Archives for September, 2008
Let’s Eliminate PMI-As-We-Know-It
Borrowers who put less than 20 percent of a home’s value down for a mortgage almost always have to secure “private mortgage insurance” (PMI) to protect their lender if they default. In 2007, PMI became became tax deductible for borrowers, thus further lowering the cost of homeownership and encouraging more people with small down payments to begin buying homes.
As it stands, the PMI creates enormous perverse incentives: it encourages lenders to lend to people who put down as little as 3 percent of the value of the home. Since it is a rare product that brings no benefit to the “consumers” who buy it (it protects only lenders), PMI encourages borrowers to do anything they can to avoid having mortgage insurance and, understandably, shop on price alone. The system set many people up for a fall by encouraging lenders to take risks with borrowers who look very bad on paper. It was also subject to manipulation. By “piggybacking” loans on top of each other, borrowers could avoid paying for PMI –which costs about $50 a month per $100,000 financed–and leave the lenders with no protection at all despite financing almost 100 percent of a home’s value.
In fact, lenders almost always buy mortgage insurance themselves for borrowers who have more than 20 percent equity in the home and roll the premiums into the interest rate. So PMI is really just a way of making borrowers pay more without actually raising the interest or fees demanded by the lender. It actually reduces the stability of the market.
Thus, those who want a more stable housing finance system should revisit PMI. If lenders wish to require buyers to purchase PMI, then it’s perfectly sensible to tax the borrowers’ insurance premiums as income to the lender since the lender derives a direct benefit from it. Since there’s no particular virtue in buying PMI, furthermore, there’s no reason to continue the consumer-side tax deduction either. Under such a system, few if any lenders would require that buyers secure PMI–which is exactly what should happen.
Lenders, instead, would secure and pay for mortgage insurance themselves and it would be deductible to them as a business expense. Borrowers, of course, would not get a “free lunch” from this—mortgage rates, fees, and other costs would rise by the cost of insurance. (Because lenders have more buying power with insurers, however, borrowers who put little down would probably see a slight reduction in total housing payments.) Since lenders would make almost all decisions about mortgage insurance, furthermore, they would have a much greater incentive to make sure that PMI worked and look out for piggyback schemes and other efforts at deception.
Getting rid of PMI-as-we-know-it isn’t a panacea. But it could make things better.
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SEC Loosens Rigid Accounting Rules
Rigid mark-to-market accounting rules may have triggered the current financial crisis by artificially undervaluing mortgages and securities (making financial institutions appear insolvent). Even the very government officials who have advocated those rules now hint that they will disregard them in valuing the government’s own mortgages, in administering any bailout! (This inconsistency undermines arguments for the bailout).
The SEC today made federal accounting rules a bit less rigid by allowing methods other than mark-to-market accounting in appropriate conditions. Thus, when mortgages have not defaulted, financial institutions need no longer treat them as worthless, even when no active market exists for the security based on those mortgages.
Hopefully, Congress will leave the SEC’s decision to reform accounting rules intact, or, better yet, push for further reform. The Congress’s Republican Study Committee has advocated a similar, but more far-reaching, reform. Similarly, Senator McCain welcomed the SEC’s decision, and apparently has advocated the reform it adopted since March.
Others supporting reform of mark-to-market accounting rules include former FDIC Chairman William Isaac, the Wall Street Journal, Jeff Miller, Holman Jenkins, and Newt Gingrich, to name just a few supporters.
Ideally, the SEC would also consider reforming other accounting rules that are burdening the economy without benefiting investors or financial institutions, such as regulations that dramatically expanded the reach of the Sarbanes-Oxley Act. A prime example would be the economically-devastating PCAOB rules on company’s “internal controls,” which cost the economy $35 billion per year, while focusing managers’ attention on trivia like which employee has access to which computer password. Those regulations were used by subprime mortgage lender Countrywide Financial to divert attention from its risky lending practices, earning it a reputation as a paragon of regulatory compliance despite its financial recklessness.
Speaking of the SEC, John McCain recently proposed appointing Andrew Cuomo to be chairman of the SEC. What an unbelievably bad choice! Earlier, we wrote about how Cuomo, as Clinton’s HUD secretary, helped cause the mortgage crisis by imposing “affordable housing” mandates that artificially created markets for risky mortgage loans to people with low incomes and little savings.
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The Market’s Winners and Losers
The People have spoken. They have picked the Market over the Government to be the chooser of winners and losers.
