University of Chicago on Credit crisis II

As I said, the crisis can be broken into four parts, origins, Liquidity crisis, incentives and the policy responses. The first two were covered here.

Incentives

Creating liquidity in the otherwise illiquid subprime mortgage market, an otherwise noble goal, created perverse incentives for the lenders. Amit Seru, Professor at the University of Chicago did a research on the both the number of loans originated and the default rate around the FICO score of 620. FICO measures the credit worthiness of individual borrowers and a score of 620 and above is considered eligible for guarentee by Fannie/Freddie. An analysis of the origination of loans around 615-619 and about 620-624 showed a sharp spike in loan origination at around 620.

Since the lenders were eager to get the borrowers at that threshold, this jump could probably be explained. But what is more interesting is that the probability of default against the FICO scores. Normally it should have a negative slope- higher the score, lower the probability. What the results showed was that there was a jump in default at a score of 620, implying the lender did not do the due diligence because he knows that for scores above the threshold, the loans can be securitized and sold off. It could also mean that the borrowers know the threshold themselves and cheat their way to get just above 620 to qualify for a loan.

Assuming the second reason, while plausible but hard to detect, is not a major factor, it is safe to conclude that ceteris paribas (loan contract terms especially remaining the same), the incentives play an important part in due diligence.

Fiscal response to the crisis

Anil Kashyap, the delightfully articulate economist (Have you read this?) is an expert on Japan. He makes a convincing case for things to avoid in a response to the crisis which has an eerie similarity to the present one (Or for that matter, most crisis have the same cause- falling house prices- When would people learn that anything that rises can fall?) Japan is famous for its lost decade because the government failed to recapitalize the Banking system for a long time. The Government initiailly tried to deny the problem. They tried to hide the bad assets by creative accounting rules - Banks were allowed to chose which ones to carry at market values and which ones at book values!! In November 1997, when multiple large institutions failed (sounds like deja vu) the government got involved in half hearted recapitalization (The amount desired by the strongest bank was given to all banks as part of recapitalization)

These attempts shows valuable lessons for the current crisis. The strong banks are likely to ask the government to buzz off when offered capital, fearing Equity dilution of the existing shareholders. But it is advisable to recapitalize strong banks (or even encourage private funding). Its critical to stop dividend payments by the newly recapitalized banks, which are frankly money laundering of tax payer money. Better still, stop dividend payments done by all banks, strong and weak for 3 years, in order to nullify signalling effects associated with dividends.

The site is new but its well worth the read.