In the FT today, Larry Summers has a really terrific column on the subprime crisis that raises three very, very interesting questions:
First, this crisis has been propelled by a loss of confidence in ratings agencies as large amounts of debt that had been very highly rated has proven very risky and headed towards default. There is room for debate over whether the errors of the ratings agencies stem from a weak analysis of complex new credit instruments, or from the conflicts induced when debt issuers pay for their ratings and can shop for the highest rating. But there is no room for doubt that - as in previous financial crises involving Mexico, Asia and Enron - the ratings agencies dropped the ball. In light of this, should bank capital standards or countless investment guidelines be based on ratings? What is the alternative? Sarbanes-Oxley was a possibly flawed response to the problems Enron highlighted in corporate accounting. What, if any, legislative response is appropriate to address the ratings concerns?Second, how should policymakers address crises centred on non-financial institutions? A premise of the US financial system is that banks accept much closer supervision in return for access to the Federal Reserve's payments system and discount window. The problem this time is not that banks lack capital or cannot fund themselves. It is that the solvency of a range of non-banks is in question, both because of concerns about their economic fundamentals and because of cascading liquidations as investors who lose confidence in them seek to redeem their money and move into safer, more liquid investments.Central banks that seek to instilconfidence by lending to banks, or reducing their cost of borrowing, may, as the saying goes, be pushing on a string. Is it wise to push banks to become public financial utilities in times of crisis? Should there be more lending and/or regulation of the non-bank financial institutions?
Third, what is the role for public authorities insupporting the flow of credit to the housing sector? The lesson learnt during the S&L debacle was that it was catastrophic to finance home ownership through insured banking institutions that borrowed short term and then offered long-term fixed-rate home mortgages. Now a system reliant on securitisation, adjustable rate mortgages and non-insured financial institutions has broken down.
Even more interesting is his conclusion:
Now, as borrowers face higher costs as their adjustable rate mortgages are reset, is not the time for the authorities to get religion and discourage the provision of credit.
I'm with Larry. One hears a lot of echoes these days of the infamous quote from Andrew Mellon, Hoover's Secretary of the Treasury, at the dawn of the Great Depression:
[T]he “leave it alone liquidationists” headed by [my] Secretary of the Treasury Mellon... felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” He insisted that, when the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. He held that even a panic was not altogether a bad thing. He said: “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people”...
There are the people who don't think the government should bail out homeowners who bought houses they clearly couldn't afford, on the assumption that rising house prices would allow them to refinance before the rates reset; one of them, a friend whose limited personal funds forced him to buy a very small house sent me a link to this cartoon.
There are other people who sympathise with the homeowners, but like Daniel Gross, don't want to bail out the bankers who made massive subprime loans, or the hedge funders who bought the securities that those loans were packaged into.
On the "they deserve it" argument, I am sceptical on both sides. Many of the people with the worst loans were pushed into them by unscrupulous mortgage brokers. The mortgage brokers systematically concealed terms and got them bad rates, but the people in the house are the ones who have to move and deal with a devastated credit record.
This applies equally well to the subprime lenders and hedge funders. Unscrupulous mortgage brokers will not suffer at all if subprime lenders go under. The subprime lenders made loans stupidly, but in good faith. The hedge funders bought assets in good faith.
Now, in ordinary times, I would not say that isolated individuals with these problems deserve a bailout. We should help people who got rooked (and tighten fraud laws to prevent other such rookings), but not to the tune of a whole house. Renting has its downsides, but they are not so great that it should be the government's business to shove everyone into their own little plot of land. On the flip side, it's tough that banks that make stupid loans go bust, but as many European and Asian banking systems illustrate, the cost to keeping failed companies afloat is much higher than the reward.
I am therefore somewhat sympathetic to people who are worried about moral hazard. But only somewhat. On the consumer side, the problem has been largely taken care of by the fact that no one wants to issue mortgages. And on the bank side . . . well, we may have bigger problems than moral hazard.
That's the classic bank run scene from "It's a Wonderful Life", possibly the best scene explaining economics in movie history. It brilliantly illustrates how panic can put a solvent financial institution into insolvency . . . which is what FDR was talking about when he said "We have nothing to fear but fear itself." Note that the solution the movie characters stumbled on was also the right one: inject cash into the economy in order to calm insolvency fears.
It is true that there will be some moral hazard attached to bailing out either banks or homeowners. Those who are bailed out, and their peers, will be more likely to engage in the risky behaviour that spawned the bailout, in the belief that the government will rescue them again. But in the case of a genuine credit crisis, the cost of moral hazard is much smaller than the cost of a genuine liquidity crisis--which will hurt, I might add, not just the homeowners and the bankers, but all of us who like to do things like borrow money, or have economic growth.
Having (barely) survived New England's real estate and economic collapse of the early 1990's, I just can't get too stirred up by the present troubles. They may be more geographically widespread but are nothing in comparison.
Now, as borrowers face higher costs as their adjustable rate mortgages are reset, is not the time for the authorities to get religion and discourage the provision of credit.
You'll have to be more specific... Making exceedingly poor choices in providing credit to people with little proven ability to pay it back is what created this mess in the first place. And while nothing should be done to discourage re-organizing debts to allow people a decent chance to repay them, discouraging the provision of new credit is exactly what the economy needs.
