Where is this money coming from? Why are we nationalizing banks again?

9 Comments

1. Dimsdale on February 18, 2009 at 11:53 am

   “And how again is nationalizing the banks going to help?”

   It won’t.? Banks made these ludicrous mortgage “deals” with the understanding that the government would absorb the risk.? Apparently, they were correct.? Nationalizing the banks will simply exacerbate the problem, putting whatever is left of the “full faith and credit” of the U.S. behind people that should not have had mortgages to begin with, and will continue to get mortgages from the now nationalized, politically “correct” banks, which will be under the control of the same schmucks that ran Fannie and Freddie into the ground.

   The bus is running off the cliff, we know where it is going, and we can’t get off.?? Nice.

   
   
   
2. gillie28 on February 19, 2009 at 1:04 am

   Part 1 – Rationale for the nationalizaion of Swedish Banks

   The following is the rationale for the nationalization of Swedish banks from the Swedish Federal Bank Chairman, Backstrom, who was minister of finance during their bank crisis.  It is from an interview with the Federal Reserve Symposium in Kansas City, last year, and shares his insight into the problems and solutions Sweden had with its banks in the 1990's.  It's a little long, but worth the read:

   First a word of thanks to the Federal Reserve Bank of Kansas City for the invitation to discuss the financial problems Sweden went through in the early 1990s. I shall also try to draw some conclusions from our experiences that may be relevant for other countries.

   Before I came to Sveriges Riksbank I was state secretary at the Ministry of Finance and involved among other things in the management of Sweden’s financial crisis. While there had, of course, been a good many indications of mounting problems, I was personally made formally aware of the acute and severe financial crisis by a phone call. At the beginning of October 1991 I had been in the job just a few days when I got a call from the head of the Financial Supervisory Authority (banking supervision in Sweden is performed by this authority, not by the central bank). He wanted to inform the Government that a large Swedish bank had more than exhausted its equity capital and would have to go bankrupt if a reconstruction could not be arranged.

   While working at the Ministry of Finance on the initial problems in the banking sector we started to study historical and international records of financial crises. Irving Fisher’s well-known paper in Econometrica, “The Debt-Deflation Theory of Great Depressions,” from 1933 provided inspiration. We also came across a new volume, The Risk of Economic Crisis, edited by Martin Feldstein and containing interesting contributions by, among others, Benjamin Friedman, Paul Krugman, Lawrence Summers and our chairman today, E. Gerald Corrigan.

   The conclusion from these sources was that a fall in asset prices, such as we had in Sweden, may create problems for private sector balance sheets, affect the supply of credit and result in payment system disturbances. Step by step this may affect spending decisions by households and firms, thereby impinging on general economic activity. A destabilised financial system can bring the economy into what Fisher termed “debt deflation”, that is, a situation where the financial crisis may become very serious and protracted.

   Thus it was important both to avoid a widespread failure of Swedish banks and to bring about a macroeconomic stabilisation. The two are interdependent. The collapse of much of the banking system would aggravate the macroeconomic weaknesses, just as failure to stabilise the economy would accentuate the banking crisis.

   
   
   
   • gillie28 on February 19, 2009 at 1:05 am

     Part 2

     The Swedish crisis – what happened?

     The economic problems in Sweden in the early 1990s should be seen in their historical context. For several reasons, economic growth in Sweden has been relatively weak ever since about 1970. Following the collapse of the Bretton Woods system the creation of a stable macroeconomic environment turned out to be difficult. Wage formation functioned badly, fiscal policy was unduly weak and this was gradually compounded by structural problems.

     Credit market deregulation in 1985, necessary in itself, meant that the monetary conditions became more expansionary. This coincided, moreover, with rising activity, relatively high inflation expectations, a tax system that favoured borrowing, and remaining exchange controls that restrained investment in foreign assets. In the absence of a more restrictive economic policy to parry all this, the freer credit market led to a rapidly growing stock of debt (Fig.). In the course of only five years the GDP ratio for private sector debt moved up from 85 to 135 per cent. The credit boom coincided with rising share and real estate prices. During the second half of the 1980s real aggregate asset prices increased by a total of over 125 per cent. A speculative bubble had been generated.

     The expansion of credit was also associated with increased real economic demand. Private financial saving dropped by as much as 7 percentage points of GDP and turned negative. The economy became overheated and inflation accelerated. Sizeable current-account deficits, accompanied by large outflows of direct-investment and other long-term capital (once exchange control had been finally abandoned in the late 1980s), led to a growing stock of private sector short-term debt in foreign currency.

