“Opacity is absolutely essential to modern finance.” “Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper.” Steve Waldman

This is a response to three posts at Interfluidity that argue that banking is essentially a con job.   The quotes here are from those posts except as noted.

While I agree on the issue of “opacity” (bankers lend money and it is difficult or impossible for depositors and creditors to monitor bank assets), I also think that Waldman is confusing two things:  modern finance and the financial systems that facilitated economic development.  They have/had very different characteristics:

• Modern banking:  limited liability, government-guaranteed deposits, high risk of loss to bank creditors (in the absence of government intervention).
• Before 1930:  at least double liability, deposit “contracts” that were always implicitly conditional, and comparatively low risk of loss to bank creditors (in the absence of government intervention).

In short, prior to the 1930s the assets of the bank-owners themselves were very much at stake with the result that their leverage ratios were much, much lower than in modern times.  (Econometric analysis indicates that  in the late 1800s neither the leverage ratio nor the size of banks was a predictor of either bank profitability or stability of profits.   Lamoreaux, Insider Lending, pp. 97-98.)

History:  Unlimited liability and the nature of the deposit “contract”: 

“A banking system is a superposition of fraud and genius”  “Banks guarantee all investors a return better than hoarding, and they offer this return unconditionally, with certainty,”  “First and foremost, they offer an ironclad, moneyback guarantee.”

Waldman’s model of banking has these properties, perhaps, because he’s referencing a world with deposit insurance instead of bank failures – that is, a world with explicitly government backed deposits:  this form of banking has been around for just three quarters of a century.  Historically banking is built on a conditional promise to depositors to return the money unless the bank closes its doors.  When the bank closes its doors, “time” is lost, but because nobody would entrust his money to a banker who wasn’t wealthy and subject to liability (either unlimited or capital calls on stock owners to pay debts), once the banker’s horses, etc. are sold, you get your money back.  Depositors understood that “time” could be lost and that only a fool would leave his money with someone who wasn’t wealthy.  The contract was conditional on the risk of temporary illiquidity and, in practice, conditioned on the assets of the banker.

To the degree that Waldman’s concept of banking is based on the Diamond and Dybvig model, even they acknowledge that the 19th century solution to the problem of bank runs, suspension (i.e. closing the bank and liquidating) also solved the problem.  It is only dominated by deposit insurance if the insurer has the ability to target a tax to those who withdrew money during a run (or to achieve the same result via inflation).

History:  Bank losses were put to the owners of the bank:  While crises and bank failures were common, there are many historical examples of major bank crises that didn’t result in losses to depositors’ principal.  (See for example the failure of Overend and Gurney in England, which was the Lehman’s of 1866.)

“Second, they point to all the other people standing in front of you to take the hit if anything goes wrong.”

This is a pure invention of modern “limited liability” banking.  Even through the early years of the 20th century, bank shareowners were subject to capital calls in the event the bank failed.  In Britain bank stock was usually purchased by paying only a fraction of par, leaving stockholders subject to a capital call that could be a multiple of the original payment.  In the US the norm was double liability, so stockholders who bought shares with a par value x, were liable for a “second” capital call of x. (Double liability was part of the National Bank Act of 1864 and also enacted by most state legislatures.  It was the law in Massachussets even earlier.)  It’s not clear that losses of principal (i.e. excluding “time”) to depositors due to bank failures were either common or large.  It’s my understanding that there were no such losses in England from 1850 through 1900 – and probably very few between 1800 and 1850.  In the US there were most likely some losses, but how significant were they after the whole legal process was complete?

 “ ‘Shadow banks’ are nothing new under the sun, just another way of rearranging the entities and guarantees so that almost nobody believes themselves to be on the hook.  This is the business of banking.”  “Since no one (most especially the financiers) believes themselves to have agreed to be the bagholder, we are left in an ocean of conflict over who must bear what costs.”

I disagree.  This is the modern business of banking.  When our financial system developed the ones who were most at risk were the bankers themselves.

