Flawed Incentives and Dubious Morals: JPMorgan & CDOs That Were "Built to Fail"

It’s been a busy week for JPMorgan Chase. It’s only Wednesday, and already the bank has settled one civil fraud lawsuit and been slapped with another one. Both shed light on Wall Street’s flawed system of incentives that helped bring on the financial crisis. They also raise questions as to the morals of bankers.

Photo: epicharmus

On Tuesday, JPMorgan agreed to pay $153 million to settle civil fraud charges brought by the SEC alleging that it “misled” investors when it sold them junky mortgage bonds. The deal in question was put together by Magnetar Capital. If you’re not familiar with Magnetar, it’s an Illinois-based hedge fund that made a killing shorting synthetic mortgage-backed securities that were essentially built to fail. Here’s how it worked: Magnetar would put down a few million bucks to start a collateralized-debt obligation (CDO), cram it full of the junkiest mortgage bonds it could find, then get a bank like JPMorgan to sell it off to investors as a triple-A, gold-plated piece of the booming housing market; when in reality it was a time bomb filled with toxic waste. Whatever Magnetar lost when the thing went bust, it more than made up by taking out massive short positions against it. For a real world corollary, consider this akin to building a crappy house, selling it to someone, and then taking out an insurance policy so that when it falls down or catches fire, you get paid big bucks. (For more on Magnetar, check out the amazing work NPR’s Planet Money and ProPublica did last spring.)

On Monday, federal regulators sued JPMorgan for allegedly duping credit unions into buying $278 million in mortgage bonds that were “destined to perform poorly,” ie, built to fail. Now, part of the reason JPMorgan emerged from the crisis relatively unscathed is that it realized fairly early on that the housing market was set to go bust; so it stopped investing so heavily in mortgage-backed securities. But it didn’t stop selling them. There was too much money to be made peddling these securities to people who were still bullish on the housing market. Was JPMorgan obligated to relieve them of this view? Of course not. Investing is like gambling. You think this horse is going to win, I think another horse is going to win; let’s see who’s right. Plus, all these deals came with “voluminous” risk disclosures stating exactly what was in these deals. So no one could claim they weren’t aware of what they were buying. What got JPMorgan in trouble is that they didn’t tell their clients that the deal had been put together so that a third party could bet against it. This is basically what got Goldman Sachs in trouble last year with the Abacus deal it put together for John Paulson.

Now, let’s consider the incentives.

We pay a lot of attention to incentives at Freakonomics. Understanding what motivates people, and how incentives align with outcomes can help uncover all kinds of interesting, unexpected things, whether you’re looking at school teachers or sumo wrestlers. It’s no different with investment bankers and CDO deals. See, the bankers at JPMorgan who sold these CDOs got paid regardless of how the things performed, whether every one of the thousands of mortgages stuffed into them paid off, or whether they all defaulted. So the incentive for the bankers was to sell as many CDOs as possible, even if they knew they were going to blow up in a year or two. It wasn’t their problem because it wasn’t their money. This raises an obvious moral question: were bankers morally remiss in pumping these mortgage bombs out into the world when they knew the wreckage they would cause? Or were they simply being good at their job? Maybe, but then how morally remiss are tobacco companies or fast food restaurants? Whether it’s cigarettes or food loaded with trans fats, society has essentially deemed that when it comes to things that aren’t good for us, as long as we know the facts, it’s buyer beware. The CDO equivalent of the Surgeon General’s warning are those risk disclosures describing what sorts of mortgages they contain. Apparently, not many buyers read the fine print.

Assuming he had the correct view of the housing market back in 2007, a “moral banker” was someone who ended up leaving a lot of money on the table. Considering the incentives as they were, how morally remiss were these bankers?

 


beuler

"Apparently, not many buyers read the fine print."

No, they trusted their bankers instead. If, over decades, you build a valuable reputation, at what point does it become worthwhile to cash in on that reputation (destroying it forever)?

Sam Faycurry

Any banker has been educated enough to understand the risk of the product their selling. But no average Joe banker selling CDOs would have even thought the recession would hit so hard. They kept "betting" on the idea that the bullish economy would continue and their customer would be safe. As for the morals of the Magnetar company. They understood the risk. Why else would they buy the insurance. Chase, and other companies, need to look into these business ideas much closely to protect their customers.

Jimmy

It's always on the buyer to know what they're buying. As long as the information was there, I don't see these traders having done anything wrong.

Whatup?

Let's use another analogy.

The bridge ahead has been swept away by a raging, flooded river. Instead of putting up a barricade, I put up a sign that says something like, "Please understand that driving this way involves risk."

The difference, in a nutshell, is the claim that a PASSIVE warning against impending doom is just as valid as an ACTIVE warning. That is, a long-winded, small-print prospectus which few people read in its entirely (except the lawyers, who have read every single word many times) is supposed to absolve JPMorgan Chase of the deaths of family nest eggs, of the lost dreams of hard-working families, of the stress and pain caused endured when people drove over the precipice into the swirling waters below?

