Good Bailouts Versus Bad Bailouts (Housing Edition)

Steve Waldman at Interfluidity reminds us that bailouts can be useful or misguided, depending on the circumstances. Trying to shore up overvalued assets is simply a bad idea and often compounds the damage.

Unfortunately, as we will discuss in this post, the use of Waldman’s criteria demonstrates that many of the proposed housing market rescue operations, particularly the idea of reviving the 1933 Home Owners’ Loan Corporation, fall into the “bad bailout” camp.

First, from Waldman:

The word “credit” comes from the Latin for faith or belief. A “credit crisis” is nothing more or less than a widespread loss of confidence in people or institutions whom we were accustomed to considering trustworthy. This is obvious, but it has implications. Right off, one can imagine two sorts of credit crises. The first, which we’ll call a “panic”, refers to an unreasonable loss of confidence in people or institutions that are fundamentally sound. The second we’ll call a “reckoning”. A reckoning occurs when there is widespread recognition that institutions heretofore deemed reliable are, in fact, not.

The policy implications of these two sorts of crisis are diametrically opposed. In a panic, government liquidity supports and even well-designed “bailouts” are entirely appropriate. When panic subsides, “mark-to-market” losses reverse, and liquidity supports can be removed. “Bailouts” end up costing taxpayers very little, and perhaps even turn a profit for the fisc, as government guarantees expire unused while taxpayers gain from appreciation of assets purchased by the government at a discount.

But in a reckoning, bailouts are dangerous. “Temporary” liquidity supports turn permanent, government guarantees crystallize into taxpayer liabilities, and assets purchased by government continue to lose value. As real wealth is channeled, either via taxation or inflation, from the population generally to the original cohort of unreliable actors, government itself becomes another institution which people reasonably come to consider untrustworthy. In a reckoning, better policy is to let institutions fail. If there are institutions that are too big to fail, they should be allowed to the brink and then nationalized, with equityholders wiped out and other obligations only selectively honored, in order to minimize external costs to the public rather than to satisfy unwise counterparties. (Obviously, this sort of discretion is a magnet for corruption. But paying off all claimants from public funds is corruption by default, and terrible precedent to boot. A reckoning is a bad situation in which quality of government matters, a lot.)

In a reckoning, the overriding policy goal ought not be to restore faith in discredited institutions, but to place firewalls between them and anything worth saving, and, most importantly, to encourage the formation of new institutions worthy of the public’s trust. That’s not as easy as cutting checks to incumbents, and it’s not a matter of “more” vs. “less” regulation. Building a better financial system from the ashes of a broken one is a project for which there are no cut-out recipes, whose inputs cannot be tallied as one-dimensional quantities, and whose results might look different from what we are accustomed to. But it’s not an impossible task, and it may well be unavoidable. A friend of mine, a pilot among other things, once related me the advice of his flying instructor: “The plane is going to land. The only question is whether you are still going to be flying it when it does.” In a reckoning, that’s advice that governments ought take to heart.

Wladman also mentions an article by Brad DeLong which considers two types of “reckoning” scenarios. If the central bank can goose asset prices enough to avert a crisis with only moderate monetary easing, it’s an “imperfect” solution (it does cause some inflation and bails out the perps). But in a serious fall in asset prices, cutting rates won’t lead to enough of a rebound to return the financial system to solvency. DeLong continues:

When this happens, governments have two options. First, they can simply nationalize the broken financial system and have the Treasury sort things out — and reprivatize the functioning and solvent parts as rapidly as possible. Government is not the best form of organization of a financial system in the long term, and even in the short term it is not very good. It is merely the best organization available.

The second option is simply inflation. Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

The inflation may be severe, implying massive unjust redistributions and at least a temporary grave degradation in the price system’s capacity to guide resource allocation. But even this is almost surely better than a depression.

Here we have two clear-headed, congruent, and persuasive analyses of financial crises with remedies appropriate to each. And as Waldman stresses, doing the wrong thing is worse than doing nothing. No action means that the bad actors fail, which he deems to be a necessary, even desirable step.

