Why Is This Man Frowning? (Recourse Finance)
Per Mark J. Perry, here's reason #1 why the Canadians avoided a bank meltdown: recourse lending:
Almost all Canadian mortgages are “full recourse” loans, meaning that the borrower remains fully responsible for the mortgage even in the case of foreclosure. If a bank in Canada forecloses on a home with negative equity, it can file a deficiency judgment against the borrower, which allows it to attach the borrower’s other assets and even take legal action to garnish the borrower’s future wages. In the United States, we have a mix of recourse and non-recourse laws that vary by state, but even in recourse states, the use of deficiency judgments to attach assets and garnish wages is infrequent. The full recourse feature of Canadian mortgages results in more responsible borrowing, fewer delinquencies, and significantly fewer foreclosures than in the United States.
This is weird in so many ways that it is hard to know where to begin, but grant him his general proposition: There is indeed something problematic about the asymmetric heads-I-win, tails-you-lose structure of non-recourse finance.
The trouble is, once you start looking for it, you find "non-recourse" under almost every rock in the capitalist garden. I'm sure Perry would be happy to show you how the same problem underlies the bankruptcy discharge, where the debtor gets to walk away from his just debts. I'll bet (although I do not know) that he feels the same way about bank insurance, like the free-handed taxpayer guarantees that allowed the mischief-makers to bring down the Savings & Loan industry in the 80s/90s.
But it doesn't stop there. When I buy a call option on LittleCo stock, I acquire the right to take the stock or throw it away--analytically no different from my right when I buy my home on a nonrecourse mortgage. I have not heard Perry howling for the abolition of the conditional claims market, and I am not holding my breath.
Or consider the corporate limited liability form itself, the greatest social invention, so Bertrand Russell is supposed to have said, of the 19th Century. Restated: the equity stake in a leveraged company is a call option on the assets--you can take or walk away, just as with stock options, just as with the nonrecourse mortgage.
Probably nobody ever understood this better than the bankers. Look at that picture above of Mr. Banker Himself, J.P. Morgan Jr. Why does he look like he is ready to explode? Because it's his own skin in the game. He was a general partner. If the deals went sour, he stood to lose every penny. No wonder he was a prudent lender. No lwonder he staked so much on personal character.
Sadly, his successors appear at last to have grasped the full implications of his insight. What caused the late meltdown? Of course you can't bring it down to one cause, but if you had to name just one, I'd say--incorporation of investment banks, the great tectonic shift from unlimited to limited liability.* That's when the bankers stopped having skin in the game: when they shifted to heads-I-win, tails-you-lose. They bankers didn't worry about taking lunatic risks because they knew the downside was yours, or rather ours (indeed, any first semester MBA student can show you, the greater your capacity to shift he losses, the greater the inducement to take a risk and the more lunatic the risks you take).
I grant, there is a great puzzle here: why do shareholders get bankers get away with it--or more generally, why does anybody ever buy stock in a bank? But the same specter haunts Perry's argument: if banks operate in a regime of nonrecourse finance, you'd think it would make them more cautious in their lending, more prudent in protecting against risks that they couldn't offload. I don't know the answer to that, but Perry doesn't even seem to notice that it is a problem.
Final Jibe: I think it's pretty rich to see an endorsement of Canadian banking from a crowd who have spent the last dozen years or more telling us about the evils of Canadian health care.
Afterthought: and how could I have forgotten the biggest nonrecourse of them all?
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*I first grasped this point in reading Barry Ritholtz' Bailout Nation, though I am not sure he would press it quite as far as I do.