Against Bailouts--Posner's Comment

If a person's assets grow in value, he can borrow more against them, or expect a lower interest rate if he does not increase his borrowing (for then the lenders have more security). This is true of houses as of other assets. In a growing economy, with the amount of land available for housing more or less fixed, the value of residential property can be expected to increase--over the long run. But in the short run, asset prices may stagnate or even decline. In recent years, homebuyers have been willing to take on historically unprecedented risk in the form of 100 percent mortgages (on the subprime bubble, see my posting of June 24) and floating interest rates. As a result, if housing prices fall, a buyer can find himself with negative equity (that is, owing more than his house is worth) and paying a much higher interest rate than the rate prevailing when he bought the house. Although a floating interest rate shifts risk from lenders to borrowers, lending without requiring a significant (or sometimes any) down payment imposes substantial risk on lender as well as borrower, since they have in effect a joint interest in the property that secures the loan. Moreover, the costs of foreclosure and resale are considerable and amplify the loss of value when housing prices fall and precipitate defaults. Back in 2005, both the Economist magazine and the Federal Deposit Insurance Corporation, along with many others, warned that American housing prices were growing at unsustainable rates; the FDIC noted that in the five years ending in 2004, U.S. home prices had risen by 50 percent. There is a long history of housing busts following housing booms, and although generally in this country the booms and busts have been local rather than nationwide, Japan famously experienced an extremely severe nationwide drop in housing prices in 1990. One might have expected concerns with the possibility of a bust, given the housing bubble and risky lending, to drive up interest rates, but this did not happen, because lenders were willing to assume a very high level of risk. In part this was because the initial lenders could sell loan packages to hedge funds and other specialists in risk bearing. The bubble burst, defaults ensured, interest rates rose--precipitating more defaults--and some lenders were wiped out. Finally the Federal Reserve Board stepped in and eased interest rates by providing additional capital to the banking industry. The only justification for bailing out risk takers is to avoid a depression (or as it is politely called nowadays, a "recession", but, oddly, the worse the macroeconomic consequences of a speculative boom and bust, the stronger the argument for punishing the risk takers (which include both borrowers and lenders) by not bailing them out. The punishment should fit the crime (I use "crime" in a figurative sense); the worse the crime, the heavier the optimal punishment, setting aside issues of detectability. If the government relieves risk takers of the consequences of their risks, there is a divergence between social and private risk. An example is subsidized flood insurance, which leads to excessive building in floodplains. There seems a particular perversity in making credit cheaper, since cheap credit fed the boom. Lower interest rates encourage borrowing and hence spending and also increase the price of imports by making the dollar worth less relative to other currencies. Moreover, government intervention to help lenders and borrowers invites further government regulation--for example limits on subprime lending. There is no more reason to discourage risk taking than to bail out the risk takers when the risks they have voluntarily assumed materialize. The losses sustained by hedge funds in the bursting of the subprime bubble lend a note of irony to opponents of taxing them comparably to other investment companies. They argue that hedge funds play an essential role in bringing market values into phase with the underlying real economic values. It now seems that a number of hedge funds were caught up in a speculative frenzy, and that far from bringing about convergence between market and real values they enlarged the wedge between them. Studies in cognitive and social psychology have identified deep causes for the overoptimism, wishful thinking, herd behavior, short memory, complacency, and naive extrapolation that generate speculative bubbles--and that require heavy doses of reality to hold in check. Any efforts to soften the blow will set the stage for future bubbles.

Comments

[Ron]

In the past month I have read perhaps 100 different versions of "a big recession is okay since we need to punish those who took big risks and lost." Here is what I do not understand: A stock market and housing market plunge will pretty obviously tip our economy into recession (or depression). How exactly will only those who took goofy subprime 100% loans be punished?

I own two homes. One has no mortgage, the other has a mortgage for 15% of the house value (not a typo). We have a sizable portfolio, entirely in low-cost Vanguard index funds, dollar-cost averaged over years. No credit card or car debt. As far as I can tell, we have not done anything risky, dumb, or worthy of the schaudenfreude spewed across comment boards lately. And yet, our portfolio has lost $750,000 in the past month.

Now hey, don't cry for me; we're not hurting. My point is that we are hit by these crashes, too, though we didn't engage in behavior that caused them. And of course, some of that money would have been spread around the economy but will not be any longer. My parents and brothers' family are in similar situations. There must be millions of others in a similar situation, though the amounts might differ.

So, how exactly does this market crash not cause a recession and how exactly do only the dumb folks get punished?

[The Divagator]

Ron, I think these are good questions, but let's take your complaint to its logical end...what happens in a market economy where "risk" is merely figurative? Wishing and hoping that ill-considered investments sink a few funds is not schadenfreude; it's merely stating a desire to avoid wider and worse effects down the line.

