Draw Breath

I've spoken before about the evidence on how SUV drivers, having exported the risks to people outside their cars, tend to drive more recklessly. Not that this makes SUV drivers a particularly unique demographic: for instance this graph suggests that, if anything, the introduction of mandatory seatbelt-wearing led to a worse situation than would otherwise have been the case in terms of overall deaths: the reduction in driver deaths was more than matched by a the growth in pedestrian and other deaths. As the study from which the graph was taken says, "to compel a person to use protection from the consequences of hazardous driving, as seatbelt laws do, is to encourage hazardous driving."¹

So. What has this got to do with the ongoing subprime crisis? Well, they're both stories about risk.

As this article in Wednesday's Financial Times (subs req'd) suggests, there is quite a bit of ground-level fraud at the root of the subprime problem.

It seems that people were falsifying applications for mortgages they couldn't afford partly by paying for people to pretend to be high-paying employers for instance. And it seems that they were encouraged by mortgage brokers to do so. As the article says,

"fraud has been detected up and down the financing chain: just as borrowers have lied to get better rates and larger loans, mortgage brokers and loan officers have lied to borrowers about the terms of their loans and may also have lied to the banks about the qualifications of the borrowers. Appraisers, likewise, have lied about the value of the properties involved.

"The recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and outright fraud," Ben Bernanke, Fed chairman, recently told lawmakers."

In other words, this weeks crisis in the securities markets hints at a disease at the roots: a pattern of reckless lending either through actual deception or through the encouraging of deception on the part of the borrower. But why would lending institutions collude in behaviour that could ultimately lead to their downfall? Why would the word be coming down from on high that volumes of borrowing was a higher priority than the quality of the loans?

The reason lies in the exporting of risk, itself the reason for the stock markets' responses to the crisis in subprime. Individual subprime mortgages were packaged together and sold on the securities markets so that all the risk didn't lie with the lending institutions, but with hedge funds. Not only did no single group own the risk, but there was an almost total disconnection between the people on the lending coalface and the people who owned the risk of their decisions.

The division between ownership and control is the classic dilemma of corporate governance - something I have a bit of a professional interest in. What happens when people - CEOs etc - get to make decisions using other people's - shareholders - money? In a sense, the subprime thing highlights another question - what sorts of risks will some people - investment bankers - take when the consequences of the risk either won't fall on them or are diluted through hedging?

The dynamics of subprime, just as with mandatory seatbelt legislation, gives us at least some part of an answer: risks are far easier to take if they're not your own.