Lend to everyone, let the government sort it out

by Rob Horning

18 December 2008

 

Reading this post in whcih Adam Levitin recounts credit-card lenders’ abuse of behavioral finance—key excerpt:

The card lender often isn’t looking to get the principal repaid. Instead, the interest rate and fees returns are high enough that they cover the cost of the principal. The principal remains outstanding, and the ideal consumer makes minimum payments forever, making enough new charges to keep the balance from ever amortizing. In effect, the consumer becomes an annuity.

—right after this post about the potential incentive to voluntarily participate in a Ponzi scheme if you are expecting a bailout—key excerpt from a paper by Utpal Bhattacharya:

We argue in this paper that if agents correctly believe in the possibility of a partial bailout when a gigantic Ponzi scheme collapses, and they recognize that a bailout is tantamount to a redistribution of wealth from non-participants to participants, it may be rational for agents to participate, even if they know that it is the last round.

—led me to this question: If credit-card companies can expect a bailout if a critical mass of borrowers default, do they become aware of point at which it becomes more prudent to lend to everyone and encourage them to charge up a storm rather than perform due diligence on the risks various individual borrowers represent? They can collect their fees from customers until the whole thing collapses, hopefully with a loud enough crash that the state will restore much of the principal. A related question: Did mortgage lenders reach that point a few years ago? Is this how investors’ cupidity led them to interpret the implicit government backing of Fannie and Freddie?

 

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