[Continued from last week's Part 1.]
By: David A. Smith
When you’ve got enough to take care of yourself, more claim checks don’t do you any good. But they can do a lot of good for all kinds of other people.
As we saw in yesterday’s Part 1, the Economist’s (May 17, 2014) review of a new book by two economists (Mian and Sufi), expounding on a theory that the Great Recession was caused by household over-indebtedness more than by bank collapse, explored the risk profile of debt and concluded, imprudently in my view, that replacing debt with equity would solve homeowners problems.
However, if the capital provider has both downside and upside, the capital provider must reinvent its business model, because the post-borrowing asset management decisions affect the lender (and of course, the borrower will soon come to resent the bank “taking a piece of my profits” in a rising market).
If risk-sharing is added to a pure debt instrument to make it more equity-like, the cost (both up front and over time) will rise, and that is anti-affordability.
Moreover, banks’ difficulties, as measured by the [risk] spread between yields on their short-term debt and that of the government, peaked in late 2008. Yet banks’ lending to business was actually expanding at the time.
Actually, the markets went kaflooey in early 2007: it just took 1½ years to manifest
This implied absence of correlation mixes the Monday-morning wisdom of post hoc analysis with the problem of phase delay: loans take time to originate, and once they are in process, the organization develops a momentum to close them. It takes an ocean liner up to fifteen miles to stop dead, and just because short-term spreads widened wouldn’t automatically cause the ship’s captain to order all back full.
Didn’t allow enough sea room
By the end of the year the spread had returned to normal thanks to the Fed’s vigorous intervention, but bank lending began to contract (see chart).
Again, that could easily be explained by phase delay: the Fed acted fast because it saw the armada of banks slowing down.
Are these things correlated? Couldn’t prove it by me.
Messrs Mian and Sufi think bank lending has an unseemly hold on contemporary thought. They fault the Fed and the Treasury for lavishing money on banks to boost the supply of credit when the problem was demand.
When the crunch hit in 2008, there were too problems: liquidity and cost. If the banks had not been given both ample liquidity and ample capital ratios (via TARP), then they would have had to reprice all their debt rollovers at higher rates. Meanwhile, if the banks had been forced (by FAS 157 or otherwise) to write their assets down based on a higher-interest-rate environment, then there would have been a cascade of defaults, and the global financial system really could have collapsed.
Poor households’ wealth had evaporated, and with it their desire to borrow, which would have been better dealt with by writing down their mortgages.
It wasn’t just poorer households’ desire to borrow, they had to borrow because they were overlevered and had lost all their optionality. They had no capacity to borrow, and they had no cash.
The poorest households generally have the least equity in their homes, and are thus more likely to be wiped out when prices decline.
That’s an oversimplification – price declines make no difference so long as the borrower is able to keep making the payments (and in that, Bernanke’s bargain-basement interest rates played an essential stabilizing role).
No downside if you keep taking the same steps every month
This imposes externalities on those with no debt: foreclosures prompt fire sales that drive down house prices more broadly, while falling net worth induces consumers to cut back, wiping out jobs.
Obviously, if a borrower can’t make the payments (because of a disruption in household income), then the borrowers with little home equity suffer a much greater loss-given-default than if the home had enough equity to be worth its mortgage at the foreclosure sale. All of that traces back to faulty underwriting, not a flaw in the debt instrument itself.
Courts should be able to write down the principal of mortgages as an alternative to foreclosure.
All that talk about ‘moral hazard’
They recommend “shared-responsibility mortgages” whose principal would decline along with local house prices.
Yes, all those loans could theoretically have been written down, but as I posted throughout the crisis, authorizing and even encouraging ‘strategic mortgage default’ would have been a terrible idea: the moral hazard and securitization-contract obligation problems were immense; and the long-term ecosystemic damage would have been brutal.
There are some flaws to this argument. Falling house prices and net worth help explain why employment started sinking in early 2008, but not why it went into free fall after the failure of Lehman Brothers.
Lehman’s gone down!
