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In the recent turmoil in financial markets over the failure of subprime mortgages, investors should remember “caveat emptor,” or let the buyer beware, said John Cochrane, Myron S. Scholes Professor of Finance. “These are matters for buyers and sellers, not regulators,” Cochrane said during a Myron Scholes Global Markets Forum, organized by the Initiative on Global Markets and sponsored by the CME Trust and Chicago Council on Global Affairs, at the CME Auditorium September 25.
“Nobody else gets hurt if you buy a lousy mortgage pool,” Cochrane said. “The government doesn’t need to write a new rule every time someone buys a rotten tomato. Investors will demand the right amount of transparency, complexity, and risk-sharing – or monitoring of mortgage pools – unless they all get bailed out and learn to count on a bailout instead.”
The problem with forcing unreasonable risk-takers to pay the price is that many lower-level investors end up in the same basket, said Raghuram Rajan, Eric J. Gleacher Distinguished Service Professor of Finance. “As a result it becomes very, very hard for the Federal Reserve to say, ‘Sink or swim. It’s your problem, not ours,’” Rajan said. “When things go sour, every politician, Wall Street analyst, and commentator is saying, ‘You should do something. Otherwise, we’re going to have the Great Depression again.’ ”
Because the Federal Reserve intervened, banks and investors did not learn a much-needed lesson of the free market, he said. “Next time around the commercial banks will go even further out on a limb and the investors will go even further down in buying short and lending long, and we’ll get an even bigger crisis until such time that the Fed really can’t do anything,” Rajan said. “That’s the kind of worry one should have about the situation.”
To lend credence to the argument that some borrowers may have been abused by predatory lenders, it’s important to consider how complex mortgages have gotten with adjustable-rate, interest-only, and interest-free mortgages, said Luigi Zingales, Robert C. McCormack Professor of Entrepreneurship and Finance, who moderated the event. “Many borrowers knew what they were doing, but a fair amount of people did not,” Zingales said.
Recent research shows that an alarming percentage of Americans do not know whether a government bond or individual stock is more risky, he said. “The finance world is becoming more and more sophisticated but consumers are not,” Zingales said. “Caveat emptor applies only if the emptor, or the person buying it, knows something about what he’s buying.”
Investors who did not risk big losses for the high returns of the subprime market should have experienced one of their best months ever during August, when the subprime market collapsed, said Anil Kashyap, Edward Eagle Brown Professor of Economics and Finance. “The fact that that didn’t happen gets completely ignored in some arguments,” Kashyap said. “That is a first-order problem with what’s happened. It’s not just that you reward the guys who took on the risk; it’s that you don’t reward the guys that were sensible.”
As mortgage rates rise in coming months, researchers should examine where the original subprime investors shifted their money, he said. “This is an important question because if you figure out what they did and when they might switch back, that could be a key to figuring out when the markets are going to return to normal,” Kashyap said. “Right now we don’t fully know this. We suspect that they were just parking it in cash of some sort, but we’re not absolutely sure.”