Predatory Lending and Bailouts

Tyler Cowan argues in today's NYT that we would be in better shape today if the Fed had not arranged the bail-in of Long Term Capital Management in 1998. He argues that:

The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good.

We should remember though that the investors in LTCM essentially were wiped out. So much for moral hazard. Cowan's argument, however, is that we were better prepared in 1998 to absorb such a crisis since we had a budget surplus and the economy as a whole was much better. But could the FED really imagine that we would have 8 years of disastrous fiscal policy that we have experienced in the 21st century?

Moreover, it is not clear that this would have dealt with the fundamental psychosis that fueled the real estate bubble. The history of WAMU, described here, is really chilling. The bank was so intent on making loans it used photos as substitutes for documents:

As a supervisor at a Washington Mutual mortgage processing center, John D. Parsons was accustomed to seeing baby sitters claiming salaries worthy of college presidents, and schoolteachers with incomes rivaling stockbrokers’. He rarely questioned them. A real estate frenzy was under way and WaMu, as his bank was known, was all about saying yes.

Yet even by WaMu’s relaxed standards, one mortgage four years ago raised eyebrows. The borrower was claiming a six-figure income and an unusual profession: mariachi singer.

Mr. Parsons could not verify the singer’s income, so he had him photographed in front of his home dressed in his mariachi outfit. The photo went into a WaMu file. Approved.

The article also describes WAMU's policy of paying real estate brokers to bring loans to WAMU. What is important about this episode is the policy of not even bothering with risk. Earning fees now when the bubble was expanding was the sole concern of the bank. I suppose one can argue that if LTCM had failed we would not have seen widespread securitization of loans, and the whole ideology that the market could police itself would have never crystallized. So sure, failure would have prevented this crisis, but at what cost.

A better scenario would have been a proper response to LTCM. This would have involved more attention to the problems of leverage and more vigorous regulation. And what would have happened to regulators who allowed LTCM to fail in 1998? They would have been vilified for causing a crisis (what happens to any policymaker who tried to stop a Ponzi scheme).

Perhaps the only benefit might have been the ruin of Bob Rubin's reputation, and this might have helped Citigroup marginally.