Tag Archives: moral hazard

Student Loans: The Next Financial Crisis? (Revised)

As I have been browsing the news the last couple of days, an article on the WSJ got me really thinking about student loan debt and the uncanny parallels shared with housing debt in the mid 2000’s. To preface, mortgage standards in the US were lowered in the early 2000’s in a push by the Clinton Administration to get people into houses. Loans that were issued by banks were sold to entities like Fanny & Freddy and then bundled into securities that were bought up and sold by different banks and hedgefunds around the US. Obviously we all know how this ended, but the issue as I see it, was two fold on the banking side of things. The first issue was the relaxed standards set by Washington for loans to be given out and the second issue was the moral hazard represented by the banks writing the loans because they could turn around and sell them just as fast as they could write them.

Almost 6 years now after all of the events of the financial crisis happened, I see a striking parallel between another type of debt and mortgages: Student loans. One of the bigger facets of Mr. Obama’s presidency has been the lowering of the barriers of entry for people to goto college. In 2011 the president enacted a program in which students can attend college and then pay after the fact as they earn at whatever jobs they may find– this program is aptly titled, “Pay As You Earn”. Under this plan, you would attend college at the cost of the government, and then 10% of your total discretionary income per year after school would be taken as repayment for the loans. If you find a job in the private sector after school then you pay for 20 years and then the remaining balance is forgiven, 10 years if you work in the public sector. (Student Aid Website)

Unsurprising to any market failure monitoring economist though, this plan is backfiring, even despite noble intentions. In an article from the WSJ we see that the plans have expanded to over 1.3 million people (originally less than a million before changes to debt forgiveness were enacted) and total debt balances rising to $72 billion from $52 billion before the easing in forgiveness measures were enacted. A moral hazard exists here between the tax payer and the schools who are now incentivized to raise their tuition prices and pay for more of the students bills because the government will pay them back regardless after 20 years and as everyone attending this great University of Michigan knows; tuition has been rising.

So the first ingredient in a recipe for financial crisis obviously being bad debt, the time must have seemed perfect for a dash of bundling; the bundling of asset backed securities. In another WSJ article, we see SLM Corp who happens to be the largest student lender in the US selling over a billion dollars worth of student loan backed securities (SLBS). The interesting part about this and other SLBS sales is that the majority of the demand for the offerings is for the riskiest parts (the most likely to default) of the securities. Why this appetite for risk? Low interest rates may be the answer. Thinking back to the early-mid 2000’s there was a refusal by Alan Greenspan to raise interest rates and people were hungry for yield; the mortgage backed securities promised a rate of return higher than what anyone could find in the bond market and was still rated AAA to top things off. Many believe that the mix of moral hazard and systemic risk present in the banking structure combined with the low rate environments was the catalyst for the financial bubble to blow up and eventually burst. These student loan offerings show that investors are indeed searching for yield wherever they can today.

With default rates on these loans continuing to rise, the government needs to act now to reform this pay as you go expansion for the student loan program. The best solution I think would be to work with colleges to lower tuition rates and quit forgiving the debt that these students take on. Because as long as people can have something for nothing, or rather, a college education at the expense of the US Taxpayer, they will continue to do just that until we are in the midst of another massive asset bubble.

Student Debt the Next Balloon to Pop In US?

As I have been browsing the news the last couple of days, an article on the WSJ got me really thinking about student loan debt and the uncanny parallels shared with housing debt in the mid 2000’s. To preface, mortgage standards in the US were lowered in the early 2000’s in a push by the Clinton Administration to get people into houses. Loans that were issued by banks were sold to entities like Fanny & Freddy and then bundled into securities that were bought up and sold by different banks and hedgefunds around the US. Obviously we all know how this ended, but the issue as I see it, was two fold on the banking side of things. The first issue was the relaxed standards set by Washington for loans to be given out and the second issue was the moral hazard represented by the banks writing the loans because they could turn around and sell them just as fast as they could write them.

