I just finished a summer school course at Harvard University and sat for my final exam a few days ago. The course's name is "Organizations, Management Behavior, and Economics", and although the topic was broad, many interesting ideas came up. A question in the final exam asked us basically to think about agency issues in relation to the current subprime crisis. An answer to part of this question seemed quite interesting to post, hence...
In order to address moral hazard or agency issues in two of the proposed levels, a quick introduction to these situations is called for. In the first place, agency issues deal with the fact that there is a separation in the wishes of a person who wants an action done, and the person who actually carries it out. One type of agency problems can be seen as ex-ante information problems (hidden information), where one of the parties carrying out a transaction has more complete information about some part of the transaction and can thus bargain in his favor. The other party, fearing this, might not be willing to negotiate and make cause the transaction to not occur at all, or for there to be adverse selection. Moral hazard, in turn, deals with (ex-post) hidden action. Douma & Schreuder (2002, p. 60), while speaking about moral hazard, say, “[moral hazard] refers to actions that parties in a transaction may take after they have agreed to execute the transaction”. With this in mind, it is possible to identify such problems at some levels of the ongoing sub-prime crisis.
Regarding sub-prime borrowers, moral hazard is bound to happen. Even though there is a label on these borrowers clearly stating that the possibility of repayment on their mortgage loans is not an optimal one, these borrowers started receiving loans at an accelerated rate during the housing market boom in the early and mid 2000s. When these borrowers received their loans, they signed a contract that stated that they would pay back the loans. Some of these borrowers intended to buy a home for their families, others just wanted to get in the real estate game and earn some money once the price of the houses they had purchased started to rise. Moral hazard shows up when these borrowers, once they have received the loan to buy a house for their family, one that would supposedly be off the market due to the fact that someone was going to live there for (presumably) several years, instead bought homes in order to sell them later, eventually flooding the market with an excess supply of houses, pushing the price of their homes down, and thus making the value of other people’s houses fall as well. Moral hazard occurs when these borrowers decided to buy houses for speculation instead of buying them as their homes, as stated in their mortgage contracts. When prices ultimately fell, those people who actually used the money correctly started getting foreclosure letters in their mailboxes. So moral hazard did play a role in the ongoing crises, but this was boosted because loan officers, thanks to agency issues, allowed it to happen.
Loan officers are hired in order to make out loans. That is their job and that is what they are hired to do, and thus why they receive a paycheck. However, the owners of the organization that issues these loans is not only interested in making loans, but making loans that get paid back and thus bring about profits. There is thus an agency issue, where the loan officer is the agent and the owner of the financial (mortgage) organization are the principals. The problem arises because both parties here don’t have the same goals, and the agent does not have sufficient (or well designed) incentives in order to carry out the principal’s will. The loan officer gets paid to issue loans, and thus, during the housing boom, loans were issued to whoever wanted to get them. In addition to this, rising house prices somewhat helped in thinking that the loans would be paid back. This agency problem led loan officers to issue loans that would not be paid to people who were not actually going to spend their money on what they said they would. Both issues thus played and are playing a role in the ongoing subprime crisis.
Even though this topic has been talked about for quite some time now, it still seemed interesting. By the way, summer at Harvard has been amazing!
0 comments:
Post a Comment