Thursday, March 26, 2009

Will the Geithner-Summers plan solve an ownership externality?

Another hypothesis about the banking crisis is that there is an externality -- certain critical institutions harm the wider economy when they hold mortgage assets, but each in its decision to hold them considers only its own costs and benefits.

I guess the story is: a bank owner thinks a pool of mortgages is worth $10 million, but owning those mortgages makes the bank excessively cautious, which somehow harms the wider economy. So the wider economy would like to see the mortgages sold to an institution whose caution would be less harmful, even if the less harmful institution valued the pool at just $5 million. But the bank owner refuses to sell for less than $10 million, so the bank owner keeps the pool and its caution.

A simple subsidy will not solve the problem. Suppose that the government said that it would pay for $5 million of the purchase price. Then potential buyers whose ownership would be less harmful to the wider economy would be willing to pay $10 million ($5 million for the pool itself and another $5 million for the government subsidy). But the subsidy also increases the valuations of the institutions whose ownership of mortgages is harmful to the wider economy. So if the harmful owners placed the highest value on these assets without the subsidy, they would do the same with it.

Nothing about the Geithner-Summers plan gives an incentive to mortgage assets to be ultimately held by the "right" institution. It only gives money to banks and creates a flurry of transactional activity, without changing the real ownership pattern that supposed created the problem to be solved.

1 comment:

Anno said...

I believe that these securitized assets are essentially common value goods. They're just streams of money coming in. (Let's ignore the value of lumping together negatively correlated streams, since companies don't seem to be hedging risk very well these days.) The failure to price them properly or to sell them isn't because one institution has a higher inherent value for them, but rather because of informational issues -- only the owner, if anyone, has any idea how much they're worth. And so in an unsubsidized market, potential buyers are too risk-averse and too scared of ending up with "lemons" to buy anything.

I'm not saying this is right, but I believe that this is what supporters are arguing. In this case, there's no welfare loss in having the buyer (or anyone else) hold the asset rather than the seller.