Some want to change the world, others to create objects of art and culture that will endure. Some strive to gain fame, while others are content to do good anonymously. For many people, though, the visible effects of one’s work are its greatest reward. For the teacher, witnessing the eureka moment when understanding finally dawns on a student; for the doctor, the incredible joy of saving a patient’s life; for the farmer, the sight of acres and acres of golden wheat swaying gently with the breeze—for all these people, their primary motivation is the knowledge that their work makes the world a better place.

  A simple experiment done by researchers at MIT and the University of Chicago verifies the importance of larger meaning to motivation and work. Harvard students, the subjects in the experiment, were asked to put together Lego Bionicle models (small snap-together models) from kits they were given (the MIT researchers probably thought this would be a real challenge for Harvard students!). Subjects were paid at a declining rate for each additional model built, so that eventually they would stop because the effort involved in building an additional model was not worth the pay. In one version of the experiment, each completed model was placed in front of the subject, and the subject was given another identical box from which to build another. In the second version of the experiment, the subject was handed a second box, but even while he or she was putting the model together, the researcher dismantled the just-completed model and put it back in the first box, so that this box could be handed to the subject when the model built from the second box was complete.

  The simple difference of whether the subject’s work was allowed to endure (at least for the duration of the subject’s participation) or whether it was undone immediately, leaving not a trace, made an enormous difference in the willingness to work, even though the monetary benefits were identical. Subjects completed an average of 10.6 Bionicles when the completed models were left standing in front of them and only 7.2 when the completed ones were dismantled in front of their eyes. Thus they continued to make Bionicles for lower wages when the experiment was structured to give the work more meaning. Seeing the fruits of your labor, even in something as trivial as model building, seems important for motivation!3

  In some jobs, it is very hard to see the effects of one’s work. On an assembly line, a worker is just one cog in a huge production machine, and her role in the final product may be small. No wonder modern management techniques try to make each worker feel important both individually and as part of a team: the Japanese kaizen system of continuous improvement, for example, involves all workers in making changes to enhance productivity, no matter how small the changes might be.

  Many jobs in a competitive, arm’s-length financial system are problematic for two reasons: First, like the worker on an assembly line, the broker who sells bonds issued by an electric power project rarely sees the electricity that is produced: she has little sense of any material result of her labors. She is merely a cog in a gigantic machine. Second, the most direct measure of a financial sector worker’s contribution is the money—the profits or returns—she makes for the firm. Money here is the measure of both the work and her worth, and this is where both the merits of the arm’s-length financial system and its costs arise.

  Take, for instance, a trader who sells short the stock of a company he feels is being mismanaged (that is, he borrows and sells stock he does not have, anticipating the price will go down and that he will be able to buy the stock back later at a lower price to close out his position at a tidy profit). Few people are more vilified than short sellers, who are seen as vultures feasting on the misfortune of others. But they perform a valuable social function by depriving poorly managed companies of resources. A company whose stock price tanks will not be able to raise equity or debt finance easily and could be forced to close down. The trader who shorts the stock does not see the workers who lose their jobs or the hardship that unemployment causes their families; all he sees are the profits he will make if he turns out to be right in his judgment. But it is his very oblivion to the larger consequences of his trades that makes him such an effective and dispassionate tool of change.

  Despite the protestations of the management of targeted firms and their political backers, the trader does not cause the firm to go out of business. If the trader is wrong and the firm is well managed, other traders will take the opposite side, buy shares, push up the share price, and make the short seller lose money. It is typically only when the short seller’s opinions are widely shared, and firm management is awful, that the share price tanks. Mismanagement is the source of the firm’s troubles; the trader merely holds up a mirror to reflect it. Indeed, the more disconnected the trader is from the people in the firm, the more reliable a mirror he is able to provide. But herein lies the rub. Because the trader is at a distance from the real consequences of his actions, the best measure of the trader’s value to society is whether he made money from the trade: a profit indicates that he was right to short the firm short and that society will benefit from his actions.

  Although market opinion is not always right, more often than not, it is. Management at the energy giant Enron lashed out at short sellers, but the short sellers, like James Chanos at Kynikos Associates, understood there was something deeply wrong with its accounting. Essentially, Enron had set up off-balance sheet entities to which it “sold” its failing projects at a hefty profit, thus creating the appearance of both profitability and growth, even though the reality was just the opposite. It was the short sellers who made Enron’s stock price plummet and forced the company to shut down even while the firm’s traditional bankers supported its creative accounting with yet more creative loans. As Chanos later wrote, defending the short seller’s role as professional skeptic: “We spoke with a number of analysts at various Wall Street firms to discuss Enron and its valuation. We were struck by how many of them conceded that there was no way to analyze Enron, but that investing in Enron was instead a ‘trust me’ story. One analyst, while admitting that Enron was a ‘black box’ regarding profits, said that, as long as Enron delivered, who was he to argue?”4