When the dice is loaded against your customers, and you don't tell them except by using generic legalese that is used even with the finest investments, that is a massive moral failure. Those "investors" were buying nothing more than lottery tickets. Yes, they maybe, possibly, just perhaps, might have come out winners...but the odds were highly against such an outcome.

You can be CERTAIN that the risk to Chase was carefully weighed by managers in the know. In fact, for all we know, JPM had already carefully calculated just how much any settlement might cost them. If so, you can be sure that JPM would never have proceeded unless the gains outweighed the risk. You know, kind of like car manufacturers who know that there is a lethal flaw in one of the models, but figures that only one person in 15,000 will actually die, and at an average settlement of X dollars per death, will only cost the company $20MM dollars, against a profit of $300MM. And so the flawed car goes to the showroom.

The way to handle such activity it to do more than take "chickenfeed" from the company. EVERY SINGLE PENNY MADE ON THIS PRODUCT should be part of the settlement, AND a strong punitive charge should be added, as well. Basically, the investors should get back every single dime they lost. Why not?

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Margaret

If JPMorgan represented junk CDOs as triple-A investments, that is fraud, pure and simple. The fact that they stopped buying (but not selling) these CDOs certainly suggests they had done their due diligence and knew them for junk.

And brokers *oppose* a universal fiduciary standard that would, in future, require them to place their clients' financial interests ahead of their own.

But unfortunately risk disclosures and the "caveat emptor" doctrine only apply to the transaction between investor and investment seller; what about the millions of innocent bystanders who did not participate in these shell games, but lost their jobs, their homes, and their life savings as a direct result? In this case, what's the difference between a Wall Street banker and a drive-by shooter?

jonathan

We are moral relativists, despite the attempts by the religious to impose versions of absolute standards on us.

Consider a person working for a railroad in Nazi Germany. He schedules trains and he knows they carry people to very bad places. But he has a wife and 2 kids. Literature is often about our complicity because we are complicit.

Ben

Please don't take the "morality" angle. We're not going to solve these problems by demanding that people be more honest. Stick with the incentives angle. The point of this is that you need regulation in spots such as this where the incentives are perverse. How can we let people buy insurance for things where they have no skin in the game (rhetorical question, of course, because the answer is that big finance has way too much political power)? Your home insurance scenario is an appropriate analogy. Or, it's like letting me buy an insurance policy on YOUR life. Gives me an incentive (admittedly morbid) to hope for you to die or even worse, to kill you.

And yet, we continue to allow our legislators do the work of the finance lobby. Where has the journalism profession gone. What a downer. Wow, I'm really depressed now. I think I just ruined my day. . .

AJ

1. I agree with Margret that there was fraud in the CDO ratings practices. This introduced a level of information asymmetry that cancelled out the risk disclosures for many investors.

2. The bankers who knew the CDOs were built to fail, and shorted them to mitigate risk, definitely engaged in 'moral' hazard.

Information asymmetry and moral hazard combined is enough for me to say, with confidence, that continued selling, without disclosure of the junk status and shorting, was indeed an immoral act.

It remains to be seen whether SEC civil actions, and changes in regulatory enforcement, will counteract the incentive structure, and prevent this type of behavior in the future. All indications are the settlement amounts are a drop in the bucket for JPMC, GS, etc. If that is the case, morality has little to do with the outcomes.

KN

It seems like what you are really asking is "Is it ever immoral to follow incentives?" Which in turn can be recast to "Is Homo Economicus a fundamentally moral creature?" Let's assume that the answer to the second question is yes (I don't happen to agree, but for the sake of argument...). If that is the case, then what went wrong here was a lack of incentives NOT to behave like a dishonest dirt bag. Where do those incentives normally come from? There is some pressure from the market (if I become viewed as untrustworthy, my future business will suffer), some from the government (if you commit fraud, you are going to jail), and I would argue that there is, or at least used to be, a social aspect (my reputation will suffer if I am seen as devious). Where did those counter-incentives break down? Or was it simply a question of magnitude? Because there was so much dough to be made that everything else didn't matter?

In any event, blaming the incentives is just another example of the abdication of personal responsibility in our society. I can't wait until this shows up as a defense in court.

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Guscat

I am wonder what were the incentives for the people who were buying these deals. Obviously, these deals weren't good for the companies buying them, but were the individuals signing off on the deals making money off of them, sort of like the people at say Washington Mutual who made lots of money making the loans that ultimately destroyed the bank? If the people doing the actual buying had incentives similar to the ones the sellers had, then all that fine print really does is cover both sides asses in case things blow up.

Joshua Northey

That is a perfectly sensible way to look at it. Fortunately there are other ways to look at it. For instance we no longer allow human beings to sell themselves into slavery, or children to work 40 hour work weeks. We made these decisions because society as a whole decided that even though some or even most of the transactions might be on the up and up, the overall cost to society was unacceptable.

Bankers are certainly within their purview to pursue their personal interest to the exclusion of all other things, but then they have absolutely ZERO right to whine about regulation. Personally I would make 40% of what Wall-street does illegal because it is actively harmful and counterproductive to the economy. The remaining 60% of business practices are safe enough to allow the market to rampage around unfettered.

