SSU Business and Economics Blog

From Michael Visser, Economics Professor at Sonoma State

Economics is a social science, which means economics is concerned with understanding human behavior. The textbook definition of economics is “the study of choice under conditions of scarcity” which is just an obtuse way of saying that we can’t always have everything, so we have to choose from among the things we can have: incentives matter.
This is a fairly simple notion, but we often forget about it when addressing big problems, such as the failure of our financial markets to function properly, California’s perpetual governance problems, the inability of the California State University to anticipate and respond effectively to a changing economic environment, etc.
It turns out that the root cause of most of these problems are cases where incentives of individual decision makers lead them to make choices that the rest of us do not particularly like.
As an example, let’s examine our economy’s recent financial meltdown. Over the last decade or so, an increasingly large proportion of mortgages required very little or no down payment. As a result, borrowers faced little personal risk by overstating income, and could get into a bigger and better house. Mortgage brokers have little or no incentive to make sure the borrower is going to be able to repay the loan because the broker gets paid a fee at escrow closing, and in most cases retains no financial interest in the mortgage after that point in time.
Bank CEOs have an incentive to make profit as soon as possible, as most of their earnings – performance bonuses and stock options – depend largely on current year performance. Bonuses and options give CEOs an incentive to take more risk than shareholders might prefer, and so as long as housing prices were rising and mortgages continued to turn over, they were willing to overlook the potential that bad information was behind the mortgages coming in. Because mortgages are long-term investments, bank CEOs prefer to sell the mortgages (in complex derivatives securities) to larger banks and other institutions looking for long-term investments, such as hedge funds. In doing so, bank reserves are freed up so that the bank can make another loan to somebody else.
This process is usually quite efficient. The problem in recent years, however, was that the mortgage assets were priced based on the bad information provided by borrowers and brokers, which overstated the ability of the borrowers to actually repay the loans backing the securities, and thus the assets were highly overvalued. When interest rates began to rise in 2005-2006, housing prices began to fall and continue to fall throughout most of the country, and accounting rules required banks to write down the value of these assets.
If you are one of these people who took out a mortgage to buy a house, and put no money down, and are left with a house worth less than you owe, you have an incentive to walk away from the house, even if you can continue to make your payments. At the same time, adjustable rate mortgages ratcheted upward, causing many people who had overstated their ability to repay (or failed to assess the risks associated with interest rate increases and the housing price collapse) to fall behind and eventually into foreclosure.
Banks holding these (written-down) assets had a lot less money coming in as well as less capital. Banks and investors realized that nobody knew what mortgage-backed securities were actually worth because the risk assessments were based on faulty information, and going back to reevaluate complex derivatives risk is tricky. Any institution with mortgage backed securities found themselves unable to move the assets off of their balance sheets in order to clear up loanable funds in order to issue new credit, mortgage or otherwise. This is how the credit markets ground to a screeching halt.
By about October, 2008 we had figured out what was going on, but the damage had been done and credit markets shut down virtually over night. Once the flow of credit stopped, real economic activity slowed dramatically, and businesses were forced to lay people off, pushing the economy deeper into recession.
Even where loanable funds were available, banks did not have a great ability to determine which borrowers were going to be able to repay because we were now in the midst of a recession, and banks can’t determine which borrowers – those who told the truth or not – are going to be negatively affected by recession. Under these conditions, banks have an incentive to tighten credit requirements and build capital rather than loan money in the face of such dramatic uncertainty, and that’s exactly what they did.
Eventually, the application of some novel monetary policy and a good amount of patience has unclogged most credit markets, though banks and borrowers both are still cautious. This caution is good for both groups, but it doesn’t do much to help the economy get back on track. For that, we need fiscal policy, and that is a topic for another day.
I am not claiming that the perverse incentives of mortgage borrowers, brokers, and lenders are the only causes of our recession; indeed, there are lots of incentives problems that have contributed to our current economic woes. I just wanted to use it as an example of why incentives matter, and the kinds of things we need to think about when constructing regulations and policies aimed at getting our financial markets back on track and encouraging them to operate efficiently. We can ignore incentives if we want, but then we shouldn’t expect to like the outcome.

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