Bankers, Risk and the Rents of Slippery Skin

12 Monday Mar 2018

Posted by pnoetx in Banking, rent seeking

Tags

Deposit Insurance, Fannie Mae. Freddie Mac, Fat Tails, FDIC, Fractional Reserves, Frank Hollenbeck, GSEs, Guatam Mukunda, Gvernment Sponsored Enterprises, Irving Fisher, It's a Wonderful Life, John Cochrane, Laurence Kotlikoff, Milton Friedman, Nassim Taleb, Ralph Musgrave, rent seeking, Skin in the Game, Too big to fail

Risk taking is important to the economic success of a nation. Creative energy demands it, and it is critical to achieving economic growth and wealth creation. But it’s obviously possible to take too much risk or risks that are ill-considered, and that is all the more likely when risk-takers are absolved of the consequences of their actions. That is, healthy risk-taking and responsibility are inextricably linked. One can’t truly be said to take a risk if the cost of failure is borne by another party. It’s easy to understand why risk-taking becomes excessive or misdirected when that is the case.

Risk Shifting

There are various ways in which a party can parlay risky undertakings into easy gains by shifting the risks to others. For example, any piece of merchandise comes with the risk that it will not perform as advertised. Some traders might be tempted to sell unreliable merchandise and shift risk to the buyer without recourse. This is an area in which we must rely on a bulwark of private governance: caveat emptor. On the other hand, government tends to subsidize risk-taking in various ways: limited liability under the corporate form of business organization, bank deposit insurance, bankruptcy laws, the implicit government guarantee on mortgage assets, and the “too-big-to-fail” mentality of government bailouts.

Whose Skin In the Game?

These are examples of what Nassim Taleb bemoans as the failure to have “skin in the game”. The quoted expression happens to be the title of his new book. I have both praised and castigated Taleb’s work in the past. He made an interesting contribution about the nature and risk of extreme events in his book “Black Swan”, such as his application of so-called “fat tails” in probability distributions, though some have claimed the ideas were anything but original. I was highly critical of Taleb’s alarmist hyperbole on the effects of GMOs. In the present case, however, he considers “the asymmetry of risk bearing” to be a major social problem, and I’m generally in agreement with the point. The most interesting part of the brief discussion at the link is the following:

“In Taleb’s universe, the fieriest circle of hell is reserved for bankers and neoconservatives. ‘The best thing that could happen to society is the bankruptcy of Goldman Sachs,’ he tells me. ‘Banking is rent-seeking of industrial proportions.’ Taleb, who became rich as a derivatives trader, is not a foe of capitalism but of ‘cronyism’. ‘If you’re taking risks, God bless you. This is why I accept inequality. I’ve seen people go from trader to cab driver and back again.’“

Banks are a prominent example of the risk-shifting phenomenon. First of all, banking institutions are not required to hold much capital against their assets. In fact, recently banks have had average equity of less than 6% of assets. That’s much higher than during the financial crisis of ten years ago, but it is still rather thin and hardly represents much “skin in the game”.

Fractional Reserves

It should come as no surprise that a bank’s assets are funded largely by account balances held by depositors (liabilities), and not by equity capital. But your bank balance is not kept as cash in the vault. Instead, it is loaned out to the bank’s credit clients or used to purchase securities. This is facilitated by “fractional reserve banking”, whereby banks need only keep a fraction of their depositors’ money on hand as cash (or in their own reserve deposit accounts with the Federal Reserve). This generally works well on a day-to-day basis because depositors seldom ask to redeem more than a small fraction of their money on a given day.

