Our creative mortgage crisis?

By Lawrence Summers

Here is a really good creative capitalism idea. All Americans benefit from increases in home ownership because of the values like hard work, community, and respect for property that ownership instills. Families want desperately to own their own homes and accumulate equity. Yet it is very hard for conventional banks that borrow money over the short term to lend over the kind of 30-year horizons that best help families buy houses.

How can the objective of ownership be best supported and how can the most adequate financing be assured? Voila, creative capitalism! How about chartering private companies as government sponsored enterprises with the mission of promoting home ownership affordability? Give them boards with some private representatives and some public representatives. Make clear that government stands behind their capital market innovations so they can borrow more cheaply and pass the savings on. Exempt them from the state local taxes that others pay. Give them specific objectives on affordability that they must meet. Rely on a special government regulator to assure that they balance their social responsibility with their drive to profit. Harness the profit motive to meet a social objective.

This is roughly the rationale behind Fannie Mae and Freddie Mac. I would submit that it is about as good or as bad as most creative capitalism ideas involving joint profit making and social objectives. But one hopes that we are now witnessing the end of this particular experiment in creative capitalism: the government is moving to pick up the pieces of the mess the GSEs have made and their shareholders are losing most of their money.

What went wrong? The illusion that the companies were doing virtuous work made it impossible to build a political case for serious regulation. When there were social failures the companies always blamed their need to perform for the shareholders. When there were business failures it was always the result of their social obligations. Government budget discipline was not appropriate because it was always emphasized that they were "private companies.” But market discipline was nearly nonexistent given the general perception -- now validated -- that their debt was government backed. Little wonder with gains privatized and losses socialized that the enterprises have gambled their way into financial catastrophe.

I wonder how general the lesson here might be. My fear is fairly general. Inherent in the multiple objectives urged for creative capitalists is a loss of accountability with respect to performance. The sense that the mission is virtuous is always a great club for beating down skeptics. When institutions have special responsibilities it is necessary that they be supported in competition to the detriment of market efficiency.

It is hard in this world to do well. It is hard to do good. When I hear a claim that an institution is going to do both, I reach for my wallet. You should too.

Comments

[Michael F. Martin]

On my view, the vision for creative capitalism is not less, but more accountability. We should be measuring and reporting more information about how firms operate. F&F are causing us plenty of pain now. But their failure has also given us useful data in designing better institutions for promoting stable growth in home ownership for the future. And the best theories for explaining the data do not suggest that a return to an entirely private or entirely public system would be less costly.

http://brokensymmetry.typepad.com/broken_symmetry/2008/07/are-fannie-mae.html

[Josh]

All Americans benefit from increases in home ownership
Is that really true? I think most people would be better off renting and having a great portfolio.

because of the values like hard work, community, and respect for property that ownership instills.

Blah blah...

Families want desperately to own their own homes and accumulate equity.
Wait a minute, you can accumulate equity in a million other ways.

Yet it is very hard for conventional banks that borrow money over the short term to lend over the kind of 30-year horizons that best help families buy houses.
It's hard to make a 30-year loan. You have a lot of inherent risks. The government doesn't have any advantage (as we are learning) over a private bank in better evaluating or hedging out those risks.

And that's just the first paragraph.

[dWj]

I would rather see these social-good/profit-motive entities put together with an explicit subsidy for the social-good end, linked (after a possible start-up period) to tangible accomplishments, and see no other privileges granted to them. A case could have been made for congressional chartering of these companies simply to overcome an initial period of developing a market that perhaps no private company would have been willing to attempt; it may be that the long-term good done by the purely private aspect of these companies would have been positive, with the short-term too uncertain to invite private investment. After a while, though, we're left with an implicit subsidy that's hard to value and hard to evaluate, and -- all the moral hazard aside -- it's hard even to guess whether the subsidy is "worth it", by any reckoning, or not.

[Kori Lambert]

It is truly unfortunate that the individuals who have been hurt most by the GSEs are the low-income individuals that they were chartered to assist. I have witnessed far too many families who were spurred on by overly eager lenders which were in turn propped up by Fannie and Freddie. These lenders used the GSE's guidelines as gospel in order to place people in houses that they were simply unable to realistically afford. Once the loan closes, the damage has been done and the borrowers are then often unable to get out from under the debt, fees and credit destruction that has been piled on top of them. Getting people into homes and keeping people in homes are two very different things.

