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THE GREAT MELTDOWN OF 08
And you were worried about the glaciers melting?
These are my consolidated posts from the two relevant POLICY THINK SITE Blogs, The Out-Lawyer’s Blog and The Human Conspiracy Blog.
They date from the first sightings of the approaching shock wave, to the arrival and immediate aftermath of the Tsunami.
Jay B. Gaskill
[This was written before the Credit Tsunami Actually Hit]
Now…I’m just a ‘country lawyer’ as the saying goes, but I do understand fundamental economics and, as a split-time Californian, I understand how it is for ‘ordinary’ people to attempt to live in an ultra-high priced real estate market, and also how what a blessing is not to live in those overheated markets.
Here’s the deal. Rents are income sensitive, but – until the current meltdown – home real estate prices have been much less so. When rents and prices for the same commodity diverge too sharply, you are on notice that there is a “correction” ahead.
The movers and shakers among the elites tend to forget the basics, from time to time. For example: Ordinary folks can only use their real incomes – those after tax, after withholding dollars we actually get to spend – to buy or rent a place to live.
Therefore, whenever there is a huge disparity between rents and real estate prices in a given area, you can be reasonably sure that there a speculative bubble has been driving up home purchase prices.
This condition is easily detected. Assume a three bedroom home in your area can rent for, say, $2000 per month, but that same home, when sold last year required mortgage payments (assuming for the purposes of my example, a fully amortized, conventional 30 year mortgage) of $4,521 per month. The new owner could not possibly rent the house, in that market, for enough to cover the mortgage. That is the bright line clear signature of a price bubble, because at some point, incomes always fail to keep up.
Most buyers in these hot housing areas already knew that dirty little secret, but went ahead with the deal anyway. What was going on? The buyer really, really wanted to live in a nice neighborhood and willfully bought into the expectation that the sale value of the home would continue to inflate (presumably along with the buyer’s income) for the foreseeable future. To be fair, that gamble did not seem unreasonable as recently as the year 2000. In fact, it worked very well for thousands of home buyers throughout the 80’s and 90’s.
The housing speculative bubble is like all the price/value bubbles of the past, with one major exception. Most speculative bubbles, especially those in the stock market (think of the internet commerce bubble of 1998-2002), pop quickly and dramatically. But a housing bubble like the present one can fester for more than a decade and collapse more gradually.
This housing bubble was caused by the perfect storm of five converging forces:
Brutal urban commutes for everyone who wanted a nice homes for the kids;
A concentration of high paying jobs in urban areas – and in may instances employers whose recruitment incentives included ‘excessive’ compensation to lure good people into an overheating housing market;
A subgroup of people who could almost, but not quite play the game in the traditional way;
An institutional disconnect between lender accountability and loan failure;
Novel financial instruments and devices that were designed to “help” subgroup (c) beat the game in the (ultimately vain) hope that future appreciation would bail them out when needed.
These were the ingredients of a pyramid game in which the collapse of the entire scheme was so deeply tied to the American financial system that the ripple effects could trigger a much worse calamity that a large number of loan defaults and evictions, as tragic as that scenario might seem to those whose lives have been disrupted.
Why this general financial vulnerability? Let’s examine the “institutional disconnect” more closely. In the old days, your original lender remained on the hook for the loan essentially forever. This meant that the loan was given real scrutiny by the bank or other lender who actually would be required to take the property back in the event the borrower defaulted. Accountability wonderfully concentrates one’s care and attention, especially when large sums of money are involved.
But the current practice is different. Real estate loans are made by broker/“lenders” who never plan to remain on the hook. These loans become assets to be acquired by the real lenders who buy the “paper” (consisting of the terms, the financial profile of the borrower and the appraisal of the home). And these paper assets are sold and resold, finding their way into the asset portfolios of your pension fund and your local bank.
The operating myth has been that home real estate loans are a secure asset, comparable, say, to gold bullion. So this “paper” (greatly exaggerated in value and security) not only found its way into the asset portfolios of banks, pension funds, it became a big part of the asset structure of the super lending institutions, “Fanny Mae” and “Freddy Mack”. These two semi-private super-lenders collectively own – and are on the hook for 5 trillion dollars worth of mortgages.
