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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20 comments so far

Yes these banks are giant bureaucracies. But lets remember that the incompetent were not permitted to fail. Instead, too big to fail became the law of the land.

This mortgage paper should be in stronger, more competent hands by now. That is how capitalism was supposed to work unimpeded.

These giant zombie banks have become quasi-government bureaucracies. Fannie and Freddie have long been so.

And that is Milton Friedman’s fault?

Posted by DanHess | Report as abusive

If the banks had been allowed to go into bankruptcy as classical economics would have dictated, their mortgage divisions would have been sold off and in turn the mortgage paper would have quickly been further sold to thousands of hungry entreprenuers.

Many ambitious small businesses would have done a much better job minimizing losses on these assets.

What is the other part of the Friedmanite solution? Rather than this foolish extend and pretend, have massive money printing just as needed to counteract the deflationary force of the credit crash. The money printing would go to the people, not to the banks. This part of the solution would actually help turn some of the bad assets good again.

Posted by DanHess | Report as abusive

This is a good example of a very common effect (bug?) of the efficient markets hypothesis.

And that is the belief in an mathematical abstraction (profits maximization under a condition of market efficiency) at the expense of wisdom, psychological insight, analysis of social context, and all the rest.

The efficient markets hypothesis should be credited with putting policy stupidity on steroids, precisely because it had the effect of discarding social intelligence.

It is true you can’t quantify wisdom. Get over it. This was once known as growing up.

Posted by nyet | Report as abusive

I can’t believe that the vast majority of skills involved in short selling requires much more than a good checklist. Otherwise I think Cynic is spot on.

Dan’s also right here; perhaps failure would have been the less painful option in the long run. We knew that, but were afraid that the failure would have been systemic, rather than localized.

Posted by Curmudgeon | Report as abusive

That’s the thing about bureaucracies – you’re not supposed to understand how they work unless you’re one of those handpicked to be told the truth to.

Those who fully understand how to squeeze billions out of the government then conveniently conceal the money in bureaucracies of their own aren’t geniuses, they’re guys with privileged insight running little empires of their own. If they can’t be held accountable, one might reasonably suspect them of having a license to steal.

After seeing how little they propose to keep doing in return for all the public favors bestowed upon them, you’d be forgiven for thinking our government ought to be nudging most major banks in the direction of the door marked “Exit From The Banking Industry”.

Of course that sort of nudging would require a different government from the one we have now. Like, one that actually works instead of just manning the ramparts of bureaucracy.

Posted by HBC | Report as abusive

Perhaps Milton Friedman is wrong.
On the other hand, how many regulatory institutions oversaw Freddie and Fannie? Did they do a good job?
And doesn’t the Fed regulate banks? And did they do a good job?
One of the main differences that there used to be between government and the private sector, was failure.
Maybe businesses failed due to circumstances beyond their control, or because of bad luck, or even unjustly, but failure allowed for other ideas, business plans, or philosophies to be tried. Now we are stuck with TBTF. Why do we think the idiots who got us into this will perform better in the future?

Posted by fresnodan | Report as abusive

When I read Cynic’s comment yesterday, I thought it was perfect – I couldn’t possibly add anything to it without seeming churlish. But now that you have marked it for special distinction, I would like to say that I don’t think it does enough to identify the agency problems behind the perverse behavior of bank executives. “Executives are never interested in recognizing their own failures. That’s painful.” Yes, but the pain arises not only from wounded vanity but from damaged career prospects.

The gist of comments posted so far is that if only the government had not interfered by supporting failing banks, then everything would be fine: in effect, that we have too much regulation rather than too little. These commentators are deluding themselves, for two reasons. First, the prospect of corporate ruin does not in fact constrain executive behavior. We know this empirically from many examples – Bear is merely the most lurid. It has also been demonstrated theoretically by various academics. It is important to understand that the people who blew up Bear made the correct decision from their own wealth-maximizing perspective, but most people grasp this point. The value of the academic work is that it demonstrates this behavior is also in the interests of shareholders – something that is much less widely appreciated. There are consequently no market forces operating to restrict banks.

