Lobby, Lend, Lobby

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A recent update to a continuing study finds a link between bailouts and the lobbying of the financial industry.

It is sometimes asserted that the housing boom of the first half of the last decade was largely a result of easy credit by the Federal Reserve – that low interest rates made it too easy for too many people to borrow to purchase a new, bigger home.

But interest rates were only a bit lower in the decade than they were in the 1990s, when there was not a housing boom. By the standards of the 1990s, one might expect the somewhat lower interest rates of the last decade to elevate housing prices only a bit (as I have estimated; Edward Glaeser of Harvard and his co-authors have, as well), rather than the much sharper increase that actually occurred.

It’s also true that bank lending standards were relaxed during the housing boom, with risky borrowers allowed to purchase homes, and all kinds of borrowers allowed to purchase homes with little money down. But as Professor Glaeser has frequently noted, for instance in this post, the housing boom is not primary explained by easy credit.

Even if interest rates and lending standards had been the same in the last decade as they were in the 1990s, however, a crisis might still have been brewing, because interest rates should have been higher during the housing boom than they were before.

Housing prices were elevated during the boom (in part for the reasons cited above) and, by comparison with the 1990s, this made it more likely that — if and when housing prices came back down — even high-income borrowers making 20 percent down payments would default. With default more likely, interest rates needed to be higher, even for high-income borrowers putting 20 percent down.

The study, by Deniz Igan, Prachi Mishra, Thierry Tressel, three economists at the International Monetary Fund, suggests that implicit subsidies and a lack of regulation helped make it possible for lenders to offer lower rates on mortgages that were increasingly likely to default. My fellow Economix blogger Simon Johnson has also noted the interplay of political influence on regulation and finance.

The study by the I.M.F. economists found that the heaviest lobbying came from lenders making riskier loans and expanding their mortgage business most rapidly during the housing boom. The loans originated by those lenders were, by 2008, more likely to be delinquent.

Most important, lobbying meant access to tax dollars. The lenders lobbying more heavily were 7 percent more likely to receive bailout funds, received larger amounts of those funds, and enjoyed a 27 percent greater increase in their market capitalization in October 2008, the month the bailout program was announced.

The authors did not disentangle the path by which lobbying brought forth bailout funds, but it is likely to have followed some combination of political access enjoyed at the time and the lobbying lenders’ assertions of need — created by the lax lending that had gone before, itself facilitated by lobbying during the housing boom years.

Nobody knows for sure how much of the blame for the housing boom can be put on the federal government, but we’re starting to see how political influence was associated with mortgage lending and, ultimately, with taxpayer subsidization of delinquent and defaulting mortgages.

What Might Cause a Two-Track Recession?

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Census Bureau data on employment by pay level cast doubt on credit-crunch and demand-based theories of the recession. One theory is that a credit squeeze left businesses short on funds, and they responded by cutting payroll, their major expense. Indeed, the bank bailouts were rationalized on the grounds that a bailout would help employers maintain their payrolls.

If cutting payroll spending had been the primary motivation of employers, then they should have cut deepest among their most expensive employees. Firing one person making, say, $2,000 a week saves more than firing three people making $600 a week.

It is true that part-time employment, which is typically low-paying, increased significantly during the recession. However, last week I showed Census data suggesting that employment of people making more than $2,000 a week may have been greater in the 12 months after Lehman Brothers failed than it was before, even while employment of people making less than $2,000 a week fell several million.

Hiring more high-paid people is not a way to reduce payroll spending.
Moreover, payroll spending now exceeds what it was when the recession began, yet employment remains millions lower. Apparently, payroll spending is not enough to bring those jobs back.

Another theory of the recession is that it was caused by a lack of demand — fewer employees were needed because employers were selling less to their customers. The low-demand theory is a good description of a couple of industries, like manufacturing and home construction, but if it described the economy as a whole we would have seen all types of employment cut, not just employment of people making less than $2,000 a week.

Another set of theories say that high-paid employees are replacing low- and middle-income employees. This replacement might come from employers’ attempts to cut personnel during the recession, rather than payroll spending. For example, employers might have worried about health insurance and other employment regulation whose costs are proportional to the number of employees they have. In this view, the bank bailout did little to prevent layoffs.

