Continuation Of Previous Post

2. Regulate safe levels of leverage and duration-mismatch. If mortgages had been restricted to 75% of the house price, a 25% fall in house prices would not cause mortgage defaults. But a 26% fall would. The only truly safe level of leverage is zero. But people want leverage, and an efficient financial system ought to let them have it. Without leverage, we would have to pay cash for our homes, or else use equity-finance, and with equity-finance the bank, as part-landlord, would want to stop us painting the walls orange. Similarly, a restriction on duration-mismatch would prevent runs, yet the only truly safe level is zero. But people want duration-mismatch, and an efficient financial system ought to let them have it. We might suddenly find ourselves with an emergency need for immediate cash. In any case, regulations limiting leverage and mismatch have been tried in the past and have failed. People want leverage and mismatch, and will always figure out new ways to get around those regulations.

I'm not sure why this has to be the case, but extra capital does make sense.

3. Government guarantees of solvency and liquidity. These can be explicit or implicit (ad hoc bailouts). Government guarantees imply regulation to try to reduce moral hazard. With the government effectively a part-owner of financial institutions, it needs to exercise surveillance, which is complex and costly. If the government were good at distinguishing good loans from bad, why would we need a capitalist financial system in the first place? Let’s have one big government bank for all savings and loans. But history tells us this won’t work any better. And governments too can become insolvent and illiquid (they can’t print foreign currency), so the guarantee becomes worthless.
   

The system needs to be onerous and explicit. Forget implicit.

And now for something completely different: let’s change how contract law handles default. A default has real costs. Lawyers and accountants get involved (which is costly in itself), and real economic activity stops while the lawyers and accountants sort out who owes whom what (which is even costlier). Networks of people (workers, managers, customers) and capital (real and financial) get broken apart, because people can’t wait. Those networks are the capital which gets destroyed when a borrower defaults. The assets become illiquid and therefore less valuable. Fire-sales reduce asset prices. This causes the crisis to spread. None of these real costs are inevitable. They could be reduced with better contract law.

I agree with this and have proposed a system of pre-arranged terms to try and avoid default.

Here it is:

"Saturday, November 8, 2008

We Should Move Away From Foreclosure System

I want to propose a thesis. The cause of this crisis was the foreclosure system itself. The crisis could have been avoided had a system been set in place that renegotiated mortgages immediately upon delinquent payments.

The cause of the crisis in the housing sector was a misallocation of resources by individual homeowners. The borrowers took mortgages that were eventually too high for them to afford. The loans/mortgages were based upon terms that were much more likely to lead to default/foreclosure.

But what if foreclosure had not been the option? What if the first option had been to renegotiate the mortgage/loan to a payment affordable to the borrower? The level of payment that the borrower could afford would then trigger a set of possible options:

1) Increase the price of the house
2) Increase the length of the mortgage
3) Base payments on percentage of income, so that they will rise as borrower's income rises.

Now, however it would be done, wouldn't this have been a better situation than the one we currently face? The reason to try a mortgage renegotiation plan now is to try and see if we can move away from the foreclosure system and devise one that keeps borrowers in their houses. Isn't that a sensible proposal?

I should add, although there's no point in putting this on my posts, that I'm attempting to be provocative and have people consider deleveraging. I'll probably be sorry I did this.

"Trying to prevent crises by trying to prevent default hasn’t worked in the past, and I think it could never work. The overarching reason is this: if the financial system seems safe, people will take bigger risks, which makes the financial system unsafe. If the government is protecting us, we don’t need to look at the risks, and will leverage up to the hilt in illiquid assets at bubble prices. Wearing seat belts makes us drive faster. "

See, this can't be correct, otherwise value investing would be humanly impossible.

"Instead of trying to prevent default, we should focus on trying to prevent default from having real costs. Reducing real costs should also reduce contagion. Enforcing contracts is legitimate government business. Default means that someone has broken a contract, so the government decides what happens next. Chapter 11 in the US was an important legal innovation which reduced the real costs of bankruptcy, but is still too slow for financial institutions. The legal consequences of default should be instant and automatic. Default should mean a change in ownership of the bank, not the breakup of the bank (unless the new owners want to break it up). Default should not mean the managers and workers lose their jobs (unless the new owners want to fire them). The new owners should be the people who suffered the default – their bonds instantly and automatically become new voting shares. The old shares can become call options, granting the right to buy a new share by paying off the old debt. Any promise will always be broken under some circumstances, and so debt becomes equity. Contract law needs to recognize the inevitability of debt-to-equity conversions, and make it instant and automatic."

I agree with this as well.