Saturday, February 23, 2008

Let banks and instos make own credit decisions

According to US betting market Intrade, there is a 65 per cent probability that the US economy will experience a recession sometime in 2008.  Some argue that the US is already in recession.  Equity markets have been particularly volatile over the past six months and credit markets have tightened up.  The bad news is that economic growth in 2008 is likely to be low;  the good news is that this isn't the end of civilisation as we know it.  Indeed the world has been in similar situations many, many times before and survived.

Australia is in a somewhat different situation to the US.  Here the Reserve Bank believes inflation is too high and the economy is growing too quickly, and has raised interest rates to slow economic growth.  Contrast that with the US, where the Fed has lowered interest rates and the Congress has passed an economic stimulus package.

Many commentators take a "morality play" approach to learning the lessons of financial crises.  We hear much about greed and fear, the instability of markets, and the need for greater government intervention.  The current financial crisis is no different.

A new term -- predatory lending -- has entered our vocabulary.  Apparently, US financial firms have been forcing the poor and minorities to take on "exotic" loans that they can ill-afford.  Further, they have then on-sold these loans to "unsuspecting investors".  As interest rates have increased, so default on these loans also increased and, overall, we now have huge investment losses.

We are led to believe that if only government would prevent these unscrupulous financial institutions from exploiting both the borrowers and investors, then this sort of thing could never happen.  There is a morality play lesson to be learned, but it isn't the stock standard lesson I have just laid out.  Some parts of the current financial crisis are due to private sector failures.  Yet the major culprit is government policy failure.

Three public policy failures contributed to the current global financial crisis:  low interest rates over the past several years, restrictive building policies, and affirmative action.

In 1992, the Boston Federal Reserve published a working paper, subsequently published in the prestigious peer-reviewed American Economic Review, which provided empirical evidence showing that banks were discriminating against minorities on the basis of race.  It subsequently transpired that the data used in the 1992 Boston Fed paper was deeply and fundamentally flawed.

The damage, however, had been done.  The Boston Fed published a document entitled "Closing the gap:  A guide to equal opportunity lending".  This document refers to underwriting standards that are "arbitrary or unreasonable".  For example, "Policies regarding applicants with no credit history or problem credit history should be reviewed.  Lack of credit history should not be seen as a negative factor."

Fast forward to 2008 and financial institutions are being pilloried for poor lending practices, yet they were sanctioned by the financial regulator in 1993.

Sloppy research leading to bad microeconomic policy is only part of the story.  The other part was occurring in the macroeconomy.  Restrictive housing policy caused housing prices to rise.  These artificial price increases were related to restricting the amount of land that was available for new housing.  Similar restrictive policies are being followed in Australia.

Of course, a large contributor was the level interest rates in the first half of the decade.  John Taylor of Stanford University -- famous for his Taylor Rule that very accurately models the US Fed Funds rate -- has argued that US interest rates were far below what they should have been and this caused over-investment in the housing market and overpricing of the housing stock.  This type of argument is consistent with business cycle theories originally posited by economists such as Ludwig von Mises and Friedrich von Hayek.

The supply of funds into the housing market also had the effect of reducing loan delinquency and foreclosure rates.  This distorted downwards estimates of risk and risk premiums, leading to mispricing in the secondary markets.  As interest rates increased and eventually housing prices decreased, so it all unravelled.

There are many lessons to be learned from this.  Most importantly, government intervention always has unintended consequences.  Anti-capitalistic prejudice led to the view that financial institutions would discriminate against minorities.  Sloppy research then led to a justification for further government intervention.

The Australian Government is about to embark on a massive bank regulation project.  This has many dangers for banks, their shareholders, customers and the economy.  In particular, we may see an outbreak of "credit snobbery" -- efforts to reduce access to credit.  It is best to leave banks and financial institutions to make credit decisions.


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