     Step by step the Swedish economy became increasingly vulnerable to shocks. During 1990 matters came to a head. Competitiveness had been eroded by the relatively high inflation in the late 1980s, resulting in an overvalued currency. This caused exports to weaken and meant that the fixed exchange rate policy began to be questioned, leading to periods with relatively high nominal interest rates. Moreover, the tax system was reformed in order to reduce its harmful economic effects but this also contributed to higher post-tax interest rates. Asset prices began to fall and economic activity turned downwards. Between the summers of 1990 and 1993 GDP dropped by a total of 6 per cent. Aggregate unemployment shot up from 3 to 12 per cent of the labour force and the public sector deficit worsened to as much as 12 per cent of GDP. A tidal wave of bankruptcies was a heavy blow to the banking sector, which in this period had to make provisions for loan losses totalling the equivalent of 12 per cent of annual GDP.

     
     
     
3. gillie28 on February 19, 2009 at 1:11 am

   Looking back, one can see that in the course of the crisis the seven largest banks, with 90 per cent of the market, all suffered heavy losses. In these years their aggregate loan losses amounted to the equivalent of 12 per cent of Sweden’s annual GDP. The stock of non-performing loans was much larger than the banking sector’s total equity capital and five of the seven largest banks were obliged to obtain capital contributions from either the State or their owners. It was thus truly a matter of a systemic crisis.

   In connection with a serious financial crisis it is important first and foremost to maintain the banking system’s liquidity. It is a matter of preventing large segments of the banking system from failing on account of acute financing problems.

   In September 1992 the Government and the Opposition jointly announced a general guarantee for the whole of the banking system. The Riksdag, Sweden’s parliament, formally approved the guarantee that December. This broad political consensus was I believe of vital importance and made the prompt handling of the financial crisis possible.

   The bank guarantee provided protection from losses for all creditors except shareholders. The Government’s mandate from Parliament was not restricted to a specific sum and its hands were also very free in other respects. This necessitated close cooperation with the political opposition in the actual management of the banking problems. The decision was of course troublesome and far-reaching. Besides involving difficult considerations to do, for example, with the cost to the public sector, it raised such questions as the risk of moral hazard.

   The political system concluded that in the event of widespread failures in the banking system, the national economy would suffer major repercussions. The direct outlays in connection with the capital injection into the banking sector added up to just over 4 per cent of GDP. However, it is now calculated that most of this can be recovered.

   One way of limiting moral hazard problems was to engage in tough negotiations with the banks that needed support and to enforce the principle that losses were to be covered in the first place with the capital provided by shareholders.

   A separate authority was set up to administer the bank guarantee and manage the banks that landed in a crisis and faced problems with solvency, though the crucial decisions about the provision of support were ultimately a matter for the Government. A clear separation of roles was achieved between the political level and the authorities, as well as between different authorities. Naturally this did not preclude very close cooperation between the Ministry of Finance, the Bank Support Authority, the Financial Supervisory Authority and the Riksbank.

   It was up to the Riksbank to supply liquidity on a relatively large scale at normal interest and repayment terms but not to solve problems of bank solvency. Collateral was not required for the loans to banks, neither intraday nor overnight. The banking system was free to obtain unlimited liquidity by drawing on its accounts with the central bank. The bank guarantee meant that the solvency of the Riksbank was not at risk. In order to offset the loss of foreign credit lines to Swedish banks, during the height of the crisis the Riksbank also lent large amounts in foreign currency.

   Banks applying for support had their assets valued by the Bank Support Authority, using uniform criteria. The banks were then divided into categories, depending on whether they were judged to have only temporary problems as opposed to no prospect of becoming viable. Knowledge of the appropriate procedures was built up by degrees, not least with the assistance of people with experience of banking problems in other countries.

