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Thursday, October 09, 2008
Handling the Economic Crisis
I started to write this as a comment on Mike Gerson’s response to this Transterrestrial Musings post on the stock market’s continued slide. Mike asked what a conservative would do about the crisis, and my response got so long that I decided to move it here.
If by a conservative Mike means the Hamiltonian kind, such a one would do exactly what President Bush tried to do: pump massive amounts of money into large financial businesses. If by a conservative Mike means the small government/free market kind, he would use whatever levers the government had (including large amounts of money, if needed) to ensure liquidity in commercial paper and overnight bank loans, and would let the companies with bad investments fail.
Let me expand on that. All of these problems arise out of two fundamental issues. First, very, very bad loans for homes became a normal part of home lending. Second, financial businesses attempted both to cover the risks they had taken on and to hide those risks in increasingly poorly-understood and novel ways.
First things first: the bad home loans. These included loans to people based on their word as to what their income was, deliberately fraudulent loans which hid their true costs, loans designed so that the borrower could meet current payments (but not future payments unless the borrower got a significant raise) and loans designed so that the borrower could make the payments, but not gain any equity. (The last is essentially identical to renting the house you “bought” from your mortgage lender, while still being responsible for the taxes, maintenance and so forth. Ugh.) In terms of the financial crisis, it does not matter whether these loans took advantage of the easily pressured or economically ignorant, or if they were fraudulent in some way, or if they were otherwise predatory. All that matters is that they happened, and that they became an increasingly large part of the mortgage pool. (Had they been maintained at the level of, say, FHA loans, there wouldn’t have been much problem, but attempting to loan large amounts of money to increasing numbers of people means that you must reach deeper into the pool of those whose ability (and willingness) to repay is lower than that of people getting conventional loans. Hence, “sub-prime.” Cumulatively, the potential default rate was rising with the increasing amount of shaky home loans, and any small economic crisis could have set it off earlier — eventually, the lending got so out of control that it didn’t even require a crisis, just the end of a bubble’s expansion period, to set it off.) The profit potential of these loans was predicated on the indefinite continuation of the housing bubble; they were in effect a Ponzi scheme.
Second, the covering and hiding of risks. Mortgage lenders knew that they were taking increasing risks. Indeed, a whole new market cropped up of companies that would make a mortgage loan, particularly on refinancing existing loans, often knowing ahead of time that the borrower couldn’t afford to pay it off, then sell the loan for a small immediate profit (usually just the points and maybe a tiny bit of interest, just that paid during the few months it took to package and sell the loans). The couple portrayed recently on Saturday Night Live (the Sandlers) were apparently of this kind. In any case, in order to sell off these bad mortgages, the lenders would bundle thousands of mortgages together, some good and some bad. They would then divide the total pool into “tranches.” So let’s say that a pool contained 1000 mortgages, of which 750 were to credit-worthy borrowers who had placed large down payments, 200 were to somewhat suspect borrowers who would be OK as long as the market value of the house continued to rise or their income rose dramatically over a period of a few years, and 50 were to people who would almost certainly default within a year or two. Let’s further make up a metric, that the first category of loan has a repayment chance of 100%, the second of 80%, and the third of 50%. Then if the total amount of money lent to create the pool was P, the total value of the pool of mortgages can be approximated to 100% * 75% * P + 20% * 80% * P + 5% * 50% * P, which works out to 0.75 + 0.16 + 0.025 or 93.5% of P. That is a 6.5% expected default rate. But now divide the pool into 1000 slices, and sell a slice of the pool (that’s what the tranches are), and you can make the argument that, because these pool slices are combined with other pool slices, even if a few people do default, the value of the pool is still sound, because the person buying the tranche only loses 1/1000 of the defaulted amount. Why, at that point, you are back up to a rock solid investment. If done once. Done millions of times, you still have an overwhelming risk, arguably a much larger risk since you can guarantee that each of your tranches will lose some of their value, but that’s been hidden by the practice of pooling the mortgages and selling slices of the pools. Then, because the buyers (investment banks, money market funds and the like) realized that they were effectively gambling, and had lost some insight into exactly what their risks were, they tried to cover these risks with credit default swaps, which I don’t entirely understand. Effectively, CDS’s are a kind of hedge against risk. Except that they are so arcane that apparently even those making them didn’t understand them very well, and the result was that risks were not covered, but deepened.