The second problem is that there is no credible alternative to intervention in a systemic financial crisis. In my opinion, it would have been better to “nationalize” the banks (fire top management, set equity values to zero, deep haircuts on long-term debt), but the fundamental choices are intervention, at vast public cost, or non-intervention, at vastly greater public cost.

There really is no useful alternative to government regulation. Yes, government bureaucrats have their own agency malincentives – everyone understands that. But it is possible to structure regulators such that their agency problems are not aligned with those of the regulated. In that case, inefficiencies merely add, instead of multiplying catastrophically.

Posted by Greycap | Report as abusive

GreyCap wrote: “there is no credible alternative to intervention in a systemic financial crisis. In my opinion, it would have been better to “nationalize” the banks (fire top management, set equity values to zero, deep haircuts on long-term debt), but the fundamental choices are intervention, at vast public cost, or non-intervention, at vastly greater public cost.”

TRUE. But in the backdrop that the Financial Institutions have NOT been Nationalized, the analysis presented in this article is, in my opinion, On Dot. Banks will keep dragging there feet on foreclosures and Short Sales unless compelled to do so.

Posted by ECircuit | Report as abusive

One thing of which you may be certain is that the banks aren’t self-defeating. If they were, they’d have openly admitted to never having actually had the money they paper-loaned out to suckers to buy houses that weren’t worth that much to begin with.

The government in the form of Fannie Mae is now lining up to buy those inflated properties off the banks for all the money the banks didn’t actually pay in the first place, and still couldn’t if held to account for their deeds.

No matter who else goes down in the drawn-out process of paper shuffling and unreturned phonecalls surrounding this de facto Bailout Part Two, it’s guaranteed not to result in defeat of the banks. Yes it should, though.

Posted by HBC | Report as abusive

“but the fundamental choices are intervention, at vast public cost, or non-intervention, at vastly greater public cost.”

I keep seeing this statement repeated, beginning from the push for TARP in Fall 2008 to current. And it is probably true. But has there been any real estimation or description of the havoc that is presumed to have occurred? Estimates of the counterfactual in dollars, or detailed descriptions of knock-on effects? Something more that a mere assertion that is the case?

What would have happened if Bear wasn’t handled to JP Morgan with a Fed sweetener, or if AIG had gone down, or Citi was ‘pre-privatized’ as Greycap laid out (equity=0, bonds=50%, etc)?

If the supposed effects are systemic and cascading bank failures due to capital inadequacy, could regulatory forbearance have stopped that effect, and would that solution been better than what we got? What might have happened, how could THAT have been handled different that what we did?

Where is the analysis that “what we have sucks, but my oh my it was otherwise going to be so bad?” I’ve done financial damage quantification in litigation, and did ‘but-for’ analyses all the time, so my question to anyone about Greycap’s assertion – prove it :)

Posted by SteveHamlin | Report as abusive

Thanks for highlighting that, Felix. You ask whether “the government [can] do anything to nudge banks in the right direction, here, to the benefit of all concerned,” and note your own skepticism that “extra layers of regulation are going to be able to improve anything.”

Those are good points. What I’d say, in response, is that I advocated greater regulatory pressure, not necessarily extra layers of regulation. The point, simply, is that if we take seriously the insights of behavioral economics into the difficulty of accepting short-term pain even if it brings long-term benefits (and I’m glad you brought Ariely into the discussion) then one solution is to ratchet up the short-term pain, so that dealing with the problem at hand becomes the more attractive of the two options.

One widely bandied-about proposal to do that is bankruptcy reform – give judges the power to restructure loans, and banks may well discover the virtues of speedy short-sales. There are others. But the key, I think, lies in avoiding “extra layers of regulation.” We don’t need a new agency, or new unit within an existing one, to micromanage the restructuring process. We simply need to change the present calculus, so that even in the short-term, resolving these loans becomes less painful than the alternative.