Some of the replacement could come from families, as they react to some new incentives presented during the recession. Unemployment insurance reduces incentives for unemployed people to accept a new job, because, for up to 99 weeks, the insurance pays them for being unemployed.

Unemployment insurance benefits are capped, so the disincentive is much less for people making $2,000 or more a week than for people making less. Some homeowners with underwater mortgages may react by earning more, while others earn less as they recognize that all their extra earning ultimately ends up with their mortgage lender.

The chart below explores the replacement theories further.

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For each of the 50 states and the District of Columbia, the chart compares the percentage change in the fraction of adults in the state who make $300-1,200 a week (the middle two-thirds of employees are paid in that range) to the percentage change in the fraction making $2,000 or more.

For example, the fraction of Arizona adults earning $300-1,200 was 10 percent lower from October 2008 to September 2009 than it was in the previous 12 months, and the fraction of Arizona adults earning more than $2,000 a week was 29 percent higher.

The low-demand and payroll-cutting theories say that the two should be positively correlated, because the states with the largest demand reductions (or the employers most motivated to cut payroll spending) would have cut employment across the board.

But the Census data suggest that they are negatively correlated (the correlation is also negative if the small or “outlier” states shown in the chart are excluded or downweighted according to population).

These patterns of employment by pay level reveal a number of insights that are not visible in the aggregate employment statistics: the credit crunch and lack of demand may have received too much of the blame for the recession’s job losses.

Holding Taxpayers Hostage

The Treasury says that we must not only send it money in the present but, but raising the debt ceiling, promise to continuing send it money in the future (government debt is a taxpayer promise to pay in the future), or else utter disaster.

Who Cares About the Fed?

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Short-term interest rates have an obvious effect on the housing market, but not the rest of the economy.

Federal Reserve policy affects short-term interest rates, bank regulation and eventually inflation. I will write about inflation next week, and my fellow Economix blogger Simon Johnson has written much about bank regulation, so today I focus on short-term interest rates.

The Federal Reserve, especially its New York branch, is actively engaged in buying and selling Treasury securities, and it lends money to banks on an overnight basis. As a result, it is widely thought that the Federal Reserve is an important determinant of the rate of interest paid on short-term Treasury securities.

By raising the supply of Treasury securities and reducing overnight lending, so-called “tight” monetary policy raises short-term interest rates. High short-term interest rates are said to discourage borrowing, and thereby curtail private sector investment projects. The idea is that private sector projects are undertaken only when their expected return exceeds the cost of borrowing.

In theory, high short-term interest rates result in relatively few capital projects, with high expected returns, and low short-term rates result in more capital projects, including those with lower expected returns.

But the effect of high short-term interest rates on Main Street’s economy has been exaggerated. Although it is commonly assumed that today’s rock-bottom rates should help strengthen a business recovery, it appears that business conditions actually have little to do with short-term money markets.

Many important private sector investment projects are relatively long term — it most likely takes a year or more for a project to be completed and deliver a positive cash flow to investors. As a result, many capital projects are financed through long-term borrowing, with equity financing, or out of corporate retained earnings, rather than borrowing in the short-term market where the Fed’s fingerprints are so obvious.

In theory, long-term interest rates could rise as the Fed tightens the short-term money market, because some savers would be on the margin of saving in either the short- or long-term markets. Equity capital markets and retained earnings could, in theory, also be subject to similar indirect effects.

Thus, the effects of Federal Reserve interest-rate policy on investment are indirect, and it is an empirical question as to whether the expected effects — tight money discourages investment projects — are significantly reflected in preventing capital projects with low expected returns.

Luke Threinen and I have measured national average profitability of capital projects from the national accounts by dividing total interest and profits in the economy during a year by the total capital stock in place at the beginning of the year. In doing so, we have distinguished residential capital (i.e., houses) from business capital.

Capital produces value over a number of years. In the case of housing capital, the value is in the form of shelter and the convenience of a home. For any piece of capital, profitability (capital’s marginal product, as economists call it) can be calculated as the dollar value it creates during a year — after subtracting depreciation, costs of labor, maintenance and intermediate goods — per dollar invested.

