How Incentives Drove the Subprime Crisis

In order to address any systemic problem, whether the goal is to change the system, regulate the system, or change the incentives driving a system, it is necessary to appreciate all the drivers operating within the system. In the case of the subprime crisis, one of the drivers was the changing nature of the subprime loans, which was not factored into the models used by the investment bankers, the credit rating agencies, and the issuers of credit default swaps.

This paper is an attempt to look dispassionately at the subprime crisis from a particular perspective, namely, the incentives that drove the system. The roles of the borrower, the mortgage broker, the mortgage lenders, the government sponsored entities and the investment banks, the credit rating agencies, and the issuers of derivatives will be analyzed, with particular focus on what motivated each actor to take the risks that it did.

While different views have been expressed as to the cause or causes of the subprime crisis, all should be able to agree that that the events which led to the crisis demonstrate the efficacy of two well accepted economic principles: the law of supply and demand, and the proposition that people generally act in the manner in which they are incentivized to act. While this is the primary thrust of the article, it will also briefly examine why neither the Paulson plan nor the Geintner plan has worked in terms of motivating banks to lend in order to reverse the downward trend of the economy.

The conclusion asserts that some of the factors that contributed to a dysfunctional system are relatively easy to fix, such as eliminating liars’ loans. Some states have already moved in this direction, although Congress seems reluctant to do so. But some of the other contributors are more deeply ingrained in our system. Compensation systems that focus on the short run at the expense of the long run obviously should be changed, but the beneficiaries of the system are resistant to change. Rating agencies that are paid by the person seeking the rating reflect not only an irresolvable conflict of interest, but also a very entrenched system. Credit default swaps, where the purchaser of insurance has an informational advantage over the provider of insurance, make no rational sense but, again, entrenched interests are resistant to change. It will take more political courage than has been shown thus far to enact legislation that will reverse the incentives that once again could create excessive systemic risk

Included in

Law Commons