For a concise history of these behemoths, originally chartered in 1938 to help provide home loans when most private lenders were out money, go to - http://www.fanniemae.com/aboutfm/charter.jhtml .
Fanny and Freddy are deeply entangled with the federal government. Given the immense sums involved, the entire financial house of cards is placed at some risk, and – because of the federal entanglement with Fred and Fan – the taxpayers and the federal deficit are tied to this vessel should it ever sink.
This is a good time for concern but not panic.
the three core principles to keep in mind:
(1) Risk takers are necessary for the larger good; without them, things
gradually stagnate and progress grinds to a halt (think of the former
Political leaders tend to ignore the third principle:
Like water seeking the lowest channel in any hydraulic system, greed seeks the most easily exploited transactions in any monetary system: Floating un-vetted loan papers as assets was an open invitation to greed-driven fraud and greed-enabled foolishness.
This raises the major public policy question of the day: Who, if anyone, should be protected against their own foolishness?
Many purchase money real estate mortgages that result in a default do not result in a loan deficiency debt collection from the evicted or defaulting home owner. The lender is simply stuck with the property and the borrower is free to walk away, leaving behind the asset, but without worry of being sued for any deficiency even when the asset is revealed to be worth less than the debt.
Ah, would that life were always that simple.
Deficient second and third mortgages and real estate secured lines of credit still must be paid back. Moreover, many of the “creative financing” vehicles designed to give the buyers temporary low payments expose these borrowers to ongoing liability, even after a foreclosure/repossession sale. And not all jurisdictions protect purchase money mortgage holders equally against a post-default deficiency.
Still, only a relatively small fraction of all mortgages are at risk. The rest of the homeowners had a large paper surplus asset and now have a much smaller one. They have a poorer resale value but the home market is now full of bargains for qualified buyers.
So what’s the big deal you ask? Here’s the analogy: You sell most of the grain for the town, and broker the rest. You suddenly discover that a small percentage of all your grain is bad. The entire town finds out. Rumors start. Pretty soon all the grain sellers you have dealt with freak out. The town freaks. You can see where this is going. No new grain. Not enough rice. Depression hysteria.
As a result of the mortgage crisis we will have to live through some uncertainty, alleviated in part by federal actions to shore up key lending institutions. The last major depression really took hold when the money supply dried up. That simply will not be allowed to take place. We did learn something from the last one.
But we should not lose sight of the larger picture. Prices are set by supply and demand and demand is limited by income.
I’m hearing hysterical voices urging us to “do something” to stem the “collapse in home prices”. One expert even proposed we try to entice foreign investors to acquire empty houses as second homes in order to keep the prices up! Am, I the only one who thinks this proposal sounds a bit perverse? We’re not facing a collapse in housing prices but a several year gradual correction. Where prices were reasonable (in relation to local incomes) in the first place, we’re seeing gradual appreciation.
Here are my main recommendations:
Yes, by all means, we should take those actions minimally necessary to head off irrational panic.
And we need to protect home purchasers from a deficiency judgment whenever the buyer didn’t commit fraud and the loans were used in the initial purchase of a primary residence.
We should prosecute fraud whenever it is clear enough to make a winning case. [This is not a time for expensive show trials ending in minor convictions or acquittals.]
We need to hold the risk takers accountable without any bailout except for the measures in the first and second points above.
Whatever else we do, we need to let the housing market correction proceed until prices self-stabilize.
We can – and should in my opinion – provide some help in the form of credit support and tax breaks for first time buyers (or post-eviction second time buyers) who want to take advantage (as the actual home occupants) of the new real estate bargains, provided that there is a sober, realistic appraisal of real income and home resale value. But we need to make certain that the original lenders cannot escape responsibility for making a bad loan.
Buyer Beware: This simple minded analysis was infected with common sense and old fashioned values. As I said earlier, ‘Accountability wonderfully concentrates one’s care and attention, especially when large sums of money are involved.’
JUST WHOSE CRISIS THIS?
