Thursday, March 03, 2011

[Non]recourse loans

NPR’s Planet Money had a podcast describing differences between nonrecourse loans, which Americans traditionally have, and recourse loans, which everyone else traditionally has. The pros for nonrecourse loan systems is that borrowers are more willing to take risks, and thus capitalize on them, increasing the general wealth, at the cost of finding it slightly harder to find banks willing to make loans and general extra volatility of the system with regards to speculative prices. The pros for recourse loan systems is that banks are more willing to make loans, so finding them might be easier, and the consequences of a default give incentive to the potential borrowers to be more conservative, reducing volatility.

What is left out of the discussion is that these systems are not in isolation. The fact that the vastly increased volatility of the nonrecourse mortgage market in the United States has been the single largest factor in the most recent financial crisis weighs in on the pros and cons, since the negative effects of that crisis has sent ripple effects across the Atlantic.

The problem, as I see it, is that we have an iterated prisoners’ dilemma: Whereas the recourse-loan-based societies might enjoy relative stability of their markets if they were in isolation, the fact that we’re all in the same boat means that if other societies “defect” to become nonrecourse-loan-based, then the volatility spills over, the value the recourse-loan-based societies are expecting from stability is decreased. In effect, it means that there’s a new pressure to cause further “defections”—the reward for increased capital risk now costs less, since they’re already incurring some volatility.