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March 31, 2008

Economist's View - 7 new articles

Resolving the Financial Market Crisis

In thinking about how to resolve the financial market crisis, I've said that we should do two things, pursue some version of a mortgage repurchase plan, and pursue some means of removing risky assets from financial markets:

[T]he Fed [can] remove risk from the market by purchasing risky mortgage backed securities... I think purchasing mortgages would [also] help to stabilize the mortgage market, so I ... favor ... the mortgage purchase plan, particularly since it helps homeowners directly. I am just not sure that it will be enough by itself to get credit flowing again. ... Because of the uncertainty about whether purchasing mortgages will be enough to stabilize markets, I would advocate doing a combination of both policies, purchase troubled mortgages and purchase troubled financial assets at the same time... (and other measures, e.g. regulatory change, could also be put into place so his is not all that can be done).

In a follow-up, I added that:

I believe a combination of both plans - the Treasury intervening to purchase mortgages and reissue them on more attractive terms, and the Fed intervening to purchase mortgage backed securities (MBS) - is the safest bet. Even if one of the measures isn't enough on its own, hopefully the combination will prove sufficient.

The analytics of proposals such as this are starting to come together. Brad DeLong has done us a favor and provided the latest step in the analytical process. Here's a fragment of a much longer post he has provided. Notice that he has also added recapitalization to the list of policies, an important innovation since this is one of the keys helping financial markets to move forward:

What do we do now? That is the subject of Larry Summers's column. We do two things. First, we have the Federal government reduce the supply of risky financial assets by having the government buy or guarantee (thus making the assets no longer risky, you see) or support the purchase of mortgages (and other things) and so push the private financial-sector supply of financial assets to the left. Second, we have the Federal government "encourage" the financial sector to recapitalize itself, thus pushing the supply up and to the right, like so:


And so pushing up the prices and reducing the interest rates charged on financial assets, making the good equilibrium reappear, and keeping us out of depression, like so:


That, in a nutshell with simple graphs, is what Larry is saying, with the addition that he thinks that we now have in motion enough policy moves to resolve the crisis and save the world economy from depression. But there are four additional points that don't fit easily on the graphs. We need to make sure that we also:

  • do smart things to try to keep this from happening again
  • assign blame and try as hard as we can--without causing a depression--to make sure that those who bear responsibility don't make out like bandits by looting the Treasury as this is accomplished.
  • make sure that others--even if they are still largely innocent bystanders at the moment--do not earn unjustified windfall fortunes in the process.
  • make sure that the upward-and-to-the-right orange-arrow movement of the supply curve does in fact take place: make sure that financial intermediaries that survive and profit because of government intervention become not just part of the problem but part of the solution: that because "much is being given to financial institution shareholders and management, [it is only fair that much] action to help the economy and protect the taxpayer... be expected in return."

Now there are three objections to this analysis and this plan of action, roughly: (1) it's immoral, (2) it's unfair, and (3) it can't work in the long run. To expand a bit ... [...Brad's post...]

Adverse Selection, Loan Defaults, and Credit Rationing

What is the source of foreclosures, interest rate resets or falling prices? In this post, I said:

It's easy to explain how interest rate resets could increase foreclosure rates since the monthly housing payment will change as a result of the reset, but why do falling prices cause increased foreclosures? Falling prices don't change monthly payments, so why do more people default?

The post then explains how falling prices can increase defaults and Richard Green provides academic work supporting the mechanism.

But falling prices and interest rate resets are not mutually exclusive explanations for rising foreclosure rates, both could be at work, and Brad DeLong presents a model that explains how, through adverse selection, rising interest rates can cause increases in defaults.

The purpose of this post is to further illuminate Brad's discussion and to explain how the adverse selection mechanism operates.

To do so, rather than try to impress all of you by building my own model, I'll avoid reinventing the wheel and will instead base this discussion on a version of the Stiglitz and Weiss (1981) model presented in Carl Walsh's Monetary Theory and Policy text (so full credit should be given to those authors). The presentation is mathematical, but along the way I will try to provide the intuitive underpinnings, so hopefully the points will be clear even if the mathematics is not.

The basic point of the model is to illustrate two things. First, how an increase in the interest rate can increase defaults. This is the main point. Second, how equilibrium credit rationing can occur, i.e. how financial markets can settle on an equilibrium where there are buyers willing to take out loans at the going interest rate, but nobody willing to lend them money at that rate, and the excess demand for loans is not resolved through rising interest rates.

I should add that there are other mechanisms that can be used to explain these results, moral hazard and monitoring cost models for example (e.g., as interest rates increase, borrowers are induced to take on more risk in moral hazard models, and the increased risk taken on by borrowers increases defaults) so this should not be considered exhaustive.

The Model:

1. The model contains a single type of lender, and different types of borrowers. The lender's expected return on loans is a function of the interest rate and the probability of repayment. The probability of repayment will vary across individuals.

2. Borrowers come in two types:

Type g: this type repays loans with probability qg Type b: this type repays loans with probability qb

It is assumed that qg > qb, so that the good borrowers (g types) are more likely to repay than the bad borrowers (b types).

3. If lenders can observe the type of borrower they are lending to, they will charge each a different interest rate to reflect differences in risk, and the market will clear without credit rationing. It will be fully efficient.

4. For example, we'll assume the supply of credit is perfectly elastic (the supply curve for credit is horizontal):


Assuming risk neutral lenders, and that they lend to a large number of borrowers (so the law of large numbers applies), the lender will charge r/qg to the good borrowers, and r/qb to the bad borrowers and will realize an expected return of r for each group (i.e., the lender receives r/q with probability q so the expected return is q(r/q)=r). There is no credit rationing, the lender simply charges risky borrowers more than good borrowers to compensate for the extra risk.

5. Now assume the lender cannot observe the different types of borrowers. What we will now show is that as the interest rate, r, increases, the fraction of bad borrowers in the loan applicant pool also increases, so the probability of default goes up.

That is the main point - when interest rates rises, the good borrowers drop out (this is the adverse selection mechanism, the good borrowers self-select out of the pool leaving a greater fraction of risky borrowers in the market).

But we can also get equilibrium credit rationing with this as well. Here's how. As r increases, the return to the lender goes up, so an increase in r increases profit. But, as we will show, the increase in r also causes the fraction of bad borrowers to go up and this increases the default rate and lowers profit. So, the net effect of an increase in r on profit depends upon which of these two effects is stronger, the increase in profit from charging a higher interest rate, or the decrease in profit from higher defaults.

To get rationing, what we have to show is that as r increases, initially profits go up since the higher price effect dominates the increase in defaults. But there comes a point in the lender's profit function where any further increase in r is not profitable, the loss from defaults increasing is larger than the profit increase from the higher interest rate, so the lender won't raise the interest rate even if there is an excess demand for loans at the current r being charged in the marketplace.

This is the credit rationing. Even if there is excess demand for loans, the lender will not raise r above the critical value of r, call it r*, where profit begins falling.

Let's show this mathematically.

6. Let g be the fraction of good borrowers among all borrowers. In order to earn an expected return of r, the lender charges borrowers (which cannot be distinguished and hence face the identical loan rate) r1 such that:

gqgr1 + (1-g)qbr1 = r = expected return if lender charges r1 to all types.