Reserve requirements are set by the Federal Reserve and range from 0-10%, depending on the size of a banks’ deposit account balances. At the upper figure, a dollar of new cash deposits would allow a bank to extend new loans of up to $0.90. This legal practice divides many in the economics profession. Some believe it represents fraud rather than sound banking. This article by Frank Hollenbeck at the Mises Canada web site states that it is improper for a bank to lend a depositor’s money to others:

“Suppose you lived in the 18th century and had 100 ounces of gold. It’s heavy and you do not live in a safe neighborhood, so you decide to bring it to a goldsmith for safekeeping. In exchange for this gold, the goldsmith gives you ten tickets where eachis clearly marked as claims against 10 ounces. …

… Quickly the goldsmith realizes there is an easy, fraudulent, way to get rich: just lend out the gold to someone else by creating another 10 tickets. Since the tickets are rarelyredeemed, the goldsmith figures he can run this scam for a very long time. Of course, it is not his gold, but since it is in his vault, he can act as though it is his money to use. This is fractional reserve banking with a voluntary reserve requirement of 50%. Today, modern US banks have a reserve requirement of between 0% and 10%. This is also how the banking systemcan create money out of thin air, or basically counterfeit money, and steal the purchasing power from others without actually having to produce real goods and services.”

Another aspect of the argument against fractional reserves is that it creates economic instability, fueling booms and busts as the quantity of money in circulation sometimes exceeds or falls short of the needs of the public. Many authorities have taken a negative view of fractional reserve banking through the years: Irving Fisher, Milton Friedman, John Cochrane, Ralph Musgrave, and Laurence Kotlikoff, to name a few prominent economists (see this recent paper by Musgrave).

In Defense of Fractional Reserves

Others have defended fractional reserves as a practice that has and would again arise in a free market environment. According to this view, depositors would accept the logic of allowing banks to lend a portion of the funds in their accounts in order to generate income, rather than charging larger fees for “storage” and administration. If the depositing public is aware of the risk and has competing choices among banks, then the argument that banks expose depositors to excessive risk via fractional reserves is moot. Fractional reserves can exist in a private money economy in which competitive pressures reward banks (and their privately circulating notes) having sound lending practices. In fact, some would say that the very idea of a 100% reserve requirement is an unacceptable government intrusion into the private relationship between banks and their customers. All of that is true.

Some have compared fractional reserve banking to the sale of insurance. Consumers buy insurance to take advantage of pooled risk, but they have no expectation of a refund unless they incur the kind of insured loss in question. Bank depositors, on the other hand, expect a return of their funds in-full. Yes, low risk is an attribute they desire, and pooling across the withdrawal needs of many depositors is one reason why banks can invest and pass a part of the return on to depositors, both in interest and reduced fees. So, despite the differing needs and expectations of their customers, there is some validity to the comparison of insurers to fractional-reserve bankers.

Amplification of Shifted Risks

Do fractional reserves allow banks to take risks without having skin in the game? Absolutely! With as little as 6% equity at risk, banks have relatively little to lose relative to depositors. Yes, banks pay the FDIC to insure deposits, and premiums are higher for riskier banks. However, not all deposits are insured by the FDIC. More importantly, at the end of 2017, the entire FDIC deposit insurance fund was about 0.7% of commercial bank assets. One big bank failure would wipe it out, or a few hundred small ones. That’s well within the realm of possibility and historical experience. So, where does that leave depositors? Their skin is very much in the game, and the game is about the risks taken by banks in investing depositors’ funds.

We now live in the era of “too-big-to-fail” (TBTF), whereby large banks (and sometimes industrial firms) are viewed as so “systemically important” that they cannot be allowed to fail. Taxpayers must bail them out in the event they become insolvent. Thus, taxpayers have skin in the game. Banks collect rents to the extent that their returns exceed those commensurate with the risks for which they are actually “on the hook”.

Another avenue through which banks off-load risk is the extent to which Fannie Mae and Freddie Mac are still presumed to have the federal government’s implicit guarantee against default on the mortgage debt they purchase from banks. That is beyond the scope of the present discussion, however. And I have not discussed the role of large investment banks in the capital markets. That’s a whole other dimension of the story. This article by Guatam Mukunda in the Harvard Business Review provides a perspective on rent seeking in investment banking.

