Information, Markets and the Subprime Mess

Though not specific to Oregon, the mortgage market mess is certainly quite relevant given that it affects Oregonians just a s much as anyone else. What strikes me most about the sub-prime mortgage crisis is how it paints, in stark relief, just how important information is for efficient market outcomes. This is a general theme, not specific to mortgage markets.

In a nutshell, the story of the sub-prime mortgage mess goes like this: Lenders, eager to generate new mortgages that they were finding willing buyers for, kept dipping deeper and deeper into the barrel of qualified borrowers. After a while they were scraping the bottom and lending to very risky buyers, compensating the risk by offering very expensive loans. But the expense of the loans was usually delayed by a small period (one, two, three years) - enough time, in other words to off-load the paper and a lot more to follow before the expense kicked in and ignited a wave of defaults. Here is where the information problem kicked in. The wholesalers who were buying the paper and bundling it with a lot of other paper and selling bulk mortgages to investment banks didn't really know what they were buying. Only the people who wrote the loans really know who it was they were lending to. Credit rating agencies were relied upon to provide evaluations of the loans, but they were not effective in assessing the increasing risk of these sub-prime loans.

Then it happened, the expensive parts of the loans kicked in, the default rates started skyrocketing and all of a sudden investment banks, taking huge losses, were not so interested in buying up new paper, especially sub-prime paper but even mortgages from borrowers of moderate risk. This meant that the amount of money available to lend to home buyers dried up precipitously. All because of a lack of information.

Information is essential for efficient markets - it is their life-blood. One of the key assumptions in the familiar Adam Smith 'invisible hand' story is complete information - essentially that everyone who participates in a market knows everything about everything. In this case when there is so little information, speculation ensues and all of a sudden a credit market that looked so efficient, collapses. What is striking to me is that when serious market failures happen (like the lack of credible information in mortgage markets) regulation is an appropriate thing to discuss. What type and how much is debatable, but hoping the market will correct itself in the face of such a lacuna of information is not good governance.

Update: an excellent article in the Wall Street Journal today on Bernanke and the Fed and their response to the sub-prime mess.