The Frannie Bailout and the Prisoner’s Dilemma

John Hempton has an interesting take on the Frannie bailout: the markets forced Treasury to take this step by being irrational. It’s almost as though there was some kind of collusion going on.

Remember the prisoner’s dilemma? Given the choice between action A and action B, action B is always preferable from an individual’s perspective, holding everybody else’s actions constant. But if everybody chooses action A, then that’s the best result of all. Here, action A is refusing to buy agency bonds at wide spreads, while action B is believing in the government guarantee and buying them. And in this case, the prisoners didn’t confess.

The bond investors kept agency spreads wide, thereby forcing a government intervention — which is an even better outcome, for them, than a government guarantee which can be rescinded at any time. Yes, the government guarantee was real — but the bond market held out, and got an even better deal. Hempton says he’s "staggered" by this — it does seem to fly in the face of the common conception of how markets work. Which probably says quite a lot about how much we really understand of how markets work.

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