Mark Thoma at Economist's View on Appropriate Response to the Mortgage-Backed Security Problem

Mark Thoma at Economist's View often has thoughtful pieces on current issues.  I don't always agree with his views, but I always find them worth considering.

I've written that the Federal Reserve's actions in bailing out Bear Stearns (and quite possibly other investment banks, before this credit crisis is resolved) is worrisome though perhaps necessary given the current interconnectedness of the financial markets and the overall economy and the huge impact that the failure of any one of the largest financial institutions might have.  It's unsavory though perhaps necessary because of the moral hazard issue:  bankers are able to exploit the markets and cash in with huge profits, but avoid most of the impact of the losses their recklessness in reaping ever larger profits may cause.  So I've argued that we cannot address the financial market crisis and remain oblivious to the real suffering of many ordinary Americans who are losing their homes, and in some cases their livelihoods, in part because of the reckless loan origination activites of financial institutions that thought they could rid themselves of the risk by securitizing the loans and passing the potential losses off to others.  In light of helping the investment banks out of their crisis, I've said we should impose new regulations that take into account the size of today's banking institutions and create some curbs to prevent the over-leveraged activity that led to the credit crisis.  I've also argued that we should give less weight to the financial institution's concerns about making modification of mortgage loans in bankruptcy possible--it wouldn't have the negative impact the banks are claiming, and it would make a real difference to individuals and families over a long term.

Mark Thoma, in his post today on the Economist's View blog entitled "Are Central Banks Planning to Make Coordinated Purchases of Mortgage-Backed Securities?" (Mar. 21, 2008) adds another thought that resonates with those I've listed above.   He has supported the idea of the Fed acting as "risk absorber of last resort" for the investment banks (and he notes that he probably should have emphasized more strongly the "last resort" nature of that action).  But he recognizes the moral hazard and fairness issues that raises as well as the fact that it is putting taxpayer money at risk.   And he makes an important statement about the relationship between progressive taxation and inequality in the context of these kinds of situations where players are able to reap huge financial rewards backstopped by the US Treasury.

One of many justifications for a progressive tax is to reduce inequities that arise because the economy departs from our ideal, textbook model. These departures from ideal conditions, and things like moral hazard and regulatory capture are certainly departures, allow income to be earned that is hard to justify. Using taxes to reduce the inequities that arise because some groups are unfairly advantaged by an imperfect system is a reasonable response to this problem.

Comments

[Nick]

At the very least any bailout related to subprime mortgages should be levied directly against the well-to-do

[Stuart Levine]

It strikes me that our current economic problems stem from over leverage. What's interesting is that the mainstream media has actually created a hierarchy of blame, with the amount of blame decreasing as one moves up the economic ladder.

Under this practice, the most blameworthy are deemed to be those in the lower middle class who tried to make something of their lot in life but had to rely on subprime mortgages to do so. Of course, they may not have grasped so desperately at illusory economic straws if their wages had kept pace with inflation, a point that is generally not mentioned.

Somewhat less blame is cast upon the bulk of both the middle class and those aspiring to be upper class who borrowed against the imaginary equity in their homes to sustain an otherwise unsustainable lifestyle.

Finally, there are the hedge fund managers and other lions of finance who traded on gargantuan leverage to obtain not simply wealth, but levels of wealth that could only be categorized as dynastic. To the extent that their activities are subject to criticism, the trope of such criticism is that these actors were simply greedy. Generally speaking, there has been little comment as to how federal tax policies encouraged their excessive borrowing.

Under the circumstances, it is time to revisit the question of how carried interests are taxed. If bailouts can be said to create "moral hazards," then it follows that we should change tax policies that encourage risky economic behavior that leads to disasters that require bailouts. Certainly, at the least, carried interests should be taxed for what they are: income received as compensation for services rendered.

[LindaMBeale]

You are absolutely right, Stuart. It is astounding that the mainstream media have consistently neglected to point out the disconnect--blaming the homeowners who took out risky mortgages and saying they'll just have to fend for themselves, let losers be losers, BUT bailing out the hedge fund managers and broker-dealers who are most responsible for creating the mess and at the same time made enormous sums of money doing so!

[LindaMBeale]

I agree, Nick, that we have to be careful when we engage in activities intended to help people out of mortgage loan problems, to be sure that our efforts are targeted appropriately. Wealthy individuals with a loan greater than the value of their homes shouldn't receive taxpayer assistance, but should be allowed to bear the loss.

And to avoid moral hazard, any assistance to subprime mortgagors will probably need to distinguish between struggling homeowners and "flipping" investors who bought properties at high prices expecting to resell quickly for even higher prices. Those investors intentionally took on the risk of loss, and shouldn't be bailed out with taxpayer money.

That said, many homeowners merit assistance. They were trying to realize the American dream, and the banks were in many ways taking advantage of that attempt, too often with the aid of inflated appraisals, careless lending, and even discriminatory lending policies. According to a recent NPR report, many banks put African American borrowers into subprime loans, even when they were qualified for prime loans at more advantageous terms.