The lender should charge:

r1 = r/[gqg + (1-g)qb]

7. Using this strategy, the lender will thus earn r if borrowers are chosen (walk through the doors of the bank) randomly. But they don't show up randomly, so this is not the end of the story.

Notice that r/qg <>1<>b. Good borrowers are paying too much, and bad borrowers are paying too little. Thus, good borrowers are more likely to drop out of the market, and the fraction of good borrowers will diminish over time increasing average default rates (perhaps because they are good borrowers they can find other, cheaper ways to finance investment) .

This is a classic lemons problem - good borrowers leave the market increasing the average risk and default rates of borrowers still in the market, interest rates go up to compensate for the higher risk, more borrowers leave the market, average risk goes up, more borrowers leave, etc. - and it will lead to market failure.

8. Now let's change the model slightly to illustrate equilibrium credit rationing. Loans are characterized by more than just the interest rate, and here we will characterize loans by three parameters, the interest rate lenders charge on loans, r1, the size of the loan L, and the required collateral on the loan, C.

9. The probability that a loan is repaid depends upon the return yielded by the borrower's risky project. Let a particular project yield a return of R. Then the lender will be repaid if

L(1 + r1) <>

That is, the lender is repaid if the value of the loan is less that what the borrower has to give up in default (the lender gets to claim any return, R, that the borrower made on the project plus the value of the collateral). This just says that the borrower repays when losses are smaller from doing so.

10. Now suppose that the return, R, is risky:

Return R = R1+x with probability 1/2 Return R = R1-x with probability 1/2

Then the expected return is R1, and the variance of returns is x2. As x increases, there is a mean-preserving spread in the distribution, i.e. risk goes up, but the expected return is not changed.

11. Next, to limit the outcomes to the ones we are interested in, assume that

R1-x < (1+r1)L - C

This means that the borrower will always choose to default when a bad outcome is drawn (-x), and will always repay when there is a good outcome (+x).

12. Thus, under a good outcome the borrower earns

R1+x - (1+r1)L

(this is the return on project minus the cost of the loan) and under a bad outcome, the borrower loses -C, i.e. loses the collateral on the loan.

13. Then the borrower's expected profit is

EπB = (1/2)[R1+x - (1+r1)L] + (1/2)[-C]

[The superscript means borrower]. That is, the borrower gets the good outcome shown in the first set of brackets 1/2 the time, and the bad outcome of -C shown in the second set of brackets the other half of the time.

14. Define x*(r,L,C)(1+r1)L - C - R1. That is, x* is the value of x such that EπB > 0 whenever x > x*, and EπB < 0 whenever x < x*. It's the point where profit turns negative.

Another way to say the same thing is that, with x* defined in this way, EπB = (1/2)(x-x*). x* gives the level of risk (how big the bad outcome must be, i.e. the size of x) where it becomes worthwhile for the borrower to walk away from the loan and default.

15. Notice that x* is increasing in r1. This means that as r1 increases, those with smaller x values drop out (i.e. those facing less risk), but the riskier borrowers (those with larger x values) remain in the pool. The mix of borrowers changes toward riskier borrowers and defaults will increase.

16. What about the lender? The lender's expected profit is

EπL = (1/2)[(1+r1)L] + (1/2)[C+R1-x] - (1+r)L

The first term is the return in the good state, the second is the return in the bad state (both happen with probability 1/2), and the third term is the opportunity cost of the funds it lends out (so the return is r, not r1, since the opportunity cost is the market return, r).

That is, the lender receives a fixed amount in the good state, (1+r1)L, but as x increases, the lender does increasingly worse in the bad state where it receives C+R1-x (i.e. as x increases, profit falls). This means that EπL is decreasing is the level of risk, x.

17. Now, let there be two groups of borrowers . Good borrowers are low risk (have small x values), bad borrowers are high risk (have large x values). Designate the x-values for each group as xg and xb, where xg <>b.

From the condition that EπB = (1/2)(x-x*), if r1 is low enough,

xg <>b <>

In this case, all loans are repaid, and all loans are profitable. If each type of lender is equally likely to be in the market, then expected profit for the lender is

EπL = (1/2)[(1+r1)L+C+R1] - (1/4)[xg + xb] - (1+r)L

This is increasing in r1.

18. But, as r1 increases, we will eventually reach the point where xg = x*(r, L, C) and the good types drop out of the market and stop borrowing (this is adverse selection at work). In this case, expected profit falls to

EπL = (1/2)[(1+r1)L+C+R1] - (1/2)[xb] - (1+r)L

Thus, EπL falls discretely when xg = x*, i.e. profit falls discretely when r1 increases and reaches

r1 = (1/L)[xg - C + R1] - 1

since this is the point where low risk types exit the market (the discrete jump comes from having two groups - with a continuum of risky borrowers, the discrete jump would be replaced by a maximum profit point, i.e. a single-peaked profit function).

19. We can show this graphically:


For loan rates between 0 and r1, no loans are profitable and none will be made. For loan rates between r1 and r*, both types of borrowers are in the market, and all loans are profitable (and profit is increasing in r).

For loan rates between r* and r2, loans are unprofitable, so no loans would be made. For loan rates above r2, loans are profitable, but only the risky group will be in the market.

Thus, credit rationing is possible at equilibrium. If loan demand is robust, lenders will increase r until it hits r*. At r*, there can be excess demand, but lenders will not raise the loan rate unless demand is so strong that rates can be profitably increased all the way to r2. Thus, if demand is strong enough to produce excess demand at r1, but not strong enough to push rates all the way to r2 or above, there will be credit rationing at equilibrium.

Conclude briefly:

We have shown two things. First, when the interest rate increases, adverse selection mechanisms can cause good borrowers to drop out of the loan pool increasing the riskiness of the average borrower. This increases default. Thus, this shows how an increase in the interest rate can increase default rates.

[Note: I wouldn't apply this model directly to mortgage markets as is, interest rate resets would be modeled a little bit differently, but the basic mechanism would be the same and is well illustrated by this and Brad DeLong's example.]

Second, the adverse selection mechanism can explain the presence of equilibrium credit rationing. There are other explanations too, e.g. moral hazard and monitoring cost models can explain equilibrium credit rationing, so there are other ways to get this result.

Summers: Steps To Safeguard America's Economy

Larry Summers, who is becoming a bit more optimistic about economic conditions, says monetary and fiscal policy measures enacted or likely to be enacted have helped to reduce the chances of severe problems, but there are still dangers to worry about and the next step for policymakers is to increase the amount of capital held by financial firms:

Steps that can safeguard America's economy, by Lawrence Summers, Commentary, Financial Times: Neither US financial institutions nor the economy are likely to suffer from a lack of central bank liquidity provision. New lending facilities are coming along almost weekly, the safety net has been expanded to include non-bank primary dealers...

At the same time, processes are in motion that may lead to new demands for more than $1,000bn in mortgages, directly or indirectly. Recent regulatory actions will enable Federal Home Loan Banks along with Fannie Mae and Freddie Mac ... to purchase more than an additional $300bn in mortgage-backed securities. ...