[M. Hodak]

Brilliant post, Larry. I had to laugh at the phrase "Government budget discipline," but I figured that in this particular piece, giving them the benefit of the doubt was just a rhetorical tool.

[Dr. T]

Kori Lambert said: "It is truly unfortunate that the individuals who have been hurt most by the GSEs are the low-income individuals that they were chartered to assist."

The above statement is incorrect. The upper middle class and wealthy persons whose stock portfolios have plummeted in value due to the cascading effects of so many bad mortgages are the ones who experienced the greatest economic harms.

The lower middle class and middle class persons who became sub-prime mortgage home buyers lost almost nothing: they had no equity in their homes. Their lack of equity was a major cause of the collapse of Fannie Mae and Freddie Mac and other mortgage brokers.

I tire of lies and propaganda. The cause of this problem was simple: when you mix together stupid government bureaucrats, greedy mortgage lenders, and greedy home buyers, you get a mortgage-related catastrophe. The solution also is simple: keep the federal government out of the mortgage business and let the states ensure that banks follow fair lending practices.

[Patrick]

This is such a great post--and yet people are still missing the point (or deliberately avoiding it, perhaps). Political failure dwarfs market failure. When governments put their hands into the marketplace for purposes other than the enforcement of property rights the result is usually a travesty.

Capitalism is about harnessing greed to allocate resources efficiently and create new wealth. It does so at the cost of inequality. If we can't tolerate that then we should tax and redistribute that wealth (at the cost of deadweight losses), but we must not pretend that capitalism can be anything other than what it is. Give a corporation conflicting imperatives and you turn the executive suite into a gladiator school where only the best double-talkers survive. In other words, corporations become primarily political creatures and markets aren't markets anymore. The economy will revert to a sort of cronyism where the fittest firms are those which best game the political process to gain government backing. Competition from more efficient firms will be smothered by taxpayer subsidies. Some of this already goes on, of course, but only in small and shrinking regions of the economy. It could get a lot worse.

Creative capitalism is neither. At best, it would be socialism without the justice.

[Jeff Mowatt]

I'm not so sure that a point is being missed Patrick. What you have there is no different to our own acceptance here in the UK, that when capitalism flounders, a government hoping to be re-elected needs to deliver a fall-back plan. Here it's 90% of the first £50K savings as we sit and wait for others to follow the example of Northern Rock.

What the post illustrates to me, is that the phrase Creative Capitalism, in the absence of being more clearly defined has morphed into everyone's bogeyman, the Orwellian Room 101 of all our secret fears. Already elsewhere, I read of it being compared to state socialism of the Mussolini flavour and the scariest thing since the Cold War and Reds under the Bed.

To a lesser degree it's also been interpreted as the kind of handouts that create aid dependency, business funding charitable causes and even the destabiliser of an ideal corporation which maximises returns to all its stakeholders.

I'd like to find such a corporation, because I'm inclined to believe that the cronyism and double talk you describe is already with us, when we have CEOs paid massive bonuses for returning losses or bankruptcy and delaying payment to suppliers and that's before we even contemplate any ethical showcasing.

it might well be socialism without the justice, but that's for those who get involved to determine. We've made some progress in fact, using business to leverage human justice but that will only be revealed to those who care to find out how much 'creative capitalism' is already in existence.

[Tracy W]

Well done, Lawrence Summers.

What the post illustrates to me, is that the phrase Creative Capitalism, in the absence of being more clearly defined has morphed into everyone's bogeyman, the Orwellian Room 101 of all our secret fears.

Actually no. For example, one of my secret fears (well, it was secret) is of the entire universe being sucked down a drain. I don't however believe that creative capitalism will increase the probability of this occurring.

I suspect most other critics of the badly-defined idea of creative capitalism have secret fears of their own that have nothing to do with creative capitalism.

I'd like to find such a corporation, because I'm inclined to believe that the cronyism and double talk you describe is already with us, when we have CEOs paid massive bonuses for returning losses or bankruptcy and delaying payment to suppliers and that's before we even contemplate any ethical showcasing.

And your approach to this problem is to recommend some undefined creative capitalism that will make monitoring CEOs even more difficult? The logic of this fails me.

[Jeff Mowatt]

Not at all Tracy. As the old saying goes - You can lead a horse to water but you can't make him drink.

A clear definition of what we prescribe, a precursor to CC is defined on my link. I just can't force anyone to read what's there.

