This morning while I was reading I remembered a conversation I had with Agnitio in 2004 which, in hindsight, is very embarrassing for me. It went along the lines of:
Me: Look at the interest rate on Hanover, its got to be worth putting some money there
Agnitio: It isn’t that much more than a bank deposit, I’m not sure its worth the risk
Me: Surely the slightly higher interest rate is a function of only a slight increase in risk
Agnitio: Not if people don’t understand/are underpricing the risks.
Now, Agnitio was completely right, risks were being underpriced because of asymmetric information. To make matters worse, people that read the interest rate like I do took it as a signal that the risk was relatively low (although I never did put any money with finance companies, I guess Agnitio must have convinced me 🙂 ) – leading to an “information cascade“.
The current situation has reinforced and extended my belief in the importance of information in the functioning of the market. I still believe that information asymmetries are the primary factor behind the current crisis.