Almost 6 years now after all of the events of the financial crisis happened, I see a striking parallel between another type of debt and mortgages: Student loans. One of the bigger facets of Mr. Obama’s presidency has been the lowering of the barriers of entry for people to goto college. In 2011 the president enacted a program in which students can attend college and then pay after the fact as they earn at whatever jobs they may find– this program is aptly titled, “Pay As You Earn”. Under this plan, you would attend college at the cost of the government, and then 10% of your total discretionary income per year after school would be taken as repayment for the loans. If you find a job in the private sector after school then you pay for 20 years and then the remaining balance is forgiven, 10 years if you work in the public sector. (Student Aid Website)

Unsurprising to any market failure monitoring economist though, this plan is backfiring, even despite noble intentions. In an article from the WSJ we see that the plans have expanded to over 1.3 million people (originally less than a million before changes to debt forgiveness were enacted) and total debt balances rising to $72 billion from $52 billion before the easing in forgiveness measures were enacted. A moral hazard exists here between the tax payer and the schools who are now incentivized to raise their tuition prices and pay for more of the students bills because the government will pay them back regardless after 20 years and as everyone attending this great University of Michigan knows; tuition has been rising.

Students are obviously carrying more debt now with this plan and the next question is what will happen to default rates now that there exists an economic incentive to not pay these loans back because the tax payer obviously will. The parallel between this easing in debt rules and mortgages while different in the total amount of money being given away is different than that of houses, still sets a bad precedent for us in a post 2008 economy.

Does ACA Legislation Prevent or Induce Market Failure?

The cornerstone of our presidents legacy rests solely on the success or failure of his oft-publicized, debated about, & seemingly misunderstood health care policy. I have recently taken the time to learn a little more about some of the provisions and general ideas that exist in the bill and if I may not have been totally sold on the bill before, I have even more questions now.

The ACA is designed as a “multi-faceted” plan (with over 1000 pages in the law its not a stretch to believe this) that tries to deal with both small group and non-group individuals who may have fallen through the cracks of the health care system before; some may have been too young to enter into medicare or too close to the poverty line to qualify for medicaid, etc. The law fights to extend medicaid benefits to more people as well as make an effort to drive down other insurance costs due to its marketplace style reduction of informational asymmetries present in the old style health care system. (US Dept. of Health & Human Services).

It is not my goal here to explain the law in its entirety but rather to point out a couple of the parts of the law that aim to fight against market failure and maybe cast a light as to their effectiveness. One of the most interesting and recently written about issues is the promotion of preventative care as a tool to help drive down future costs for healthcare companies due to the fact that they now theoretically will be insuring those that have much larger future expected costs.

Thusly, it seems prudent to take a look at whether or not the logic behind the pushing of preventative care is actually sound despite what we may think at first glance. The first issue that comes to mind with the focus on preventative care is the new potential for the abuse of this care. A study in Oregon dating back to 2008 that simulated the extending of Medicaid benefits to include more people in the low income bracket as well as expanding coverage to make it more affordable to use a primary care doctor shows the problems that seemingly defy logic. Those people who won the lottery for expanded Medicaid benefits went to the emergency room a whooping 40% more than the part of the group who did not enjoy the benefits of expanded primary care coverage (NYTimes).

Another interesting facet of the cost/benefit focus of preventative care again comes from the New York Times, once again the thought that a focus on preventative care would deal with problems now in a more cost effective manner than would be used later does not seem so clear. Canadian women were separated into two different groups; one that would have regular mammograms and breast examinations and the other that would only have routine breast examinations and no mammograms. The doctors found at the end of the trial (which appeared in the British Medical Journal) that the death rate between both groups was in fact the same, which leads some researchers to question the cost effectiveness of this preventative approach to medical health. In fact, the researchers took things even further and hypothesized that the unnecessary treatments administered to women while obviously did not lead to lower healthcare costs, could also lead to harmful health effects from routine surgery as well as the fact that some cancers that are benign can turn malignant and spread after being biopsied. The article talks more specifically about the meaning of thing in the medical world and how treatment may or may not change, but I think its worth thinking about on a much broader level. If one of the main points of the Affordable Care Act is to reduce costs to both insurers as well as the insured, then it should probably be the case that it actually happens.

