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Market Failure, Mortgage Style

Wednesday, June 11, 2008 | 10:25 AM

In our prior post, I alluded to the failure of markets and mortgage origination. This requires additional discussion.

When discussing free markets versus regulation, one of the basic tenets of laissez-faire economics is that human beings are rational, self-interested actors. This turns out to be a faulty premise. Humans can be illogical, irrational, and overly focused on the short term to the detriment of long-term performance results.

Case in point: Mortgage brokers and underwriters reckless lending to unqualified borrowers during the 2001- 06 housing boom. The immediate gains in compensation for all parties involved seemed to totally overwhelm the longer-term concerns of ensuring loans get repaid.

The repayment of principle should be the single most important concern to any firm that lends money. Once that became secondary, we were set up for our market failure.

Under normal circumstances, the fear of losses and eventual business failure operates within the marketplace to prevent businesses from doing anything too stupid. Lenders should have been self-interested enough to not recklessly lend money to people who couldn't repay it. However, that seems to not applied this time around. According to the Mortgage Lender implode-o-meter, 262 major US lending operations have gone belly up since late 2006.

The normal operations of the marketplace simply failed to work. Where markets fail to prevent recklessness, irresponsibility and behaviors that inflicts significant damage on the broader economy, some form of limited government preventative regulation is called for.

A great nation, even a mostly capatilistic one (with quadrennial socialism) such as ours is not obligated to allow these failures to cause unfettered and ongoing economic ruin. The alternative is what we have today: An environment where anything goes, no referees are on the field, and the current housing and credit crisis was allowed to develop the unfettered.

There is a balance between free-market competition, and limited government regulation where absolutely required. The Greenspan Fed 's ideological preference for the former, has led to a situation we are where we are all but guaranteed the latter.

UPDATE: June 13, 2008 1:32pm

Paul Krugman notes:

The late Milton Friedman agreed, calling for the abolition of the Food and Drug Administration. It was unnecessary, he argued: private companies would avoid taking risks with public health to safeguard their reputations and to avoid damaging class-action lawsuits. (Friedman, unlike almost every other conservative I can think of, viewed lawyers as the guardians of free-market capitalism.)

-Bad Cow Disease