Now, as long as the housing prices were rising, this was not a problem. As ARMs came due and one’s income wasn’t sufficient, one could refinance. Similarly, an interest-only loan didn’t pose a problem when you sold your house, because you were still getting equity (from the rising house price, rather than from a combination of the rising house price and paying down the principal balance of the loan). But the availability of easy credit, even for those who couldn’t repay the loans, resulted in a building boom, raising the housing supply dramatically. Demand over supply is directly proportional to price: as the supply begins to exceed the demand, the price begins to drop. In other words, the natural market forces worked predictably (so predictably that we sold our house one month after the peak of the market, and have rented since), and the housing prices started to fall. But uh oh, that means that you couldn’t refinance your ARM because you had negative equity, and you couldn’t sell your house with a principal only loan because you had no equity. (OK, in reality, this was only true on the margin, but that was enough.) The resulting rise in mortgage defaults, followed as night follows day by home foreclosures (which, tragically, increased the supply of available housing still further — instant vicious cycle), meant that the investment banks, money markets and pension funds suddenly had to calculate their real risk. But because they had sliced up, sold and resold, and covered their mortgage investments with CDS’s and other, even shakier, hedges, they could not do so. That is to say, they could not value their assets.
When a company cannot value its assets, it’s not quite the same as when an individual cannot do so. Individuals generally operate on a cash basis; companies generally operate on an accrual basis, recognizing both revenue and expenses as they are incurred, not as they are satisfied. So if a vast proportion of your assets are of unknown value, and the rules require you to mark to market, how do you value your assets? How do you know if your assets plus equity exceeds your liabilities? In other words, how do you know if you are bankrupt? Well, the truth is, you don’t. And so when Fannie and Freddie failed, Lehman realized that it was bankrupt. It had been for some time, but hadn’t known. But now that it knew, it had to (as a public company) declare it, and that triggered all kinds of mechanisms to protect the remaining assets to pay off creditors and (if money was left) shareholders. But the creditors included companies like other investments banks and insurers, so there were several high profile failures in a very short period of time.
And because companies that held mortgages couldn’t value their assets, and thus didn’t know if they were bankrupt, prudent institutions stopped lending money. If you make an overnight bank loan of $200 million, and the bank goes under, you are out $200 million. The same goes with commercial paper (overnight loans to companies). And so the credit markets froze, not solid, but bad enough to panic investment bankers, one of which happens to be our current treasury secretary.
So up to this point, I don’t think you’d get much disagreement except on details and expansion of unclear points. All sides pretty much agree on the sequence of events and the proximate causes. The disagreement is over root causes, and specifically whether this was due to deregulation, or Congress insisting on ever riskier loans, or greed. All of these are actually implicated (though it’s not so much deregulation as failure to regulate something that wasn’t regulated before in any case). And they’re also fairly irrelevant to solving the current crisis (though not to preventing future crises).
So how to solve the crisis? The Hamiltonians look at the last link in the chain: the investment banks and other large financial institutions that are failing. And their preferred solution is to pump massive amounts of money into those institutions (both through the bailout package, and through the massive inflation that the world’s central banks are currently causing by lowering interest rates), so as to ensure that they aren’t bankrupt, so as to ensure that the credit markets (both overnight bank loans and commercial paper) keep moving. An aside, by the way, the horror stories about not being able to buy a car miss the point: individuals don’t have a problem valuing their assets and liabilities, so it’s always possible to calculate the risk inherent in lending to them; it’s only the institutional lending that is at issue (bad though that is). The socialists look at theory, and say to nationalize the financial industry. The social democrats (which is where most Democrats, at least in the national party leadership, fall) and populists (including McCain) look at the first link in the chain, and want to refinance people’s mortgages through the government, end the distasteful practices of the large institutions, and want to punish their executives. Ironically, those last are closest to the mark, of those groups that have a chance at making policy on the matter.
