Russ Roberts

Kling on the Unseen World of Banking, Mortgages, and Government

EconTalk Episode with Arnold Kling
Hosted by Russ Roberts
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Arnold Kling of EconLog talks with EconTalk host Russ Roberts about the weird world of banking. Why do mortgages look the way they do? What do banks contribute to economic activity? How does regulation and legislation change the structure of what banks do? What would banks look like and the housing market look like if government were less involved? Kling discusses these questions and more including the hidden subsidies built into the current structure of the mortgage market. The conversation is an imaginative exercise in the microeconomics of finance and credit.

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0:36Intro. [Recording date: June 24, 2010.] Imagine a little bit about a world without government particularly in the credit and mortgage markets; try to think about what the world would look like if government's role was different from what it is now. Tendency to try to recreate things that went bad during the crisis. Might want to move away from that instead of trying to recreate what we had before--better, of course. EconLog post imagining what a world would look like without government intervention in a mortgage market. What do banks do, or what might they do in a world less regulated? What is the role of banks in connecting people with money and people who don't have money? Question that has produced plenty of argument. People who are not in the financial sector--entrepreneurs looking to fund investments or households trying to save--would love to have on their balance sheets risk-free liquid assets, things that look like checking accounts. At the same time, they would like to have on the liabilities side of their balance sheet risky liabilities--consumer debt that has no collateral behind it, or long-term investments that are not illiquid, e.g., planting fruit trees that aren't going to produce fruit for quite a while. Nonfinancial sector wants to have riskless liquid assets and issue risky illiquid liabilities. See the financial sector as taking the opposite side of that. They hold the risky illiquid assets like the shares in the fruit trees and they issue riskless liquid liabilities, like checking accounts. What a bank is, is just somebody--an economic agent that connects people on both sides of the transaction. In one sense they are on the opposite side of the transaction, but they are really bringing together folks from the other side. So, I'm a professor. In good years, I spend less than I consume, so I have what we call savings. I have to decide what to do with that, diverse things. Some of the money I'm going to put into assets I don't expect to get at for a while--those fruit trees, that I hope will have a higher rate of return. But I want to keep a lot of my money safe for an emergency or a sudden unexpected purchase. I don't want to keep it under my mattress because it might get stolen if my house got broken into. So, a bank, for starters, is a safe place. But I'd like, when I come back to get my money--I don't want to say to the bank that every 6 weeks I'm going to take a certain amount out; I want to say here's a bunch of my money, take good care of it, put it in a vault; and in the meantime, you may want to do something with it so that when I come back in 3 or 5 years I'd like to get more than when I started. I'm willing to let you, the bank, do something with my money so long as you are able to pay me back at this unexpected time in the future. The bank then is going to look for opportunities to lend that money at rates higher than they promised me--so they can cover their costs--and some of the things they are going to do are going to involve housing. Some will involve small businesses that want money up front. How do we connect those two stories? One question to ask is: What can a bank do that you can't do for yourself? It has economies of scale--it's expensive to put a vault in your house, but if you spread the cost of a vault over lots of people, that's one story. Not my key story. One of the things a bank can do is diversify. Hard for me to buy small shares in lots and lots of risky investments. But a bank, with economies of scale, can do that; and because it has a diversified portfolio, it gets a better risk/return tradeoff. A piece of that even more important: I don't want to become an expert on who is reliable and who is likely to pay me back. The bank is doing that for me. That's the second story. First: diversification. They also diversify across consumer needs. You may need to take out money tomorrow; I may need to take out money next week. By having a diversified set of consumers, they don't need to have all their money withdrawn at once. Diversification at the lending end, deposit end. Develops expertise in assessing and managing loans--when to squeeze the borrower, when to give extension, foreclose, etc. In underwriting--selecting risk--and in managing the portfolio the bank applies expertise.
9:02Third thing that happens with banks is that in order to do that they have to have a reputation for doing that. If you don't believe the bank is good at doing what it does you won't trust it with your money. Of the three, it's the reputation that creates the volatility in finance. Reputations can rise and fall. Can rise inappropriately--banks can take more and more risks. Reputation doesn't rise and fall very much elsewhere in the economy. It can. But when I say "Honda makes a reliable car," it's a reputation they've earned over the years; they have worked hard to gain that reputation; they have an enormous stake in maintaining it. Things can happen unexpectedly--the Toyota brake problem has hurt their reputation. Somewhat less now. Looks like bad luck or the way they handled it poor. In the corporate world generally, corporations develop reputations and as long as they have a stake in it, they are pretty good at maintaining it. Wal-Mart has a reputation for low-cost items of reliable quality; grocery stores have reputations for particular quality produce and cleanliness of stores. Land's End has a reputation--they don't make their own clothes, but source them from reliable places; if the buttons fall off they replace them. But with banks, different situation. More fragility with banks. If an auto manufacturer's product is starting to deteriorate, unless they build a car that is going to be fine for 5 years and then collapse altogether, chances are you are going to observe the deterioration quality. People hear about frequent trips to the shop and the reputation goes away. In the case of banking, reputation stays good until it's too late to do anything about it. Part of that is the nature of the way banks make their money. They don't have all the money in the bank at the same time. And we don't want them to. As the depositors, we want to earn interest on the money. We are willing to take some risk--not that all the loans will disappear, one way you destroy your reputation. But the other thing that worries you is what if all the depositors show up at the same time--what's called a run on the bank. Historically happens from time to time. Banks usually stem that tide. Before the government was involved, they created consortiums to solve that problem. They also limit your ability to have your money on demand. So, if you want to get some interest, if you want the bank to be the middleman, I know they have to use both my money and someone else's money; I know I might have to forego immediate access to my money. I might have to announce when I want my money, accept a delay in return for the fact that they'll be able to invest it more effectively. All sorts of contracts to do that: Certificates of Deposit--CDs. You can withdraw early, but you don't get as much interest and may pay a penalty. Distinction without a difference. A bank ad on radio, that's been involved in the recent financial crisis: ad offering cash back on their credit card of 5%. That's a lot of money. But whose money are they playing with? They are playing with my money--the taxpayer money. A lot of incentive when banks don't have to bear the downside risks to offer rates of return they wouldn't ordinarily think of offering. Can degrade--lose--their reputation. One way would be malfeasance: pushing the envelope, holding an inadequate amount of capital. Or we could just imagine a madness of crowds. Many mechanisms by which banks can overcome the madness of crowds. Distinction, banks can overcome the distinction between being insolvent and being illiquid. If a bank is insolvent it means that even if you gave it all the time for all its assets to mature, it would still end up having negative net worth. Couldn't keep all its promises. If it's illiquid, maybe if you forced it to sell all its assets at a moment's notice to meet its promises, maybe to meet a bank run, it wouldn't have sufficient assets. But if it could keep going it would have positive net worth. It can be hard to tell the difference; hard to value the bank's assets. People still disagree about whether the banks were insolvent during the financial crisis. There are people who will adamantly proclaim that City Corp. was insolvent in 2008; there are people who are equally adamant in claiming it was just illiquid. But if a bank is demonstrably solvent it is hard for it to have a liquidity crisis. It can go out and borrow money from investors--here's my balance sheet. In our economy, it can go to the Fed's discount window, go to interbank market. A lot of people describe the financial crisis by saying the interbank lending market broke down because people just didn't trust the value of mortgage-related assets. Everybody lost liquidity, and then just a question of who is solvent and who is not. The way it was phrased was "banks were afraid to lend to each other." Why were they afraid? "Well, their balance sheets had these complex instruments, hard to value, not sure what the value was." But the flip side was that alternatively, they are complex but we were pretty sure what the value was and it was a lot less than they were listed on the books. Illiquidity vs. insolvency. Hard to tell, but now as time passes, clear that there was a lot more insolvency than people claimed at the time.
