Asymmetrical information

Over the past few days, I've noticed an upsurge in liberal blogs claiming that of course, borrowers don't bear any responsibility for their current straitened circumstances.  After all, there are two parties in a transaction, and the lenders are professionals and should have known better.

This post by Matt Yglesias makes that argument:

There really is plenty of blame to go around here. But I just don't see how more than a tiny fraction of it could possible adhere to our electrician or teacher or secretary who's decided, basically, that the financial services professionals and government regulators know what they're doing. Now could she have known better? Sure. She could have been reading Dean Baker and Paul Krugman and others. The idea that this lending was all being undertaken on a false premise that a nationwide housing bust was impossible wasn't a highly guarded secret. I was, for example, familiar with the chart above and with the analysis suggesting that a bust was, in fact, likely. And I believed that analysis. But at the same time, I write about U.S. public policy debates for a living. If there's a dissident line of thinking that, despite its general unpopularity, is popular among left-of-center economists--well, that's the kind of thing I know a lot about. But our nurse? Why would she know?

Think back to 2006. It's not as if CNBC and your paper's real estate section were rigorously probing this question. Alan Greenspan and Hank Paulson weren't saying "the economy seems dangerously vulnerable to the possibility of a nationwide decline in real estate prices, something that major financial institutions' models say is impossible but that history says is likely." And to be fair and non-partisan, it's not as if Harry Reid was saying it either.

This assumes, of course, that the primary risk is a decline in house prices.  The lenders should have known that house prices might decline, and therefore the lenders should bear the losses attached thereof.

It seems to me that this sort of acts like borrowers shouldn't have any obligation to repay money on an asset that has fallen in value--as if there were some sort of moral right to take highly leveraged bets on housing and pass off any losses to someone else.  The borrowers ought to have known that they couldn't be repaid, because of course the natural and right thing to do, in the event that an item you have purchased on credit falls in value, is to default on your loan.

On the other hand if we assume as a matter of public policy that people who have signed a loan contract are actually obligated to pay back the money they borrowed even if their house is not rapidly appreciating, then the primary risk is not a fall in house prices; it is that borrowers will not be able to repay the loan.

Who knows more about your future income prospects:  you, or a bank?  Who knows more about your budgeting skills:  you, or a bank?  Who knows more about your health, personal habits, and home maintenance skills?  Who knows better whether you're likely to move two years after buying for a boyfriend or an employer? Are bankers somehow more aware than ordinary Americans that recessions happen, companies fold, people lose their jobs?

Of course, falling house prices make things harder because you can't sell or refinance your way to stability.  But unless you just suddenly lost your job--in which case, you probably can't be helped by a workout, because you don't have any income--then it's not reasonable to say that all the information was on the banking side.  People knew a lot.  They just chose not to think about it.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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