Dealing with Adverse Selection in the Mortgage Market (Brad DeLong)


The guvmint can step into the market to a certain degree and make a positive [regulatory] difference to help ‘make markets’. However, there is a certain loss to both Wall Street and Main Street in terms of utility by excessive meddling (e.g., price fixing and competitive ‘bargains’). The way to sort this giant mortgage mess out is via good old-fashioned contrition, not appeasement. That being said, people need to take their medicine now (with a little oversight like a spoonful of sugar) and get over it. The home price inflation scenario, like the ’99 tech bubble was a ponzi scheme. This is how republics lose their sovereignty (check the story on many parts of Eastern Europe). If people cannot be trusted with their own money, they lose it. That’s the way the game is played. If people don’t want guvmint making all their choices for them, they best keep their respective households in order.


Suppose that a bank calculates that the net value of the mortgage to the bank as a fraction of its principal is equal to five years’ interest minus the chance of default:

π = 4r – d

And suppose that the homeowners and homebuyers who come to the bank have a chance of default which is:

d = 15% + 20r2

Then bank profits expected from a typical homeowner and home buyer are:

π = 4r – 20r2 – 15%

Which means that a bank can make profits as long as:

5% ≤ r ≤ 15%

And if there are a bunch of competitive banks, and if homeowners can comparison shop, competition will push the interest rate down to 5% and a bit more. And the observed default probability will be 20%.

Now suppose that there is bad economic news: the default probability rises by 5% to:

d = 20% + 20r2

Then, the way I have rigged this scenario, interest rates rise to 10%: no bank can make money charging less than 10%, given the new, higher default probability–and the observed default probability will rise not by 5% but by 20%, to 40%. The big increase in default, you see, comes not from the bad economic news but from the fact that a lot of people who could still make their mortgage payments at the old interest rate cannot make them at the new one.

And if the default probability rises even more, to:

d = 21% + 20r2

then the market collapses. There is no interest rate at which any bank–even a monopoly bank–wishes to be in this business. No loans are made at all.

Suppose that at this stage the government steps in. “We,” the government says, “are going to cap your default losses at 20%.” Then banks look at the situation and once again discover that it is profitable to make loans at any interest rate above 5%. Competition chases the market interest rate back down to 5% again. There is a problem–at a 5% interest rate default losses are not 20% but rather 26%–and so the government has to kick in money. But maybe a 26% default rate with the government having to kick in some money is better than a 40% default rate from a cultural, sociological, political, and in the presence of aggregate demand externalities economic point of view. And surely it is better than a complete collapse of the mortgage market.

That is the logic behind Frank, Dodd-Obama, the Barr-Tyson plan being pushed by Hillary Rodham Clinton, and the other variants: that when the major cause of large-scale defaults is not the fecklessness of the borrowers but rather the fact that the market equilibrium has high interest rates that are themselves both the consequence and cause of high default rates, that the government has a market-making role to play by providing guarantees. This seems to me to be a good logic.


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