Policy Court

Opinion of the court, delivered by David Lamb, signed by William Leich
If you have ever been to an airport, contracted a computer virus, or taken a look at the Social Security system, you know that security often isn’t secure.  And even though Wall Street bankers call subprime mortgages “securitized,” they know that the difference between “securitization” and securitization is a matter of bears and bulls—and not the type found in the zoo.

The subprime mortgage crisis that became the financial crisis that became the recession that became the Great Recession wasn’t a consequence of market failure or misguided risk-taking.  Rather it was the result of individuals—bankers and homeowners—behaving like individuals at the expense of the broader economy: exploiting bankruptcy laws that mitigated their own risk, not by removing it, but by imposing it on third-parties.

Subprime mortgages are called “secure” because their loan value is designed not to exceed the value of the property.  This means that if a homeowner becomes delinquent on a mortgage, the lending party can foreclose on the home and recover the loan’s entire value.  As long as real estate prices are static, banks don’t carry significant risk writing mortgages without down payments.

The problem is that this system depends on home values not falling below mortgage values.  When they do—when delinquent borrowers owe more than their houses were worth—creditors can be stuck with a deficit: their collateral—the house—is worth less than their credit—the mortgage—which means foreclosure doesn’t bring all of their money back.

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Opinion of the court, delivered by Nicole Adams, signed by David Lamb
Why did the banker cross the road?  Because there was a $100 bill on the other side.  Why didn’t the economist?  Because he reasoned that if the $100 bill was real, someone would have already picked it up.

The bill was fresh from the Philadelphia headquarters of the United States Mint; what the economist thought was a piece of counterfeit currency was actually bailout money, planted on the other side of the asphalt for the banker who the federal government knew didn’t accept the idea of market efficiency.

President Obama and his administration predicted the banker would reason that if the efficient-market hypothesis (EMH)—the theory that the prices at which all financial assets are traded reflect all known information—held true, then commodity prices never would have spiked in the summer of 2008, real estate prices wouldn’t have increased by 50% from 2000-2007 and since lost those gains, and the “dot-com bubble” wouldn’t be a case study on human psychology applied to economics.

Although many economic theorists still hold that investors are rational, and use the EMH as evidence that stock prices mirror real stock values and that outperforming the market is therefore impossible through any means other than luck, a growing number of financial economists are beginning to doubt the EMH.  Over the past fifteen years, free stock-trading websites have made available information that was previously difficult, if not impossible, to find.  And yet an increase in real-time financial information has correlated with an increase in bad investing—the dot-com bubble, the oil speculation bubble, and the American housing bubble have all come since then.

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