529: Popular != Good Policy

Peter Suderman writes,

this episode and the swift bipartisan opposition it generated is so revealing, not only about the short term political instincts of the Obama administration, but about the longer term political and policy dynamics of sustaining the welfare state.

He is writing about President Obama’s proposal to tax savings from “529 plans” for college saving, which the Administration has since backed away from. I read Suderman as saying that the larger point is that when it comes to unsustainable fiscal policy, we have met the enemy and he is us. My comments:

1. Re-read Lenders and Spenders. Government debt inevitably leads to political strife.

2. 529 plans are regressive. Nearly all of the benefit flows to people with high incomes.

3. 529 plans are yet another enabler for colleges to boost tuitions.

4. 529 plans subsidize affluent people for doing what they would have done anyway–send their kids to exclusive, high-priced colleges.

529 plans are terrible public policy. Instead of demagogically criticizing the Administration’s proposal to tax them, I would say let’s get rid of them altogether.

How to Live Beyond Your Means

1. The WaPo reports,

Today, they struggle under nearly $1 million in debt that they will never be able to repay on the 3,292-square-foot, six-bedroom, red-brick Colonial they bought for $617,055 in 2005. The Boatengs have not made a mortgage payment in 2,322 days — more than six years — according to their most recent mortgage statement. Their plight illustrates how some of the people swallowed up by the easy credit era of the previous decade have yet to reemerge years later.

Living rent-free in a $600,000 house is a “plight” only in the sense that at some point you may have to stop.

2. John Cochrane relays,

80% of Greek debt is now in the hands of “foreign official.” Now you know why nobody is worrying about “contagion” anymore. The negotiation is entirely which government will pay.

I must be really old-fashioned or something. But paying taxes so that Greek governments can live beyond their means or that people can live in houses twice the size of mine rent-free is not really my idea of “the things we all do together.”

PG County Foreclosure Story Focuses on the N-word

This WaPo story is long, but nonetheless incomplete.

Using court and land records, The Post analyzed 173 home purchases in Fairwood that wound up in foreclosure between 2006 and 2008.

In 43 of those home purchases, borrowers financed 100 percent of the cost of the home with loans that had high interest rates and reset periods within three years. The loans were of the type that Angelo Mozilo, the CEO of defunct subprime lending powerhouse Countrywide Financial, had called “toxic” because they offered such onerous terms. He warned his own company in internal e-mails that the loans were “the most dangerous product in existence.”

Nearly all the remaining loans The Post examined contained features associated with high default rates, such as low or no down payments, interest-only payment periods and higher rates than prime loans.

Only seven out of the 173 defaulters received the most favorable lending terms, known as conventional 30-year fixed interest rate loans. These “prime” loans are the least likely to fail, experts agree.

The neighborhood is described as primarily African-American, with a median income over $170,000.

Some questions that I have:

1. Why were so many loans made with zero down payment? If the median family income is that high, should there not have been higher down payments?

2. If the borrowers put nothing down to begin with, then foreclosure cost them nothing in terms of lost equity. Presumably, if they were affluent before, they are still affluent now. If not, why not?

3. Did anyone benefit from making these loans? The companies that ended up owning the mortgages took huge losses (taxpayers also may have been involved in some way, through bailouts). Companies that originated subprime loans but did not hold them (the “originate to distribute model”) picked up some small fees, but my guess is that they competed away a lot of profits by incurring marketing costs, and in any case enough of them went out of business that you can hardly envy their franchises.

4. When did borrowers start to fall behind on their payments? If it was within a year of buying the home, then you can be sure that even if the borrowers had gotten prime, thirty-year fixed rate loans they still would have defaulted.

Remember, it was the WaPo that said on January 1st that “narrative” is “out” and “facts” are “in.” Their story is instead all about narrative (the N-word, as I call it), and I think it could use more facts.

Yanis Varoufakis talks with Russ Roberts

He says,

You and I would not be talking about Greece today if Greece in 1999 by some miracle of politics and rationality had stayed out of the Eurozone. That is the reason why it is such a disaster; and it’s why it’s so significant in the world economy and pipsqueak Greece has been dominating for three years. The headlines of [?] which is a sign that something is definitely wrong with the international economy. And the reason for that was that Greece was in the Eurozone. The tragedy of course is once you are in, you can’t get out. You are trapped. And so on and so forth.

The podcast is a year old. It is of interest now because he is now finance minister of Greece.

What’s In Alexis Tsipras’ Wallet?

He is soon to be the Greek premier. The Independent reports,

A Syriza government would have to rely on taxes but tax revenues are down as people wait to see if taxes will be reduced by the new government. This means that Greece may only have the money – though this is disputed by Syriza leaders – until the end of February to pay state employees and pensions and service the debt.

As a far leftist, we can presume he wants to spend lots of other people’s money. Where can he get it?

1. Greek taxpayers. Greece actually was supposed to run a primary surplus this year, meaning that they would only have to borrow to pay interest on debt, not to fund ordinary spending. But apparently the Greek taxpayers do not see it that way. UPDATE: Tony Yates points out a problem even if you have a primary surplus and decide to blow off the interest on your debt. (pointer from Mark Thoma),

the Greek government does not have the funds to stand behind its own banks. They would be left insolvent by a Greek default [economically, they are already, really]. A run on Greek banks, either prompted by default or the threat of it, could not be stemmed by a credible guarantee of deposits.

