Dealing with the Financial Crisis, Stage III: Nationalization

Stage I of dealing with a financial crisis is to provide liquidity to the banking system at high interest rates in order to keep commerce and finance liquid while punishing feckless overleveraged financiers. We passed out of Stage I at the end of last year. Stage II is forgetting about punishing feckless financiers and focusing on lowering interest rates in order to raise asset prices to keep finance solvent. We are now in Stage II.

Now Alan Blinder says that it is time to--in a limited way--move on to Stage III: nationalization.

Here is his case for a partial nationalization of mortgage banking:

From the New Deal, a Way Out of a Mess: I have several reasons for focusing on just one aspect of the mess: the potential tsunami of home foreclosures.... Foreclosures throw families -- some of whom were victims of deception -- into the streets. They erode home values, damage neighborhoods and reduce the values of other properties, thereby intensifying the decline in housing prices that underlies many of our current problems. And they might even cut into consumer spending, which would really throw us into recession.

A second reason is that reducing the wave of foreclosures would mitigate the closely related financial crises in home mortgages and the alphabet soup of financial creations based on them.... A third reason for focusing on foreclosures is that we've seen this film before. During the Depression, President Franklin D. Roosevelt and Congress dealt with huge impending foreclosures by creating the Home Owners' Loan Corporation. Now, a small but growing group of academics and public figures, including Senator Christopher J. Dodd, Democrat of Connecticut, is calling for the federal government to bring back something like the HOLC. Count me in.

The HOLC was established in June 1933 to help distressed families avert foreclosures by replacing mortgages that were in or near default with new ones that homeowners could afford. It did so by buying old mortgages from banks.... mThe scale of the operation was impressive. Within two years, the HOLC received about 1.9 million applications from distressed homeowners and granted just over a million new mortgages.... Its total lending over its lifetime amounted to... 5 percent of a year's gross domestic product at the time. (The corresponding figure today would be about $750 billion.)

As a public corporation chartered for a public purpose, the HOLC was a patient and even lenient lender. It tried to keep delinquent borrowers on track with debt counseling, budgeting help and even family meetings. But times were tough in the 1930s, and nearly 20 percent of the HOLC's borrowers defaulted anyway.... The HOLC closed its books in 1951... with a small profit. It was a heavy lift, but the incredible HOLC lifted it.

Today's lift would be far lighter. And a good thing, too, because our government is far more timid and divided than Roosevelt's....

Details matter, so here are a few: First, any new HOLC should refinance only owner-occupied residences. Speculators can fend for themselves -- or go into default. Similarly, second homes or vacation homes should be ineligible, as should very expensive real estate. (Precise limits would vary regionally.) Third, mortgages obtained via misrepresentation by borrowers should be ineligible for HOLC refinancing, but cases of fraud or deception by the lender should be treated generously. Fourth, as the original HOLC found, not all bad mortgages can be turned into good ones....

What about the operation's scale? Based on current estimates, such an institution might be asked to consider refinancing one million to two million mortgages... as much as $200 billion to $400 billion. The midpoint, $300 billion, is one-seventh the size of Citigroup and would rank the new institution as the sixth-largest bank in the United States....

[T]he new HOLC seems likely to turn a profit, just as the old one did. But even if it loses a few billion, we must remember its public purpose: to help the economy recover, not to make a buck. By comparison, the new economic stimulus package has a price tag of $168 billion.

Comments

[Cranky Observer]

As an ordinary, everyday works-for-his-money taxpayer (not working class, but that is where I started too), the only way I could see this even being a gleam in Congress' eye is if every single dollar in bonus, and salary above $125,000/yr, paid to every single executive in the financial industry since 1998, is clawed back first. Otherwise all that we would have is the mother of all moral hazards, except this time with real weapons of mass destruction. It would be an open invitation for the financial industry to loot and, let's be honest, enslave every working person in the United States forever.

Cranky

[Neal]

How does this address the issue of the high cost of houses as opposed to the income level of the buyer? If we went back to the historical standard of the allowable house price being 3 times the annual income, what would the ownership rates be at with 2005-2007 prices?

The reason why so many people got into trouble and will remain in trouble, no matter what the "reasonable rate" is, is that they could only afford the house they got by financial gimmickry and shading (or obscuring)the truth.

And doesn't the assumption that ever-rising values and permanent re-financing availability that allows the purchase of what one cannot afford form one very plausible definition of speculator?

Something does need to be done. I'm not sure nationalization of the morgagge industry at existing price and morgage levels is the answer.

[Queequeg]

First Blinder says: "Foreclosures throw families -- some of whom were victims of deception -- into the streets. They erode home values, damage neighborhoods and reduce the values of other properties, thereby intensifying the decline in housing prices that underlies many of our current problems. And they might even cut into consumer spending, which would really throw us into recession."

Later, he says: "First, any new HOLC should refinance only owner-occupied residences. Speculators can fend for themselves -- or go into default."

If he believes the first, why does he say the second? If a bank forecloses on a rental property owned by a speculator, the tenants are thrown out onto the street. And the foreclosure of a spec property erodes values of neighboring properties and damages the neighborhood. So why does Blinder want to treat them differently?

