An excerpt from a Harvard Business Review article (which itself is a piece from a book by Prof. Bhide) talks about the consequences of automating many finance decisions, in particular mortgages….
The traditional lending model was built around case-by-case judgment. Home buyers would apply for loans from their local bank, with which they often had an existing relationship. A banker would review each application and make a judgment, taking into account what the banker knew about the applicant, the applicant’s employer, the property, and conditions in the local market. The banker would certainly consider history—what had happened to housing prices, and the track record of the borrower and other similarly situated individuals. But good practice also required forward-looking judgments—assessments of the degree to which the future would be like the past. Dialogue and relationships were also important: Bankers would talk to borrowers to ascertain their beliefs and intentions. And staying in touch after the loan was made facilitated judgments about adjusting terms when necessary.
Over the past several decades, centralized, mechanistic finance elbowed aside the traditional model. Loan officers made way for mortgage brokers. At the height of the housing boom, in 2004, some 53,000 mortgage brokerage companies, with an estimated 418,700 employees, originated 68% of all residential loans in the United States. In other words, fewer than a third of all loans were originated by an actual lender. The brokers’ role in the credit process is mainly to help applicants fill out forms. In fact, hardly anyone now makes case-by-case mortgage credit judgments. Mortgages are granted or denied (and new mortgage products like option ARMs are designed) using complex models that are conjured up by a small number of faraway rocket scientists and take little heed of the specific facts on the ground.
The securitization and sale of mortgages has meant that financial companies’ loan origination is no longer limited by their deposit base or capital, allowing some institutions to capture a very large share of the market. Countrywide Financial, which was started in 1969, grew from a two-man operation into a mortgage behemoth with approximately 500 branches. Before it imploded, in 2007, it was issuing nearly a fifth of all U.S. mortgages. The government/private hybrids Fannie Mae and Freddie Mac made Countrywide’s role seem small. When they were taken over by the Treasury, in 2008, the two enterprises owned or had guaranteed about half of the country’s $12 trillion worth of outstanding mortgages. Since then, their share of the market has only gone up.
The buyers of securitized mortgages don’t make case-by-case credit decisions, either. For instance, buyers of Fannie Mae or Freddie Mac paper weren’t, and still aren’t, making judgments about the risk that homeowners would default on the underlying mortgages. Rather, they were buying government debt—and earning a higher return than they would from Treasury bonds. Even when securities weren’t guaranteed, buyers ignored the creditworthiness of individual mortgages. They relied instead on the models of the wizards who developed the underwriting standards, the dozen or so banks (the likes of Lehman, Goldman, and Citicorp) that securitized the mortgages, and the three rating agencies that vouched for the soundness of the securities.
Dispensing with judgment has also helped funnel the mass production of derivatives into a few mega-institutions, posing systemic risks that their top executives and regulators cannot control. (See the sidebar “Derivatives for Robots.”)
Derivatives for Robots
Little good has come of this robotization of finance. Reduced case-by-case scrutiny has led to the misallocation of resources in the real economy. In the recent housing bubble, lenders who, without much due diligence, extended mortgages to reckless borrowers helped make prices unaffordable for more prudent home buyers.
The replacement of ongoing relationships with securitized, arm’s-length contracting has fundamentally impaired the adaptability of financing terms. No contract can anticipate all contingencies. But securitized financing makes ongoing adaptations infeasible; because of the great difficulty of renegotiating terms, borrowers and lenders must adhere to the deal that was struck at the outset. Securitized mortgages are more likely than mortgages retained by banks to be foreclosed if borrowers fall behind on their payments, as recent research shows.
When decision making is centralized in the hands of a small number of bankers, financial institutions, or quantitative models, their mistakes imperil the well-being of individuals and businesses throughout the economy. Decentralized finance isn’t immune to systemic risk; individual financiers may follow the crowd in lowering down payments for home loans, for instance. But this behavior involves a social pathology. With centralized authority, the process requires no widespread mania—just a few errant lending models or a couple of CEOs who have a limited grasp of the risks taken by subordinates.