Here are the Market’s choices for winners:
1. Those that live in their homes, versus those that purchased houses to be flipped (third letter).
2. Homeowners that purchased a house that they could afford with a 30-year fixed, versus the over-extended with an adjustable rate.
3. Small local banks that didn’t make ARM loans with no money down, versus big ones with mortgage-backed securities.
4. Those that saved their money, versus those betting on the stock market.
5. Those who pay for their cars with cash, versus those who finance them.
6. Those who pay for their expenses with cash, versus those who run up credit card debt.
7. Those who save money for their kids’ college funds, versus those who rely on loans.
8. Those who chose preferred stock, versus owners of common stock.
9. Those industries that are needed by and contribute to today’s economy, versus those that rely on subsidies voted for them by politicians.
10. In the global market—the Market will choose economies that have less debt and low inflation, versus big spending governments with easy monetary policy.
In general, the Market will choose the prudent. Who would have the Government picked as winners? The Market’s choices for losers. The Bailout would have picked all of the losers above.
Risk is not immoral: everyone should be able to invest as they choose, but they do so at their own risk.
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What Are Markets For?
There are all sorts of people today who normally talk about free markets but who have got themselves into a tizzy over the failed bailout. We need to get one thing straight - the bailout was the wrong answer to the wrong question. To begin with, the plan was merely postponing the inevitable, as a letter in the Wall Street Journal pointed out this morning:
The lesson of past financial inflection points is that we must let the markets reallocate capital from less efficient to more efficient uses. The sad fact is that we need to go through a brutal process of resizing down our financial and real-estate industries. Actions to try to recapitalize doomed financial companies only postpone the day of reckoning, which will make matters worse as the Japanese learned in the 1990s.
Secondly, we have to ask how to protect future viable assets and investments, not just what we should do about past failed assets and investments. The bailout plan is exactly the wrong approach. It puts in them in jeopardy because not only does it tread down the policy road that led to the Great Depression, as Martin Hutchinson powerfully argues, but because real capitalism provides strict disciplines that actually provide better protection than government regulation. We will not succeed in protecting our children from a future financial meltdown if we merely put in place the exact parameters for it to happen again.
Markets are all about the efficient allocation of capital. As has been demonstrated on this page repeatedly, government caused the market to misallocate badly. If we go further and have government misallocate the capital by design, then we will have made one of the biggest missteps in economic history, worse than FDR and co, because we will have completely ignored the lessons of the great depression. A market correction is, in a very real sense, necessary. Government cannot bring that about.
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Republican Study Commitee plan now best viable alternative
The stunning defeat of the Hank Paulson’s socialism-for-Wall Street bailout on Monday has just made planks of a pro-free market alternative much more viable. As Open Market has noted before, The Republican Study Comittee, a caucus of pro-market members of the GOP Congress, has presented such a plan that would be much more effective at stopping the contagion than the Paulson bailout, and many of its provisions would not cost taxpayers a dime.
The RSC plan is chock-full of measures to remove barriers to economic growth and market-distorting subsidies. It would suspend capital gains taxes to put trillions of dollars of capital in the economy, and set Fannie Mae and Freddie Mac, which as CEI has documented were at the root of this crisis, on the road to full privatization.
Most importantly for the crisis at hand, the RSC plan would make regulatory agencies suspend the mark-to-market accounting rules that a range of experts agree are spreading the contagion by forcing solvent banks’ to “write down” their assets, based on the last fire sale of a highly leveraged bank. As Gary Gorton, finance professor at Yale and member of the National Bureau of Economic Research has written, “With no liquidity and no market prices, the accounting practice of ‘marking-to-market’ became highly problematic and resulted in massive write-downs based on fire-sale prices and estimates.”
You can read more about mark-to-market regulations in my op-ed in the Wall Street Journal last weekend. My Open Market post early last week, as well as CEI’s new podcast, explains how the Paulson bailout may make things worse by forcing more paper losses that threaten healthy banks with “regulatory insolvency.”
The problem with the Paulson buy-up plan or some new variant of it is if the government pays pennies on the dollar, mark-to-market rules would make every other bank take this paper loss on its books. So there will be a tension between getting the best deal for the taxpayer and not spreading further systemic risk from massive writedown the government purchase could force. Even Ben Bernanke acknowledged this tension in his Congressional testimony last Tuesday.
All the more reason to go with the RSC plan instead of a reformulated Paulson plan, which would throw $700 billion and the free market out the window and still not solve the crisis at hand.
