Why banks are self-defeating on housing

By Felix Salmon
June 30, 2010
Cynic has a spectacularly good comment which is worth elevating to a blog entry of its own:

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Why are banks so bad at short sales, even when such things are clearly in the banks’ interest? Cynic has a spectacularly good comment which is worth elevating to a blog entry of its own:

It’s tempting to lay the blame on servicers’ lack of incentive to process these short-sales speedily. Or to suspect that banks aren’t eager to speed the process, because they’d like to wait to recognize the losses until their balance sheets are a little more robust, even if that ends up costing them more in the long run. And those are real problems, but they’re not the whole picture.

The bigger problem here is Milton Friedman. There is an absolute refusal to recognize the possibility that, for a variety of reasons, the lenders will not act in their own best interests unless forced to do so. That runs directly contrary to the axiomatic tenets of neoclassical economics – surely sophisticated businesses will always pursue their own economic self-interests, and have the ability to discern it.

But, alas, not. Banks are also bureaucracies; Weber is as relevant as Friedman. Speeding this process would involve massive hiring. Since there aren’t enough qualified people – short-sales used to be comparatively uncommon – that means that there will be a substantial lag as staff is trained. Moreover, banks are both loath to hire staff for what they perceive to be a short-term problem, and reluctant to expand payroll at this moment in time. And it goes beyond hiring. Few banks view restructuring, short-selling, or foreclosure processing as core to their missions. These are unglamorous areas of the bank. The executives in charge rank low on the totem poll, and are poorly positioned to press for the necessary changes. Finally, there’s outright denial. Executives are never interested in recognizing their own failures. That’s painful. They’d rather avert their eyes, even if that proves costly. Every short-sale is an admission of error, and forces the bank to pay the piper. No one is going to make a performance-related bonus for completing transactions faster that cost the bank huge amounts of money – even though that’s precisely the sort of performance that the bank ought to reward, because it results in long-term relative savings.

This is precisely where regulatory pressure is most useful – in compelling businesses to do things that are in everyone’s interest that they might not otherwise be willing to do themselves. But admitting that a free market might not produce such an outcome is simply too painful for leading economic policy makers, let along Congressional Republicans. And so we watch.

Dan Ariely loves to talk about how as individuals we’re incredibly bad at doing things which involve short-term pain for long-term gain: going on a diet, or quitting smoking, or reducing carbon emissions. He even has a great first-person story about this, dating to a time when he was diagnosed with hepatitis C:

The initial protocol called for self-injections of interferon three times a week. The doctors advised me that after each injection I would experience flu-like symptoms, including fever, nausea, headaches and vomiting. But I was determined to kick the disease, so every Monday, Wednesday, and Friday evening for 18 months I plunged the needle deep into my thigh. About an hour later the nausea, shivering and headache would set in.

Every injection day was miserable. I had to face giving myself a shot followed by a 16-hour bout of sickness in the hope that the treatment would cure me in the long run. I had to endure what psychologists call a “negative immediate effect” for the sake of a “positive long-term effect”.

At the end of the 18-month trial, the doctors told me that the treatment was successful and that I was the only patient in the protocol who had always taken the interferon on schedule.

Bank executives, it’s worth remembering, are human. Every time you do a short sale, you take a substantial loss on your loan. And no one likes doing that: it’s painful. So it’s understandable, from a psychological perspective, that they will drag out the process as much as possible, putting off until tomorrow the pain they know has to come at some point. They might even prefer a foreclosure to a short sale, on the grounds that it’s theoretically possible that they’ll end up getting more money for the house in the end, even though they know that in aggregate the bank’s losses on foreclosures are always going to be bigger than its losses on short sales.

Can the government do anything to nudge banks in the right direction, here, to the benefit of all concerned? And if so, what? Intuitively I find it hard to believe that extra layers of regulation are going to be able to improve anything. And Cynic’s points about the lack of qualified staff, and the existing staff’s lack of status within the bank, are well taken. These are deeply ingrained problems, which don’t have easy solutions. Which in turn is yet another reason to be bearish on the housing market over the medium term.


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