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Root Causes of Mortgage Crisis

posted Mar 24, 2012, 10:26 PM by Simon Nguyen   [ updated Jun 18, 2012, 1:52 AM ]
The recent mortgage crisis in the U.S. was a perfect case of the principal-agent problem.

When people want to purchase a house, they usually don’t contact the bank/mortgage lenders directly for financing. They seek the assistance of a real estate broker or realtor. When the banks want to invest by lending money to potential home buyers to earn interests, they usually don’t deal with borrowers directly (not at first). They delegate this responsibility to a real estate broker or loan officer.

In other words, borrowers rely on the realtors to set up their mortgage applications and the banks rely on the same people to filter out unqualified mortgage applicants.

The main problem here is that the realtors neither work for the lenders nor the borrowers. They don’t get paid a salary; they earn money through commissions. The more applications processed the more commission money they make. More importantly, the money to be lent is not theirs. Real estate brokers have no financial incentives to fulfill their oversight responsibilities. 

During the crisis, many realtors and loan agents overlooked and in some cases, fabricated the qualifications of applicants. As a result, many people were approved for mortgages they couldn’t afford. Subsequently, a lot of people defaulted on their mortgages leading to foreclosures.

But real estate agents were not the only culprits. The bank executives were also to blame for the mess. These people are not dummies. They foresaw the problem long before it became a problem, but chose to turn a blind eye. What were their motives?

The salaries and compensation packages of many bank executives are contingent on performance. Performance is evaluated based on stock prices and revenue. The executives had every incentive to ignore the mortgage problems to bolster short-term revenue, and they did just that. After all, the money lent was not theirs; it belonged to the depositors and shareholders.

The unqualified applicants too shouldn’t be exempt from the blame. Nobody is naive enough to believe he or she could buy a half-million-dollar house making $30,000 a year. As soon as these people saw home prices going down and their mortgage payments ballooned, they opted for foreclosure. They did not lose anything. If they weren’t buying the houses, they would have to pay rent anyway.

There were other factors that contributed to the mortgage crisis. But at the core, the principle-agent problem was the main factor.

Simon Nguyen, M.A. Economics