I think it's because he sees a moral dimension in this. He wants to punish speculators. In your gut, most of us feel he's right. But that's an emotion, not a thought. Is it rational to reduce foreclosures in some neighborhoods but to encourage them in speculation-heavy neighborhoods? I'm not sure that's helpful, in the long run. Your thoughts, Brad?

[M Papadopoullos]

It is not clear how these loans could be extricated from the soup into which they were thrown. How does this show up on the balance sheet of a CDO holder.

How would the scheme be financed?

[M Papadopoullos]

It is not clear how these loans could be extricated from the soup into which they were thrown. How does this show up on the balance sheet of a CDO holder.

How would the scheme be financed?

[Ivan]

Like other commenters, I see the major flaw in Blinder's plan is that he avoids discussing the fact that even with the current dip, housing remains grossly overvalued by historical measures, and the expectation of continued increases that made it attractive to purchasers even in the face of this imbalance (particularly compared to equivalent rent) is gone. Therefore, the slide will continue as long as the imbalance persists and buyers stay on the sidelines. This would then mean that continuing sliding prices will make people default, even with these new "affordable" mortgages; the "walk-away"/"jingle mail" phenomenon is very real.

If Blinder's plan intends to halt the slide of housing and prop up prices, then the fundamentals that underpin the housing markets (e.g., the magnitude of the tax-advantaged status of mortgage interest) need to be altered to make buying even more attractive than renting, so that the current price delta can be justified. This is, of course, grossly regressive as it's a windfall for disproportionately-wealthier property owners and hurts disproportionately-poorer renters and prospective buyers.

[save_the_rustbelt]

We could be fast approaching the point at which entire urban counties such as Wayne - Michigan (Detroit) and Cuyahoga - Ohio (Cleveland) could become non-viable.

Some of the inner ring burbs of Cleveland, formerly affluent burbs of Cleveland, now are trying to hire enough police to avoid the Robocop scenario (ditto for Detroit, home of Robocop).

Of course I have a grudge because the foreclosure avalanche started in the rustbelt five years ago and nobody in Washington gave a damn, no one in academia gave a damn and no one on Wall Street gave a damn.

Beware the canary in the coal mine, when it falls over dead anticipate bad news.

[walkingdaline]

I'd prefer to let a few banks fail, until the clamours from the right for a New Deal-style bailout grow so frenzied that they seize David Frum in their rage and offer his still-beating heart in sacrifice at their new temple to Roosevelt and Keynes.

[save_the_rustbelt]

Cranky:

I have wanted to do a clawback for executives who took bonuses and stock options while underfunding employee pension plans.

Like your idea too. It will never happen.

The best we can do is hope for some civil suits and possibly some prosecutions.

[Doctor Jay]

If the foreclosures we are seeing are due to families being unable to make payments, then sure, we can nationalize. But isn't it the case that many foreclosures are due to families walking away from houses that have lost value and are underwater? Nationalization doesn't do anything for that.

All those loan agents who encouraged borrowers to be creative with their loan applications should have a clawback, too. And the parties who should go after them are the people who hold those loans now. Is that going to happen? Probably not, it probably isn't worth enough on a case-by-case basis to do it.

The entire system needs a different structure. What if loan agents had to pay back their fees, plus interest and maybe a penalty, on any loans they made that were foreclosed? Or even a fraction of it. Contractually. Might that make a difference?

[Anon]

Yes, yes, now that the profits have all been privatized and pocketed - loan origination fees, bonuses, bond sale fees, etc. etc. etc. etc. - now the bankers come along and urgently need for the risk and the losses to be publicized via a government bailout. What a surprise.

For every loan which ends up being privatized and eaten by the government, the government should claw back 200% of the losses from every executive and every corporation involved in making, packaging, and selling that loan.

"Fraud by the lender should be treated generously", ho, ho, ho. So what if Citibank loaned someone $1,000,000 on a $500,000 property? The government bailout agency should still happily pay Citibank its $1,000,000 in the process of bailing out the homeowner... After all, we're just doing this *for the homeowner* (envision a small tear in my eye)... Citibank's $1,000,000 is purely incidental, a mere byproduct of this homeowner-helping plan.

Ho, ho, ho. I wish I could laugh harder but the political reality is that this is likely to happen. Nice job, being a banker.

[Tom O]

Speaking as a mortgage guy of 25 years experience, I can only say that this is ivory tower nonsense. If the plan only covers owner occupied loans done without fraud, it eliminates probably 9 out of ten high LTV loans done since 2005.

A "no income documentation" loan program is not the same thing as a "no income qualification" loan program. "No Qual" means the lender does not ask borrowers to state their income, which eliminates any possibility of fraudulent misstatement. These programs were exceedingly rare. "No Doc" means borrowers were required to state their income, but not automatically required to prove it. It absolutely does not mean borrowers were allowed to lie about their income, and any borrower who did so was technically committing fraud (look at the paragraph just above where you sign a standard FNMA form 1003 loan application). Since essentially all of these "no income documentation" loan applications contained completely fallacious income information, the great majority of owner-occupied foreclosures would not be subject to assistance under this proposal.