   The Swedish Bank Support Authority had to choose between two alternative strategies. The first method involves deferring the reporting of losses for as long as is legally possible and using the bank’s current income for a gradual writedown of the loss making assets. One advantage of this method is that it helps to avoid the bank being forced to massive sales of assets at prices below long run market values. A serious disadvantage is that the method presupposes that the bank problems can be resolved relatively quickly; otherwise the difficulties compound, leading to much greater problems when they ultimately materialise. The handling of problems among savings and loan institution in the United States in the 1980s is a case in point. With the other method, an open account of all expected losses and writedowns is presented at an early stage. This clarifies the extent of the problems and the support that is required. Provided the authorities and the banks make it credible that no additional problems have been concealed, this procedure also promotes confidence. It entails a risk of creating an exaggerated perception of the magnitude of the problems, for instance if real estate that has been taken over at unduly cautiously estimated values in a market that is temporarily depressed. This can lead, for instance, to borrowers in temporary difficulties being forced to accept harsher terms, which in turn can result in payments being suspended.

   The Swedish authorities opted for the second method: disclose expected loan losses and assign realistic values to real estate and other assets. This method was consistent with other basic principles for the bank support, such as the need to restore confidence. Looking back, it can be said that in general the level of valuation was realistic.

   
   
   
   • gillie28 on February 19, 2009 at 1:15 am

     http://www.riksbank.se/templates/speech.aspx?id=1…

     This the reference to the above article.  Sorry, I was mistaken about the date…it was written in 1997:

     
     
     
   • gillie28 on February 19, 2009 at 1:17 am

     Conclusion of article:

     Conclusions

     The problems in the Swedish banking system at the beginning of this decade seem to have been more extensive than those which arose in Sweden in the early 1920s. The two periods also differ substantially in the management of the crisis. This may have had a bearing on the very different course of events in these two crises. In the early 1920s the fall in GDP totalled 18 per cent and the price level dropped 30 per cent in the course of two years. In the 1990s the loss of GDP stopped at around 6 per cent and the price trend did not become really deflationary.

     Allow me now to summarise what I consider to be the most important lessons from Sweden's financial crisis:

     1. Prevent the conditions for a financial crisis

     The primary conclusion from our experience of Sweden's financial crisis is that various steps should be taken to ensure that the conditions for a financial crisis do not arise.

     – Fundamentally it is a matter of conducting a credible economic policy focused on price stability. This provides the prerequisites for a monetary policy reaction to excessive increases in asset prices and credit stocks that would be liable to boost inflation and create the type of speculative climate that paves the way to a financial crisis.

     – Looking back, it can be said that if various indicators that commonly form the background to a financial crisis had been followed systematically, then incipient problems could have been detected early on. That in turn could have influenced the conduct of fiscal and monetary policy so that Sweden's financial crisis was contained or even prevented. In spite of the evident signs, few if any in the public discussion warned of what might happen. Martin Feldstein offers an interesting explanation in his introduction to The Risk of Economic Crisis from 1991. At that time the industrialised world had not experienced an outright financial crisis since the 1930s. As a result, economists had devoted relatively little work to the analysis of this subject, being more concerned to understand the more normal economic world. This symposium is a positive sign that matters have changed in that respect. The conclusion drawn by the Riksbank is that various indicators must be followed systematically with the aim of detecting any signs of potential financial problems and systemic risks.

     – In Sweden's case the supervisory authority was not prepared for the new environment that emerged after credit market deregulation. This meant that during the 1980s the banks were able to grant loans on doubtful and sometimes even directly unsound grounds without any supervisory intervention. In addition, in many cases the loans were poorly documented. The lesson from this is that much must be required of a supervisor operating in an environment characterised by deregulated markets.

     2. If a financial crisis does occur

     In a sense all major financial crises are unique and therefore difficult to prepare for and avoid. Once a crisis is about to develop there are some important lessons concerning its handling that can be learnt.

     – If an economy is hit by a financial crisis, the first important step is to maintain liquidity in the banking system and prevent the banking system from collapsing. For the management of Sweden's banking crisis the political consensus was of major importance for the payment system's credibility among the Swedish public as well as among the banking system's creditors throughout the world. The transparent approach to the banking problems and the various projects for spreading information no doubt had a positive effect, too.

     – The prompt and transparent handling of the banking sector problems in also important. The terms for recapitalisation should be such as to avoid moral hazard problems.

     – Automatic stabilisers in the government budget and stimulatory monetary conditions can help to mitigate the economy's depressive tendencies but they also entail risks. Economic policy has to strike a fine balance so that inflation expectations do not rise, the exchange rate weakens and interest rates move up, which could do more harm than good. In this respect a small, open economy has less freedom of action than a larger economy.

     – It is important both to avoid a widespread failure of banks and to bring about a macroeconomic stabilisation. The two are interdependent. The collapse of much of the banking system would aggravate the macroeconomic weaknesses, just as failure to stabilise the economy would accentuate the banking crisis.

