I’ve been AWOL from blogging not by choice but due to an injured right wrist. Hopefully it makes it through this post and a few others today but if this ends somewhat abruptly you can assume that I’m not as healed as I think.
One of the advantages of being unable to operate a keyboard is that you have a lot more time to read and a somewhat long but very interesting and provocative piece by a Russell Roberts, a professor of economics at George Mason University caught my eye. As I said, it’s long, about 40 pages but an easy read. It is emphatically not your typical economics paper meant only for other economists.
Mr. Roberts holds forth with a thesis that you’ve seen before, specifically that the finance game is rigged in favor of the financial institutions and their managers at the expense of the taxpayer. The attraction of his work is that he takes the time to develop his ideas and ably demonstrates how perverse the system has become. He covers all the usual players in the financial crisis and does a particularly good job of ripping Fannie (FNM) and Freddie (FRE) apart. The crux of his argument is that in finance at least (though one might not have to stretch too hard to include other industries) the country has lost the discipline that the potential for loss brings to commerce. This is the Executive Summary of his work:
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.
It will take you about half an hour to read this paper and trust me, it will be time well spent.
As fortune would have it, a front page article in the WSJ yesterday morning illustrates how far we’ve left behind the concept of loss as a part of the equation in investing and banking. The authors chronicle the pervasiveness of “extend and pretend” in commercial real estate lending.
Banks are applying it, in particular, to commercial real-estate lending, where, during the boom, optimistic borrowers got in over their heads to the tune of tens of billions of dollars.
A big push by banks in recent months to modify such loans—by stretching out maturities or allowing below-market interest rates—has slowed a spike in defaults. It also has helped preserve banks’ capital, by keeping some dicey loans classified as “performing” and thus minimizing the amount of cash banks must set aside in reserves for future losses.
Restructurings of nonresidential loans stood at $23.9 billion at the end of the first quarter, more than three times the level a year earlier and seven times the level two years earlier. While not all were for commercial real estate, the total makes clear that large numbers of commercial-property borrowers got some leeway.
But the practice is creating uncertainties about the health of both the commercial-property market and some banks. The concern is that rampant modification of souring loans masks the true scope of the commercial property market weakness, as well as the damage ultimately in store for bank balance sheets.
As the article points out the ability of banks to continually roll over their commercial real estate loans as well as ignore the reality of the market value of their portfolios is enabled by the policies of the regulators. While it might be preserving, at least for now, the viability of the lenders the practice has real repercussions for the economy.
The authors correctly point out that by deferring recognition of values, an artificial floor is placed under the market and potentially keeps the market from reviving. Moreover, as the banks grapple with these zombie loans, their ability as well as propensity to supply new loans to the economy is crippled. As they point out, it’s the same sort of stagnation that has done much damage to the Japanese banking system for decades.
This is the evasion of loss that Roberts talks about in his paper. Neither the bankers nor the real estate investors are forced to realize the existence of bad loans and bad investments. Rather the regulators seeking to avoid reality allow the perpetuation of an accounting fiction. While a bad investment is kept on life support, the bankers continue to profit via salaries and bonuses and the investor is allowed to defer losses all at the expense of the larger economy.
How you change the status quo is the obvious question. One is tempted to look at the financial regulation bill just produced by Congress and despair. Roberts provides a thought on what we might do.
Milton Friedman once observed that people mistakenly believe that electing the right people is the key to better public policy. “It’s nice to elect the right people,” he said, “but that isn’t the way you solve things. The way you solve things is to make it politically profitable for the wrong people to do the right things.” To do that, we, the people, have to favor a different philosophy for the relationship between Washington and Wall Street than the one we have now. We have to favor a relationship where there is both profit and loss.