economics Archives

September 25, 2008

my thoughts on the financial crisis, second edition

A couple of days ago, I wrote a long post in which I tried to explain what had actually happened with the mortgage mess in the financial market. I took it down for a bunch of reasons, but mostly because I realized that, although I know more about how it worked than most of my friends, I didn't know enough.

Fortunately for me, the NPR show This American Life did an hour-long broadcast where they explain it in depth, and they did a pretty good job. Even more fortunately, there is now a transcript available, so you don't have to spend an hour listening. I think it was well done, and it does a very good job of showing the natural market motivations that arose to cause a lot of people to make a lot of bad decisions, without having to postulate any criminal conspiracies.

So, what to do about it? I find it hard to know what to advocate. The Paulson Plan looks at the moment like it is going to go through. I think it could work, if it is managed intelligently, and I think that Paulson has the skills to manage it intelligently, but a) he could make a mistake, and b) he could find his hands tied by the fact that he is working for the US government now, and not for the board of Goldman Sachs, and he must therefore show that he can be persuasive to a set of people that thinks along completely different lines. One major advantage that could come of the Paulson Plan is that, suddenly, the zillions of mortgages that have no clear owner will have a clear owner, and it will be possible to re-negotiate the terms of those mortgages. One downside to that, of course, is that you'd be hard-pressed to find an American who wants to be in debt to the government (and to their primary financial interface to the US taxpayer: the IRS.) And I haven't even begun to touch the ideological arguments over whether the government should be in the business of mortgage administration, or of buying commercial securities on the open (albeit distressed) market.

I find that I am not all that concerned with "punishing the guilty". There was clear fraud, at the very least on the part of the mortgage brokers who put down fictitious salary numbers on behalf of their clients. Those would not be hard to prosecute, if the clients who were sold the mortgages have held onto their documents. That would be far more satisfying to me than arbitrary caps on executive pay, which have no economic basis and, as far as I can tell, have only been proposed in order to make the "have-nots" feel like the "haves" are being punished at least a little.

What I do care about is the systemic problem. (Of course I do; I'm an engineer.) I'd love to get my hands on the design of a proper regulatory system for the US. Over the last twenty or thirty years, the financial markets have become an amazing ground for creative engineering. This has a lot of parallel with the computer technology world, and probably for a lot of the same reasons. The only way to devise appropriate regulation for such financial innovation is to innovate. The Fed needs a well-paid team of financial strategists to go over new products as they come out, and as they go to market; the job of these strategists is to look for things like asset bubbles—sudden inflations in house prices, or sudden explosions in the number of mortgages approved; that is, precisely the sort of thing that people were spotting four or five years ago—and dig around for the causes. You can't regulate effectively until you have seen the consequences, both expected and unexpected, of a new activity.

I still think Hank Paulson is a smart guy, and I still hope that his plan works. I wish I had some more effective way than "a blog with a small readership" to debate these ideas with policymakers though.

October 3, 2008

Why direct mortgage subsidy is a bad idea

In my continuing series (okay, well, two posts make a series I guess) about the economy, I want to address why the populist approach won't work.

A friend pointed me the other day to a Guardian article which was full of the usual ignorant mish-mash of "solutions to help Main Street, not Wall Street" and included this:

At the same time, several steps can be taken to reduce foreclosures. First, housing can be made more affordable for poor and middle-income Americans by converting the mortgage deduction into a cashable tax credit.

The Guardian article is the only place I've seen this idea explicitly, seriously suggested, but I have seen a similar sentiment ("The government should be helping out Main Street, not Wall Street!" "The real victims here are those who took out subprime mortgages? What's in it for them? Why aren't we helping them out directly?") in very many places. But actually, the idea of "giving money directly to Main Street, and letting Wall Street hang" is precisely counterproductive to this goal.

So, let's think about this for a minute. Pretend that, suddenly, the US passes legislation to allow mortgage interest to be a tax credit. What this means is that you can tell the US government that you spent $X on mortgage interest in 2008, and they will subtract $X from your tax bill. If this makes your tax bill negative, the government will send you a check for $X - (your tax bill). It is basically saying, "the US government will pay your mortgage interest."

This sounds great, doesn't it? If you're a US citizen with a mortgage, anyway. But let's think about it for a minute. The interest on a loan is the money that the bank who owns the loan is making, as recompense for your having taken their money to buy something for yourself. Generally, when you have first bought a house, the mortgage interest comprises the majority of your payment. (Play with a mortgage amortization calculator if you don't know what I mean.) So the Guardian writer is proposing, basically, that the government should pay the bit of people's mortgages that makes up the vast majority of the monthly payment right now. It also means that the government should pay, over the life of the loan, the part that is the payment to the lender for having made the loan. And so:

  1. This will make it a lot easier for people to pay the mortgage, at least in the first few years.
  2. This means that most of the mortgages that have been sliced & diced into CDOs will be good.
  3. This means that the banks who bought CDOs will receive the profit, that is the mortgage interest, courtesy of the US government.
  4. This means that the "toxic debt" won't be toxic anymore.
  5. This means that the CDOs will have precisely the inflated value that the banks assumed all along that they would have.
  6. This means that the US government will directly be paying interest money to the banks who hold the debt, that is, the investment banks who bought the CDOs.
  7. This means that the "bad, stupid" CDOs that the investment banks bought won't be so stupid after all—they'll be guaranteed by the full faith and credit of the United States government! There will be a party on Wall Street again after all!

It's a great way to get the money straight to Wall Street, with some incidental benefit to Main Street. But wait, I thought we were supposed to be bailing out Main Street and not Wall Street? Oops.

The best feature about the Paulson plan is that it pays a fair price (including the pessimism about Main Street being able to pay their mortgages) for these CDOs, and since it's a fair price, they will be able to sell these CDOs for at least the price paid, in future. The taxpayer will not, in the end, lose money if this plan is executed properly. (Yes I know, that's a big "if", but at least it's not a dead certainty that we'll lose money.) The plan has the side benefit, which Congress seems to have noticed, that the US government would hold a lot of slices of a lot of mortgages, and it would suddenly become possible (as it isn't at the moment) to put these mortgages back together and re-negotiate the terms with homeowners on the edge, and try to keep them in their houses. But the main benefit is that Paulson has come up with a way to put a bunch of taxpayer money on the line to keep the economy functioning, and get the money back in the end, so that the taxpayer won't be out of pocket in the end. This is the part that I love. How many government employees do we have who can still think of ways to retain the taxpayer's money in such an impressive way?

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