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The Price of Risk
Seems to me when you get right down to it, a lot of what's gone wrong in the economy, if not the country, stems from the failure of the market to accurately price risk. It sounds obscure, but if we don't get this right, we're looking at a shampoo economy -- bubble, bust, repeat -- for years to come. Not to mention environmental degradation and war.
What is 'the price of risk,' how did it get too cheap, and why is this such a problem? After all, cheap's good, right? Read on.
Buying insurance is a good way to think about these problems. When you purchase insurance, you pay a premium to insure you against some risk, whether it's getting sick or your house burning down. For the system to work, the price of the insurance must reflect both the likelihood that the event will occur and the cost of its occurrence.
If the premium is too low given these criteria, you don't have enough of an incentive to try to diminish the risk. Why be careful, when the cost of being careless is minimal?
Now think about the world of finance. Suppose you're lending me the money to buy a home. Presumably, you're pretty interested in my ability to pay you back, so you engage in some careful 'underwriting' -- learning as much as you can about my creditworthiness. If you think I'm a bad risk, no loan for me. If you think I'm probably okay, but you're a little nervous about that $1,000 I owe to Tony Soprano, you'll raise the rate of interest on the mortgage loan.
In other words, any signals that that the risk of repayment may be higher than you -- the lender -- like, should translate into a higher price of risk, in this case through the terms of the mortgage (higher down payment, higher interest rate).
Of course, false signals can raise the opposite problem. If a discriminatory lender believes that people from neighborhood X are credit risks, she will raise the price of borrowing too high and unfairly block creditworthy X-dwellers from opportunities they need and deserve. That's illegal, but it happens all the time.
That's an old problem. Our new problem is that risk has been under-priced, leading all kinds of people to get in over their heads. I'm not saying such people are blameless. But it's human nature to trust the price system, including the part that prices risk. Those folks who shouldn't have taken on sub-prime, no-doc, low-loc, NINJA (no income, job, or assets) loans, believed lenders who said they could afford them.
And they could have, if their home prices kept defying gravity, which any sensible risk-assessor could have told them wasn't going to happen. But that was only one thing that jammed the risk-pricing signal.
Another was the fact that lenders increased their distance from borrowers. You'd also be a lot less prone to worry about my ability to service my loan if you could turn around and sell that debt to someone else. Of course, that 'someone else' might still worry about the health of the loan, but if the bad one is chopped up, mixed in, and sold with good ones -- which is exactly what happened with so-called mortgage-backed securities -- debt holders down the line couldn't price risk accurately either.
So far, we've identified two suspects in the mystery of why risk was under-priced: financial "innovation" and bubble mentality.
But there's much more. The recent case of Fannie Mae and Freddie Mac shows what happens when institutions have the implicit backing of the government (that's us, btw), i.e., they're too big to fail. In this case, the good folks at Fan and Fred will under-price the risks in the loans they're taking on because they know that if the loans fail, the taxpayer will step in and make up the difference. So, why worry? Bear Stearns, too.
Why is this a problem? Well, there are millions of people who are now losing their homes who would be happy to answer that question for you, but as I've written in this space before, bubbles, born of under-priced risk, are terribly damaging, much more so than economists typically admit. The last two recessions were brought to us through bursting bubbles (housing, today; IT in 2001; some would add banking in the 1990-91 downturn), and self-inflicted recessions are really something we want to avoid.
That's all pretty obvious stuff, at least with hindsight (you want to go deeper into the mortgage meltdown, read Mark Zandi's crystal clear explanation in his new book, the royalties of which go to an investment fund for disadvantage areas--you go, Mark!). But once you start worrying about this problem of inadequate risk-pricing you see it in a lot of scary places.
The most important is also the least well-recognized: the environment. Obviously, it's widely known that we've got an existential challenge on our hands, but it's too rarely tied to under-pricing the risk of environmental degradation. Because our risk horizons are short, and we're very price sensitive in this country -- the whole damn election seems to be reduced to the price of a tank of gas--the real price of much of our economic activity fails to reflect the damage to the planet. This isn't surprising, because the damage is now most evident in faraway places (see Artic Circle) or down the road a number of years. But if prices truly reflected the present value of these future "costs" -- if the prices were accurate from the perspective of environmental risk -- a lot of stuff would cost a lot more than it does.
Gas at the pump provides a timely example. Economic realities, leavened with some speculation, are pushing up the price and sending us a signal to do the right thing: conserve and look for alternatives. From my perspective (and from Al Gore's too, I'd say), the current price of fossil fuels is more in line with the risks that using evermore of it poses to our environment. And what are we doing? Begging the oil companies to quickly poke more holes in the ground and lambasting the politicians who have the spine to stand up against this knee-jerk reaction. We want our risk under-priced and we want it now!
Please don't get me wrong. Much of my economics career has been devoted to analyzing the squeeze on middle- and low-income families, and I absolutely recognize the conflict between higher prices on goods which comprise a disproportionate share of their budgets and the need for these goods to accurately reflect the risks they engender. That's why we need progressive solutions, such as taxes on carbon with rebates to those with lower incomes, and aggressive pursuit of alternatives.
