How To Explain the Mortgage Fraud Crisis: A Nash Equilibrium or a Nash Conspiracy?

The recent passing of Princeton University Nobel Laureate in Economics, Professor John Forbes Nash, Jr., more popularly known as the paranoid-schizophrenic genius featured in the 2001 movie A Beautiful Mind (inspired by Sylvia Nasar’s biography and starring Russell Crowe), is an appropriate time to admire Nash’s work and consider its applicability to the field of Behavioral Forensics.

Behavioral Forensics is a body of work that can assist anyone from governance leaders to fraud investigators in understanding why people commit fraud. You can read more on this approach to understanding the fraud phenomenon in the book, A.B.C.’s of Behavioral Forensics (Ramamoorti, Morrison, Koletar & Pope, 2013, Wiley). Let’s see if the late Professor Nash’s work can add insight into Behavioral Forensics.

Professor Nash’s greatest contribution to economic game theory—that studies strategic behavior of interacting opponents—has come to be called the Nash Equilibrium. The Nash Equilibrium is a concept of game theory where the optimal outcome of a game is one where no player has an incentive to deviate from his or her chosen strategy after considering an opponent’s choice. In other words, an individual can receive no incremental benefit from changing actions, assuming other players remain constant in their strategies. (According to Nash, “an equilibrium point is an n-tuple such that each player’s mixed strategy maximizes his payoff if the strategies of the others are held fixed. Thus each player’s strategy is optimal against those of the others.”) This equilibrium typically holds true for a non-cooperative game involving two or more players. Each player is assumed to have knowledge of the strategies of all of the other players and each player acts rationally. The outcome of the game will be determined by the set of strategies of each player and their corresponding payoffs. The Nash Equilibrium is attained when no player has anything to gain by changing his or her own strategy. Let’s apply the Nash Equilibrium to the U.S. mortgage crisis.

By way of summarizing the mortgage fraud crisis, an entire market of mortgages was originated all too often with “bad paper.” Congressional policy to create affordable homeownership, under the Community Reinvestment Act, may be considered the first step in this process. With the acquiescence of Fannie Mae and Freddie Mac, the race to provide homeownership to everyone was on. Mortgage brokers sold mortgages to buyers of homes with the inability to repay the mortgages due to predatory lending, ignorance, and oftentimes, fraud. After origination, the mortgages were usually resold in the secondary market to participants undoubtedly having knowledge of the quality of the paper. These mortgages were then rated by the big, but rather conflicted credit ratings agencies and resold on Wall Street as exotic financial instruments with names like residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs, even synthetic CDOs). Ultimately, the only non-participant in all this wheeling-and-dealing, the U.S. taxpayer, bailed out the entire market.

An essential key to this mortgage lending crisis is the market’s belief that Fannie Mae and Freddie Mac guaranteed these mortgages even if they, as guarantors, became insolvent – – which as it turns out was a valid strategy. At this point, let’s juxtapose the economic concept of a moral hazard into each participant’s strategy. In essence, a moral hazard occurs when one takes more risks because someone else bears the burden of those risks, if the strategy fails, and losses are incurred. In the mortgage fraud crisis, each player is passing the bad paper simply because it’s profitable whenever the risk-taking pays off. Each participant is working under the assumption that someone else bears the risk of loss should a mortgage, portfolio, or tranche become impaired.

Can Nash’s insights into game theory shed some light on U.S. mortgage fraud crisis? After all, each market participant stood in Nash Equilibrium. The game was non-cooperative and involved numerous market participants. Each understood the other’s strategies and acted in their own self-interest.

The Nash Equilibrium also provides insight into another question that has frustrated the U.S. taxpayer. Why haven’t more bankers gone to jail? Part of the answer lies in the requirement for the prosecutor to prove mens rea or criminal intent beyond a reasonable doubt. In the case of the mortgage fraud crisis, those standing in the Nash Equilibrium are, by definition, non-cooperative. Proving a well-orchestrated criminal conspiracy by individual defendants is challenging because the market participants are not communicating game-playing strategies with each other. Further, each participant plays a single, isolated role (e.g., consider the separation of mortgage initiation, mortgage servicing functions, and selling RMBS and CDOs on Wall Street). The market participants are also presumed to have knowledge of the criminal and regulatory rules enforced by DOJ, SEC and banking regulators, and thus, constrain their behavior to provide the perception they are within legally permissible boundaries. However, proving that any one individual or defendant violated these rules by knowingly transferring impaired mortgages onto the next participant has proven challenging for prosecutors. As recently as this week and after remaining silent ever since the 2008 collapse of Lehman Brothers, ex-Lehman Brothers CEO Dick Fuld attempted to make the brazen argument that while there were multiple external factors for the demise of Lehman, the decision makers inside of Lehman played by the rules, and were blindsided by the “perfect storm” of external factors. (For a Lehmann insider’s viewpoint, and an alternative account, see the 2010 book by McDonald & Robinson, titled, A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers).

In an attempt to hold sophisticated market participants criminally liable for their individual roles, can a prosecutor charge a “Nash Conspiracy?” Each defendant would be charged with a Nash Conspiracy imputing knowledge of the non-cooperative game strategy on each defendant. The object of the conspiracy being a “moral hazard” whereby all defendants are taking unreasonable risks creating “systemic risk” to the entire U.S. economy, but knowing full well the U.S. taxpayer could ultimately bear the burden of loss (in the so-called “too big to fail bailouts”). For this purpose, we now have a new “systemic risk regulator” under the Dodd-Frank Act of 2010, the Financial Stability Oversight Council (FSOC), that has the power to identify and designate certain financial institutions as being “systemically important.” Presently, the concept of a “systemically important financial institution” (SIFI) in the U.S. extends well beyond traditional banks and is often included under the term non-banking financial company. It includes large hedge funds and traders, large insurance companies, and various and sundry systemically important financial market utilities. In future financial crises, the SIFI-designated entities would primarily be on the hook, because their individual activities would be perceived as creating systemic risks to the entire U.S. economy.

Although not as vindicatory as seeing an executive in handcuffs, the SEC and DOJ have had much success extracting large settlements from financial institutions as opposed to individual defendants. In these civil lawsuits, the government has a lesser burden of proof in establishing the corporate entity acted with the requisite level of intentional wrongdoing, known as scienter. Although regulators were probably not thinking in Nashian terms, the essence of these civil suits is to hold institutions accountable for their market participation in the mortgage fraud crisis.