Should we start sending keys to the banks? 12

Prime Minister's suggestion to limit borrowers' liability to their collateral (i.e. real estate) is yesterday's news now. Besides, it was likely a mere negotiating move (as shrewdly pointed by Janis Ikstens), i.e. Prime Minister's Dombrovskis response to the "aggressive" remarks made by Anders Borg, Swedish minister of finance. And yet, another purpose of this proposal is, probably, to test public opinion on such things. So here is my opinion as well. In short, it's hard to be excited about such an initiative - which I will refer to it as 'limiting liability'.

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First, lets start with the simplest observation. If such a decision would apply to all existing contracts (which seems to be the idea), we're really talking about government-authorized default on the loan obligations. From the banks viewpoint, this implies an increase in country-specific risk. They wouldn't turn around and leave (banks are not children), but they would factor that risk into their future decisions. This means higher interest rates for future borrowers and, as a result, less credit. As businesses would find it more expensive to raise capital, this would have a negative effect on future economic growth.

Second, Prime Minister Dombrovskis said such a move would make banks more cautious and future crises less likely. I just don't see what systemic effect this could have on banks' appetite for risk taking. However, limiting liability to the collateral would have the effect of offering borrowers an investment opportunity in which the gains on the upside belong to them, but the losses on the downside are limited to the collateral. This would provide an incentive to invest in real estate for speculative motives. A problem of adverse selection would materialize, in which banks would have to deal with an increased number of high-risk borrowers. Banks would respond by increasing the share of down payment and also by credit rationing, i.e. reducing credit funds available. Both would make it harder for regular people (and firms) to obtain loans.

If the above paragraph was somewhat technical, consider this. It was always possible to borrow against collateral only. All one had to do is to establish a limited liability company (LLC) and have it ask the bank for a loan backed by real estate. This would limit liability to whatever is on the balance of this LLC, i.e. collateral. Anyone would tell you that banks would charge a higher interest rate and demand a greater down payment from an LLC. Naturally, individuals can borrow on much better terms than LLCs precisely because of unlimited liability! What the proposals amounts to is legislating LLC-style borrowing only, which would make it much harder (and more expensive!) for individuals to borrow.

Third, a somewhat more complicated argument. But lets start with acknowledging that limiting liability may have some very positive effects in the context of this crisis. If a large number of people could walk away from the mortgages they cannot afford and start a new life, this would go some way to breaking out of the recessionary spiral. But lets think about the consequences of this. An individual would "send the keys to the bank" (i.e. default) if

total liability - market value of collateral > present value of expected costs of bad credit history

Naturally, individuals who default on their loans would find it difficult to convince the banks of their credit worthiness in the future. So the number of defaults would be smaller than the number of people for whom (liability>market value of collateral). But still, given extremely low rental costs, it is likely there would be many such people. The banks would see a sharp increase in their non-performing loans (NPLs) and have lots of real estate on their assets. Naturally, banks would rush to raise liquidity by selling all this real estate. Such a fire-sale would reduce real estate prices even further, shrinking banks' balance sheets and increasing pressure to raise liquidity. We have seen something very similar in the U.S. during this crisis. As a result, you're looking at either another full-blown financial crisis - with (even more) disastrous consequences for the real sector, or massive government bail out of the banks. Since the latter is more likely, we are really talking about Latvian (and Swedish) taxpayers paying for this policy initiative.

If you accept the above prediction - in the end, the cost of "limited liability" is largely borne by the taxpayers - lets make a shortcut and ask whether taxpayers should offer borrowers the following deal: "We would pay the remainder of your loan if you hand over the collateral (real estate) to us". The benefit (to the taxpayers) is that this may end the crisis faster by resolving the problem of bad loans. What about the costs? There are two. First, the prudent (who didn't borrow, or borrowed but can pay) pay to the reckless (who borrowed more than they could afford). Many of the reckless are probably those who did it for investment purposes, i.e. 'speculated'. By most ethical standards, such a 'socialization of losses' is grossly not fair. Second, you introduce the problem of moral hazard. Such a precedent would mean more excessive risk taking in the future because of the perception that the "gains are privatized, but losses are socialized". This would make future crises more likely.

To sum up, this seems like a very bad idea now (during the recession) and, probably, a bad idea for the future (after the recession). I think that blaming (and punishing) the banks would be a great temptation to all kind of populist politicians in the run-up to the elections. However, this might be equivalent to shooting yourself in the foot. Finally, it is likely that we would need some taxpayer-financed solution to the burden of bad debt. However, such a solution should not let any participant of the 'credit orgy' to emerge unscathed. This also applies to the borrowers.

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Komentāri (12) secība: augoša / dilstoša

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Svins 23.11.2009 11:13
Dear Vjačeslavs,

Please could you comment the opinion of other economist Mr. Uldis Osis in his article here:

Is he right or wrong, and where is he right and where is he wrong?

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reality 20.10.2009 18:38
Otrdiena, 20.oktobris (2009) | Portāls
Nobela prēmijas laureāts, Prinstonas universitātes profesors Pols Krugmans aicinājis Balto namu nacionalizēt Volstrītu.