Bagehot’s Lombard Street is in many ways about the growth and contraction of a shadow banking system.  The “bill-brokers” — of which Overend was by far the largest — grew up as undercapitalized shadow banks that relied extremely heavily on the lender of last resort facilities of the Bank of England in crisis.  The Bank objected to the quantity of Overend bills it had discounted and told Overend/the bill-brokers that they would have to find their own source of capital in the next crisis.  In 1866 the Bank of England kept its word and Overend failed.  As noted above, the Overends had to sell their personal assets (and there was a capital call on shareowners), but every penny was repaid to creditors.

After this crisis, British finance continued to flourish.   The lesson I draw from this is that the key to central banking and a strong financial system is knowing when to close the liquidity spigot.

In fact, it is possible that the problem created by bank failures in the depression may not have been losses to depositors (although they were certainly the more visible), but the wiping out of the stratum of society that had the reputational and financial assets to be bankers or invest as shareholders in banks (i.e. the capacity to answer and the willingness to risk a capital call).

Opacity, confused creditors and growth

“Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper.”
“Industrialization occurs in societies with corrupt and fragile big banks.”

From a historical perspective this is unsupported by the evidence.  Societies that develop and prosper have banks that pay their depositors back from the assets of the owners of the bank, should the bank fail.  This is the reason bankers were trusted with “other people’s money” in Venice, in Amsterdam (each, the center of world trade in its time), in 18th and 19th c. England and in the US through the 1920s.  Only in modern times did anyone imagine it is possible to have financial system populated by entities with complete limited liability.  (Observe that banking systems will full liability also can collapse – usually because the flourishing economic activity that made it worthwhile for bankers to take the risk of losing all their property evaporates for external reasons.)

I think the truth that underlies Waldman’s argument is that it’s impossible to have a truly competitive financial system, without destroying the financial system itself – and this is one of the greatest errors of modern finance. Why?  Historically, bankers must take risks and their assets must be at risk; bankers will only do this if they make a hefty return.  In modern times, they must be highly compensated simply to keep them from taking advantage of their access to other people’s money and their abundant opportunities to profit from activities that tend towards fraud.  They will be wealthy, they will control the payments system, and they will favor policies that are in their own interests, not those of the general public.  They will be the target of populist complaints.  If you try to address these complaints by introducing too much competition, you will compete away the profits that will compensate them for their risk (or their access to pilferable funds).  Theory tells us that given too much competition, bankers will decide they’re better off stealing people’s money.

(cf. “Information asymmetry (the source of opacity) is built into the very fabric of the division of labor in complex societies. …  insiders’ privileged position and knowledge enable them to extract rents.”  http://epicureandealmaker.blogspot.com/2012/01/all-together-now.html  )

Banking and capitalism

Bankers have historically been the “capitalists” of their time, but only if one understands “capitalism” in the Marxist sense of the word.  Bankers are the wealthy making profits off their wealth.  In modern times where non-wealthy individuals enter the banking profession, the bankers are profiting from their position in a company that has vast amounts of money at its command.  Because these companies have limited liability — and abundant government support systems — however, society, not the owners of the bank are the true sources of their capital.  When profits are being made off of capital provided by the public, a better word for what the bankers are doing is probably best characterized as socialism.  (cf.  Prof. Varma on safe assets, h/t Ashwin Parameswaran)

“Part of what makes an FDR different from a Mitt Romney is that an FDR understood his power to be derived from more or less arbitrary privilege, while a Mitt Romney imagines himself to have “eaten what he killed” in brutally efficient markets.”  Yes.

“They persuaded themselves, long before they persuaded the rest of us, that any games they played for their own enrichment would necessarily lead to social gain over the long term.”  This is very true too.  One thing I’ve learned from blog discussions is that traders think it’s socially efficient for them to make money off of the sorry, uninformed creature who thinks that asset is worth what he’s paying for it.  (They  obviously missed the Econ 101 class on asymmetric information and efficiency.)