Beyond that, there is a huge issue of fairness in asking renters (most of whom are priced out of the home purchase market) to subsidize high home prices with their tax dollars. The increase in median home prices has far outstripped the increase in median household earnings. We can either increase nominal earnings by inflation, inflate purchasing power by loosening lending standards (again), use tax dollars to directly or indirectly subsidize home prices or let prices fall to equilibrium and the chips fall where they may. As painful as it is to those who hoped to gain from their real estate purchases, or those who hoped to profit from lending to them, they have to right to ask others to pay for their mistakes.

[Tom O]

Last sentence should have read...

As painful as it is to those who hoped to gain from their real estate purchases, or those who hoped to profit from lending to them, they have NO right to ask others to pay for their mistakes.

[bigTom]

There are a couple of coupled, but separable? problems here. First are the forclosures, and the effects on families, and neighborhoods. The second is the insolvency of many of the banks. The first problem looks pretty intractable, as it is caused largely by underwater mortgages, the second could be handled by nationalization of failing banks -as we've seen with Northern Rock.

The first problem is more difficult, as others have noted the problem is that houses were bought at well above a reasonable price, and trying to prop up prices will in the long run be futile as well as expensive. There are only two ways out of the first problem. The most obvious is a period of sustained high inflation, which would eventually trick down to the housing market. The second is to renegotiate mortgages, by cutting the principal owed -not the interest rate. I don't think we are close to being ready for either of these solutions.

[R]

I guess none of the commenters live in the bay area, since on one seemed to pick up on the part about "very expensive real estate" being excluded. Let me guess, anything over $1 million will be considered very expensive, because who else but fat cats would buy such an absurd home. Are there any million dollar homes in Berkeley? Palo Alto? Sunnyvale?

If you have one of those houses, and it drops the 20% that the renters are begging for, you're out $200,000. But, you get no help and of course you will be expected to pay taxes to help out the little guy who got burned by the evil banker, right?

[Detlef]

In what way is that "nationalization"?

Does the state / tax payer get shares of any of the banks / investment banks involved with those mortgages? You know, the ones that made those risky loans? Doesn´t look that way. Unlike China and the Middle East countries.

In fact, the American tax payer in this proposal is asked to shoulder the risk and pay the banks. It´s maybe "nationalization" of the financial risk but it´s not nationalization of any of the actors and their assets creating that risk.

[jerry]

There is something very attractive about walkingdaline's plan. Can I sign up for your newsletter?

[peterbob]

If you add up the votes, most people are not going to be directly affected by the drop in house prices. The renters, those with a mortgage before 2002, and those who own outright. I hope elected officials remember this. Because I will absolutely not vote to re-elect any politician who votes for a bailout.

The only justification for any intervention, in my opinion, is to minimize the collateral damage. The means lessing the effects of a credit crunch and allowing people to buy/sell houses if they want to. The solutions for these problems would mostly be to shine light on things: allow house prices to fall quickly to fundamental levels (by rent/income, etc., housing is overvalued by double digits), and allow Wall Street to quickly put a market value on securities. Once that happens, then people will start buying houses (which will employ people in related industries and help state property tax collections) and banks can start lending money to good NEW borrowers.

There will be pain, but I want the economy to move forward. I don't care about helping those who made bad bets in the past.

[piotr]

Didn't we just have a jolly good time criticizing Castro? This suggests two step approach:

1. Nationalization.

2. Economic sanctions.

[shander]

Peoples lives are being wrecked due to economic policies designed to stimulate the economy with unsustainable low interest rates that drove up home purchasing power temporaliy.

If asset prices get repriced based on future interest rates based upon a true price parity inflation rate retirement accounts will be drastically discounted too (how high would interest rates need to be if china stopped increasing its US debt holdings and interest rates had to rise to a level that would encourage sufficient saving to cover that).

This great experiment with keeping the economy humming via low cost of capital created pitfalls greater than a slower economy would have...locking people into debt and retirement speculation.

[zanon]

Alan Binder misstates the issue, and the distortions are willful.

First of all, everyone knows that foreclosures don't throw anyone out into the street. It just makes them renters. But of course "Foreclosures make families -- some of whom were victims of deception -- return to renting" does not have the emotional punch of the people like Binder need to wick up before sticking the long suffering taxpayer with yet another bill to bail out bankers.

Secondly, the problem is not house declines -- the problem is that prices got way out of line with incomes! Was the problem with the internet economy that Pets.com lost market value, or was it the fact that Pets.com was valued at $3B in the first place? This insane focus on propping up prices, no matter how ludicrous, makes no sense -- why oh why can't we have a better press corp that brings this simple question up?

Of course, Alan saves the best nightmare for last: "And they might even cut into consumer spending, which would really throw us into recession." Given that consumer spending is at an all time high, and consumer savings is at an all time low (and in negative territory), and trade deficits and account surpluses are also running at record levels, doesn't someone, anyone, think that it's high time american consumers cut their consumer spending just a little bit and start saving just a little bit? What a maroon.

