A friend sent me a link to Richard Posner’s column in the Washington Post, From oil spill to the financial crisis, why we don’t plan for the worst.
For the most part, I agree with Mr. Posner’s column, but I do have some thoughts.
I think Posner misses the role government played in the financial crisis. I agree with Russ Roberts’s take that there was a feeling government would step in if things got bad. Robert’s makes the case that the precedence of bailouts had been set for 30 years. Government officials were deeply entwined in the debacle by setting public goals to expand home ownership and directing Freddie and Fannie to buy bad mortgages to fulfill their goals of expanded home ownership. They had a horse in the race. Why would they let if fail?
Government involvement distorted price signals in the market – something that gets no attention in the media. Instead of buying a mortgage based solely on the economics (can this guy pay it back, will the house be worth this much?) they were also buying an implied option of a government bailout (if the guy can’t pay back or housing prices go down, government will step in and I’ll get something back).
I know that’s hard to see, but it’s easier if you personalize it. What would you do if an irresponsible friend asked for a loan and said he was willing to pay an interest rate of 10%? The 10% sounds good. Where can you get that kind of interest rate? But, based on his history, you decide to pass because you realize 10% isn’t enough to compensate for the high-risk of not getting your money back. That’s a price signal. You just sent a signal to your friend that a 10% interest rate is not high enough to compensate you for the risk.
And, you just priced the loan very much like how the free market would price a mortgage loan.
Would you change your mind if some other responsible party co-signed his loan? Maybe his Mom, who has a good track record, says if you accept 9% interest, I’ll pay you if he doesn’t. Your risk just went down substantially. Now, you’re pricing the loan based on the Mother’s ability to pay back, not your friends.