Moreover, legislation to reduce foreclosures being pushed by Senator Christopher Dodd and Representative Barney Frank could result in the federal government purchasing or providing guarantees that enable the purchase of several hundred billion dollars worth of mortgages.

The confidence engendered by all of this has led to some normalisation in credit markets. ... It is sometimes darkest before the dawn. For the first time since last August, I believe it is not unreasonable to hope that in the US, at least, the financial crisis will remain in remission. ...

While spreads have come in somewhat, markets continue to price in significant probabilities of default for even the most apparently strong financial institution, reflecting in part concerns about their solvency. At the same time it needs to be recognised that the federal government is bearing credit risk in extraordinary ways through its implicit guarantee to the GSEs, the lending activities of the Fed and the general backstop it is providing to the financial system.

All of this implies that a priority for financial policy has to be increases in the level of capital held by financial institutions. Capital infusions to date fall far short of prospective losses. Without new capital, the financial sector will operate with too much risk and leverage or will put the economy at risk by restricting the flow of credit. ...

The policy approach should start with the GSEs. These institutions' viability ... depends on the implicit federal guarantee of their several trillion dollars of liabilities. ...

It is not appropriate that their shareholders' "heads I win, tails you lose" bet with the taxpayer be expanded for this purpose. Given their past and prospective losses, their regulator – supported by the Treasury, the Fed and, if necessary, Congress – should insist that they stop paying dividends and raise capital promptly and substantially as they expand their lending. ...

Because they do not have a similar public mission and are operated with more financial rigour and closer regulation, the situation is somewhat different with respect to other financial institutions.

As part of its dialogue with financial institutions, the Fed should push for further efforts to raise capital. Consideration should be given to collective actions designed to destigmatise cutting dividends or raising equity. The idea of linking access to Fed credit and measures to attract capital should also be explored. At a time when much is being given to financial institution shareholders and management, action to help the economy and protect the taxpayer should be expected in return.

Is Poverty Caused by Irrational Behavior?

Is the poverty trap caused by a fundamental change in behavior once the number of problems an individual faces crosses some critical threshold?:

The sting of poverty, by Drake Bennett, Boston Globe: ...In the community of people dedicated to analyzing poverty, one of the sharpest debates is over why some poor people act in ways that ensure their continued indigence. Compared with the middle class or the wealthy, the poor are disproportionately likely to drop out of school, to have children while in their teens, to abuse drugs, to commit crimes, to not save when extra money comes their way, to not work.

To an economist, this is irrational behavior. It might make sense for a wealthy person to quit his job, or to eschew education or develop a costly drug habit. But a poor person ... would seem to have the strongest incentive to subscribe to the Puritan work ethic, since each dollar earned would be worth more ... than to someone higher on the income scale. Social conservatives have tended to argue that poor people lack the smarts or willpower to make the right choices. Social liberals have countered by blaming racial prejudice and the crippling conditions of the ghetto... Neoconservatives have argued that antipoverty programs themselves are to blame for essentially bribing people to stay poor.

[Charles] Karelis, a professor at George Washington University, has a simpler but far more radical argument to make: traditional economics just doesn't apply to the poor.

When we're poor, Karelis argues, our economic worldview is shaped by deprivation, and we see the world around us not in terms of goods to be consumed but as problems to be alleviated. This is where ... bee stings come in: A person with one bee sting is highly motivated to get it treated. But a person with multiple bee stings does not have much incentive to get one sting treated, because the others will still throb. The ... poorer one is ... the less likely one is to do anything about any one problem. Poverty is less a matter of having few goods than having lots of problems.

Poverty and wealth, by this logic, don't just fall along a continuum... They are instead fundamentally different experiences... At some point between the two, people stop thinking in terms of goods and start thinking in terms of problems, and that shift has enormous consequences. ...

If Karelis is right, antipoverty initiatives championed all along the ideological spectrum are unlikely to work - from work requirements, time-limited benefits, and marriage and drug counseling to overhauling inner-city education and replacing ghettos with commercially vibrant mixed-income neighborhoods. ... "It's Econ 101 that's to blame," Karelis says. "It's created this tired, phony debate about what causes poverty." ...

Karelis ... remains relatively unknown... A few, though, have taken notice... "There's not much evidence in the book, and there are a lot of bold claims, but it's great that he's making them," says Tyler Cowen, an economics professor at George Mason University. It "was a really great book, and it was totally neglected."

The economist's term for the idea Karelis takes issue with is the law of diminishing marginal utility. In brief, it means the more we have of something, the less any additional unit of that thing means to us. ... In many cases, Karelis says, diminishing marginal utility certainly does apply: Our seventh ice cream cone will no doubt be less pleasurable than our first. But the logic flips when we are dealing with privation rather than plenty.

To understand why, he argues, we need only think about how we all deal with certain familiar situations. If, for example, our car has several dents on it, and then we get one more, we're far less likely to get that one fixed than if the car was pristine before. ...

Karelis argues that being poor is defined by having to deal with a multitude of problems: One doesn't have enough money to pay rent or car insurance or credit card bills or day care or sometimes even food. Even if one works hard enough to pay off half of those costs, some fairly imposing ones still remain, which creates a large disincentive to bestir oneself to work at all.

"The core of the problem has not been self-discipline or a lack of opportunity," Karelis says. ... The upshot ... for policy makers, Karelis believes, is that they don't need to fret so much about the fragility of the work ethic among the poor. In recent decades, experts and policy makers all along the ideological spectrum have worried that the more aid the government gives the poor, the less likely they are to work to provide for themselves. ... It was this concern that drove the Clinton administration's welfare reform efforts.

But, according to Karelis, that argument is exactly backward. Reducing the number of economic hardships that the poor have to deal with actually make them more, not less, likely to work, just as repairing most of the dents on a car makes the owner more likely to fix the last couple on his own. ... (One federal measure Karelis particularly likes is the Earned Income Tax Credit, which, by subsidizing work, helps strengthen the "reliever" effect he identifies.) ...

Karelis ... believes ... the strength of his arguments is less in how they fit with the economic work that's been done to date on poverty - much of which he is suspicious of anyway - but in how familiar they feel to all of us, rich or poor. "The bee sting argument, or the car dent one," he says, "I've never had anybody say that that isn't true." [See also On Poverty, Maybe We're All Wrong]

"Obama and the Class Question"

Richard Florida takes a look at how support for Democratic presidential candidates varies across the creative and working classes, and the how the variation "raises an interesting dilemma for campaign strategists":

Obama and the class question, by Richard Florida: ...Pundits on all sides have framed this election - and especially the Democratic primary - as turning on the traditional fault lines of race, gender and generation.

The talk shows go on and on about how Mr. Obama is attracting black and young voters and how Ms. Clinton finds her voice among women and baby boomers.

But what is seldom discussed and yet most interesting... At bottom, both the Democratic primary and the upcoming general election turn on an even deeper economic and social force: class.

In 2002, I defined a new creative class of inventors, entrepreneurs, engineers, artists, musicians, designers and professionals in idea-driven industries.

Today, nearly 40 million American workers fit into that group, 35 per cent of the total working population and a good deal more than the 23 per cent who make up the working class. ...