Yet policymakers and now economists seem galvanized by the need to prevent mortgage borrowers from losing their homes on a large scale, despite the growing evidence that some are abandoning their mortgages by choice rather than necessity (see here and here for a few of many examples). They don’t acknowledge why residential real estate prices are declining: they are out of line with incomes and rentals. In communities where housing didn’t boom but employment is still solid, prices are not plummeting. It’s the ones that experienced feverish appreciation that have not only fallen but still have further to go. But those also happen to include large prosperous markets, most notably Florida and California.

But increasingly, remedies that would once be considered desperate or unduly socialistic are now getting traction. First we had the Bank of America “buy us out of our bad mortgages” plan, which is getting a more serious hearing than it deserves. Per the New York Times:

A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government — now that it is in trouble.

The proposal warns that up to $739 billion in mortgages are at “moderate to high risk” of defaulting over the next five years and that millions of families could lose their homes.

To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.

Readers probably know that I am on the left end of the political spectrum, but this offends me as a bad use of public funds. I don’t believe in throwing good money after bad. Tanta isn’t positively disposed either:

….if you “position” it as a bailout of homeowners, nobody will “perceive” it to be a bailout of the bond market…..

Nobody is going to create a functioning new agency with the relevant expertise and staffing and funding and clear mandate out of thin air fast enough to do what this wants to do, if what we want to do is stave off recession. FHA probably has the expertise to credibly attempt the loan-level workouts, but not enough hands to get saddled with $739 billion worth that has to be dealt with before everybody’s lawns go brown. Ginnie Mae is, in my view, one of the most efficient and quietly professional government agencies ever: they run a highly successful program with a tiny staff. I can’t imagine Ginnie Mae is ready to manage reporting and remittances on a brand-new government-owned pool o’ junk of this size with existing resources.

So of course the whole thing would be outsourced to some private company. I’m sure there’s a financial institution out there willing to write up a proposal for how the government can pay it a management fee to orchestrate the government’s bailout of its last attempt to manage mortgage-lending-related program activities.

And now, even worse, we have A-list economists singing the praises of a kissing cousin of the BofA proposal, namely, bringing back the Depression Home Owner’s Loan Corporation. From Alan Blinder in “From the New Deal, a Way Out of a Mess,” in the New York Times:

Now, a small but growing group of academics and public figures, including Senator Christopher J. Dodd, Democrat of Connecticut, is calling for the federal government to bring back something like the HOLC. Count me in.

The HOLC was established in June 1933 to help distressed families avert foreclosures by replacing mortgages that were in or near default with new ones that homeowners could afford. It did so by buying old mortgages from banks — most of which were delighted to trade them in for safe government bonds — and then issuing new loans to homeowners. The HOLC financed itself by borrowing from capital markets and the Treasury.

The scale of the operation was impressive. Within two years, the HOLC received about 1.9 million applications from distressed homeowners and granted just over a million new mortgages. (Adjusting only for population growth, the corresponding mortgage figure today would be almost 2.5 million.) Nearly one of every five mortgages in America became owned by the HOLC. Its total lending over its lifetime amounted to $3.5 billion — a colossal sum equal to 5 percent of a year’s gross domestic product at the time. (The corresponding figure today would be about $750 billion.)

As a public corporation chartered for a public purpose, the HOLC was a patient and even lenient lender. It tried to keep delinquent borrowers on track with debt counseling, budgeting help and even family meetings. But times were tough in the 1930s, and nearly 20 percent of the HOLC’s borrowers defaulted anyway. So the corporation eventually acquired ownership of about 200,000 houses, nearly all of which were sold by 1944. The HOLC closed its books in 1951, or 15 years after its last 1936 mortgage was paid off, with a small profit. It was a heavy lift, but the incredible HOLC lifted it.

Today’s lift would be far lighter. And a good thing, too, because our government is far more timid and divided than Roosevelt’s.

Contemporary mortgage finance is also vastly more complex. In the 1930s, banks knew all of their customers, and borrowers knew their banks. Today, most mortgages are securitized and sold to buyers who do not know the original borrowers. Then mortgage pools are sliced, diced and tranched into complex derivative instruments that no one understands — and that are owned by banks and funds all over the world.

