Mark Thoma: Adverse Selection, Loan Defaults, and Credit Rationing
Dealing with Adverse Selection in the Mortgage Market

Hoisted from Comments: Bank Capitalization

Hoisted from Comments: Tom R asks:

Grasping Reality with Both Hands: Economist Brad DeLong's Fair, Balanced, and Reality-Based Semi-Daily Journal: There is one thing I don't understand in all this. If financial institutions are undercapitalized, i.e lack liquid assets, but are in all other regards viable, why don't owners of liquid capital (read W Buffett) buy them and hold the assets until the income stream makes them whole with nice profits to boot.. Of course I know that there are times when this does not happen, i.e. now, but what does this say about the capitalist system? Can we stipulate that capitalism in inherently flawed? Is the flaw behavioral? (We have nothing to fear but fear itself?)

The way Larry Summers puts it is roughly as follows:

At the level of each individual bank, each individual bank that finds itself overleveraged is more-or-less indifferent between whether it solves that overleverage problem by raising more capital or by shrinking the volume of loans it makes and the amount of bonds it holds. But all the rest of us would much, much rather that the banks as a whole raise capital rather than cut back on their assets.

There is a Keynesian aggregate demand externality roaming about here...