Let us pretend I run a small colony and it is a market driven freedom loving society. I let people exchange goods and trade with few rules. But then a couple of the residents start taking advantage of the rest and impoverishing them, to the point where the viability and sustainability of the whole colony is endanger. How far do you think their cries that all the exchanges were fair and legal should get them when I am examining how to deal with this problem?

By all means if banks want to abrogate any responsibility they have to society as a whole let them, but then they should expect to have their activities very tightly constrained because of how destructive they can be.

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Clancy

The final sentence sets up a false dichotomy. The bankers were indeed just following incentives, but at the same time they were behaving immorally. If you ask me what the solution is, I would choose one that changes the incentives rather than trying to morally shame the bankers into leaving money on the table. Making a fuss about immorality won’t solve much on a system level, but that doesn’t let anyone off the hook on a personal/moral level. We cannot pretend they were doing the right thing just because they followed incentives.
I think it’s ok to set high moral ideals even knowing that most humans could never live up to them. If we just consider following incentives to be sufficiently moral behavior, then morality has no meaning. The whole point of a system of morals is to tell us what is right especially when it goes against incentives for personal gain.

Greg

No doubt the bankers received fees for their "services," but to suggest that "JPMorgan who sold these CDOs got paid regardless of how the things performed" is simply wrong. In the notorious Squared CDO deal, JPMorgan owned more than 85% of the "bonds that were “destined to perform poorly,” ie, built to fail."

So it was their money at stake.

I'm not sure about their morality, but the facts suggest the bankers were bad at their job.

paul o.

I don't know too much about this, but I understand that one of the failures was the complicity of the rating agencies that rated these bonds as AAA. the ratings agencies such as S&P and moodeys are paid directly for their work by the banks that issue these bonds. So even if the ratings agencies see a flawed bond, they may not properly assess the low percentage outcome of market failure. Or in the case of CDO's, not consider in their models that the bonds would fail if housing prices fell off by 5% combined with all the adjusted rate mortgages in the bond kicking in at the same time.

If I rated bonds, I would have an incentive to make my boss happy, instead of issuing a lower rating based on a an outside chance of a bond collapse.

Isaac

Sounds like a car maker that knows they are producing a defective product. Don't we still hold them responsible? Why is a selling a car or appliance with known issues bad but selling toxic money that's "designed" to fail okay?

It's like a casino that knows all of the cards or a restaurant that uses ingredients that would appall any customer but they do it anyway because it's cheaper while hiding the truth from the health inspector. It's one thing to be ahead of the curve but another if you are cheating people out of their money.

Michael

I am confused by the logic in this post. If I understand correctly, the heart of the "fraud" was simply the notion that someone else was betting these mortgages would fail. Even if there was evidence of objective fraud (i.e. the AAA rating was incorrectly applied), from the text of this post, it still seems others betting against the mortgage's in question is the heart of the fraud case.

By this logic, a huge percentage of all investments would be fraud. If I am brokering a deal in gold, this logic indicates I am defrauding the buyer because I know the seller believes gold prices will go down--and vice versa. Like the JPMorgan instances my gold "deal had been put together so that a third party could bet against it," that is, gold prices. Of course any deal involving shorting stocks would be fraudulent. And say that the bubble went a few more years before bursting. Would Magnetar have been the victims of fraud because others had been betting the housing market would not yet fail?

Unless there is more to JPMorgan’s actions than stated in the post, I am not clear about the questions of morality and incentives. It appears the incentive of JPMorgan was to meet demand of customers who wanted to bet for the mortgages and also of those who wanted to be against them. With hindsight it is easy to tell which investments are "toxic," "time bombs" or "crappy." But that is not so easy ahead of time. A lot of investors made a lot of money backing "toxic" mortgages long after experts were proclaiming they would fail, and these0investors might have also. Going back to my examples of the gold sale, would I be morally remiss in brokering such as sale if I had an opinion either way regarding whether gold prices would rise or fall?

I cannot see how the logic of this case is designed to accomplish anything except deny investors freedom to invest money how they see fit by criminalizing the offering of such deals.

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KenC

The problem is that a company like JPMorgan has two groups with different incentives. There's the group that is building these product, the CDOs, that it sells to clients. They get a fee. The more CDOs it makes and sells, the more fees they generate. If the client wants to buy, they'll make it and sell it to them.

Then there's another group, the traders. They take bets on the market. They look at your CDOs, and in fact look at all the CDOs regardless of where they originated and make bets for or against them.

You can get the odd situation where one group is selling a CDO to a client, which the traders from the same company may bet against. As long as they don't talk to each other, it's supposedly kosher. It's when they do talk to each other, and work together, that causes the problems.

Reeves Faveor

I believe that the bankers were significantly morally remiss. Many of these bankers knew they were taking advantage of the more uneducated lower class and selling mortgage bombs to them. Many of these people had no idea these mortgages would default and would lose money while the bankers got money from the insurance. Basically, its just a scheme where the expert lies to the common person and ends up profiting while the average person suffers.