Fraudulent subprime mortgages

The market seems (more or less) competitive on the supply side.  So the greater the opportunity for fraud (by lenders), the more lenders will enter the market.  This will bid down prices (interest rates on loans).  The loan contract will move toward lower price, lower quality.  Of course prices are lower on average but for those who end up ripped off the real price, ex post, is much higher.

On average who loses from such a shift?  Well, to some extent there is a pooling of heterogeneous tastes into a single market segment.  The ones who don’t like the lower price, lower quality equilibrium will be the higher valuation buyers for the contract, that is the wealthier people in the relevant loan class, not the poorer people.  The poorer buyers in the market segment might well be better off.

This result does not require buyers to be wary about fraud.  It is even possible to get a superior outcome if buyers are totally unaware of prospects for fraud.  To the extent buyers are suspicious, they will invest resources in monitoring the behavior of suppliers.  Often such monitoring is simply keeping/capturing pecuniary externalities, and thus it is oversupplied relative to a first best.  If buyers are fully unaware there will be no socially wasteful monitoring and the lower prices still will arrive.

You might say "Ah, but we cannot dismiss pecuniary externalities when insurance markets are incomplete."  I might say "Ah, but aren’t buyers generally risk-loving in terms of prices"?

The bottom line is this: whenever you see fraud, apply tax incidence analysis to understand the final results.


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