no third solution

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The Moral Hazard of Sub-Prime

October 7th, 2008

The moral hazard of the subprime market for loans is essentially this: Sooner or later…the only people left to borrow money are those to whom no sound banker would lend a dime under ordinary circumstances.

With that in mind, one of my professors from Grad School e-mailed me the following article in PDF form the other day, which I’ve since seen floating around the Econosphere. It is a NYT article discusses the moral hazard of Fannie/Freddie moving in to the subprime market, from September, 1999:

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government subsidized corporation may run into trouble in an economic downturn, promting a government rescue similar to that of the savings and loan industry in the 1980’s.

I’ve been singing that tune for a few years now, as I previously blogged in 2006, everyone thought they’d be one of the lucky ones who could beat the mortgage bubble.

With all the low-interest mortgage options that have been available – especially due to the prevalence of variable rate mortgages, I think it’s fair to assume that alot of people who couldn’t afford to buy (or otherwise invest in) real estate used the ARM to keep their payments within the realm of affordability, on the expectation that when the ARM expired, they’d be able to sell it. Sell it to whom? Everyone else in the market bought on the same speculation – or refinanced on the same speculation.

Economics, for the most part, is not rocket science. Incentives matter. Price controls don’t work. Supply and demand ultimately prevail.

I should qualify, that sub-prime lending, in and of itself, is not prone to any particular moral hazard. In a free market (we do not have, nor did we in 1999, a free market) interest rates match time preferences of borrowers and lenders. In a free market, risky business pays a higher price, which discourages behavior prone to risk, and encourages people to reduce the risks within their power to control. Only when the market is manipulated, when the costs of doing such business are hidden from plain (and examined) view, when the risks are concealed to the borrowers, does moral hazard begin to enter the picture.

And what a mess it leaves, eh?

no third solution

Blogging about liberty, anarchy, economics and politics