Owners of capital prefer their capital to be more profitable, rather than less. It’s the profitability of capital (after taxes and subsidies; more on those below) that makes an owner willing to purchase capital in the first place.

Chart 1 compares the profitability of housing capital to the inflation-adjusted return on one-year Treasury bills (for comparability with T-bills, housing profitability is adjusted for property taxes). Consistent with the view that tight monetary policy both raises Treasury bill rates and reduces housing investment, the two series are positively correlated. The home-mortgage market appears closely linked, so high Treasury bill rates cause banks to charge more for home mortgage loans, which discourages homeowners and landlords from building homes unless the demand for homes is sufficient (i.e., landlords can earn enough rent from their tenants to cover a high mortgage rate).

Among other factors, easy credit from the Federal Reserve in the early and mid-2000s made it easy to buy and build homes, and as the inventory of homes grew the amount of rent that each home could earn (many homes went vacant, for example) fell, which shows up in Chart 1 as especially low values for the red series. In this way, the housing cycle of the 2000s confirms the usual story about how monetary policy can affect housing investment.

The usual story about Federal Reserve policy and business investment says that a similar process works on the business sector: High Treasury bill rates cause banks to charge more for business loans, which discourages business from investing unless demand for their product is sufficient (i.e., businesses can earn enough profit from their operations to cover a high loan rate).

Our findings for the business sector are quite different from the usual story. Chart 2 compares the profitability of business capital to the inflation-adjusted return on Treasury bills, and the correlation is negative.

One way that easy monetary policy could hurt business investment is by encouraging home-construction activity, and home construction takes resources away from business construction.

The evidence in Charts 1 and 2 suggests that the housing market can be stimulated by easy monetary policy, at least in the short run. But the link between monetary policy and the business sector is much weaker, and our data are consistent with the view that, holding constant the rate of inflation and the amount of banking regulation, monetary policy does not have a discernible effect on the cost of business capital.

Tell-Tale Sign

In 2008, I was of the opinion that easy monetary policy cannot explain much of the housing boom. When Professors Krugman and Delong came to agree with me, I immediately realized that I was likely wrong!

Here was my 2008 reasoning:

"Suppose that annual real interest rates were going to be one percentage point (100 basis points) lower for a year. Then the cost of buying a house, holding it for a year, and then selling it would be essentially one percent less. The low one-year interest rate would not affect the selling price at the end of the year because, by assumption, the reduction lasted only for a year and the next buyer will be back to normal interest rates. So the source of benefit from the low rate is that the initial buyer reduces the carrying cost for a year."

Professor DeLong was also part of Cato Issue in which I expressed the opinion above. More than a year later, he expressed the same opinion (without giving me credit, but that's beside the point):

"If you believe that the Fed kept the fed funds rate 2% below its proper Taylor-rule value for 3 years, that has a 6% impact on the price of a long-duration asset like housing. Even with a lot of positive-feedback trading built in, that’s not enough to create a big bubble."

A day later, Professor Krugman picked up on this reasoning, and nodded approvingly to Delong. All of this pointed strongly to the fact that I need to think again about my 2008 conclusion. Here's where I went wrong:

It's true that short term mortgage rates were a bit lower than normal during some of the housing boom. But the "normal" short term mortgage rate would not be the proper benchmark if the housing market really was anticipating the kinds of technical change I was writing about.

I explained how fundamentals -- the real prospects for technical change -- were temporarily pushing up housing prices. Even without subsidies, this process would efficiently raise the probability of a housing price crash, because nobody knew for sure when and how much technical progress would be realized.

But mortgages include a put option: the homeowner can trade in his house keys for the lenders' erasing his payment obligation. And the housing boom I described above (or, for that matter, any process that caused housing prices to rise and increased the probability of a crash) was increasing the value of that put option. Absent subsidies, lenders would not be giving away such a valuable put option so cheaply -- they would have charged more than normal either in the form of higher mortgage rates, higher closing costs, or lower LTVs (when multiple transactions are packaged into one "mortgage", all of these might just show up in "higher mortgage rates").

So even if short term mortgage rates had been "normal", that would have been consistent with a large subsidy, because the unusual housing price dynamics called for extra mortgage charges to reflect the enhanced value of the put option typically included with mortgages.