19:21If you compared people's views of Freddie Mac and Fannie Mae, the meter has shifted much more toward insolvency. The meter may be shifting more toward liquidity in the case of Citi Group and Bank of America. Some have been able to repay their TARP loans is indicative that they really were solvent; just a matter of keeping them going a little longer. Don't really have controlled experiment because the Fed gave away profits to big banks by buying, paying interest on reserves, keeping short term interest rates low, buying up these assets above their market value. Mortgage backed securities are still sitting on balance sheets at unrealistic levels. Fannie and Freddie: found an old story from June 2008, three months before they were taken over by the government. When they were taken over later, a lot of people told me [Russ] they are cash-flow positive. In June of 2008, the Congressional Budget Office (CBO) said that Fannie and Freddie might cost the taxpayers as much as $50 billion, with 50-50 chance it would be zero. According to the CBO now, it's $390 billion. Illiquidity argument seems to have lost out in the case of Fannie and Freddie.
21:56Mortgages. When you have a large asset you want to purchase, typically you'd like to purchase that with some borrowed money, not all cash. Asset is somewhat liquid, nothing like cash and nothing like Picasso--somewhere in between. Want to borrow the money. If you want to buy a $250,000 house, we can imagine a world where the buyer's got to come up with the whole thing. One way to borrow would be to go around to a bunch of people and say if they lend me the money, I'll pay you back at some point in the future--we'd agree to time frame--inspect the house, good neighborhood; asset could depreciate but will take care of roof and gutters. Could go around to a bunch of people and borrow $10,000 from each of them to accumulate enough, and will of course put some of my own money down. Very costly on my part. And their willingness to lend it to me--significant part of their wealth so they would want a high rate of interest. What the bank does is accumulate that money from a bunch of people, and lends me $200,000; I can put down $50,000 of my own money, or 20%. Bank pools money together. You speculate in your post that the United States is the only country that has a 30-year mortgage. That's a little extreme: it's way more common here than other countries and there are a lot of countries where it doesn't exist. The alternative would be a much shorter mortgage. Why do we have such long mortgages? Short answer is the Great Depression and custom. Back up a little bit. What I think is peculiar about our mortgages is what I call the invented options. One of the options is the option to turn in the keys and walk away from the mortgage. That is known technically as a non-recourse loan, meaning that if I default, the bank has no recourse other than to take possession of the house. They can't go after me and my assets. Combination of being state law--though there are some states that allow recourse loans--and general custom involved in the direction of states that have non-recourse loans. In other countries, e.g., Canada, mortgage loans have recourse. If you borrow $200,000 on a $250,000 house and now the value of the house has gone down to $190,000--because some factory left or some crime has developed in the town. With a non-recourse loan your best strategy might be to just walk away from the house, even though you may have other assets that would allow you to pay the mortgage. In Canada that strategy would not be good--recourse loan. After the bank forecloses the house and loses the money, they may come back to you for the deficiency. They say "We were only to collect $190,000 on a $200,000 loan; pay up the other $10,000." Changes your incentives a lot. In America, with so many non-recourse loans, the option to default is quite valuable; and most valuable for loans where you make a low down-payment. When you make a low down-payment, that increases the likelihood that the price of the house will fall below the value of the mortgage. Leverage: the more leveraged you are, the higher the proportion of the loan that uses other people's money, the smaller a change in the asset price that would put you under water. Increases the value of the default option, which in theory should make the default option expensive for lenders and should cause the interest rate to be higher. So in the United States, the non-recourse nature of the loan makes the default option valuable; recent trend toward low down-payment mortgages makes that option even more valuable and should raise interest rates as a result. The other option that's valuable is the prepayment option--option to refinance the loan typically without any penalty. If you take out a 6% loan and six months later the rates are down to 5.5%, you can get rid of your loan and take out a 5.5% loan without penalty. Then the bank, which was expecting a particular inflow of cash, now will see a smaller amount. One-way option: If rates go up to 7%, the banks don't have the option to make you refinance into a 7% loan. If it were properly priced in, that option would impose pretty high interest rates on the types of loans that have become typical in the United States--a 30 year loan, the option is valuable because you pay off relatively little principal early in the life of the loan. For any option, the longer it's outstanding, the more valuable it is. The most common adjustable rate mortgage (ARM), weird thing called a teaser ARM, where you get a below-market interest rate to start with in exchange for what the bank hopes will be a higher rate later on. If you take out a teaser-rate mortgage, your hope is that in a couple of years interest rates will have stayed low enough that you can refinance and not have to pay the adjustment rate. Another mortgage where the option is valuable. We've evolved in this country mortgages with extremely valuable options for borrowers. My hypothesis: those options have not been priced properly because of government policies that subsidize those types of mortgages. If you took the government subsidy rug out of the 30-year, low-down-payment, no-recourse mortgage the interest rate on that mortgage would be high relative to something like a Canadian 5-year mortgage--constant rate for 5 years with recourse to the lender. Could get a 5-year Canadian rollover mortgage with a rate of 4%; have to pay 6.5-7% for the American 30-year mortgage; would rather pay Canadian rate. That's how the market would work to eliminate the 30-year fixed rate mortgage if it were allowed to work.
31:39Undeniable--it's an unseen economic insight about how government policy can do things and we get used to it. The non-recourse part: the government in many states in the United States has a law that says the bank can't come after you for extra. That privilege--normally you'd have to pay for it. But the government forces everyone to pay for it. The only way it can do that is if it provides subsidies to borrowers who take advantage of that option. Even if the law said you are not allowed to offer a recourse loan, the interest rate on these non-recourse loans would be higher if the market were working. In particular, it would be much higher on loans with low down-payments. The incentive for people to buy a house with less than 10% down in a world with non-recourse loans--would not have the incentive to do that; banks would be imposing a high interest rate penalty. If I buy the house now with 0% down I can get a 6% interest rate; I can bring that interest rate down to 5.5% if I wait and save up for 10% down. But there are states that have recourse loans. For a while the story was that those states were states where interest rates were lower. Ability to enforce recourse loans has deteriorated. Custom in the United States that you can walk away from the house. Interest rate differentials have gone away. Court has to be willing to enforce taking away your car, garnishing your wages. Other part: pre-payment. I could lock in an interest rate and forego my right to refinance, in which case I'd get a lower interest rate. Can I do that now? I believe not. Pretty hard to include a prepayment penalty in a mortgage. During the recent financial crisis, consumer groups took the view that prepayments were anti-consumer, even though they are pro-consumer in the sense that they allow the consumer to get a lower interest rate. Difficult. Go back to the Great Depression. Borrowers were defaulting on these 5-year balloon mortgages; typical mortgage is 5 years, no principal amortization. The entire loan is due in 5 years; but all of a sudden circumstances have changed and the borrower is having trouble borrowing. Mortgage default. Borrower has a harder time paying it back; have to pay it back all of a sudden after 5 years or get a new loan. Government says: We don't like that. We'd like amortizing mortgages, where people pay off some of the principal gradually--that's safer--and we'd like them to be over 30 years and at fixed interest rates so borrower isn't facing interest rate risk. So they set up the Federal Housing Authority (FHA) to offer those kinds of loans. Create a Savings and Loan industry under separate structure called the Federal Home Loan Bank Board. Almost by law that they couldn't offer adjustable rate mortgages; certainly by custom if not by law. Savings and Loans went belly up in the 1970s and 1980s because they were taking too much interest rate risk. Government still wants to keep this 30-year fixed rate mortgage as a standard, so they expand the role of Fannie Mae and introduce Freddie Mac to keep it going. The problem is the taxpayers were taking the tail risk--the risk that these options would turn out to be extremely valuable. The taxpayers were on the hook for the default option becoming valuable and also on the hook for the prepayment option becoming valuable. Interest rate risk is not in this instance what destroyed Freddie and Fannie. Only $390 billion and counting; differs from official government number which is $145 billion--CBO number has different accounting standard than the Treasury one.
