Agency Bounds on Firm Rationality
The events to be described here took place about six months ago, but it came up in conversation over the weekend, and I thought I'd share it here.

A very good friend of a very good friend bought a house. It was a short sale with two lien-holders — this had been an 80/20 deal — which you can imagine is administratively complex; the total debt was on the order of $350,000 — I don't remember the exact figure — and he and the seller had agreed to a price of $253,000. The primary lien-holder had signed off on an agreement allowing the second lien-holder to receive $11,500, while the second lien-holder had agreed to accept 5% of the sale price. 5% of $253,000 is $12,650, so they were a bit stuck.

The climax came when the buyer was in an office with his real-estate agent, on a speaker-phone conference call with lower-level employees of both lenders, neither with the real authority to renegotiate either agreement. In lieu of being able to negotiate, they began yelling at each other for a protracted period of time, over which it occurred to them that there was nothing in the agreements stipulating a minimum dollar value that either bank would accept. Accordingly, they lowered the sale price to $230,000, of which 5% would be $11,500, and the buyer walked away $23,000 richer.


Most of the time for most purposes, firms, especially large firms, tend to behave more "rationally" than individuals; commercial mortgage prepayments, for example, are much more sensitive to interest rates than you're average conforming home loan. There are certain important quirks of firm behavior, though, stemming from the fact that they are not really unitary actors, but collections of agents with varying knowledge and authority, and sometimes that results in firms acting clearly against their own interests.

Update: Felix Salmon suggests this may be rational behavior in a repeated-game, or (perhaps relatedly) an aversion to outcomes perceived as unfair in some sense. An interesting suggestion, but I think if the lenders' representatives had had the authority to change the deal to split the other $23,000 among themselves, they probably would have; this is a story of individuals doing what's easiest for them rather than their employer, partly due to constraints created (on some level) by the employer.
- posted by dWj @ 11:52 PM