Missing the point on the “wages of sin”

Ryan Avent seeks to rebut Matt Klein on the issue of whether a popped real estate bubble must have adverse consequences on the economy as a whole. Afterall, as Avent points out the houses are built and in the worst case we can just let them rot and turn our efforts to gainful production. He “dreams of a day when the only people who suffer from money-losing investments are the money-losing investors.”

The problem with our reaction to the real estate bubble is that the “money-losing investors” haven’t lost their money (yet). The houses were built on debt and there are vast losses on that debt that have not yet been realized.  There’s no issue of morality here.  Someone has to take the losses.  It should have been the banks (who had vast exposure on second liens) and the mortgage investors. Instead, we’ve been protecting the financial sector by convincing people to continue making payments at bubble prices on their houses.  That’s the point of HAMP, the government modification program.

The “wages of sin” language is unfortunate, but the point that nothing good can come of prolonging the financial sector’s realization of its losses over a decade or more remains. The nature of debt means that losses must be realized — and this truth remains with or without moralistic framing.

Vast numbers of mortgagees still owe twice as much as their homes are worth are are continuing to make payments (in December 2012 30% of mortgagees in the crisis states were underwater, 4.7% of all mortgagees owed twice as much as their homes were worth) — in part because the payments have been temporarily reduced through HAMP and HAMP-like mods. These payments are going to support the banks and mortgage investors, who are currently accounting for these loans as though there are no losses (i.e. because payments are current). Instead of these individuals’ income being freed to circulate in the economy productively, this income is spent on preventing the realization of losses in the financial sector.

People who know economics generally assume that what is happening can’t happen, because it doesn’t make sense.  Any rational homeowner would walk away from a mortgage that’s the double the value of the home — and indeed sometime over the course of the 40 to 50 years that this debt is to be paid most likely the homeowners will choose to walk away. However, currently large chunks of U.S. income are being spent on preventing the realization of financial sector losses. I would say that it’s no coincidence that the overall economy is simultaneously remarkably weak.

Given how poorly our financial system is functioning when it comes to simply recognizing losses and moving on, Matt Klein may be right to ask: “Wouldn’t it be ironic if our unwillingness to punish reckless lenders for their sins crippled our economy for a generation?”

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