Mispricing risks creates problems

The European Union is facing a sovereign debt crisis because many European nations took on debts that eventually became unmanageable. Greece and Italy have a high risk of default on their sovereign debt, which could create a contagion effect that would threaten the economic stability of the EU and the rest of the world.

This crisis, though not entirely like the complex 2008 financial crisis, is underlined by the same principles. The 2008 financial crisis and the current European sovereign debt crisis were ultimately caused by a miscalculation of risk. In the United States, investors thought that the securitization of sub-prime mortgage loans was a safe investment because they bundled several loans together and were backed by homes — it was thought that home prices couldn’t fall. This meant that many financial institutions invested in risky investments that were mislabeled as AAA-rated safe investments.

These risky assets were falsely labeled by credit rating agencies that were hired by the banks that sold the assets. This is an obvious conflict of interest that made it virtually impossible for credit rating agencies to accurately and honestly assess and price the risks of these assets. If investors had appropriately appraised the risk on mortgage-backed securities, the 2008 financial crisis could have been averted.

Sovereign debt is usually considered safer than private debt; it is thought that a nation is less likely to default on its debt than a corporation or an individual. This idea is founded on the belief that a government can always raise taxes to pay its debts.

Italy and Greece were able to indebt themselves so heavily because investors did not consider them to be risky borrowers.  If the risk of default on Greek and Italian government bonds were appropriately priced, Greece and Italy would not have been able to indebt themselves to nearly the current levels and the crisis could have been averted.

The important thing that we should learn from these crises is that the incorrect pricing of risk — or the lack of transparency or symmetrical information in markets — can lead to an economic crisis.

In both crises, investors misunderstood the risks associated with the investments they made. In reality, there is risk in any investment and the appropriate pricing and assessment of risks can prevent economic catastrophes.

James Johnson is a psychology senior and may be reached at [email protected].

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