So anticipated government subsidies to the mortgage market magnified the housing price cycle. Prices would have gone up and come down even without them, but to a lesser magnitude. And the calculation I made in 2008, and Professors DeLong and Krugman reiterated in 2010, understates the housing price impact of those subsidies.

[Note: the elasticity of housing supply also needs to be considered (read more about that here), but that's separate from what Mulligan-DeLong-Krugman said about mortgage rates]

Your Government Is Selling Puts, Putting Your Money at Risk

The Congressional Oversight Panel has reported that the Treasury Department leveraged limited bailout money to insure assets worth many times more. These guarantees could have, and implicit guarantees may still, cost the taxpayers trillions.

The Panic of '08: Recession Cause or Effect?

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The financial panics of last September and October will always be part of the story of this recession, just as bank failures are always part of the Great Depression story. But recent research questions the claim that the financial panics themselves contributed to their contemporaneous and severe employment downturns.

In his academic research, Ben S. Bernanke blamed part of the Great Depression of the 1930s on banking panics. And this time last year (at the height of the panic in the commercial-paper market) he was telling President Bush that if “we don’t act boldly, Mr. President, we could be in a depression greater than the Great Depression.” A lot of taxpayer money was spent based on this theory.

Some recent research supports an alternative view: that those financial panics did not cause depressions, but are merely symptoms of deeper economic forces.

The U.C.L.A. economics professor Lee Ohanian’s recent paper has looked at monthly data from the 1930s and finds that bank failures came well after manufacturing establishments had sharply dropped their work hours. Moreover, the banks failing during the initial panics were known to be weak. Whatever brought those weak 1930s banks down had already hit the manufacturing sector hard.

The timing was different in this recession — the largest employment drops seemed to come immediately after the financial panic — but a recent paper by Ravi Jagannathan, Mudit Kapoor and Ernst Schaumburg of Northwestern argues that the coincidence is just as misleading. They argue that the changing global economy — with more employment of residents in developing countries like China — created a glut of savings in those countries, and was destined to reduce employment in developed countries regardless of whether there had been a financial panic.

The foreclosure crisis is not fully behind us, and the time may come again when it looks like “banks are in trouble.” When that time comes, will taxpayers still believe Mr. Bernanke’s theory that they are better off financing bailouts than letting a bank panic run its course?

Did the TARP Increase Lending?

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Economic theory casts significant doubt on the claim that public purchases of bank equity would cause banks to lend more. Now the government’s own watchdog confirms the theory.

During last year’s financial crisis, regulators and market participants grew alarmed at the low levels of bank capital. This motivated the bank bailout, and promises to the public that the bailouts would get the banks — especially nine “healthy banks” targeted by Treasury officials — lending again.

Bank capital refers to the excess value of banks’ assets over their liabilities. Bank capital belongs to the bank shareholders, but provides a degree of insurance to the bank’s creditors — its depositors and bond holders — because their claims on bank assets are senior to those of bank shareholders. Some claim that adequate bank capital is also essential for lending.

The Federal Reserve and the Bush administration let some banks fail last year, but ultimately desired to do something to replenish bank capital. They convinced Congress that they could do so, and had $700 billion (almost $7,000 for every United States household) earmarked for that purpose. Almost $300 billion of that amount had been awarded to banks between late October 2008 and inauguration day, in the form of Treasury purchases of newly issued bank stock.

Officials never admitted to the taxpayers (whose money they requested) that the marketplace might largely, if not entirely, thwart their recapitalization efforts. The market might well react to Treasury share purchases by reducing private holdings of bank capital.

Nor did officials admit that, even if the bailout helped replenish bank capital, banks might not want to use their newfound capital for lending. This was also a relevant consideration, because it is possible that lending opportunities determine bank capital, rather than the reverse.

Part of the bank bailout law established an Office of the Special Inspector General for the Troubled Asset Relief Program (a.k.a. “SIGTARP”) “to conduct, supervise and coordinate audits and investigations of the purchase, management and sale of assets under the TARP.” The inspector general was appointed by President George W. Bush and approved by the Senate.