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Bailout fails — Move on to Mark-to-Market Reform
Oh, Happy Day! And it certainly is for all those who value freedom, responsibility and the true free market in which individuals are free to profit from their risks on the condition that they don’t stick the rest of us with their losses.
It’s not hyperbole to say the Republican and Democratic backbenchers who defied both parties’ leadership to defeat this $700 billion package of Wall Street socialism literally saved America. Whatever their reasons, this defeat (or rather victory for freedom), means that America is much less likely to turn into France, Venezuela, or the old Soviet Union, as this bailout/nationalization package would have set us on the road to becoming.
Several great speeches on the Right and Left were given. Democrats Brad Sherman of California and Earl Blumenauer of Oregon gave powerful speeches against corporate giveaways. And conservative leaders of the Republican Study Committee — such as Jeb Hensarling, Jeff Flake, Mike Pence, and of course Ron Paul — spoke about how government intervention was largely the cause of this predicament, but the bailout would doom arguments for the free market form here on out. The idea of the government making this kind of outlay to high-flying risk takers just didn’t jibe with members, and certainly not with the American people.
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Investing in Communal Failure: The Current Economic Crisis as a Result of Regulation
Unfettered greed is the suspect many point at to explain the current economic crisis. To some extent, they are right, but it isn’t irrational greed on the part of bank managers or fat cat CEOs. It is the unwieldy bank regulations that forced the entire industry to walk the proverbial plank and then blame it for drowning.
Critics have alternately claimed that over-regulation and under-regulation are the causes for the current crisis. I believe one specific regulation, the Community Reinvestment Act (CRA), should shoulder a lot of the blame for creating an environment where a lending institution’s short-term survival hinged on it making the decisions that in the long-term would likely cause its demise.
As I noted in my paper The Community Reinvestment Act’s Harmful Legacy, one of the effects of the CRA was the creation of a weapon that has been effectively utilized to extort money from lenders. When lending institutions wish to open a new branch, expand, or merge, they must apply for permission from one of the four governing bodies (Federal Reserve, Office of Comptroller of the Currency, Federal Deposit Insurance Corporation, and Office of Thrift Supervision). Their request can be postponed or outright denied if any community group files a CRA protest. Lending institutions can of course fight these protests, but CRA investigations can take months and cost large sums of money.
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Stocks Climb as House Rejects Bailout
Though the bill may have been defeated for the wrong reasons—like the lack of freebies, giveaways, and handouts that many on the left had hoped for—the defeat of the bailout bill in the House has brought stocks out of their decent. The Dow Jones is now climbing.
But how can this be? How could a bill that was designed to save our economy, our country, and the world be the cause of the Dow’s drop today? Easy, the bill was introducing such incredible uncertainty into the market that investors were panicking.
It could also be that Wall Street—despite the recent bank closings—is still smarter than Washington. The reactions of investors suggests they realize the bill may have done more harm than good.
For more on why a defeated bailout bill is a very good thing and why the world doesn’t need saving, read John Berlau in today’s American Spectator.
Stay tuned to OpenMarket for John Berlau’s reaction to the bailout bill’s defeat. Also, check out our Bailout Watch page at CEI.org.
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BREAKING NEWS: Bailout Vote Fails in House
The House of Representatives just voted down the $700 billion corporate finance bailout, despite earlier urging from President Bush to push the measure through. Look for in depth analysis from our very own John Berlau and the rest of the policy team as the day progresses. Read CEI’s roundup of the continuing finance crisis (and sign up for email updates) here.
NEW: John Berlau responds (and speaks!) in reaction to today’s vote. Updated post and audio clip here.
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Podcast on the Bailout & Financial Meltdown
LibertyWeek, CEI’s weekly podcast, covered the bailout and the financial meltdown on Wall Street in its last episode. “Bailouts & Ballparks” features an interview with John Berlau, Director of the Center for Entrepreneurship at the Competitive Enterprise Institute.
My guest co-host William Yeatman and I discuss with John how excess regulation, the Federal Reserve, failed housing programs, government sponsored enterprises, and corruption brought Wall Street to its knees. The three of us come away from the interview with a different conclusion than the mainstream media. Rather than labeling the meltdown as a failure of the free market, we showed that there wasn’t all that much freedom in the housing market to begin with. This lack of freedom was the real problem.
Episode 9 runs about 42 minutes and covers a slew of other stories. You can subscribe to our podcast on iTunes or using RSS.
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