At first glance the focus on preventative would seem to be a good thing for insurance companies, but if stories like Oregon’s and Canada’s are true then it is the exact opposite. The focus on preventative care has the potential to create an entirely new segment of moral hazard that will have to be dealt with all of the while trying to deal with another.

Mankiw: The Scientist is also the Philosopher

In his New York Times post today, Harvard economics professor Gregory Mankiw wrote that the “dirty little secret” of economics is that policy recommendations nearly always include political viewpoints as well as economic analysis. While this should come as no surprise to Michigan economics students, it does present a serious discussion of how economic data is presented.

Mankiw brings up the Democratic position as being for societal good. Decisions are made that may not be beneficial for all, but can help a majority. To demonstrate this, he gives two moving examples.

“Imagine that you are on a bridge and see a runaway trolley car below you, hurtling toward three children playing on the tracks. A fat man is standing next to you. You can push him off the bridge and into the path of the trolley, killing him but saving the children. What do you do?”
– Mankiw (2014)

In this scenario, with relatively clear protagonists (innocent children) and what Mankiw paints as an antagonist (a fat man – note that including the description of being fat does nothing but decrease the value Mankiw wants to portray on this man’s life), Mankiw argues that many wouldn’t hesitate to save the children. However, he gives a second example that makes the decision cloudier.

You are a doctor with four dying patients. One needs a new liver, one needs a new heart, and two need a new kidney. A perfectly healthy patient walks into your office for his annual checkup. Are you still willing to pursue the utilitarian course of action? – Mankiw (2014)

In this second example, Mankiw argues that it is harder to make the decision to sacrifice one person’s life for others due to his natural rights. So how can we translate these sensitive personal decisions into a person’s economic beliefs? Mankiw references the Affordable Care Act, which ended many people’s perfectly good health insurance plans in order to make insurance available for others. For some, especially in rural areas, insurance costs have increased by more than 100%. Small businesses have had to significantly add to their expenses by offering insurance to their full-time workers. Overall, the question for what to look at comes back to whether the ACA was a utilitarian decision – helping Americans get access to previously inaccessible coverage – or unfair to people perfectly happy with their coverage.

With so much data, it is more important than ever to understand the motives behind the numbers. Has the data been “cooked” to fit the argument? One example that I believe is a perfect example is the argument for increasing the minimum wage. Even in our class blog, articles have been posted which reference data supporting both sides. My own prior post references that a raise to $10.10 would reduce the quantity of low-wage jobs by 16%. This recent revised post, on the other hand, argues that the same increase wouldn’t reduce the amount of jobs available. In both cases, Mankiw is spot on when he stresses the importance of understanding the purpose of the data before interpreting the results.

(Revised) The Housing Bubble: Fannie and Freddie

The system involving Fannie Mae and Freddie Mac needs to be reformed. According to the Wall Street Journal, “Many in Washington say they want to get rid of the [Fannie and Freddie], but they want to preserve many of the benefits that those companies enabled – namely, providing a steady source of relatively chap 30-year, fixed-rate mortgages”. Fannie and Freddie do not make loans, but package mortgages into securities that are sold to investors. As mortgage guarantors, Fannie and Freddie promise to pay investors back when the loans default. On the one hand, Fannie and Freddie serve an important role as middlemen bringing buyers and sellers together. On the other hand, Fannie and Freddie stick the government with a huge bill when loans default.

