Monday, September 6, 2010

Plausible Deniability?

Plausible deniability?
(Fox News website, by John R. Lott, Jr., 2008)

The mortgage crisis has produced a massive case of political amnesia. That happens when one is trying to redirect blame for something that could cost up to $700 billion. Some who now claim that the mortgage crisis is the result of too little regulation saw things more clearly when so much wasn’t at stake. The New York Times editorialized on Saturday that “This crisis is the result of a willful and systematic failure by the government to regulate and monitor the activities of bankers, lenders, hedge funds, insurers and other market players.” If you believe the Times or the Obama campaign, everything but government regulation is to blame for the crisis. Yet, it is not just economists who were predicting these problems. For example, a September 30, 1999, article in the New York Times predicted exactly what has happened:

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people . ''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.'' . . . Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's. ''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.'' . . .

Indeed, during the late 1990s, the Clinton administration and Fannie Mae bragged (Los Angeles Times, May 31 1999) about how they had lowered the standards required to borrow money for homes to increase borrowing by groups that otherwise wouldn’t qualify. Their goal of increasing minority ownership was surely a laudable one, but making others pay for the voters’ altruism has real costs. As even the New York Times understood in 1999, as long as housing prices kept on going up there was no problem with this system. If someone couldn’t pay their mortgages, they could sell their property. There was no threat of default. However, a lack of down payments meant that people defaulted on their mortgages. Unfortunately, these insights don’t fit the current political template. With just 43 days to the election, the New York Times and others want to be in sync with the Obama campaign’s attack on the Bush administration not having enough regulation. It particularly doesn’t fit the fact that McCain was criticizing Fannie Mae and Freddie Mac for years along the lines of the New York Times 1999 article. Ironically, in other articles, the New York Times described the Democrats as “important political allies” of these two government-sponsored enterprises. The New York Times is right that “Taxpayers have every right to be alarmed and angry.” But they should read their old news articles to see whom they should get angry at.

Is the proposed bailout bill the answer? $700 billion for the bailout is a lot of money. The costs so far of the Iraq war are probably even a couple hundred billion dollars less than that. But if the $700 billion wasn’t bad enough, it is on top of the giant bailout just announced a couple of weeks ago for Fannie Mae and Freddie Mac. The costs are likely to grow further when Democrats add on their demands to subsidize homeowners. The argument is that something has to be done now. We're in a panic, and mortgages supposedly can’t be sold for what they are really worth. The fear is that with the value of assets so low, financial institutions will try to sell off their mortgage-backed securities, driving down the price of those assets and making financial institutions insolvent that would otherwise be financially viable. What the government proposes to do is buy these assets when they are low, when people are panicking, and resell them later once confidence has been restored. Supposedly, the government could actually make money. There are some real problems with this argument. First, even if most people are behaving irrationally and don’t understand the true long-run value of these mortgages, just like the government is proposing to do, others can make money by buying these assets at fire sale prices and reselling themselves once the crisis is past. In fact, if this panic explanation is true, there is a strong reason to believe that this desire to make money, to see the chance to buy low and sell high, would actually keep the price from falling very much. McCain’s proposal on Friday to provide bridge loans would let the companies themselves decide whether this panic explanation is true.

If the government’s argument is right, one first has to assume that all those smart people in government are a lot smarter than people in the finance industries. Ironically, the government will be hiring private evaluators to determine how much the government should pay for these assets. Given that government regulation -- forcing mortgage companies to make loans that they didn’t want to make -- created this problem, it is not obvious why government officials should be so wise right now. Increased stock prices after the bailout’s announcement isn’t necessarily evidence that the bailout is needed. Stock prices might also be rising simply because the government is promising to pay a lot for some worthless assets. If so, that is nice for stockholders of affected companies, but not so nice for the rest of us. But for the sake of argument, let’s assume that only the government’s offer to purchase these mortgages can prevent panicked sellers from sending prices down. It still isn’t clear that you want to subsidize these companies. As the 1999 Times article noted and McCain has continued to point out, such subsidies create incentives for companies to take unjustified risks in the future. Imagine how your gambling behavior would change if the government promised to cover your losses and let you keep your winnings.

The government may also end up managing or owning these companies. Political considerations, not efficiency, will end up being the goal. A simple demand might be what company managers can be paid. But private shareholders have a lot better incentive deciding the costs and benefits of motivating managers than political constituencies who have little at stake in whether the company makes the right decisions. Some parts of the proposed legislation released over the weekend are also worrisome. For example, at least in the first draft, the proposed power given to the Secretary of the Treasury would be unlimited and unchecked. It emphasizes the possible problems that can arise from drafting legislation too quickly: “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.” Why do people put so much faith in government correctly solving this problem when the debate can’t even honestly discuss what caused it? With all the pressure to get things done quickly, it seems unlikely that things will be properly sorted out. With $700 billion at stake, let’s make sure that we really have a very good reason for spending the money.

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