Virtuality and the Financial Crisis: Part 2

Corrective measures envisioned by lawmakers in the heat of the financial crisis are directed toward strengthening oversight of financial markets. The regulatory system including the Federal Reserve, the Securities Exchange Commission, and other Federal agencies collectively may have been unable to detect the formation of a speculative bubble in the housing market; or perhaps the system detected problems but failed to act on a timely basis. Interest rates could have been raised to reduce the amount of credit available for house purchases, and abusive lending practices could have been curtailed giving potential buyers more accurate information about their ability to carry a mortgage, and thus reducing the chances of defaults and foreclosures later on.

Overhauling and strengthening regulatory oversight of financial markets is a sensible step, but not enough to prevent a recurrence of the frenzied pursuit of profit that precipitated the crisis. Not all mortgage lenders succumbed to the lure of higher profits through securitization of loan portfolios.

Many local and regional banks, for example, continued doing business as of old. They held to the traditional policy of making prudent loans to qualified borrowers in their communities, and keeping on their books the mortgages they issued to home buyers. Such policy acts as a brake on greed by underscoring the lender’s interest in making sure potential borrowers can repay their mortgage loans; it also reinforces prudent behavior on the part of realtors and appraisers because the lender needs a realistic assessment of the market value of a house as collateral for a loan. Moreover, by insisting on documenting income sources, traditional policy reinforces the honest behavior of borrowers.

The essence of traditional policy is a direct connection between lender and borrower. When that connection is broken by securitizing mortgage assets, the incentive for actors in real estate and financial services to act prudently and ethically is substantially weakened.

A marketable security based on mortgage assets is an abstract financial instrument that carries no information about borrower and lender. An investor who purchases such a security is concerned only about its current price, potential for future price appreciation, and the dividends it pays. There is no direct relationship in the financial marketplace between borrower and investor or between lender and investor.

The parties to a real estate transaction are related to each other only by the formal roles they play in the transaction; the informal relationships that are essential to reinforcing appropriate behavior in any group are entirely absent. So, it is not surprising that predatory and abusive lending practices had become widespread, and that lenders were less than eager to meet with financially strapped borrowers to resolve problems.

The set of relationships defined by a real estate transaction has come to resemble a virtual team in which the members are place markers for required roles. Each role – agent, broker, lender, and borrower – can be played by one individual today and another tomorrow. Ideally a virtual team shares a common purpose. The parties to a real estate transaction may or may not have a common purpose. Be that as it may, even if there were a shared goal, it would be extremely difficult to ensure that each member of a virtual team contributes to that goal to the best of his or her ability, since personal relationships are weak or non-existent.

If transactions in the financial marketplace continue to reflect the kind of disconnection prevalent among the individual and institutional actors in the real estate bubble, the absence of effective mechanisms of social control evident in virtual teams will inevitably facilitate new crises in the future.