[Written just as the Credit Wave reached shore]
It should be obvious - but apparently is not - that when public policy drives bankers to make imprudent loans in service of an ideal (everyone gets to “own” a fine home regardless of ability to pay), there will eventually be a crash. The only surprise here is the staggering scale and worrisome pervasiveness of the ensuing financial toxicity.
For a brilliant indictment of the liberal-ideological mindset when it is forced on the otherwise cautious banking community (by George Neumayr, got to this link: http://www.spectator.org/dsp_article.asp?art_id=13970 .
But there is another dimension to this, captured in a single slogan: “It's the incomes, stupid!”…
crisis was driven by a doomed attempt over decades to sell too much, too fast
to people who earned too little. Even when
The cost of a typical American car has been driven up many multiples of the core manufacturing costs for its essential transportation function as a direct result of mandated technological additions (not just the relatively cheap seat belts, but sophisticated systems for air bag deployments, for example). Whatever the merits of these additional features (they would be frills in poorer countries) for safety, pollution control and other salutary goals, they have had three negative effects: (1) much higher purchase costs, (2) fewer owner driveway repairs (3) high computer chip vulnerability leading to non-repairable failures – even at your local garage.
All this still might have worked except that real incomes for most working Americans didn't keep up. [The days when Dad traded in the three year old car on a new one are long gone.]
Why all this happened is difficult to untangle, but the big picture is clear enough. We Americans, the people who pioneered mass production, invented television, computers and the internet, among many, many other gifts to the world, have simply lost our effective monopoly in making the very things that originally made us great.
Put crudely, the smokestacks were allowed to resettle elsewhere while we tried to retain the clean stuff - design, advertising, finance, research and intellectual property. So the subset of our population that works in these “clean” fields get the better paying occupations while the former manufacturing employees lost income, some would say irrevocably. [On that pessimistic point, I disagree, but that is for another article entirely.]
In general, it is an unpleasant truth that the world economy differentially drains incomes from those parts of the local economy where skill levels in-country and outside are approximately similar. Put another way, the cost of paying workers always seeks its lowest practical level. The elites have been relatively protected from this trend, while our country’s non-professional workers have not.
An artificially loose credit system has operated, until now, as a subsidy mechanism to partly compensate our income deficient workers by flooding the market with low cost Wal-Mart style imports from Asian sweatshops, and big ticket items whose true cost was masked by unrealistically easy borrowing.
The coming populist revolt may make things better or worse, but come it will.
Intelligent solutions take more time and heavy lifting than the unintelligent ones. The elites are on notice. This week’s events tell us something else:
[The Credit Tsunami Arrives]
As I write this, the federal establishment is trying to contain the economic spillover damage from the collapse of a huge real estate pyramid scheme that has entangled itself with the banking and credit systems such that many large scale lending institutions must either be allowed to fail or somehow must be “rescued” by a massive infusion of public funds on the order of a trillion dollars (all told).
How Big is Big?
let’s get a handle on the scale.
The US GNP for 2007 was about 13.8 trillion dollars and the current national debt is about 9.7 trillion. For the first half of this year, the federal deficit was reported by the Treasury Department at about .311 trillion.
News flash: Our debt/deficit was growing before the proposed bailout but that was nothing compared to what we are about to see…
comparison purposes, as recently as 2000, our GNP was only 10.5 trillion,
compared with Japan’s 4.8, Germany’s 2.2, Britain’s 1.5 France’s 1.5, and
China’s 1.3 (all approximate numbers).
I’m employing some rough and ready arithmetic and just to arrive at an appreciation of the scale of the current bailout proposal. Here are some scale elements to ponder:
The total national debt is about 70% of the Gross National Product.
The current federal deficit (if below .4 trillion as reported) is still less than 3% of the GNP.
If we retire only 50% of the current (pre tsunami) debt over the next 10 years, this would require a budget surplus of about .7 trillion dollars every year and – obviously – a complete halt to deficit spending.
The Chinese and other foreign interests own an embarrassingly large percentage of the national debt.
The pending .7 trillion bailout is about twice the size of the current deficit and about 5% of the entire national debt. It would have been almost 10% of our country’s gross national product in the year 2000.