Conclusion

The combination of deposit insurance, TBTF and other risk-insulating subsidies, layered on top of a fractional reserve banking system, places banks into Taleb’s “fieriest circle of hell”. These factors blunt bank incentives to manage risk effectively as well as consumer incentives to conduct adequate due diligence in their banking relationships. It means that risk is not priced properly, because banks are likely to ignore risks from which they are shielded. Therefore, banks may allocate resources into excessively risky uses. The consequences for depositors and taxpayers can be dramatic.

Fractional reserves are not “fraud” in the sense that the system has unsuspecting victims. Anyone who has watched “It’s a Wonderful Life” knows that banks lend your deposits to others. But fractional reserves magnify the risk-mitigating privileges conferred upon the banking industry by government through various mechanisms. This “risk-cleansing” is converted to rents and collected by banks for their shareholders, but the risks are still borne by society. To the extent that fractional reserves create instability, deposit insurance is viewed as a necessity, but banks should pay a market premium to an insurer to cover the actual risk inherent in the system. Too-big-to-fail should end, as should the implicit subsidy collected by banks through the government-sponsored enterprises.

Enduring A Dead-Weight Dominion

13 Wednesday Jan 2016

Posted by pnoetx in Big Government, Macroeconomics

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Tags

Anthony de Jasay, Automatic Stabilizers, Big government, Boom and Bust Cycle, central planning, Code of Federal Regulations, Double Taxation, Federal Reserve, Final Output, Government intervention, infrastructure, Intermediate Transactions, John Maynard Keynes, Keynesian Economics, Malinvestment, Mark Skousen, Mercatus Center, Shovel-Ready Projects, Spontaneous Order, Stabilization policy, Too big to fail, Underconsumption

government-intervention

If you hope for government to solve economic problems, try to maintain some perspective: the state has unique abilities to botch it, and its power to distort and degrade the economy in the process of “helping” is vast. Government spending at all levels copped about 18% of the U.S. economy’s final output in 2014, but the public sector’s impact is far more pervasive than that suggests. Private fixed investment in new structures and equipment accounted for only about 16% of Gross Domestic Product (GDP); the nonresidential portion of fixed investment was less than 13% of GDP. I highlight these two components of GDP because no one doubts the importance of capital investment as a determinant of the economy’s productive capacity. But government is a larger share of spending, it can divert saving away from investment, and it creates a host of other impediments to productivity and efficient resource allocation.

The private economy is remarkable in its capacity to satisfy human wants. The market is a manifestation of spontaneous order, lacking the conscious design of any supreme authority. It is able to adjust to dynamic shifts in desires and resource constraints; it provides reliable feedback in the form of changing prices to modulate and guide the responses of participants through all stages of production. Most forms of government activity, however, are not guided by these signals. Instead, the state imposes binding and sometimes immediate constraints on the decisions of market participants. The interference takes a number of forms, including price controls, but they all have the power to damage the performance and outcomes of markets.

The productive base at each stage of the market process is a consequence of the interplay of perceived business opportunities and acts of saving or deferred consumption. The available flow of saving depends on its rewards, which are heavily influenced by taxes and government intervention in financial markets. It’s worth noting here that the U.S. has the highest corporate tax rates in the developed world, as well as double taxation of corporate income paid out to owners. In addition, the tax system is used as a tool to manipulate the allocation of resources, drawing them into uses that are politically favored and punishing those in disfavor. The damaging impact is compounded by the fact that changes in taxes are often unknown ex ante. This adds a degree of political risk to any investment decision, thus discouraging capital spending and growth in the economy’s productive base.

The government is also a massive and growing regulator of economic activity. Over 100,000 new regulatory restrictions were added to the Code of Federal Regulations between 2008 and 2012. Regulation can have prohibitive compliance costs and may forbid certain efficiencies, often based on flimsy or nonexistent cost/benefit comparisons. It therefore damages the value and returns on embedded capital and discourages new investment. It is usually uneven in its effects across industries and it typically reduces the level of competition in markets because small firms are less capable of surviving the costs it imposes. Innovation is stifled and prices are higher as a result.