“What the market will bear” is not a sufficient statistic for ones social contribution. Sometimes virtue and pay are inversely correlated. Really! People have always been greedy, but bankers have sometimes understood that they are entrusted with other people’s wealth, and that this fact imposes obligations as well as opportunities.

I’m not sure that the right approach to this problem is to place “obligations” on bankers.  I’d opt for incentives.  Jamie Dimon’s houses and financial assets should go on the block to pay creditors if J.P. Morgan fails.

Would this reduce risk-taking?  Absolutely.  But in a good way.  Bankers need to be incentivized to take reasonable risks, not unreasonable ones.  Keep in mind that industrialization and modern banking was born in an environment with precisely these characteristics.

Does (financially-supported) growth require misinformed bank creditors? No

“I claim we would forego a lot of plain booms, the kind that ultimately enrich investors as well as society at large, if we didn’t have a financial sector skilled at getting people to assume risks they’d not directly consent to take.”

I think that what Waldman is missing here is that historically bank accounts in industrial regions start out as loans.  That is they are discounts not accounts.  So no bank creditor is putting their savings at risk, instead the bank (as noted above most likely the wealthiest person in town) is lending to the local entrepreneurs and tradesman, but avoiding having to maintain much of a stock of gold by clearing the whole town’s transactions on his books.  In a well functioning financial system, the town banker can send those debts to the big city and sell them off if he happens to need cash.  There ends up being a large network so that long-distance transactions can be cleared in the big city.  Basically finance is a debt clearing system that requires, in theory, no capital or actual savings at risk at all — but only a bunch of entrepreneurs/tradesmen who are willing to lend to each other because an entity with reputation (the bank) is underwriting the loans. In practice, people with money to lose have to guarantee that the system is sound.  These bank-guarantors make it possible for the system of unsecured trade credit that makes the economic world go round to operate.

Can finance solve the problem of systemic risk?  No, and neither can government.

“Diversification and maturity transformation can protect us from idiosyncratic shocks, and Murphy is right to point that out. But they cannot protect us from systematic misfortunes.”

Finance is unstable, so if a basic precept upon which most banker’s decisions have been based (e.g. the Bank of England will maintain its peg to gold) a lot of bankers can fail and lose their fortunes, taking the economy down with the bankers. (The worst of the bank failures in the Depression took place around the same time or after the Bank of England went off gold in Sept 1931 — causing a big hit to balance sheets around the world.)  Bagehot recognized that banking is a system of credit, so by definition its always within the realm of possibility that the whole system collapses.  There’s no reason the system can’t be born again – as long as there’s someone with assets to lose who recognizes trading activities he’s willing to finance.  But, of course, the process is excruciating.

“But on systematic risk allocation, I think it unquestionable that status quo finance is completely terrible.”  Agreed.  But this is not a problem with banking.  It’s a problem with limited liability banking where the people making the lending decisions can put the ultimate losses to someone else.

Regulation

If regulation will be very intensive, we need regulators who are themselves good capital allocators, who are capable of designing incentives that discriminate between high-quality investment and cost-shifting gambles.

I’m not convinced there is an alternative to the threat of personal losses to keep managers of “other people’s money” honest.  The banks have too much incentive to infiltrate whatever regulatory system is put in place, so it’s probably close to impossible to keep it from being captured in one way or another.

Have we reached the apotheosis of finance?  That is, did we once have a functional (though always changing) financial system that evolved to the degree that it is now on the path to implosion?  Far from Waldman’s view that finance has always been this way and this is the way it must be for growth to take place, I think that finance once had very different characteristics from that which it has today and that the loss of those characteristics significantly increases the likelihood of the total collapse of which  Bagehot warned.

The questions, for me, are:  Is the financial system dying from the effort to turn it into a competitive industry?  And can we save it?

Note: I edited  a phrase that was too strongly worded, and tweaked the text.