38:22Historical account, talked about it in previous podcast. Explain the role that Fannie and Freddie played in making 30-year mortgages more attractive than they otherwise would be. Has to do with a bank's willingness to hold this 30-year asset. Fannie and Freddie allows them to get this asset off their books. Imagine you are a Savings and Loan, and you have mortgages that take 30 years to repay, and you've got deposits that can be withdrawn at a moment's notice. You can see how fragile that setup is. If the market isn't smooth and stable, unsustainable imbalance between the duration of your assets and the duration of your liabilities. If interest rates go up a little bit, let's say you are paying 3% on deposits and earning 6% on your mortgages. Now rates go up by 5 percentage points. So, you could get 11% on new mortgages, but you issued 6 mortgages at 6%. And now your deposits cost you 8% on deposits, now losing money on everything. Can't do that for long without going bankrupt. What you need is to be able to borrow long as well as to lend long. At least issue 10-year debt to make sure you don't get caught. Freddie and Fannie had the ability to do that; would cost much more for a typical bank. They had reputations in international capital markets; in a much better position to finance mortgages. What they were essentially doing was issuing bonds--debt--where instead of having to pay a depositor back on demand, they had a long, slow rate which matches the loans they were collecting from. That would have worked out pretty well. Passage from Joe Stiglitz where he explains that the markets would work out pretty well if you had Fannie and Freddie. What he forgot about was the fact that Fannie and Freddie would have their own incentives to push the regulatory envelope, and that's why we're out the $390 billion and counting. Does raise the possible question. Market failure of a sort. It's a failure of the market to provide the sort of mortgages that Joe Stiglitz might want to provide. Traditional market failure is no one owns the fishing rights so people overfish; collectively destroys the fishing ground. Really stretching the term to say there is some kind of market failure in the mortgage market because you don't get the kind of mortgages that Stiglitz wants. Does raise the possibility: could a private financial institution emerge that would play the role of Fannie and Freddie, that would extend the length of a mortgage beyond what it would be in the absence of such a financial intermediary. Might see 5-year loans, or short-duration loans, or if longer-duration loans they'd have relatively high down-payments; world would do okay. To get the longer duration you need to have some way to manage the interest rate. That's where you need either banks that can develop the ability to issue long-term bonds to investors, and investors want to invest in those. Individual bank would struggle to do that. A well-capitalized bank wouldn't be in any worse position than Freddie Mac and Fannie Mae, other than that the bank wouldn't have the implicit guarantee from the government that if all else fails the bonds would be paid off by the government. Means they'd have to offer a higher rate of interest to attract the long-term loans, and provide some kind of assurance about their capital. Might have to hold more capital than Freddie Mac and Fannie Mae. A lot more. At times they were leveraged 60,70 to 1. Interest rates would generally be higher on 30-year type loans. Borrowers would probably be willing to share some of the risk of interest rates moving and not have such a valuable prepayment option. Seems like a good thing. Slightly less pleasant to be a buyer of a home; more pleasant to be a taxpayer. Stability to the system.
45:36Question is, and maybe our punchline: Who is benefiting from this current system? Why is it that the political forces are so strong as to maintain it? Think of this as a short-run and a long-run discussion. Short-run discussion: Right now, the government is running Fannie and Freddie, and presumably doing so to make sure buyers can get access to mortgage financing in a relatively turbulent time. They are very anxious about the price of housing in certain markets and low interest rates which are artificially low right now are helping to keep the price of housing higher than it otherwise would be. Big short-run incentive for the government to continue the subsidy that the system has created in the past. Is there a long-run incentive as well? Rent-seeking story. Can see the beginning of it if you read Michael Lewis's first book, Liar's Poker, where he describes what's going on in the 1980s at some Wall Street firms. Looking for profit opportunities; notice that U.S. mortgage debt market is huge. Biggest debt market; and Wall Street isn't involved very much. But there is the potential to be involved with it if you could securitize more mortgages. But securitization only makes sense if these embedded options are important. If you had 5-year mortgages, you couldn't carve them up into complex tranches to get any profit. But 30-year mortgages you can carve up into different securities. Is that because people have different tolerances and tastes for risk? Yes, and because people have different habitats; and frankly because I think Wall Street can fool people. Story about Abacus investment: SEC is accusing Goldman Sachs of misleading investors. If you read Michael Lewis's book from 25 years ago, they are in the business of trying to take advantage of their customers all along. Michael Lewis gives examples for himself: customer doesn't know what prices will be, don't calculate the risk properly. A lot of their ability to create market is their ability to take advantage of other people's stupidity. But aside from that: they are carving up these securities, making money trading these securities, giving advice to other people in these securities. Huge profit opportunity for Wall Street. If banks were issuing 3- or 5-year CDs or other forms of debt and funding 5 year mortgages, nothing in it for Wall Street. Wall Street firms worked the political process in order to establish mortgage securitization. Now we are at the point where many politicians are sold on the idea that mortgage securitization is absolutely necessary: we cannot have a mortgage market without securitization. Might be true for the 30-year fixed rate mortgage, but that in turn means that the 30-year fixed rate mortgage needs to have the tail risk taken by taxpayers. Wall Street has proven that it couldn't take the tail risk. Tail risk: risk of extreme events--e.g., big drop in house prices or extreme move in interest rates. We haven't had an extreme move in interest rates since the 1980s. What Wall Street wants is for Freddie Mac and Fannie Mae to stay alive, but revert to the model that Freddie Mac had in the 1970s: purely government agency, no private shareholders, no mortgage portfolio to speak of. All it did was guarantee against the default risk. Took care of the default option but not the prepayment option.
52:10So, if we asked Wall Street, as if it were an oracle: that seems a little bit good for you and not for me, they would of course respond and say, well, not good for you as a taxpayer. We made a mistake; it got out of hand; we're going to make sure it doesn't get out of hand again and put some restrictions on. And it's good because it means home buyers can finance their mortgages at a low price! A little misleading because that low cost of capital for home buyers helps raise the price of housing artificially. Sure. But the violins they'll play are the violins for the first-time home buyer, affordability of housing, maintaining of houses. Create a broad lobby in favor of that. Alternative to buying a house is renting, which is not homeless. If you do not own a home you are not usually home-less. You are a renter. Real comparison: buying a house with a subsidized mortgage for $200,000 versus buying a house with an unsubsidized mortgage for $180,000. Different people benefit from those different setups. Depends a lot on your timing. Another aspect John Papola was talking about the other day, excellent point: when you increase home ownership artificially, which is what we've labored to do for a long time in the United States, certainly since the Great Depression and then with greater zeal starting in the early 1990s and then in the early 2000s when it exploded--2006-2008--one of the things you do is make it harder for people to move. Has impacts on the labor market. When you are unemployed, and you think maybe you should move, the fixed costs of moving in and out of property are very substantial. Why is it so expensive to buy and sell a house? A lot of it is state regulation about registering the deed; but maybe it's not. It's your largest asset. Buying and selling a house and then buying another one because you have a different opportunity in another market to work or because you have a baby or because your kid has gone off to college are all very expensive. We've distorted that choice dramatically by making it so relatively inexpensive to buy a house. Not clear that home ownership has only benefits and no costs. It lets you play your stereo as loud as you like, and in your early years that's one of the main attractions. You can nail a lot of things into the wall. And you get a back yard.
56:20Related but somewhat different topic: General interest rate policy of the Fed. If you look at the Fed in the last 10 years, something of a roller coaster. We had a period when interest rates plummet--Federal Funds rate plummets around 2001; 9/11 attacks, fear of internet bubble bursting. Then they stay very low for a number of years. Then they start rising rapidly; John Taylor has criticized this emphatically. Ben Bernanke, in response to the 2008 crisis brings interest rates down to ¼ of 1 percent right now, extremely low, close to zero. Is that affecting all interest rates? And if so, what does that do to the allocation of capital in the United States as we jerk this interest rate around? My personal opinion is that the capital markets determine interest rates and the Fed is very often following. Don't like to interpret events as being Fed-caused. Russ: Used to be in that group, but not now. Right now, you can't get much for your money. Why? Let's look at economic fundamentals, get the Fed out of the discussion. People are very anxious about the future, worried on the savings side, saving more than they used to but not saving an extremely large amount. On borrowing side, people are anxious because they are not sure the business they want to start will be successful. A lot of businesses are humming along, doing okay, would like to use the financial markets to smooth their inflow and outflow of cash. Why is the market interest rate so low if it's not the Fed? Kling: I guess that really the demand for borrowed funds on the part of businesses is low. It's not clear where you want to expand; stage of business cycle where businesses want to see profits before they expand. True; also folks waiting to see which way the government and economy are going to go. Liquidity on the part of the Fed. Short-term inflation low; not clear that real interest rates are a lot lower than usual.