Up to this point, creative-class people have predominantly cast themselves as politically independent or "post-partisan," and their political sympathies have been up for grabs.

The traditional Republican platform of individualism, economic opportunity and fiscal responsibility appeals to them; but so, too, do the Democratic values of social liberalism, environmentalism and a progressive track record on gay and women's rights.

Democratic candidates such as Bill Bradley and Howard Dean attracted the creative class in the 2000 and 2004 elections. But no one has caught fire with this class like Barack Obama. ...

To get a better sense of how this deep this support runs, I asked opinion pollster John Zogby to look into how creative-class people were voting in this primary season.

The result: On issue after issue, they preferred Mr. Obama to either Ms. Clinton or Republican John McCain by wide margins. ... Mr. Obama even bests Ms. Clinton and Mr. McCain substantially on the issue where he is allegedly weakest - "combating terrorism" - registering 50 per cent of creative-class support compared with 24 per cent for Ms. Clinton and 18 per cent for Mr. McCain. ...

Mr. Obama consistently polls strongest in cities and regions with significant creative-class concentrations. Ms. Clinton, on the other hand, has scored better in industrial states with dominant blue-collar towns, where voters are anxious about the economy and job prospects.

Ms. Clinton is more popular among voters without college degrees. Meanwhile, ... Brendan Nyhan has crunched numbers that show a college education to be a big predictor for Obama support.

This divergence in the electorate raises an interesting dilemma for campaign strategists.

Is a coalition between the creative class and working class even viable? Appealing to them both will prove difficult. The creative class anticipates the future while the working class is, in many senses, seeking protection from it. ...

It will be difficult for Ms. Clinton to win wholehearted endorsement of the creative class, as committed as she is to specific programs.

It will also be hard for Mr. Obama's rhetoric of hope and change to resonate with those who are falling farther and farther behind economically. In coming years, it will be vitally important for progressive political leaders to reach out to the working and service classes, and in ways that enable them to connect to the new creative economy.

But in the short months remaining until the general election, deep-seated working-class anxiety about economic and social change is not likely to be overcome.

Clearly, neither race, gender, nor age can provide the core support necessary for a sustainable political majority. Just as Franklin Delano Roosevelt forged a new majority on the swelling ranks of blue-collar workers, so must the candidate and party that hope to win this election, and shape the political landscape for years to come, gain the support of today's ascending economic and political force - the creative class.

Comment Policy

Everyone seems to be posting their comment policies lately. Here's mine:

I don't have an explicit policy.

I do delete obvious spam, no surprise there.

And sometimes, maybe it's the last straw after a string of irritating comments, maybe I've had a bad day, maybe a comment crosses some line, e.g. racism, maybe I misinterpret, but there comes a point where I go from passive to aggressive at which point one of three things happens:

I respond with my own comment, and the tone isn't always pleasant. I usually regret this right away, pleasant tone or not, and, fortunately, I have the power to fix it. So I do - I delete my own comment.

So, it's my own comments that get deleted the most. By a huge margin. It's not even close. The only complication here is if someone has already responded to my comment. Then I'm usually stuck leaving it.

At this point I promise myself I will never, ever again respond to anyone in comments, at least not negatively - it doesn't do much good anyway and I don't always think the response through as much as I should - and that lasts until a comment sends me over the line again, I respond and regret it, make the promise anew, but really mean it this time.

The second response is to delete the comment. I usually regret this too, but not always. But mostly I do regret it and, after a bit, if I was smart enough to "unpublish" rather than "delete" the comment, I repost it. However, if I'm sufficiently irritated to take action, I tend to choose delete since, at the time, I have no intention of reposting the comment, ever, and it saves me the trouble of deleting it later.

The third response is to ban the person from commenting at all. Right now, there is one person in that category, but the number changes over time. I've lifted it three times for that person (more or less, can't remember for sure), but it hasn't worked out very well and a more extended break is now in place. I might lift it on some particularly forgiving day, but for now, it stays.

I don't do this unless there have been repeated instances where I've had to ban someone's comments. There's no list of things I can point to that says this is what will cause you to get banned, this won't, it happens when I've had enough. But it's always after repeated troubles and interaction, so while it's often a surprise to the person when they get banned, it shouldn't be.

But even in these cases, even when someone deserves to be banned, I start to feel I should give them another chance and, after awhile, I almost always lift it. How long before the ban is lifted varies, sometimes it's an hour later, sometimes it's the next day, one time it was many months later, there just comes a day when I feel like lifting it and do. And it's mostly worked, when people comment again their behavior changes or they quit commenting altogether. But not always and there's no doubt someone will get banned again before too long. Hopefully, they'll even deserve it.

One last thing. As the election approaches and the trolls begin coming out in force I plan to get more aggressive, particularly in removing arguments I find wrong or misleading, etc. I won't try to list what will or won't get comments removed, but I will know it when I see it - if it pollutes the discourse I will remove it, and I will be the judge of what does and does not cross the line. I'll probably make mistakes, but that's how it goes - it's a pretty big job just keeping up with comments and I'll do the best I can, but it comes down to my judgment about what I do and don't want appearing here. Some of you won't like it - but some of you don't like it when I don't do anything to moderate comments - so anything I do (or don't do) will cause objection from some people. So, I'll just do what I think is best. Once the election is over I'll probably relax things once again.

So, that's it, that's how it works. It pretty much comes down to me removing the things I think ought to be removed, and if something is a persistent problem, keeping it away for a more extended period. If there's no adaption after a few iterations, the ban becomes permanent.

Ultimately, I want to encourage, not discourage comments, and to maintain a healthy and informative discourse (so, please join in, the more of you who comment the better). I wish I had the time to moderate comments more effectively and to interact more, but that's not possible - e.g., I may not actually have the time to do as much moderation as I'd like as the election approaches, and I certainly don't do as much as I'd like now. So I depend upon those of you who do participate to help me to make comments a place where people can respond intelligently to information in the main post, interact with others doing the same thing, and help all of us to learn more about the topic in the process. It's always disappointing when the comments deteriorate into one of the many degenerate forms comment threads can take.

links for 2008-03-30

March 29, 2008

Economist's View - 5 new articles

"The Smart Way Out of a Foolish War"

The war. When will it end?:

The Smart Way Out of a Foolish War, by Zbigniew Brzezinski, Commentary, Washington Post: Both Democratic presidential candidates agree that the United States should end its combat mission in Iraq within 12 to 16 months of their possible inauguration. The Republican candidate has spoken of continuing the war, even for a hundred years, until "victory." The core issue of this campaign is thus a basic disagreement over the merits of the war and the benefits and costs of continuing it. ...

The contrast between the Democratic argument for ending the war and the Republican argument for continuing is sharp and dramatic. The case for terminating the war is based on its prohibitive and tangible costs, while the case for "staying the course" draws heavily on shadowy fears of the unknown and relies on worst-case scenarios. President Bush's and Sen. John McCain's forecasts of regional catastrophe are quite reminiscent of the predictions of "falling dominoes" that were used to justify continued U.S. involvement in Vietnam. ...

[T]he war has become a national tragedy, an economic catastrophe, a regional disaster and a global boomerang for the United States. Ending it is thus in the highest national interest.