[Altoid]

Blinder's right about one thing: the costs will be socially-borne. The question is whether we're all better off saving the afflicted banks and-- probably NOT coincidentally-- all those impossible-to-value securities produced by issuing banks and traded around as if they were worth something and whose existence now threatens the bond insurers as well as the holding banks and investors; or by doing something else. For moral reasons I'd like to do something else. I agree with Cranky in that I want bankers to give back everything except reasonable salary (but how much of that did *they* put into inflated real estate?) and I also want the same for mortgage brokers whose only job was to originate mortgages and pass them on to someone else.

What Blinder is talking about, as someone already pointed out, is socializing the losses. Once again. Nothing new here; it's S&L all over again. But he must think the losses are enormous if he's willing to trot out the mom & apple pie bathos.

Well, we're all going to pay some price. After the S&L stuff, which was what, half a trillion or so, we were supposed to have learned something. After Enron too. Instead, lobby and campaign money bought near-complete de-structuring of banking (anybody remember Glass-Steagal?) and creation of financial instruments went completely haywire, aided by back-scratching within the institutions responsible for valuing these instruments. I think they're the most culpable, and I think they *should* go under since they've served no useful purpose, and I think their officers should be prosecuted if that's possible. Fraud, maybe? Violation of fiduciary responsibility? That's where I'd start.

And I'd say the whole regulatory structure needs to be put back in place, and I'd say that mortgage originators have to hold the mortgages they originate for a stated period of years, say at least a third of the term. And I'd say that anyone who doesn't act in good faith in valuing securities-- and any relationship with an investment entity is prima facie evidence of not acting in good faith-- will have committed a hard-time felony and the institution involved must be dissolved. And I'd say we need staffing at the appropriate agencies to enforce the rules. Something along those lines.

They say after about two generations we lose connection with why we have certain regulations and institutions. That would have been about the 80s, when we should have re-learned the needs for financial regulation. But interested money bought the interests another generation of freedom from oversight. Time for another two generations of regulation.

[zanon]

ALTOID: you said "Blinder's right about one thing: the costs will be socially-borne"

This will probably be true, given the unholy nexus we have between a Fed who rushes the economy from bubble to bubble, a political system who will leave no "victim" behind, a financial system that is backstopped by the Fed and inevitable government largess, and a press that continues to publish crap like "foreclosure = homelessness".

But does it *have* to be true? Clearly not.

-zanon

[wimpie]

Alan Blinder said it best when he said "The last duty of a central banker is to tell the public the truth."

[Maynard]

Economists have either become very farsighted or very paranoid. Here we are in stage III of dealing with financial crises, talking about the Great Depression, and unemployment is still 4.9 percent.

[gordon]

Maybe this floating straw called HOLC might better be grasped using debt rather than an outright payment to banks by HOLC for their worthless securities. Instead of, as Blinder suggests, buying old mortgages from banks (which implies giving the banks good money in exchange for worthless securities), the US Govt (via HOLC or whatever) might lend instead. This would inject money into the banking system, which is no doubt a major objective of the exercise, but money which would have to be repaid later. At least that way the US taxpayer might have the satisfaction of thinking that their children might live to see some payback for the bailout.

Think Brady Bonds, this time for banks rather than Mexico.

[zanon]

MAYNARD: Amen to that. But Wall Street might have some writedowns.

WIMPLE: I'd just be happy if they stopped lying to themselves and admitted they were part of the problem.

-zanon

[albrt]

There is a fairly straightforward step that would address many of the problems with this program: triple the number of bankruptcy judges, make bankruptcy the intake process for "troubled" homeowners, let the bankruptcy judge decide the value of the home, then let the new federal mortgage bank pay the old lender whatever the bankruptcy judge determines the fair value to be.

This is basically the same as a cramdown, except that it takes the loan off the books of the lender so it can use the cash to do whatever else it needs to do.

Bankruptcy judges are not perfect, but they are about the best people we have for visiting moral hazards on the hazardors, and otherwise cutting through the Gordian knots of improvident financial transactions.

[albrt]

There is a fairly straightforward step that would address many of the problems with this program: triple the number of bankruptcy judges, make bankruptcy the intake process for "troubled" homeowners, let the bankruptcy judge decide the value of the home, then let the new federal mortgage bank pay the old lender whatever the bankruptcy judge determines the fair value to be.

This is basically the same as a cramdown, except that it takes the loan off the books of the lender so it can use the cash to do whatever else it needs to do.

Bankruptcy judges are not perfect, but they are about the best people we have for visiting moral hazards on the hazardors, and otherwise cutting through the Gordian knots of improvident financial transactions.

[r flanagan]

Blinder makes sense.

Philosophical objections:

o Moral hazard. That's a theoretical term without content. Businessmen take risks ,whether or not their predecessors have been punished for taking similar risks. It's the nature of the beast.

o Lack of fairness . Of interest only in a discussion of morality. Not in a discussion of preventing a painful depresssion. A guy's got to do what a guy's got to do.

Practical objections:

o But it will be of only limited value. Doing nothing is of much less than limited value. It's of zero value Fix the things we can fix.

o No one will really be dispossesed ,they'll just become renters. That we'll have a vast number of people needing housing at the same time there is a vast stock of rentable houses suggests it's not beyond the wit of man to devise a solution.However upsetting that is to laisse faire purists.

