The Sub-Prime Mortgage Crisis: A Tragedy of the Commons

When I think of a "commons" I think of the lands held in common in the past by villages in England. All the people in the village had equal right to graze their sheep in the village commons. Each villager individually would profit more by grazing more sheep on the commons. But if the village as a whole tried to graze more sheep than the commons could support, they would ruin the land and everyone would suffer. Thus the tragedy. Unless the village could agree on managing the commons in a way that guaranteed its continued health then the villagers each by seeking to maximize his own benefits would reduce the benefits for all.

In the mortgage industry, each firm has an equal right to attract customers and make mortgage loans. Each firm profits more by making more (good) loans. But there are only so many potential borrowers who can afford a mortgage. In the past lenders had been restrained from making loans to people by banking regulations and practices that encouraged them to limit the risk they accepted in their portfolio. With the development of mechanisms allowing them to make mortgage loans, package them into bundles and pass the risk on to market investors, thos past restraints were removed. The firms then had the incentives to make more and more loans, and collectively put a lot more money out on loan than the borrowers could collectively pay off. The market crashed.

Of course, the situation is not quite that simple. Wnen sheep overgraze a common pasture, it is not simply that all the grass is gone. Weeds invade, erosion occurs, soils deteriorate, and the pasture degrades. So too, in the sub-prime mortgage crisis, the overlending lead to increased housing prices, overbuilding, excess investment in housing, and a housing bubble. As mortgage funding becomes less available, the bubble burst, the supply of houses on the market goes up while the number of buyers and their ability to buy goes down, prices fall, the market for new homes goes down, builders suffer.

It sounds to me like a tragedy of the commons. The prevention is to institutionalize methods to prevent the firms from "overgrazing" the field of potential mortgage borrowers. We call the institutionalized controls "regulations". I think the institutionalization term is well chosen. We need not only new laws and regulations, but also effective oversight mechanisms and agents to see that the laws and regulations are enforced.