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COMMENTS (42 to date)
Erik writes:

This looks hot! Unfortunately, I won't be able to start listening until tomorrow. Glancing at the synopsis, I see little data from other countries aside from Canada.

So before I forget: EconTalk topic request! I would love an hour devoted to a comparative look at where the regulation-innovation balances fall and what the outcomes are in the UK, France, Germany, Japan, India, China... Good reading suggestions are also gratefully accepted.

Tom writes:

first I want to thank you for putting all this work into econtalk. It is very enjoyable.

One thing that bugs me though is that you seem to take over more and more of the talk time. It's not that I am uninterested in your opinion, but I feel that your solo podcasts are a better way of delivering that. When you have guests on it'd be nice if you got more out of them :)

thanks, Tom

Rain in Spain writes:

http://news.bbc.co.uk/2/hi/business/6129014.stm

I've been living in Spain for many years, and prior to moving here I built houses in various parts of the U.S.

In my experience, 40 year mortgages are the standard, when you ask what a property will likely cost, among Europeans.

At least the Brits, Germans, and most definitely Spaniards, who I have spoken to about real estate, seem to have always mentioned monthly payment amount, based on an amortized 40-year loan.

Spaniards also most certainly just walk away from their homes, especially the ones that have realized they're paying an insanely high price per square foot, and are now "upside down."

John writes:

I love when Roberts reacts and gives his opinions! His reactions are always interesting, and sometimes really funny...

John Strong writes:

You didn't explain why subsidized loan markets cause house prices to be higher! Why is that?

Obviously, the subsidy will stimulate demand (some people who would be renters of 1000 foot apartments become owners of 2000 foot homes). But supply ought to catch up with demand. I don't see why the equilibrium price would be any higher. Please explain.

With respect to professor Robert's comment that being a renter doesn't mean you are "homeless," I refer you to this old article by Spencer MacCallum The Anarchist Case for Land-Leasing versus Subdivision. I see no improvement to our rigid and consumer-unfriendly market for living environments until we liberate ourselves from the subdivision concept. I'd love to see EconTalk address that issue (as I have told Dr. Roberts in several pestering e-mails). A market that ceased to disciminate against renters in favor of homeowners would offer more choices to consumers and have fewer toxic macro effects.

rhhardin writes:

Bonds, even Treasuries, have a prepayment option, namely a schedule of call prices vs date.

In mortgages, the equivalent would be prepayment penalties in declining amount.

It's a way of sharing interest rate risk.

rhhardin writes:

On Fed caused vs market caused interest rates - the interest rate is an output from the economy.

The Fed target rate is a crutch for the open market operations desk, telling it when to buy or sell debt, thus changing the money supply.

The rate they get though remains always an output.

If there's no obvious flood of cash or drought of cash, the rate has to be pretty close to what the market would want "on its own."

On low rate of return, a retiree is actually better off with zero inflation and zero interest income because there's no tax loss; he'll be living on principal in any case, but it's just less obvious when interest rates are higher.

Justin P writes:

Re: "Reputation doesn't rise and fall very much elsewhere in the economy."

You have mentioned reputation a few times on Econtalk, and I was wondering if you could have a show just on the economic impact of reputation.