Terminating U.S. combat operations will take more than a military decision. It will require arrangements with Iraqi leaders for a continued, residual U.S. capacity to provide emergency assistance in the event of an external threat ...; it will also mean finding ways to provide continued U.S. support for the Iraqi armed forces as they cope with the remnants of al-Qaeda in Iraq.

The decision to militarily disengage will also have to be accompanied by political and regional initiatives designed to guard against potential risks. We should fully discuss our decisions with Iraqi leaders..., and we should hold talks on regional stability with all of Iraq's neighbors, including Iran.

Contrary to Republican claims that our departure will mean calamity, a sensibly conducted disengagement will actually make Iraq more stable over the long term. The impasse in Shiite-Sunni relations is in large part the sour byproduct of the destructive U.S. occupation, which breeds Iraqi dependency even as it shatters Iraqi society. In this context, so highly reminiscent of the British colonial era, the longer we stay in Iraq, the less incentive various contending groups will have to compromise and the more reason simply to sit back. ...

Ending the U.S. war effort entails some risks, of course, but they are inescapable at this late date. ... U.S. military disengagement will accelerate Iraqi competition to more effectively control their territory, which may produce a phase of intensified inter-Iraqi conflicts. But that hazard is the unavoidable consequence of the prolonged U.S. occupation. The longer it lasts, the more difficult it will be for a viable Iraqi state ever to reemerge.

It is also important to recognize that most of the anti-U.S. insurgency in Iraq has not been inspired by al-Qaeda. Locally based jihadist groups have gained strength only insofar as they have been able to identify themselves with the fight against a hated foreign occupier. As the occupation winds down and Iraqis take responsibility for internal security, al-Qaeda in Iraq will be left more isolated and less able to sustain itself. The end of the occupation will thus be a boon for the war on al-Qaeda...

Bringing the U.S. military effort to a close would also smooth the way for a broad U.S. initiative addressed to all of Iraq's neighbors. Some will remain reluctant to engage in any discussion as long as Washington appears determined to maintain its occupation of Iraq indefinitely. Therefore, at some stage next year, after the decision to disengage has been announced, a regional conference should be convened... -- ...which would help mitigate the unavoidable risks connected with U.S. disengagement. ...

The overall goal of a comprehensive U.S. strategy to undo the errors of recent years should be cooling down the Middle East, instead of heating it up. ...

We started this war rashly, but we must end our involvement responsibly. And end it we must. The alternative is a fear-driven policy paralysis that perpetuates the war -- to America's historic detriment.

Andrew Sullivan forecasts the fate of Bush and Cheney.

Alan Blinder: How to Cast a Mortgage Lifeline?

Alan Blinder gives details on how to structure a modern version of the depression-era HOLC program. The program is an attempt to reduce the number of foreclosures and stabilize financial markets:

How to Cast a Mortgage Lifeline?, by Alan S. Blinder, NY Times: The financial markets are downright scary. And it seems unlikely that we can extricate ourselves from the current series of rolling financial crises without improving the situation in three related markets: those for houses, mortgages and securities based on mortgages.

In a previous column for Sunday Business, I advocated one possible approach: creating a modern version of the Home Owners' Loan Corporation, or HOLC, the Depression-era entity that bought up old mortgages and issued new, more affordable ones in their stead. ...

But this is one of those cases where the devil truly is in the details. How would it work in practice? Let's concentrate on six major design issues:

STRUCTURE The original HOLC bought mortgages outright. But Representative Barney Frank, the Massachusetts Democrat, and Senator Christopher J. Dodd, Democrat of Connecticut, ... are now cooperating on a different ... approach [that] would use a beefed-up Federal Housing Administration to guarantee new mortgages ... instead of buying up old ones. The effects would be much the same: old, unaffordable mortgages would be replaced by new, affordable ones; and the government would then assume the risk of default. But in the Frank-Dodd proposal, the federal government would be a big insurer rather than a big bank. Because the approach actually has a chance of becoming law, let's adopt its structure.

BAILOUTS The Frank-Dodd plan for a Super F.H.A. ... must not be too generous in shielding people and businesses from the consequences of their own bad decisions — both for economic reasons (to minimize moral hazard) and for political reasons (to gain voter support). So, what to do?

In the Frank-Dodd approach, existing mortgages would be bought below face value, forcing investors to ... "take a haircut." But homeowners who get nice, new mortgages to replace their nasty old ones should also be made to pay for the privilege. If not, the Super F.H.A. would be flooded with applicants. So the proposal would make homeowners relinquish part of any price appreciation on their houses for as long as their Super F.H.A. mortgages remain in effect.

Good idea. But I'd go further, by also making beneficiaries of the plan forfeit the right to take out second mortgages or home equity loans.

LEGAL SAFE HARBOR ...[M]ost mortgages these days are bundled into pools, turned into marketable securities, and then sold to investors all over the world. ... To buy selected mortgages out of these pools, the Super F.H.A. must clear a legal hurdle. Servicers are petrified of lawsuits if they sell individual mortgages — which are, after all, owned by other people — "at a loss." So, to unfreeze the market, Congress must pass legislation shielding servicers from legal liability when (as now) market conditions depress prices. ...

SETTING PRICES The HOLC bought pre-existing mortgages at a discount. The Super F.H.A. would use government guarantees to induce private businesses to do so. In either case, we need prices for the old mortgages.

Conceptually, the answer is simple: Haircuts should reflect current market values... But there is a problem: With the resale market for mortgages virtually shut down, there are hardly any market prices.

The draft legislation is vague on this point, perhaps necessarily so. My suggestion is that the Super F.H.A. categorize the mortgages ... into, say, "high," "medium" and "low" qualities and, based on its best guesses of fair market value, post initial buying prices for each type.

Then it should adjust those prices according to whether mortgage owners rush in to sell (meaning that the prices were set too high) or stay away (meaning that the prices were set too low). Thus can the government synthesize a market until a real one re-emerges.

SUNSET Emergency measures must not outlast emergencies. ... The legislation will ... end the granting of Super F.H.A. mortgages after a few years.

ELIGIBILITY AND SCALE How large should the mop-up operation be? Mr. Frank and Mr. Dodd are thinking about one million to two million mortgages, but they understand that a larger number might be necessary to stem the downward spiral.

Clearly, we would limit Super F.H.A. to refinancing primary residences — no second homes or houses bought "on spec," please. There should also be upper limits on both family income and house value — no McMansions. Beyond that, the Super F.H.A. would have to develop sensible criteria to screen out applicants who can afford their current mortgages without any help and those who cannot afford even new, less onerous mortgages.

The urgency of creating something like the HOLC or a Super F.H.A. has grown ... since I wrote my previous column. Credit markets remain traumatized despite [an] aggressive ... Federal Reserve. ...

Now we have the Frank-Dodd proposal, which, while not a panacea, offers a smart approach to a knotty set of problems — an approach that should breathe some life into the housing market, the mortgage market and the related securities markets. Their design is not flawless. But do you know of any perfect solutions? It deserves our support.

