Helicopter Larry

In the FT today, Larry Summers has a really terrific column on the subprime crisis that raises three very, very interesting questions:

First, this crisis has been propelled by a loss of confidence in ratings agencies as large amounts of debt that had been very highly rated has proven very risky and headed towards default. There is room for debate over whether the errors of the ratings agencies stem from a weak analysis of complex new credit instruments, or from the conflicts induced when debt issuers pay for their ratings and can shop for the highest rating. But there is no room for doubt that - as in previous financial crises involving Mexico, Asia and Enron - the ratings agencies dropped the ball. In light of this, should bank capital standards or countless investment guidelines be based on ratings? What is the alternative? Sarbanes-Oxley was a possibly flawed response to the problems Enron highlighted in corporate accounting. What, if any, legislative response is appropriate to address the ratings concerns?

Second, how should policymakers address crises centred on non-financial institutions? A premise of the US financial system is that banks accept much closer supervision in return for access to the Federal Reserve's payments system and discount window. The problem this time is not that banks lack capital or cannot fund themselves. It is that the solvency of a range of non-banks is in question, both because of concerns about their economic fundamentals and because of cascading liquidations as investors who lose confidence in them seek to redeem their money and move into safer, more liquid investments.Central banks that seek to instilconfidence by lending to banks, or reducing their cost of borrowing, may, as the saying goes, be pushing on a string. Is it wise to push banks to become public financial utilities in times of crisis? Should there be more lending and/or regulation of the non-bank financial institutions?

Third, what is the role for public authorities insupporting the flow of credit to the housing sector? The lesson learnt during the S&L debacle was that it was catastrophic to finance home ownership through insured banking institutions that borrowed short term and then offered long-term fixed-rate home mortgages. Now a system reliant on securitisation, adjustable rate mortgages and non-insured financial institutions has broken down.

Even more interesting is his conclusion:

Now, as borrowers face higher costs as their adjustable rate mortgages are reset, is not the time for the authorities to get religion and discourage the provision of credit.

I'm with Larry. One hears a lot of echoes these days of the infamous quote from Andrew Mellon, Hoover's Secretary of the Treasury, at the dawn of the Great Depression:

[T]he “leave it alone liquidationists” headed by [my] Secretary of the Treasury Mellon... felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” He insisted that, when the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. He held that even a panic was not altogether a bad thing. He said: “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people”...

There are the people who don't think the government should bail out homeowners who bought houses they clearly couldn't afford, on the assumption that rising house prices would allow them to refinance before the rates reset; one of them, a friend whose limited personal funds forced him to buy a very small house sent me a link to this cartoon.

There are other people who sympathise with the homeowners, but like Daniel Gross, don't want to bail out the bankers who made massive subprime loans, or the hedge funders who bought the securities that those loans were packaged into.

On the "they deserve it" argument, I am sceptical on both sides. Many of the people with the worst loans were pushed into them by unscrupulous mortgage brokers. The mortgage brokers systematically concealed terms and got them bad rates, but the people in the house are the ones who have to move and deal with a devastated credit record.

This applies equally well to the subprime lenders and hedge funders. Unscrupulous mortgage brokers will not suffer at all if subprime lenders go under. The subprime lenders made loans stupidly, but in good faith. The hedge funders bought assets in good faith.

Now, in ordinary times, I would not say that isolated individuals with these problems deserve a bailout. We should help people who got rooked (and tighten fraud laws to prevent other such rookings), but not to the tune of a whole house. Renting has its downsides, but they are not so great that it should be the government's business to shove everyone into their own little plot of land. On the flip side, it's tough that banks that make stupid loans go bust, but as many European and Asian banking systems illustrate, the cost to keeping failed companies afloat is much higher than the reward.

I am therefore somewhat sympathetic to people who are worried about moral hazard. But only somewhat. On the consumer side, the problem has been largely taken care of by the fact that no one wants to issue mortgages. And on the bank side . . . well, we may have bigger problems than moral hazard.



That's the classic bank run scene from "It's a Wonderful Life", possibly the best scene explaining economics in movie history. It brilliantly illustrates how panic can put a solvent financial institution into insolvency . . . which is what FDR was talking about when he said "We have nothing to fear but fear itself." Note that the solution the movie characters stumbled on was also the right one: inject cash into the economy in order to calm insolvency fears.

It is true that there will be some moral hazard attached to bailing out either banks or homeowners. Those who are bailed out, and their peers, will be more likely to engage in the risky behaviour that spawned the bailout, in the belief that the government will rescue them again. But in the case of a genuine credit crisis, the cost of moral hazard is much smaller than the cost of a genuine liquidity crisis--which will hurt, I might add, not just the homeowners and the bankers, but all of us who like to do things like borrow money, or have economic growth.