A word on politics and then I'll stop. Obama gets all of the above (full disclosure: I'm an informal advisor to the campaign). I know he's adjusted his position on drilling, but he's got to be pragmatic right now. If he fails to get elected, we won't have any chance of correcting the epidemic of risk under-pricing, whether it's in financial markets or energy. Especially on the latter, and even more especially compared to McCain, he plots a regime-changing path that we can't afford not to take.
Remember, "conservative" used to mean risk-averse. Now it means "risk be damned, I want my oil, my house, my risky financial instruments, and my government bailout when they fail." You can even see where they under-priced the risk of their war in Iraq, with that nonsense of how we'd be embraced as liberators.
Enough, already. We've got a chance to show these greedy, short-sighted, risk mongers the door. Let's be sure to take advantage of it.
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Machiavelli had a saying. "When their is blood on the streets, buy land."
This economy is a fire-sale for the benefit of the rich.
Conservative were always able to keep their morals and ethics till Bush became a conservative.
Bwahahahahahahahahahahahahahahahahahaha.
Oh God. Stop it. Please. You're killing me.
Bwahahahahahahahahahahahahahahahahahaha.
Until Bush. Oh God. Oh no. Stop. Please.
Bwahahahahahahahahahahahahahahahahahaha.
Nixon. Raygun. Goldwater. Bush is just the icing on the cake.
Regarding global warming and the risks:
If the global warming deniers are wrong and we do nothing, we risk losing a habitable planet.
If the environmentalists are wrong and we do something, we will have -- perish the thought -- wasted some money.
Do we want to accept the risk of doing nothing?
what i find intriguing is that the housing bill makes it voluntary for the lender to agree to re-structure loans for borrowers who meet quite rigid criteria. The idea is that lenders would be willing to take 90% of current value to avoid losiing more to foreclosure. However, this idea does not seem to be having the desired impact as lenders seem reluctant to do so. There must be something I don't know that is discouraging lenders from getting out of bad loans. I would suspect it has something to do with tax write-offs. The lender takes the foreclosed home and sells it for whatever the market will bear and then writes off the amount the home would be worth if sold for its appraised value. There is some gimmick at work. The bill itself is fishy, How many laws are written that make discretionary decision-making part of the bill. I hope someone much brighter than I can explain why a lender would choose to take less from a home sale than could be obtained by transferring that mortgage to FHA. Is something smelling bad or am I standing next to a fish market?
Californiadreamer,
In your state (and mine), lenders already have this option and take it quite often. It's called a short sale. Maybe some states don't allow this. The question is why does the federal have to be involved at all. Do they believe they are more intelligent than our state legislators? Maybe it's because they did such a good job with Freddie Mac and Fannie Mae? I'm sure glad they're around to save us from ourselves.
There's no risk involved when the wall street boys and financial institutions essentially own the government because they bribe the politicians either to pass laws allowing them to loot the country, or to avoid paying taxes. The current problems in our economy don't lend themselves to a traditional market analysis because there's no economic principles involved. Instead, we simply have a bunch of con men looting the country and sending all the money to secret accounts overseas. That's not economics -- it's called pillaging, if anything.
There was no "risk" that many borrowers would not be able to make payments when interest went up, or that property might decline in value and people with 100% financing would be underwater. That wasn't a risk, it was guaranteed. The key was to sell the loans before the truth came out. It's like the Music Man: the key was to get out of town before the day of the "big parade," when the public would discover they had bought non-existent musical instruments from a con man.
We don't need a market correction. We need all the financial leaders -- wall street, main street -- in prison, along with the politicians who have accepted bribes to keep their mouths shut while this robbery was being carried out. Then we need to start over.
Thanks for laying it all out so nicely. The mortgage crisis is nothing more than a pyramid scheme backed by the U.S. Government. Shameful all around.
Conservatives don't want a "government bailout when they fail." How much mortgage investment was made - not as a primary residence - but as a speculative investment based on a housing bubble? There is certainly no bailout warranted, and I would expect none to be given. Sounds more like Uncle Sammy trying to shore up a market (which is dumb).
Your idea of taxing carbon and giving the dough to the poor as 'rebates' is ridiculous on its face. Why not open up a boatload of jobs in the domestic oil industry? We'd add jobs in construction, manufacturing, engineering, distribution, clerical, etc. How about nuclear? Why not build nuclear to eliminate the use of fuel oil - and commit that production back to be burned in diesel engines? Again, construction, distribution, maintenance jobs, and increased supply in fuel to drop prices. Simply put, there is no more efficient fuel for long-distance transport than petroleum, and there won't be in the near future.
