The US sub-prime mortgage crisis and the ensuing credit crunch will be the subject of forensic analysis and discussion for some time yet – with good reason.
An increase in the numbers of low- and middle-income American households defaulting on their mortgages has somehow sparked a chain reaction, leading to the international financial system teetering on the brink.
One of the strongest themes that has emerged in the analysis of the wreckage so far is the role that incentives (or lack thereof) played in creating and compounding the mispricing of risk. One of the most crucial lessons from the sub-prime crisis is that in markets with asymmetric information between buyers and sellers, the configuration of incentive systems for intermediaries matters.
Any structural misalignment of incentives can not only result in market failure in individual markets but can compound, leading in this case to the near collapse of the international banking system.
That might sound a bit dramatic, but it’s certainly the case with the sub-prime saga. Intermediaries (mortgage brokers and financial advisers, for example) play an important role in markets where information asymmetries exist between buyers and sellers.
We can explain the importance of intermediaries in consumer markets by relying on a little bit of behavioural economics. In markets for complex products, such as financial products, consumers find it hard to make decisions about which product is right for them. They suffer from information overload and confusion.
This is particularly the case where there is seemingly little differentiation between the choices available, or when the benefits and costs of products are stretched over a long period (as is the case for super and mortgages).
Intermediaries play an important function in these types of markets, acting as “choice editors” for consumers. That means they simplify the complex array of choices and help remedy some of the information asymmetries. In the mortgage market, mortgage brokers help consumers overcome their information deficit in regards to the true cost and benefits of the financial products available.
And through gathering information from borrowers, they also assist lenders in assessing the capacity of borrowers to repay.
Without “choice editors” such as mortgage brokers and financial planners, many consumers wouldn’t participate in the market or would make poor decisions and suffer the consequences.
The market overall would be less competitive as consumers’ uninformed purchasing decisions would mean there was little pressure on suppliers to offer good deals to consumers.
“Choice editors” can also add value though strategic advice, ensuring consumers make the most of their decisions.
But what happens when the financial incentives of the choice editor are not in alignment with the interests of the consumer?
Economists call this a principal-agent problem. Commissions paid by product issuers often mean that incentives (that is, remuneration) for the agent or choice editor are not related to whether or not the agent acts in the interests of the principal (that is, the consumer).
This is what happened with mortgage brokers and the role they played in the sub-prime crisis.
Upfront commissions of 50 to 70 basis points encouraged the mortgage brokers to recommend loans at the maximum loan-to-value ratio in order to maximise their commission, regardless of whether this was in the interest of borrowers.
The negative effects of this misalignment of interests were exacerbated by the fact that as well as acting as agents for borrowers, mortgage brokers also played an important role in assisting lenders to assess the capacity of mortgagees to repay.
Remuneration was tied to a successful product sale, and importantly to the size of the mortgage issued, meaning that many brokers assisted people in qualifying for credit that they couldn’t possibly repay.
Not only did mortgage brokers not act in the interests of borrowers, they also failed to act in the best interests of lenders as well.
The ill effects of this incentive system took on structural significance because the loans were repackaged and sold as collateralised debt obligations (CDOs).
Indeed, credit scores were “gamed” by mortgage brokers, which meant the CDOs carried far more default risk than the risk rating assigned by agencies.
But how is all this relevant to financial advisers in Australia?
Consumers seek out financial advice in order to make sense of the very complex world of saving and investment, and to help them to determine the best strategy to preserve and maximise their wealth.
Yet where financial planners are paid by product issuers, their financial interests are not completely aligned with getting the best deal for consumers.
Any economist will tell you that self-interest is a guiding principle of markets, but in this instance, the self-interest of an adviser can conflict with the interests of their client.
Often this conflict will be at the margins, but at times it comes starkly to the centre.
Already we have examples of this occurring.
Westpoint, with its underlying mezzanine funding arrangements, was clearly too risky to be sold to retirees; however, its average 10 per cent upfront commission made it a very attractive proposition to some planners.
Similarly, upfront product commissions based on the amount of funds invested has recently resulted in some advisers using margin loans to inappropriately leverage clients’ investments. Because of the information asymmetries, it’s always going to be the case that disclosure of these conflicts is not a sufficient safeguard.
These examples are often argued by some people to be extreme cases. But so long as advisers are remunerated by commission from product issuers out of clients’ accounts, rather than on the basis of services provided, then the principal-agent problem persists.
The misalignment of incentives for financial planners in Australia has fortunately not yet resulted in systemic issues, like the mispricing of credit risk in the US.
But the latent potential remains.
One scenario could have the commissions issue play out as a government debt/adequacy issue.
As the superannuation system matures and the gnawing effect of product commissions has a direct impact on retirement saving – but also an indirect impact through the type of competition that commissions generate – we are very likely to see cases of retirement income inadequacy.
Consumers who thought that the advice they received was helping them build their nest egg will realise in 40 years’ time that they don’t have as much as they thought and commissions either ate up part of their buffer or resulted in them being placed in an inferior product.
After all, a 1 percentage point increase in net fees can reduce the accumulated benefit at retirement by as much as 40 per cent.
Clearly in complex markets, where consumers rely on choice editors, for those markets to be efficient and effective, we need incentive systems which align the interests of the principal (consumer) and agent (adviser).
Ideally this could be achieved by ensuring that remuneration systems are paid in a way that aligns them.
The emergence of the fee-for-service model is a solution to the principal-agent problem in financial planning, but we also need to ensure it stays the course and ensures advisers act in the best interests of their clients.
In analysing the sub-prime crisis, as always, it’s easy to be wise after the event. And while this took place in credit – not investment – markets, we still shouldn’t rule out its lessons for financial advisers.