     References

     Feldstein, M., (ed.), (1991), The Risk of Economic Crisis, NBER Conference Report, University of Chicago Press, Chicago and London.

     Fisher, I., (1933), The Debt-Deflation Theory of Great Depressions, Econometrica, vol. 1 (October), pp. 337-357.

     Ingves, S. and Lind, G., (1996), The management of the bank crisis – in retrospect, Quarterly Review, No. I, pp. 5-18, Sveriges Riksbank.

      

     DOKUMENTATION

      

     The Swedish Experience |  139 Kb

     
     
     
   • gillie28 on February 19, 2009 at 2:05 am

     Points against nationalizing banks:

     Is the Sweden plan so much better?

     Paul Krugman, Brad DeLong, and Matt Yglesias are all endorsing the Swedish plan for partial bank nationalization.  Maybe it's better than what we'll get (I haven't read through the latest draft), but I don't think they are addressing the weaknesses of the idea.  Namely:

     1. Solvent banks don't need to be nationalized.  Insolvent banks should be shut down.  Maybe they're mostly insolvent, but that is second-guessing market prices just as much as Paulson's view that bank assets can be bought on the cheap.  The implicit view is that current equity markets are overvaluing these banks.  (It is complicated, however, because current equity prices are not independent of the government plan and there can also be hovering in the neighborhood of insolvency.)  An alternative proposal, of course, is to reveal which banks are solvent and which are not.

     2. There is much talk about taxpayers participating in the upside.  First, bank ownership is probably not an efficient way of redistributing wealth (is it what you want for Christmas?).  Second, Greg Mankiw's friend scored a telling point:

     …we would all be better off if high schools taught the Modigliani-Miller theorem. MM implies that the price of the asset (again,assuming the auction gets it right) will adjust to offset the value of any warrants Treasury receives. In this case of a reverse auction, imagine that the price is set at $10. If Treasury instead demands a warrant for future gains of some sort, then the price will rise in the expected amount of the warrant — say that's $2. Then the price Treasury pays for the asset will be $12. Some people might prefer to get $12 in cash and give up a warrant worth $2 in expected value. Fine, that's a choice to be made. But the assertion that somehow warrants are needed is simply wrong.

     I haven't seen a good response.

     3. Swedish governance is in many ways of higher quality than American governance.  It involves lower transactions costs, more social unity, and it is more inclusive of many different interest groups.  For one thing, the concentration of wealth in Stockholm makes it harder to use policy to redistribute wealth across regions.  Instead they redistribute wealth across genders and age groups but those forms of redistribution don't distort the banking system so much.  The Swedish banking system is also "small as a whole" compared to surrounding markets; you can't say that about the USA.  Note also that Swedish banks, circa the early 1990s, were simpler creatures than today's American banking firms.

     4. The U.S. doesn't have any tradition of successful nationalization.  We've had plenty of interventions, but for whatever reasons nationalization has not been the preferred model.  I don't think it is just ideology.  The diffuse and highly federalistic American political system is lacking in accountability and thus it is poorly suited for such policy actions.

     5. Nationalization makes it harder to raise private capital next time there is a crisis.  It is a high time preference solution.

     6. Presumably the government wants to show it is doing a good managerial job, but in fact the sector needs to shrink.  And would a government-owned bank cut off the flow of credit to, say, Chrysler ?http://www.marginalrevolution.com/marginalrevolution/2008/09/is-the-sweden-p.html

     
     
     
4. gillie28 on February 19, 2009 at 1:36 am

   Part 1

   This is from a Financial Times blog by Willem Buiter

   Professor of European Political Economy, London School of Economics

   Home loans in the US: the biggest racket since Al Capone?

   February 18, 2009 11:45pm

   The Obama administration today unveiled the Homeowner Affordability and Stability Plan – measures to help financially challenged homeowners to avoid foreclosures.  The program has three key components.  The first is $75 bn of Federal government money to subsidise the modification of home loans (I believe $50bn of this was already in Treasury Secretary Geithner’s earlier announcements on the Financial Stability Plan).  The Federal government is also making an additional $200 bn of capital available to Fannie Mae and Freddie Mac, so they can expand their mortgage lending and guarantee activities.  The second is to “Institute Clear and Consistent Guidelines for Loan Modifications”: a standardized framework for dealing with troubled mortgages.  The third is an overhaul of bankruptcy laws to allow judges to force the writedown of principal on mortgages for bankrupt homeowners or to force lenders to reduce mortgage rates.

