Tag Archives: mortgages

It’s Time to Change the Incentives of Regulators

One of the primary reasons that regulation slows down economic growth is that regulation inhibits innovation.  Another example of that is playing out in real-time.  Julian Hattem at The Hill recently blogged about online educators trying to stop the US Department of Education from preventing the expansion of educational opportunities with regulations.  From Hattem’s post:

Funders and educators trying to spur innovations in online education are complaining that federal regulators are making their jobs more difficult.

John Ebersole, president of the online Excelsior College, said on Monday that Congress and President Obama both were making a point of exploring how the Internet can expand educational opportunities, but that regulators at the Department of Education were making it harder.

“I’m afraid that those folks over at the Departnent of Education see their role as being that of police officers,” he said. “They’re all about creating more and more regulations. No matter how few institutions are involved in particular inappropriate behavior, and there have been some, the solution is to impose regulations on everybody.”

Ebersole has it right – the incentive for people at the Department of Education, and at regulatory agencies in general, is to create more regulations.  Economists sometimes model the government as if it were a machine that benevolently chooses to intervene in markets only when it makes sense. But those models ignore that there are real people inside the machine of government, and people respond to incentives.  Regulations are the product that regulatory agencies create, and employees of those agencies are rewarded with things like plaques (I’ve got three sitting on a shelf in my office, from my days as a regulatory economist at the Department of Transportation), bonuses, and promotions for being on teams that successfully create more regulations.  This is unfortunate, because it inevitably creates pressure to regulate regardless of consequences on things like innovation and economic growth.

A system that rewards people for producing large quantities of some product, regardless of that product’s real value or potential long-term consequences, is a recipe for disaster.  In fact, it sounds reminiscent of the situation of home loan originators in the years leading up to the financial crisis of 2008.  Mortgage origination is the act of making a loan to someone for the purposes of buying a home.  Fannie Mae and Freddie Mac, as well as large commercial and investment banks, would buy mortgages (and the interest that they promised) from home loan originators, the most notorious of which was probably Countrywide Financial (now part of Bank of America).  The originators knew they had a ready buyer for mortgages, including subprime mortgages – that is, mortgages that were relatively riskier and potentially worthless if interest rates rose.  The knowledge that they could quickly turn a profit by originating more loans and selling them to Fannie, Freddie, and some Wall Street firms led many mortgage originators to turn a blind eye to the possibility that many of the loans they made would not be paid back.  That is, the incentives of individuals working in mortgage origination companies led them to produce large quantities of their product, regardless of the product’s real value or potential long-term consequences.  Sound familiar?

A government that hands out privileges can expect corruption

According to the Washington Post, the mafia is heavily involved in Italy’s renewable energy market. This is not particularly surprising given that firms in that market compete on a manifestly uneven playing field.

The Godfather Movie in TextIn a market characterized by a genuinely level playing field—one in which no firm or industry benefits from government-granted privilege—the only way to profit is to offer something of value to customers. If you fail to create value for voluntarily paying customers, they won’t volunteer their money. It’s that simple.

But things are different when the playing field can be tilted through government-granted privileges. This is because when the playing field can be tilted, firms have an incentive to find some way to persuade the government to tilt it their way. And the most persuasive techniques aren’t always above board.

The problem is that objective standards for playing favorites are hard to come by. This can corrupt even well-intentioned programs that privilege particular behavior in the name of serving the general good.

Imagine you are a politician and you want to reward firms that specialize in renewable energy. How do you determine who makes the cut? What if you want to reward companies that securitize mortgages for low-income households. How do you decide whom to reward? Or say you want to bailout “systemically important” banks. Where do you draw the line between systemically important and systemically unimportant?

Without objective guideposts, subjective factors loom large: whom do you interact with the most? Whom have you known the longest? Which firms share your ideological perspective? Which are headquartered in your hometown?

Even the most well-intentioned of politicians are susceptible to these considerations because all humans are susceptible to these considerations. That’s why a slew of research has found government-granted privileges are often associated with corruption. For example, in an examination of 450 firms in 35 countries, economists Mara Faccio, Ronald Masulis, and John McConnell found that politically connected firms are more likely to be bailed out than non-connected firms. It’s possible that more deserving firms just happen to be politically connected, but this strains credulity. A more plausible explanation is that in the absence of an objective standard for dispensing privileges, politicians reward those they know.

And when that is the case, firms make it their business to get to know politicians. Just ask Angelo Mozilo, the politically ensconced former head of Countrywide Financial. Countrywide supplied the loans that were repackaged by the federally backed Fannie Mae. And since Countrywide’s business model depended on the favor of politicians, Mozilo made sure he was in good standing with his benefactors. Under a program known internally as the “Friends of Angelo” program, Countrywide offered favorable mortgage financing to the likes of Senate Banking Committee Chairman Christopher Dodd and Senate Budget Committee Chairman Kent Conrad.

The conventional route to profit is to please one’s customers. But when firms are able to profit by pleasing politicians, they will do whatever it takes to please politicians. Which brings us back to Italy and renewables. The current investigation (known as operation Eolo after the Greek god of wind) first bore fruit in 2010 when eight people were arrested for bribing officials with cash and luxury cars. Armed with more evidence, officials have now arrested another dozen crime bosses.

It is good, of course, to have police who investigate these matters. But a far simpler, equitable, and efficient solution is to create a truly level playing field for business. When politicians cannot tilt the playing field in favor of particular firms or industries, businesses have nothing to gain from bribery and connections.

Put away the honey jar and you won’t have an ant problem.