[Tracy W]

Not at all Tracy. As the old saying goes - You can lead a horse to water but you can't make him drink.

And this means?

Jeff Mowatt - from your link: P-CED places people at the center of economic development. P-CED takes the bottom line one step further: to people, past numbers. Enterprise profitability and economic success cannot be fairly measured in terms of gains of money capital alone. Profit is redefined in human terms rather than pure quantitative analyses that remove human and social concerns in the name of profit.

You are making exactly the same mistake that Nancy Birdsall did.

Profit is a way of addressing human concerns (I don't know what concerns you think are "social" but not "human"). If you are making a profit in a market economy, this means that you are providing a good or a service that is worth more to humans than the resources that went into creating it. Profit-seeking behaviour leads us to address human (and, thus, presumably social) concerns.

If profit-seeking behaviour is not addressing human concerns, then the right solution is to address the property rights system so it does.

[jb in pa]

The second half of Lawrence Summers' experiment at applying his expertise/opinion to this situation is to test it against the conditions of the portfolios of the executives of Fannie Mae and Freddie Mac.

[Jeff Mowatt]

What this means is that where I've pointed out some achievements in the pursuit of "creative capitalism", you've not taken the opportunity to examine these.

I don't see that Nancy Birdsal made a mistake. Advocating and lobbying, in the context of pitching the ideas at government gave us the opportunity to leverage change in Eastern Europe.

If you care to read on, you'll find the point, that all business is in some form social, offering as illustration the contribution of Microsoft to empowerment in the information age. Yet Bill Gates himself once said "Poor people don't need computers" emphasising that many were disenfranchised and of little consequence.

Our aim is deliver a form of business which addresses the needs of those who fall through the cracks of opportunity.

What this means is that where I've pointed out some achievements in the pursuit of "creative capitalism", you've not taken the opportunity to examine these.

Where did you point out these achievements?

I don't see that Nancy Birdsal made a mistake.

The mistake she made was to assume that profit-maximising behaviour did not increase social gains. To quote Ms Birdsal: The incentives for corporations whose workers, shareholders and customers are far-flung geographically to eschew expected profits in the interests of social gains are limited.

To quote Adam Smith: "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."

The baker can make a profit by pursuing the social gain of supplying people with bread. The baker does this by producing bread that is worth more to the people buying it than the value of the individual components of the bread. If avoiding starvation is not a social gain, then what is?

The website linked by your name included the statement I quoted which made the same mistake as Nancy Birdsal - it assumed that there is a conflict between profit-making and human concerns. But the baker who keeps me fed is making a profit by addressing my human concern of keeping away hunger pangs by producing a product that is worth more to me than the sum of its inputs. The money tells you that, there's no need to add an extra layer of information on top.

Advocating and lobbying, in the context of pitching the ideas at government gave us the opportunity to leverage change in Eastern Europe.

That's nice. Profit-maximising behaviour fills up farmers markets, corner stores, and supermarkets with food everywhere markets are allowed to operate.

If you care to read on, you'll find the point, that all business is in some form social, ...

I have some other comments, but I first want to get something cleared up - what do you mean by social? If all business is in "some form" social, then presumably you think that there are some other forms that are not social. What are those other forms?

[Jay]

Nationalize! Nationalize! Nationalize!!!

The government screwed things up big time, but if we look to history we know politicians will blame the "free market" (which there is none, but such a lie is in their self-interest) and we will get more government intervention, which will surely cause more problems in the future (another government created bubble).

[cathyf]

[quote]The lower middle class and middle class persons who became sub-prime mortgage home buyers lost almost nothing: they had no equity in their homes. Their lack of equity was a major cause of the collapse of Fannie Mae and Freddie Mac and other mortgage brokers.[/quote]

I call bulls***. When a family loses their house to foreclosure they lose a whole lot more than equity. They are left with a judgement, typically 1-1/2 to twice the mortgage balance, hanging over their heads forever, or for seven years after they declare bankruptcy. If they couldn't afford the mortgage, they are going to be able to afford the judgement? Even in a non-recourse state they are left with the foreclosure on their credit ratings.