Political and Economic Toxicity
The leaders who are attempting to sell the federal bailout are describing it as a purchase of “toxic” assets. This is an adroit way of distracting us from the fact that the real estate bubble was a giant pyramid scheme. As you can see from the scale discussion above, it was a very large scam in which the “assets” to be purchased – mortgages secured by hugely overvalued real estate – are the “bag” that pyramid scheme dupes are left holding when the entire investment house of cards falls down on them. But the “dupes” to be rescued in this catastrophe are not the home buyers-in-default. No, we are to rescue the allegedly hapless lenders who should have known better and probably did. The parties to be rescued are the very architects of the scheme.
should we support this particular bailout?
The case is being presented that the damage to the ready flow of money
in the form of credit lending capability in the
that the claim that we cannot rescue the flow of credit in the
Underwriting a Pyramid Scheme
This whole mess began two decades ago when federal policy makers decided to promote home ownership with an enthusiasm that violated the rules of common sense. In effect federal policy underwrote and promoted a massive pyramid scheme based on a mythical, never-ending real estate boom, supported by the myth of forever secure jobs and endlessly rising incomes.
When the government effectively forces lenders to provide purchase money for poorly qualified buyers under conditions and circumstances so unrealistic that a brutal correction is inevitable, there really will be a correction and it really will be brutal. Overvalued assets are still subject to the laws of supply and demand because demand is always constrained by income. A postponed reckoning for short term profit taking defines a pyramid scheme. The reckoning has arrived.
Here are three populist rules that any elected public official ignores at great peril:
The political elites who appropriate the money of the people to bail out miscreant / negligent elites are accessories to the original crime.
The experts who couldn’t see the train wreck coming until too late who promise, “Trust me this time, I really know how to fix this,” cannot be trusted.
Those who advocate throwing good money after bad are almost always fools. If it doesn’t work in the slot machines and gaming tables, why will it work better when you start adding the zeroes?
As I write this, Speaker Pelosi’s strong arm tactics have run afoul of the public opinion polls. The approval level for this bailout hovers close to that of the congress itself.
The house did not approve the package.
Only 205 voted in favor -- 228 against.
Democrats: 140 for --- 95 against.
Republicans: 65 for --- 133 against.
There are two obvious, but under-discussed problems with the now stalled bailout package:
[A] Almost unlimited power to allocate appropriated moneys is vested in one office – that of the Treasury Secretary, but Mr. Paulson, the person (who frankly sometimes looks like someone about to go into cardiac distress) is a lame duck. A sum of money that amounts to a significant fraction of the entire GNP and enormous power is being handed over, not just to Mr. Paulson, but to his political replacement, identity unknown.
[B] The authorization process (by a congress under extreme duress) has an eerie resemblance to those high pressure real estate bidding war-driven sales. In effect we are witnessing writ large the recapitulation of the same high pressure real estate deals that ignited the hyper-inflated home price inflation bubble. The Congress is reenacting the drama that lurks at the heart of the current mess. Thousands upon thousands of homeowners have been through that brutal home buying experience: Bid now, bid high or you can’t stay in the game! And do it quickly! Yes, we know it’s a bit too much money – but you can’t lose.
Except, of course, we “common” Americans know that you can and do lose…
The credit crisis has exposed that the emperor is far, far more naked than any of we “common people” ever dreamed.
thought, for example, that the
this time there was a covert second money supply, even larger than the
“official” one. It is private “paper” in
the form of all of those mysterious financial instruments traded among lending
institutions. Private paper is not
backed by the fed in the same way that
instruments are the “new cash”, and their markets currently dwarf all the
Negotiations will no doubt continue, because an actual credit infarction would be nearly fatal to a system so dependant on the second tier currency of private paper.
Credit liquidity is essential because there is no near term prospect of going cold turkey. But are we really expected to allocate the better part of a trillion dollars to the control of same credit structures, institutions and elite managers who brought us to this impasse? Must we really trust a single bureaucrat, however expert, to buy our way out?
We are witnessing the biggest game of chicken in the last 75 years.
THE GREAT REJECTION OF
It was a legitimate populist eruption. The End of the World is not at hand. But the end of the “boomer” domination of American politics is within sight. To them, it just seems like the end of the world.