The government played a critical role in the housing bubble. Burton Malkiel writes in A Random Walk Down Wall Street, “The government itself played an active role in inflating the housing bubble. Under pressure by Congress to make mortgage loans easily available, the Federal Housing Administration was directed to guarantee the mortgages of low-income borrowers”. The government vehicle that guaranteed these loans was Fannie and Freddie. Creating a classic moral hazard problem, the government takes on a majority (if not all) of the risk. As a result, lenders loosened their standards and provided loans to noncredit worthy individuals because the government was there to assume the risk. Although there are many other factors that contributed to the housing bubble, an important factor was government policies that encouraged lenders to lower their standards.

After the initial increase in demand caused by low-income borrowers entering the market, the housing bubble continued to grow in size due to a positive feedback loop. According to Malkiel, “The initial rise in prices encouraged even more buyers. Buying houses or apartments appeared to be risk free as house prices appeared consistently to go up. And some buyers made their purchases with the objective not of finding a place to live but rather of quickly selling (flipping) the house to some future buyer at a higher price”. Speculators, who purchased real estate with the intention of selling for a profit, contributed to strong demand and further pushed prices upwards. The implicit government guarantee essentially eliminated credit risk for investors, which is the risk of default. The belief that prices will continue to rise created “castles in the air”.

As it always does, the bubble finally popped. Interest rates, which were low in the years prior to the financial crisis, began to rise (i.e. interest rate risk). Demand for houses slowed down and prices fell. Mortgages grew to exceed the value of the underlying asset (i.e. the house or apartment). As a result, homeowners chose to default and allow the lender to repossess the asset. The increase in the supply of homes caused prices to fall drastically. The burst of the housing bubble brought on the recent financial crisis in which Fannie and Freddie defaulted. In September 2008, the government bailed out Fannie and Freddie.

Fannie and Freddie caused many problems as quasi-public institutions. According to the Wall Street Journal,

In addition to serving as mortgage guarantors, the firms also amassed over the last two decades huge investment portfolios, which helped them generate larger returns to appease shareholders. The companies claimed that these portfolios helped reduce borrowing costs for homeowners, but critics argued that they simply used their implied government guarantee to profit between the spread on those investments and the cheaper debt-funding costs”.

Using the implicit government guarantee to benefit in the market place is a misuse of power. Fannie and Freddie are a duopoly, which were able to reap huge profits before being bailed out. Currently, lawmakers are working on a new system in which the good aspects of Fannie and Freddie would be preserved. According to the Wall Street Journal, “The plan, by Senate Banking Committee leaders Tim Johnson (D.,S.D) and Mike Crapo (R., Idaho), calls for replacing Fannie and Freddie with a new system of federally insured mortgage securities in which private insurers would be required to take initial losses before any government guarantee would be triggered”. Forcing private insurers to face losses would hopefully discourage irrational risk taking by decreasing moral hazard. Although there is uncertainty surrounding the future of Fannie and Freddie, the need for change is clear and there are certain agreed upon principles – make the “implied” guarantee explicit, get rid of those investment portfolios, require more capital and tighter regulation.

The real questions is whether Fannie and Freddie will remain (in a reformed system) or will be replaced. If replaced, then who will be the successors? I believe this is a very tough question to answer. Although big banks could easily handle this role, this would intensify concerns about certain institutions being too-big-to-fail. I look forward to hearing more about the Senate Banking Committee’s plan.

The Housing Bubble: Fannie and Freddie

The government, particularly Fannie Mae, played a critical role in the housing crisis. Leading up to the financial crisis, Fannie Mae purchased a colossal amount of mortgage-backed securities (MBS) from Wall Street. Although the MBS originated from Wall Street’s investment bankers, the underlying mortgages came from lenders that provided the loan directly to the consumer. The lenders are responsible for assessing the creditworthiness of the consumer. Burton Malkiel writes in A Random Walk Down Wall Street, “The government itself played an active role in inflating the housing bubble. Under pressure by Congress to make mortgage loans easily available, the Federal Housing Administration was directed to guarantee the mortgages of low-income borrowers”. The government vehicle that guaranteed these loans was Fannie Mae, which assumed all the risk when it purchased the MBS. The government taking all the risk creates a classic moral hazard problem for Wall Street as well as the lenders. The lenders loosened their standards knowing that Wall Street would buy the mortgages (securitize them) and sell them to Fannie Mae. In short, the housing bubble can be traced to lenders that loosened their standards due to the government’s policies.