There was hurricane going on outside and the banks needed shelter.  The Fed provided the shelter.  But it turns out the shelter wasn’t just for one night and it wasn’t just for one bank.  The Fed provided shelter to all the banks for months on end.  Some banks were sheltered at the Fed for more than a year.

It is this long-term aspect of the Fed’s “emergency” lending that forces one to question whether this was emergency lending at all.  And raises the following questions:

Did the banks have a duty to construct their own shelters to weather the hurricane?
Or is the Fed their liege lord with a duty to protect them?  If the Fed has a duty to protect the banks in a hurricane, then what is the likelihood that the existence of that duty is the reason the hurricane lasted so long?  (These storms are clearly not acts of God, but entirely endogenous to the actions of the banks.)
By providing such extensive shelter, does the Fed discourage the banks from building their own storm-worthy shelters?

Did the banks pay a fair rate for the shelter?  Did they just do the dishes every night or did they pay a “normal times” market rent of say 5% of the market value of the shelter per annum or did they pay a rate closer to the value to them of the shelter?  Aren’t liege lords entitled to something like a third of their clients’ gross revenue annually in good times and in bad?

What about the decision the Fed makes about who gets shelter?  Does the Fed provide shelter to all the banks, or only to a select few banks?  Should consumers — or non-financial firms — have access to this shelter?  If not, why not?

There are two basic ways to make a financial system safer: insurance and regulation.

There is undoubtedly a third way to make the financial system safer:  regular failure of financial institutions.  This is the only proven way to make a financial system safe, since its the one that existed from the 13th century and was the foundation on which the modern financial system was built over more than half a millenium.

Minsky is regularly discussed, but his ideas don’t seem to have actually penetrated the discourse:  stability is destabilizing.  The most stable financial system it is possible to achieve is one with regular bank failures.  The analogy is to the management of forest fires which when allowed to occur regularly have the beneficial effect of clearing the undergrowth, revitalizing the forest, and reducing the likelihood of a truly destructive conflagration.

The problem in our financial system is not an insufficient supply of safe assets, but the concept that there is such a thing as a safe asset.  Keynes’ clear explanation of the ephemeral nature of liquidity debunked this view generations ago. (See Ch 12 of the General Theory, well discussed here).

Regular failures of financial institutions are the best way to ensure that the risks inherent in every financial asset are constantly being taken into account.  It is far more likely to be successful than insurance, which given the political muscle of the financial industry is guaranteed to be underpriced (see the experience of the FDIC, from 1996 to 2006 most banks paid nothing in FDIC premia) or regulation, as the regulators are unlikely to ever have a deep enough understanding of the current structure of the industry (which is always morphing in light of new regulations) to keep banks from making short-term profits while putting the losses to the taxpayer.

The only long-term solution to this problem is financial institution failure, regular, repeated and built into the very structure of the market.

The Bank of England was founded in the 1690s to fund the British debt.  In 1711 the Bank was required by law to discount exchequer bills on demand.  As North and Weingast observed in their seminal paper, the Bank’s support of government debt (e.g. through discounting exchequer bills) was crucial to the British ability to finance (and win) the Napoleonic Wars.  This is indubitably an important role of a central bank — but then every British county wasn’t issuing its own debt and the Bank certainly wasn’t buying the debt of the counties.   The modern European situation is more complicated than the early British case.

The lender of last resort role that DeLong claims “got its start” in 1825 was played by the bank in 1763 at end of the Seven Years War, in 1772 not altogether willingly after causing the collapse of the speculative activities of Alexander Fordyce’s bank, in 1783 at the end of the American Revolution (anticipating the normalization of trade the Bank in fact conserved gold reserves that fell to 8% by favoring private credit and restricting discounts of exchequer bills) and of course in 1797 when the strains of financing the wars led the Bank to seek authority for an emergency suspension of gold payments from the Privy Council (later confirmed by Parliament).  (See Clapham’s history of the Bank of England and Jacob Price’s articles on the Bank.)