But a libertarian/small government/free market type of conservative looks at the problem a little differently. Given how the problem came about, the reason that loans aren’t being made is because financial companies cannot value themselves. But value is fundamentally just what someone is willing to give up to get the thing being valued. If you offered me a thousand risky mortgages and I only had to invest $100, I’d take them right now, cash. Because if only one paid anything, I’d be OK, and if none of them paid off, I’d be out only $100. If you offered me those same mortgages at more than a few tens of thousands of dollars, I’d refuse, because I couldn’t afford the potential loss. So in order to value the mortgages, and, more importantly to the issue at hand, the various securities based in some way on mortgages, you have to be able to sell them. But no one is selling them, because they think the government might just come in and buy them up (the populists’ view) or insure them (the Hamiltonians’ view) such that the institutions can make more money from the government than they could selling the securities on the civilian market. Once the securities start selling, to anyone, the market can value the assets, and thus value the financial companies holding the assets, and thus evaluate risks, and thus the credit will start flowing again naturally.
In other words, the crisis is being deepened by the government’s actions. By declaring a vast crisis, and the need for the government to massively intervene, after already intervening heavily by taking over Fannie and Freddie and stabilizing AIG, the government shut down the market for these securities precisely at the point that the credit markets were freezing up. Had the government let these companies fail, the companies would have started selling off their securities at low enough prices to clear the market (it’s that supply/demand/price thing again), and the credit market would have started up again on its own. Now, let’s cover the downsides, because the first objection to this is going to be either, “People are going to lose their homes,” or, “People are going to lose their jobs.” Actually, both of those are net positives for the economy, though painful for the individuals caught up in it.
First, there is no reason why people with sound credit and a good payment record would lose their homes. [UPDATE:] For that matter, even if someone had a bad payment record and poor credit, they would be likely to keep their home if they had any means and desire to do so. Even if someone bought up a mortgage at a serious discount, they’d still make more money with the homeowner paying on the house than with it sitting vacant. So foreclosure would only happen for those who couldn’t make their payments, hadn’t been making their payments, and had no way out of this: they would almost certainly be bankrupted. But that clears the books: they can go on to rent, reestablish their credit within their extant means, and generally get on with life. By clearing their liabilities through bankruptcy now, those who would have gone bankrupt eventually have a head start on fixing the problem, and in the meantime have not dug themselves into a deeper hole. It’s painful, but not fatal, and arguably less painful than holding on for longer and eventually going bust in any event. [UPDATE:] If you lose your home from this, one of the problems of course is the loss of equity in the house. But by definition, you are losing the house because the equity wasn’t sufficient, or at least wasn’t sufficiently liquid, to cover your housing-related or other liabilities. It’s fun to live beyond your means, but since we no longer have debtors’ prisons (thankfully), eventually you have to either pay up by handing over assets, or pay up by going bankrupt and seeing your credit tank. Next time, buy a house that you can make the payments on.
The argument for people losing their jobs is based on companies going out of business, and that’s certainly going to happen, but this too is a good thing. Companies that were risky and greedy will get wiped out, and their assets will be bought up by companies that weren’t risky and greedy. Those companies will expand, and will need workers, and so eventually all those left unemployed will be reemployed in a more productive business. The shareholders will be wiped out, true, but that is the downside risk of investing. (The upside being the tons of money made as the stock value rises. The trick is to buy low and sell high. This requires actually understanding the companies you invest in, and not being greedy or risky yourself. Don’t tell anyone.) The thing is, a lot of the investors are money markets, mutual funds, and the like, and a lot of people’s 401k’s and IRA’s and pensions will be hit by this. Well, that’s what Social Security and similar programs were made for, a retirement income of last resort. Again, painful, but next time invest in more solid ways. (Index funds are a good bet, because they’ve never lost money over a 20 year period, and when you get close to retirement, move more of your money into even safer government bonds. Don’t tell anyone.)
