Arnold Kling  

The Original Sinn

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An Interesting Editorial... Clay Shirky Podcast...

Hans-Werner Sinn writes,


The lack of equity resulted largely from the concept of "limited liability," which provided an incentive for excessive leveraging. Earnings left inside a financial institution can easily be lost in turbulent times. Only earnings taken out in time can be secured.

Sinn does not mention this, but reducing dividend taxes may have exacerbated the problem. Double taxation of dividends encourages firms to retain more earnings, reducing the incentive to live on the edge.

Sinn argues that limited liability is a fundamental cause of financial instability. Equity-holders have a huge incentive to take risks, because they gain on the upside but leave others with losses on the down side. On the other hand, I would argue that this creates a countervailing incentive for debt-holders to monitor firms really closely and to restrict their risk-taking. The question is why the countervailing incentives do not operate effectively.

Sinn argues that home-buying in the U.S. has a similar asymmetry. If you home gains in value, you win. If it loses value, the bank loses. Your personal assets cannot be tapped by the bank.

The way to counter limited liability in home buying is to require a large down payment. The emergence of mortgages with low down payments as the dominant form of housing finance is a key element in the crisis.

Thanks to Mark Thoma for the pointer.


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COMMENTS (10 to date)
Todd writes:

Can't the lender pursue a deficiency judgment in many states, thus providing a way to tap your personal assets?

E. Barandiaran writes:

Arnold,

Anyone familiar with the research on banking theory and practice knows how wrong Professor Sinn is. The issues he mentions and you have been highlighting during the past few months have been discussed many times. After every crisis the same lessons have been learnt but reforms suggested by "extremists" have not been implemented, like those proposed by Henry Simmons during the Great Depression. Indeed, your proposals are very similar to some made by Simmons. Don't be surprised if you fail to persuade 99.9% of your colleagues--as it happened to Simmons at a time in which economists were quite eager to consider "new" ideas.

Steve Sailer writes:

Keep in mind the toll that political correctness takes on effective monitoring of borrowers. It makes obvious reality checks unutterable. An email from one financial officer to another wondering how can all those Mexicans out in California afford $500,000 mortgages would be sure to wind up in the hands of civil rights lawyers in a discrimination suit's discovery process.

DWG writes:

Todd:

As I noted in a comment to a post by Arnold last week:

http://econlog.econlib.org/archives/2008/10/the_political_e_1.html#comments

in many states, notably California and, I understand, Florida and Nevada, deficiency judgments are not available legally for first mortgage loans or are not practically obtainable. Where this is the case, one would have expected that lenders to be more likely to require higher down payments. That this has apparently not been the case in those states, one can only agree with Arnold that the "suits' did not communicate with the "geeks."

El Presidente writes:

Arnold,

"Sinn does not mention this, but reducing dividend taxes may have exacerbated the problem. Double taxation of dividends encourages firms to retain more earnings, reducing the incentive to live on the edge."

I absolutely agree. But Capital Gains taxes do the same. A gain isn't realized until equities are sold. Perhaps we need to acknowledge that too.

"On the other hand, I would argue that this creates a countervailing incentive for debt-holders to monitor firms really closely and to restrict their risk-taking. The question is why the countervailing incentives do not operate effectively."

So the guys with less should keep tabs on the guys with more and constrain their behavior? Are you sure you're not a socialist? :-)

El Presidente writes:

Oh, I get it. The guys with MORE are supposed to keep tabs on the guys with LESS and constrain THEIR behavior. I see. Well, I guess that's better then. Right?

Kevin writes:

This is craziness. Equity holders do not have a huge incentive to take risk through leverage. The returns go up, but so does the likelihood that the equity gets wiped out. If what you were saying were true, the only equity we'd see would be tiny stubs looking to earn 50% and expecting to be gone in a year. The real countervailing incentives are:

1) The asymmetry is priced into the capital structure already.

2) Money gets more expensive as the capital structure gets filled with more and more debt.

3) Debt holders do have covenants that monitor firms closely and regulate their conduct. It only looks like they don't work because you don't hear about the ones that do.

You could say that these things didn't happen in the mortgage markets, and I'd agree. Each of the above had been regulated away.

Babinich writes:

"Sinn argues that home-buying in the U.S. has a similar asymmetry. If you home gains in value, you win. If it loses value, the bank loses. Your personal assets cannot be tapped by the bank."


As someone that has spent time and money maintaining and upgrading a home I can say confidently that Mr. Sinn's argument is flawed.

Acad Ronin writes:

The capital gains exemption (US$500K for a couple) on housing means that owners have an incentive to invest in housing, especially via sweat equity. The capital gains exemption makes some investment in a house more tax efficient than investing in the stock market. Also, the do-it-yourselfer converts labor income into untaxed capital gains. Then there is the issue that Babinich mentioned. We invest in our houses to tailor them to our preferences because of the untaxed consumption income we get from the improvements. This is one reason why the monetary rent equivalent is generally an underestimate of the returns to ownership. Lastly, given the conventionality of most peoples' taste, the improvements we make generally increase the mortgage lender's equity cushion over time, over and above the paydown of the mortgage principal. (Of course, sometimes you have to deduct from what you are willing to pay for a house an amount to undo some or all of a previous owner's improvements.)

Lord writes:

Lenders simply didn't care anymore whether the loans would be repaid because the security for the loans was the property with the assumption prices would only go up. Lenders were gambling a greater fool would always come along paying a higher price and lending a greater amount. The buyers were only pawns used to by institutions to gamble with and eventually against each other. The innovations were just methods to raise the size of the wagers.

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