The nitty-gritty ugliness of foreclosure has HUGE negative externalities. When you have a $75,000 house that has a $100,000 mortgage on it at 12% interest and the home"owner" defaults, and then the copper thieves and the junkies destroy it so that it sells for $3,000 ($1,000 of which goes to the broker), the losses are not just limited to the mortgage-holder's $98K loss. There is also the damage to the defaulting "owners" who simply give up on ever working and getting ahead for the rest of their lives because it's just going to be taken away anyway. There is the damage to all of the neighbors whose property values get hit. And THEIR mortgage holders if they get forced into a foreclosure that otherwise wouldn't have happened. And there is all of the wealth never created because people with hopelessly negative net worths lose the ability to advance themselves.

Which, of course, goes back to the underlying premise: "All Americans benefit from increases in home ownership because of the values like hard work, community, and respect for property that ownership instills." But that's only if it is SUCCESSFUL home ownership. The converse is also true: All Americans suffer from failures in home ownership because of the values like hard work, community, and respect for property that are destroyed when ownership fails.

So you have a poor family with lousy credit that buys a house for a $100,000 mortgage at 12% interest. A house that would only be worth $75,000 if not for the government programs artificially boosting homeownership for people who have no business buying houses. What is the alternative world without the government program? A landlord, with an excellent credit rating, buys the house for $15,000 down and a $60,000 mortgage at 5%, and rents it to the same family. He is able to pay the mortgage, and make an excellent return on his equity, all at a rent payment less than the mortgage payment in the $100K at 12% scenario. The family is able to save the difference and invest it in some more highly-valued activities: paying all of their bills on time so that their credit rating climbs, training to get a better job, buying a more reliable car so that they can take a better-paying job far from public transportation, even saving for a down payment on a house that they can afford later.

As other people have already said, no, some people SHOULD be renters. And government programs that push them into homeownership followed by default are not just foolish and ineffectual. They are great big nasty evils which do great big nasty damage to people.

[Stephen W. Stanton]

These sentences are brilliant:

Inherent in the multiple objectives urged for creative capitalists is a loss of accountability with respect to performance... It is hard in this world to do well. It is hard to do good. When I hear a claim that an institution is going to do both, I reach for my wallet.

This message should be repeated every time you hear someone laud "corporate social responsibility" and "the triple bottom line".

The regular bottom line captures as much as we can reasonably expect from an enterprise. Let companies compete for employees & customers based on non-cash considerations (e.g., being a "green employer"). But this is a means to an end... Profits and wealth maximization.

Companies can't succeed by mistreating workers and polluting. They'll lose customers and workers too fast. This is healthy. This is capitalism, pure and simple. And it's creative enough on its own.

[katieteller]

Brilliant post Dr. Summers, as always, though I'd agree with the others that homeownership isn't in the best interest for everyone. I think that the idea that "we all should own a home" is one of the major underlying causes of the subprime debacle. It's appropriate to put blame on irresponsible buyers/lenders, or Fannie and Freddie, or rating agencies, or the Fed, but when you get to the root of the problem, I think it's the belief that we all should be homeowners that got us into this mess.

At any rate I think there will be no problem in building a serious case for greater regulation now.

[anon]

Hindsight is 20/20

[ssg13565]

I think that the current mortgage crisis is what happens when the federal government decides not to have an explicit housing policy. You notice in the news that whenever there are discussions about the mortgage/housing crisis, the government is represented by the FED and the Treasury. No mention is ever made of the Secretary of Housing and Urban Development. Do we still have such a cabinet position? What has this person been up to for the last 7+ years?

[Jay]

"All Americans benefit from increases in home ownership because of the values like hard work, community, and respect for property that ownership instills."

As Cathy points out this argument is false. An accurate statement might be "All Americans benefit from increases in the diversification of everyone's savings". Of course when someone with maybe $20k in a 401k goes out and purchases a home by leveraging up $15k on a $300k home that person becomes less diversified. And then when one consider the percentage of savings in U.S. treasuries for low income people in their 30's it is no surprise why families with lower incomes are doing so poorly (think about all those social security taxes sitting around in risk free assets at the time in ones life when they should be investing aggressively).

The problem for Americans is that they are financially illiterate. Although, this is a good thing for politicians who know they maximize their power by not teaching simple truisms like A = L + E at their indoctrination centers.