With the better part of a year to examine the evidence, SIGTARP released an audit report on Monday. It concluded (p. 30) that “…lending at [the nine targeted banks] did not in fact increase….”

The report goes on to lament that this episode could “damage the trust that the American people have in their Government.”

I would put it stronger: This episode is an expensive example of public policy promises that were doomed to failure because they were known at the outset to defy economic theory.

Why Markets, Not the Treasury, Determine Bank Capital

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Bailout mania began with the Bush administration’s attempts to boost bank capitalization rates. The Obama administration’s reaction to bank stress-test results marks an important change by asking failing banks to raise their own capital rather than injecting another round of taxpayer funds. Yet neither administration has admitted to the public how difficult it is for the Treasury to have an impact on bank capitalization, because the market works to offset Treasury transactions in bank capital.

Bank capital refers to the excess value of banks’ assets over liabilities. Bank capital belongs to the bank shareholders, but provides a degree of insurance to the bank’s creditors –- its depositors and bond holders –- because their claims on bank assets (in the case of bankruptcy, for example) are senior to those of bank shareholders. Some economists also think that adequate bank capital is also essential for lending.

As the housing market crashed, so did the value of some of banks’ important assets: residential mortgages and mortgage-backed securities. This not only reduced the value of bank stocks, but heightened the risk that bank creditors might not be paid in full, because bank capitalization rates (the amount of bank capital per dollar of bank assets) were falling. Some thought that bank lending would suffer, too.

The Federal Reserve and the Bush administration let some banks fail, but ultimately desired to do something to replenish bank capital. They convinced Congress that they could do so, and had $700 billion (almost $7,000 for every United States household) earmarked for that purpose. Almost $300 billion of that amount had been awarded to banks between late October 2008 and Inauguration Day, in the form of Treasury purchases of newly issued bank stock.

Although the Federal Reserve and the Bush administration included quite a number of officials who once admired the power of free markets, none of them admitted to the taxpayers (whose money they requested) that the marketplace would largely, if not entirely, thwart their recapitalization efforts. The market would react to Treasury share purchases by reducing private holdings of bank capital, and react to Treasury share sales by increasing private holdings.

As noted above, bank capital belongs to the shareholders. Moreover, a variety of market mechanisms permit shareholders to increase or decrease bank capital. New shares can be issued in the private sector, or old shares bought back. Dividends can be increased, or decreased. Banks can merge with each other in cash deals, which decrease the combined capital of the merging banks and increase cash paid to shareholders.

Thus, bank capitalization rates are expected to suit shareholder interests, not the United States Treasury’s. Markets will neutralize Treasury transactions regardless of whether the Treasury reasonably desires banks to be more capitalized, because the bank capital belongs to the shareholders, even if the shareholders’ desired capitalization is “unreasonable” or “panicked.”

In other words, bank shareholders will have whatever capitalization level they want to have, and if they don’t like the level foisted upon them by the Treasury, they can easily grind it back down to their preferred level. And they have done just this, again and again.

Although lawmakers acted surprised, it is more than coincidence that payouts to bank industry shareholders occurred at the end of 2008 as the United States Treasury was “injecting capital.” Banks paid dividends that were far greater than what was commensurate with their profitability.

Joe Nocera reported in The New York Times that JPMorgan Chase’s chief executive, Jamie Dimon, told his employees that the $25 billion they obtained from selling equity to the Treasury would help them acquire competitors.

These are all ways how Treasury bailout funds ended up with bank shareholders rather than adding to bank capital, as bailout advocates led taxpayers to believe.

Several banks are now trying to give back their taxpayer capital injections — i.e., they are asking Treasury to sell back their bank shares. (Perhaps they find the Treasury to be an extraordinarily meddlesome shareholder.)

If the Bush administration had been right that Treasury purchases of bank stock raise bank capital, shouldn’t Treasury sales reduce bank capital? Recent events suggest not. Bank cash going back to the Treasury will be largely offset by cash coming in from the private sector: an offset mirroring what we saw in the fall, when cash coming in from the “capital” injections was spent on dividends, cash mergers and the like.