[Steve Weston]

Forget all this. All we have to do is get Congress to DOUBLE THE MORTGAGE INTEREST DEDUCTION FOR 2007 & 2008.

This would provide both immediate relief, encourage those in a bad financial situation to remain in their homes and not walk away and let them fall into foreclosure. Finally, this would help both thos people who didn't take those risky adjustable mortgages, as well as those who did. Thus this solution is more "fair."

This would also provide immediate, direct, in the form of tax refunds, stimulus to the economy.

[Altoid]

zanon: Of course it has to be that way. If we don't all feel it through government action, we'll all feel it through government inaction, or more likely some combination of action and inaction. If securities collapse, and bond insurers collapse, and banks fail, and property values slide even more seriously, there'll be consequences throughout the economy. Ditto if tax money goes to save the securities and the banks and maybe, incidentally, some of the mortgagees. Mistakes this gigantic, that have to do with our international circulating and reserve medium, cannot happen without consequences to everyone. It's just a question which individuals pay what.

Look at the tens, perhaps hundreds, of billions foreign banks have already taken in writedowns on these securities. American banks have taken some, as I recall, but they either lack the resources of the foreign banks or the ability to get government backing, so I don't think they've written down as much. So there's a lot more to go. And who's going to make the municipal pension funds and other public securities holders whole? Lots of problems have already come to light there. And so on.

I may be wrong, but I see the fundamental problem they're grappling with as being that no one knows anymore what the value of any of a very large class of securities is. Nobody knows how good are the promises of payments. That's a first-rate crisis in the international dollar-based financial system. A good indicator, for me, is that every time there's any hope of rescuing bond insurers or other outfits connected to this paper, stocks instantly rally.

Gordon's suggestion is interesting and I think the Fed has already done that, haven't they? Didn't they announce back in August that they'd accept mortgage-backed paper for overnight borrowing direct from them, and allow much longer repayments than usual? I wonder how that's working out.

[christofay]

I haven't read all of the comments here, and I make whoopingly bad mistakes sometimes, but Cranky's opening comment will probably make the most sense and only sense. If we must bail, then let's appoint some responsibility.

[zanon]

ALTOID: Let me ask you this -- do you feel house prices in the US (now running 8-10x income) are sustainable? Bear in mind that historically, they've run 3-4x income.

If you think house prices are unsustainably high, then don't you think they have to come down? What mechanism would you prefer they use to do this? So far, all the proposals I've seen have been focused on propping the prices up, or they want to inflate away the value of everything else to bring real prices inline. If you do think prices are too high, and need to come down, what mechanism do you propose.

I'll be open about my preference -- I think house prices are too high compared to income, and I think this ratio should return to historic norms by houses selling for less than they used to.

You also note that there will be consequences in the economy if some securities, banks, etc. fail.

Don't you think some sectors of the economy should have some consequences. For example, shouldn't banks that made prudent decisions survive, and banks that made bad decisions go out of business (re: Northern Rock in the UK)? Don't you think that the no-doc, zero down backed CDOs Wall Street asked to buy should fail, since they were a bad idea? Don't you think that the US consumer savings rate should be, well, positive -- at least a little? Don't you think that the US current account deficit should be at something other than a historic high?

These would be some consequences of house prices falling. I don't think they are all bad.

The poor pension funds and securities holders who might not be made whole are a fact. They bought some investments that might go down in value. I can find sob stories on the other side too -- honest savers who kept scrimping for a down payment, only to see values rise faster than they could save, honest brokers who would not issue no-doc, zero down loans, only to see business go to other, less scrupulous businesses, etc. If we're going to light a candle for those who might not be made whole, let's light one for *everyone*.

You might see the problem as being "no one knows what these things are going to be worth". I have an idea for a starting guess: value the security if housing prices fall back in line with historical norms.

-zanon

[r flanagan]

"Don't you think some sectors of the economy should have some consequences"

Nope.

I think we should avert an increase in our already outrageous levels of homelessness. AOBTW we should reduce the chance of a depression with adverse consequences for prudent , sensible banks etc. who hadn't been part of the sub prime comedy hour.

From the standpoint of economics ,punishing one set of irrational risk takers won't deter any large % of the next set of irrational risk takers .

From the standpoint of morality..............I'm happy to delegate that matter to the good lord, if there happens to be one.

The task which we should consider is not creating a perfect world, just one that's better than if we hadn't acted.

[Jessica]

Here are some purposes a government response to the foreclosure situation might have:
1) To save the economy as a whole from a severe recession or worse.
2) To rescue financial companies
3) To save those in danger of losing their homes (and to protect against foreclosures triggering a spiral downward that endangers millions more home owners who seem safe at this time)
4) To maintain (restore) fairness for renters, especially those who played by the rules and who were priced out of homes by home prices driven up by bad loans
5) To save the construction industry
6) To start correcting a pattern of capital mis-allocation that has poured money into financial engineering and construction at the expense of social infrastructure, both tangible (roads and bridges) and intangible (education at all levels of society)

Here are some political realities (IMHO)
1) No matter what the actual purpose of any plan, it will be presented as being aimed at either 1) or 3)
2) There is a fair amount of popular support for 1, and for 3 and 4, probably a bit less for 5), but almost none for 2
3) In our political system of the last however many years, the prime objective will be 2). 1 will be used as cover for this and 3 and 4 will be set against each other to distract from the package actually being about 2. Professor Delong always asks why we can not have a better press. This is part of the answer.
4)Our current political system is not able to even notice 6, no less do anything about it. To the extent that any program aids the financial institutions, it most likely will make 6 even worse.