It seems obvious that a bank with a lousy reputation would lose customers and need to pay higher returns to get customers. A firm with a really bad reputation would just go out of business, as customers flock to firms with better reputations.
Yet, it seems that reputation isn't as big a factor as you'd think it would be. Some firms with horrible reputations are still in business, especially in banking and finance.

Also thinking about the experts, what happened to them? Bernanke, got re-appointed, even though his reputation should have been completely shot, over his "great moderation" BS. What about all those Pop financial analysts on the news program? I know you've asked this before, but the Economics profession in general, what happened to their reputations? They have seem to have gone up, not down, even from the pop economists that got the bubble so very wrong from the start.

I really would like to listen to a whole podcast on reputation and economics. Sowell seems like a good choice, since I think his latest book on intellectuals, hits on that subject in a few places. Maybe another Mungercast?

emerich writes:

Not sure if you guys had your hearts in this. Arnold's points clarify the nature and structure of the subsidies for mortgages in the U.S. and were interesting, but I was expecting a wider exploration of what the financial industry would look like in the absence of regulation based on Russ's intro.

Arnold's comment about interest rates being entirely market determined leaves me nonplussed. Fed buying and selling of assets and the consequent changes in the money supply don't affect rates? Real rates? nominal rates? Interest-rates and money growth played no role in the housing bubble? During the depression, the Fed had nothing to do with the low nominal and high real rates? Rates in the late 70's and early 80's (short rates around 20%), and the drop in rates in the 80's had nothing to do with Fed policy? Does the Fed then have nothing to do with inflation, if it is only following the market? If this argument can be sustained it would be worthy of a podcast. Certainly none of your monetary expert guests like Sumner and Taylor ever suggested anything remotely similar.

Mike Montchalin writes:

Emerich wrote,

Arnold's comment about interest rates being entirely market determined leaves me nonplussed.

Me too!

Very, very few take that position? Who else agrees? Bob Hoye, Tim Wood, Matt Stiles,... (me); Not too many. Russ admits that he used to be in this group.

Great podcast. Hopefully there will be a lot of comments. Maybe Arnold will come back for an encore.


Richard W. Fulmer writes:

John Strong
You wrote:
"You didn't explain why subsidized loan markets cause house prices to be
higher! Why is that?

"Obviously, the subsidy will stimulate demand (some people who would be
renters of 1000 foot apartments become owners of 2000 foot homes). But
supply ought to catch up with demand. I don't see why the equilibrium
price would be any higher. Please explain."

In a city like Houston, which has no zoning laws, you're right, supply will catch up with demand. Housing prices in Houston remained fairly stable during both the boom and the bust. In other areas, however, laws such as zoning restrictions, "smart growth" policies, and "green space" requirements, prevent supply from ever catching up to demand. See Thomas Sowell's book, "The Housing Boom and Bust," for more information.

Big Al writes:

Strong vote for Russ. He's an excellent interviewer and is better than anyone I've ever heard at stating his own views in a thoughtful, open and inviting way that encourages useful comment from his guests. If I were teaching a class in interviewing, I would want to use the best models, and Russ Roberts would be one of them.

Mike montchalin writes:

re, 45:36

Question is, and maybe our punchline: Who is benefiting from this current system?

Before the current system broke, the intended beneficiary was the buyer, but he only got to pay higher prices. The real beneficiary was probably the builder, which resulted in more bathrooms, bedrooms & square feet per person than at anytime in our history.

As the existing system broke, the beneficiary was the seller, the flipper.

Now the real estate market is completely broken and in disarray. There is no way for anyone to benefit and therefore no reason to borrow.

Stephen writes:

At first I thought this interview was delving into intergalactic economics. And then I realized it was "Kling on..."

John Strong writes:

Richard W. Fulmer writes:

In a city like Houston, which has no zoning laws, you're right, supply will catch up with demand. Housing prices in Houston remained fairly stable during both the boom and the bust. In other areas, however, laws such as zoning restrictions, 'smart growth' policies, and 'green space' requirements, prevent supply from ever catching up to demand. See Thomas Sowell's book, The Housing Boom and Bust, for more information.
Very interesting, Richard. Thanks for taking time to answer my question. I did not know Thomas Sowell had written a book about the housing market! I will definitely pick up a copy.

Is that all Arnold Kling meant? That "Smart Growth" and "No Growth" have made supply inelastic?

Big Al writes:

Regarding the CBO estimate in june 2008, of $50B on the cost of Fannie and Freddie: Is there a link to a reference on that? Thnx

Christian writes:

No government? That's easy: poof! No more property rights, which are created by legislation and case law. Poof! No more corporations, which are created by state law. Poof! No more contracts, which are created by legislation and case law. Poof! No more court system to enforce any rights, privileges or obligations anymore.

A common theme on this show, which drives me nuts by the way, is this bright line distinction between "government" and the "market," or "command and control" and "emergence." I submit that these concepts do not exist, or, at the very least, they bleed together so thoroughly that drawing a distinction between the two is a fool's errand.

Economics, like psychology and sociology and all other social science, is modern day alchemy. One day, when neuroscientists finally figure out how the brain works, all questions about human behavior will be answered. Until then, we will have economists, psychologists and sociologists all peddling their world view without any idea what truly spurs human behavior.

Robert Kennedy writes:

I'm still trying to get my head around the dynamics of how the Feds or states impact 30 year mortgages and the lack of a pre-payment penalty. Would those go away if Fannie Mae & Freddie Mac were not involved? what would be the environment where loans with pre-payment penalty would be priced differently? would 30 year mortgages emerge in some other form?

I get the subject of non-recourse loans, i think. i can see why they are valuable. Would they exist without regulations? might lenders offer non-recourse loans at a higher interest rate if they weren't constrained by regulations?

I'm also not sure about the differences in states regarding non-recourse. One online check suggested that 12 states have non-recourse regulations in place. Arnold suggested that other states have defacto non-recourse because courts don't make it easy for lenders to pursue other assets. Is that true? I didn't get the sense of any data to back that up?

I'm also a bit cynical about the real value of non-recourse loans. do borrowers really factor that in when deciding on a mortgage? obviously strategic defaults have emerged in recent times. I'm a bit cynical that these same borrowers were conscious of such when they first got their loans.

I'm also with emerich a bit, particularly on the last section. The topic of how the Federal Reserve impacts real interest rates is very interesting but the discussion here was very shallow. the podcast ended with me wanting to hear more.

Mike Montchalin writes:

re: Robert Kennedy

I'm also with emerich a bit, particularly on the last section. The topic of how the Federal Reserve impacts real interest rates is very interesting but the discussion here was very shallow. the podcast ended with me wanting to hear more.

Here is a chart from the Elliot Wavers. It sure looks like the Fed follows the market during the ten year period of that chart.
h
http://www.elliottwave.com/images/marketwatch/Fedfollows012208.gif

If Arnold Kling is right, 'that the fed follows the market,' it is huge because virtually everybody believes the FED controls the market. Virtually everyone believes the fed occasionally
errs in judgment, or blunders in judgment. But there is little doubt among them that 'the FED is in control.'

