Jeffrey Miron: No bailout; abolish Fannie Mae & CRA

by Kurt Schulzke on September 30, 2008

“Talk of [financial] Armageddon . . . is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.” So says Harvard economist Jefffrey A. Miron, writing today at CNN.

What does Miron say government should do now?  For starters, stop the cruel pretense that people who can’t pay back a freely-negotiated mortgage should be homeowners:

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

Much of that subprime lending was driven by America’s ultimate warm-hearted economic ignoramus, Jimmy Carter, and his not-so-warm-hearted successor, William Jefferson Clinton. Jimmy Carter introduced into America’s housing market a distinctly un-American law, the Community Reinvestment Act (”CRA”). Later, Clinton turned the CRA into his policy baby and an economic and political force.

More from Miron:

The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.

See Point 1 here.

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.

In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This “moral hazard” generates enormous distortions in an economy’s allocation of its financial resources. . . .

Hmm. Now I am starting to wonder if Dr. Miron mightn’t be reading I Perceive. See Point 2, here.

Further, the current credit freeze is likely due to Wall Street’s hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents. . .

Anticipation of the bailout will engender strategic behavior by Wall Street institutions as they shuffle their assets and position their balance sheets to maximize their take. The bailout will open the door to further federal meddling in financial markets.

Exactly. Economists and negotiators call this game theoretic behavior. Wall Street — or whatever has taken its place — is gaming this process, bluffing big time, doing their best to stampede America into a buying their white elephant. America needs to call their bluff.

So what should the government do? Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay . This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

Confirmed. Miron is reading I Perceive.

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.

What should Congress do? Abolish the two FMs and the CRA. Let the banks do what banks were made to do: sink or swim on their own.

Read Miron’s full article at CNN.