U.S. Recession Probabilities

My colleague Jeremy Piger's recession probability index has been updated (previous) with the latest data - through January 2008:


As you can see, historically, the index has been accurate. Currently, it's still headed upward, but it's not yet to the level where a recession is indicated:

Historically, three consecutive months of recession probabilities exceeding 0.8 has been a good indicator that an expansion phase has ended and a new recession phase has begun, while three consecutive months of recession probabilities below 0.2 has been a good indicator that a recession phase has ended and a new expansion phase has begun.

Let Them Eat Their Losses

Daniel Gross, like most everyone else, is unimpressed with John McCain's economic policies:

Staying on Bush's Course Here's some straight talk: McCain's fiscal program is either a joke or a fantasy, by Daniel Gross, Slate: In the last week, the three remaining presidential candidates made big-picture economic speeches.... Barack Obama ...[and] Hillary Clinton ... have remarkably detailed (and remarkably similar) platforms on how to attack the various economic woes facing America. ...

Unfortunately, the brains behind [John McCain's] economic operation seems to be former Sen. Phil Gramm, the Texas A&M economist-turned-senator... And the sections on McCain's Web site about domestic policy reveal, as Matt Yglesias noted, "a nearly astounding level of vacuity."

Reading McCain's economic agenda and listening to his speech, it appears that the problem with the last eight years is that we haven't seen enough tax breaks for the wealthy, that economic royalism hasn't been pursued with sufficient vigor, and that the middle and working classes haven't been stiffed sufficiently.

McCain wants to extend the Bush tax cuts, which he once opposed as a needless sop to the rich in a time of war. (I await David Brooks' inevitable explanation of how opposing taxes in a time of war in 2001 and 2003, when deficits were low, but supporting them in 2011, in a time of war and high deficits, is deeply moral and admirable.) But McCain wants to see Bush's tax relief and raise it some. ... "In all, his tax-cutting proposals could cost about $400 billion a year, according to estimates ... by CBO and the McCain campaign," the Wall Street Journal reported. And how to make up for the lost revenues? Hmmm. McCain promises to cut earmarks; to eliminate waste, fraud, and abuse; and to reduce the projected growth of Medicare; but he won't provide many numbers. ... Essentially, McCain wants to cut revenues by about 15 percent from current levels, with nothing close to that in spending reductions... Here's some straight talk: McCain's fiscal program is either a joke or a fantasy.

McCain's housing speech ... provided a good description of the problem. But his solution to an era in which financial deregulation set the stage for federal bailouts, rampant speculation, and reckless lending is ... less regulation. ...

For McCain, ... [p]oor decisions should not be rewarded—unless those poor decisions are made by really rich people who run investment banks and hedge funds. While "those who act irresponsibly" shouldn't be bailed out as a matter of principle, it's OK to take extraordinary measures to help banks prevent "systemic risk that would endanger the entire financial system and the economy." Obama and Clinton—and the Bush administration...—have argued that it might be possible to spare further systemic risk if something were done to buck up the fortunes of homeowners. Bollocks, says McCain. People should just put up more money for down payments and work harder to keep current with their mortgage payments. ...

At a time of rampant economic insecurity and low consumer confidence, at the end of a business cycle in which median incomes didn't rise and the percentage of working people with health insurance fell, McCain won't succumb to the easy temptation of saying that government policy can help improve the situation. But smart politics? I wonder. What's left of the Republican Party is becoming increasingly downscale, and many swing states have been ravaged by the housing crisis (Nevada, Florida) and globalization (Ohio, Michigan). Besides, he's already got the let-them-eat-cake vote sewed up.

Update: From Paul Krugman:

The Gramm connection, by Paul Krugman: Aha: the Politico notices that Phil Gramm, McCain's economic guru, can also be viewed as the father of the financial crisis.

The general co-chairman of John McCain's presidential campaign, former Sen. Phil Gramm (R-Texas), led the charge in 1999 to repeal a Depression-era banking regulation law that Democrat Barack Obama claimed on Thursday contributed significantly to today's economic turmoil. ...

According to federal lobbying disclosure records, Gramm lobbied Congress, the Federal Reserve and Treasury Department about banking and mortgage issues in 2005 and 2006.

During those years, the mortgage industry pressed Congress to roll back strong state rules that sought to stem the rise of predatory tactics used by lenders and brokers to place homeowners in high-cost mortgages

Where have I seen that before? Ah:

His chief economic adviser is former Senator Phil Gramm, a fervent advocate of financial deregulation. In fact, I'd argue that aside from Alan Greenspan, nobody did as much as Mr. Gramm to make this crisis possible.

Seriously, the Gramm connection tells you all you need to know about where a McCain administration would stand on financial issues: squarely against any significant reform.

links for 2008-03-29

March 28, 2008

Economist's View - 4 new articles

Trust in the Fund

This is worth echoing:

About the Social Security trust fund, by Paul Krugman: I see from comments on an earlier post, plus some of the incoming links, that the whole "there is no trust fund, so the system will be in crisis in 2017″ thing is still out there. So I'm just going to reprint what I wrote about this three years ago:

Social Security is a government program supported by a dedicated tax, like highway maintenance. Now you can say that assigning a particular tax to a particular program is merely a fiction, but in fact such assignments have both legal and political force. If Ronald Reagan had said, back in the 1980s, "Let's increase a regressive tax that falls mainly on the working class, while cutting taxes that fall mainly on much richer people," he would have faced a political firestorm. But because the increase in the regressive payroll tax was recommended by the Greenspan Commission to support Social Security, it was politically in a different box - you might even call it a lockbox - from Reagan's tax cuts.

The purpose of that tax increase was to maintain the dedicated tax system into the future, by having Social Security's assigned tax take in more money than the system paid out while the baby boomers were still working, then use the trust fund built up by those surpluses to pay future bills. Viewed in its own terms, that strategy was highly successful.

The date at which the trust fund will run out, according to Social Security Administration projections, has receded steadily into the future: 10 years ago it was 2029, now it's 2042. As Kevin Drum, Brad DeLong, and others have pointed out, the SSA estimates are very conservative, and quite moderate projections of economic growth push the exhaustion date into the indefinite future.

But the privatizers won't take yes for an answer when it comes to the sustainability of Social Security. Their answer to the pretty good numbers is to say that the trust fund is meaningless, because it's invested in U.S. government bonds. They aren't really saying that government bonds are worthless; their point is that the whole notion of a separate budget for Social Security is a fiction. And if that's true, the idea that one part of the government can have a positive trust fund while the government as a whole is in debt does become strange.

But there are two problems with their position.

The lesser problem is that if you say that there is no link between the payroll tax and future Social Security benefits - which is what denying the reality of the trust fund amounts to - then Greenspan and company pulled a fast one back in the 1980s: they sold a regressive tax switch, raising taxes on workers while cutting them on the wealthy, on false pretenses. More broadly, we're breaking a major promise if we now, after 20 years of high payroll taxes to pay for Social Security's future, declare that it was all a little joke on the public.

The bigger problem for those who want to see a crisis in Social Security's future is this: if Social Security is just part of the federal budget, with no budget or trust fund of its own, then, well, it's just part of the federal budget: there can't be a Social Security crisis. All you can have is a general budget crisis. Rising Social Security benefit payments might be one reason for that crisis, but it's hard to make the case that it will be central.

