The cost of mortgage agency bailouts

I’ve read varying estimates of the cost of the mortgage bailout, including a sum of $1 trillion mentioned in The Wall Street Journal.  I have no idea what the number will be (and I’m not ruling out zero, or close to zero) but here is how to think about the costs:

1. Reimbursing agency debt holders is a transfer, not an economic cost.  No resources are destroyed by the reimbursement.

1b. The previous bad lending involves a cost — in this case too many homes — which already has been incurred.  This is not a cost of the bailout per se.

2. If government taxes the citizenry to raise money for the bailout, those taxes involve a deadweight loss.  Maybe 20 percent of revenue raised is a decent estimate of this cost.

3. Bailing out debt holders means that future lenders won’t be as careful as they should be.  This problem dates from LTCM, or even further back, and it gets worse each time.  The result is excess leverage and leverage of the wrong kind, namely to "too big to fail" institutions, which then become even bigger and more leveraged.  I haven’t seen a back of the envelope estimate of how much that really costs, much less a careful estimate, but this is a very important magnitude for calculating the net cost.

4. Often in these plans equity holders are (nearly) wiped out.  So beware all the talk of moral hazard.  The real moral hazard is on the side of future creditors, not the current, possibly-soon-to-be-extinguished equity holders.  They really are getting burned.

5. If the government dallies in executing the bailout, borrowing costs for the entire economy will rise.  A bailout has to be swift and decisive, assuming you want to do it.  Yet a swift and decisive bailout will likely involve errors of detail.

6. Doing a justified bailout this time makes it harder next time to avoid an unjustified bailout.  The bailout mentality is contagious in the political arena.

7. The transfer to the debt holders is generally regressive, at least under the likely assumption that the marginal taxpayers are less wealthy than the debt holders.  Of course some of the debt holders are foreign governments, which adds another element to the mix.

8. When it comes to the mortgage agencies, there is no real choice but to bail out the debt holders.  The alternative is a run on the dollar and collapse of faith in U.S. government securities and the end of the world.


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