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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Interesting that you humanize those people who have taken out loans they couldn't afford but de-humanize just about everyone who doesn't agree with Obama's (your) economic policy. Your compartmentalized way of thinking does not help sell your argument and in fact gives more credibility to those who oppose you.
Have you ever applied for a loan?
One has to wonder...
The job of the lender or his front man is to make sure you dont take out a loan thats too much for you to handle. You dont just say... I want that house, lend me 500K.
In that respect the potential buyer has to provide pay stubs, tax returns. W2s and bank statements
What happned was not that the borrowers lied.. because if you do the required legal deligence.
But because the mortgage and finanical institutions .. did not do the job they are leaglly required to do. They looked the other way in order to make a quick buck and pass the loan on to some one who thought they had done their job.
In other words financial institutions frauduently were qualifing people for the loans they received, that they could not have/should not have qualified for. W/O that happening, bad loans would have been rare!
Regards
Unfortunately, under Reagan deregulation of the banks and savings and loans, they did it "legally." I'm old. I remember when banks couldn't do mortgages. Oh my! And what a concept! The S&L that gave you the loan HELD it. Wow. What a concept. The people that loan you the money have to take (hold) responsibility for their actions.
"The job of the lender or his front man is to make sure you dont take out a loan thats too much for you to handle. " Not at all. The job of the lender is to make sure that the interest rate they give you makes them a profit. That's why different credit scores get different interest rates. It's all based on risk. If they don't do a good job, they go out of business (or at least should). Of course, if the secondary mortgage market wishes to bear the risk, it makes it less risky for lenders to give a loan and then sell it to this market.
The problem as to many of the 'conservatives' discussed in this article is that enough of them don't lose their personal assets when things turn bad. They have diversived their assets using their knowlege of business and move it at peaks to less risky investments or hid it in off-shore banks, or buried under layers of ownerships, also evading taxes. If the laws were redone so that those who set those risks would lose a lot of their personal assets and wealth if they make mistakes, not get paid if they take a company into a dive, have them lose their ability to get another decent job, then it might change things. They also must not forget the cycles of business, thinking they have 'beat' it. That is not realistic and also is part of such persons mentality.
A key point. The risks are in most cases externalized.
'Frankly, when you compare how America has responded to the 1973 oil shock and how Denmark has responded, we look pathetic.
“I have observed that in all other countries, including in America, people are complaining about how prices of [gasoline] are going up,” Denmark’s prime minister, Anders Fogh Rasmussen, told me. “The cure is not to reduce the price, but, on the contrary, to raise it even higher to break our addiction to oil. We are going to introduce a new tax reform in the direction of even higher taxation on energy and the revenue generated on that will be used to cut taxes on personal income — so we will improve incentives to work and improve incentives to save energy and develop renewable energy.”
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What an inane comparison. Denmark is a small country. They do not require a massive transportation system to move people and goods. Rising fuel cost are devastating the airline and interstate trucking system. It easy to say raise taxes on energy when you moving across Kansas, but 10 Kansas is a different ball game. Think sometime
I think it is going to be a painful, but inevitable transition. Is that enough thinking for you?
so we are going to continue forever to use imported oil to transport goods across Kansas in trucks?
the airlines have been having problems for years. They have made flying such an unpleasant experience that I don't have much sympathy for them.
Airlines charge to little for their tickets and are constantly either in bankruptcy or on the verge of it, and taxpayers are on the hook for supporting the infrastructure of this private enterprise. With few exceptions, air travel is a "want" and not a "need", and that industry should be left to its own devices like other businesses.
Interstate trucking should be devastated, and return to the vastly more efficient rail network that was left to decay in the interest of the oil, truck and tire industries. The truck should be taking the freight to the rail terminal, and the train should take it beyond Kansas. One guy moving one container at 6 mpg is incredibly wasteful and an inefficient use of resources.
Speaking of pathetic, picture Friedman on PBS telling the oil companies "they...ca
Golly, the world sure is flat isn't it?
It's the same old 'energy amnesia' . As soon as prices return to a semblence of normal, we have to have more powerful, HUGE, and shiny gas guzzlers to make up for whatever. I've seen this cycle through the 1970's ......and now. Smaller trucks and wagons are used a lot in European cities to deliver food and FRESHER foodstuffs
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