Finally, once again we see that DeLong grossly misinterprets the point of Lombard Street.  Bagehot most definitely did not support lending against assets independent of the quality of their origination.  He states explicitly:

The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.

It happens, however, that in 19th century England the combination of personal liability of the banker and capital calls on shareholders to honor the debts of bankrupt joint banks was sufficient to ensure that origination practices were extremely careful.  Needless to say when origination practices are sound, a central bank’s practices do not need to be “over-nice.”  However, when rot has been allowed to grow in the financial system to the degree that the largest banks are being sued for fraud over their origination practices of their loans, central bank practices will have to be more careful than those of the19th c. Bank of England — at least if the goal of the central bank is to preserve financial stability (and not simply to bail out the banks).

The underlying problem in the Eurozone is the intra-European balance of payments problem.  Until a politically feasible plan to manage European imbalances is in place, the aggressive action by the ECB, called for by Martin Wolf and Paul DeGrauwe, may well turn out to be nothing more than a palliative.  Such palliatives are dangerous, because the need for political action is so great that anything that lulls Europe’s politicians into a sense that they do not need to act boldly today, may have the effect of aggravating the fissures leading to crisis and create a problem that is even harder to resolve.

My reference point in these thoughts is the central bankers’ decision in 1925 to work with the Bank of England in its project of maintaining the peg to gold.  Over six years the imbalances that made the peg unsustainable did not resolve, but instead were aggravated by politicians making parochial decisions and by a general sense of stability that allowed imbalances to grow ever greater.  In 1931 when Britain finally abandoned the peg to gold, the world economy faced a greater crisis than it probably would have faced in 1925.

I think the ECB is doing a good job of making sure that the politicians know that they are the ones who need to act.  While none of us can be sure that Europe’s politicians will successfully muddle through and give birth to a stronger Eurozone, the likelihood of success is much greater while the pressure of looming financial crisis bears heavily on the shoulders of the politicians.

Rortybomb directs us to Matt Rognlie‘s critique of “deleveraging.”  Rortybomb correctly points out Rognlie’s error in using aggregate data to discuss consumer behavior and links to a year-old analysis explaining that it’s the middle class that’s overleveraged.  I have a different bone to pick.

While Rognlie nominally acknowledges that the deleveraging problem is specific to the aftermath of an asset bubble (“consumers and businesses experienced an enormous hit to net worth”), he restates the problem as something that is not precisely the same, that consumers desire to spend less and save more.

The aftermath of an asset bubble implies that many economic participants owe more than the value of the assets securing the loan.  This has the immediate implication that either (i) defaults must take place, transferring full ownership of the assets to the lenders or (ii) assets are “locked in” and those who hold title to the assets cannot sell them (because the assets undersecure a lien, so in some sense this title is only nominal) or (iii) some combination of (i) and (ii).

The theory to which Rognlie refers tends to assume that (i) takes place instantaneously:  After a bad economic realization,  borrowers who owe more than the asset is worth strategically default, and losses are immediately recognized as lenders sell the foreclosed assets off to the highest bidder == highest value user.  Economic recovery takes place quickly because the model doesn’t allow for assets to be held and used by low value users.

As I understand his argument, Richard Koo sees solution (i) as so full of costs that typical economic models don’t recognize that it can be rejected out of hand.  And indeed most policy-makers seem to agree with him.  Banks are not asked to recognize their losses, borrowers are induced through temporary payment reduction plans like HAMP to continue making payments on loans that would lead to strategic default in an economic model, etc.

The balance sheet recession theory focuses on a world, like the one we are experiencing now, where strategic default does not take place on a large scale, and assets continue to be held by entities that are paying more money for them then they are worth on the market.  Such debtors have the use of the asset, but cannot sell it because the market value is insufficient to pay off the debt.  They are “locked in” at least until such time as they choose to default and transfer ownership to the lender.  This implies that we are now are in a world where assets are not as easily transferred to their highest value use (whether due to policy decisions, social pressures, or other concerns) as economic models tend to assume.

