The Bankers' New Clothes: What's Wrong With Banking and What to Do About It by Anat Admati & Martin Hellwig

Author:Anat Admati & Martin Hellwig [Admati, Anat & Hellwig, Martin]
Language: eng
Format: epub
Tags: Theory, Economics, History & Theory, General, Political Science, Banks & Banking, Business & Economics
ISBN: 9780691156842
Google: _rrmdpoWyh4C
Amazon: 0691156840
Publisher: Princeton University Press
Published: 2013-02-15T05:00:00+00:00

TWO How Borrowing Magnifies Risk

1. Government borrowing follows a somewhat different logic. Whereas the resources that private borrowers can use to pay for expenditures and to repay debts are determined by their incomes and their assets, the resources that governments can use depend on their ability to raise revenues through taxes. Borrowing is a way to relieve current taxpayers, for instance, from the burden of a war or to mislead the public about the costs of current government policies. Reinhart and Rogoff (2009) provide a comprehensive account of government borrowing and bank–government relations over eight centuries. They show that excessive government borrowing has repeatedly led to defaults; given the involvement of banks in financing governments, these defaults were often accompanied by bank failures and banking crises. In some countries in Europe, the causation was recently reversed as banking problems in Iceland, Ireland, and Spain and government support for the banking systems of those countries crippled the finances of those countries’ governments. As the Spanish and other Southern European governments have come under pressure, they have, in turn, leaned on their banks to lend to them.

2. As explained by Hyman (2012), buying on credit has exploded in the twentieth century in the United States, with the General Motors Acceptance Corporation among the pioneers in allowing people to buy first and pay later.

3. We discuss the situation of default in Chapter 3 on the “dark side of borrowing.” The costs and considerations from the lender’s perspective are discussed in Chapters 7 and 9.

4. For example, many borrowers in Ireland went into personal bankruptcy because of their mortgage debt (see Lewis 2011). More recently, Spanish borrowers have been faced with losses and legally owe some of their debts even if evicted (see “Spanish Homeowners Rally Together to Fight Evictions by Banks,” The Telegraph, May 2, 2012).

5. For example, mortgages are nonrecourse in Florida, Arizona, and Texas. In California, only the first “purchase money” mortgage is nonrecourse (Ghent and Kudlyak 2009). In the case of second mortgages, which are “junior” to first mortgages and receive payments only after the first mortgages have been paid, borrowers are not entitled to this protection. California Senate Bill 458, introduced in July 2011, would extend nonrecourse protection beyond first mortgages (see “Real Estate: New Short Sale Law,” The Examiner, July 15, 2011).

6. The creditor might have trouble selling the house, and additional value could be lost in the foreclosure process, as well as due to lack of maintenance. The process can be quite inefficient. Campbell et al. (2011) show that the “foreclosure discount” is 27 percent. See also Michael Wilson, “Foreclosures Empty Homes, and Criminals Fill Them Up,” New York Times, October 14, 2011.

7. This example is simplified, without affecting the points we make, by ignoring the interest rate on the loan and the benefits from living in the house. In Chapter 8 we discuss return on equity relative to the total cost of borrowing, including the interest.

8. More generally, the magnification of the upside applies when the investments increase in value by more than the interest rate charged for borrowing.

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