[ken]

We shouldn't indict the idea of government trying to do good, just because the process got corrupted. While not defending the existence of the two FM's, they shouldn't be discounted for the wrong reasons. A lot of what Summers says is valid, but one sentence stands out in particular:

"The illusion that the companies were doing virtuous work made it impossible to build a political case for serious regulation"

Politicians never want to do anything they believe would be politically unpopular, which is why the US is in such a financial mess today. Their top priority is getting re-elected, and they will do anything they have to do to achieve that goal, no matter the damage they cause. However, if we use that reason for abandoning creative government (the FMs are not capitalism of any stripe), then we are basically saying we can not trust government. However, we have no choice but to trust government, the nation just has to invest more time managing, and do a better job of selecting, its politicians.

I would also like to point out that, even in spite of the lack of oversight of lenders and their guarantors, this crisis probably wouldn't have happened if interest rates were not artificially driven to absurdly low rates, by a government intent on mortgaging the nation's future in the absence of any semblance of an economic plan. For a country that is able to finance seemingly every purchase with long term debt, the price of everything (especially housing) becomes very dependent on interest rates. All forms of consumption ended up being financed by debt. The low rates enabled and encouraged speculation in the housing markets, which drove construction of homes that weren't needed, and ultimately forced housing prices down. Without an oversupply of houses, there wouldn't be a sustained depression in the housing markets. In certain markets, like Florida, Las Vegas, parts of Southern California, and Arizona, the oversupply of houses combined with foreclosures will prevent property values from recovering for years.

So while we're faulting the concept of creative government, we shouldn't ignore the impact of the disastrous policies of an ignorant administration that ironically claims to be business-oriented.

[LJ]

It is truly unfortunate that the individuals who have been hurt most by the GSEs are the low-income individuals that they were chartered to assist. I have witnessed far too many families who were spurred on by overly eager lenders which were in turn propped up by Fannie and Freddie
Posted by:Kori Lambert | July 16, 2008 at 04:59 PM

I think you are confusing FRE and FNM with Subprime lenders like CFC adn New Century etc. The reality is their loose lending standards created the crisis in confidence from which we now suffer.

In no way am I letting the GSEs off the hook. They became bloated examples of socialized capitalism that deserve to rid from the face of the earth. However, they in no way made zero down loans to one million dollars on stated income, stated asset loans with 560 credit scores.

The responsibility in this fiasco lies with the regulators that didn't do their jobs and instead ate pop rocks, collected pay checks and laughed while the economy burned.

[Mark H]

I'm reminded of the starving artist that has as yet to make it big. The Stevie Nicks waitressing tables in Hollywood while Mick writes a new song. The failure of the group’s first album and the following year to make the group to be as we all know it today. It was an early time in America just the same. The horse and farmer, or the rush for gold pan handled from the stream, the boom age of oil. The local bank with limited funds to capitalize the foundations of freedom and the yet unborn families of today with only the promise of governance for its fairness of honesty, and preservation of its people’s values.

The premise of networking in a new age is a form of creative capitalism that promotes a level of competition that is as unharnessed as it is controlled. Government backed funding of long term debt is of course its primary concern to preserve and protect the value of the goods we all must exchange to get along peaceably.

If the division is class from the depth of ones wallet, the deadbeat dad, or the high finance authority, regardless, they all sustain and preserve a common good, and its common equity. When a system of value changes it is not so unusual for more to be left behind sooner than its own timely demise as trash.

What is and does become unusual are so often than not are those that have the preservation and the persistence to create, invent, and to cast a new light that otherwise is left hidden until discovered. A man can wear only so many hats and fill only so many shoes yet, must always face and comply with regulation that withstands the greater good at whatever cost there is to bear for the preservation.

We are left more so in the dark when nothing changes, physically or otherwise. Economically, this view point does not instrument the need for change as a measure of change guarded by the simplicity of having first accomplished a goal or an objective correctly to begin with.

You stand with a dollar in hand, printed on a paper processed from the mulch of a tree and claim it can only ever cost more than less when in the first place you hadn't the notion or the idea to have ever invented the wheel in the first place.

The wheels of change are the reasons for change and the direction followed is not certain to the measures of the course we have already taken.

If the measure is energy then naturally if the alternative form replaces the present state of form, then there is a course of change in the making unmeasured.

If that measure of growth is the function of a changing market place then it is only a matter of time before the correct course of adaptation is realized where the preservation of the greater good is measured only by its future gain leaving in its way its futures past.

We'll likely see the dawn of a new age where so little fuel goes such a long ways and the fuel is as free as the air we breathe.

[Steven E. Landsburg]

Bravo.