Thursday, November 8, 2007

Passbook Savings: a Cure for the Banking and Real Estate Crisis

Just like hemlines, banking practices change with the times. Downpayments have come back into fashion, much to the consternation of credit lovers everywhere, who thought themselves the vanguard of the cashless society. Would-be home buyers find themselves scrambling for something to put on the barrelhead. Personal finance writers have suggested that they borrow from retirement accounts or life insurance policies, or through margin loans collateralized by their stocks and bonds. Other suggestions include finding out if your employer has a program to assist employees to buy homes, or making a withdrawal from the First National Bank of Parental Munificence. The one thing that gets little or no attention is the simplest way of all to put together a downpayment: clamp down on spending and build up savings.

Reading this advice, one senses little movement up the learning up. The subprime mess, and the credit crunch and banking crisis that ensued, are the product of a 60-year expansion in the availability of consumer credit. Almost unheard of before World War II, 30-year mortgages became readily available for returning GIs. The 20% downpayment typically required until the 1980s was a sharp departure from the 50% downpayment usually needed in the 1930s and before. Credit cards , an innovation that came to fruition in the 1950s, allowed just about anyone to sign chits, formerly the reserve of the wealthy at their exclusive clubs. Levels of household debt grew ever larger, and downpayments required for home mortgages and car loans grew ever smaller. Government policy encouraged and facilitated borrowing, with deductions for mortgage interest (and, for a while, even interest on personal debts like credit cards), and sponsorship of entities like Fannie Mae and Freddie Mac to create a secondary mortgage market.

The growth of the credit monster reached its high water mark in the last few years, with the emergence of the no doc, no downpayment, option to defer repayment mortgage. What a wonderful innovation! Your aspirations, your dreams didn't need to be limited by your educational attainments, career choices, income or net worth. You simply sat down with a mortgage broker, shuffled some papers around, and ended up with much to boast about at cocktail parties.

We're now in the processing of learning how the story ends. Like all no free lunch stories, the denouement is that there is no such thing as a free lunch. Lenders have a bad habit of expecting repayment. You don't enhance your lifestyle by borrowing. All you do is frontload it. You're able to consume more sooner. But your consumption later in life is constrained by the fact that you have loan repayments to make. (Think about your student loans if you don't believe this point.)

The subprime mess stems in part from the fact that the borrowers simply didn't have adequate financial resources for traditional (i.e., prudent) loans, and therefore resorted to teaser rate, no downpayment, option ARM loans. Whether they had moderate incomes and couldn't easily save, or made good incomes but wouldn't save, they weren't prepared for the risks of using easy money to finance their homes. Squirrels that store a lot of acorns survive the winter. But we're now seeing what happens to squirrels that aren't so thrifty.

Policymakers seeking to address the subprime and associated messes are calling, variously, for lenders to give borrowers breaks, taxpayer funded assistance for low and moderate income defaulting homeowners, Federal Reserve interest rate cuts, and the imposition of new duties on mortgage brokers and lenders. But are we dealing with the illness or just treating symptoms? How about encouraging people to help themselves?

A baseline problem is that personal and household balance sheets have been deteriorating for many years. Savings rates are now effectively zero, and sometimes negative. On average, Americans are borrowing to finance their current lifestyles. The myriad ways of providing consumer credit --and delaying its repayment--seem innovative and even wondrous. But so did the Titantic.

As our credit-besotted nation piles up on icebergs of unmanageable debt, perhaps we should consider treating the illness. Personal and household balance sheets need to be strengthened. The medication needed is well-known: savings. But like other medications, it's easy to forget to take, especially when yet another sale at the mall beckons with siren song. The government has contributed to the problem by making it easy to borrow. The government should now contribute to the solution by making it easy to save.

Here's our proposal. The first $10,000 of interest income (and equivalents like dividends paid by money market funds) should be exempt from taxation (with $20,000 exempt for couples filing jointly). By exempt, we mean exempt: no regular tax, no alternative minimum tax. All interest income and equivalents above $10,000 (or 20K for married couples filing jointly) should be taxed the same as qualified dividends (which, for those of you who aren't lucky enough to receive qualified dividends, are taxed at lower rates than the salary or wage you earned working from 9 to 5). This proposal will provide an incentive to those with moderate or middle class incomes to save in the pedestrian, low interest accounts available to them. Passbook savings, money market accounts and CDs might enjoy renewed popularity. People who badly need savings might start to put a few nickels away. With some time and effort, they might accumulate a decent downpayment, qualify for a loan that won't wreck their finances in a couple of years, and attain true home ownership. Perhaps, just this once, the middle class could get a break.

Yes, this proposal would also benefit the well-to-do. Those with a lot of savings would pay lower taxes on interest income. But the banking system would benefit from larger amounts of retail deposits. As we are in the process of learning, the big banks were (and perhaps still are) heavily funded by short term, easily spooked money. Old-fashioned savings accounts and CDs are much more stable sources of funding. And if there's one thing banks need now, it's stability.

The many years of central bank sponsored easy credit have fueled asset bubbles. Banks, being at the heart of the credit extension process, have in effect become speculators in asset values. That hasn't worked out real well. Let's ease them back toward their traditional roles as lenders to borrowers who are well-prepared to repay the loans.

Environmental (?) News:
banana spill in the North Sea.

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