Carpe Diem

More on the Subprime Bailout: Moral Hazard

New York Sun: Wall Street critics are coming out in force against President Bush’s proposal to prevent subprime mortgage lenders from foreclosing on some homes.

Chief among the complaints is the notion of moral hazard — that borrowers who voluntarily took on too much risk are now being rewarded for their bet.

Let’s review moral hazard:

Moral hazard is the prospect that a party insulated from risk may behave differently than it would if it were fully exposed to the risk. For example, an insured party’s behaviour might be more risky than it would have been without the insurance. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.

Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. A moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly. Taxpayers, depositors, other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions.

Moral hazard can also occur with borrowers. Borrowers may not act prudently when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend using their cards, because without such limits those borrowers may spend borrowed funds recklessly, leading to default.

Bottom Line: Because of moral hazard alone, the subprime bailout is a BAD idea.

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Top 6 Reasons The Subprime Bailout is a BAD Idea

No Government Methadone for Reckless Credit Junkies

Top 6 Reasons The Subprime Bailout is a Terrible Idea, using information from yesterday’s WSJ editorial:

1. Investors and mortgage servicers have incentive to avoid foreclosures on their own. Investors typically lose 30% to 50% of the unpaid mortgage balance when a home has to be resold due to foreclosure. So they have every incentive to renegotiate subprime loans that are expected to become delinquent. And that process is already well under way.

2. The U.S. economic and legal systems are built on the sanctity of contract, and even the hint that government is compelling investors who now own these mortgages to take less money puts the U.S. on a very dangerous road.

3. It will raise the future risk premium that investors will demand for investing in U.S. real estate, which means it will be costlier to get a mortgage in the future.

4. Which borrowers will qualify for the lower interest rate payments? Almost all subprime borrowers will argue that they should benefit from loan forgiveness, especially if they’ve been responsible and sacrificed to make their payments. More than 95% of homeowners are making their payments on time, and it would be unfair for them to pay more in taxes to assist those who’ve been less responsible.

5. The evidence suggests that even when troubled borrowers receive a generous reset on their mortgage payments, as many of 40% of those borrowers still eventually default. The refinancing plan might only delay the day of reckoning and lead to bigger losses in a falling market.

6. Part of the plan would allow states to float more tax-exempt bonds to refinance subprime borrowers. This is clearly a taxpayer-financed bailout.

Bottom Line: The subprime bailout would be like a taxpayer-funded methadone program for reckless credit junkies and investors. We should learn to “Just Say No” to bad ideas like this.

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Housing Quiz: Which House Has….??

One house has hot and cold running water, electricity, central air conditioning and flush toilets. The other does not. One owner has a computer, a high speed connection to the Internet, a DVD player with a movie collection, and several television sets. The other has none of these things. One owner has a refrigerator, a vacuum cleaner, a toaster oven, an iPod, an alarm clock that plays music in the morning, a coffee maker, and a decent car. The other has none of these. One owner has ice cubes for his lemonade, while the other has to drink his warm in the summer time. One owner can pick up the telephone and do business with anyone in the world, while the other had to travel by train and ship for days (or weeks) to conduct business in real time.

Read more here from Coyote Blog, via Cafe Hayek.

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Why The Goldilocks Economy Can Handle $3 Gas II

In a previous CD post, I wrote about the relative affordability of today’s $3 gasoline, measured as share of disposable income. After the Federal Reserve released data today on third quarter household net worth ($528,000 per household), I thought it would be interesting to look at the cost of gasoline as share of per-capita household net worth.

Using data on household net worth from the Federal Reserve, historical gasoline price data from the EIA, and population data from Economagic, the graph above show the historical series of 1,000 gallons of gasoline purchased at the average retail price in a given year, as a share of per-capita “household new worth” in that year.

In 1949, the retail price of gas was only 27 cents, but it took 4.2% of per-capita new worth to purchase 1,000 gallons of gas, making gasoline almost three times as expensive then compared to today, when it only takes 1.44% of per-capita net worth to buy 1,000 gallons of gas at $3.

To be as expensive as gas in 1981, measured as the cost per 1,000 gallons as a share of per-capita net worth, gasoline today would have to sell for about $6.50 per gallon.

Bottom Line: Gas today, even at $3, is relatively affordable and is actually cheaper than the decades of the 1940s, 1950s, 1960, 1970s and 1980s, when the price of gas is measured relative to our increasing household wealth. Goldilocks can handle $3 gas.
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U.S. Household Net Worth At Record High of $59T

RECORD: $528,000 Net Worth Per Household

WASHINGTON (Reuters)The net wealth of U.S. households rose to $58.60 trillion in the third quarter as financial asset gains outpaced slowing real estate values, a Federal Reserve report on Thursday showed (see chart above).

In the July-September period household net worth grew for the 20th consecutive quarter and established a new record high. The record $58.6 trillion posted in the most recent quarter was up from the second quarter’s $57.98 trillion, the previous record high. Compared to last year, household net worth has increased by $4 trillion, which translates to more than $36,000 of additional net worth per American household.

