Beyond Optimization

February 3, 2010

If you drop a letter off at the post office without proper postage, they will return it to your home address marked “Insufficient Postage” to try again. Now, anyone who’s thought about this system a bit realizes that you could easily put your intended recipient’s address as the “Return address” and thus get your mail delivered for free. Perhaps people are uncertain that it would really be delivered, especially if you drop off a letter in NYC with a return address in Oklahoma or something. But I don’t think people use this method for local deliveries, either. The most important reason for this, I’d guess, is that most people believe it is morally wrong to mail letters this way, a consideration which isn’t an absolute bar on immoral behavior, but ¬†imposes a mental cost higher than the $.42 it takes to buy a first-class stamp.

An entrepreneur might notice this loophole and think, “Hey, I can design a system to protect against this kind of cheating.” But implementing this system, as any security system, is not free. Were the Post Office to implement it, the cost would have to be embodied in the price of first-class stamps. If the program wasn’t able to pay for itself through increased compliance, the cost of stamps would remain higher than otherwise. Without knowing for sure, one would expect that it wouldn’t be profitable, simply because most people don’t mail letters this way. The Post Office knows that most people don’t, so they continue to return letters with insufficient postage to the return address. It’s not that the Post Office could never do anything about this loophole, they simply choose not to, because the increased cost they would incur is an indication that more security would be a waste of resources.

My point here is that people are complicated. They do respond to incentives, but those incentives are more numerous than it might seem at first. If you try to start a business with the model “People only care about money and will steal anything if they get a chance,” your business is going to fail. People care about their own honesty and integrity, too. You can’t sit down and work out exactly the optimal amount of security you need because of that, but if you try to ignore it completely, your business will fail.

Now that was just a prelude so that I could say something about last Friday’s Planet Money podcast. On the show, they were talking with a lawyer who gives advice to homeowners. Recently, many homeowners have found themselves “underwater,” meaning they owe more on their mortgage than the value of their house. Many actually could afford to make the payments on these homes, but were considering not doing so, letting the bank foreclose and take the loss in value. From a purely financial perspective, it’s an easy calculation. Your credit score will take a hit, say 200 points, but as a mortgage-payer, you have to decide whether that score is worth $100,000 to you. And anyway, if a home you purchased loses $100,000 in value, why should you be the one to take the hit, and not the bank who sold you the mortgage?

Asked for her take on the morality of the situation, the lawyer, Mary Kinsley, says, “Breach of contract … is an economic decision.” She acknowledges that right now, there is a stigma attached to not paying your debts, but points out that traditionally, there has been a stigma attached to many things that we now accept as normal, such as divorce.

Kinsley’s analysis is right as far as it goes, but it’s important to recognize what a massive change this attitude, if widespread, would have on the market for loans. An important factor in the value of any loan is the risk of borrower default. This is why the rate on home loans is 5.25% while the rate on government t-bills is less than 1%. There are many things that banks do to mitigate that risk, of course. Banks have always had the security of knowing that they can foreclose on homes in extreme circumstances, thus salvaging some value. But the banks have had another valuable protection against risk in the form of the social stigma attached to not paying your debts in this country. They knew that if borrowers could pay their loans, they would.

So we’re talking about a change in social norms, or a change in the environment in which banks do business. Twenty years ago (say), if you had tried to sell mortgages that treat borrowers as any other business, making a financial transaction that they have no qualms about walking away from, you wouldn’t have been able to sell any mortgages. The reason is simple: your analysis was overestimating the true risk of default, causing you to set rates at an inappropriately high level. But now, the situation is changing as public sentiment turns against banks. These days, everyone knows that banks don’t hold mortgages, they repackage and resell them to thousands of other investors. And truly, why should you take a huge loss on your house just so that other rich investors can make a profit?

This post ended up being longer than I intended, past the point where semi-interested readers would read the whole thing. So I’ll use this last paragraph to recap: prices reflect a lot more than just supply and demand, narrowly defined. When businesses set prices, they have no choice but to account for the wide variety of factors that affect profitability, including the general environment in which they operate. You can’t run a successful business without seriously considering who your customers are and how they are likely to behave, beyond simple considerations of what goods and services they want. And, as the banks are learning, you can’t easily take a transaction that works for certain people in certain circumstances, then change those conditions, and expect the transaction to continue working. How about a one-line summary, in parting? If you think morality and trust aren’t important under capitalism, you’re dead wrong.

Addendum: If you’re interested in this topic, and would like a better, more thorough, and more interesting exploration than I am capable of, I recommend Armen Alchian’s paper “Evolution, Uncertainty, and Economic Theory” (PDF).

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