If Arnold Kling is right, the real market works a lot differently than the way most people think.... and the FED can not be blamed for what they have no control over.

One more thing: It is a tribute to econtalks listers that they latch onto minor details of the podcast and consider them even if it is so outrageous as to leave them nonplussed!

Mike montchalin writes:

http://market-ticker.denninger.net/archives/2010/02/10/C1.html

The link is to Karl Denninger's blog. About a quarter of the way down from the top,... or maybe a third, Denninger addresses the Q of whether the FED follows the market. He uses another chart showing the FED follows.

To salvage the idea that the FED leads, we would have to allege that the market is so genius as to be able to virtually always guess what the FED is going to do.......

If it is a game of guessing brinkmanship, it seems there would be higher highs and lower lows. The follower would be especially exposed at tops and bottoms. Who turns first?

The Market. And the FED is exposed as the follower.

Juan Carlos writes:

John Strong wrote:

"You didn't explain why subsidized loan markets cause house prices to be higher! Why is that?

Obviously, the subsidy will stimulate demand (some people who would be renters of 1000 foot apartments become owners of 2000 foot homes). But supply ought to catch up with demand. I don't see why the equilibrium price would be any higher. Please explain."

In addition to what Richard said and that explains some regional differences I would say that eventually the supply do catch with the demand and then is when the the bust comes despite continuing and increasing subsidies.

emerich writes:

Perhaps I misunderstood what Arnold meant by "the Fed follows the market." I would agree that a strong case can be made that the Fed uses market signals in making its policy decisions. My favorite example is that the Fed looks at Fed Fund futures as a guide, and FF futures are the market's best guess at what the Fed is thinking and likely to do. A mirror looking in a mirror. But if both mirrors are flawed, won't the flaws compound? Didn't the Fed get things wrong again and again? (30's, 70's, 2000's...)

Trent Whitney writes:

I really liked the discussion about the history of the 30-year mortgages in the United State, especially the unseen effects of them.

It's part of the larger issues, which you briefly mentioned, about how we don't always ask why things are the way they are; when we do, we often don't analyze the true costs involved.

That made me remember a podcast from many months ago that spoke to the bus system in Santiago, Chile, that spurred me to research some local public transportation systems. It didn't take much time to find out that large federal subsidies are masking the huge financial operating losses - yet seemingly nobody questions this. So now you've motivated me to learn more about our own mortgage system, as well as those in other countries.

Russ Roberts writes:

Big Al,

I had said that in June of 2008, the CBO estimated the cost of Fannie and Freddie might reach $50 billion but there was a 50% chance that the amount would be zero.

I misremembered the facts though not in favor of the point I was making. It was actually July 2008 and the amount was $25 billion.

The story is here.

Christoph Lubenau writes:

I was really hoping that Messrs. Roberts and Kling would talk about the tax deductibility of mortgage interest in the US. Please correct me if I am wrong, but I believe the US is the only developed country that allows for such a “free ride”. I know for a fact, this is not possible in Germany.
Consequently, why the hype about mortgage rates being at an all time low? If one can’t stomach a 3% difference in interest rates because their monthly payments will be too high, then they probably shouldn’t own a home in the first place.

Also, Mr. Roberts asked at one point something along the lines of; how can private banks compete with the government entities and how can they get a piece of the pie when Freddie and Fannie offer such low mortgage rates. I think the banks don’t even want to make home loans at 4 or even 7% interest, for them it is much more lucrative to offer credit cards, for example, with >10% interest while the home serves as collateral.

Keep up the great work - can’t wait till next week!

Robert Kennedy writes:

Thx, Mike montchalin, for that chart. very interesting!

Is a comparison of Fed Funds rate to the Three Month Treasury Yield a useful barometer? Is the latter primarily market driven? is the latter a useful barometer of other market yields?

If it is a useful market indicator, might it represent that the market is good at anticipating what the Fed will do next?

Or were there other top down policies that were driving down rates before the Fed Funds rate could respond?

If it can be shown the Fed is mostly following the market in this regard, what do we learn? Classically, for the period of 200 to 2004, it would suggest the supply of lendable money was outstripping the demand for deposits & loans, right? what was going on during that period? was it a lack of business confidence due to the dot.com bust and 9/11?

dieter writes:

This is yet another episode based on the OMH (omniscient market hypothesis). The only thing the market supposedly isn't omniscient about are real or imagined distortions by the governement. This despite governement being the most transparent actor in the markets, provided the rule of law is being kept. (Venezuela need not apply).

I fail to see how markets were prevented in any way to price in the distortions, which were mentioned by Arnold Kling. There were no price controls on MBS and other securities after all.

The story around here in the german speaking world is that german bankers were uninformed, surprised and offended by the whole non-recourse business. Non-recourse loans are denounced as yet another irresponsible american lending practice. This interpretation is just a convenient way to divert attention from the fact that these bankers could and should have priced these modalities in.

I disagree with Russ Robert's depiction that governements issued a law to "prevent bankers from going after creditors" and therefore distorted markets. After all it is governement, which has to go after creditors on behalf of the banks and can therefore define the terms on which it is willing to do so. And those terms are a matter of public record.

I also disagree with the post-hoc rationale that "to big to fail" and an implicit guarantee for Fannie and Freddie were expected during the housing bubble. Why, if this were the case, did the markets panic in 2008?

I am furthermore highly skeptical of most of the ever more complicated post-hoc explanations of the financial crisis. I think most of the analyses of this kind attribute more rationality to the motives and actions of market participants than there really was. Otherwise it shouldn't be so complicated to find out what exactly motivated the participants. In fact we could simply ask them. The pricing models for MBS didn't even allow for the possibility of falling house prices, as far as I know.

P.S.:
@Russ:
Are you aware of Erik Falkenstein? I think he would make a great guest for the show.

http://falkenblog.blogspot.com/2010/03/why-envy-dominates-greed.html
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1420356
http://falkenblog.blogspot.com/

Mike Montchalin writes:

emerich wrote:

Perhaps I misunderstood what Arnold meant by "the Fed follows the market." I would agree that a strong case can be made that the Fed uses market signals in making its policy decisions.

Mike: What I am objecting to is the widespread belief that Greenspan, and now Bernanke, have some kind of nuanced understanding as to whether the economy is too hot, cold, or Goldilocks. And that Ben Bernanke is carefully applying his foot to the only tool he has to carefully control the economy's temperature.

emerich continued,

My favorite example is that the Fed looks at Fed Fund futures as a guide, and FF futures are the market's best guess at what the Fed is thinking and likely to do. A mirror looking in a mirror. But if both mirrors are flawed, won't the flaws compound?

Mike:
Yes. That is what I was thinking, too. The question is, which of the mirrors has a glimpse of reality and is reacting more to reality than the other mirror?

It would be the mirror that changes its interest rate first: the market.

emerich continued,

Didn't the Fed get things wrong again and again? (30's, 70's, 2000's...)

The two charts that show the FED following the market are not conclusive, but very suggestive.

