Delusions on Both Sides
By Arnold Kling
My answer is, “yes.” There were delusions on both sides.
In the private sector, many lenders and investors became deluded about the virtues of credit scoring. Credit scoring is a good technique for assessing risk, but people forgot that rising home prices cover up all sins. What they thought was brilliant mortgage underwriting was in fact just luck with rising house prices. When the luck ran out, it turned out that credit scoring is only a tool, not a magic potion.
The other private-sector delusion concerned derivatives. See my post on systemic risk. Financial institutions thought that they were getting rid of risk, but instead they were just passing it around, as in the card game Old Maid. The contingency plans that companies formed to deal with risk have proved impossible to execute collectively in practice.
Government regulators can be faulted for two things. First, they enabled the private sector delusions. Regulators did not sound warnings about credit scoring, and they issued only minor scolding on derivatives.
Second, government operated under the delusion that low-down-payment mortgages are a good thing. I have coined the expression “home borrower” to describe someone who puts little or nothing down to buy a home. Government encouraged home borrowing, and that made the bubble inflate higher on the way up and crash harder on the way down.