Moral Hazard, the Subprime Market and the Nanny State

Foreclosures tick up a bit, and government officials are falling all over themselves to save people from themselves. Ohio is planning on issuing a $100 million bond to bail troubled borrowers out. See this article in USA Today for details. And now, Freddie and Fannie already under significant pressure for their financial shenanigans, are rolling out new products to deal with the fall out.

Fannie and Freddie innovating to help out is not as big an issue for me personally. Though, I suspect the political pressure being brought on them has something to do with it.

Here is where the moral hazard comes in though. If states like Ohio, or probably California soon, or even the Federal Government spend tax dollars to essentially bail out borrowers who made poor decisions, then what is the incentive for those borrowers or any borrowers to do their due diligence and make sure they can afford a home? There is none. This was not a failure of the private market. People made bad decisions, and companies made bad decisions in extending credit. The rush of politicians to shield people and companies from their poor decision is one step further down the road of infantalizing the populace.

This is bad from an economic standpoint because of the moral hazard, and how it distorts future market decisions, and even worse from a policy perspective because it reinforces the idea that the government is the answer to everything.

So, maybe next time, I have difficulty paying the bills, I'll send a request to my buddies in Washington, they can pay it for me. We can call it an earmark, after all, there's no reason I should starve because I spent too much money going to Vegas. (ed: is it possible to spend too little money in Vegas?)

Subprime (Again....)

Felix Salmon over at his new blog points an article at Bloomberg, which I hadn't noticed. Fremont General, a large-sized originator of "subprime" loans, has recently sold several chunks off at a loss. The latest was a $2.9 billion chunk of loans, while we don't know the explicit quality of these loans, we can make a few assumptions here. First, Fremont sold these at a $100 million discount. Do the math and that is an expected loss of about 3.45%. If we make the assumption that this particular chunk of loans is representative of the market, then the so-called meltdown in subprime is not something to feared, it'll hurt, but it is not the end of the world.

Also, I would point out, this how healthy financial markets work. They discount and work through the bad stuff. Just as we did after the S&L crisis. In the apartment market we are already seeing that, with reversions of condo-conversions happening, and some minor REO stuff on failed conversions. There is significant amounts of "vulture" capital waiting to make a play.

Watch the subprime market, but if Fremont General is any indication, it won't be as bad as some are prognosticating.

Chasing Yields

The more and more data that I look into, it becomes apparent that Fed Chairman Ben Bernanke may have been on to something with his notion of a liquidity "glut." I wouldn't use the term glut, because that implies an excess of what the market demands. I don't believe that is the case, as the supply of capital has shifted to the right in a traditional AD / AS framework, we would expect more investment at a lower interest rate. Let me fill you in on some of the research that I've done. First let me preface it with the conventional wisdom in Commercial Real Estate, which is that investors are chasing yields, and so are banks. This is true, low lending rates have driven down cap rates and in some cases, below lending rates, meaning the owners are what I call "momentum" investors. They are gambling that the market will appreciate. This is particularly evident in Southern California. Rule of thumb, anything below about a 6.25% cap based on actuals, is someone who is banking on momentum, or they are engaging in a redevelopment through conversion or rehab.

So back to the story, I am doing some research on India for my global macroeconomics class, and interestingly enough real yields on Indian debt have declined over the last several years. We can mark this off as coincidence, based on better management of inflation by the Central bank. Yet the key story is that inflation accelerated in 2006, from 3% to about 6% (according to the Economist Intelligence Unit), and interest rates did not respond. What was astounding to me, and this really connects into monetarism, is that the supply of M2 jumped from a growth rate in the teen, about 18% in 2005 if memory serves, to over 24% in 2006. Inflation up? Coincidence? I'll let you be judge. So, in India we have declining real rates of interest.

Across the small pond we call the Pacific Ocean, and across a few mountains, we come to lovely state of Texas. So how are India and Texas linked? From 1990 to 2002, gross nominal yields averaged about 17.5%. By 2006, those same yields had fallen to 11.6%. As they say, the plot thickens....

More on Subprime

And this is what passes for analysis from Nouriel Roubini:

"This fairy tale spinned by free market supply side voodoo fundamentalism zealots will blame the otherwise appropriate current Congressional action on predatory lending for being one of the main causes of the credit crunch that will lead to a painful recession (as the WSJ editorial page recently claimed) while forgetting that predatory lending practices developed by free unregulated markets created the toxic waste that is subprime and near-prime mortgages.. This voodoo religion cabal will also incorrectly blame regulators"

I am not sure if this whole sentence qualifies as "analysis." I recognize that we as the blogging community are not all that filtered, but as an economist, we do like approach things from an objective manner. Roubini clearly does not, and lets his emotions color his analysis, which is very unfortunate. It may fire up his fans, but hardly leads to intelligent debate.