But this complexity bolsters the case for government intervention rather than undermining it. After all, how do you renegotiate terms of a mortgage when the borrower and the lender don’t even know each other’s names? This is one reason so few delinquent mortgage loans have been renegotiated to date.

Details matter, so here are a few: First, any new HOLC should refinance only owner-occupied residences. Speculators can fend for themselves — or go into default. Similarly, second homes or vacation homes should be ineligible, as should very expensive real estate. (Precise limits would vary regionally.)

Third, mortgages obtained via misrepresentation by borrowers should be ineligible for HOLC refinancing, but cases of fraud or deception by the lender should be treated generously. Fourth, as the original HOLC found, not all bad mortgages can be turned into good ones. Where families simply can’t afford to be owners, the new HOLC should not be asked to perform mortgage alchemy.

What about the operation’s scale? Based on current estimates, such an institution might be asked to consider refinancing one million to two million mortgages — proportionately less than half the job of its predecessor, and maybe less than a quarter. If the average mortgage balance was $200,000, the new HOLC might need to borrow and lend as much as $200 billion to $400 billion. The midpoint, $300 billion, is one-seventh the size of Citigroup and would rank the new institution as the sixth-largest bank in the United States.

Given current low interest rates, a new HOLC could borrow cheaply and should find it easy to earn a two-percentage-point spread between borrowing and lending rates, for a gross profit of maybe $4 billion to $8 billion a year.

What about loan losses? A 10 percent loss rate, or $20 billion to $40 billion, spread over the life of the institution, seems incredibly pessimistic. (The original HOLC experienced a 9.6 percent loss rate during the Depression.) So the new HOLC seems likely to turn a profit, just as the old one did. But even if it loses a few billion, we must remember its public purpose: to help the economy recover, not to make a buck. By comparison, the new economic stimulus package has a price tag of $168 billion.

This all sounds too good to be true, right? Because it is.

I will go through a short list of the problems and misguided thinking; no doubt alert readers will come up with more.

The biggest, and most deceptive, is that the analogy to the old HOLC is wrong. Mortgages in those days bore no resemblance to thecontemporary versions. Consider these comments from Richard Green (hat tip Mark Thoma):

When the Home Owners Loan Corporation was invented, it was in response to an economic tsunami that swamped lenders and homeowners. Moral hazard was not much of an issue, as loans were stringently underwritten (typical LTVs were 50 percent at origination). But loans had short terms, and therefore were vulnerable when people were forced to refinance in the teeth of the great depression. The HOLC allowed for massive loan modification and helped get incentives for borrowers and lenders aligned correctly.

Now, however, we are in the midst of a crisis that has arisen in part because of agency problems throughout the lending chain. To bail out lenders through some sort of HOLC setup could very well encourage excessive risk taking in the future, which is of course problematic.

While Green’s big reservation is moral hazard, consider the economics. These were 50% LTV loans, yet the HOLC experienced 9.6% in losses. It’s cavalier to assume that a loss rate of 10% is “incredibly pessimistic” when the mortgages acquired will probably have zero to negative equity and housing markets are still falling.

Second, this program is an administrative nightmare. Individuals will have to apply, due diligence will need to be done (are they lying when they say they are owner-occupants? How are you going to verify that?) How will you set terms? Determine ability to pay? There’s no point in going though the hassle and expense of acquiring the mortgage and issuing a new one if the borrower is promptly going to go into arrears (Blinder grandly throws in the idea of counseling, which is important, but it adds more time and costs too).

Third, the requirement (which is lnecessary from a political standpoint) that fraudsters can’t participate, is often pretty grey. Yes, there was a lot of income misrepresentation, but it was often aggressively encouraged by the lenders. Does any misrepresentation rule a borrower out? What if the broker asked the borrower to leave the income line blank, or told the borrower to sign blank forms and they’d complete them? As you can see, some cases would boil down to “he said, she said,” assuming anyone had the time to dig that deep. More probable is that any misstatement of income is a knock-out.

Of course, it may prove that that requirement alone will sufficiently reduce the pool of eligible loans so as to neuter the program. As far as I’m concerned, that would be a good outcome.