In today’s New York Times, a moderate voice, speaking reason and truth to panic and obfuscation about yesterday’s failed “rescue”, slipped into print under the editorial radar.
Titled, “An Alternative to Armageddon”, the piece came from a new web based addition to the NYT’s business section.
Some key pull quotes will follow and I follow them with the web link.
“The failure of the United States government to emerge as a willing buyer for hundreds of billions of dollars of toxic assets will accelerate the painful process of de-leveraging, bringing with it more bank failures. That, in turn, will shrink the size of the private sector balance sheet that consumers and companies have come to rely upon.”
After discussing the rescue of Washington Mutual and Wachovia, and the adroit employment of F.D.I.C. guarantee mechanisms to sweeten the pot for the acquisition of these institutions, the author (“Rob Cox”) added that –
“These deals — along with JP Morgan’s acquisition of Washington Mutual in another F.D.I.C.-brokered deal on Thursday — show that willing buyers can be found for distressed institutions with the government mechanisms that are already available. The more the government helps, up front or through some sort of insurance, the less risible the price a savior will offer.
And he closed the piece with this:
“As the credit spigot dries up further, it will be harder for companies to borrow and invest in their businesses, despite the Federal Reserve’s separate efforts to flood the system with money. It will cost more for consumers to mortgage their homes or gear up their car purchases. But the additional pain of living without the [Bailout] could be beneficial in the long run, if it brings more reliance on sound market principles.”
HERE’S THE LINK TO THE ENTIRE PIECE:
The bottom line: We’ve been addicted to a toxic credit-based finance system; withdrawal from the addiction is very painful but not Armageddon.
REFLECTIONS ON THE COMING POPULIST REFORMATION
Under huge duress, the US Senate has approved a slightly amended version of the bailout, the House has agreed and the President has signed it into law.
In 2006, 2007 and earlier this year, I posted some observations about a resurgent American Populism. A brief reprise:
Here’s the deal: We’ve evolved two cooperating political elites, each of which runs one of the two parties and shares three common traits: (1) high education levels, (2) important wealth (3) a distrust of the populist vote bordering on fear. Winning elections for each requires a periodic courting ritual during which the populist vote (on which success depends) is earnestly sought, followed by a measure of post-election betrayal.
The corporate country club conservatives and the Lexus limousine liberals have so far succeeded in achieving a rough division of the populist center: social populists on one side, economic populists on then other.
But conditions are rapidly changing.
As the conservative and liberal elites grapple with the implications of coming populist reformation, everyone should remember that the main populist strands of opinion, concerns and perspectives are not the only such threads in American politics, just the ones most often neglected by the elites of the left and right.
This is why populism tends to erupt from time to time, instead of congealing around a particular party or set of interest groups. The center of gravity of American populism is located among those who are too busy working, earning and living real lives (elites would say “mundane” lives, here) to become political junkies. They periodically awake -- like the mythical sleeping giant – only when provoked by prolonged policy neglect or irritated into sufficient anger by repeated disregard of their core values and concerns. When the elites forget who really serves whom for long enough, there is hell to pay.
Populism has a sharply different look and feel in the USA as opposed to – say- Venezuela or Iran because the American middle class is so well entrenched and numerous that its numbers overwhelm those who cling to hereditary privilege. While ours is not a fully “classless” society, its various divisions tend to be blurry and membership levels very fluid as people and families migrate from hardship to wealth and back again. This is the country where the less wealthy can reasonably aspire to wealth and the wealthy can reasonably worry about losing everything.
In this milieu, there are only two great “class” divisions in the populist mind that really matter: those who work, create value and struggle to make productive things happen for themselves, their families and the community at large, and those who manipulate the former group. In the populist mind, the manipulative class includes the idle rich, the idle poor, and the political and cultural leaders who exploit the productive “class”.
The coming populist reformation will be driven by the events and exigencies of the next few years because these challenges will bring the failures of elites of right and left to address the core populist values and concerns into sharp relief.