From a philosophical perspective, even the best cost/benefit comparisons are suspect as tools for evaluating government intervention. Don Boudreaux quotes Anthony de Jasay’s The State on this point:

“What could be more innocuous, more unexceptional than to refrain from intervening unless the cost-benefit comparison is favourable? Yet it treats the balancing of benefits and costs, good and bad consequences, as if the logical status of such balancing were a settled matter, as if it were technically perhaps demanding but philosophically straightforward. Costs and benefits, however, stretch into the future (problems of predictability) and benefits do not normally or exclusively accrue to the same persons who bear the costs (problems of externality). … Treating it as a pragmatic question of factual analysis, one of information and measurement, is tacitly taking the prior and much larger questions as having been somehow, somewhere resolved. Only they have not been.“

Poorly-executed and inappropriate stabilization policy is another way in which government distorts decisions at all stages of production. There are many reasons why these policies tend to be ineffective and potentially destructive, especially in the long run. Keynesian economics, based on ideas articulated by John Maynard Keynes, offers prescriptions for government action during times of instability. That means “expansionary” policy when the economy is weak and “contractionary” policy when it is strong. At least that is the intent. This framework relies on the notion that components of aggregate demand determine the economy’s output, prices and employment.

The major components of GDP in the National Income and Product Accounts are consumer spending, private investment, government spending, and net foreign spending. In a Keynesian world, these are treated as four distinct parts of aggregate “demand”, and each is governed by particular kinds of assumed behavior. Supply effects are treated with little rigor, if at all, and earlier stages of production are considered only to the extent that their value added is included, and that the finished value of investment (including new inventories) is one of the components of aggregate demand.

Final spending on goods and services (GDP) may be convenient because it corresponds to GDP, but that is simply an accounting identity. In fact, GDP represents less than 45% of all transactions. (See the end note below.) In other words, intermediate transactions for raw materials, business-to-business (B2B) exchange of services and goods in a partly fabricated state, and payments for distributional services are not counted, but they exceed GDP. They are also more variable than GDP over the course of the business cycle. Income is generated and value is added at each stage of production, not only in final transactions. To say that “value-added” is counted across all stages is a restatement of the accounting identity. It does not mean that those stages are treated behaviorally. Technology, capital, employees, and complex decision-making are required at each stage to meet demands in competitive markets. Aggregation at the final goods level glosses over all this detail.

The focus of the media and government policymakers in a weak economy is usually on “underconsumption”. The claim is often heard that consumer spending represents “over two-thirds of the economy”, but it is only about one-third of total transactions at all levels. It is therefore not as powerful an engine as many analysts assert. Government efforts to stimulate consumption are often thwarted by consumers themselves, who behave in ways that are difficult for models to capture accurately.

Government spending to combat weakness is another typical prescription, but such efforts are usually ill-timed and are difficult to reverse as the economy regains strength. The value of most government “output” is not tested in markets and it is not subject to competitive pressure, so as the government absorbs additional resources, the ability of the economy to grow is compromised. Programmatic ratcheting is always a risk when transfer payments are expanded. (Fixed programs that act as “automatic stabilizers”, and that are fiscally neutral over the business cycle, are less objectionable on these grounds, but only to the extent that they are not manipulated by politicians or subject to fraud.) Furthermore, any measure that adds to government deficits creates competition for the savings available for private capital investment. Thus, deficits can reduce the private economy’s productive capacity.

Government investment in infrastructure is a common refrain, but infrastructure spending should be tied to actual needs, not to the business cycle. Using public infrastructure spending for stabilization policy creates severe problems of timing. Few projects are ever “shovel-ready”, and rushing into them is a prescription for poor management, cost overruns and low quality.