You seem to be arguing that anyone who makes an economic decision "in good faith" should be held harmless. In that case, the government should bail out the one million small businesses that go bankrupt every year, since surely almost all of these people acted "in good faith."
It is curious how people who claim that markets are infalliable, or at least infinitely superior to government, demand government bailouts when the market stops providing the returns they want.
Have Stephen den Beste and Megan McArdle ever been seen in the same room together? All this post needs is a Stardate.
Shorter Megan McArdle: I'm with Larry, but then again, I'm hearing voices these days. Or rather, the echos of voices: some from the past, some from Slate, some from a movie I once saw. Such a mess, such arguments, such tsurris! Oy! I say, listen to Hollywood and take out a bridge loan. It may not make you a better person, but it's better than single payer health care.
Darn it, what about those of us who have been renting because we weren't stupid or reckless enough to "buy" a house we couldn't afford using a loan we couldn't afford?
It's our turn now: we want all the crooked lenders and (almost equally-crooked) "stated income" buyers to take their medicine. Default, damn you, and go bankrupt too. House prices should fall, and fall a lot, until people who work for a living and pay their bills can afford homes again.
Nothing makes me more angry than all the rent-seeking schnorrers who want me to pay more taxes to subsidize them to swank it in their 100%-financed bubble-priced mansions while I sweat in a little apartment. I don't see why providing fancy housing to deadbeats should come before providing affordable housing to honest people.
If you would prefer a more moderate formulation, then try this on: rewarding rent-seekers with bailouts would impose very large costs on honest market participants. That would be bad public policy.
Forget moral hazard of a homeowner bailout -- how about ethically justifying taking my money to keep someone in a house they can't afford. How about you give me some money to pay my credit card bill?
Housing already enjoys a subsidy that dwarfs most the other entitlement programs. That has always been justified by the observation that high home ownership is correlated with high civic participation. But as we know correlation does not imply causation, and the lower home ownership rates in Europe, for instance, don't seem to have reduced their civil societies.
You may not remember the last time this came up as a big issue, but I do.
The savings and loan crisis was precipitated by a similar bubble:
Savings & Loans attracted depositors by offering high interest rates, backed by FDIC insurance. Then they made risky high-rate loans, backed by real estate, in many cases to insiders or people connected to insiders (see Silverado).
Then, as now, the folks involved made boatloads of money off fees, so they had an interest in cranking money through the system, and didn't particularly have any vested interest in the long-term performance of the loans.
When the real estate went south, the developers walked away - they'd already raked their money off the top. Then the Savings & Loans collapsed, but again, the folks who had milked the system had already made their pile.
Who was hurt? Not the small depositors, who were insured to $100,000... and not the large depositors either, because in a bout of taxpayer-funded magnanimity, the FDIC decided to pay off ALL deposits, even those over $100k. So the players who took a higher rate of return in exchange for higher risk... got their higher rate of return, with NO risk. Nice deal if you can get it.
So everyone benefited, right?
Oh - the taxpayers. You and me. We paid out in excess of $100 billion dollars.
That's what you call a state-enforced transfer of wealth, I believe. And we're being asked to do it again - once again to bail out folks who made boatloads of money off 'risky' investments, but don't actually want to lose anything when the risks actually materialize.
One good idea is to amend the bankruptcy code to permit homeowners to amend the terms of their mortgages, for example by reducing them to approximately the value of the house, eliminating prepayment penalties, and reducing the interest payment. This idea is mentioned in today's New York Times by Senator Durbin and Representative Barney Frank.
The idea fits with bankruptcy practice, which treats a secured debt as secured only to the value of the collateral, and unsecured for the balance, and which generally permits business debtors to rewrite the terms of loans. It solves the CDO problem. It generally benefits the class of people we want to help, homeowners who are in over their heads, but are in a position to pay reasonable amounts for their homes. It put the loss on the greedhead investors, where it belongs.
It won't cost taxpayers anything. What could be better?
Except, the bank in It's A Wonderful Life was not solvent. Like all banks in fractional reserve systems, its very business model relies on insolvency. We tend to sweep this detail of modern banking under the rug, but it is indisputably true.
Bailouts do not suggest that it need be a recurring process, encouraged because people are given help.
That view is one reserved for business through male dominant aggression that is well embedded in American society and proven time and again - but typically for men only.
Unpenalized, men apparently are un-rehabilitated whether that topic is crime or normal business.
It is a male ordered view of the world that has given men far too much leeway to decide their own affairs, and presumes that they will be honorable or ethical, though they have not proven to be over the long haul.
If men were honorable, there would be no need of government regulation, or the prison system.
Good government regulation is centered upon prevention not clean up from the messes men make, even with the help of their women.
When government overestimates the legitimacy of men with aggressive ideas that make them money, and does not put in the kinds of safeguards that protect people, men are apt to take advantage of one another - as per their nature. Slapping the hands of business aggressors is rarely enough to prevent future outbreaks. That is how America wound up with Enron.
Congress needs to take a broad view for the American people, decide whose side it is on, presumably citizens, and take the steps required to protect them adequately, and efficiently, thereby withdrawing an unfounded faith in the financial markets that they have the best interests of the American people in mind; they don't; they may never have. And Congress cannot afford to overlook that fact in their regulatory schemes. Citizens don't need both Congress and business selling them out. With government like that, who needs Congress? It is little better a plan than "anything goes," and "every man for himself." That has never been good enough for business, and it is not good enough for government.
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