   Are there too many foreclosures?  What determines the socially optimal number of foreclosures?  Foreclosure is the taking by the creditor of the collateral offered for a loan, following a default on the loan by the borrower, and the sale of that collateral by the creditor so he can recover what is due to him.  We have foreclosures because there is collateral and because there is uncertainty about the future financial circumstances of the borrower.  We cannot eliminate all uncertainty about the future financial circumstances of the borrower.  Still, there are several ways to eliminate foreclosures altogether.

   The first would be to forbid offering residential real estate as collateral (or at any rate to forbid the offer of an owner-occupied home as collateral for a loan).  Home loans (in the sense of loans to purchase a home with) could be unsecured, or secured against other assets.  Alternatively, households would have to save up the full purchase price of the property.  Finally, you could stipulate that a mortgage could only be given with 100 percent mortgage protection insurance attached – covering all contingencies (death, disability, ill-health) that might impair the ability of the mortgage borrower to service the mortgage.

   This eliminates foreclosures but would also seriously reduce home ownership.  So let’s try something else.

   What are the costs of foreclosure? Who bears them?  Are the private costs smaller than the social costs?

   Transaction costs

   Foreclosure is step in a well-understood contractual arrangement – a change of title happens: the house that was mine is now under the control of the mortgage lender who can sell the property to recover the sum owed to him.  As it happens, foreclosure eats up a lot of real resources: time, lawyers’ fees, bailiffs, other legal fees, surveyors’ fees, etc.  This is a real resource cost, not the redistribution of property rights.  It has been estimated at between $50,000 and $80,000 per foreclosure.

   The transaction costs associated with foreclosure are outrageous.  It clearly makes mortgage lending a less profitable attractive activity to engage in and reduces the size of the mortgage market.  It makes sense, from a social efficiency point of view, to make foreclosure cheaper and easier.  This could be achieved most easily be strengthening the rights of the creditor (the mortgage lender) vis-à-vis those of the debtor (the mortgage borrower).  The proposals that I have seen, however, all want to make foreclosure more difficult, by entrenching the owner-occupier more securely in the family home.

   Neighborhood blight

   Another cost often attributed to foreclosure is ‘neighbourhood blight’, that is, negative externalities associated with foreclosures and the associated repossessions and evictions. The value of neighbours’ properties goes down and pretty soon the weeds are growing through the cracks in the pavement, homes are boarded up and the entire neighbourhood risk going down the snytgard.  This argument makes no sense and appears to be an example of confusing association (or correlation) with causation.  What is likely to have a stronger negative effect on the value of neighbouring properties: an owner-occupier who can no longer afford the mortgage he has taken on, or the forced sale of his property to someone who can afford it?  The answer seems pretty clear.

   Declining, blighted neighbourhoods are likely to be found in regions that are in economic decline, like parts of the American Mid-West.  In such regions, there are likely to be more existing homeowners who lose their job or become worse off for other reasons and who as a result cannot keep up with their mortgage payments and face foreclosure, than there are would-be home owners ready to take on a mortgage and buy a home.  So rising foreclosures are likely to be followed by periods during which more properties stand empty, inviting vandalism or use as a crack den.  The neighbours try to move away from such toxic properties and the blight spreads.  The fundamental driver of all this is, however, the economic decline of the region.  Foreclosures do not cause neighbouring property values to fall.  Both foreclosures and declining property values are driven by broader economic conditions.

   Wailing waifs

   One reason foreclosures are so politically sensitive is that they are associated with the dispossession of owner-occupiers and the eviction of families.  Distraught parents standing on the stoop of what used to be the family home, clutching a few meagre belongings.  Crying children.   There is even a sub-conscious association of foreclosures with homelessness.

   Foreclosures don’t just involve owner-occupiers, however.  Buy-to-let owners have mortgages also.  But let’s leave that aside.  The reason that foreclosures involving owner-occupiers are an issue has to be either that (even after allowing for the transaction costs of foreclosure), the value of the home that is lost to the owner-occupier is greater than the value of the home to the bank and/or that there are serious distributional or poverty issues associated with foreclosure.