But those who insist that we face a Social Security crisis want to have it both ways. Having invoked the concept of a unified budget to reject the existence of a trust fund, they refuse to accept the implications of that unified budget going forward. Instead, having changed the rules to make the trust fund meaningless, they want to change the rules back around 15 years from now: today, when the payroll tax takes in more revenue than SS benefits, they say that's meaningless, but when - in 2018 or later - benefits start to exceed the payroll tax, why, that's a crisis. Huh?

I don't know why this contradiction is so hard to understand, except to echo Upton Sinclair: it's hard to get a man to understand something when his salary (or, in the current situation, his membership in the political club) depends on his not understanding it. But let me try this one more time, by asking the following: What happens in 2018 or whenever, when benefits payments exceed payroll tax revenues?

The answer, very clearly, is nothing.

The Social Security system won't be in trouble: it will, in fact, still have a growing trust fund, because of the interest that the trust earns on its accumulated surplus. The only way Social Security gets in trouble is if Congress votes not to honor U.S. government bonds held by Social Security. That's not going to happen. So legally, mechanically, 2018 has no meaning.

Now it's true that rising benefit costs will be a drag on the federal budget. So will rising Medicare costs. So will the ongoing drain from tax cuts. So will whatever wars we get into. I can't find a story under which Social Security payments, as opposed to other things, become a crucial budgetary problem in 2018.

What we really have is a looming crisis in the General Fund. Social Security, with its own dedicated tax, has been run responsibly; the rest of the government has not. So why are we talking about a Social Security crisis?

Interest Rate Resets, Falling Prices, and Foreclosures

I didn't post John Berry's most recent article, Fed Actions Defuse Subprime ARM Rate Reset Bomb, because I wasn't sure if interest rate resets are the major source of the foreclosure problem. There's evidence that falling prices are the main source of the foreclosure problem, not interest rate resets, and I didn't want to push the "don't worry so much" point, or focus attention on resets, if that is not the right thing to look at. First, here's Brad DeLong's summary of John Berry's article:

John Berry Notes that the ARM Reset Bomb Has Been Somewhat Diffused..., by Brad DeLong: He writes, for Bloomberg:

Bloomberg: Many analysts and public officials have said that foreclosures of subprime adjustable-rate mortgages would soar this year as owners' monthly payments jumped when interest rates reset to a higher level. Not only is that unlikely to happen, this year's resets of earlier vintages of subprime mortgages may even reduce some payments that increased in 2007. The reason? The index to which many ARMs are tied is the six-month London inter-bank offered rate, or Libor, and that rate has fallen from more than 5.3 percent last fall to about half that level. The Federal Reserve's cuts in its target for the overnight lending rate -- the last to 2.25 percent on March 18 -- from 5.25 percent in mid-September, plus actions to increase liquidity in the inter-bank lending market, have caused the Libor to fall.

Unfortunately, most of the defaults and foreclosures that have wreaked havoc in financial markets haven't been due to resets so far. Many borrowers simply bought a house or condo they couldn't afford unless bailed out by rising prices, and lower rates alone won't help them much. Still, the big drop in Libor means there likely will be many fewer foreclosures than there would have been.

Much of the discussion about the danger of resets has focused on the initial interest rate, or ``teaser rate,'' that ARMs carried. That left the impression it was a very low rate that would adjust up a lot. Most of the initial rates were 8.5 percent or above, and now many are set to adjust hardly at all...

Here's why I wonder if this is missing the main factor behind foreclosures. This is Richard Green (original post with graph):

Is Everything we Know About Subprime Wrong?, by Richard Green: Yesterday I saw a great talk by Paul Willen of the Boston Fed. An earlier version of the paper he gave is here.

I don't think I am caricaturing what he said to say when I describe the following takeaways from his talk:

(1) Falling house prices lead to defaults more than defaults lead to falling house prices. ...

(2) Interest rate resets have little of anything to do with the large number of defaults we are observing. For the vast majority of subprime loans, defaults or refinances happen before resets take place. It is moreover the case that the size of the resets is smaller than most of us think, because the initial teaser rates are pretty high.

(3) While ARMs have higher default rates than FRMs, putting ARM borrowers into FRMs will not necessarily reduce defaults. ...

Beyond this last point, a working paper I have with Cutts and Ramogopal shows that ARM borrower are fundamentally more likely to be risk-takers than FRM borrowers, so the difference in loan performance between the two products may say more about the distributions of the different borrowers, rather than the products themselves.

In any case, all of this means that many of the policies being pushed at the moment (such as interest rate freezes) may not be particularly helpful in resolving the crisis.

I decided to post on this after all because a debate has broken out about whether Berry's conclusion about resets is correct. But if resets aren't the big problem we should worry about, whether he's right or wrong isn't as important and we should shift our focus away from resets and toward policies that prevent or attenuate falling prices.

With respect to the debate over resets, here's Andrew Leonard with a summary of Yves Smith's criticism of Berry's conclusions:

Whatever happened to the great ARM reset crisis?, by Andrew Leonard: Remember all the concerns expressed about the great ARM reset bulge of 2008, when the introductory, low-rate periods of millions of adjustable-rate mortgages were supposed to expire and send countless more American homeowners into foreclosure?

On Thursday, Bloomberg News columnist John Berry suggested that the reset crisis wouldn't be as bad as once predicted. He gave two reasons: First, the interest rate cuts orchestrated by the Fed are having the desired trickle down effect of putting downward pressure on the interest rates that various ARMs will reset at, and second, contrary to popular belief, most borrowers don't actually have mortgages with absurdly low initial interest rates, so they won't suffer too much damage. ...

Berry based his conclusions on data presented in a recent report from two New York Federal Reserve Bank economists...

I read Berry's column on Thursday and considered noting it here. How the World Works savors contrarian takes. But in my judgment, over the past two years that I've been following his coverage of the Federal Reserve and the economy, Berry has consistently understated the potential harm that might be wreaked by the housing bust and credit crunch. ... So I decided not to call attention to yesterday's Berry column, figuring it just wasn't that interesting that someone who has a track record of optimism about the economy was ladling out some more good cheer.

With this background, readers might therefore understand why I was intrigued to read Naked Capitalism's Yves Smith analyze Berry's column this morning and call it "extraordinarily misleading."

Emphasizing that the data Berry based his conclusions on came from just one month of mortgage-backed securities issued by just one mortgage lender, Smith took the time to look at a database containing information on 38 million mortgages issued between 2004 and 2006. That database shows that out of 8.4 million ARMS originating during that time period, only 9.1 percent had initial interest rates of 8.5 percent or higher. A whopping 1.1 million were 2 percent or lower. (Contrast that to Berry's assertion that "most of the initial rates were 8.5 percent or more.") ...

Again, though, we shouldn't get too wrapped up in this debate if it is not the source of the problem. If it's prices and not resets, then policy prescriptions need to deal with price effects, e.g. setting a price floor, rather than wasting a lot of time constructing proposals to insulate homeowners from interest resets.