Observe, in addition, that spending less in order to have the means to make a debt payment on an underwater loan to a financial institution is very different in macroeconomic terms than spending less in order to invest the money in some asset.  The reason for this is a simple matter of accounting:  banks assume when they lend that the debt will be repaid (at least until such time as there is a significant default and they transfer the loan to an impaired asset category).  Thus the payment of debt has already been accounted for by the bank in its assets and adds nothing to the economy’s capacity to lend.  Savings/investment are a very different matter, because these are sums that an entity sets aside to provide itself with future income, but there aren’t many realistic future housing market scenarios in which reducing the negative equity in your home from 50% to 49% by making a year’s worth of payments is going to result in future income within the next decade or two.

Thus, it’s not true that all the two-earner households who have become one-earner households and are now cutting back on consumption in order to make their mortgage payments on underwater homes are “saving” in a meaningful macroeconomic sense — because many of these households don’t expect these payments to result in home equity for at least a decade (and since they are likely to lose the house in the end anyhow, they are really just renting == consuming housing services), and the banks’ current balance sheets are founded on the assumption that these payments will be made.  These households are cutting back on their economic activity, but the “savings” from doing so added to economic activity in the year in which they took out the loan and bought the house, not now.  Only if you want to argue that when banks don’t have to recognize losses on the bad loans they made, that also constitutes savings for macroeconomic purpose, can you claim that the vast amounts currently being paid on underwater mortgages are savings.  This is, however, at best a disputable position.

In short, in order for Rognlie’s theory to apply to our current situation he needs to consider the effectiveness of monetary policy in an environment where a principal goal of policy-making is to protect financial institutions from experiencing (or at least realizing) losses and where the policy is implemented at the cost of obscuring the valuation information available to shareholders and of encouraging deeply underwater consumer-mortgagors to continue making payments on their loans (e.g. HAMP).   Confusing the macroeconomic effects of paying off debt for the purpose of incrementally reducing negative equity (and in many cases insolvency) with the macroeconomic effects of saving is a serious error, but one that is easily made by those who work with models that don’t take insolvency and the bankruptcy process into account.

After all, Lehman Bros. made clear that anyone who holds equity in a financial institution can expect to get nothing when the company is wound up — in fact, it looks like the unsecured creditors will get 20 cents on the dollar.  What happened to the $640 billion in assets and $26 billion in shareholders’ equity that was reported for May 2008?  You can be sure that a large chunk of it ended up being posted as collateral on derivative obligations and thus removed from the control of the bankruptcy estate.

Why after this experience would anyone own the shares of a financial institution that could possibly go bankrupt or be resolved?

Another concern is what will happen when some large real economy firm ends up with such big derivatives exposures that its shareholders get treated the same way as Lehman’s.  Will one-time equity investors decide that, after the recent changes to the bankruptcy code, being a shareholder of a listed stock is just an option on nothing at all?

Unintended consequences, indeed.

Update 10-8-11:  In case it wasn’t clear, the issue that is created by the new bankruptcy code is that is that in the months leading up to a bankruptcy (or resolution) the claims on the firm’s assets are likely to change dramatically with the result that the accounting statements don’t reflect the relevant information.  So the underlying problem is that equity investors are asked to invest blindly.  While this problem is worse for financial firms, it’s far from clear that the problem is limited to them.

Note that I am not asking (yet) whether the central banks should not have intervened in 2008 or today to protect wholesale funding markets. I am asking what should have been the long-term plan after the 2008 intervention — and what should be the long term plan after today’s intervention.  I am asking why we are seeing the same problem arise, when there were 2-3 years of relative stability in which to move away from this reliance on wholesale funding.