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  1. Anonymous

    What about serial refinancers? Fifty percent of all originations in the last four years have been refinances. Are we going to reward the home ATM crowd by bailing them out?

  2. Anonymous

    Brad DeLong suffers from the lack of imagination too often typifying the closed system/closed minds of economists. “Government is not the best form of organization…”

    And, Professor, what is ‘the best form of organization’? Your answer, steeped in more than a century of economic science, is, of course, ‘the private sector’?

    Really? Are you so certain? And, have you considered all possibilities? I mean, for example, you don’t mention (my guess: don’t even think about)the nonprofit sector….

    We live in times in which the private sector has brought the world to the brink. Yet, our robot economists trot out cliches like “Government is not the best form of organization….”

    They don’t base these cliches in either actual track record/empirical facts — or in creative, imaginative problem solving looking forward.

    They simply revert to what their closed minds tell them is ‘truth’.

    This is nothing more than the dead hand of ‘free market’ ideology. It has nothing whatsoever to do with problem solving in the reality-based universe.

  3. RK

    Within the past 30 to 35 years, a shift has occurred in the way we perceive the homes in which we live. There is probably some critical point at which this shift began to take on momentum, and accelerate, but I leave that determination to others. Whereas in the past we thought of our homes purely as places to live, with a savings account feature, (the principal amortization), today we consider them as investment vehicles.
    Further, we have been encouraged in this belief by pronouncements throughout the public and private sectors. And who would blame us. The home is the
    only “investment” available to the general public which permits “margin” of 80%, 90% and even in some cases, 110%. Hedge funds can be geared 10 to 1, but margin requirements on stocks are limited to 50% for the retail investor.
    Unfortunately, the one characteristic homes do not possess is liquidity. And we are now at a juncture
    when the equivalent of the Treasury or SEC has altered the margin requirements. It is going to take a “sea change” in attitudes, towards those of Japan,
    Germany or the nordic states, to bring us back to
    something resembling sanity.

  4. Anonymous

    Let the creative destruction begin, top to bottom. This is what we do best, and the result will be meaner, leaner and gosh darn more likeable than turning our tax hoard into the next Countrywide.

  5. Anonymous

    One Iraq war –that’s $3 trillion to you, Mr Bush
    The Nobel laureate economist Joe Stiglitz says the US has grossly understated the cost of the conflict

    Three trillion dollars – or about £1.5 trillion – is a lot of money, particularly when contrasted with the White House’s initial estimates of $50-$60 billion. It dwarfs even official estimates of the cost of the war so far as about $645 billion.
    There is even a figure for Britain: more than £20 billion for direct military and social costs, not including some of the wider economic consequences. That, however, no longer looks such a big number when set against the £100 billion of Northern Rock debt the government has just taken onto its books.

    ** There are $1 trillion in outstanding subprime mortgages, with potential losses estimated at about $250 billion, said Bose George, an equity analyst with Keefe, Bruyette & Woods Inc. Columbia University professor Charles Calomiris pegs the losses even higher — at between $300 and $400 billion.

Merrill Lynch’s Bostjancic said the biggest impact of rate resets, from a dollar perspective, will come in the third quarter of 2008. She sees losses from all loan defaults exceeding $500 billion in 2008.

  6. Deborah

    I could be wrong here, but my impression of the mortgages of the 30s were that they were given based on affordability with something in the range of a 10 year repayment schedule.

    Today’s mortgages are standard for a 30 year term, something that ought to have been adjusted as interest rates went down. There ought to have been regulation as to what the maximum borrowing term could be based on the interest rate, with 12 years at zero percent and 30 years at 12 or more percent.

    If you want a strong economy, the maximum qualifying term for the current 6% mortgages should be around 21 years.

    Instead we had mortgages even longer than 30 years offered.

    Another disaster in underwriting standards was to increase the qualifying income with declining interest rates when the opposite should happen. Say you want to leave the 30 year standard, well, then at 0 percent you should have to qualify for the loan with 15% of income, not up to 50% as some under writing standards went to. So the 6% mortgage should not have been issued with more than about 22% of gross income.