[Cranky Observer]

> Moral hazard. That's a theoretical term without content.
> Businessmen take risks ,whether or not their predecessors
>have been punished for taking similar risks. It's the nature
> of the beast.

If "businessman" cashes a $3 million/yr paycheck and $20 million/year bonuses when the numbers look good, and turns the business over to the taxpayer when the numbers look bad even if he was responsible for transforming the good numbers into the bad (or just lying about the numbers being good) it is a little unclear to me where he is taking any "risk". The guy who runs the indie movie rental storefront down the street from me and who pays his own salary and medical costs out of his receipts is taking a risk, so is the family the two blocks the other way who own three independent auto repair shops {grandma is too old to change tires now so she runs the front desk}; the guy with the guaranteed $3 million paycheck not so much.

And if "moral hazard" is just a phrase, why does the financial industry use it so liberally when it is testifying before Congress asking that draconian laws be imposed on consumers?

Cranky

[Altoid]

zanon: See Jessica's comments above. I think she's spot on. And for the financial system, I think the money value of homes is important only insofar as it affects cash payments on mortgages and peoples' ability to keep on spending for consumer goods. The big crisis for people like Blinder is to maintain both flows of cash however it has to happen. That's how I interpret his expressed concern for Bob & Betty Borrower. He's trotting them out like the insurers trotted out Harry & Louise to torpedo any attempts to cut their control over health care dollars. He might care on some level for the plight of upside-down borrowers, but not so much as to shape policy. No one in his position can.

Now I agree that housing prices got way out of line, especially in certain markets (which I do not happen to live in), and probably still are too high. They'll come down way or another, slowly, because that's how housing prices move on the downside. The upside-down borrowers are in trouble now but lenders will change their rates and policies to protect themselves against the long-term fall (assuming they do away with brokers who only originate loans), so there's a definable group of buyers in trouble. And I think we can isolate a fairly small group of people who are primarily responsible. I don't know what can be done about them other than possibly civil suits, if the courts will even allow that. Recent decisions aren't encouraging in that regard.

I also think there's another reason you hint at-- incomes just haven't kept pace even with inflation, let alone bubble-inflated house prices, for something like 4/5 of the work force for many years now. Almost none of the "productivity gains" of the last decade or so went into workers' pockets; they went to officers and shareholders. That money has to go somewhere, and current policy and business ethos, reinforced by union weakness, energized by the end of the Cold War with its need to show that ordinary people live better under capitalism, together have reignited the Great Barbecue.

The fire they're playing with is the air we all breathe, ie money. But most of them have very short-term goals and live with very short-term performance evaluations based on narrow views of their own performance. The word for this kind of hazard escapes me at the moment. But it's real. None of them bears individual consequences for the damage they collectively do. That's what needs to change-- it should be the goal of any regulation, which we sorely need. An old saw, maybe from the FDR administration, has it that business is too important for the country to be left to businessmen to run. Much more so for banking and the financial system.

What happens now? What Jessica says. And the effort will be to achieve some combination of individual and governmental (ie tax-financed) loss-bearing that will render financial institutions harmless to the extent possible while restoring as much value as possible to the securities that include some slice, dice, or tittle of mortgage payments in their cash flows. These losses are too enormous to confine to the borrowers and banks. The securities are the big game here, not the homeowners. And even if this operation succeeds, which we should all hope it does for the sake of our own finances, it can't help but accelerate the rest of the world's transition to a more responsible world currency system. I think they're prepared to leave us behind if we won't go along and let us struggle to catch up. What we're banking on is that we're like the securities, too important to fail. This administration is really testing the limits of that argument.

[anon]

Housing prices going down slowly is good? Why? So that young couples who were not dumb enough to mortgage their futures on a house in 2006 will have to wait until 2015 for prices to slowly return to reasonableness. So Boomers who took out too much HELOC will wait until 2010 to find out that they're underwater and can't afford their house anymore? How is an inflated housing market a good thing for anyone other than realtors and mortgage agents and Boomers who saved too little to retire without selling their grossly price inflated house? Do you people also think that we should keep crude oil prices at $100/barrel as not to shock the oil producers?

Housing for your family is not an investment. It's an expensive to maintain long term consumerable. Anyone who thought otherwise is an idiot.

[Altoid]

anon: if you're reacting to my last post, I said they come down slowly because that's what I've seen and heard from people who talk real estate. I didn't say it was good. And these guys may be wrong. But most of the time houses don't turn over very fast and people tend to value them near what they paid for them, especially if they bought recently. Assessments won't change fast either. On the other hand, bank appraisers won't value houses at what was paid in the good times. Put that together and it says owners tend not to sell unless they have to. They keep hoping they'll get their price. If a *lot* of people *have* to sell, and if banks have a *lot* of foreclosed or abandoned houses to dump, prices will fall a lot faster than they would otherwise.