I would like Arnold Kling to comeback to suggest a story as to what was going on if it wasn't the FED.

It is widely believed that it was the FED, Volcker, that put an end to the inflation of the seventies. If it wasn't the Volcker FED, and the FED was only following the market, why did the market turn from what looked like a future of hyperinflation?

The Peter Blair Henry podcast comparing Jamaica & Barbados impressed me a lot.... the importance of policy.

Although Jimmy Carter appointed Volcker, it wasn't until Reagan was elected that we veered from what appeared would be hyperinflation. Was it policy? or the FED?

Jim writes:

How can a podcast, which ostensibly is devoted to government distortions in the mortgage and housing market, in over an hour of conversation, not mention the mortgage interest tax deduction once?

Apart from that there was some very fuzzy thinking on both Russ's and Kling's part.

For a guy who spent so much time studying the GSE's, Kling seems woefully uninformed about how modern investment banks model and hedge interest rate and prepayment risk.

For instance, a bank borrows in the money market and lends in the capital market can use an interest rate swap to hedge the risk. That's why interest rate swaps exist.

Additionally, the conversation about embedded options also seems to go off the tracks. The discussion on the non-recourse aspect of home mortgages seems ungrounded.
- In California, purchase money loans are no-recourse, but refi money loans are. Presumably these could be compared.
- Commercial mortgages are virtually all no-recourse. Why is this?
- The so-called default option has been worthless for the vast majority of loans for the vast majority of the postwar period. In fact for 20% down purchase, the default option is virtually worthless.
- The no-recourse loans also exist to incent banks not to overextend credit (though apparently it didn't work...)

As to the prepay option, the mortgage passthru market (pools of mortgages which pass through principal and interest directly) is one of the most liquid and deepest markets in all of finance. And all it trades on is prepayments. What indication does Kling have that banks are mispricing the prepay option? Additionally, banks do have the ability to hedge this risk with interest rate options (via swaptions, callable bonds, etc.)

Finally, by the end something must have gotten to Russ, when he effectively said 'I know people are saving more, and businesses are borrowing less, but why are rates so low?'

Despite all this, still love the show.

Jim writes:

Wow. I went and read Arnold Kling's original post on EconLog 'Remarks on U.S. Mortgage Finance', and he is much more wrong than I realized originally.

His points:
(1) is simply wrong other countries have 30 year mortgages
(2) is simply a wrong opinion. Hundreds of millions of dollars of 5 and 7 year balloons exist, but they're not particularly popular borrowers, probably because they don't like the uncertainty of having to roll their debt. People seem to prefer 5 and 3 year teaser ARMS, which they treat like balloons, but in a worst case can live with the adjustable rate rather than refinancing. That Kling doesn't know this makes the rest fairly suspect.
(3) I'm not sure how he thinks the government is 'subsidizing' the default and prepay options. A mortgage is a contractual obligation entered into by two willing parties.
(4) as I pointed out above, a teaser arm is typically treated like a balloon by both borrower and lender. He should know this.
(5) the slicing and dicing is largely customer driven. That is, different investors have different appetites for interest rate exposure and assets and liabilities to match. I know Kling would find it hard to believe, but much slicing and dicing exists for this. The original sequential CMO's were created specifically to mitigate prepay risk, so insurance companies could buy mortgages.
(6) Agree. Anything less than 15%-25% down is foolish.

The agency securitization market worked for a long time, and FNMA and FHLMC as government sponsored mortgage insurers I think was a reasonable model. I agree that FNMA and FHLMC with a massive and levered portfolio based on subsidized cheap debt with profits going to shareholders is a terrible idea.

But for a guy who seems to speak authoritatively on this subject, he doesn't seem to understand some simple aspects of it. 'Liars Poker' is a great read, and offers some insights, but (1) its fairly dated in terms of where the market has gone, and (2) Michael Lewis is a great writer, but he's not very quantitative. He assumes at times that because he was faking it everyone else was too.

Alex writes:

One fact that I did not hear in the discussion is that banks were implementing short term mortgages (such as the 2-5 year contracts Arnold Kling suggested in order to bring about more parity between bank asset and liability durations) with option ARMS and other "exotic" mortgage contracts. For example, see this paper by Piskorski and Tchistyi (2010). To illustrate the point: you can think about a 5 year mortgage contract as a 30 year contract with an ''event'' at 5 years in which you can either sell the home, refinance the debt or realize a reset to a new rate of infinity. The banks implemented such a contract by choosing a reset to 10% rather than infinity.

Arnold Kling writes:

Jim writes,

I'm not sure how he thinks the government is 'subsidizing' the default and prepay options. A mortgage is a contractual obligation entered into by two willing parties.

The government did not require Freddie, Fannie, or any too-bog-to-fail institutions to hold enough capital to cover their tail risk. Hence, it was profitable for these firms to accept small yield advantages on 30-year mortgages in exchange for large tail risk.

It is true that banks can use the credit markets to trade interest rate risk. That is why I do not think we necessarily need the GSE's. But the risk does not just go "into the market" and dissolve. Somebody ends up bearing the risk. My worry is that "somebody" will be the taxpayer, in which case the risk will not be properly priced.

It could be that the market will underprice the tail risk on its own, because of limited liability. It may be optimal from a bank CEO's point of view to take large paychecks most years in exchange for having their firm go bankrupt when there is a rare event. But I think the big distortion comes from the government's too-big-to-fail policies.

I cannot be certain how a free market would emerge. Maybe the 30-year mortgage would dominate even if the people pricing the tail risk also were taking the tail risk. But it's an experiment that we have not observed.

Tom of the Missouri writes:

I am listening to Arnold's discussing about mispricing 30 year mortgages. A long time ago, I was a part owner of a small village bank, was once a bank examiner and have for the last 30 years been a real estate investor. I am not sure what the statistics are now, but 20 to 30 years ago, everyone in banking knew that the standard length of real estate mortgage loan was 7 years, regardless of the typical 20 or 30 year nominal terms. Despite the recent aberration orgy of lending to unverified and unqualified no down payment buyers, I presume it is still somewhere near that figure. American's are an upwardly mobile bunch, as Russ has argued many times when discussing other subjects. That in my opinion is why Bankers can make 30 year loans. On average when they legally tie up their money for 30 years, they always knew that it was, on average, only 7 years. That is still a liquidity risk that has to be managed, but not near the problem it would be if it was really 30 years.

AHBritton writes:

Russ,

I would like to point out a pervasive form of confirmation bias that I think you might have illustrated. When Kling mentioned that long term (say 30 year) mortgages provide more opportunity for securitization and that Wall Street used that to take advantage of their clients on occasion your immediate response was something along the lines of, "I don't know if I believe that." This at first might seem like a healthy form of skepticism about a claim… this is only true though if it is evenly applied and followed through on often. Otherwise it is easy to be skeptical about only the things you are already less inclined to believe (convincing yourself it is a virtuous trait) and easily accepting of things that you are more inclined to believe. In reality it would be almost MORE unbiased to easily ACCEPT claims on both sides of an issue, then you would at least be treating the evidence equally, although the best choice in my opinion is to be skeptical of claims on both sides.

