Wednesday, September 26, 2007

Today my Head Wants to Explode

So, besides the subsiding sinus pressure of the traditional Back-to-School bug that tends to bite the faculties of America's colleges and universities, there are other things making my head want to explode. An article appeared today in the NY Times indicating that companies that rated the securites that were purchased with subprime mortgages as collateral were inappropriately inflating those securities' ratings to make them look better on paper. It's unclear whether Bear Stearns, et al. asked the ratings agencies to do this for them, but this is really bad.

I have a previous post on this that talks about moral hazard, but this story on the security rating agencies adds a completely new layer to the insanity. Basically, what comes out of it is two-sided moral hazard where both parties to a contract have an apparent incentive to deliberately engage in bade behavior. We're waaaaay past supply and demand here. What makes this stuff mind blowing is that the existence of a stable equilibrium is usually not very likely in general terms-- usually only for certain numerical examples with restrictive assumptions. Second, optimal contracts that can overcome the moral hazard problem tend to be characterized partially, and the contractual relationship has to be repeated in order for the contract to carry much weight. There's lots of really hard math involved in the theoretical excursions into this area, hence head explosion.

Bottom line-- the more layers of moral hazard you add to a problem the more chaotic and unpredictable the result, and the more likely it is that bad things happen. Bad things happened.


  1. excellent short take on two sided moral hazard.

  2. Glad to have a theorist's approval. And, of course, you understand that the short take constitutes nearly all I know about the matter.