OBAMA’S TRAINING WHEELS
[Written as the Great Bailout of 08 Began]
The McCain campaign launched a short spot on YouTube highlighting his leading role in fighting to curb the Fanny & Freddy excesses against democratic resistance. The video includes a clip from President Bill Clinton corroborating that congressional democrats resisted his own efforts to accomplish the same. Go to this link-
As I write this, the Obama express appears headed to the White House, leaving the behind Bush presidency - and any political figure tainted by association - as road kill.
happens with respect to the bailout of the
In other words, a recession seems far more likely than not.
If Senator Obama is elected, he will be one of the nation’s most eloquent presidents and one of the least experienced. But circumstances will have sharply curtailed his freedom of action.
Adding roughly a trillion dollars to debt, facing a recession that requires the stimulus of tax cuts and – if possible – more stimulus spending – will leave the new president almost no budget discretion. It will be nickel and dime liberalism because all the really big money will have already been taken off the table.
Obama’s anti-deregulation rhetoric discloses a profound misunderstanding of free market capitalism and his tax policy betrays full-on ignorance of the dynamics of the wellsprings of free market innovation. This is requires an extended discussion, mostly omitted, but my libertarian friends will understand. The de-regulated airlines and our less-than-properly regulated mega financial institutions are not pure free market systems at all, but quasi-monopolies for which regulations are designed to reign in monopolistic abuses but often have the opposite consequence. Democrats strongly resisted greater regulation of the sub-prime lending institutions because their social agenda – lending to the poor in below market deals – would have been derailed.
free market world of Obama and friends involves socialization of failure and
the political exploitation of success. [Just follow the sub-prime money flow to
politicians, including the junior Senator from
DANCING WITH BEARS
GREENSPAN IN THE DOCK
[Written last week, when Greenspan was summoned to Henry Waxman’s committee in the House.]
Today's headlines suggest that former Fed-Head Alan Greenspan has abandoned all his free market principles, shouldered all the blame for the mortgage crisis and has humbly signed on to the Obama campaign as the resident bad example, presumably to be paraded before select audiences wearing a dunce cap.
How quickly the politicians discard their former heroes when expediency trumps fidelity.
As a young
graduate student in New York, Greenspan belonged to a group that was in the
thrall of the author-philosopher Ayn
Rand (Alisa Rosenbaum), a refugee from communist Russia (where the Soviets had
essentially destroyed her parent’s business). She was a fiercely anticommunist
atheist who defended the ethic of rational self interest against cultural and
political forces that enforce a sacrificial ethos, deride profit and sap achievement. She had no formal economic training. She loved
Later in life, Mr. Greenspan was asked if he was still a follower of Ayn Rand's philosophy (Objectivism). He said he was an agnostic where Ms. Rand was concerned.
Under blistering examination in congress yesterday, Mr. Greenspan was asked whether he had given up his libertarian market principles, and he said “partially”, then he attempted the kind of nuanced answer that congress, the president and media had accepted without question when he was at the top of his game. Not this time. Nor did anyone listen carefully.
despised libertarians, not so much because they “believed in” free market
capitalism, but because they lacked core moral values. In Ayn Rand's ideal
world, her economic heroes were productive, hard working, men and women of
great personal honor and integrity. And they were not shielded from the
consequences of failure by complex credit instruments. In a scene in one of her novels an “old
fashioned” banker (when
Accountability for failure wonderfully concentrates the mind.
When governments or networks of financial institutions, acting like a government, mess with the natural risk consequence mechanisms that attend ordinary free transactions they rob the market at large of its internal corrective checks and balances. No regulatory scheme is perfect and no regulatory body can be more effective than a system that requires full transparency and accountability.
Markets that eliminate the consequences of failure – or transfer those consequences to innocent third parties, or try to dilute them – no longer function as rational and impartial pricing mechanisms. Put differently, such markets can no longer be trusted.
Mr. Greenspan's problem (shared by almost everyone in the Beltway bubble) was not a failed economic theory but failed real world practice. Compared to Ms. Rand's “old fashioned” values, Wall Street and “post-modern” banking operate in a morally bankrupt culture. Fiscal bankruptcy followed. And that consequence was as inevitable as hypothermia and death following a naked frolic with polar bears in their natural habitat.
Without accountability for failure, “there ain't no such thing as a free market”.
The story continues…