I’m reminded (on a tangent) of Carnegie’s case for a truly confiscatory estate tax. He didn’t want the government to end up with all his money; he wanted to provide a stark an unappealing alternative, to incentivize his fellow moguls to allocate it charitably on their own. Carnegie believed that it was in their interest to do so, that they were best equipped to do so, and that absent an external stimulus, they were unlikely to do so. That’s a good formulation. Government often works most effectively by resetting the default option, and in the process, making decisions that are painful in the short-term but appealing in the long-term, relatively more appealing in the short-term as well.

Posted by Cynic | Report as abusive

So, banks are either purposefully acting in a way that has a malicious effect on homeowners, or are incompetent in managing their businesses?

Neither inspires much confidence, particularly as they move to water down financial regulation and codify “too big to fail” as a legitimate business model.

Posted by HotPanini | Report as abusive

Hm. I like the idea of allowing judges to modify mortgages in bankruptcy, but I’m not sure that would solve this problem. One aspect of the present system that I do like is that you can be insolvent, when you’re underwater on your house, but still not have to declare bankruptcy.

Posted by FelixSalmon | Report as abusive

You and I may both like the idea of allowing judges to modify mortgages in bankruptcy, but bankers loathe it. Their hate, in fact, is out of all proportion with its potential economic impact. As a behavioral economist might point out, most people are so outraged at the notion that a partner in a transaction will get away with something, that they’re willing to sacrifice their own self-interest, to a degree, in order to stop them. Bankers are no different. Part of what restrains them from restructuring mortgages is the sense that their clients don’t deserve a break; that clients assumed risks that they are no longer prepared to shoulder and are offloading them back onto the banks; or, to put it crudely, that their clients deserve to suffer. When I talk to bankers, I get precisely that sense of moral indignation on the issue – and it’s clearly present right here in your comments section, as well.

That’s why I think judicial modification may prove disproportionately effective. Bankers really, really don’t want to have a judge write down the value of a mortgage. It’s the principle, not just the principal, to coin a phrase. Faced with the prospect of borrowers going to court to force modifications on them involuntarily, I think many banks will reconsider the merits of their own short-sales, principal write-downs, and other proactive solutions. Either outcome may ultimately be in their longterm self-interest, but we likely need the prospect of external intervention to force internal reform.

And I’d note that this still wouldn’t require borrowers who are underwater on their loans and thus insolvent to declare bankruptcy. It’s a painful, humiliating process, and most people avoid it even when filing is in their economic interest. I wouldn’t expect that to change. They can stick it out; they can walk away; or they can file. The choice remains their own.

Posted by Cynic | Report as abusive

Just so we’re all on the same page here: banks already *are* in the habit of writing down troubled equity values. They do it for so-called mortgage relief financiers all the time, otherwise none of those shyster punks could make a living at what they do. Despicable as it is, this back-room deal’s done daily.

But with few exceptions, banks do not offer the same breaks to Aunt Fannie or to borrowers who would like a shot at making a go of things directly with their bank. That’s from whence the worst of the un-fumigable fish market aroma’s now emanating.

You can lead a bank to justice but you’ll never make it think it’ll get caught.

Posted by HBC | Report as abusive

“. . . clients assumed risks that they are no longer prepared to shoulder and are offloading them back onto the banks . . .”

Cynic, I would agree with you, except that bankers don’t seem to have nearly as big a problem with it when it’s a large commercial borrower. I think ultimately it might come down to the fact that if I owe $1000, the bank is in control; if I owe $100,000,000, I’m in control.

Posted by Curmudgeon | Report as abusive

curmudgeon: Banks negotiate with commercial borrowers because they can get equity interests by doing so, because both parties know what claims and assets are worth, and if they don’t negotiate the commercial borrowers will go into bankruptcy court and possibly cram them down to an even lower level with higher legal expenses an waste of time. Homeowners are not generally interested in giving the bank an equity interest in their future earning power or admitting quickly that they have no equity in the house, and since mortgages are one of the easiest forms of secured claim to prove, banks would rather foreclose, request a lift stay if the homeowner enters bankruptcy, and recover the full value of the collateral than negotiate with an unsophisticated party.