Historically, economic instability has often been a consequence of poorly-timed monetary policy actions. Excessive money growth engineered by the Federal Reserve has stimulated excessive booms and inflation in the prices of goods and assets. These boom episodes were followed by market busts and recessions when the Fed attempted to course-correct by restraining money growth. Booms tend to foster misjudgments about risk that end in over-investment in certain assets. This is especially true when government encourages risk-taking via implicit “guarantees” (Fannie Mae and Freddie Mac) and “too-big-to-fail” promises, or among individuals who can least afford it, such as low-income homebuyers.

Given a boom-and-bust cycle inflicted by monetary mismanagement, attempts to stimulate demand are usually the wrong prescription for a weak economy. Unemployed resources during recessions are a direct consequence of the earlier malinvestment. It is better to let asset prices and wages adjust to bring them into line with reality, while assisting those who must transition to new employment. The best prescription for instability is a neutral stance toward market risks combined with stable policy, not more badly-timed countercyclical efforts. The best prescription for economic growth is to shrink government’s absorption of resources, restoring their availability to those with incentives to use them optimally.

The more that central authorities attempt to guide the economy, the worse it gets. The torpid recovery from the last recession, despite great efforts at stimulus, demonstrates the futility of demand-side stabilization policy. The sluggishness of the current expansion also bears witness to the counterproductive nature of government activism. It’s a great credit to the private market that it is so resilient in the face of long-standing government economic and regulatory mismanagement. A bureaucracy employing a large cadre of technocrats is a “luxury” that only a productive, dynamic economy can afford. Or can it?

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

A Note On Output Measures

More complete aggregations of economic activity than GDP are gross output (GO) and gross domestic expenditures (GDE). These were developed in detail by economist Mark Skousen in his book “The Structure of Production“, published in 1990. GO includes all final transactions plus business-to-business (B2B) transactions, while GDE adds the costs of wholesale and retail distribution to GO. Or as Skousen says in this paper:

“GDE is defined as the value of all transactions (sales) in the production of new goods and services, both finished and unfinished, at all stages of production inside a country during a calendar year.“

GO and GDE show the dominance of business transactions in economic activity. GDE is more than twice as large as GDP, and B2B transactions plus business investment are twice the size of consumer spending. According to Skousen, GDE varies with the business cycle much more than GDP. Many economic indicators focus on statistics at earlier stages of production, yet real final spending is often assumed to be the only measure of transactions that matters.

Government “Planning” A High-Density Housing Crash

29 Tuesday Sep 2015

Posted by pnoetx in Housing Policy

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central planning, Chinese malinvestment, Densification, Detached Housing, Fannie Mae, Freddie Mac, High-density housing, Housing, Housing inflation, Joel Kotkin, New Geography, Oversupply, Regionalism, Too big to fail, Urban planning

How will the next housing bust play out? Joel Kotkin believes that it will be an unavoidable consequence of “high-density” policies imposed by central planners. That is Kotkin’s major theme in “China’s Planned City Bubble Is About To Pop—And Even You’ll Feel It“, an essay in New Geography.

Central planning generally achieves undesirable results because it is incapable of solving the “knowledge problem”. That is, planners lack the detailed and dynamic information needed to align production with preferences. Freely-operating markets do not face this problem because voluntary trade between individuals establishes prices that balance preferences with resource availability. There are severe frictions in the case of housing that slow the process, but it is almost as if central planners willfully ignore strong signals about preferences, instead promoting measures such as “containment policies” and “regionalism” that restrict choice and inflate home prices. Of course, the technocratic elite think they know what’s good for you!