[Ron]

Divagator, how exactly will only funds with ill-considered investments get sunk? I don't have any of those, and I lost a truckload of money this month. My parents don't have any of those, and they lost a lot of money this month. I am sure that a lot of people don't have any of those, and they lost a lot of money this month. How will all those losses not lead to a severe recession, and if it will lead to that recession, shouldn't the Fed take actions to prevent it?

Personally, I think it's ridiculous that people who shouldn't own a home got loans and bought houses they couldn't afford. I also think it's shameful that a lot of finance folks made so much money off of this situation. But, it seems to me that tanking the overall economy is a poor way to punish those bad buyers and sketchy bankers.

If you think it's acceptable to let the economy tank in the hopes of teaching subprime borrowers and hedge funds a lesson, then you'd better have a job that isn't dependent on the economy. Hey, are you a tenured professor? :)

[Richard]

One response to Ron is that whether his investments were conventionally "responsible" or not, he was voluntarily accepting risk linked to other admittedly less responsible market participants. Responsibility is not the test; risk taking is. He sought the rewards of equity investments, and one of the risks is of the systemic market nature. Another way to think about this is that unrealized capital gains fueled by unsustainable leverage never "really" existed, and so weren't lost; the accounting was simply corrected.

Having now read both Becker and Posner on this topic, I agree with Becker in principle, that central bank intervention is warranted only to protect the real economy (not meaning Ron's capital losses -- or mine, which are similar but somewhat smaller) from spillover damage. Becker argues that evidence of such effects requires concrete indicators of a slowdown; the Fed and other central banks (which appear to also agree with Becker in principle) evidently are convinced, on balance, that they can discern evidence of such effects earlier than Becker can with more subtle financial indicators -- indicators that point toward the ensuing credit crunch harming the operations of ordinary, profitable enterprises that are typical of the bulk of economic activity.

The main problem, leading potentially to moral hazard, is that any central bank intervention is inherently a blunt instrument that aids the unworthy as well as those in which those of us not culpable for the current state of affairs has a stake. The decision if and when to intervene must reflect a weighing, as best possible, of the moral-hazard cost against the real-economy benefit. It is as simple -- and, of course, as complex -- as that.

[Professor Bear]

Ron --

You seem to feel that it is the govt's job to shield you and other high-risk investors from the downside of risk. I would personally argue that shielding downside risk is exactly what set the stage for the current debacle that is playing out on Wall Street, and that Fed actions to prop up the price of devalued assets only serve to encourage more malinvestment of real U.S. capital going forward. We really don't need more of this at the moment, as we have an excess supply of 2.2 million or so vacant homes to work through thanks to the malinvestment which has already occurred as a consequence of the housing bubble.

Disclosure: I am not tenured.

[Jas Jain]

"In the past month I have read perhaps 100 different versions of "a big recession is okay since we need to punish those who took big risks and lost." Here is what I do not understand: A stock market and housing market plunge will pretty obviously tip our economy into recession (or depression). How exactly will only those who took goofy subprime 100% loans be punished?"

-x-x-x-

Hello,

Good question. The answer is: We must pay the price for living in bad neighborhood (irresponsible Americans) and having bankers and financiers, supported by the Fed, who encouraged "reckless mortgage lending."

We are all in it together does apply to some extent.

Best of luck to you.

Be Safe!

Jas

[U of C law student]

Ron:

While I'm sorry for your loss (that isn't meant to sound funereal), fed intervention will only increase the likelihood that your bad fortune will replay itself in a decade or three. By intervening, the fed will promote risk-taking strategies that account for a probable future bail-out.

I worked for a bank that lended very conservatively. This bail-out provides an unfair competitive advantage to risk-takers over responsible lenders: the risk-takers get to keep their wild profits without their due losses, while the responsible lenders chug along with average profits and no government boost. This bail-out discourages responsible lending. If you were a bank and wanted to adhere to the strategy you purport to be responsible (i.e., giving mortgages to those who can reasonably afford repayment), why would you do so after witnessing this bail-out for your irresponsible competitors?

A government bail-out has broader negative implications for the economy as a whole than any benefit you--and other individuals with great investable assets--might receive in your portfolio.

[Kieran]

The problem with a Fed "bailout" is that it does not resolve the problem, it only delays its consequences. Enabling debtors to acquire more debt to pacify short-term debt calls and margin calls may enable these business to pay their bills this month. If the underlying problems are not addressed, however, and individuals continue spending more money than they earn, and corporations continue making loans to debtors that cannot reasonably be expected to pay them back, the problem will only grow in magnitude. There are still ads all over the internet offering $600,000 mortgages for less than $2,000 a month. Until that stops, it does not matter what the Fed does. The Fed can lower the rate to zero, and the boom will still bust. The only thing the government can control is who will bear the greater brunt of the crash. While we all will doubtless suffer some of the after-effects, I suggest that those who were culpable should bear the full force of the reaction that was destined to come their way.

