The Activist Economist
“If one attains positions of power, one should view them as opportunities for social change.” Joseph Stiglitz
This week, the Raffles conversation in Business Times interviewed 2001 Nobel Price winner for economics Joseph Stiglitz. He actually made a comment on the recent subprime woes. For someone critical of IMF’s handling of the asain financial crisis, he did not mince his words about the recent sub-prime problem.
In it, he was asked whether the problem is more serious than officially acknowledged, and will it spread beyond the sub-prime segment.
“The sub-prime segment is where you would have expected the problem to show up first,” he says. “At the heart of the problem was a failure of incentives and accountability. It used to be that if you, as a bank, made a mortgage loan, you kept it in your portfolio. If it was a bad loan, you felt the consequences.”
“What we now have is a ‘mortgage originator’. He originates the mortgage, and gets a fee for that, but he doesn’t bear the consequences of a bad loan.”
“And the investors have not been thoughtful enough about the risks they were taking; the nature of the sub-prime market was to take advantage of people who didn’t understand finance. So we have these loans called ‘teasers’, where for the first 3 yrs the rates are very low and there’s negative amortisation, so people take the mortgage thinking they’ll refinance it in three years, believing the mkt will go up. The originator tells them, don’t worry, the market will be so much higher in three years that you can refinance, take out another new loan at another teaser rate. Yes there might be some transaction costs, but don’t worry about those, you’ll make so much money that you’ll be able to pay it all off.”
“Well they were wrong. It was like a Ponzi scheme. Prices could’nt continue to remain low. Greenspan actually encouraged people to take out these variable rate mortgages – this was when interest rates were at an all-time low, and they could only go one way. Now credit conditions have changed, people can’t refinance, and the day of reckoning has come.”
And why will the problem spread?
“The sub-prime mess affects the people who took out 100% mortgages. They are the ones who will have the problem first. If you took out a 90 per cent mortgage, that’s not sub-prime. But if the price of your property goes down by more than 10 per cent, it might pay you to default.”
But the more important knock-on effect of the US mortgage bust will be on the broader economy, says Dr Stiglitz.
“The reason why it is likely to have a macroeconomic consequences goes back to the role the housing sector and these mortgages have played in sustaining US economic growth, via consumption. The US can’t continue to have negative savings. So if we go from a savings rate of minus 1.5 per cent to plus 1.5 percent, that’s a big change in consumption. It has to slow down economic growth.”
And how bad could it get?
“The magnitude of the slowdown depens on how quickly all this occurs. If we go from -1.5 to +3 on savings, which would be a return to normal by American standards, and we do this over a 4 yr period, what you will see is a protracted period of slow growth, but not a recession.
“But if credit markets seize and it all happens quickly , then we could have stalled the economy.”
No related posts.
If you enjoyed this post, please consider to leave a comment or subscribe to the feed and get future articles delivered to your feed reader.
Comments
No comments yet.
Leave a comment