So in other words, even subtle, minute, and easily defensible skepticism (skepticism is health right?) can actually LEAD to further bias and confirmation. This leads me to a question, of all things, why would you be so knee-jerk skeptical of claims of such dishonesty? If a group of people believes they can get away with making money through dishonest behavior than economics would predict an increase in such behavior would it not? Do you really think Wall Street traders are above putting their thumbs on the scales?

Luke J writes:

Unintentionally, this podcast presents several reasons why fractional reserve banking is a bad idea.

Russ Roberts writes:

AHBritton,

It is certainly true that skepticism can be misleading.

As to the underlying question of whether to believe Arnold's claim--yes, people in all walks of life can be tempted to put their thumbs on the scale. But the customer is usually aware of this. In financial transactions, both buyers and sellers are often savvy. So presuming systematic deception is problematic for me to believe. It is more believable when buyers do not bear the consequences of bad purchases and surely there are situations in financial markets when that is true. So I remain skeptical but open to persuasion.

AHBritton writes:

"yes, people in all walks of life can be tempted to put their thumbs on the scale. But the customer is usually aware of this."

Aware of the possibility of being cheated, or actually being cheated?

"In financial transactions, both buyers and sellers are often savvy."

They definitely can be savvy… many can also be duped rather easily. In 2005 Harry Markopolos wrote a 21-page memo that he submitted to the SEC titled "The World's Largest Hedge Fund is a Fraud"… and this was 6 years after he initially suspected something and told the SEC.

Now I doubt you are surprised at the SEC's failing, but were you not surprised by the MANY supposedly well informed investors who bought into this? Apparently largely on name recognition alone? Where were the savvy investors after someone was literally TELLING them it was a fraud?

"It is more believable when buyers do not bear the consequences of bad purchases and surely there are situations in financial markets when that is true."

I think you over estimate the ability of people to be scammed. Maybe you think only the ignorant public fall for Nigerian Princes, but I happen to not put as much stock in the certainty of massively higher intelligence among the investment class.

"So presuming systematic deception is problematic for me to believe."

I don't think first hand accounts and felony convictions are presumptive.

"So I remain skeptical but open to persuasion."

I'm not exactly sure how much persuasion you need when there already exists people admitting first hand that they were involved, when there are people in jail, when people have written books about performing these scams… what exactly would persuade you?

Richard W. Fulmer writes:

Juan Carlos points out that supply and demand eventually balance even when prices are artificially raised by government interference. I agree. If the government were to decree that eggs now cost a million dollars each, supply and demand would balance at zero (zero eggs demanded, zero eggs supplied). Still, there would be one less source of affordably priced protein and, to that extent, demand would not be satisfied. Similarly, if housing prices are artificially raised, supply and demand reach a balance at the new price level. Yet, demand for affordable housing goes unsatisfied as a result.

Nick writes:

Thanks Russ for your informative discussions on these matters.

I have one question on the discussion of market prices vs. subsidized prices for housing, and it involves some of the political arguments made when passing much of housing legislation. In your opinion, is there validity to the following argument?

With no subsidy, less people would be homeowners; more people would rent. In general, when a single person is both responsible for something as well as receiving the benefits of the work, they have a better incentive to do a good job - when a building owner owns all fixtures in a building and a shop manager renting the space pays the utility bills, the building owner, not seeing the benefit of reduced utilities is less likely to keep the fixtures in prime operation, unless it detracts from the rent that can be collected.

Similarly, homeowners - as a rule - take better care of their homes than renters and landlords in the same circumstance. Is it not a benefit to society, then to have subsidized housing that increases total homeownership?

I agree the way many of these organizations (Fannie and Freddie) may need to be scrutinized, but isn't the goal of stronger communities, better, cleaner, safer neighborhoods with more clear responsibilities of homeowners, etc. still desirable?

Thanks.

Russ Roberts writes:

Nick,

People who own things often take better care of them than renters. But when you buy a house with zero down or very little, you're renting from the bank. Politicians used your justification for enriching builders, realtors, Wall St, and some home buyers. But the benefits of home ownership come from working to earn enough money to buy a house, not having a piece of paper that makes you the titular owner.

Paul W writes:

Russ,

Long time listener, first time caller (commenter?) Econtalk is fantastic, I've recommended it to all my friends. Usually I don't have much to add, but I've worked in the mortgage/banking industry over the past 3 years and I'd like to give my two cents on the state of the housing market in the US.

First, in regards to how banks can hold short term deposits to fund long term liabilities. Here, derivatives are the answer, they can hedge interest rate risk by entering a swap. For example a bank agrees to pay a fixed rate to their counterparty and receive a variable rate. This way the fixed rate income they receive (from the mortgages) gets paid out to the counterparty. Then the counterparty pays the bank a variable rate, which they use to pay the depositors. In practice the variable rate they receive from the counterparty is higher than the deposit rate and the bank can make money on the spread while "eliminating" the interest rate risk. Eliminate is in quotes because there are second order effects, but those can be hedged as well using more complicated derivatives.

Second, I think the mortgage market in the US is the best model in the world. It is far more efficient for banks or private investors to hold the interest rate risk and credit risk than individual consumers. Institutions can hedge interest rate risk very cheaply but individual's can't. There are significant gains from economies of scale. The system broke down in part because credit risk was very mispriced. I believe this was in part due to complexity in the system, everyone was passing the risk on to someone else to the point where no one really understood their true exposure. Lots of simplifying assumptions were made and they turned out to be wrong. For years people sought safety in complexity (i.e. diversification) when in reality the complexity lead to greater interconnectedness and fragility.

Third, on a personal note I am a little worried about how certain you sounded about the virtues of the Canadian model of mortgages. Generally you are very open to both sides of the argument but on this issue you came off as rather one sided. You usually approach both sides of an issue with a healthy dose of skepticism.

I hope my comments were helpful.

Best,
Paul

Brian Clendinen writes:

Let me be clear, when referring to the Fed setting interest rates they were discussing real rates. Arnold is not suggesting the government does not influence inflation.


I agree with Arnold on the market setting intrest rates except in the short term. The government is so large they can effect rates in the short term. Not sure the maximum duration but I would say at best if the government thru everything they had maybe 16 months depending on how the market reacted. This would cost taxpayers a lot of money though. Nor does Arnold believe that laws can have long term effects on interest rates. What he is saying is the Fed set the real interest rates to whatever they say they should be. In the end long term economic fundamentals which the market reacts to will determine interest rates.

I wish they would of discussed the most positive effect of homeownership. It is an automatic saving mechanism. Granted people refinance and tax the saving out of their home but physiologically home ownership tricks people into save huge amount of money which they have invested in their homes they would not otherwise due if they rented. Historically speaking home ownership was the least volatile type of saving over the long term after pure cash.

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