There's no such thing as a well functioning securitization market

Funny article on DealBreaker about mortgage securitization:

But I don’t know. To have a functioning securitization market, you really do need two things: you need investors who believe that they’re getting what they’ve been promised, and you need originators who believe that they’re offloading the risks they’re trying to offload. Certainty is a key part of the deal for the securitizer, and I sympathize with the securitizers who want a little more certainty than the previous generation ended up with. 

And this is from a securitization skeptic! Originators make the credit decision, and agency risk mean that investors will always be sold something other than what they think they are being sold. The purpose of finance is to make good credit decisions, and securitization undermines this. We need a functioning financial system, which means we should have no securitization market.

What is the tipping point for US Debt?

Megan says it is 80% of GDP (kind of). Her mental models of understanding sovereign debt dynamics however, are wrong, not because she's dumb, but because the standard models we all carry around for this stuff is incorrect.

A country is not like a household, in that it can issue it's own currency and that it can force that currency to be accepted and used because it has the power to tax.

However, a household can replicate this if parents issue scrip in payment for chores, but also demand scrip in exchange for privileges (like allowances, later curfews, etc.) In such a situation, is there a "tipping point" for parental scrip? Is there some ratio after which the parent has just issues too much scrip and now will need to start borrowing scrip from other parents in order to pay it all back?

Of course not. If a parent accidentally over issues scrip, then the children, with excess scrip, will bid up the price for whatever scarce good they want which they can buy in scrip. Back in the real world, this is called inflation, and yes national debt levels can get high enough to trigger inflation.

But inflation is only triggered when the children actually start bidding up prices in scrip. If the children just save the scrip, then there is no inflation. So "excess" scrip is measured not in %s, but in the psychological impact it has in scrip users. You only know when you have "excess" when you start seeing inflation, and kids can decide to spend scrip at any point.

Parents don't need scrip from other parents unless they want to hire other people's children, and those other children want to buy things only available in their parents scrip.

Bank capital requires should change the real economy

Slate has a piece on higher banking capital requirements. It's pretty awful, and at one points invokes the Modigliani Miller theorm. Ye gods. An excerpt:

Banks, like other companies, can finance their activities either with debt or with equity. And one common proposal to make the banking system safer is to force banks to rely more on equity-finance and less on debt-finance by increasing the required capital ratio that they have to hold in order to lend. People who own stock in banks hate this idea, since it would involve sharply devaluing the value of their existing shares. But it would clearly make the financial system less vulnerable to runs, so a key question is whether there's any good reason not to do it. The most simplistic answer is "no", that per the Modigliani-Miller Theorem the capital structure of a firm is irrelevant so we could get a free lunch here.

But that's not right. What Modigliani-Miller says is that capital structure is irrelevant in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information none of which applies.

Bank lending is capital constrained, not reserve constrained. So to increase capital requirements will increase the cost of credit by constraining its supply. Modigliani-Miller has little to do with it (MM is not applicable in many circumstances).

If credit contracted, it would lower the price of credit-intensive goods (like housing) and in the current economic climate would probably cause the economy to contract, and further increase unemployment.

To keep that from happening, the reduction in private sector credit needs to be met by larger Government deficits. A government can discipline banks without impacting the real economy only if it is willing to capitalize the private sector directly by running larger deficits.

Securitization of real estate serves no purpose

Slate has the standard argument support securitization of real estate, namely that it helps diversify idiosyncratic risk:

Say you have enough money to buy 100 houses. If all 100 of those houses are in Atlanta, you'll have a much easier time scouting the properties for potential purchase and managing them. But you'll also be exposed to a lot of Atlanta-specific risk. Something bad could happen in that particular metro area. But if you take those 100 houses and combine them with 100 houses in Chicago and 100 in Phoenix and 100 in Riverside County and 100 in Sacramento and 100 in Miami and 100 in Providence and 100 in Las Vegas and 100 in Houston and 100 in New York, then you have a pool of 1,000 houses that's much less volatile than the original 100.

The problem with that is that a pool of 1,000 houses is going to be very expensive. But if you slice that pool into 1,000 pieces, then each resulting security will be as cheap as one house, only with dramatically less volatility.

The alchemy is not that sophisticated, and while you can't "guarantee returns no matter the vacancy rate or the economic climate" you can truly reduce the average volatility without reducing the average return. It's basic diversification that works for the same reason that holding an S&P 500 index fund is probably a better idea than rolling the dice and buying a single S&P 500 stock at random.

The purpose of banking is to make credit decisions by having private capital in first loss position against default. To ensure that that private capital remains in first loss position, any loan extended by an institution which has made a credit evaluation should stay on the books of that institution until the loan has matured.

This may make loans more expensive, but you're getting what you are paying for -- good credit decisions where the incentives are to lend out money when you expect it will be paid back.

Let's look at the other side, of how much cheaper loans benefit consumers. Prior to the mortgage securitization in the 1970s or so, homes in america were plentiful and cheap. There was no problem with there being insufficient capital in that area resulting in a shortage of housing stock. So what problem is being solved here? Cheaper loans did raise house prices and result in more outstanding debt that then had to be services. Good for the financial industry, good for existing homeowners, but not obviously good for society at large.

Interfluidity: Borrowing is a feature, not a bug

SRW is supportive of wealth distribution per se. He has a long post on inequality, but never talks about how other tools, such as immigration policy, might also have some bearing on this subject.

What I wanted to raise was his point that, to support inequality, the poor had to borrow more which the Fed supported via lower interest rates.

Obviously, one can invent any number of explanations for the slow and steady decline in real rates that began with but has outlived the “Great Moderation”. My explanation is that growing inequality required ever greater inducement of ever less solvent households to borrow in order to sustain adequate demand, and central banks delivered. Other stories I’ve encountered don’t strike me as very plausible. Markets would have to be pretty inefficient, or bad news would have had to come in very small drips, if technology or demography is at the root of the decline.

SRW is a monetarist, and therefore beleives that somehow, the quantity of reserves banks trade with one another to clear cheques, impacts the aggregate demand, but has never been clear on exactly how. Here is his mechanism -- lower interest rates generate the "ever greater inducement of ever less solvent households to borrow in order to sustain adequate demand" -- because how else can it work? And the biggest ticket item households can leverage against is real estate, so housing is the closest you can come to for a monetary mechanism.

There is a simpler way for the Government to stimulate aggregate demand: higher deficits through lower taxes of more spending, depending on your politics. When you are a currency issuer, you don't borrow to spend, you simply spend the currency into existence, and tax it into non-existance if you spend too much.