What causes a cloudburst? More prosaically, what panics the herd? Both are often signaled by a loud noise, and Lehman’s sudden and total collapse was a global signal that a world drunk on risk had had too much. It was time for a global asset revaluation, and that meant global defaults.
After a world drunk on risk, a world of global-regulatory hangovers
By examining only loans from banks to business, they ignore the contraction in consumer credit and in lending by other financial institutions. And had more banks been allowed to fail, the supply of credit would undoubtedly have shrunk further.
Yes, it would have. TARP worked because it was fast and it was balance-sheet equity.
But their broader point about the danger of debt is correct.
“Debt is the anti-insurance,” they assert.
The authors’ point is correct, but their description of it is wrong: debt isn’t anti-insurance, it’s anti-optionality.
When expressed as a series of payments, insurance looks just like savings: The saver (person who buys the policy) makes periodic regular payments, which accumulate value to the saver. Only the payoff rules are different: where the saver is always entitled to the total earnings from his or her investments, the policy holder is entitled to a lower payment at the end (surrender value), but higher conditional payments if something bad happens.
Has she got driver’s insurance?
So if we pair insurance (a series of payments with a conditional positive payout) with high-leverage borrowing (a series of payments with a conditional big negative payment if the loan goes into default), it’s evident that the resulting synthetic product reduces the borrower’s losses given a default, because the insurance payment mitigates the mortgage risks. That’s why so many lenders require insurance of one form or another – life insurance, health insurance, hazard insurance – in the aggregated loan product or package.
Insurance + loan = Lower risk in exchange for higher periodic cost.
“Instead of helping to share the risks associated with home ownership, it concentrates the risks on those least able to bear it.”
That’s simply wrong. Insurance doesn’t concentrate risk, it transfers risk from the policy buyer to the insurance company – or from someone poorly able to bear the risk to an institution with tremendous capacity to bear risk.
“It’s just like the first time I came here, isn’t it?
We were talking about automobile insurance, only you were thinking about murder.”
What is needed, they argue, is to make debt contracts more flexible, and where possible, replace them with equity.
Debt and equity are the endpoints on a continuum of risk and collateral choices. Some debt instruments (e.g. mezzanine, participating, subordinated debentures) have equity-like characteristics. One can slide up and down the risk curve anywhere one wants.
To compensate for the risk of loss, lenders, they reckon, would have to charge a fee equal to 1.4% of the mortgage, or receive 5% of any increase in the value of the property.
Borrowers wouldn’t pay the 140 basis points a year; the markets would compete it out. And calculating a 5% of equity buildup would be insanely complicated to calculate (even assuming the two parties were of good faith and had perfect information), and when we add the principal-agent risk and the risk of fraudulent or incomplete certification by the borrower, the increase in known administrative costs will surely outweigh the value of the decrease in foreclosure risk.
Yes; yes, I have plenty of money in the bank
The authors also endorse a proposal by Mark Kamstra and Robert Shiller to link interest on sovereign bonds to gross domestic product.
It just trills from the tongue
Though Dr. Shiller’s no dummy, I wonder how the markets would price that risk, as well as the potential for (say) gaming the GDP calculations.
Such an arrangement would have made it easier for the governments of Spain, Greece and Ireland to keep servicing their debts when their economies imploded.
Not that the ECB would ever allow no-longer-sovereign nations to play with risk spreads in that way. File this one in the realm of intriguing-but-impossible.
In the Game of Coins, whoever rules the Draghi rules the realm
University education is also ripe for more equity-like financing, since students do not know how much they will eventually earn.
Now that makes sense, because a university education is an asset whose economic value is both hard to determine and entirely dependent on post-loan decisions by the unreliable borrower (a/k/a the student) –
In Australia and Britain, they pay a fixed percentage of their income; the authors recommend instead linking repayment to the health of the job market, an idea first proposed by Milton Friedman.
– but what makes even more sense is forcing universities to bear first-loss risk on their students who fail academically, and first-loss risk on their students who fail economically.
Time to rethink that degree