The fact that a form of funding that was rejected by the market in 2008 was approved by regulators in 2011 is frightening.  The fact that many of the largest money market fund providers are still trying to get away with selling generic “prime” funds and filling them with financial commercial paper is frightening:  where are the money funds that have non-financial exposure only?  Where are the money funds that offer (taxable) US exposure only? Why are our money fund choices so limited?

As far as I can tell the history is pretty clear:  Once there has been a bailout on the scale of what took place, long-term financial stability is best served not just by announcing an end to the bailouts, but by acting on that announcement when, inevitably, the market challenges your will.  Holding the line both shakes the financial system to its core and, simultaneously, creates the faith that this is a financial system with central bankers who know how to do their jobs.

What events am I thinking of?   The Bank of England’s bailout of the Dutch banking system in 1763, followed by its refusal to bail it out in 1772 (when the cause of the crisis was speculation).  (I happen to think that this is turning point when the center of the European economy switched decisively from Amsterdam to London, but I digress.)  The Bank of England’s bailout of the bill brokers (mostly Overend) in 1857, followed by its announcement not to support them in the future, and its decision in 1866 not to support them in a crisis.  Watching the structure of the financial system shake to its foundations was probably the impetus that drove Bagehot to write Lombard Street — and to write approvingly of the Bank of England’s decision not to support Overend.  Observe how robust the British financial system was when it came out of this crisis; Britain had decades of stable banking, precisely because the banks and shadow banks (i.e. bill brokers) were scared of the central bank.

History of course is not destiny.  It should be possible for regulators to read the events of 2008 and force the changes that the market is demanding without the economy experiencing another major financial failure that shakes the financial system to it’s foundations.  It will, however,  require strong-willed regulators who are capable of demanding changes in our financial structure that will most likely have the effect of significantly reducing the profitability of banks.  The question is whether the regulators here and in Europe are up to this job.  I certainly hope so, but the continued reliance of banks on wholesale funding is a very bad sign.

The idea that a program to reduce principal balances on mortgage loans will cure the nation’s housing ills at little or no cost has been kicking around since the very early stages of the foreclosure crisis and refuses to die. … Why do so many wonks love principal reduction? Because they think principal reduction prevents foreclosures at no cost to anyone—not taxpayers, not banks, not shareholders, not borrowers.  It is the quintessential win-win or even win-win-win solution.

The logic of principal reduction is that in a foreclosure, a lender recovers at most the value of the house in question and typically far less. … In contrast, reducing the principal balance to equal the value of the house guarantees the lender at least the value of the house because the borrower now has positive equity and research shows that borrowers with positive equity don’t default. … Lenders could reduce principal and increase profits!

These economists assume that the argument in favor of principal reduction is founded on microeconomic principals — a search for the trade that creates the greatest economic surplus.  And, thus, they “disprove” the argument by questioning whether principal reduction is profitable for the lenders.

The problem with the principal reduction argument is that it hinges on a crucial assumption: that all borrowers with negative equity will default on their mortgages.  … in this simple example, the lender will obtain more money by choosing to forgo principal reduction.  The obvious response is that the optimal policy should be to offer principal reduction to [the borrower who will default on the mortgage] and not the other.

In fact, the strongest arguments in favor of principal reduction do not rely on the assumption that everybody wins.  Here are three such arguments.

(i)  The concept that mortgage debt should not be written down as a matter of course depends on specific view of debt.  The basic question that arises when one discusses “debt” is:  Is a promise to pay a fixed sum of money absolute or is it negotiable?

In general in the context of the modern American economy, the conclusion is that the debt becomes negotiable when the borrower declares bankruptcy.  Thus, United Airlines and a variety of other businesses have been able to discard their pension plans without liquidating the business and distributing a fair share of assets to the pensioners.  Similarly if a corporation has a mortgage, the “cram down” provision in Chapter 11 allows the bankruptcy court to write the amount of the debt owed down to the value of the property.  In fact, “cram down” exists in personal bankruptcy law as well — but there is one exception to it:  primary residences.

