Friday, August 17, 2007

Say No to Bailouts

Paul Krugman tells us to "Say No to Bailouts" in his column today, and he's largely right:

Consider a borrower who can’t meet his or her mortgage payments and is facing foreclosure. In the past, as Gretchen Morgenson recently pointed out in The Times, the bank that made the loan would often have been willing to offer a workout, modifying the loan’s terms to make it affordable, because what the borrower was able to pay would be worth more to the bank than its incurring the costs of foreclosure and trying to resell the home. That would have been especially likely in the face of a depressed housing market.

Today, however, the mortgage broker who made the loan is usually, as Ms. Morgenson says, “the first link in a financial merry-go-round.” The mortgage was bundled with others and sold to investment banks, who in turn sliced and diced the claims to produce artificial assets that Moody’s or Standard & Poor’s were willing to classify as AAA. And the result is that there’s nobody to deal with.

This looks to me like a clear case for government intervention: there’s a serious market failure, and fixing that failure could greatly help thousands, maybe hundreds of thousands, of Americans. The federal government shouldn’t be providing bailouts, but it should be helping to arrange workouts.
I don't see the market failure, but I don't disagree with the last paragraph if that assertion is removed. We had financial innovation that lowered the upfront costs of financing real estate transactions and raised the costs in the event of default. That we are now "in the event of default" and seeing the higher transaction costs does not mean we have a market failure. That, by itself, does not warrant the government involvement.

However, in addition to the shift on financing arrangements, we had fraud at various points in this process, and determining the financial penalties in those instances would likely have to be worked out over years in protacted legal battles. Congress can pass legislation to substitute for those battles. I haven't seen a better idea than Dean Baker's, which I discussed in the last post.

The consequence of passing it is that it gives the borrower the upper hand in the workout negotiations--the borrower can stay and pay rent as a substitute for the mortgage, and the holder of the mortgage can hold or sell the property (without evicting the tenant) in light of that. I presume that most dispositions will be in either of two forms. Some borrowers will realize that they really cannot afford the house and find a more affordable one, without being evicted unless they also cannot pay rent. In other cases, the holder of the mortgage will sell the property back to the borrower at a discounted price, with new financing on more sensible terms from a new lender. This avoids the need for the government to get actively involved in the terms of the workouts, placing the cost of disposing the property on the lending community where it belongs.

And what of the Wall Street entities that have taken a financial beating as the bottom dropped out of this market? They get to be the roadkill on the capitalist highway, food for scavengers in the financial market. You wouldn't know it from the headlines dominating the news media today, but there are plenty of financial institutions that have been prudent and maintained their liquidity though this chaos. They are going to get some bargains in the months to come.


Jonah B. Gelbach said...


Well said. One interesting issue I've been thinking about vis a vis all this has to do with the increase in transactions costs that you (and Krugman) flag.

The securitization of pieces of mortgages surely increases the transactions costs of workouts. One view of this fact is that we're stuck with it. Another view is that it creates an opening for further innovation---namely, firms specializing in re-assembling troubled mortgages.

It seems to me that re-assembly is a necessary part of workouts, as well as outcomes like your

In other cases, the holder of the mortgage will sell the property back to the borrower at a discounted price, with new financing on more sensible terms from a new lender.

If the mortgage hasn't been fully assembled, there would surely be title/lien problems with this otherwise-sensible approach.

So one way to reconcile your dispute of Krugman's market failure claim, I think, is that there are market failures only if there is some reason to think that the re-assembly market has a failure.

If there is a failure, then the issue isn't just your point about higher TC "in the event of default". Rather, the event of default is the event of a (most likely unforeseen) market failure. On the other hand, if re-assembly can be done competitively without market failures, then what we really have is a situation in which the higher transaction costs "in the event of default" can actually be reduced via further financial innovation.

Could markets in re-assembly be competitive? Well, obviously there are already secondary markets in these securities--that's how we got to this point. The key question is not whether these markets exist, or even whether there are short-term liquidity problems like those that have hit the markets recently. Rather, the key question is whether there is some distinct failure related specifically to the re-assembly of all chunks of a mortgage.

To be sure, there are some conceivable hitches. For example, holdup problems could arise if a holder of the last non-re-assembled chunk of a mortgage figures out its status. Obviously being the last holder conveys bargaining power, and this could cause inefficient delay.

