The Big Short: Role Play

In 1965 Ed and Carla Langenberg took out a 20-year mortgage from Preble State Bank to purchase their first (and only) home. The down payment was 20%.

Here were the risks:

Ed and Carla:

• If they failed to make their loan payments they would lose the house.
• When the bank sold the home to recoup their loan the first 20% of loss, if any, was borne by Ed and Carla.
• Preble State Bank intended to hold the mortgage for up to 20 years. Which means

1. If Ed didnt pay, they lost money.
2. Which means they looked at his work history.
3. They had to decide they trusted him to pay it back.

In The Big Short

• Borrowers obtained loans without effectively confirming their income.
• 0% down payments were common.
• Banks expected to write the mortgage, collect a fee, then sell the mortgage but retain servicing income. Which means

1. If the borrower didnt pay, investors lost money.
2. If there was a loss, given no down payment, investors lost money.

• Incremental federal government deficits (above a $300 billion norm) from 2009-2012 total about $3.9 trillion or about $12,200 for every man, woman and child or $48,800 for a family of four. At 1% = $488 interest payments per family annually, at 2% = $976 per year.

https://datalab.usaspending.gov/americas-finance-guide/deficit/trends/

QUESTIONS (There isnt a right or wrong on this)

1. What are the benefits, and costs, to society of securitization of home loans?

2. Compare and contrast the incentives for moral hazard in the modern, securitized system with prior practices in the 1960s from the standpoint of:

1. Borrowers
2. Banks
3. United States (society) as a whole

3. Discuss whether you believe this, or a similar situation, can be prevented in the future without resorting to a police state or massive killing off of imperfect people (which has been attempted multiple times this century)?

[Hint: Your answer cannot be a variant of people should because that never happens]

4. What specific legislative or regulatory actions would you recommend to discourage excessive moral hazard?