Kotkin begins by drawing a contrast between policies that led to the last housing crisis and the short-sighted policies now in place that could lead to another:

“If the last real estate collapse was created due to insanely easy lending policies aimed at the middle and working classes, the current one has its roots largely in a regime of cheap money married to policies of planners who believe that they can shape the urban future from above.“

The list of bad government policies precipitating the last housing bust is long, and I have discussed them before here on Sacred Cow Chips. They included federal encouragement of loose lending standards, a strong bias favoring mortgage assets embedded in bank capital standards, the implicit federal guarantee of Fannie Mae and Freddie Mac against losses, the mortgage-interest income tax deduction, and an easy-money policy by the Federal Reserve. These all represent market distortions that led to a malinvestment of excess housing. Several of those policies are still in place, and today the presumption of “too-big-too-fail” financial guarantees by the federal government is as strong as ever, so risk is not adequately managed.

But the tale of today’s housing market woes told by Kotkin really begins in China, where the government has been on a high-density housing binge for a number of years:

“As a highpoint in social engineering, a whole new dense city (Kangbashi) has been constructed by the Ordos, Inner Mongolia city government, in the middle of nowhere, growing, but still apparently mainly vacant. … The key here is not so much planning, per se, but planning in a manner that ignores the aspirations of people. Americans no more want to live stacked in boxes in the middle of nowhere than do their Chinese counterparts.“

Kotkin is too generous to central planning, and he is sloppy about the distinction between public and private planning efforts: while China’s current real estate difficulties may be a case of extreme negligence, central government planning always has and always will suffer from a mismatch between preferences and supplies that is strongly resistant to self-correction. Ultimately, resources are wasted. In any case, China’s easy monetary policy and efforts to “densify” led to an inflation of urban housing prices. The situation is unsustainable and the market is now extremely weak.

Can the U.S. “catch China’s cold”, as Kotkin suggests? That’s likely for several reasons. First, as noted by Kotkin, the Chinese government’s efforts to stabilize domestic asset prices and maintain economic growth have led to restrictions on foreign investment, which will undercut asset values in the U.S. (and even more in Australia). More importantly, governments in the U.S. have caught an extreme case of the “planning bug” with the same bias in favor of high density as the Chinese central planners:

“… increasingly, particularly during the Obama years, state planning agencies, notably in California, and the federal Department of Housing and Urban Development (HUD) have embraced a largely anti-suburban, pro-density agenda.“

Kotkin cites evidence of a strong preference among U.S. households for detached housing, but government authorities prefer to dictate their own vision of residential life:

“… like Soviet planners and their Chinese counterparts, our political elite and the planning apparat seem to care little about preferences, and have sought to limit single-family homes through regulations. This is most evident in California, notably its coastal areas, where house prices and rents have risen to hitherto stratospheric levels.

The losers here include younger middle and working class families. Given the regulatory cost, developers have a strong incentive to build homes predominately for the affluent; the era of the Levittown-style ‘starter home’, which would particularly benefit younger families, is all but defunct. Spurred by the current, highly unequal recovery, these patterns can be seen elsewhere, with a sharp drop in middle income housing affordability while the market shifts towards luxury houses.“

In an interesting aside, Kotkin emphasizes that high-density housing is often more expensive to construct than single-family homes, so it does not advance the cause of affordability, as is often claimed.

The close of Kotkin’s essay summarizes misguided policies now in place and the ominous conditions they have created in some of the nation’s most expensive housing markets:

“Today’s emerging potential bubble is driven in large part by low interest rates and a new post—TARP financial structure, anchored by ultra-low interest rates, which favor wealthy investors…. This, plus planning policies, has accelerated a boom in multi-family construction, much of it directed at high-end consumers. In New York and London, wealthy foreigners as well as the indigenous rich have invested heavily in high-rise apartments, many of which remain empty for much of the year. In San Francisco, for example, roughly half of all new condos are owned by non-residents, including both Chinese investors and Silicon Valley executives. … Since the vast majority of people cannot afford to buy these apartments, even if they want them, this kind of construction does little to address the country’s housing shortage.“

Housing policy has long been dominated by subsidies that encourage over-investment in housing. At the same time, restrictions increasingly limit the development of detached homes, which is what most people prefer. Local control over decisions about housing development is being compromised by intrusive federal policies of “regionalism” that demand more high-density housing in costly areas. These policies are unlikely to benefit low- and middle-income households, who are increasingly unable to afford the high cost of quality urban housing as either renters or buyers. Either prices must adjust downward, as Kotkin suggests, or more subsidies will be required to keep the bubble inflated. Like China, we will be unable to stave off a correction indefinitely.