That’s what’s happening at banks such as BB&T, which plans to pay back $3.1 billion to the Treasury. At the same time, BB&T will issue $1.5 billion in common stock and cut their dividend by $0.725 billion per year. In two years’ time, the combination of those two actions alone will raise $2.95 billion, almost entirely offsetting the cash going to Treasury as it sells back BB&T shares.

The Obama administration’s reactions to bank stress-test results are refreshingly cognizant that the marketplace, and not Treasury injections, will determine bank capitalization. When the latest stress tests find that a bank has too little capital, the Obama Treasury (unlike the Bush Treasury) is asking that bank to raise its own capital, rather than arranging for a Treasury “injection.”

The moral: Bank capital is determined by the market, not the amount spent by taxpayers on bank bailouts.

CORRECTION: A previous version said that National City shareholders got cash from the merger -- they did not receive much, but as PNC shareholders they continued to get a historically high dividend ($0.66 per share) through January 2009.

Flashback: Treasury Capital Crowds Out Private Capital at BB&T

Treasury "capital injections" just result in greater payments to bank industry shareholders. Some of the ways it could work is that a bank receiving TARP money would buy back its shares (or buy, for cash, shares of competitors), use the Treasury funds to forestall raising new capital that (thanks to the recession and housing crash) would have been necessary, or cut dividends.

The same argument implies that payments from a bank TO the Treasury would reduce payments from banks to bank industry shareholders (or increase payments from shareholders to the banking industry).

That's what's happening at BB&T. They plan to pay back $3.1 billion to the Treasury. At the same time, they will issue $1.5 billion in common stock and cut their dividend by $0.725 billion per year. In two year's time, the combination of those actions will raise $2.95 billion.

Why do Troubled Banks Pay Dividends?

A recent study documents how troubled banks continue to pay dividends.

Dividends are paid because the taxpayers are giving the banks more cash than the banks' shareholders' want to have in the banks. This is not Monday morning quarterbacking, but rather the prediction of economic theory that has been recognized for decades and was applied to the bank bailout this fall.

Flashback: Treasury Capital Crowds out Private Capital

It is reported that Goldman Sachs will issue common stock to repay their TARP loan.

It is neither a coincidence nor a surprise that Goldman issues shares at the same time that they repay their TARP money. I explained last fall how Treasury "capital injections" just result in greater payments to bank industry shareholders. One (of many ways) it could work is that a bank receiving TARP money would either buy back its shares (or buy, for cash, shares of competitors), or use the Treasury funds to forestall raising new capital that (thanks to the recession and housing crash) would have been necessary.

The same argument implies that payments from a bank TO the Treasury would reduce payments from banks to bank industry shareholders (or increase payments from shareholders to the banking industry). That's what we see with Goldman's new issue.

Politicians told us that TARP money was actually going to be lent to bank customers, rather than paid to shareholders -- they were wrong.

For more examples, see my posts under the "bailout" label.

Waiting for the Subsidy

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Subsidies can have a perverse effect on activity if they are debated too long. The banking sector bailout is one example; the purchase of hybrid automobiles by Chicago cab drivers is another.

Hybrid automobiles can save gas, especially in urban driving conditions when the automobile is moving slowly or idling, when alternative power sources have a bigger advantage. A problem is that the purchase price of hybrid vehicles is often higher, and many are less spacious than the more ubiquitous sport utility vehicles.

A significant fraction of the taxicab fleet may be well suited for hybrids, because many of the miles driven are in urban conditions, and often the vehicles have only one passenger. Thus I have been surprised to notice so few hybrid taxis in Chicago, where less than 1 percent of cabs are hybrids.

In an admittedly unscientific survey, I watched for Toyota taxis with about 100,000 miles. I assumed that many drivers of Toyotas would be likely to buy a Toyota for their next taxi, and that the Prius — the company’s hybrid model — would get their consideration. I asked the drivers about buying a Prius.

The drivers told me about the Chicago City Council’s debates about transforming the city’s taxi fleet.

The council has debated mandating hybrid purchases. But the rumor among taxi drivers is that in addition, or perhaps instead, the city or other government agency will eventually subsidize the purchase of a hybrid.

Drivers have decided that they should not purchase a Prius or other hybrid until the subsidy arrived. Buying one now would mean over-paying.