   There may be something to the first of these points.  To most people, a home is more than a hotel room.  It becomes part of what you are – it gets under your skin.  I am quite willing to believe that.  I don’t, however, believe that this emotional attachment to the place you live in is identified with owner-occupancy.  Until I was 21 years old, my parents always lived in rented accommodation.  We spent 14 years in the same rented place in Brussels.  It was very important to me – it was our ‘home’ – and even now I often remember it.  I also remember quite well the (rented) house we lived in for two years in Luxembourg.  I was eight when we left; I cried my eyes out, in part because I really loved that house.  Are we going to give tenants special rights and financial assistance because the place they rent is worth more to them than it is to their landlord?

   If foreclosure leads to poverty, that poverty may be of concern to and a responsibility of the state, but only because it is poverty, not because it is poverty due to a specific event or cause – foreclosure.  I believe a civilised, compassionate society tries to eliminate poverty.  It does not have a special policy for eliminating poverty suffered by former owner-occupiers who have lost their homes because of foreclosure.

   Homelessness is a curse.  But it is a curse regardless of whether homelessness is suffered as a result of an owner-occupier and her family experiencing foreclosure and eviction, as a result of a tenant being evicted by his landlord, as a result of divorce or mental illness, or as a result of a natural disaster or a war.  In addition, only a small fraction of foreclosures leads to homelessness.  Most victims of foreclosures manage to find cheaper accommodation.

   Is home ownership is ‘a good thing’?

   Why do politicians of all political colours and parties get their knickers so twisted about people losing their homes?  In the case of the Tories in the UK and the Republicans in the US, the answer is obvious.  Both parties believe that home owners are conservative.  Not it the sense that people who are inherently conservative are more likely to become homeowners (although they may believe that as well).  This is not a selection story but an osmosis story.  Home ownership makes people more conservative.  So both Tories and Republicans do everything they can to encourage home ownership.

   But so do (New) Labour in the UK and the Democrats in the US, so it’s no longer a left-right thing.

   
   
   
5. gillie28 on February 19, 2009 at 1:38 am

   part 2

   The one argument for encouraging home ownership that makes sense is that owner-occupiers look better after their property and its immediate surroundings than would a tenant.  This is a simple principal-agent story where it is costly for the principal (the owner) to monitor the care and attention the agent (the tenant) bestows on his property.  Add some neighbourhood externalities (I don’t want to live next door to a place where they don’t mow the lawn or paint the exterior of the house), and you have an argument for encouraging owner-occupancy, say by subsidising it.

   Subsidise owner-occupancy if you must, not borrowing secured against residential real estate

   But a subsidy for owner-occupancy is something completely different from subsidising borrowing using residential real estate as collateral.  If they exist, the benefits from owner-occupancy are there regardless of whether the owner-occupier has a mortgage or not.  It doesn’t matter whether she borrowed to buy the house, paid in cash, stole it, inherited it from her parents, or built it with sweat equity on land won in a raffle.

   The US does not encourage owner-occupancy directly, say by paying each head of household who is an owner-occupier, a given amount of cash each year.  Instead it encourages and subsidises a particular form of borrowing, regardless of what that borrowing is spent on.  Funds, after all, are fungible.  I can withdraw equity from my house by taking out a first or second mortgage against it, or by increasing the size of an existing mortgage, and spend the proceeds on Cuban cigars.

   All this is rather insane.  Through the deductibility of mortgage interest from taxable income, the US tax payer gives vast subsidies to borrowing secured against a particular type of collateral – residential real estate.  What so special about this borrowing and this collateral?  Fortunately, the UK has abolished this boondoggle.  In the US, other forms of preferential treatment for home ownership are piled on top of the mortgage interest-deductibility.

   Over half the stock of home loans, and virtually all new home lending in the US are heavily subsidized by the lending and guarantees of Fannie Mae, Freddie Mac, Ginnie Mae and assorted aller smaller government agencies.  The direct interventions of the Fed and the Treasury in the market for residential mortgage-backed securities, announced as part of the credit-easing policies of the FEd represent further quasi-fiscal subsidies to housing finance.  This is on top of the creation by the Fed of at least a dozen facilities that accept RMBS as collateral for Fed loans in the earlier stages of the financial crisis. All these quasi-fiscal interventions by the GSEs and the Fed are deeply non-transparent as regards the magnitude of the subsidies involved.  They also evade the normal scrutiny and accountability to Congress that is associated with explicit subsidies by the Treasury.