  Chanos made millions and acquired fame from his analysis and his willingness to challenge the herd on the question of Enron’s value, but it is this very strength of the arm’s-length system—that money is the measure of all things—which also is its weakness. An old Latin saying, Pecunia non olet, translates as “Money has no odor.” The very anonymity of money, the fact that it is fungible and its provenance hard to trace, also makes it a poor mechanism for guiding employees’ activities toward socially desirable ends. Did the trader make her returns by being more astute than others like her, or did she make it by front-running her clients (trading ahead of a large client order so as to make money when that client’s order moved prices)? Did the mortgage broker make his fees through offering a variety of sensible options to the professional couple who were looking to upgrade their house, or by urging an elderly couple to refinance into a mortgage they could not afford? Although the former course is preferable in each case, the latter is easier for the trader or broker; and because the wrong choice also makes money, has few immediate consequences, and sets off few alarm bells, it is the one that is most tempting.

  In sum, bankers are not the horned, greedy villains the public now sees them to be. In the classes I have taught over the years, the future bankers were as eager, friendly, and ready to share as the other students in class, although perhaps a little smarter (remember, this was a time when the financial sector paid far more than other professions and attracted the best talent). I have no doubt they continue to be decent, caring human beings. But because their business typically offers few pillars to which they can anchor their morality, their primary compass becomes how much money they make. The picture of bankers slavering after bonuses soon after they had been rescued by government bailouts was not only outrageous but also pitiable—pitiable because they were clamoring for their
primary measure of self-worth and status to be restored.

  Usually, competitive market mechanisms keep the search for profits on a track that also ensures it enhances value to society. This is the fundamental reason why free-market capitalism works and why bankers usually do good even as they do very well for themselves. However, the fault lines we have identified can warp the tracks. The finely incentivized financial system can then derail rapidly. By putting all the blame on the financial system, we fail to recognize the role played by the fault lines. Excoriating the immorality of bankers has made for good rhetoric and politics throughout history, but it is unlikely to address the fundamental reason why they can cause so much harm. Let us see how these effects were at work in the origination of dubious subprime mortgages.

  Brokers and What Went Wrong

  There were plenty of examples of horrendous mortgage loans made in the run-up to this most recent crisis. Many were made by New Century Financial, which was founded in 1995 with about $3 million of venture capital, as government support to the subprime market increased. Because subprime lending was an innovation with enormous potential opportunities, it attracted ample venture-capital funding. New Century went public in 1997. After surviving a scare the next year, when Russian loan defaults caused investors to flee risky businesses and some subprime lenders went out of business, it grew rapidly.

  Companies like New Century reached customers mainly through small, independent mortgage brokerages. Mortgage brokers found customers, advised them on available loans, and collected fees for handling the initial processing. With New Century and its rivals competing fiercely for business, brokers often favored lenders who were able to make loans quickly. As one broker put it, he liked working with New Century because it was “very easy.”5 New Century rarely demanded reviews of the appraisals on which loans were based. Because it outsourced business to brokers, it could ramp up its business quickly, without having to hire a lot of employees or find office space. Brokers worked out of their own homes and cars and were often willing to go to customers’ homes in the evening or on the weekend. As a result of such rapid expansion, New Century was the second largest subprime mortgage lender in the country at one time, originating nearly $60 billion in mortgages in 2006.

  It does not take a genius to push loans to those who have credit problems, and New Century did not penalize brokers for the quality of loans they originated until in early 2007, when it was too late.6 The Wall Street Journal highlighted an example of the kind of loans being made.7 Ruthie Hillery was struggling to make the $952 monthly mortgage payment for her three-bedroom home in California. In 2006, a mortgage broker persuaded the 70-year-old Hillery to refinance into a “senior citizen’s” loan from New Century that she thought would eliminate the need to make any payments for several years. Instead, the $336,000 adjustable-rate loan started out with payments of $2,200 a month, more than double her income. By the end of the year, when she could not keep up payments, Ms. Hillery received notice that New Century intended to foreclose on the property. As her lawyer put it: “You have a loan application where the income section is blank. How does it even get past the first person who looks at it?” According to Ohio’s assistant attorney general, Robert M. Hart, New Century’s underwriting standards were so low “that they would have sold a loan to a dog.”8

  New Century was immensely successful for a while in spite of its appalling credit standards. And despite the prominence given in the media to such cases, it grew not primarily because it preyed on vulnerable retirees but because of rising house prices and securitization. With house prices rising, New Century’s brokers could make loans with affordable initial teaser rates, anticipating that by the time borrowers had to make higher payments, their house prices would have risen, and they could refinance once again into a low rate. Indeed, this scheme was a virtual money machine, because the cost of refinancing could repeatedly be swept into the new, larger, mortgage—until house prices stopped rising. At that point, all those mortgages with resets to higher rates would turn into real debt—the kind that actually has to be repaid—and the high required repayments would resemble the balloon repayments that proved so burdensome to homeowners during the Depression.