Regardless of whether it is realistic to expect Chicago to someday subsidize purchases of hybrid taxis, the fact is that some cab drivers are considering the possibility. If taxi drivers consider future subsidies in their industry, then so must bank executives.

Last fall the public learned that banks were not selling many of their legacy mortgages and mortgage-backed securities, despite the impression that ownership of the assets were hindering the banks’ lending. A variety of theories have been put forward to explain this failure, and to suggest what the government might do to fix it.

But the lack of trade in mortgage-backed securities may have something in common with the lack of trade in hybrid Chicago taxicabs. The secondary market for legacy mortgages may have stagnated largely because of the (ultimately correct) anticipation of a huge government subsidy. As I wrote last week, banks were not “unable” to sell their legacy mortgages; they were prudently unwilling to sell because they expected the government to eventually step in and help push the prices of the assets higher.

There would have been two preferable possibilities: for the government to come forth quickly with its subsidy, or make it clear from the beginning that no subsidy was coming. With both Chicago taxis and the secondary market for mortgages, the government did neither. Instead, it only fueled rumors that subsidies were on the way, and froze the same markets it intended to stimulate.

Encouraging the Sellers, Not the Buyers, of ‘Toxic Assets’

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Last week the Obama administration released what has become known as the “Geithner plan”: an administration policy to reorganize asset ownership in the banking sector. The plan may have its desired effect of loosening up the market for “legacy assets,” but probably not for the reasons the Obama administration has stated.

Banks own mortgages (either directly, or through ownership of mortgage-backed securities) whose values plummeted in 2008, because the mortgages are collateralized with real estates whose values crashed.

Conventional wisdom about the banking crisis says that bank lending to the wider economy cannot occur because banks have been unable to sell these assets, which adds to their difficulties in making new loans.

As United States Treasury Secretary Timothy Geithner says, a secondary market for mortgages “does not now exist” because there is a “lack of clarity about the value of these legacy assets [which makes] it difficult for some financial institutions to raise new private capital on their own."

I agree that (to a good approximation) a secondary market for legacy mortgages does not exist. But the biggest reason is not lack of clarity, but rather the lack of a viable government policy to deal with the banking crisis. Until now, perhaps.

But let’s stick with the conventional wisdom for a moment more. According to that wisdom, it does not help for the Treasury and the FDIC to subsidize and leverage the purchase of legacy mortgages from banks as Secretary Geithner proposes, because the plan does nothing to (a) create clarity in legacy asset value or (b) ensure that banks no longer have significant direct or indirect holdings of mortgages on their balance sheets.

As Professors Paul Krugman and Joseph Stiglitz have explained, the Geithner Plan does increase the value of legacy mortgages to its owners, because it subsidizes the purchase of them. But it does not increase the clarity of those values, and in fact reduces clarity.

Consider an example, again from the conventional wisdom. Market participants are not sure whether a pool of mortgages will be worth $30 million or $50 million, and are concerned that the current owner knows a bit better and thus will offer for sale only the weakest of the weak. This $20 million worth of uncertainty, according to Secretary Geithner and the conventional wisdom, stops the secondary market from operating.

Thanks to the emergence of the Geithner plan’s subsidy and its leverage, the pool of legacy mortgages last week suddenly became worth $40 to $90 million (the Geithner subsidy raises private investors’ value of all types of bad mortgages, and its leverage increases the gap between the value of the best and the value of the worst). Yes, the legacy mortgages are worth more, but the profit of owning them is now less certain.

To make matters worse, the Geithner plan has no provision to stop banks from funding some of the ventures that will purchase the banks’ own legacy assets. The result may be bank ownership of mortgages that is less direct, but ownership nonetheless.

Thus, if the conventional wisdom is right, this plan will fail because it creates no clarity, and it does little to separate banking from legacy mortgage ownership.

But I believe that the conventional wisdom is highly exaggerated. Instead, the secondary market for legacy mortgages has stagnated largely because of the (ultimately correct) anticipation of a massive government subsidy. Banks were not “unable” to sell their legacy mortgages; they were prudently unwilling to sell because they expected the government to eventually step in and help push the prices of those assets higher.

