Bank lending is getting expensive

Another idea

This seems too sensible to make it through Congress:

So what should the government do? Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.

Now what?

Former student John Tamny has an idea:

It’s probably naive to ask this considering the basic governmental incentive to grow, but if Washington won’t countenance the market-clearing and cleansing process that would be a path to recovery, why not at least minimize the government’s role through basic industrial policy? We always hear about how tax cuts “cost” the Treasury versus “stimulus” and $700B in spending that will allegedly aid the economy at a profit, but if bank balance sheets really are a mess, why not zero out capital gains treatment on the purchase of toxic securities to foster a private rescue?

Houses vs. Stocks: its not even close

New research from Robert Shiller:

Shares have been remarkably consistent over the past two centuries in their 7% real returns. In Jeremy Siegel's book, "Stocks for the Long Term," he finds that real returns averaged 7.0% over nearly seven decades ending 1870, then 6.6% through 1925 and then 6.9% through 2004.

The average real return for houses over long time periods might surprise you. It's zero.

The argument for a bail out

Seems clear we are trading short run gain for long run pain. But here is a clearly articulated argument for doing so.

Banks can lend to consumers and investors about 12 times their capital base. If they have to write off 20% of their capital because of losses, that means they either have to sell more equity or reduce their loan portfolios. As an example, for every $1,000 of capital, a bank can loan $12,000 (more or less). If they have to write off 20% ($200), they either have to sell stock to raise their capital back to $1,000 or reduce their loan portfolio by $2,400. Add some zeroes to that number and it gets to be huge.

And that is what is happening. At first, banks were able to raise new capital. But now, many banks are finding it very difficult to raise money, and that means they have to reduce their loan portfolios. ...

I don't want to name names, as this letter goes to about 1.5 million people and I don't want to make problems for some fine banking names; but there is a silent bank run going on. There are no lines in the street, but it is a run nevertheless. It is large investment funds and corporations quietly pulling their money from some of the best banks in the country. They can do this simply by pushing a button. We are watching deposit bases fall. It does not take long. Lehman saw $400 billion go in just a few months this summer. Think about that number. Any whiff of a problem and an institution that is otherwise sound could be brought low in a matter of weeks. And the FDIC could end up with a large loss that seemed to have come from out of nowhere.

More Government Risk Subsidies

It seems like everywhere you look these days, people are looking for the government (i.e., taxpayers) to cover the costs of risky behavior. One of the most important lessons of economics (in my humble opinion, of course) is that if individuals don't pay the full cost of their risky behavior, they will engage in more of it. And, for some reason, we seem to have developed a fairly wide concensus in this country that it's not "fair" for people to pay higher prices to cover the cost of risky behavior.

Here's an article from Business Week that discusses the case of Citizens Property Insurance, a quasi-governmental insurer in Florida. Originally planned to be an insurer of last resort, it has become Florida's top underwriter of homeowners' insurance. What happened to the other insurance companies? As the article notes: "Faced with state-imposed limits on raising rates to cover their risks, insurers began to pull out of Florida." Isn't it obvious why rates needed to increase? Perhaps to cover the likely costs of damage? Instead, you will have taxpayers subsidizing the risky behavior of their fellow citizens (assuming the company can come up with the money to cover these risks in the event of future claims).

Financial innovation circumvents short-selling ban

Merton Miller, Nobel Laureate in economics, and thesis advisor to my colleague Bill Christie, once wrote that every important financial innovation was designed to circumvent regulation. An example from our textbook is that Euro dollars (dollar denominated savings accounts offered by European banks) were designed to circumvent Regulation Q, the 5.25% price ceiling on what US banks were allowed to pay depositors.

Now we see money flowing into betting markets to circumvent the ban on short-selling financial stocks.

BetsForTraders.com, a financial bookmaker, has reported volumes up by more than 400 per cent since last Thursday's ban, with almost all the increase in activity in bets against banking stocks.

Bad Economy=Entrepreneurial Opportunity?

Is the weak economy especially hard on smaller businesses? Or does it help create more entrepreneurial opportunities? Depends on who you ask. Here's the New York Times' view along with a counter-view from the Independent Street blog at the Wall Street Journal. (HT: Slate)

Economists against the bailout

Dear Fellow Economist:

I write to encourage you to sign the attached letter opposing a broad, open-ended bailout of the financial sector. ...

Wayne T. Brough
Chief Economist, FreedomWorks

-------------------------

September, 23 2008

An Open Letter to the United States Congress:

We, the undersigned economists, write to strongly advise against the proposed $700 billion bailout .....

In addition to the moral hazard inherent in the proposal, the plan makes it difficult to move resources to more highly valued uses. Successful firms that may have been in a position to acquire troubled firms would no longer have a market advantage allowing them to do so; instead, entities that were struggling would now be shored up and competing on equal footing with their more efficient competitors. ...

Is the stock market over-valued?

Historically, at least, P/E ratios look big. Unless of course you think that growth prospects have improved in the last five years.