Dave Altig, over at macroblog covers this ground from a less excited perspective yesterday. The risk is two fold From a housing perspective, how long does the reduction in credit to the riskier borrowers last? And what effect does that have on housing demand? Secondly, does the default risk as Altig points out spread to commercial mortgages?


The answer remains... we shall see.


As a side note, apartments will likely benefit from the lack of liquidity in the subprime market. This will be very regional, but could spell good news for places like North Scottsdale, and other prime Class A buildings / Locations, who lost a lot of renters to conversions and for-sale housing.

More Thoughts on Subprime

Alex Tabarrok at Marginal Revolution hits the nail on the head on what really distresses the whole bubble blogger / subprime bear contingent. It comes through in their language (McMansions, Housing ATM, 'binge' borrowers, reckless, etc etc, ) (ed: we get the point) . It really is about expanded access to credit, that the poor and unwashed, might (gasp) actually be able to buy a house. As the Instapundit would say.... read the whole thing

Inflation- Current CPI Report

Dave Altig, over at the always excellent macroblog, has an interesting post with a round-up of the recent inflation report.

Altig is eminently more qualified than I to discuss the details of inflation reporting. Suffice it to say, the news is not looking good on that front, and it is making it increasingly less likely that the Fed will lower short-term rates. A lot of the recent market talk has focused on the idea that inflation will fall exogenously because of slower growth. Suffice it to say, this is not proving to be the case. My thinking is not fully fleshed out, but taking a look at the CPI, I pulled out some components, as proxies for the tradable goods sector, and for the protected sector. I pulled appliances, machine tools, shelter and education. Appliances and machine tools are very open to foreign competition, and education and shelter are not (for obvious reasons). Education costs are an old story, and as expected have been increasing on average over 6% a year. Shelter, though is weighted as a fairly large portion of the CPI. For a while, it seemed to increase at about the general rate of inflation. Then recently, particularly in the second half of 2006, that rate of increase shot up averaging 4% for the last six months. For the first two months of the year, it is an excess of 4%. As has been noted previously, shelter costs are lagging, so that inflationary pressure will likely subside by the second half of 2007. Still, for me the more disturbing trends was the proxy variables for appliances and machine tools. This tells me that import pricing, which has been a deflationary drag on the overall CPI is no longer helping out, and because of that, inflation risks remain to the upside. Those betting on a fed rate cut anytime soon, do so at there own risks. I have been an optimist up to this point on the fate of the economy, but numbers like these don't help the case. The imbalances being built up by China and to a lesser extent Japan (via the carry trade) are beginning to show up outside of the commodity markets.

Light Posting

I got caught up in a few things at work and also for school. As such, I'll cross post my essay here. This essay was written for my favorite class so far in my MBA. Why??? Well, duh, its econ! And as my professor said, loving economics is a good thing.

Without further ado...

Essay 2

If one considers two countries that have different levels of technological infrastructure (e.g., expenditures on private and/or public research and development, large amounts of spending on advanced university research centers for "high technology", extensive patent laws that are enforced aggressively within the country, etc.), which country might be more at risk relative to long-run economic growth? Explain using the module. Can public policies be developed to try to alter this situation, and if so, what measurements might help us summarize the extent and impact of such public policies on economic growth?

The two countries that are the subject of this essay will be called Techie and Laboria. Techie is characterized by high levels of technological infrastructure, with quality universities, government subsidized R&D, strong protections for intellectual property, an efficient and well protected patent systems, and a strong respect for the rule of law, as it is aggressively enforced. Laboria is quite the opposite, it has weak institutions, bribery is commonly known, intellectual property protection if it exists is weak, and the few universities that do exist are oriented toward educating the elite and are considered prestigious because graduates are strong candidates for entry into the civil service.

Risks to Growth

Techie will likely be the least at risk relative to long-run economic growth. Its institutions and technological infrastructure make it more likely that it will see continued Total Factor Productivity (TFP) growth. High levels of research spending make it more likely that breakthroughs will occur and strong intellectual property laws that are vigorously enforced provide an incentive for private-sector agents to continue to pursue research. A strong university system makes it likely that Techie will be strong in basic research, which seems to provide the foundation for future technological change, which leads to higher TFP through better machines and workers. Due to its excellent university system, strong institutions, and strong legal apparatus, superior products and companies will have access to the marketplace. The best products will have the chance to succeed, and the energy of entrepreneurs and business people, will be focused on satisfying market needs rather than responding to the dictates of government or working to influence those dictates to benefit themselves.