[UPDATE:] Of course, the government can ensure that those who lose their jobs don’t get new ones, as they did during the 1930s, and are doing in Michigan even now. (This is one of the major reasons I left Michigan: the state government was determined to kill off any vestige of the economy by taxing heavy manufacturing equipment owned by the dying auto industry in the state, and then service companies which had managed to survive the dying auto industry, at increasing rates.)
The underlying assets, the houses, are not going anywhere, and the market, left to its own devices, will recover (someone will buy those assets when the price gets low enough) with less overall pain than if the government tries to fix things so that nobody feels pain. Bankruptcies, whether personal or corporate, are how free markets move unproductively-invested capital into productive use. Otherwise, the unproductive capital keeps being unproductive. And that — keeping unproductive, risk and greedy ventures afloat — is exactly what the government is doing to all of us right now. So bend over and prepare to take it, because it’s going to get a lot worse before it gets better. The last time something similar happened was the Great Depression of the 1930s, and the government’s attempts to help apparently prolonged that one by seven years.
UPDATE: Minor spelling and grammar edits, and a couple of sentences clarified slightly. Also added two points (marked in the text) in response to an email, and a link to the government prolonging the Great Depression.
Comments
First, there is no reason why people with sound credit and a good payment record would lose their homes. Even if someone bought up a mortgage at a serious discount, they’d still make more money with the homeowner paying on the house than with it sitting vacant. So foreclosure would only happen for those who couldn’t make their payments, hadn’t been making their payments, and had no way out of this.
More to the point, people making their payments can’t possibly lose their homes to foreclosure, even if their credit history isn’t good. If their bank goes under, somebody will buy up the mortgage, and they can continue making payments and thus be entitled to keep their house. No amount of crisis in the mortgage industry permits foreclosure on a mortgage that is being paid according to its original terms, even if the new lenders _were_ stupid enough to think they’d be better off foreclosing.
Nobody was ever going to be forced out of their home because the mortgage market was in crisis. The only people who are losing their homes are people who are unable to make their mortgage payments, and frankly even at the market’s peak, those people were going to lose their homes anyway. The best they could ever have hoped for was to sell before foreclosure for at least as much as they owed. If they got lucky on the timing they’d have made a profit, but they’d still have lost the house to do it.
But creditworthiness doesn’t enter into it from the perspective of the individual homeowner, nor does the presumed intelligence of the mortgage industry. Only ability and willingness to comply with the terms of the mortgage contract. Do that and you can keep your house, even if your credit score sucks and your banker is a fool. Don’t do that and you’ll lose your house, even if you’re an 800 and your banker is a Nobel laureate.
Posted by Matt on 10/10/2008 at 09:56 AMMr. Medcalf:
The amount of time you must have put into writing this, and obviously into understanding it, is impressive, as is the net result. I hope you don’t mind me forwarding this to everyone that I know who is struggling with what is going on, and is aghast when i say to let the banks fail. You pretty much sum it up, while I fail to get the point across every time.
Hopefully, it doesn’t take a world war to pull us out of this one, like it did last time.
Posted by on 10/10/2008 at 11:51 AMMatt, I phrased that poorly. I meant to say that no one would lose their homes if they were making the payments, and if they were not, they would still likely have every opportunity to keep their home. Thanks for catching that for me.
Goober, feel free, and thanks.
Posted by Jeff Medcalf on 10/14/2008 at 12:06 PMI knew we should have let those crooks sink. So what can we do about our IRA’s? When I talk to my planner, she reassures me I am diversified…
What are some good questions to ask her so I can watch her squirm?
She lives in a very nice house.
Posted by on 10/16/2008 at 06:38 AM