    This way there is built in ability to handle changing interest rates and changes in household circumstance.

  7. Doc Freaking Out Holiday


    OT: Yah know that paranoid thing I deal with regarding The Pension Protection Act, i.e, the little matter of DOL underwriter exemptions, which allow hedge funds to use pension funds to invest in derivatives like CDOs ??

    That feeling just got worse after reading this little bonus clip — and in all honesty there is a tsunami headed towards pension accounts, which will be ground zero for money market liquidity!!! DANGER!!! read your prospectus and head for the high ground!!!

    United States Government Accountability Office
    GAO Report to Congressional Committees
    CORPORATIONJuly 2007

    In January 2007, DOL officials orally directed PBGC to have no direct
    contact with OMB without DOL’s approval, a condition that PBGC
    officials believe has strained the relationship between DOL and PBGC
    budget offices.

    DOL now closely monitors PBGC’s interactions with
    OMB by attending meetings and participating in telephone calls. DOL
    officials said that such action is needed to coordinate with PBGC in
    order to provide OMB examiners with a consistent message. OMB
    officials said that DOL’s review of PBGC’s budget submission was

    One former PBGC
    Executive Director also noted that PBGC could not be just like any other
    DOL agency, because if it were, the Secretaries of the Treasury and
    Commerce, by a two-vote majority, could theoretically directpolicies of
    another federal cabinet department.

    The uncertainty of PBGC’s status has resulted in confusion over the extent
    to which DOL has the authority to manage PBGC’s operations. According
    to our internal control standards, agencies should ensure that key areas
    of authority and responsibilities are defined and communicated. However,
    neither the board, DOL, nor PBGC has developedformal policies and
    procedures to define its authorities and responsibilities. Instead, PBGC
    officials typically react to DOL’s periodic written and oral
    communications, which PBGC officials said sometimes become a part of
    PBGC’s operational framework.

    ** Well worth looking at the fine print in the 1000 page PPA doc, which both Obama and Hillary voted for…obviously McCain as well, as SIFMA is highly connected and will tap your cash accounts!!

  8. don

    Not to quibble over semantics, but what you refer to as “socialistic” is not socialism. Socialism is social ownership over the means of production in which investment decisions are based on the perceived benefit of society rather than based on private interest of profit making.

    What you refer to as socialistic is really a form of taxpayer subsidized financial/banking, etc. (in this case) welfare.

  9. Dave Raithel

    If a homeowner thinking exactly and only like an economist isn’t an instance of “false consciousness”, then I don’t know what else could be. RK above appropriately gives reasons why we might sometimes think like an economist, and the first Anonymous responder to CSF re Roubini appropriately gives reasons why we often do not.

    So I’ll give my attention to the dilemmas that Mr. Smith appropriately makes explicit by recounting what I learned – or what I think I learned – from Hyman Minksy (who is why I stumbled into Naked Capitalism.) My training is in philosophy, but I took a course from Minksy in the Spring of ’81 – the spring that Reagan and Reaganomics took the political field. The semester was Minksy expounding upon Reaganomics and “free market” ideology – all we read was the Wall Street Journal and the research papers he assigned – no text book. So it was a lot of him. I appropriated from him two main perspectives: His tripartite model of “finance entities” (the ponzi/ the hedge/ the rational); and his argument for regulation and government intervention. That argument was essentially this: Reagan is right, in a capitalist society, capitalists create jobs – when the collective outcome of their respective decisions are the “right” ones. When the collective outcome are the wrong decisions, you really only have two options: Do nothing (as suggested by the interesting use of “creative destruction” above – I don’t think that’s exactly Schumpeter’s meaning, but it is poetically sound) or you can re-establish a more reliable and predictable flow of funds to the capitalists. Minksy would then add his quips that Keynes figured this out because he took Marx seriously, which is different from being dogmatic, such as are those people who won’t take Keynes seriously precisely because they accuse Keynesianism of being Marxism in disguise. Minksy would say that one can either choose to be ideological about things and so limit choices by that ideology, or one can choose to determine what in fact is causing what and how to stop that when it is bad and how to promote that when it is good. Of course, the ideological elements return in those evaluations – but if is agreed good that capital be sustained, then how that’s to be done was, for him, a factual and not an ideological matter … Or so I thought I had learned…

