A big, fat "I told you so" from Joe Stiglitz

Eighteen years ago, he warned of the "perverse incentives" implied by mortgage securitization.

Published December 4, 2008 8:44PM (EST)

In the brand-spanking-new issue of the Economist's Voice, economist and Nobel Prize laureate Joseph Stiglitz takes a look back at a paper he wrote almost 20 years ago "commenting on the move -- just beginning then -- towards securitization."

(Securitization is the process of turning an asset into an security, as in, most famously, a group of mortgages into a mortgage-backed security contract that can then be bought or sold or further divided and redivided in all kinds of innovative ways.)

After recapitulating some unkind words about the "incompetency of banks" as proven by "a series of disasters -- "real estate loans ... loans to Third World countries, oil and gas loans," Stiglitz unburdened himself of some qualms about the possible downstream effects of securitization and their potential "perverse incentives."

...When banks retained the mortgages which they issued, they had greater incentives to screen loan applicants. The brokers who write the mortgages often receive commissions on the loans they write, with little or no accountability on their efficiency in screening. Their incentives are thus only to ensure that the loans meet (on paper) the requirements of the loan... [T]he broker has an incentive to find an appraiser who will appraise the property accordingly. The question is, has the growth in securitization been a result of more efficient transactions technologies, or an unfounded reduction in concern about the importance of screening loan applicants? It is, perhaps, too early to tell, but we should at least entertain the possibility that it is the latter rather than the former.

In other words, what would happen once neither brokers nor bankers had an incentive to ensure the loan-worthiness of loan recipients, once all the loans were packaged up into securities and resold to Norwegian townships or New York hedge funds?

"We now know the answer," writes Stiglitz.

Get this man on Paul Volcker's Economic Recovery Advisory Board, ASAP!

A citation for the original paper: Stiglitz, Joseph (1992) "Banks versus Markets as Mechanisms for Allocating and Coordinating Investment," in J. Roumasset and S. Barr (ed.) The Economics of Cooperation.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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