There seems to be a tension between two of the key notions being bandied around in the crisis.

The notion of ‘moral hazard’ assumes that individuals acting as units will engage in activities (take on greater risk) because they know they are immune from the consequences of these actions (government bail out). Yet the notion of ‘systemic risk’ indicates that there are dynamics larger than individual units at play in the unfolding of events.

The most convincing indication of the tension comes, in how they encode different courses of action, in how they are counterposed as justifications for government intervention.  Creating moral hazard worsens the financial system, but stemming systemic risk is essential.

What is the big story here?  Is the ‘decade of moral hazard’ over as the Financial Times suggests (both in the sense that the Fed refused to bail out Lehman; and in the sense that the crisis might be seen as unraveling an accumulation of morally hazardous behavior)? Or is this about the rise of systemic risk that must be managed?…

There’s an interesting video on FT today (John Authers, the Short View) reporting on some research which posses an empirically supported challenge the random walk hypothesis from efficient market theory.  Historical research done by London Business School shows that there has been, in practice, a momentum effect during the 20th century in the way the market has moved.  According to the study, the effect can be traced across several markets with the exception of the U.S.  (See synopsis or press release.)  Authers concludes that “maybe there’s something to be said for trading heavily and just looking at who’s hot…”

Any guesses or predictions as to what the potential performative effect of a piece of research like this might be?

(In passing, I was puzzed as to what ‘big mo’ might mean.  Turns out it has some rather naughty uses which I’ll leave the reader to look up on their own.)

Comment on ‘Last year’s model: stricken US homeowners confound predictionsBy Krishna Guha and Gillian Tett The Financial Times, Comments and Analysis, January 31, 2008 19:01

Story The Financial Times raised an interesting question this week about changes in consumer repayment behavior, and the failure of mathematical models to keep up to these changes in relation to the subprime mortgage mess. It would seem that a statistically visible number of consumer have been opting to continue repaying their credit card bills and car loans even while defaulting on their mortgages. This contradicts conventional wisdom which suggests that rather than risk foreclosure, households would prioritize the home over small debts, paying mortgage payments first and foremost when in financial trouble.

Malcolm Knight, head of the Bank of International Settlements, summed up this new pattern of repayment as follows (quoted by Guha and Tett):

“Now what seems to be happening is that people who have outstanding mortgages that are greater than the value of the house, or have negative amortization mortgages, keep paying off their credit card balances but hand in the keys to their house… these reactions to financial stress are not taken into account in the credit scoring models that are used to value residential mortgage-backed securities.”

The article goes on to suggest two possible reasons for the change in behavior that escaped the mortgage default models: first that it may be due to cultural changes that lessen the stigma associated with missing a payment or loosing a home, and second that people may no longer have an incentive to pay mortgages where the loan-to-value ratio has become excessively high with dropping property prices. That is, they’ve decided it’s just not worth it.

Implications Drawn to its logical conclusion, what this piece implies is that on a large scale the American consumer no longer minds having their property taken away from them and might even willingly abandon it once they’ve calculated that it’s too expensive. Hmmm. That sounds kind of… doubtful. Consider the gushing tears and suicidal thoughts of precarious homeowners featured so prominently in Scurlock’s (albeit melodramatic) documentary, Maxed Out. It’s unfortunate that these financial journalists, who appear to live across the pond in London, only had access to macro data. If they had had the chance to come over and investigate the actual practices of American consumers up close, they might have considered dropping culture and economic rationality – two of the falsest friends the social sciences have ever confabulated – and discovered some more plausible reasons to account for this new consumer behavior. Hint – it’s a risk model. FICO® consumer credit bureau scores which receive so much attention in consumer circles – and almost none in the financial press related to the mortgage crisis – are one of the key pieces of information used for matching loan products to consumers in the U.S. In 2001, after pressure from consumer groups started to build in Washington, the scores were released to the public which is now able to purchase access to their scores (see So consumers know a thing or two about how the models work, and there is plenty of advice in circulation to tell them how to behave accordingly. What is ironic is that the scores only came to public attention after they were adopted by the Government Sponsored Agencies (GSEs) in 1995 as a sub-component of their automated underwriting programs (Loan Prospector® at Freddie Mac and Desktop Underwriter® at Fannie Mae). From there they worked their way through the mortgage industry into the securities underwriting models (such as S&P’s LEVELS®). Interestingly enough, no mortgage data used to calculate FICO® scores, which were originally designed as risk indicators for small consumer credit, supporting in particular the credit card industry. They were never redesigned to accommodate the mortgage markets because the bureaus have traditionally not had access to mortgage data.

Conclusion Since these scores are the obligatory passage point to further consumer credit and play a role in refinancing – i.e. getting out of a subprime loan, getting another mortgage… and so on – a move to preference credit cards payments over home loans would probably not have much to do with a growing indifference towards foreclosure. Rather it would be a performed consumer response targeted at protecting their precious risk scores. Not convinced? Remember the Paulson Plan released in December? It suggested interest rate freezes on ARMs but would have limited these to cases where the borrower had a FICO® of 660 or more. This means that the category of people the federal government will agree to rescue pay their credit card bills faithfully and on time… even when they can’t afford their mortgages. In this light, paying credit card bills would be a way of waving a white flag that cries out ‘help me (I’m helping my self)’, and not at all a way of bailing out of an overpriced home. If we can consider changing consumer behavior a form of getting it right, then at least one risk model didn’t get it wrong… At least, not this time.