13 August 2008

What if the Mortgage Companies Failed?

Would there really be a problem if these entities just failed? Are they like banks in that they would start contagion
This is the question asked by James K in a comment on a previous post.

The answer is, I'm not sure. I'm not an expert in the mortgage industry by any means. But what happens is that the mortgages get packed and sold to investment firms. As the high-risk packages, made up of the sub-prime mortgages, are not being repaid, nobody wants to buy those right now, and so the investment banks that sell them are currently refusing to make funds available to the subprime mortgage firms. That is, the investment banks are the secondary lenders that make money available to the primary lenders (who make the money available to the home buyer), which, if I understand correctly, they do by purchasing the loans from those primary lenders (that purchase refills the coffers of the primary lender, so they can make more loans).

If I have that wrong, I hope someone corrects it.

So I suppose the danger is that large losses accrue to the investment banks themselves, reducing the supply of credit available in general, perhaps wiping out mom and pop's lifesavings, and in general creating the "contagion."

But I have doubts the contagion would create a long-term depression, as opposed to a short-term slump--a "correction: if you will. Keep in mind that it's primarily the sub-prime loans that aren't being repaid. Those are buyers who over-extended themselves. Most of them aren't impoverished, and haven't gone to living on the street, but have had an income decline they couldn't afford because they were living on the edge. Foreclosures are at about 1 in every 200 homes, and housing prices have declined--in some areas--by 10-20%. That sounds horrible, but it's only .5% of homes, and the values haven't been totally lost. That is, the lenders can regain some of the money that the defaulters can't repay by selling the house at a lower price.

So the lenders will lose money. Fannie Mae and Freddie Mac--government created, but publicly traded, lenders--have lost, respectively, $1.3 billion in the last quarter and $5 billion in the last year. That's big amounts for those firms, but they're also the biggest mortgage backers in the country, so they're taking the lion's share of the losses. Quadruple that amount and it's still not that big a chunk of the U.S.'s $13 trillion economy.

And of course saving the mortgage firms doesn't come free. There's not some great untapped reserve of money that can be used painlessly to save them; the money will be diverted from other uses. Or more likely, we'll try to borrow more by selling more federal securities, thus continuing upward pressure on interest rates, with the attendant economic effects. Notably, what I've noticed in the arguments for rescuing the mortgage industry is a focus only on the primary effects on the industry itself--I haven't seen much on the secondary effects of industry failure or secondary effects of industry rescue. I rather suspect Bastiat's ghost might be muttering something about the seen and the unseen. I think the real question is which course of action has the greatest benefit/cost ratio.

If there is some reason to mitigate the losses, I think it would be wise to do the minimum--do what it takes to keep the effects from snowballing and wreaking great harm to the economy (and let's face it, at 5.7% unemployment, our economy is a long way from being wrecked), but not enough to let the lenders off the hook for their bad decisions.


James K said...

Thanks for the discussion. I think the essential difference from New Zealand's mortgage industry is that we don't have mortgage securitisation, so the banks hold on to the mortgages they create.

I think you are right that the indirect effects are the important ones. Banks failing for making mistakes is just life. Banks failing because other banks have failed is contagion. The trouble is separating the two.

Honestly I don't credit the economic doomsaying that is so common at the moment. It won't be like the 1970s because you don't have price controls or high inflation to screw things up and it won't be like the Great depression because you don't have FDR to screw things up.

James Hanley said...

We don't have inflation...yet. All of us monetarist inclined folks in the U.S. are a little uneasy. Bernanke hasn't yet exhibited a particularly steady hand at the tiller, and seems at least marginally less anti-inflation than his predecessors Vlcker and Greenspan. If the economy doesn't warm up soon, he may feel pressure to do something foolish.

As to the banks failing, perhaps we just need to dampen the ripple effects. Although I agree that the doomsday folks are a bit overwrought. I don't think the failures are a big enough part of our economy, or likely to become so, to throw the whole country into crisis. And of course it was caused by other factors, like the increase in fuel prices which has cost jobs. Get the overall economy moving again, and the mortgage business will sort itself out.

James K said...

As Adam Smith put it "there is a lot of ruin in a nation". As North Korea and Zimbabwe demonstrate you have to work really hard to screw an economy up.

Basically, as long as prices are free to adjust things will sort themselves out, sooner or later.