Household wealth has increased by almost $20 trillion in the last five years, and the average American household now owns about $528,000 worth of stuff (assets, real estate, etc.), free and clear of any debt! In 2002, average household wealth was about $370,000, and today it’s more than half a million dollars. Therefore, in just the last five years we’ve become more than a third richer (+43%), which is truly amazing!

Bottom Line: In spite of $100 oil, $3 gasoline, a weak dollar, and subprime mortgage troubles, Americans are wealthier than ever before, and probably wealthier than any country on the planet, with average household wealth of more than $500,000!

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Jaw-Dropping Compensation: $1m College Coaches

This year, for the first time, the average earnings of the 120 major-college football coaches hit $1 million, a USA TODAY analysis finds. That’s not counting the benefits, perks and myriad bonuses in their contracts.

Four coaches — Oklahoma’s Bob Stoops, Alabama’s Nick Saban, Florida’s Urban Meyer and Iowa’s Kirk Ferentz — already have cracked the $3 million mark, leading a spiral that shows no sign of slowing.

At least 50 coaches are making seven figures, seven more than a year ago, and up from only five in 1999. At least a dozen are pulling down $2 million or more, up from nine in 2006.

Here’s
a link to a searchable compensation database for college football coaches, and here is a link to the latest AAUP report on faculty salaries (see Table 4).

Questions:

1. Where’s the outrage about this from college students? College students around the country often protest about the “unfairness” of low wages in foreign “sweatshops” making university apparel. Shouldn’t they be protesting the “unfairness” of “excessive” football coach pay and relatively low (“sweatshop”?) wages for college professors? After all, the universities that the students attend pay their college professors with PhDs less than 10% of what they are paying the football coaches (see chart above).

2. AFL-CIO spokesman R. Trumka said “Workers are rightfully outraged when they learn about jaw-dropping executive compensation packages. It’s time to put the brakes on runaway CEO pay.”

Where’s the outrage among UAW workers and taxpayers in states like Michigan where college football coaches at UM and MSU make $1 million to $1.5 million per year? Isn’t it time to “put the brakes on runaway college football coach pay?”

3. Isn’t rising compensation for college football coaches a perfect example of the rising income inequality over time that generates so much outrage? Certainly the gap in salaries between college coaches and college professors has risen over time, just as the gap in salaries between college professors and college secretaries has probably risen over time. An historical analysis would probably show an increasing share of total university payrolls going to the football and basketball coaches, or to the highest paid 1%, 5%, or 10% of university personnel (including presidents and deans).

Bottom Line: If the general public can understand that market forces ultimately determine the compensation of college football coaches, perhaps they can understand that market forces also determine CEO salaries; and since the salaries of both are rising over time, perhaps they can understand that rising income inequality is the natural and expected outcome of an increasingly competitive marketplace, which increasingly rewards scarce talent? One can always be hopeful.

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Economics of Handicapped Parking

I have several problems with handicapped parking:

1. Too many people get handicapped parking permits who probably shouldn’t qualify. Notice in the sign above, it shows a picture of a WHEELCHAIR. How many people do you see parking in handicapped parking spaces who actually get out of their vehicle in a wheelchair? Almost none. If we restricted handicapped parking to people in wheelchairs, we would need only a fraction of the currently available handicapped spaces.

2. Most parking lots have WAY too many parking spaces allocated for handicapped parking, resulting in an extremely inefficient allocation of the most valuable real estate of any parking lot. I don’t know this for sure, but I suspect this is because of government mandates.

For example, I just left a parking lot at the University of Michigan, Flint campus, near the center of campus, representing some of the most valued parking spaces on campus. There are 20 handicapped parking spaces in that lot, and ALL 20 of the parking spaces were VACANT as I left campus at about 8 p.m. I’ll have to check that lot during the day, but my initial impression is that the university has OVER ALLOCATED handicapped parking spaces. I don’t think there would ever be any cases when ALL 20 spaces would be used.

I’m not sure what a pure private market solution to handicapped parking would look like, but I’m pretty sure it would be more efficient than the current situation. After all, private companies like airlines figure out how to accommodate handicapped travelers using market pricing, without any of the inefficiencies (lots of unsold seats) of handicapped parking.

A couple of solutions come to mind:

1. A football stadium, university or Wal-Mart could provide shuttle service to handicapped drivers from remote lots, instead of reserving prime parking spaces that go unused much of the time.

2. Couldn’t a stadium, university, or Wal-Mart be allowed to dynamically adjust the number of handicapped parking spaces over time (daily, weekly, monthly) to meet the actual demand, instead of allocating spaces based on some government-imposed formula?

I couldn’t find much about the “economics of handicapped parking,” but here is one article from the Mises Institute.

Carpe Diem

Real Compensation Growth Highest in 7 Years

According to today’s report from the BLS, hourly compensation increased 5.9% from the third quarter of 2006 to the third quarter of 2007, the largest four-quarter gain since an increase of 6.7% from the fourth quarter of 1999 to the fourth quarter of 2000. On an inflation-adjusted basis, real hourly compensation in the nonfarm business sector increased by 3.3% during the same period, matching the third quarter of 2003. The 3.3% growth was the highest since the third quarter of 2000, and is almost 3 times the average of 1.35% since 2001.

Stocks rally on strong economic data: DJIA is up by 200 points today.