The housing bubble grew massive as demand pushed up prices. Low interest rates allowed an enormous amount of credit expansion, which supported the increase in demand. The increase in demand and rise in prices began to resemble a positive feedback loop. According to Malkiel, “The initial rise in prices encouraged even more buyers. Buying houses or apartments appeared to be risk free as house prices appeared consistently to go up. And some buyers made their purchases with the objective not of finding a place to live but rather of quickly selling (flipping) the house to some future buyer at a higher price”. The introduction of speculators who purchased real estate with the intention of selling for a profit is a classic sign of a bubble. Eventually the bubble popped (as it always does). In this case, mortgages grew to exceed the value of the underlying asset (i.e. the house or apartment). As a result, homeowners chose to default and allow the lender to repossess the house. The increase in the supply of homes caused prices to fall dramatically. The collapse in prices and burst of the housing bubble was, for lack of a better word, devastating.

Following the government bailout of Fannie and Freddie, I believe the need for reform is clear and the basis for the reform should include removing the implicit government guarantee. According to the Wall Street Journal, “Two key lawmakers on Tuesday said that they would soon propose legislation to eliminate the housing-finance giants. Highflying shares of Fannie and Freddie dropped sharply; Fannie lost nearly a third of its value”. As long as the government institutions such as Fannie and Freddie take on all the risk, moral hazard is going to distort financial markets. Fannie and Freddie, which are part pubic and part private, do not make any sense to me because of the looming perception that the government will not allow it to fail.

Fortunately, lawmakers are devising an alternative that would remove Fannie and Freddie from the picture. According to the Wall Street Journal, “The plan, by Senate Banking Committee leaders Tim Johnson (D.,S.D) and Mike Crapo (R., Idaho), calls for replacing Fannie and Freddie with a new system of federally insured mortgage securities in which private insurers would be required to take initial losses before any government guarantee would be triggered”. I think this might be a good plan because moral hazard would be decreased. Forcing private insurers to face losses should discourage dangerous risk taking, which would eliminate the implicit promise of government backing and decrease moral hazard.

Big Banks & Moral Hazard

After the Great Recession, many economists cited moral hazard as the prime reason to not bail out failing banks.  Nevertheless, our country proceeded to bail out many major financial institutions in order to minimize the impact that widespread bank failures would have on the economy and equity markets.  Why?

The answer seems to lie in the level of influence financial institutions have on the US economy; it is extremely difficult to let banks fail because they constitute such a significant portion of the economy.  In the USA, for example, the financial sector produces nearly 10% of GDP (NYT: The Rich Country Trap).  Because financial institutions produce such a large portion of the nation’s GDP, they are extremely influential and important to this nations economic success.  Indeed, policymakers call upon the heads of financial institutions when they need help with the nation’s economic problems.

Nevertheless, if we want to reduce moral hazard, we must confront big banks.  In an IMF conference in 2013, Ben Bernanke stated that banks must be allowed to fail in order to eliminate the threat moral hazard.  That said, as the failure of Lehman Brothers in 2008 showed, bank failure can have devastating consequences on the economy.  As such, Bernanke believes that policy makers need to devise a systematic and controlled way for banks to fail.  This systematic failure should minimize the impact of bank failures on the economy.  While I do not understand the details of this systematic failure, my hunch is that Bernanke has proposed gradual bank failure, where failed banks slowly fall out of existence with the help of the government as opposed to dropping out of the economy at the onset of bankruptcy (Bloomberg: Bernanke Says Failing Bank Process Needed to Reduce Moral Hazard).