Thus, the basic principal on which the American economy functions is that debt has an element of negotiability.  One almost always has the right to threaten to declare bankruptcy and then force the creditor to write the debt down closer to its fair market value.  It doesn’t take very sophisticated economic analysis to understand that this property of the American economy helps reduce the likelihood of asset price bubbles, since it gives creditors a strong incentive to lend no more than the property is likely to be worth over the life of the loan.

While it is true that primary residences are excepted from cramdown, this doesn’t really explain why the American understanding of debt should differ just because that debt relates to a primary residence.  Obviously it’s in corporate interests to treat corporate debts as negotiable and consumer debts as absolute, but I suspect that it would be close to impossible to find a rational justification for such treatment of consumers as second class citizens.

(ii)  Moral hazard for financial institutions is created when loans against assets are protected from being marked down to their market value.   If banks are allowed to profit from their role in creating an asset price bubble in housing, then they are not discouraged from repeating the same behavior.  Thus, banks need to lose money on these underwater mortgages, or they will face incentives to be careless about lending against overinflated housing values and will promote housing bubbles again in the future.

(iii)  Most importantly, however, principal reductions are probably necessary for economic recovery.  A borrower whose house is worth 50% of the loan and gets a standard HAMP modification will, typically, (1) within eight years face a 33% increase in mortgage payments that were already set at the boundary of affordability and (2) not be in positive equity territory for 20-25 years (recall that a standard HAMP modification is not fully amortizing over 30 years).  In other words these are borrowers who are at high risk of default for the next quarter century.

The simplistic “will he or won’t he” analysis presented by the Federal Reserve economists failures to capture the nature of the housing market where “will he or won’t he” needs to be asked in every period until the loan is fully paid off.  Laurie Goodman (the report is not available on line as far as I now, but a report on a lecture using similar data is available here) has done this analysis and concluded that principal reduction is necessary to reduce the number of future defaults.

Our current housing policy is likely to prolong the experience of housing market default across a decade or even longer.  Those who support principal reduction are concerned that the economy will not recover until the constant influx of foreclosed homes onto the market slows.  There are two surefire ways of achieving this end:  the first is a general inflation that will pull house prices along with it and the other is a massive reduction in principal balances that will enable the vast majority of those who cannot afford to pay their mortgages to choose to sell their homes.

Of course, principal reductions are not costless — they are designed to place a fair share of the costs of a housing bubble on financial institutions.  Principal reductions are, however, almost certainly less costly than attempting to push most of the costs of a housing bubble that was inflated by under-regulated out-of-control financial institutions onto middle class consumers, whom economists are imagining will one day soon have the financial wherewithal to support a growing economy.

On the financial side, the point is that we measure growth by output of final goods and services, and fancy finance is an intermediate good; so if you think Wall Street was wasting resources, that just says that more of the actual growth was created by manufacturers etc., and less by Goldman Sachs, than previously estimated.

This just shows how little economists have tried to understand the nature of recent financial innovations.  Wall Street can now create synthetic assets.  That’s what a synthetic CDO is — it goes on someone’s balance sheet as an asset and there’s no requirement in accounting conventions that it go on somebody else’s balance sheet as a countervailing liability.  AIG is just an illustration of how the accounting for such CDOs takes place.

In an environment where Wall Street can fabricate assets that enter into financial accounts in this way, it’s not realistic to claim that “fancy finance is just an intermediate good”.  That used to be true in the good old days, when there was no reason to believe that the CDS contracts underlying synthetic CDOs would be enforceable contracts, but after the CFMA of 2000 (and other changes in the law), that isn’t true anymore.

For this reason, the economic assumptions underlying analyses like Krugman’s and Steindel’s do not reflect reality — and in fact they function as a blinder that prevents these economists from seeing and understanding what’s actually going on.  By assuming that financial institutions can’t do what they did do, economists hobble their understanding of the nature of the current economic malaise.