Friday, June 18, 2010

Weekend Read: Gambling with Other People's Money

I wanted to save this 'white paper' for a weekend when it can be isolated since it's very well written and touches on countless themes we've discussed over the past 3 years on FMMF.  Everything from asymmetric corporate compensation (heads you win, tails you still win!) [Sep 27, 2008: Heads We Win, Tails We Win]  [Oct 30, 2007: You're Fired! Now Here is $160M to Help Ease the Pain] supported by a crony board of director system so fortress like Carl Icahn has a hard time penetrating it, to the disaster that is FanFredron [Sep 7, 2008: Bailout Nation Continues - Fannie/Freddie Now Owned by You], to 'financial innovation' [Sep 10, 2009: Goldman Sachs CEO - "Ok I Admit It, Some of our Financial Innovations are Socially Useless"] by hedge funds masking as "banks" who are happy to gamble on anything that could generate profit knowing the "taxpayer/Fed" always is an implied backstop, to government whose only care in public policy is how to win the next re-election, to our lovely central bank and all the "good it does", to a culture where a celebrated Secretary Treasury works tirelessly to repeal Glass-Steagall & then immediately resigns to take on a decade long reign at eventual ward of the state Citigroup (collecting $100M along the way) [Jun 26, 2009: Bloomberg - Paul Volcker Marginalized; Major Push Back on Curbing Excess. Our Life of Financial Oligarchy Does not Change], to the fraud that America is still about 'capitalism' - rather than corporate socialism (Cramerica - for the corporation, by the corporation) [Mar 19, 2010: Two Corporations Begin Run for Congress.  Yes, I am Serious].... the whole works summarized nicely in 1 spot.

If you want a good overview of how we got here and a bevy of potential solutions (not that they will stand a chance of happening) I encourage this weekend read: Gambling with Other People's Money: How Perverted Incentives Caused the Financial Crisis

Author:  Russell Roberts is Professor of Economics at George Mason University, the J. Fish and Lillian F. Smith Distinguished Scholar at the Mercatus Center, and a research fellow at Stanford University's Hoover Institution.

I'll cut and paste the executive summary and his proposed solutions below just to give a flavor of the piece.

Executive Summary

Beginning in the mid-1990s, home prices in many American cities began a decade-long climb that proved to be an irresistible opportunity for investors. Along the way, a lot of people made a great deal of money. But by the end of the first decade of the twenty-first century, too many of these investments turned out to be much riskier than many people had thought. Homeowners lost their houses, financial institutions imploded, and the entire financial system was in turmoil.
How did this happen? Whose fault was it? Some blame capitalism for being inherently unstable. Some blame Wall Street for its greed, hubris, and stupidity. But greed, hubris, and stupidity are always with us. What changed in recent years that created such a destructive set of decisions that culminated in the collapse of the housing market and the financial system?
In this paper, I argue that public-policy decisions have perverted the incentives that naturally create stability in financial markets and the market for housing. Over the last three decades, government policy has coddled creditors, reducing the risk they face from financing bad investments. Not surprisingly, this encouraged risky investments financed by borrowed money. The increasing use of debt mixed with housing policy, monetary policy, and tax policy crippled the housing market and the financial sector. Wall Street is not blameless in this debacle. It lobbied for the policy decisions that created the mess.
In the United States we like to believe we are a capitalist society based on individual responsibility. But we are what we do. Not what we say we are. Not what we wish to be. But what we do. And what we do in the United States is make it easy to gamble with other people’s money—particularly borrowed money—by making sure that almost everybody who makes bad loans gets his money back anyway. The financial crisis of 2008 was a natural result of these perverse incentives. We must return to the natural incentives of profit and loss if we want to prevent future crises.
Proposed Fixes

An unpleasant but unavoidable conclusion of this paper is that Wall Street was (and remains) a giant government-sanctioned Ponzi scheme. Homebuyers borrowed money from lenders who got their money from Fannie Mae, Freddie Mac, and banks that borrowed money from investors who expected to be reimbursed by the politicians who took that money from taxpayers. Almost everyone made money from this deal except the group left holding the bag—the taxpayers. There is an old saying in poker: If you don’t know who the sucker is at the table, it’s probably you. We are the suckers. And most of us didn’t even know we were sitting at the table.
Here are some changes that would move us away from crony capitalism and toward the real thing:
  • Don’t try to re-create the old system while trying to make it “better.” There is a natural wariness about securitization right now. That is good. Let it blossom. There is a natural wariness about zero-down mortgages. That is good. Let it blossom.
  • Recognize that having every American own a home is not the American Dream, but the dream of the National Association of Home Builders and the National Association of Realtors. The government should fund any government programs to increase homeownership out of current tax dollars where the costs are visible. Don’t reform Fannie and Freddie. Don’t resurrect them. Get the government out of the business of hidden subsidies to mortgage interest rates.
  • Be aware that the Fed is certainly part of the problem and may not be part of the solution. The Fed created the artificially low interest rates that helped inflate the housing bubble. The Fed then raised interest rates too quickly with disastrous effects for the adjustable-rate mortgages encouraged by their low-interest- rate policy. Monetary policy should not be left to any self-proclaimed or publicly anointed maestro. Following an automatic money growth rule or the Taylor rule would have avoided much of the pain. Somebody needs to hold the Fed accountable for funding exuberance.
  • Restrain rather than empower the Fed. It has played a major role in exacerbating the moral-hazard problem. It is not good for a democracy when an agency as unaccountable as the Fed acquires even more power and uses it in ad hoc ways.
  • Take the “crony” out of “crony capitalism.” Rescues have distorted the natural feedback loops of capitalism. Removing the cronies will not be easy, and economists should not make it more difficult. The near-universal praise by economists for the actions of Bernanke, Paulson, and Geithner and the near-universal condemnation by economists of the decision to let Lehman Brothers enter bankruptcy greatly reduce the credibility of any promise by policy makers to act differently in the future.
  • Stop enabling obscene transfers of wealth. In this crisis, average Americans have sent hundreds of billions of dollars to some of the richest people in human history. This has been done over and over again in the name of avoiding a crisis, akin to putting out every forest fire. But this only postpones the day of reckoning. Eventually a conflagration comes along that consumes everything. The better the citizenry understands this reality, the better the chance that political incentives will change. If people don’t understand it, the political incentives will stay in place. Economists play an important role in how people perceive what has happened. We should stop being the enablers of such obscene transfers of wealth by claiming they are necessary for stability.
  • Excoriate, condemn, and call to account rather than praise and honor policy makers who make creditors and lenders whole. Zero cents on the dollar for bankrupt bets made by lenders and creditors would be ideal, but it is unlikely to be a credible promise. So let’s start more modestly. A ceiling of 50 cents on the dollar for creditors and lenders when the institutions they fund become insolvent is a natural place to start. Even this may be too difficult for politicians to stomach. But economists should be able to support such a move and preach its virtues.
  • Rescuing rich people from the consequences of their decisions with money coming from average Americans is bad for democracy. It is bad for democracy because the Fed and the Treasury are spending trillions of dollars of taxpayer money with very little accountability or transparency. It’s bad for democracy because it means that some people have to live with the consequences of their decisions while others get rescued. That in turn creates a very destructive feedback loop of rent seeking, where losers seek government help after the fact rather than making careful decisions before the fact.

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