"Daži analītiķi, to vidū arī es, uzskata, ka vismaz dažām bankām nepieciešama liela kapitāla iepludināšana uz nodokļu maksātāja rēķina. Vienīgais ceļš, lai to izdarītu, ir dažu banku nacionalizācija uz laiku," Krugmans izteicies The New York Times. Viņa raksts ''Bankās ne viss ir kārtībā'' kļuvis par atbildi uz jauniem skandāliem, kas saistīti ar bonusu izmaksu bankām, kuras sākušas uzrādīt pozitīvus finanšu rezultātus. ''
U-ū-ū, Vj.Dombrovska kung' - laiks jaunam komntāram !!

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P-P! > ME 12.10.2009 11:10
Nope, I don't know what y'all speak about in economics; ah'ma rednekk AhT speshalist.

Whose efficiency gains did you mean anyway, and what outcome would you want to achieve?

I'm lazy to look for a link, but, according to US Treasury mortgage metrics report, almost 40% of modified mortgages with debt service reduced by 20% or more were delinquent again within 6 months.

Of course banks want a floor under their losses – the more of it the better (more efficient for them). What’s in it for others, however, other than becoming liable for big chunk of bad debts?

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Jevgenijs Steinbuks 11.10.2009 13:05
Great work, Slava. I thought exactly along the same lines when I read the Financial Times article on this new government initiative. One more point to make - Latvian real restate market (as well as other financial markets) are extremely shallow, so offering an OPTION for taking recourse mortgage for the future loans might be a good idea for soring out more and less risky borrowers, and lowering adverse selection problem. I made a similar point in the US context when presenting my paper on subprime mortages at BICEPS about a year ago.

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ME 09.10.2009 23:07
Sure I should, but you kind of know from PE, that politicians are not benevolent social planners :)

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xi 09.10.2009 09:50
I think this plan does have some advantages. First, if 'peace time' interest rates are too low (think of 2006-2007), then making borrowing more expensive is a good think. It helps to avoid future bubbles. And maybe also stimulates a shift of economic activity away from construction and towards of other stuff that can be collareralized (tradable goods).
Second, the game of "who pays the banking sector loses - Latvia or Sweden" will sooner or latter turn more nasty. There is too much money involved. And in this game 'limited liability' legislation can lower Latvia's costs, if it plays its cards right. I personally think that Swedes deserve to pick up the bulk of that bill.

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diMka 08.10.2009 23:49
to ME:
concerning risk free arbitrage, you have to account for the time and return this investment would yield.

concerning the support:
Banks will charge higher interest rates, because of implied put option. And this would make difference between bank and investment bank smaller, so indeed this will increase probability for a bail-out necessity.

Probably there is a political need for government to debate such a proposition (regardless of the probability that it will be passed). I mean public has to be kept by some action in their favor.

Probably putting all the blame on those who struggle to repay their loan is not fully correct, as well, but is there any other mechanism how to provide support to them?

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kreesls 08.10.2009 20:03
So it means that "status quo" is the best option? Where were you when all this started three years ago? Did you were saying the same - that everything is as it ought to be and there is nothing to worry about until we all ended up we all know where? This obsession with free market ideas looks more like some secular religion that is immune to criticism and admitting its own mistakes.

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Rita N 08.10.2009 20:00
Love the title.

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ME 08.10.2009 19:36
"in the name of basic fairness, if nothing better can be "worked out", no matter what the political cost" - you know usually in economics nobody speaks about "basic fairness", the only thing is efficiency gains or losses. Compare States ( efficiency ) and Europe ( fairness ), see the difference in innovation ?

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ME 08.10.2009 18:29
Hmm, There is one more interesting proposition. Assume that there will be such legislation. Clearly the majority would use this option and thus banks would get a lot of real estate on their portfolios. As banks are not real estate companies they would need to sell this real estate. If there will be huge supply in the market then the price will be rather low. Thus if one has a lot of money then it would be possible to buy "bad" assets and after some time ( difficult to estimate ) to sell it... That is what we call arbitrage free profit...

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P-P! 08.10.2009 18:23
Well, then what do you say about the following, where prudent taxpayers, if I understand it correctly, would still end up paying, only WITHOUT the benefit of owning that asset in the end?

"The strategy also includes a scheme to assist household borrowers, which would offer government guarantees for restructured loans on condition that debt service is reduced and part of the loan is forgiven once the borrower has resumed repayments. However, this would be activated only if there was a significant improvement in the headline fiscal balance (before bank restructuring costs)." --

And a bit more here:

"Kredītņēmējiem, kas atbilst šiem kritērijiem un kas ienākumu samazināšanās dēļ vairs netiek galā ar saistībām, banka ar valsts garantiju palīdzību restrukturizē parādu, 20% no tā iesaldējot. Tādējādi samazinās ikmēneša maksājums. Ja kredītņēmējs nevar segt arī samazinātos maksājumus, viņa vietā maksā valsts (pēc tam palīdzība jāatmaksā). Savukārt pēc programmas beigām, ja kredītņēmējs savas saistības ir pildījis apzinīgi, banka noraksta 10% no kredīta summas."

How good an idea is that?

I think virtually anything is better than taxpayers assuming banks' risk AND STILL not being in a position to support borrowers (rather than their lenders) should large numbers of the former fail.

Banks know it will be unpalatable for government to sit on their hands and repeat: your contract is none of other taxpayers' bloody business. Yet that's precisely what the government should do, in the name of basic fairness, if nothing better can be "worked out", no matter what the political cost.

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