  New Century’s management must have known that house prices would not rise indefinitely. So why did they continue making risky mortgage loans almost until the day they filed for bankruptcy? One answer is that the company did not hold on to the mortgages it made but sold them to investment banks who packaged them together and sold securities (which were vastly overrated by the rating agencies) against the package to Fannie and Freddie, pension funds, insurance companies, and banks around the world.

  So did no one care about credit quality? The investment banks (and their rating agencies) did care, after a fashion. To sell the mortgages on, they had to satisfy themselves that the underlying credit quality was sound. In the past, when a bank made a mortgage loan that it intended to hold on its books, it called the prospective borrower in. The loan officer interviewed him, sought documents verifying employment and income, and assessed whether the borrower was able and willing to carry the debt. These assessments were not just based on hard facts; they also included judgment calls such as whether the borrower seemed well mannered, cleanly attired, trustworthy, and capable of holding a job. Cultural cues such as whether the applicant had a firm handshake or looked the loan officer in the eye when answering questions no doubt played a role—as, unfortunately, did race. But many of these judgment calls did seem to add value to credit evaluations. So did the loan officer’s knowledge that his client would be back to haunt his conscience if he put him in an unaffordable house.

  But as investment banks put together gigantic packages of mortgages, the judgment calls became less and less important in credit assessments: after all, there was no way to code the borrower’s capacity to hold a job in an objective, machine-readable way.9 Indeed, recording judgment calls in a way that could not be supported by hard facts might have opened the mortgage lender to lawsuits alleging discrimination. All that seemed to matter to the investment banks and the rating agencies were the numerical credit score of the borrower and the amount of the loan relative to house value. These were hard pieces of information that could be processed easily and that ostensibly summarized credit quality. Accordingly, the brokers who originated loans focused on nothing else. Indeed, as the market became red-hot, they no longer even bothered to verify employment or income. Part-time gardeners became tree surgeons purportedly earning in the middle six figures annually.

  The judgment calls historically made by loan officers were, in fact, extremely important to the overall credit assessment. As they were dispensed with, the quality of mortgage-origination decisions deteriorated, even though the hard numbers continued to look good till the very end. It really does matter if the borrower is rude, shifty, and slovenly in the loan interview, for it says something about his capacity to hold a job, no matter what his credit score indicates. Moreover, brokers and New Century had an immense incentive to keep the volume of originations up so that they could collect fees—and they now knew which numbers to emphasize. So brokers felt little compunction in helping willing borrowers massage their credit scores, and they recruited pliant appraisers who would keep the loan-to-value ratio down by offering outrageously high appraisals for the house.10 Because they seemed willing to do virtually anything to close the deal, New Century’s loan department became known as “Close More University.”11

  Eventually, though, New Century’s weak standards caught up with it. Increasingly, its borrowers could not even make their first few payments and defaulted. These defaults were problematic because the banks buying the mortgages for packaging could return mortgages that defaulted early to New Century. With more and more mortgages returning onto its books, and lenders withdrawing their lines of credit, New Century eventually filed for bankruptcy. One has to marvel at the sheer chutzpah of New Century’s founder, Brad Morrice, who said in a news release announcing the co
mpany’s bankruptcy on April 2, 2007, that it had “helped millions of Americans, many who might not otherwise have been able to access credit or to realize the benefits of homeownership.”12 He neglected to mention that for millions of these homeowners, their houses were like millstones around their necks, drowning them in a sea of debt.

  Assigning Blame

  The private financial sector bears an enormous responsibility for what happened. But did the brokers act immorally? Clearly, misleading retirees about their payments was wrong and bordered on the illegal. But although these are the cases that still make the headlines, it is not obvious that predatory lending of that sort was the norm. Brokers and firms like New Century provided many a homeowner with what they were asking for: refinancing at low rates, with little thought for the future. Should the broker have counseled the debt-ridden homeowners they were working with to cut back on consumption, pay off credit card debts, and move to a smaller, more affordable house? Perhaps some would have done so had they thought they would see their clients again. Knowing, however, that the mortgages they originated would be packaged and sold, they had little stake in the relationship, other than the fees—fees that indicated to them they were doing God’s work. Arm’s-length transactions do not foster empathy or a long-term focus.

  There is, however, another check on arm’s-length transactions—a well-functioning competitive market. If New Century had been forced to sell its originations for fair value, it would never have originated the risky mortgages it did or put so many borrowers into unaffordable houses. The competitive market would have provided the mechanisms to keep First Century on track. Somehow, and unfortunately, the market was willing to pay much higher values for these mortgages than they were worth and did not exercise its customary discipline.