On price floors and mortgage bailouts to prevent foreclosures, it's nice to see people coming around to the idea. Ryan Avent of The Bellows discusses how we determine irresponsible actions, if we even can, and what this means for policy:

More on Mortgage Bailouts, The Bellows: It should be clear that I'm coming around on the idea of providing assistance to struggling homeowners, for a number of different reasons. A big one is that the case for concern about moral hazard grows weaker by the day. In looking at McCain's mortgage assistance plan (which is, basically, there will be none), you see that he doesn't want to reward those who got themselves into this position by acting irresponsibly. But is it the case that most of the people harmed by the housing collapse are those who acted irresponsibly? ...

The ... fate of an individual homeowner depends on the state of the market. McCain says he doesn't want to reward folks who bought a house knowing they could only afford it if prices continued to rise. Fine. How does he feel about folks who bought a house knowing they could afford it so long as prices didn't decline by 20 percent? Or so long as half the surrounding homes didn't enter foreclosure?

Why is this important? Let me quote OFHEO:

The causal relationship between home prices and foreclosures is two-directional: high foreclosure activity can both cause and be caused by home price declines. Home price declines can cause foreclosures by decreasing the equity homeowners have in their properties. Mortgagors are much more likely to default on their loans if the current value of their property falls below the outstanding loan balance... Declines in home prices will increase the frequency with which homeowners ... "walk away" from the property and the mortgage.

Home foreclosures contribute to weakening prices by introducing additional supply to the inventory of unsold homes. Compounding this influence is the fact that the sellers of foreclosed homes, frequently creditors, may be strongly averse to holding onto the property for an extended period of time. As a result, they may be willing to sell for lower prices than resident homeowners.

So, we had some borrowers who were going to default if prices quit skyrocketing. When prices quit skyrocketing, they went belly up, and prices stopped rising entirely. Then the borrowers who needed prices to rise at least a little went belly up, pushing prices downward. Then the borrowers who needed prices to at least stay level went belly up, pushing prices downward. You see where this is going.

At the same time, troubles in credit markets due to defaults have pushed up key interest rates and made it difficult for potential buyers to get loans, heaping still more downward pressure on housing markets. The end result is that a lot of people who weren't speculating, and who weren't really being too reckless, have found themselves in a great deal of trouble.

At some point the best way to handle this issue is not to make sure that wrongdoers are punished, because the damage has simply spread too far and included too many people who weren't trying to game the system. At that point, you bail out the system to keep it from sinking, and you fix the rules that allowed this situation to arise in the first place. We're at that point, and the failure to recognize that fact will mean that this cataract just sucks in a steadily widening field of homeowners, who are steadily less responsible for the problems we face.

That's the argument I've been making, "you bail out the system to keep it from sinking, and you fix the rules that allowed this situation to arise in the first place."

Update: I have a question, and it's come up in comments as well. It's easy to explain how interest rate resets could increased foreclosure rates since the monthly housing payment will change as a result of the reset, but why do falling prices cause increased foreclosures? Falling prices don't change monthly payments, so why do more people default?

I can think of one reason. Every month, a certain number of people will become unemployed and the unemployment event itself could cause foreclosures if they cannot meet monthly payments. But the problem is worse when prices are falling below loan values since if the person needs to move to take a new job, the only option they may have is to move and default on the loan, or stay where they are and default on the loan (and there's no longer any equity in the house that can be used to tide them over until they get another job). Thus, as housing prices fall and this happens more and more often, we see foreclosure rates increasing (the fall in housing prices may be associated with rising unemployment rates making it worse). Similarly, many housing sales are driven by divorce. When this happens and neither person can make the payments alone, it's often necessary to sell the house. If prices are falling, default is more likely since they may not be able to make up the difference between the loan value and the value of the house. Neither of these explanations have much to do with people making bad decisions about the housing purchase per se, if they had stayed employed or stayed married they could have made the payments, but that's not what happened. When housing prices are falling below loan values, the problems people experience in life are amplified.

How else could falling prices increase foreclosures?

Paul Krugman: Loans and Leadership

What do the presidential candidate's responses to the mortgage crisis tell us about the kind of president each is likely to be?:

Loans and Leadership, by Paul Krugman, Commentary, NY Times:

When George W. Bush first ran for the White House, political reporters assured us that he came across as a reasonable, moderate guy.

Yet those of us who looked at his policy proposals — big tax cuts for the rich and Social Security privatization — had a very different impression. And we were right.

The moral is that it's important to take a hard look at what candidates say about policy. ...[P]olicy proposals offer a window into candidates' political souls... Which brings me to the latest big debate: how should we respond to the mortgage crisis?...

Mr. McCain is often referred to as a "maverick" and a "moderate"... But his speech on the economy was that of an orthodox, hard-line right-winger. It... was more about what Mr. McCain wouldn't do than about what he would. His main action proposal, as far as I can tell, was a call for a national summit of accountants...

Mr. McCain more or less came out against aid for troubled homeowners: government assistance "should be based solely on preventing systemic risk," which means that big investment banks qualify but ordinary citizens don't.

But I was even more struck by Mr. McCain's declaration that "our financial market approach should include ... removing regulatory, accounting and tax impediments to raising capital." ... Mr. McCain is selling the same old snake oil, claiming that deregulation and tax cuts cure all ills.

Hillary Clinton's speech could not have been more different.

True, Mrs. Clinton ...[has] echoes of the excessively comfortable relationship her husband's administration developed with the investment industry. But the substance of her policy proposals..., like that of her health care plan, suggests a strong progressive sensibility.

Maybe the most notable contrast between Mr. McCain and Mrs. Clinton involves ... restructuring mortgages. Mr. McCain called for voluntary action on the part of lenders — that is, he proposed doing nothing. Mrs. Clinton wants a modern version of the Home Owners' Loan Corporation, the New Deal institution that acquired ... mortgages..., then reduced payments to a level ... homeowners could afford.

Finally, Barack Obama's speech ... followed the cautious pattern of his earlier statements on economic issues.

I was pleased that Mr. Obama came out strongly for broader financial regulation... But his proposals for aid..., though significant, are less sweeping than Mrs. Clinton's: he wants to nudge private lenders into restructuring mortgages rather than having the government simply step in and get the job done.

Mr. Obama also continues to make permanent tax cuts ... a centerpiece of his economic plan. It's not clear how he would pay both for these tax cuts and for initiatives like health care reform, so his tax-cut promises raise questions about how determined he really is to pursue a strongly progressive agenda.

All in all, the candidates' positions on the mortgage crisis tell the same tale as their positions on health care: a tale that is seriously at odds with the way they're often portrayed.

Mr. McCain, we're told, is a straight-talking maverick. But on domestic policy, he offers neither straight talk nor originality; instead, he panders shamelessly to right-wing ideologues.

Mrs. Clinton, we're assured by sources right and left, tortures puppies and eats babies. But her policy proposals continue to be surprisingly bold and progressive.

Finally, Mr. Obama is widely portrayed, not least by himself, as a transformational figure who will usher in a new era. But his actual policy proposals, though liberal, tend to be cautious and relatively orthodox.

Do these policy comparisons really tell us what each candidate would be like as president? Not necessarily — but they're the best guide we have.

links for 2008-03-28