DanHess: You’re exactly right. Say what you will about the private sector, if you have a bunch of assets that aren’t worth what they used to be worth but are still worth something and you need to liquidate them for cash to repay debt, there are plenty of guys with an entrepreneurial bent who will knock each other over to make tiny guaranteed margins on labor-intensive deals. For anyone who doubts, go look at how many guys in bad suits show up to a foreclosure sale with cash in their pockets, or how accurate the pricing is on eBay for goods worth $50-$100. Rarely do you get something truly worth $70 for only $60, because there are capitalists who love trading too much to permit you to get that opportunity. On a large scale we have lots of agency problems, fraud problems, bureaucratic problems, etc. On the scale of dealing with a small pile of specific mortgages, there are plenty of people who want to put up their own cash to fix enormously complicated situations so long as they reasonably forsee making 15-20% on their equity. The problem is that government-backed zombie banks will happily continue to pay useless employees huge sums to deal with these problems poorly in exchange for RoEs in the -5 to +5% range, blocking entrepreneurial capitalists.

Posted by najdorf | Report as abusive

You know, I shifted my return thinking there. Really there are two types of entrepreneur – those who want to make fast near-guaranteed slim margins on a high volume of transactions (buy the house out of foreclosure with cash, clean the trash out of it, and flip it to the first buyer who can get approved for a mortgage) and those who want to make 15-20% on longer-term, more targeted equity in exchange for risk and hard work (buy properties in troubled neighborhoods and rehab them, hold out for top resale price ideally based on neighborhood and market turnarounds). Both can do a better job than banks at working out distressed mortgages, because they’re not anchored to the old price and they’re doing what they like to do instead of what they hate to do.

Posted by najdorf | Report as abusive

It’s amazing how very few people at the top have been fired over this entire mess, both in private and public sectors. Which bailed-out banks’ high level executives lost their job? None that I know of. Same with regulatory agencies, except the prerequisite transition of administrations after the 2008 election.

My point is, if the bankers who made those terrible bets on mortgage backed securities were fired, new executives would have no problem cleaning up the mess someone else before them created and call it their own success.

That leads to my other point, the whole effort of propping up weak banks didn’t just create moral hazard, it created enormous economic hazard as well, and both will last for a long, long time. It’s probably the worst, dumbest thing this President, whom I respect enormously, has done since taking office.

Economics and finance is not hard science, ‘experts’ have been proven wrong time and again. That doesn’t mean we shouldn’t give financial expects and economists a fair hearing; but common sense should always, always trump ‘expert opinion’.

My common sense take-away from the Great Recession is this:

1. TBTF entities are simply too big to exist. If we can’t force them to break up, we should make it economically unprofitable to get or remain so big (make it a % of GDP).

2. Nobody should be allowed to bet money they don’t have. If hedge funds or whoever want to bet on things, they should be required to keep reasonable ratio of collateral vs. bets; so that if worst case scenario does happen, they have enough reserve to pay out. (Think casinos.)

If financial reform bills (assuming this is an on-going effort) do not achieve these basic goals, we would have failed.

Posted by jian1312 | Report as abusive

I invest in pre-foreclosure houses via short sales and some banks are better at the big picture than others. I just had an offer turned down last month by a Suntrust Bank Short Sale Negotiator. The loan had PMI (25% coverage). The bank determined through a BPO (broker price opinion) that the property was worth $90,000 and had a loan exposure of $104,000. The house has been on the market since Jan.2010 at a range from $98k down to $93k, and my 70,000 net,net offer has been the only serious offer in 6 months. So if they accepted it, they would only be out $8,000 at the end of the day, yet they prefer to take their chances with a foreclosure, incur holding costs, maintenance, winterization, risk vandalism & theft, plus attorneys fee’s and court costs. All the metrics I’ve reviewed point to a short sale as the least risky solution for all parties. Their decision is going to cost them alot more in the long run.

Posted by RDJ511 | Report as abusive
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