Should You Worry About Sub-Prime Mortgages?

May 23, 2007

Comments

The housing market really isn’t my thing, but James Hamilton does have a pretty good post that looks at a potential problem with sub-prime loans. Still, you are interested in such things, head on over and check out that post. Here is the main conclusion,

The ultimate discipline, then, must come from these final holders of the mortgages. I have two concerns about whether the incentives have indeed been structured to work in society’s best interests here. The first is whether these final holders of the loans perceive them to be insured through implicit government guarantees, for example through Fannie Mae and Freddie Mac or the too big to fail doctrine. If so, then there may be a serious moral hazard problem here that has promoted excessive risk-taking behavior from these final investors

My second concern is whether certain institutions such as public pension funds ([1], [2]) may in fact desire assets with low probabilities of catastrophic outcomes, with the technological advances to which Bernanke refers giving them new opportunities to assume risks that may not be desirable from the perspective of broader social goals.

For this reason, the number one question in my mind that we should be asking here is, Who is the residual holder of this risk?

And that is not a question that was addressed in Bernanke’s remarks.

One response to “Should You Worry About Sub-Prime Mortgages?”

Edgardo

May 23, 2007 at 7:27 am

As an economist I stopped reading Hamilton’s blog sometime ago. Most of his posts, and all posts by his co-blogger, are just a manipulation of data with little economic insight.
Now Hamilton says “I have two concerns about whether the incentives have indeed been structured to work in society’s best interests here.” Indeed he is not talking about the mortgages as private contracts, otherwise he’d fail Econ 101. His concern is a government action but he should know better: as long as you ignore the details of how policies are designed and implemented (that is, as long as you ignore the lessons from Public Choice and related disciplines), all government actions can be seen as posing a moral hazard problem. If you ignore all that, you can always answer his question by saying government is the residual holder (see David Moss, When All Else Fails – Government as the Ultimate Risk Manager, Harvard, 2002).