[MT]

I agreed with every sentence Posner wrote as I read it - in principle. But what I saw in the markets last week was worrisome that we had reached the point of crisis where a really big and very highly leveraged institution might fail and that created a very grave risk too great - both in probability and potential adverse outcome - for a prudent decision maker. All rules have exceptions. I saw bid-asked spreads widen enormously on liquid stocks which I could only rationalize by saying that the market makers were trying vigorously to raise cash on an intraday basis. I saw a stock move 7% in an hour with no news. I saw a defense stock go down 10% one day and up 20% the next, on no news either day. When financial assets were being so plainly mispriced and it was plain the mispricing was liquidity driven, it was prudent to set aside principle and intervene to stabilize the markets so that rationality could have a fighting chance.

I enjoyed Posner's acknowledgment of the work being done in behavioral economics. When I was in school, you were associated with more classical schools of thought. As applied to subprime lending, it is dawning on us that, while all of us are in part irrational, there are citizens who educate themselves in compensating ways, and many who don't, and also that our society has a constant stream of messages, from peer pressure to corporate advertisements to political pandering, that are targeted to cause the irrational brain to act in a particular way, and those who are more rational have to design rules that, although they constrain the freedom of the rational actors, protect all of us from the consequences of an overflow of irrational behavior.

[Bill]

Americans had around $10 trillion dollars in aggregate home equity and have around $9 trillion in outstanding mortgage debt on family residences. The aggregate home equity number may have just dropped by a few trillion.

Every real estate market is different, but the one I’m familiar with is probably representative of many. In the late nineties, you could buy a 1200 s.f. house for just under $100,000. At the market peak in early 2005, that 1200 s.f. house sold for ~$240,000. One local project has been steadily lowering prices and is now offering the house at $135,000, and is just starting to get traffic.

But something else has changed. The government has learned to make money in the business. Our impact fees in 1997 were less than $5,000 per unit. Impact fees today can be over $40,000 per unit. Between these fees and increases in material costs, there really is no incentive to build new housing today. Those building are just doing it to liquidate inventory.

The number of people with at-risk loans is spooky and this problem might just get a lot worse before it gets better. I say let water find its own level.

[nolonger]

What is the difference between the Fed intervene and the rescue organized by a Citadel or a JP Morgan? Doesn't the action of private rescue effort also bail out the unsuccessful risk-taker and lead to more risk taking?
A problem facing a fund manager is in fact the same as that faced by a bank - both invest in long term projects and assume investors do not all demand their money back at the same time. Once there is a run, then it doesn't matter whether your investment is sound or not.

[David Barker]

Posner says "In a growing economy, with the amount of land available for housing more or less fixed, the value of residential property can be expected to increase--over the long run."

See Eicholtz, "A Long Run House Price Index: The Herengracht Index, 1628-1973" Real Estate Economics Summer 1997 v25(2) p. 175-92. This paper shows that, even over a long time period in a central city location, house prices do not always appreciate significantly. The same point is made by Robert Shiller in the new edition of Irrational Exuberance.

[Wes]

...a mortgage...[and]...Vanguard index funds...As far as I can tell, we have not done anything risky, dumb,...You don't specify what index but if it was a safe index (e.g. government bonds) then it was probably a dumb investment in that if you did the math accurately you would find that you were paying more on your mortgage than the return on your funds. If it was an risky index with a return greater than your mortgage payments (e.g. stocks) then you were essentially borrowing money to invest in the stock market which goes down as insanely risky in my book. Then again, with government debt as high as it is, any investment in the stock market at all is insanely risky in my book. Anyway, basically, you set yourself up to lose from a downturn in either the housing market or the stock market and if both went down you set yourself up to lose on both....we didn't engage in behavior that caused them.Borrowing money to invest definitely contributed to the bubble. Depending whether or not you've been selling anything lately you may also have been contributing to the bust.

[Health Insurance Quotes]

No way, should the Feds intervene.

[mpg]

One thing I haven't seen discussed much - the money the Fed "intervenes" with - would that be money raised from the taxpayers?
Also, I've read that the Fed is accepting various types of these "assets" as collateral. Prudent?

[talon]

Has everyone forgot friedman's "A monetary history"? many loan that seemed sound in 1929 looked bad ex-post
1932-33 after credit dried up and buyers couldn"t get financing.
looking at backward indicaters is a poor guid to the future.

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