One of the things about the Financial Crisis is that it was not really a macro economic problem, but a conglomeration of micro economic problems. These micro economic problems are all incentive problems. These incentives problems were spread throughout the financial system.
One incentive problem was the reduction in mortgage down payments to make housing more “affordable”. Consider the following example to highlight the problem. A family, the Smiths, want to buy a house for $100,000. Normally the Smith’s would have to have a down payment of $20,000. But with a reduction in the required down payment to help make housing more affordable, the Smith’s only have to come up with 5% or $5,000. But this lower down payment increases the likelihood that the Smith’s will default on their loan. Suppose after buying the house with the 5% down payment, but housing prices drop and the house is now worth $90,000. Yet the Smith’s are paying on a loan of $95,000. Unless there is an expectation that housing prices will start going up again the Smith’s now have an incentive to walk away from house. And this leads to another incentive problem.
Most mortgages are non-recourse loans. A non-recourse loan is one where if the borrower defaults the only option the bank has it to take possession of the house. They cannot take the Smith’s car, garnish their wages or seize any other assets. The Smith’s credit score can take a hit, bit aside from that the lender has no other recourse hence the term non-recourse. So, there is an incentive to bail on a house that is underwater than to try and stick it out to avoid even worse financial outcomes.
Of course, if housing prices are going up, none of this is not much of an issue. If the Smith’s buy their house and then a year later it is worth $110,000 they now have $15,000 in equity and they are less likely to default. The more the house appreciates the less likely they are to default.
This is the kind of incentive that made Mortgage Backed Securities (MBS) less desirable when the housing market stopped going up and prices reversed course. Suddenly all those people who were securitizing mortgages were looking at having to buy back mortgages that may have looked good initially…given that housing prices would continue to go up. Then factor in the effects of credit default swaps and now you are looking at a problem of systemic risk–i.e. risk that the entire system might come crashing down.
Another incentive problem was the “too big to fail” or more accurately the “too interconnected to fail”. Imagine we have 3 banks. The Bank of the U.S., The Bank of New York, and the U.S. Bank. The U.S. Bank has been rather imprudent. They have been underwriting and securitizing mortgages that are not very good, but so long as housing prices go up, they look good. Then housing prices stop going up and the U.S. Bank is holding many of the loans it underwrote. But as these mortgages start to fail and the U.S. Bank is seeing it’s capital requirement start to head below the regulated levels, so they have a couple of options, try to sell assets, these dubious MBS, or go and beg for a bail out from Uncle Sugar. Uncle Sugar brings in the executives of U.S. Bank and here is their story.
“Uncle Sugar, you have to come up with a rescue plan. You see, if you don’t we’ll be forced to sell these MBS at fire sale prices, and while that is really bad for us, think about the Bank of the U.S. and the Bank of New York! They hold quite a few MBS, some we originated, and some they originated. But if we fire sale, well the value of their MBS will decrease and they could be in trouble with regards to their capital requirements, necessitating another fire sale!! The whole system could collapses!!!”
It is a compelling story because it is a scary story. Yes, as the imprudent Bank of the U.S. dumps MBS on the market the prices for all MBS could decline. Leading to liquidity problems for the Bank of the U.S. and the Bank of New York. But if the Uncle Sugar, aka the government, bails out the U.S. Bank they are sending a very clear signal–imprudence will not be punished…so be imprudent and rake in the big salaries and bonuses when times are good and we got your back when they are bad.
Capitalism is a profit and LOSS system. If you get rid of the losses via government protecting people from imprudence you simply get more imprudent behavior. Over 140 years ago Walter Bagehot noted this in his book Lombard Street. He noted that when a bank is sound, but illiquid the central bank should lend to such a bank at a suitably high enough interest rate. However, when a bank is not illiquid, but insolvent…you let that bank fail. The failure of that bank will send a clear and unambiguous signal: imprudence will kill your business. During the 2008 Financial Crisis the U.S. and Fed pretty much guaranteed everything. Not just deposits, but everything. Such an approach does not stabilize the financial system in the long run…it makes the financial system less stable as people realize that being imprudent is actually good for the bottom line because you are backed by the full faith and credit of the American taxpayer. Oh…and if you think this is capitalism…well you are retarded. This is crony capitalism. Go look where little Timmy Geithner, Obama’s former Secretary of the Treasury, is working these days.
