Wednesday, 10 November 2010

Mortgage forgiveness and moral hazard

Stephen Kinsella of Limerick University popped up on Newstalk this morning to tell the country that concerns that the floated mortgage debt forgiveness might cause increased problems of moral hazard as absurd, or somesuch dismissive noun. His argument is put here.

It wasn't a complete or particularly coherent argument, which is forgiveable given the live radio context, but I feel a need to point out that Stephen's performance leaves me feeling that his is the absurd position on this issue. And he can't be given the same forbearance for his blog posting.
It is worth parsing his argument to see how poor it is, riddled with omission, straw men and simple appeal to emotion.

Stephen makes three supposed points referring to moral hazard, conveniently labelled one, two and three in his post. Let's look at them:

"First...the Irish economy has already been
 pumped full of moral hazard because of the bailout of Ireland’s banks
and bankers"

Well, I don't disagree with this, but point out that the bank bailout was stupid and most likely has increased moral hazard, but for lenders of risk capital. What is at issue here is whether to compound one immeasurable level of stupidity (the bank guarantee/bailout) with another (mortgage debt forgiveness) which would extend the exacerbation of moral hazard from risk capital lenders to the borrowers as well - a type of "why stop now?" type of argument. Strange indeed. Stephen's argument might also seem to imply that we should all be allowed our share of moral hazard, that it simply isn't fair or that households should not miss out on this fun. I would characterise that as a rather strange type of analysis of welfare economics.

"Second, the moral hazard existed at the point of sale–the bank
 selling the mortgage had more information about the likely evolution 
of the market...

...Recent research has shown that rising house prices were driven predominantly by increases in the size of mortgages that banks were willing to give, meaning the banks were the engine of the housing bubble, not interest rates or population. The average person just wanted a house to live in."

I don't know how to interpret this. He makes a claim and doesn't support it. To state that "the moral hazard existed at the point of sale" and was manifested through the lender, suggests that the lender had strong belief when they made the loan that they would not be made to bear the cost of any default, over and above their contracted security. Does Stephen have any proof of that? I am not aware of anything that suggests that banks believed they could rely on anything more than the ability of the borrower to repay and the strength of the backing collateral (the house). So this claim is just absurd.

But Stephen then confuses this non-argument by going on to claim that house prices were being driven by the size of mortgages (well, d'uh Stephen, it was a monetary and credit bubble), but doesn't make it clear how that matters for his argument. It is simply a well accepted fact; people wanted/needed larger mortgages to buy property and took increasing personal risk (gearing) to do so, banks wanted/needed to make larger mortgages available and took increasing risk (gearing) to do so. If Stephen has evidence that either side had some information that led them to believe they had some "get out of jail free" card in the event that something went wrong he should actually state it. Otherwise he has not pointed out any moral hazard.

And Stephen then descends into something which is pretty deplorable for an academic economist. He resorts to argument from emotion: "The average person just wanted a house to live in". But I don't give Stephen full credit here. This is even worse than an argument from emotion, it is just plain stupid. There was and is plenty of housing available. People could have rented a house or apartment. Would that have sated this desire of the "average person"??? Moreover, this average person could have found "a house to live in" at a rental yield so low that it made the very idea of buying over renting totally irrational - in fact it was.

So to number three:
"Third, the worry is that these bailed out homeowners would start
 taking out more debt, thinking they’d be bailed out again. Think about
 this for a second from your own point of view. Say a bailout happens 
for you and your wife with a 600,000 euro mortgage on your home. Say through some mechanism the bank forgives 200,000 euros of the mortgage, you keep your home, and you continue to pay a reduced amount to the banks. You and your wife have spent probably two years getting letters and phone calls from banks and solicitors, you’ve gone through the stress of nearly losing your home. A note about the debt forgiveness exists on your credit record. You are not going to start running up debt again, and
even if you’d like to, you’ll be stopped. The moral hazard argument is flawed and useless. We should discard it."

This is flawed by not properly identifying where the issue of moral hazard is really concentrated. Increasing problems with moral hazard will come from all those people who will try to manage their financial affairs in order to qualify for a bailout. For example, we are probably talking large sums here, potentially multiples of gross annual earnings for individuals. People will be incentivised to make their financial position appear worse than it is, or heaven forbid actually deliberately make their financial position worse than it is (why bother with this saving lark, lets blow some cash on holidays etc.) as they reorder their priorities away from paying off their mortgage. Just like a lot of people tried to distort their financial position during the bubble in order to qualify for a larger mortgage, a lot of people will certainly try to distort their financial position in order to qualify for debt forgiveness.

And there is more. The moral hazard will in fact be most likely to affect the children of those people who get the bailouts, or those people who won't get the benefit of this bailout. They will be the ones watching risk being absolved and factor that explicitly or implicitly into their future decisions.

After that series of non-points Stephen then makes some intellectual doodles before signing off. They are all pretty specious, but I find this one probably the most unforgiveable for a supposed Economics professor:

"Fully cleansed, functioning banks, homeowners taken out of substantial negative equity and consuming and investing again, and a clear signal to the markets that Ireland has put its house–no pun intended–in order, may be worth it"

There is a serious ommission of fact that mortgage debt forgiveness will spark increased solvency problems for the banks - they are writing off yet more assets, OK - and not help to "cleanse" them, but require us to put more taxpayers capital into them under the current polices.

With that in mind I hope readers of this blog will immediately understand why I find this statement completely unconscionable. We are talking about a redistribution of wealth here. Ireland's economic problem is a hangover from a massive savings/investment imbalance. A mortgage debt forgiveness program will simply take capital from members of society and give it to some others - completely arbitrarily. Note that the capital might be "taken" via even more borrowing by government, which of course has to be repaid by taxpayers.

Back to Econ 101 for you Stephen. How does such a redistribution of capital either:

  • increase the total amount of capital available, or
  • increase gross saving in Ireland

It doesn't, unless the capital is coming from foreigners, say in the form of default on (foreign)bank bondlholders - but Stephen doesn't say that, nor does he show any indication that he understands that only with such an inward foreign transfer of wealth, would his argument hold water. That is a shocking, shocking piece of supposed analysis from an Economics lecturer.

No, our big mistake was the bank guarantee and subsequent bailout, as I have stated many times over. We should have taken AIB and Bank of Ireland under national administration at the earliest possible sign that they might fail (for "liquidity" or solvency reasons) and then recapitalised at minimum possible cost to the taxpayer, leaving shareholders and then bondholders progressively down the capital structure to take the losses. Thinking we can make debt somehow evaporate (when as I stated it is merely an act of transferring wealth) is seductive, but flawed and dangerous in equal measure. We risk merely compounding our problems and mistakes.


Fungus FitzJuggler III said...

Absoid is an adjective!

Well put refutation of stupidity.

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Jim Thomson is clearly a finance expert who did not read or understand the blog at all! THIEF!

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