    I don’t believe that “creative destruction” in the form of a Bonus Army marching on Washington and literally millions of unemployed people standing in soup lines was thought good at the time (by most people, anyway, though some did then see the collapse they’d been awaiting for two generations), and I don’t think that the world as it could develop per Roubini’s 12 Steps will be thought good. The fact that preventing a collapse might entail benefitting people who in some moral sense ought not is, well, “a contradiction of capitalism”, as I sometimes like to quaintly say…

  10. Anonymous

    I have a lot of dumb questions. I keep reading and reading about the mortgage crisis and I just keep getting stuck at the same points.

    If judges dealing with foreclosures in court are demanding to see the paper before foreclosure, then how can both lender and borrower easily facilitate a refinance without producing that same paper?

    Does this mean the lenders didn’t verify who actually holds the paper? Does this also mean each new refinance created new paper?

    And this new paper was also sliced and diced?

    So that means that the same house had had its new loans sold each time. And the only way that would be possible would be if the lenders inflated the value of the house which wouldn’t have happened if they didn’t agree to lend to the borrower. Otherwise, the equity in the house would eventually be negative–which is where we are now due to dropping housing prices.

    And I assume, the lenders agents or brokers received fees and bonuses that encouraged them to freely lend money based on this over-inflating of a house’s price.

    This is why everyone keeps referring to the mortgage crisis as a Ponzi scheme? And now, the lenders want to be rewarded with a bail-out?

    Then, No. Absolutely not.

    It was the lender’s role to maintain perspective just as it’s the bartenders role to shut off his best customer whose on their way to getting drunk.

    I think the reason I find this so hard to follow is it defies basic rational and sound economic sense: which is simply, live modestly within your means.

  11. juanramon-54

    Isn’t it time to get beyond strategies for bailing out mortgage borrowers and lenders, and strategies for keeping capital flowing smoothly into the housing market? As Yves reminds us frequently, we have bigger problems on our plate.

    Don’t we need to invest more capital in better transportation and energy life support systems, to insure the survival of our civilization for another generation or two?

    Can we continue to devote trillions to “the American Dream of Homeownership,” when the people living in those suburban tract homes won’t have affordable fuel for their cars to get them to their jobs?

    Just asking.

  12. RK

    The questions you raise should be the subject for an essay, not a comment. Unfortunately, as my late mother in law used to say, “The squeaking wheel gets the grease”. We lurch from crisis to crisis, and when a calm period intervenes, instead of facing the long term fundamental problems, we assume
    that everything is now fine.
    A single example suffices to illustrate a point you raise: The infrastructure of the US was built on a
    presumption, post WW2, of $2 oil. Cheap heat, electricity and cheap transport to work and to shop. All those structures have now been built. And now,
    with $100 oil, the remote detached single family home, relying on these inputs, is in moving toward
    obsolescence. Unfortunately, we have not yet got past the denial stage to anger, bargaining or acceptance, before which no collective action is possible. And the costs will require great sacrifice.

  13. Anonymous

    The fed is trying for DeLongs option number 2, inflation to effectively reduce debts. The questions are can they do it? can they control it?

  14. Anonymous

    It is the height of unfairness to ask people who showed the restraint not to buy houses beyond their means to now bail out the individuals who were less responsible.

    There are so many reasons a bailout of any sort is terrible public policy. First, it presents a real moral hazard problem; borrowers have incentive to act irresponsibly again in the future if the government will bail them out when things go bad. Second, any way you slice it, government action amounts to a transfer from those who chose to act responsibly to those who chose to act irresponsibly; there is no way such a transfer can be justified. Third, government action will keep housing prices artificially high, when prices need to fall to reasonable levels.

    I imagine most policymakers know that it is unfair and irresponsible for the government to bail out the lenders and borrowers who have made bad decisions. It would be wonderful if the government showed the ability to, for the first time in some time, choose the equitable and wise path as opposed to the one that translates best into short-term political support.

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