(As usual the efficiency problem isn't the case of the last holder that uses bargaining power, but rather jockeying on the part of multiple agents to achieve that bargaining power.)

To the extent that auctions or hiding any given loan's re-assembly status can avoid such holdup problems, it seems likely that such a market could avoid serious failures.

Suppose that market failures turn out to exist in re-assembly and be severe enough to cause non-existence of the market. I'm skeptical that this would happen, but let's say it did.

Perhaps the most reasonable government policy (leaving aside Dean Baker's) intervention might then be to have Fannie Mae do the re-assembly and then re-sell the fully titled mortgage security on open financial markets. There would, by hypothesis, be high costs for Fannie Mae in re-assembly. But surely we could expect the demand side of such markets to be competitive. The sort of workouts that Krugman proposes or re-sales that you mention would then be feasible via direct negotiations between residents and their new creditors.

Obviously this isn't my field of expertise, so I'm curious as to your thoughts.

Jonah B. Gelbach said...


Thanks for your reply.

Just to be clear, I didn't at all think you were equating high TC with market failure, nor did I mean to.

Placing legal tenancy rights in the hands of borrowers certainly does have (salutary, in my view) distributive effects. But unless there is some sort of market failure in the way re-assembly of legal rights to the mortgage income flow occurs for securitized mortgage rights, the Coase Theorem would seem to suggest that the location of the "incentives and control of the process" isn't relevant to the resulting existence or nonexistence of renegotiation.

Which is another way of saying what I meant to suggest before: IF assignment of tenancy rights makes a difference other than in distribution, then I think there must be a relevant market failure. And if there is one, it would have to be related to how the legal rights to securitized mortgages are reassembled.

Again appealing to Coase logic, it's similar to the case of the train giving off sparks that cause fires in many farmers' property. If multiple farmers can't solve a collective action problem, then it matters for the allocation of resources to whom you assign the property right (to railroad=can emit sparks, to farmers=no sparks unless a bargain is reached allowing sparks).

The various slices of these mortgages are assets like any other, so reassembly doesn't obviously seem like it would bring a market failure. But if there is one, say due to holdups, then it seems to me that (i) there might be a role for govt, and (ii) that role should be limited to reassembly followed by resale, rather than direct bailouts of homeowners.

Sorry if I was unclear at first!

ed said...

Baker's proposal to allow people to stay in their houses and pay rent seems a bit problematic to me. I'm not sure if I understand it correctly, or why you support it.

I agree that the current mess will probably require that some owner-occupied housing be turned into rental housing, and perhaps letting some people stay in their homes and rent, rather than move, could have some efficiency benefits. But it sounds like Baker's proposal would require the rent amount to be determined outside the market, by "independent appraisers." I have little faith in this process...isn't trusting "appraisers" how we got into this mess in the first place?

I also think that some of the rhetoric about "people losing their home" is overdone. This isn't a case of losing the family farm that has been in the family for generations, it is mostly a case of people who made unwise purchases in 2005 or 2006. Yes, some of those people will lose their homes and have to go back to renting, like they should have been doing in the all along anyway. They also lose their down payment (if any), and their credit is wrecked, but this doesn't seem unfair to me. Why should we feel especially sorry for them?

Anonymous said...

Baker proposal would have some hurdles . . .

Anonymous said...


The problem with appraisals was attributable to who was hiring them. Mortgage issuers make their money from issuing mortgages. Since they knew they could dump their mortgages on the secondary market, they had little reason to care of the mortgage could be paid off. This meant that they wanted high appraisals to ensure that the mortgage could be issued.

Since appraisers knew it was up to the issuers to hire them (generally they work as independent contractors), they knew that they should come in with high appraisals if they would continue to be hired.

By contrast, if the hiring is done by a judge in a foreclosure case, with no obvious stake in a high or low rental appraisal, presumably the appraisers would use their best judgement.

Andrew Samwick said...


I'm thinking of what's likely to happen when the government decides it has to "do something." If it has to do something, I like Dean's proposal. I also remember this, and so I think it's worth exploring some protection for borrowers.


David Sucher said...

Can anyone help me with this question:

Where is "Private Mortgage Insurance" (PMI) in this whole story?

I was under the impression that any loan greater than 80% LTV required it. Did that disappear under Bush?