Sunday, March 25, 2012

Crisis and Regulation, part one

I watched Inside Job for the first time this week, and it got me thinking about financial regulation and the crisis of 2008. What struck me most about the whole thing was how ill-designed the subsequent Frank-Dodd regulatory bill was.

To start with, lets investigate my diagnosis of what caused the financial crisis, and what did not. The crux of the problem was asymetric information, where one side in a transaction has more information than the other. With asymetric information, markets cannot funciton efficiently because supply and demand equilibrium rely on both parties maximizing their utility; with asymetric information, prices will either be too high or too low, depending on whether the buyer or seller has the information advantage.

This was exactly the situation that arose in the market for mortgage-backed securities. Mortgages of individual homeowners were combined into securities and sold by the original lending institution. The mortgage payments from the mortgages that comprised the security than went to the new owners of the security.

Many of these securities were backed by mortgages that were given to NINJAS- no, not those ninjas, but people with No Income, No Job, No Assets- obviously the type of person who is likley to default or at least be delinquent on their mortgage. But the originators of these loans did not care, because once the made the loan, they simply combined the bad mortgages into mortgage-backed securities and sold them to someone else.

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