For precisely the opposite reason, Laboria faces a far greater risk of stagnation. Weak institutions, and a cosseted elite rule a country with little respect for the rule of law, but rather on the rule of whom you know. Little or no research means that Laboria does not innovate but rather copies. The lack of an intellectual property framework reduces the incentive to innovate, because it is easier to simply copy others, especially since the marketplace is directed towards ruling coterie’s benefit. The closed nature of Laboria’s economy allows the elites who hold special licenses to import certain goods to gain monopoly profits. Overall, the lack of genuine market system, strong rules for enforcing contracts, and a closed economy, as much as a lack of technological research capability inhibit the growth of Laboria.

Policy Guidelines-Techie

Techie should take further steps to open its economy to foreign trade, as it will benefit from a wider pool of investment capital and foreign technical know-how. It should continue to invest heavily in education and research. Education investment is dependent on its level of development. Techie should invest where it will gain the greatest returns. Techie should continue to insure that playing field is level for all competitors and that price signals are accurately given in the economy. Private property rights, both physical and technical should continue to be enforced. In other words, Techie should strengthen the public policy steps it is already pursuing to maintain increases in TFP.

Policy Guidelines-Laboria

High investment in universities or shipping students off to foreign countries is a standard practice in less well off countries. It is in fact, the wrong step to take. The best thing that Laboria can do, is the hardest, and that is begin to open its economy and loose the “animal spirits” of free enterprise.

Property Rights

The first step in this process is codifying and establishing property rights, and working to ensure the legal system protects them. Hernando De Soto identifies undefined property rights held by the poor as a huge source of untapped assets, which can power economic growth by establishing a basis for credit to be granted. I would also argue that a stable monetary framework is an essential part of stable property rights. Through inflationary monetary policies governments undermine the property (savings) of its citizens.

Trade

After property rights on a physical level, trade needs to be opened up to bring in foreign expertise and technology. As the economy opens up, workers will need to be educated and labor laws relaxed.

Human Capital

Education should initially focus on literacy for the general population and primary education.

Transparency and Government

The size and role of government should be reduced to reduce the scope for bribe taking and rent seeking. This is a long process in a country, and one of the best ways to reduce corruption is by promoting transparency in government, and by limiting its role. As the income of the country starts to grow through the basic steps of reducing the diversionary role of government, the middle class will grow and in the process create the basis cultural and societal framework that is conducive to a strong civil society that will promote greater advances in growth.

Innovation and Intellectual Property

At this point as the returns from playing catch up begin to diminish, it will be necessary to build on physical property rights by implementing increasingly stronger intellectual property protection. Coincident with the development of an innovation oriented growth policy; competitive universities and research institutions should be developed. The development into serviceable products of basic research should be left to the private sector as they will be market driven and have a better idea of how basic research should be translated into an actual product. The key point here is that the incentives for innovation should be created through the introduction of a serviceable and enforceable patent system. Though, the optimal balance must be found between intellectual property protection and the diffusion of innovation, so that organizations don’t hide behind intellectual property laws to protect their monopolies and therefore retard innovation that is essential to continued growth.

Markets and Regulatory Policy

I am hesitant here to strengthen the hand of government because it is often used to deaden the “invisible hand” rather than strengthen it. In this case, there is a role for government in ensuring a clean civil service, open entry into markets, and protecting the populace. In doing all this, the government should work to make sure that the tax base is broad and as non-distortionary as possible. It is here in the tax code that in rich countries, especially the United States that there has been numerous avenues opened for rent seeking. The tax code should be as neutral as possible in concerning the actions of economic agents. The specific role of government should focus on consumer welfare and regulatory agencies should be held to a strict standard of cost-benefit analysis when implementing new regulations.

Conclusions

The challenges that Laboria and Techie face are very different, and the consequent policy prescriptions are slightly different. Techie’s policy should focus on continuance of its existing policy and adapt government regulation to technological change. Laboria faces the much greater task of reorienting its entire framework towards a growth-oriented policy. The best thing Laboria can do is to begin to level the playing field and allow the market to work. As this process opens up, Laboria will grow faster than Techie because it will be playing catch up, and we will begin to see economic convergence between the two. As that happens, the policy of Laboria needs to change its emphasis towards Techie’s initial emphasis on promoting innovation. Good policy will promote strong growth in TFP.