For my parent's generation, financial institutions made finnacial decisions judiciously since bad decisions usually resulted in bad consequences. For example, their mortgage required 20% down payment with a mortgage that was supported by my father's income. The bank that made the loan was taking the risk. If my parents defaulted the bank would lose the money.
When there is no risk, financial decisions may be skewed towards higher risk choices. For example, if I had zero risk of losing money, I would invest in highly speculative stocks for a possible big gain.
Fast forward to the early 2005. Mortgage loans were being collateralized and banks no longer carried the risk of default. Mortgage brokers made loans to almost everybody because the brokers were not affected by the risk of a poor loan. They were compensated for completing applications. As a result, there were a number of very risk loans made resulting in a housing bubble.
As I understand it, a similar situation exists for student loans. All student loans are guaranteed by the government. Student loans cannot be eliminated by bankruptcy. The school and the lending institution carry no risk. Thus, very risky loans are sometimes made, which is creating an education/tuition bubble.
When institutions have zero risk when making a loan, poor lending decisions can be made. Perhaps a solution is for student loan lenders to start assuming some or all of the risk for making student loans.
For more on Crossing Generations, check back every Wednesday for a new segment.
This is not financial advice. Please consult a professional advisor.
Copyright © 2012 Achievement Catalyst, LLC
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1 comment:
Right on. For capitalism's "invisible hand" to be effective, poor decisions and risk-taking that doesn't pan out must have consequences. Otherwise, as you say, the 'system' does not work. Imaging how your psychology would change if you knew, during a visit to a casino, that most or all of any money you lost gambling would be handed back to you as you exited. That's what bailouts do.
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