Now put on your socialist hat for a bit - if you really want to crack the nut of energy usage, mandate a MAXIMUM single-family house size. Here in the midwest, we have numbskull local governments dictating a MINIMUM home size to shore up their tax base. There's no reason for a family of 4 to need over 3,000 square feet of living area, let alone Fat Albert's 10,000+
Jared, I sincerely hope that you and Robert Reich become permanent economic advisers within the Obama administration. We the people need trusted voices to speak on our behalf, as opposed to the corp elite former Goldman Sachs CEO's of the past that got us into this mess with their support of Reagonomics/Rubinomics, which gave us the deregulation of the financial (Rubin), telecommunucations and off shore manufacturing with no domestic protections (NAFTA). Not to mention tax reudctions for the wealthy, while the middle and poor pay the majority of national revenue that pay the incomes of those in government. The corporate power of money has corrupted our country at the expense of the majority of people who now will never know the meaning of wealth in their lifetime. The corruption and greed in our country and world is deep and needs to be addressed by someone who holds high moral character and integrity.
A major problem for Obama is that his economic advisors are neo-Friedmanites Goolsbee and Furman. Rubin also has an advisory capacity. And while I like Reich for a lot of reasons, he is an unrepentent globalist - advocating increased social safety nets which are needed but only a band aid solution to the deeper structural causes of our economic woes.
The democratic platform is only marginally better for working people than thr republicans, especially in regards to trade and the economy
It is through the allocation of risks that businesses gain windfall profits. Consider the risk of a factory putting polutants into the air or water. It is the public that bears the risk and the businesses scream if you try to regulate their practice or hold them responsible for the effects of their activity.
Media making excuses for the robber barons.
Afterall, who do you think pays the medias salary?
Corporate robbery.
Very good article sir, and right to the point. I am curious, deos anybody know what the % of royalties in drilling offshore goes to the state? I know in Africa they only pay 10% and have very little environmental worries, so why would they drill in the U.S if they can do it cheaper in Africa. That is the stupidity of the whole offshore argument, the other thing to note is how do you tell a private company who to sell its oil to.
Agreed Kalimuzo! It needs to be said over and over and over again! The oil they drill, our oil, off the coast of our country, will not be sold solely to the US. It will be sold to the highest bidder on the world economy, ie. China, India, etc. And the rich will get richer! Good old "supply side" Reganomics.
Funny how this bit of info is continuously left out of the discussion by the MSM!
It needs to be repeated it every time the issue is brought up!!! Who gets the oil? Who gets the oil? WHO GETS THE OIL? Maybe then people would realize this is just a land grab while one of their boys is still in power.
They whine about taxes, they whine about being picked on, but when it comes time to do what's right for your country, they're MIA. If this problem is so devastating that the only fix is offshore drilling, then why would they not sell OUR oil to US citizens only? Could it be that they're the unpatriotic ones?
Exactly, and although the article is informative it does give Obama an out when it comes to his reversal on off-shore drilling. This is disingenous since as you mention any oil produced in the US ends up on the world market, not guaranteed to the US, and the impact on the market non-existent. WE NEED HONEST DIAGLOGUE ON ENERGY--NOT ANOTHER CANDIDATE SPEAKING DOUBLE-TALK. Obama already letting us down.
Risk has no price when you have socialized it, and pocketed the loot while dumping the costs onto the poor and middle class. That's what fascism is all about.
So true :( How did we get here?
too many rubes voting for flag pins or for the guy they'd like to have a beer with...
"stems from the failure of the market to accurately price risk"?
When "greed" is labeled "a failure to accurately price risk", and scams with acronyms like "SIV" abound, it is a sure sign that the prisoners are running the jail.
Said the prisoner: "I did not strangle my wife, your honor; I merely showed her how to conserve her energy by avoiding the exertion of breathing.".
there are a number of risks that the market will not consider unless the government places the costs on the source of the risk- i.e. the business activity.
Well written, witty and apt.
Great post, but it leaves out an important issue. I watched a PBS program on the effects of credit to the poor. A car dealer would sell cars to people with low income and credit scores with no down payment. Of course the buyer would get a horrendous interest rate. Very often the payments were higher than what was sustainable. The poor person loses the car and any payments that have been made. While I benifit from this system (low interest because of a great credit score) I don't understand how this is sustainable and fair. I get a car loan for 8.25 % because I can afford the car, and someone just sqeaking by has to pay 28%? I just don't get it. The same goes for mortgages. Has our banking system gone predatory? Where is the moreal compass?
It's pretty easy to understand. Would you be willing to lend the money to the low income/credit borrower at the same rate as a great income/candidate?
There's a limited amount of money that anybody has available for lending. Before giving it to a more risky borrower, the lender wants to make sure it's worth his while (that is, that he's being compensated for the higher likelihood of never seeing that money again).
The government-backed "bailout" did not exactly provide a soft landing for Bear-Stearns investors. I seem to recall that they are going to get about 10 cents on the dollar. And I expect the BS executives probably took a hit to their reputations and probably had to find new jobs (though maybe they had golden-parachutes or enough previously ill-gotten gains to not care?).
Your point about short-term vs. long-term is right on, though. One of the worst aspects of capitalism is its tendency to make decisions based on a very short-term outlook. The only way to prevent this from institutionalizing boom-and-bust economics is for the government to provide regulation and incentives to encourage the decision-makers to factor the longer-term needs of the nation into their decisions.
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