Not that either one, a slow or fast decline, is good in itself. If I had to sell and move in a hurry I'd hope for a slow decline. If I was upside-down and borrowing against appreciation to buy my cars and appliances and pay off credit cards, I don't think I'd be happy with prices getting back down to normal in a hurry. I just think we have to deal with what's likely, and unfortunately the homeowners in trouble, imho, are the least likely to get much of what they need.

[Dobedo]

How is the ultimate effect of Binder's proposal different from the ultimate effect of Japanese government economic policy after their real estate bubble burst?

If it's not too different, do we really want to spend a lot of money to have the type of economy Japan has had for the last ten years?

[JonF]

Re: If a bank forecloses on a rental property owned by a speculator, the tenants are thrown out onto the street.

One badly neded reform: rental leases should not be affected by foreclosure except that the lease should pass to whomever owns the property afterward, (and be binding on them). The new lease holder could of course choose not to renew and give the tenant the required notice when the lease was up, but it is an appalling scandal that renters who have done nothing wrong should be evicted as the result of a foreclosure. A reform of this sort would also help maintain property values by keeping the house occupiued and maintained-- indeed, it would be beneficial even to the banks since they could ultimately get more for the property and would have income coming from it in the meantime.

Re: It is not clear how these loans could be extricated from the soup into which they were thrown.

Not a problem. The Wall Street banks themselves are buying the bad mortgages out of their securities-- that's the meaning of all these write-downs you are reading about. The investors of course are more than happy to see defaulted mortgages exit their CDOs.

Re: But isn't it the case that many foreclosures are due to families walking away from houses that have lost value and are underwater?

Investors (AK speculators) are doing that, but rather few people do that in homes where they live, unless the payments are such they can't afford them.

Re: What if loan agents had to pay back their fees, plus interest and maybe a penalty, on any loans they made that were foreclosed?

Mortgage companies were and are required to repurchase loans that go into foreclosure too soon after their sale to other buyers (generally, the Wall Street banks or Freddie/Fannie) This is why New Century, American Home and others went belly up. I'm not sure that driving even more folks in bankruptcy would be a good idea, and I don't think it would be constitutional (see: ex post facto law) to apply such a law retroactively.

Re: remember Glass-Steagal?

Anyone think Glass-Stegal has anything to do with the current mess? If so, how? The Wall Street banks which bought and securitized all these mortgages are investment banks, not deposit banks, and no one is in danger of losing their savings account because of them. Morgan Stanley, Merril Lynch etc. are essentially brokerages and always have been.

Re: I think their officers should be prosecuted if that's possible.

What did they do wrong-- legally or ethically, not practically. Sure there's enough blame to go around the whole planet seven times on this one, but with some few exceptions most of it is blame for being being stupid, greedy, and careless, not criminal. And even if you criminlaize such things, the ex post facto clause of the Constitution still is in your way.

[RC]

So by the NYT story there is still money to be made in this and yet the citizen is still being asked to bail out the banks because there isn't 'enough' profit for them to bother with? From everything the professor says in this piece there is no huge financial calamity waiting for us, just one the banks don't want to be responsible for.

Also since it was the loan originator that caused most of the problem why not have the responsibility for these failing loans revert back to the loan originator. I would guess that anyone with a bad loan could tell you who sold it to them. You could also have the final loan holder responsible for a portion of the cost just for sharing in this orgy of greed.

Of course none of this will happen and the taxpayer will end up giving an interest free loan to cover these mortgages while things work themselves out. That is the way of the west.

[Charles]

This is NOT nationalization. There is no possibility that the USG is going to take over Countrywide and start selling houses.

The correct term eludes me, but a lot of very smart people have been abusing the language.

[RC]