It seems clear that to avoid another bank collapse, we must reduce the effects of moral hazard.  Ironically, however, banks are so influential that many policymakers lack the guts to address the issue or moral hazard.  Consequently, banks continue to operate knowing that in the event of disaster, the government will likely come to their aid.  To address the issue of moral hazard, therefore, it seems that we must have a transition period, where systematic failure is implemented, bank regulations are increased, and moral hazard is reduced.  Naturally, during this transition period, bank profits and GDP will fall, and this fall in GDP will be painful.  But just like saving money, it will be beneficial in the long run; this transition period will reduce moral hazard while forcing banks to appreciate risk and operate in a responsible manner.

It will be very challenging to find politicians willing to take us through this transition period.  Certainly, politicians proposing a painful transition period won’t easily win the favor of voters.  Maybe, though, if we can sever the ties between political fundraising and banking, we may be able to elect such a politician.

What’s the Easiest Way to Clean Up a Mess? Don’t Make a Mess

A WSJ article reports that Chinese banks are finding creative ways to deal with “non-performing loans.”  Specifically, these banks are raising capital to offset the losses they will inevitably incur when borrowers default on these non-performing loans.  Combined with gradual write-offs of bad debt, this increase in capital is intended to lessen the need for a government bailout. (Beijing Tests Tools to Tackle Bad Debt).

As was the case for many American banks after the housing crisis in 2008, government assistance was necessary to absorb the losses brought about by non-performing loans.  McKinsey estimates that over the next 5 years, Chinese banks will require $320 billion in capital to prevent non-performing loans from causing bankruptcy.  While this $320 billion is not as much as the near $500 billion pumped into the US economy by the TARP program, it is still a substantial amount of money that the government must spend.  And when the government spends money bailing out banks, it means the government is not spending money elsewhere (like improving education or infrastructure).  In my opinion, bailing out banks is certainly not the best use of the government’s money.

While reading the WSJ article cited above, one thing in particular stood out to me: the entire article discusses how Chinese banks are working to reduce the consequences of non-performing loans; not a single sentence discusses how Chinese banks are working to prevent non-performing loans in the first place.

After a little google searching on the topic, I found a few unsatisfying articles discussing how banks can reduce non-performing loans, but none of the proposed strategies really seemed effective.  For example, one article discussed how in late 2013, JPMorgan Chase announced that it would no longer issue student loans because on average, the risk of default on student loans is too high (Without “Meaningful Growth” in Student Loans, JPMorgan Chase Stopping Them Altogether) .  To the credit of JPMorgan Chase, not issuing loans at all is definitely one way to eliminate non-performing loans.  But the market demands student loans, and by choosing to not issue these loans at all, JPMorgan is reducing opportunity for students who will not default.  In this way, I don’t see JPMorgan’s solution as a viable way to reduce the number of non-performing loans in the long-term.

That said, reducing the amount of non-performing loans should be a top priority for economists and financial experts.  If we can reduce the amount of money the government spends on bailouts, we can redirect this spending to areas where it will have a greater impact of the country’s welfare.  Alternatively, we could not spend this money at all, helping to drive down America’s excessive pile of debt.  I’ll be interested to see how the focus of economists and financial experts evolves as the country recovers from the Great Recession, as I believe there should be less effort spent on solving the problem and more effort spent on preventing it.

As the economy continues to recover, I think increased regulation will likely be the primary way that the US addresses non-performing loans.  And while regulation has its place, I think that intrinsically motivating banks to issue smart loans is much more effective than extrinsically forcing them to do so.  To achieve such intrinsic motivation, we need to reduce moral hazard by allowing failing banks to fail.  By doing so, I believe we can demonstrate to banks that they are solely responsible for their own successes and failures, and hopefully banks will respond by making smarter lending decisions.