2. Non-bank investors willing to invest in Greek bonds. Considering that Tsipras does not sound particularly eager to pay off such investors, they might be a bit shy.

3. Banks willing to invest in Greek bonds, since those bonds carry zero risk (according to capital regulations). Still, I can imagine that bank managers are a tad worried that the regulators who designated sovereign debt as risk-free don’t actually have any money with which to back that up.

4. The European Central Bank, which just announced a big “quantitative easing” program, so it needs stuff to buy. The question is how eager Germany and other European countries are to be Tsipras’ sugar daddies.

Pointers in (1) and (4) from Tyler Cowen. Possible outcomes, in order from highest probability to lowest:

1. Eurocrats devise a new elaborate shell game under which they funnel money from other countries to Tsipras while pretending not to do so, hoping that ordinary voters in those countries will not notice, or that even if people notice they will be powerless to do anything about it.

2. The European central bank goes ahead and buys bonds from Tsipras, because the alternative is scarier.

3. Tsipras ends up implementing austerity, because his wallet is empty.

4. Tsipras ends up printing a new Greek currency, as Greece exits the Euro.

What I am Reading

1. Michael Shermer, The Moral Arc. I am only a few pages in, and he already has cited Bill Dickens and Bryan Caplan, among others.

2. Jeffrey Friedman and Wladimir Kraus, Engineering the Financial Crisis. This is a re-read for me. They share with me the view that risk-based capital rules contributed heavily to the crisis. They make a very subtle point, though. They do not believe that bankers went all-out to maximize the effective leverage of their banks. Thus, the authors reject the moral hazard arguments of deposit insurance and too-big-to-fail.

The way I would put their argument is this. Suppose that bank managers were, for whatever reason, actually quite concerned about risk exposure. They thought, even if incorrectly, that the value of keeping their franchises intact and avoiding trouble was very important. Even so, with the risk weights that regulators placed on different assets, the effective rate of return on mortgage securities was much higher than that on other asset classes, including low-risk mortgage loans. Thus, the risk-based capital rules, along with the lenient ratings by rating agencies of mortgage securities, served to steer capital into high-risk mortgage loans and thereby into feeding the housing bubble.

In making their argument that the crisis was in my terminology a cognitive failure rather than a moral failure, the authors point out that if bankers had merely wanted to maximize their exploitation of implicit and explicit guarantees, they could have acted differently. They could have held higher-risk, higher-return tranches of mortgage securities. They could have held less capital (before the crisis, major banks tended to have leverage ratios well below regulatory limits).

Fiscally Responsible Italy

Lawrence Kotlikoff writes,

As for Italy, its fiscal gap of negative 2.3 percent is the lowest of any of the 24 included countries. Indeed, Italy can spend almost €180 billion more and still be able to meet all its expenditure obligations. The source of Italy’s long-term fiscal solvency is its two major pension reforms that have dramatically reduced its pension obligations. In addition, Italy has strong control of its health care spending.

Pointer from Greg Mankiw.

This is why accrual accounting would be an improvement. Under the present system, politicians have an incentive to run up their debts in the form of obligations in pensions systems. By not using this trick, Italy managed to be fiscally responsible.

Nassim Taleb Quote Bleg

I remember Taleb saying something to the effect that risk in financial markets is like a lion (or tiger?) hunting, in that it will find the weakest prey. Can anyone find such a quote? I have tried basic Google searches and searches through my blogs, but without success.

Peter Wallison and the N-word

He says,

By 2008, before the financial crisis, there were 55 million mortgages in the US. Of these, 31 million were subprime or otherwise risky. And of this 31 million, 76 % were on the books of government agencies, primarily Fannie and Freddie. This shows where the demand for these mortgages actually came from, and it wasn’t the private sector. When the great housing bubble (also created by the government policies) began to deflate in 2007 and 2008, these weak mortgages defaulted in unprecedented numbers, causing the insolvency of Fannie and Freddie, the weakening of banks and other financial institutions, and ultimately the financial crisis.

Remember what the Washington Post Style section proclaimed on January 1st. Narrative is out. Facts are in.

Of course, in addition to the Freddie and Fannie securities, there were lots of private-sector securities backed by risky mortgages. My contention is that this boom was fueled by risk-based capital rules, which stated that once these loans were packaged into securities, divided into tranches, and blessed by rating agencies as AAA, banks could earn three times the return on such mortgages as could be earned by originating and holding an old-fashioned, low-risk mortgage.

How do you say ‘Have a Nice Day’ in Japanese?

John Mauldin writes,

If interest rates were to rise by a mere 2%, it would take anywhere from 80 to 100% of all Japanese tax
revenues simply to pay the interest on the Godzillaesque Japanese debt.

If you read Mauldin, you should do so over a period of time, to get a sense of his biases, which are strong.

However, his views are consistent with my emphasis on the notion that governments and banks are subject to multiple equilibria, and that when leverage is high, the movement from one equilibrium to another can be sudden and catastrophic.