Bailouts and Destruction: Your Risk, Our Reward

31 Sunday May 2015

Posted by pnoetx in Big Government, Regulation

≈ 1 Comment

Tags

Bailout Barometer, Dodd-Frank, Federal Reserve Bank of Richmond, Financial Risk Taking, Holman Jenkins, Housing Bubble, John Ligon, Too big to fail

The federal government creates some artificial incentives for financial risk taking. These are mostly guarantees against losses, either explicit or implied by similar, past acts of loss indemnification, i.e, bailouts. Under this regime, successes accrue to private risk takers while failures are borne by taxpayers and others from whom resources are diverted by artificially low user costs. This is a huge source of waste, pure and simple.

The financial crisis that began in 2007 featured bailouts of a variety of privately-owned institutions such as banks and insurers, as well as government-sponsored enterprises (GSEs: Fannie Mae and Freddie Mac). So-called financial reforms enacted in the wake of the crisis, especially those embodied in the Dodd-Frank Act, did nothing to eliminate the expectation that losses, should they occur, would be met by a rescue package.

“This approach to financial regulation, while a natural response to a market failure narrative, only increases the vulnerability of financial system to regulatory failure. Regulatory failure played an important role in the last crisis by concentrating resources in the housing sector, encouraging reliance on credit-rating agencies, and driving financial institutions to concentrate their holdings in mortgage-backed securities. Dodd-Frank gives regulators more authority and broad discretion to shape the financial sector and the firms operating within it.“

The Federal Reserve Bank of Richmond’s so-called “bailout barometer” shows the share of implicit and explicit federal guarantees on a large class of financial liabilities. It reached a total of 60% at the end of 2013. When losses are covered, who cares about risk? Did any of this change, as a lesson learned, after the last financial crisis? No. Instead, we have this:

“The 2010 Dodd-Frank law has certified various large institutions as “systemically important,” as prelude to burying them in costly regulation ostensibly for safety purposes but partly to divert lending to politically favored sectors. This hasn’t helped the economy. It probably hasn’t done much to make the financial system safer.“

That quote is from Holman Jenkins in “Bank Bashing: the Modern Nero’s Fiddle“. Jenkins accepts “too big to fail” (TBTF) and government guarantees as a reality, blaming the financial crisis on other aspects of government regulatory policy. And there is plenty of evidence that the government contributed in a number of ways, contrary to the usual media narrative. I don’t disagree, but federal guarantees have, and still do, distort risk-reward tradeoffs faced in the financial sector. And the guarantees don’t stop there: federal bailouts of large or politically-connected firms in other industries are now more commonplace and they will continue. Today, the expectation of federal bailouts even extends to other levels of government saddled with insolvent pension funds and other debts that can’t be paid.

Even now, the federal government is creating conditions that may lead to another financial crisis: in addition to the high bailout barometer, bank reserves are plentiful thanks to Federal Reserve policy, and the government seems eager to have those reserves invested in new mortgage lending. Here is John Ligon on this point:

“Two recent examples: Fannie Mae recently started a program guaranteeing loans with as little as 3 percent down payments, and, earlier this year, the Federal Housing Administration reduced by 50 basis points the annual mortgage insurance premiums it charges borrowers. …

A great irony, though, is that these affordable housing initiatives have had the exact opposite of their intended impact: These programs encourage higher levels of debt, increased housing prices (and lower affordability) in many markets, and greater risk within the overall housing finance system.”

