Saturday, October 11, 2008

A big smoking hole in the ground: Moral hazards in many shapes and colors

PRE-POSTSCRIPT: Christopher Caldwell has an excellent article in the London Financial Times setting straight the political reality of this crisis: "pragmatism" not only doesn't work, it's precisely what got us into the crisis to start with. "Ideologues" are supposed to be bad, mean people who block "pragmatism"; in fact, they block politically gratifying but false solutions that just cause more problems down the road. It's too bad there weren't more -- many more -- "ideologues" standing in the way of government-sponsored subprime mortgages. There should also have been more "ideologues" (meaning, people who actually know something) more insistent on deflecting the rescue push in a more helpful direction.

The incoherent response of the US and other governments is also a case of "pragmatism": myopic reaction, shaped by panic, and not calming down and thinking it through. The economic knowledge to thread governments and markets through this mess is available in abundance. But politicians, journalists, and others in the chattering classes often don't want to hear it.
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After a busy week, a few brief items to post.

Anyone paying attention to the financial crisis is aware of the role of subprime mortgages and their sponsorship by Fannie Mae and Freddie Mac. They form the weakest part of the mortgage market, so it's no surprise that the crisis hit there first, then spread.

But why the rest of the housing market? It's because of the powerful collective delusion shared by banks, credit markets, the public at large, and the regulators themselves that housing prices would "have to" keep going up forever at eight or 10 per cent a year. This misperception is a textbook case of "bubble" psychology. In an undistorted market, lenders, home buyers, and everyone else, would have perceived risk more realistically and acted accordingly. Subprime mortgages would still have happened, but at a lower volume and higher interest rates.

This misperception played a crucial role in the subprime mortgage fiasco. If I lend you $500,000 for a house, and you're not a good credit risk, but housing prices rise 10% next year, it's fine. If you default and I foreclose on your house, I can sell it for $550,000. I've made money in this supposedly dire scenario. If I expect housing prices to behave that way into the indefinite future, I'm going to be a complacent creditor, willing to lend to just about anybody.

But if housing prices start dropping and appear ready to keep dropping for at least several years, the picture changes drastically. If you're a good credit risk, I'll lend to you, perhaps at somewhat tougher terms (more down payment, higher interest rate), but let you, the borrower, assume the risk of your house falling in value. (You always have the alternative of not buying at all and renting instead.) If you're a bad credit risk and in danger of default, there's no way to avoid losses somewhere: you will lose if and when you sell your house, or I will lose when you default and I'm left with a $500,000 mortgage attached to a $400,000 (say) house.

It is here that we see how Fannie and Freddie set up lenders for unwittingly assuming big risks. Fan and Fred didn't redistribute income or wealth; they redistributed risk, from home buyers, then to the banks lending the money, and finally to the bondholders who bought the mortgages in the form of Fan-Fred bonds. The F-F business model was to buy the mortgages from the bank as bonds and at a discount, then resell them at full value to bondholders. The bondholders did this because behind F-F was the implicit government guarantee of bailout in case of default.*



Whence the fuel for the bubble in the housing market generally, that part not subprime?

We've already heard from many about moral hazard, the term economists use for some third party (usually government, although it doesn't have to be) guaranteeing an outcome for a certain class of people, regardless of their own mistakes or outsized risks they take. Fannie and Freddie were complex schemes of moral hazard.

But, all over the advanced world, central banks have also long been in the habit of creating moral hazards from policies of cheap credit, holding interest rates artificially low. The money supply grows too fast, but it's in the form of credit, not cash. The result is not "inflation" as we usually understand it (rising consumer and producer prices), but asset bubbles (stocks, houses) and misinvestment. Overly-easy lending practices make everyone too casual about what they invest in and lull them into a false sense of complacency. It wastes scarce savings (capital). Above all, it creates the illusion that certain favored assets du jour will just keep going up in price. In other words, cheap credit enables and promotes bubbles.

Is this possibility relevant to the recent economic history? You bet: it describes the Fed's behavior in 1995-99, as it enabled a massive stock bubble. As the Fed's commitment to price stability wavered in the late 90s and during the 2001 recession, it describes even better the 2002-07 housing bubble, which was accompanied by other classic inflationary signs, such as a falling dollar and rising prices for imported natural resource like oil.**

People wonder if the huge injections of credit by the Fed and other central banks over the last few years will lead to inflation down the line. The response is, they already have done so. These injections kept housing and natural resource bubbles going for several years. But it's not possible for central banks to keep manipulating economies and financial markets indefinitely this way. Eventually everyone gets wise and readjusts their behavior and thinking. That's what's been happening for the last year or so, and we're now heading into deflation, at least for a while.
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* Where did Fannie and Freddie's profits go? F and F both sold stock to shareholders, and they got some of the net proceeds. The rest went into that Congressional patronage pot already mentioned, the Affordable Housing Trust Fund.

** Slightly older but relevant to the present crisis are the 1980s bubble and 1990s post-bubble stagnation of Japan. Again, the central bank played a pivotal role in spreading lots of cheap credit around and driving up real estate and other asset prices to fantastic levels.

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