   The only priviliged treatment of residential housing that makes a modicum of sense from the perspective of encouraging owner-occupancy (as opposed to borrowing to fund whatever expenditures using residential housing as collateral), is the ability to postpone capital gains taxation on the sale of one’s principal residence, and to have one capital-gains-tax-free realisation during one’s lifetime (taken generally when people size down on retirement or when the kids have flown from the nest).

   The bloated US housing stock

   The extreme fiscal largesse bestowed on residential housing, directly and indirectly through mortgage interest deductibility, has led to a massive misallocation of investment in the US.  There has been overinvestment in the private residential housing stock and underinvestment in just about every other form of fixed capital: infrastructure, public amenities of all kinds (sports facilities, public recreational facilities, parks etc.), commercial structures, plant and equipment.  It is time to correct the distorted incentives that are at the root of this misallocation.  The easiest way to do this, in the current tax system, is to end the deductibility of mortgage interest in the personal income tax, close down Fannie and Freddie and end the role of the US government in the provision of residential mortgages.  A focused social housing program is of course a legitimate activity of the Federal government.  It should be on-budget, that is, fiscal rather than quasi-fiscal.

   The $275 bn hand-out

   The Obama administration is going to ease the burden on existing financially challenged mortgage borrowers.  As much as $75 bn will be used to compensate the lenders – the banks or to bribe them into accepting easier financing terms for financially stressed borrowers.  That’s nice.  It will, of course, encourage moral hazard.  People who have mortgages that have become too large for them to service and who have not bothered to purchase the right kind of mortgage protection insurance are getting ex-post free mortgage protection insurance from the tax payer.  It will encourage future reckless borrowing by would-be home-owners with residential ambitions larger than their wallets.  It is tax on the prudent to subsidize the imprudent.  It is both inefficient and unfair.  Fannie and Freddie will expand their lending and guarantees thanks to the addition capital provided by the Treasury.

   A simpler, standardised framework for dealing with troubled mortgages would be welcome, as it could reduce the cost of foreclosures and also the cost of voluntary renegotiations of the terms of the mortgage contract between borrowers and lenders.

   It is especially important that an end be put to those complex securitisations of residential mortgages that make it effectively impossible to renegotiate individual mortgages that are bundled with thousands of other mortgages and God knows what else down seven layers deep in some CDO.  I would favour simplifying the procedures for foreclosure to reduce their cost.  Increasing creditor rights, limiting the grounds for appeals by the borrower and other measures speeding up the foreclosure process would make mortgage lending a more profitable and attractive activity, and would also make lenders willing to consider application by more risky borrowers.

   Modifying bankruptcy laws to allow judges to force the writedown of mortgages looks like a prime example of populist pandering and insider or incumbent protection.  It will hurt future mortgage borrowers. Those who already have their home loans will like it.  Those who won’t be able to get a home loan in the future because of these measures will probably blame the banks rather than the politicians that brought in these inane laws.

   Especially when judges are elected, as they often are in the US, I hate to think of the political shenanigans that will be the inevitable outcome of greater judicial discretion in forcing lenders to accept writedowns of their loans.  Judges in the kinds of courts that deal with distressed mortgage lending are unlikely to have invested in a Ph.D. in Law and Economics.  They are likely to be lawyers – full stop – and not very good lawyers at that (is ‘not very good lawyers’ an oxymoron?).  They know nothing about markets and incentives, valuation and credit risk.  They will make future mortgage lending much riskier and much more costly for the lender.  Only the best risks will be able to get loans.

   The quasi-socialised, opaque system of residential mortgage financing in the US is wasteful and distortionary to a degree that is truly staggering. How can this grotesquely distortionary and deeply unfair system be killed off when so many undeserving over-indebted homeowners who also happen to be marginal voters, so many politically well-connected interest groups and so many influential politicians all have their snouts in the trough? It is clear that the Obama administration far from using the opportunity sent by the crisis to cut the mortgage monster down to size, is instead feeding it and beefing it up further.

   The fiscal and quasi-fiscal costs of this massive subsidization of residential mortgages will become apparent during the years to come, as mortgage related government expenditures rise and revenues fail to materialise. But that will be then – sometime in the future. This is now. And now always wins. Myopia, opportunistic behaviour and insider protection: welcome to US home financing policy.

   But that will be then – sometime in the future.  This is now.  And now always wins.  Myopia, opportunistic behaviour and insider protection: welcome to US home financing policy.