There is no doubt that taxpayers will be called upon to cover losses should another financial bubble pop, whether that is in housing or other assets. The one-sided risk this creates represents a transfer of wealth to the financial sector. What’s worse is the contribution of government policy to the sort of economic instability this creates.

Government’s Siren Song of Mortgage Risk

19 Friday Dec 2014

Posted by pnoetx in Uncategorized

≈ 1 Comment

Tags

Arnold Kling, Dodd-Frank, Fannie Mae, Foreclosure, Freddie Mac, Housing Crisis, Interest-only loans, Nontraditional mortgages, Option ARMs, Peter Wallison, Subprime lending, Too big to fail

What’s not to like about cheap, easy housing credit? It would be hard to criticize if it developed in response to real risks and rewards in a free market, devoid of interference by public authorities. Lenders with their own capital at risk tend to keep their pencils sharp when assessing collateral and borrower repayment capacity; borrowers respond to rate incentives by adjusting the timing of their consumption and their borrowing demands. This helps keep the extension of credit at manageable levels relative to earning power, and discourages destructive boom and bust cycles in housing prices. Conceivably, such arrangements could give rise to a more stable and prosperous economy with relatively, realistically easy credit as a by-product. If so, I’m all for it.

Unfortunately, that is not the sort of housing finance market we have in the U.S. In particular, bank lending often carries little real risk to anyone but taxpayers. Depositors who fund bank lending are almost always 100% federally-insured. As for bank capital, large institutions may be rational to regard themselves as too-big-to-fail, meaning that federal authorities will come forward with bailout money should they fall on hard times. Borrowers are encouraged by mortgage agency buyers (Fannie Mae and Freddie Mac) whose implicit federal guarantees reduce the nominal cost of borrowing, and whose standards of credit quality tend to move procyclically. Borrowers are subsidized by the tax deductibility of interest costs. Bankruptcy laws and foreclosure rules make collecting on bad debts more difficult. Finally, there is always pressure on lenders to engage proactively in high-risk community lending.

When risks are meaningless to market participants and rewards are inflated, the normal self-regulatory function of the market is suspended. Who cares about mistakes when you don’t have to pay the consequences? But society ultimately pays in misallocated resources, higher taxes and unstable markets. And while the costs to lenders and borrowers are blunted, most don’t get off scot-free: other consequences may include falling housing prices, widespread personal bankruptcies and damaged credit, foreclosures, stricter regulatory oversight, and a prolonged follow-on episode of hard credit.

The expansion of credit leading up to the housing crisis was marked by the rise of non-traditional mortgage products, which typically involve risky collateral and borrowers with tenuous credit. Interest-only mortgages reduce the borrower’s monthly payments, but the borrower fails to build their equity cushion over time. Payment option adjustable rate mortgages (ARMs) can be criticized on the same grounds, except they are arguably worse. Subprime mortgages are characterized by high loan-to-value ratios and tend to be marketed to borrowers with less than stellar credit histories.

Arnold Kling reviews a new book by Peter Wallison on the role of “non-traditional” mortgages in the financial crisis. Wallison highlights the culpability of government in encouraging the subprime lending boom, especially Fannie and Freddie. He also points to the failure of government to institute real reforms to prevent the recurrence of such a crisis:

“Congress mandated regulation of practices that played no role in the crisis, either because legislators wanted to mislead the public or were themselves misled. Meanwhile, they did not confront the issue of what do about Freddie Mac and Fannie Mae, and they left the door open for the return of nontraditional mortgages. Indeed, Melvin L. Watt, the recently appointed regulator of Freddie Mac and Fannie Mae, is once again calling for the loosening of underwriting standards.”

The drift back to risky lending is underway. Dodd-Frank will not stop it or end “too-big-to-fail” risk-taking and cronyism. The best advice to potential borrowers is to emphasize adverse personal and economic scenarios when evaluating a loan offer, and try to resist the temptation to over-invest in housing. AS voters, we should demand an end to destructive government intervention in housing markets and home lending.