We all witnessed last week the massive capital gains to banks that came with the unveiling of the Geithner plan. A bank would have been foolish to sell off its legacy mortgages during the fall or winter, before such a plan was unveiled and executed, because a fall or winter non-bank buyer of legacy mortgages would likely be ineligible for the ultimate subsidy.

Thus, the secondary market for legacy mortgages has failed so far due to the lack of a plan rather than a lack of clarity. In order to get the market operating again, the Geithner plan does not need to alleviate the market weakness improperly identified by its authors, but only needs to stay on the path to execution.

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.

Will the Geithner-Summers plan solve the Lemons problem?

One hypothesis about the banking crisis is that a secondary market for mortgages "does not now exist" (quote from Mr. Geithner's oped introducing the plan) because there is a "lack of clarity about the value of these legacy assets [which makes] it difficult for some financial institutions to raise new private capital on their own." (quote from U.S. Treasury fact sheet).

I guess the story is: a bank owner thinks a pool of mortgages is worth $10 million, and therefore refuses to sell for less than that. Potential buyers of that pool think it is worth $5 million, and therefore refuses to buy for more than $5 million. The market does not exist because the sellers value the assets less than potential buyers do.

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 would be willing to pay $10 million ($5 million for the pool itself and another $5 million for the government subsidy). The problem is that the bank owner (presumably aware of the subsidy) may not want to sell for less than $15 million. The reason is that he might be able to buy the pool from himself -- in which case he would pay $10 million for the asset (that's what he thinks it is worth) and another $5 million for the subsidy. So if he can sell to himself for $15 million, why should he sell to another buyer who will pay only $10 million?

You might say that the Treasury or FDIC would not allow a sham transaction like I just described. Well then you are saying that the Treasury or FDIC will micro manage things -- good luck with that!

The Geithner-Summers plan is more complicated than the simple subsidy described above. But my intuition is that even the complicated version misses the point that a subsidy raises every one's valuations of the item subsidized, rather than (as supposed needed) raising the valuations of some relative to the valuation others. Thus, the Geithner-Summers plan looks like giving taxpayer money to banks and creating a flurry of activity without really changing any of the fundamentals (reminiscent of what I wrote last fall about the Paulson plan).

Commenters: do you know of anyone who has worked out an explicit lemon's model and then added the Geithner-Summers plan to it?

Still More Evidence that Public Capital Crowds Out Private Capital

Wells Fargo chairman now explains that without TARP money, his bank would have simply obtained the funds privately.

U.S. Bancorp Shows How Public Funds Crowd out Private Funds

U.S. Bancorp took $6.6 billion in TARP funds in 2008. At the same time, they maintained their dividend (continuing a 75 year tradition of maintaining or raising it).

This month they announced that they would give the TARP money back to the Treasury. How will they replace it? But cutting their dividend for the first time in at least 75 years!

It is not a coincidence that U.S. Bancorp cut its dividend at the same time that they repaid the TARP money. I explained last fall how Treasury "capital injections" just result in greater payments to bank industry shareholders. One (of many ways) it could work is that a bank that had become less profitable during this recession would either cut its dividend in the absence of Treasury funds, or (as with TARP recipients like U.S. Bancorp) use the Treasury funds to maintain the dividend it had prior to the recession.

The same argument implies that payments from a bank TO the Treasury would reduce payments to bank industry shareholders. That's what we see with U.S. Bancorp.

Top Republicans say banks should be allowed to fail

reports the IHT. The first bank bailout was needless. If enough Senators recognize that a second bank bailout would also be needless, then we taxpayers may be lucky enough to stop at one bank bailout.

I believe that both of the Senators in the report voted for the first bank bailout. So maybe more politicians are adopting the opinion that bank bailouts waste tax dollars.

Still No Payroll Collapse

At the end of September, both Democrat and Republican politicans tried to scare us into believing that payroll spending would collapse.

The chart below (including the BEA's release this morning) shows that payroll spending has barely hiccuped, let alone collapsed, in the four months since those alarms were issued.

Although something is clearly awry in this economy, it is hard to show that a credit crunch is that important, given that trillions of dollars continue to flow from business to households in the form of wages and other personal income items.