Bryan Caplan  

The Subprime Crisis: Why Asymmetric Information Didn't Save Us

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If I Had a Billion Dollars: My... Caveat Emptor: Will The Buyer ...
Foote, Gerardi, and Willen's subprime manifesto is theoretically enlightening as well as empirically edifyingUnlike many economists, they understand asymmetric information on an unusually deep level.  Standard adverse selection models suggest that the market for iffy mortgage-backed securities would never get off the ground:
In the securitization process, lenders screen potential borrowers and originate mortgages, then package the mortgages for sale to outside investors. Yet investors cannot verify how carefully the screening is actually done. The problem is worse if the lender retains no skin in the game, so that any credit losses on the mortgages are borne solely by the investor. Given these informational problems, it is reasonable to think that investors would be concerned about purchasing any mortgage-backed securities. This is the prediction of textbook theories of asymmetric information, which imply that if such asymmetries had been a problem for mortgage-backed securities, we would not have seen an explosion of securitized mortgage credit driving housing prices higher while investors were cheated. Rather, the opposite would have occurred. Mortgage credit would have dwindled as investors, like buyers looking over used cars with broken odometers, walked away from the deals.
So why didn't this asymmetric information "problem" prevent the crisis from happening in the first place?
Yet even though buying and selling mortgages involves some degree of asymmetric information, securitized mortgage credit did explode and house prices did move higher. The best explanation for this correlation places higher price expectations at the front of the causal chain. If investors believed that housing prices would continue rising rapidly, then it didn't matter what a mortgage borrower's income or credit score was. In the event that the borrower defaulted, then the higher price of the house serving as collateral would eliminate any credit losses. In the words of Gorton (2010), higher housing prices cause securitized mortgages to become less "information sensitive," meaning that their profitability depends less on potentially unverifiable characteristics like borrower credit scores and incomes. So in the early 2000s, when price expectations rose, investors became eager to invest in securitized mortgages--even those that were clearly identified as "reduced documentation"' or "no documentation," for which originators avowed that the loans had not been painstakingly underwritten.
You could object that asymmetric information models are overly rational.  What's wrong with a simple "naive investor" model?
The problem with this theory is that the facts do not support it. To make an obvious point, many Wall Street investors who lost money were seasoned financial professionals, a group generally not known for being overly trusting of those on the other side of high stakes deals. More importantly, facts 3 and 5 showed that the institutional framework behind mortgage securitization was not new. Investors had ample time to discern the relevant incentives and act accordingly. Public discussions of potential moral hazard issues surrounding mortgage-backed securities had been common as well.
Elegant conclusion:
In short, the idea that the underwriting standards of lenders who sold loans might be different from the standards of portfolio lenders is not a sophisticated idea from a graduate seminar in information economics. Rather, it is a simple concept that was understood by virtually everyone. It does not imply that well-informed insiders were able to expand credit by taking advantage of ill-informed or neophyte outsiders. Instead, it implies that higher price expectations expanded credit by lessening the impact of any informational problems inherent in the securitization process.



COMMENTS (9 to date)
8 writes:

It's the end of an 80 year debt cycle. People become more and more daring as the cycle develops and the Great Depression fades into the background. The vast majority of investors simply move with the herd. Any time a financial professional steps out of line they are taking a huge career risk. When you fail alone, you can't blame the market for being stupid, even if it is. When you fail with the herd, well, look at all these people who got it wrong! Where are you going to take your money?

Size also matters. The funds driving the market are sovereign wealth, pension funds and endowments. It's turning an aircraft carrier.

Finally, there haven't been any prosecutions for fraud. One explanation for the story that makes sense is that financial institutions were engaged in, at the very least, unethical behavior that would have gotten a firm in trouble 50 years ago. This goes with the cycle though: investors are most naive and firms the most crooked at the top. When the bottom hits, firms will be honest again, and no one will want to do business with them.

Richard writes:

To the extent the authors are arguing against a "naive investor" theory of the crisis, they are arguing against a straw man, as no intelligent analyst of the crisis has relied on that theory.

This paper is already a year old, and even a year ago the facts in it were already widely known. Housing prices kept rising because everyone expected them too. Until they didn't. Nothing new under the sun. Nothing is added by looking through the "asymmetric information" lens: it was obvious even in 2008 that subprime was a bubble, not a lemons market.

Glen S. McGhee writes:

Asymmetrical flows of information abound -- consider the education sector.

Accreditors supposedly screen schools for the quality of instruction, and the credentials of their instructors, but no one can verify this. It is a black-box that everyone relies upon when making major spending decisions.

For a whole host of reasons, no one is staying away, either.

Steve Sailer writes:

Here's a short story I published in 2008 that explains what the the housing bubble in Southern California's exurbs looked like to people on the ground:

http://isteve.blogspot.com/2010/03/unreal-estate.html

Steve Sailer writes:

Something like 7/8ths of all the total declines in home prices in 2007 and 2008 (i.e., before the recession kicked in -- in other words, the declines that were more the cause of the recession than the result of the recession) came in just the 4 Sand States (CA, NV, AZ, and FL).

In other words, just as Angelo Mozilo and Henry Cisneros of Countrywide Financial said repeatedly, the Housing Bubble was a bet on Hispanics.

And now we know what happened, but nobody wants to think about it because they don't want to get Richwined.

Richard writes:

"The Housing Bubble was a bet on Hispanics."

Not true. The housing bubble was a joint bet by (often Hispanic) homebuyers and their lenders that continued increases in housing prices would enable the homebuyers to repay the mortgages. Neither the homebuyers nor the lenders expected the homebuyers to be able or willing to repay the mortgages if prices stopped rising.

EclectEcon writes:

So long as the investors could buy insurance in the form of credit default swaps from companies like AIG, they didn't have to worry about the credit-worthiness of the homebuyers. But that just pushed the due-diligence question back one step to the insurers. And insurance companies should have known all about the moral hazard and asymmetric information problem.

Himanshu Sanguri writes:

This theory of asymmetric information reminds me of The Black Swan by Nassim Nicholas Taleb. Here, the non scrutinized borrowers became a black swan for the poor investors. More often Bastiat had also stressed on the practice of distinguishing between what is seen and not seen before making any final conclusions.

Harold Cockerill writes:

I question the existence of the asymmetry for many of the borrowers and lenders. If you are putting down little or nothing on a home purchase and the bet goes wrong what have you lost? I think in many cases the buyers ended up better off because they lived in house on which they had ceased payment for a significant period. They were actually renters to begin with and then stopped paying rent but didn't move out.

Many of the investors had an implicit backstop from the federal government. How much did buyers of paper from Freddie and Fannie lose? A lot of tax dollars went into both. The greatest asymmetry is in the knowledge of the taxpayer and the politician handing out tax dollars to buy love and votes. In this matter the politicians have arranged to decrease the number of people paying taxes such that less pressure is brought to bear to be careful with the money.

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