Perhaps someone could correct me if I am wrong, but this issue seems to be a fundamental weakness in the financial sector in dealing with bursting bubbles. For example in Japan many home owners ended up with mortgages far larger than the value of their homes, now the same is happening in the US.
So here is a different solution to the problem, though it may well have been tried. Real estate is usually mortgaged on the basis of someone valuing properties based on the sale prices of similar properties in the area, their condition, etc. One could then have a government regulation, clause in the mortgage agreement, even a kind of insurance to include revaluations when the market goes down.
For example people might in good times borrow 80-90% of the value of a house based on this professional valuation. This valuation is usually accurate because people who do valuations have their reputations on the line and banks have prospered assuming they are honest in their jobs.
People in a declining market who have negative equity in their home could apply to have the house revalued, or valuers could simply look at the whole market and readjust their appraisal of a homeowner's value based on the reduced value of other homes nearby. So this need not necessarily cost the homeowner, though they might ask for a personal revaluation based on work done to the property, damage, etc.
If the property is then revalued at below the mortgage cost, then the homeowner, or homeowners as a group, even nationwide might apply to have their mortgages reduced to the value of this mortgage or less. In effect at that point no one would owe more on a house than they could sell it for, and with the reduced mortgage the payments would also decline which would stimulate the economy. This would make it easier for them to refinance, sell, or pay off the mortgage. There could also be a provision that if prices recovered before they sold then the mortgage might go back to the original amount. Jingle mail would be drastically reduced.
This would be ok for most homeowners because even though the mortgage and payments might grow again later, the house would be worth more to compensate.
1. One advantage of this is that banks and other lenders can clearly see how much they have lost and how much overall the market has declined. If mortgages are reduced then subprime bonds can be easily revalued so the market can see how much they are really worth. Also the bond holders might have their bonds increase in value if mortgages are later increased with revaluations.
2. The homeowners receive relief tailored to their needs because one can assume they probably can pay off a house more easily with this lower mortgage and repayments. So there are less people losing their homes and this is less depressing on prices.
3. The government or insurance companies could finance this because this would tend to cushion the aftermath of a bubble by providing a safety net. If necessary they might even reduce the house mortgage to 90% of revaluation so people have an equity to build on. These mortgages might be more easily sold off by the banks to free up their funds, perhaps to a government agency.
4. While some people might damage their homes to reduce their mortgage the revaluation mainly is done by comparing other property values and sales. Ultimately if people damage their homes for a low mortgage they would have to spend the money to fix them later anyway, so there is little incentive to do so.
5. This allows the market to be more resilient because if it goes down then there is much less damage to banks and home owners. Since the damage is less, people automatically pay less each month, houses can be resold rather than foreclosed, credit ratings are less damaged, and the market can more easily recover and go up again. Often people might pay less when the market goes down but suffer few other effects, similar to a reduction in interest rates by the Fed to stimulate the economy. Banks might lose temporarily, but if they continue to hold the mortgages it is only a paper loss that might recover. They might even offer this deal on the provision that the mortgage goes up more than the original loan if the house values increases greatly. So the bank might make more money in a rising market, the house repayments increase and put a brake on people's spending, this slows the bubble's expansion, and when the market drops the losses are offset against these profits.
Sorry for the long post but it is a difficult system to explain in a few words.

[Altoid]

Charles: socialize the losses, privatize the profits. It's the Republican way.

Modern ones take it a step further and say that if a government can do something pretty much at cost, it's stepping on private profits and should get out of the way. *And* should provide money to make up for any shortfalls in expected profits. *And* do it without collecting any taxes.

Really, their religion seems to begin and end with loaves and fishes.

[Queequeg]

RC, the gist of your suggestion might happen eventually. Sheila Bair, chairman of the FDIC, says mortgage servicers should, in some cases, forgive some mortgage debt for some underwater loans. This could be especially useful if appraisers use those reappraised houses as comparables. That would accelerate price discovery.

[RC]

Hi Queequeq,
I'm also thinking of this as a more permanent feature of the housing market and what effect it would have on economics generally. Normally in a market prices can be flexible because people and businesses make profits and losses and average them out. The problem with the housing market is that prices cannot easily fall and the market freezes up. An insurance company might offer this for quite a low premium because it would normally only be needed when the market falls which is rare. For example the government might mandate insurance premiums on a house of say $500 to cover this situation. This goes into a fund which is then used to bail out underwater loans as they occur. The premiums could be worked out on past history. Insurance normally covers most disasters and this would free up the market more quickly.

[Jon]

Whatever happened to the concepts of "responsibility" and "accountability?"

Why should people who work hard and are saving up money for a down payment and a cushion big enough to weather a personal financial storm before buying a home be made to help pay for the homes of people that they couldn't afford in the first place. If people bought homes that they couldn't afford, if the real estate market turned against them, then they were speculating. If people bought homes without having a financial cushion to weather a personal financial storm like unemployment for a period of time, then they were irresponsible. If people bought homes and then turned around and took out home equity lines of credit on them to pay for vacations, more expensive cars, in-ground pools, etc., then they were irresponsible. If the responsible members of society are required to bail them out then what's the social cost of this? How many responsible taxpayers will decide that it's time for them to get what they can get and let the costs fall where they will as long as they don't fall on them.

Moral Hazard not only has a financial and economic cost, it also has a social cost.

If the government wants to resolve the situation in an equitable and fair manner that sends the right financial and economic signal then they will set up an entity to resolve the mess but such that all parties in the mess end up paying a significant penalty. Lenders that are solvent but illiquid should be injected with liquidity at a penalty rate. Lenders that can be saved should be saved with a significant penalty. Homeowners who can be rescued should be rescued. Homeowners who engage in "jingle mail" should be punished just like the irresponsible lenders. They should be required to pay significant fines and a portion of the shortfall that results from a resale of the property. Like lenders, homeowners should not be allowed to escape responsibility for their actions.

Neither lenders nor "jingle mail" homeowners should be allowed to socialize the costs of their irresponsibility for engaging in what was ultimately little more than a giant real estate Ponzi scheme.

If accountability means that some people will have to drive a VW bug instead of a Lexus then why shouldn't people be held accountable? Let the "jingle mail" homeowner downscale. Let the financial houses and their managements pay for their irresponsibility. Heck, let the CEOs downscale to a VW bug. It's a great car for the budding college student, I'm sure it'll work out great for irresponsible lenders, executives and home buyers too.