Rate Watch #1339 – Why Markets Fail – Imperfect Information.
October 25, 2021
By Dick Lepre
A recap of last week's fundamentals is here.
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Why Markets Fail
I believe that it is worth looking at the mortgage mess/credit crisis of 2008 and asking, "What exactly went wrong here?"
I am a believer in free markets. This is the "invisible hand" notion of Adam Smith. Smith demonstrated that, in a free market, an individual pursuing his own self-interest tends to also promote the good of his community as a whole through a principle that he called “the invisible hand”. He argued that each individual maximizing revenue for himself maximizes the total revenue of society as a whole, as this is identical with the sum total of individual revenues. (Last 2 sentences were cut and paste from Wikipedia.)
The implication here is that investors in, for example, Mortgage Backed Securities will make decisions to invest in high yield mortgage securities and the market will constantly correct prices so that there will be maximum benefit.
Smith's notion was formalized by the First Theorem of Welfare Economics. This states (and this is a bit of a simplification) that competitive markets tend toward the efficient allocation of resources. The Second Theorem of Welfare Economics states that even in the case of intervention (a government mandated reallocation of resources) the market should still function so as to achieve what is called Pareto efficiency. In its simplest case, Pareto efficiency relates to the notion that if goods can be reallocated to as to make one person better off and no one worse off this constitutes what is called a Pareto improvement.
The implication exists also that interventions which are socially driven reallocations of resources should still be handled by the market. Smith implies that letting the markets do the work leads to the most desirable outcome absent intervention.
So where am I going with this? My point is that the reallocation referred to here was the opening of mortgage credit to a significantly larger set of people. This was the heart of the subprime thing. Whether it was government intervention in mandating that FHLMC and FNMA buy subprime mortgages or pure Wall Street greed i.e. the pursuit of profit by individuals and corporations markets should have corrected prices to make this work.
All of this is great but it obviously failed in a massive way. Why? I think that the answer is incredibly simple. Smith's notions assume that the markets have the quality of perfect competition. On the surface this means that neither the buyer nor seller has market power. Perfect competition implies several things one of which is of substantial importance in the case of the mortgage mess. Perfect competition assumes that both the buyer and seller have perfect information.
Perfect information may, in a sense, be an ideal but accurate information is not and stated income lending is close to being the opposite of perfect information. In short, markets participants did not make accurate choices in originating subprime loans or buying subprime MBS because they had inaccurate information about borrower income and inaccurate forecasts of the default rates associated with subprime. This lack of accurate information existed at both ends: 1) borrower income and 2) a clear assessment of the risks of the MBS sold to investors. The Wall Street investment banks which securitized this debt did so in a manner so as to obfuscate the ability of investors to ascertain risk. They had support from the three debt rating firms.
I do not regard the buyers of MBS to have been blameless. They did not pay someone to objectively rate these securities but chose instead to rely on what at that time were 3 debt rating firms. Those firms were paid by the sellers of MBS and their opinions were not objective.
I am implying that it was not subprime per se but stated income subprime and inaccurate forecasts of subprime defaults which created the mortgage mess. Accurate information about borrower income was easily obtainable but it was avoided and instead bad information was fed into the market and the market failed.
Having acted as a consultant to lawyers in mortgage fraud cases the one constant I saw was that all of the lenders who were victims of fraud deliberately close to not verify borrowers’ incomes. Every loan had an IRS form 4506 enabling lenders to obtain actual income from IRS but none of these lenders chose to execute the 4506. They, in essence, chose to have imperfect information. They did this because they assumed that the party they sold these mortgages to would be assuming all of the risk.
Bad information was also provided by groups such as NAR (National Association of Realtors) which admitted that its estimates of Existing Home Sales from 2007-2011 were inflated.
I want to add a note here that Adam's Smith's "invisible hand" theory is not universally accepted and that there are modern interventionist theories which also have popularity. That aside, I strongly believe that taken either inside or outside of Smith's notions this market was cursed by allowing and, in fact, encouraging bad information.
Another example of the effect of imperfect information in markets was presented in Michael Lewis' "Flash Boys: A Wall Street Revolt." This made the case that imperfection could occur not in information but in time. If one party has access to equity trading a millisecond before most other market participants that party can make profit by front-running trades.
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