Can we blame Wednesday's stock market plunge on human neuroanatomy? Specifically, are we wired to be suckers for subprime loans? Just such a hypothesis is suggested by Jonah Lehrer at the Frontal Cortex blog. (Thanks to Boing Boing for the tip.) Lehrer believes that neuroeconomics research demonstrating the physical roots of short term instant gratification helps explain why would-be homeowners are lured into mortgages that promise a couple of years of low payments before socking them with fat hikes in monthly payments that they can't afford.
The best evidence for this idea comes from the lab of Jonathan Cohen. Cohen's clever experiment went like this: he stuck people in an fMRI machine and made them decide between a small Amazon gift certificate that they could have right away, or a larger gift certificate that they'd receive in 2 to 4 weeks. Contrary to rational models of decision-making, the two options activated very different neural systems. When subjects contemplated gift certificates in the distant future, brain areas associated with rational planning (the Promethean circuits of the prefrontal cortex) were more active. These cortical regions urge us to be patient, to wait a few extra weeks for the bigger gift certificate.
On the other hand, when subjects started thinking about getting a gift certificate right away, brain areas associated with emotion - like the midbrain dopamine system and NAcc -- were turned on. These are the cells that tell us to take out a mortgage we can't afford, or run up credit card debt when we should be saving for retirement. They are our impulsive pleasure seekers, the hedonists inside our head.
The insight that human beings are often imprudent pleasure-seekers, while not exactly earth-shaking, might explain some borrower behavior. But not all! Another reason that Americans charged into no-money-down, option-ARM mortgages is that they never thought they'd get stuck with the bill. Since home prices seemed on a never-ending upward climb, many borrowers explicitly planned to refinance or sell their house and get into a new mortgage before the end of the initial two or three-year period of low payments. And as long as the housing boom rolled merrily along, they could get away with it.
But then the wheels came off. In many markets, home prices have stopped appreciating, or have begun to fall. So people are stuck. This is not a law of neuroeconomics; it's the law of what goes up, must come down.
However, given the neurochemically induced human propensity to engage in harmful behavior, how much worse does it get when lenders have a financial incentive to encourage borrowers to do stupid things?
We are often told that the explosion of derivatives trading in the past decade has dispersed risk so widely through the financial community that it has contributed to greater system stability on the whole. But how often do we hear that the increased security for banks and other institutions comes at the expense of individual financial safety?
It is testament to how fast markets are moving right now that "Money for Nothing and Checks for Free: Recent Developments in U.S. Subprime Mortgage Markets," an International Monetary Fund study of the subprime mortgage crisis, dated July 2007, already emits the musty smell of decaying papyrus. (Thank to RGE Monitor for the pointer.)
For example, in light of the past couple of weeks of market turbulence, I wonder if authors John Kiff and Paul Mills would like to rephrase their calm opening statement: "Notwithstanding the bankruptcy of numerous mortgage companies, historically high delinquencies and foreclosures, and a significant tightening in subprime lending standards, the impact thus far on core U.S. financial institutions has been limited."
But for that, we'll have to wait and see. The most interesting argument in "Money for Nothing..." is the suggestion that safely dispersing risk into the wider financial community comes at a price: "new [mortgage loan] origination and funding technology appear to have made the financial system more stable at the expense of undermining the effectiveness of consumer protection regulation." (Italics mine)
The reasons are manifold, but ultimately it comes down to the fundamental way in which securitization snaps the intimate links that used to exist between lender and borrowers. Lenders used to have an incentive for determining whether a borrower could meet the financial obligations of a loan. Borrowers, if something went wrong, knew who to ask for help, or who to sue for fraud. That's all changed. Today, a mortgage originator makes a loan, then sells it off to another party who bundles that loan with other loans into a mortgage security. Those securities are then, in turn, chopped up into pieces and reconstructed as derivative securities that are again sold off. And even the risk that somewhere along the line, someone might default on their obligations can and is sold off to additional third parties. In this context no one enjoys and incentive to do due diligence, and tracing the liability chain becomes fiendishly complex.
In recent days, both Republicans and Democrats have started talking about tightening up the rules on predatory lending. Kiff and Mills observe that "Some politicians and states' attorneys-general have advocated passing the liability for predatory lending to the investment banks and rating agencies involved in securitizing such loans. These calls reflect frustration that, given the widespread bankruptcy of subprime originators, there are few solvent parties liable to pay restitution for such misdemeanors within the securitization chain."
But the problem with any such reintroduction of risk and liability onto the balance sheets of high-flying hedge funds and investment banks and rating organizations works at cross-purposes to the entire flow of financial innovation over the past decade, which has served to insulate those institutions from taking the fall when something goes wrong. For Kiff and Mills, this is reason for caution: Don't kill the golden derivative goose!
When considering future policy changes, regulators and lawmakers need to balance carefully the need to limit future predatory lending excesses, while preserving a model that has successfully dispersed losses from higher-risk mortgages away from the banking system and maintaining the ability of stretched but viable subprime borrowers to refinance when confronted with reset payment shock. This is a challenging task within a regulatory and legal framework ill-suited to provide consumer protection in an originate-to-securitize financial system.
But as we survey the financial landscape in mid-August, 2007, watching investors grow more tense by the day, it's worth wondering whether maybe, just maybe, the system as a whole would be more secure if individual homeowners had been a bit more rigorously defended from the depredations of the "system."
As humans, we may be wired for short term gratification by nature. But investment banks and hedge funds are structured that way on purpose, by humans. It appears we all need to be protected from ourselves.