Perverse Incentive System - II

One of the factors that has never been blamed for the sub-prime fiasco is competition.

That is obvious because competition is considered the foundation of the free-market system, and hence criticizing competition is equal to challenging the market itself.

Competition is thought to lead to better products/services, which is assumed will lead to a better society, or at least a more efficient economy.

Competition is never thought to be a market destroying culprit. This is heretical.

Questioning the utility of a competitive market will naturally lead to calls for more regulation - an absolute anathema to the free-market.

So, market participants have an incentive to avoid the elephant-in-the-room.

Let's take a recent example.
The falling standards of mortgage-approval were a direct result of increasing competition.

As more mortgage-players entered the market, customers became a hot property. And in order to secure more customers, lending-standards were lowered. And they were lowered to such an extant that the ability to repay the debt was forgotten.

The mortgage companies were able to ignore the loan-worthiness of the debtors because they never expected to be paid by them - they expected to be paid by those funds and investors who would buy these packaged loans in the form of Mortgage-Backed-Securities (MBS), Collateralized-Debt-Obligation (CDO), etc.

Once these mortgages were packed into an instrument, all that the manager had to do was get a sufficiently high rating from a rating agency to justify a good return for the company and a good bonus for himself, and everybody could go home happy via a short stop at the bank.

The rating agencies had their own perverse incentive system - but that's another post.

Higher competition (for more customers) led to lower standards - which ultimately led to the blow out in the markets.

Had competitive pressures not been high, it is conceivable that the markets would not have suffered a collapse.