Market-Based Management®

Someone Finally Takes the Time to Analyze the Housing Bubble

In an age where everyone seems to boil complex issues down into simple platitudes, such as “greed,” it is nice to see that Dr. Arnold Kling has taken the time to dissect the Financial Crisis of 2008. Of course, any comments I have on the paper will do it little justice, but (with apologies to Dr. Kling) I will endevour to try and provide some summary for our busy blog readers who may not have the time to read the entire paper.

Although there are many insights in the paper, perhaps the most profound is Dr. Kling’s discussion of how the regulatory remedies for past financial crises ended up contributing to the future ones. For example, after the record number of bank failures and home foreclosures in the 1930s (a problem exacerbated by regulatory prohibitions on bank branching), the government began encouraging 30 year mortgages, introduced the mortgage tax deduction, and added depositor insurance. Although very popular (the mortgage tax deduction is very popular with me), these measures rewarded indebtedness and encouraged folks to spend more on housing. If we fast forward to the rampant inflation of late 70s and early 80s, we find savings and loans holding portfolios of 30 year mortgages whose values were rapidly being destroyed by inflation. Additionally, the S&Ls were forbidden from raising the interest rates they paid above a specified “Q” rate. As potential depositors could get more for their money in money markets with the same amount of liquidity, they withheld their funds from the S&Ls. Subsequently, the S&Ls found themselves in the lose-lose situation of holding imploding assets and facing a dry creek for cash flow. Desperate, and with the knowledge that the government insured their customers’ deposits, many S&Ls went “long” on high risk deals with the potential to save them. Eager to keep these institutions open, regulators complied (another underlying current in Kling’s article is that the supposedly “un-greedy” regulators appeared at best indifferent and at worst played cheerleader to the actions of “greedy” bankers). After many S&Ls went bust, regulators started to explore ways of avoiding what had caused the S&L Crisis. The Q rate was phased out, but the problem of inflation eroding mortgage assets remained. The solution was to encourage the securitization of mortgages.

Securitization promised increased lending to poorer potential homebuyers while supposedly spreading the risk. However, the Basel Accords (an agreement reached in 1988 among the central bankers and regulators of ten countries including the U.S.) inadvertently increased the risks associated with securitization. As far as I can tell, the Basel Accords included a provision which attempted to set standards for capital reserves held by banks. However, banks often held reserves in many different forms (cash, government bonds, corporate bonds, and mortgaged-back securities). Basel tried to get regulators to agree on how “valuable” each of these different types of reserves were according to their risk, which was assessed by a risk multiplier against their face value. For example, as cash and government bonds hold little risk, every dollar of cash or bond counted as a dollar in capital reserves. Since corporate bonds are considered riskier than government bonds, a bank holding corporate bonds in reserves could not count them at face value but at a discount. For example, $1 in corporate bonds may only count as $0.50 worth of reserves. Although not in the top tier of gash or government bonds, guess which type of financial instruments were considered to have the next least risk? Yes, mortgage backed securities! Accordingly, the banks loaded up on them. This overvaluation of mortgaged-backed securities essentially allowed banks to lend more and keep lower capital reserves. Unfortunately, when the price of these mortgage-backed securities collapsed, banks’ reserves fell below minimum requirements leading to what is best described as the insolvency of the banking system.

Of course, there are many more worthy points to mention (for example how in 1968 the government used Fannie Mae and Freddie Mac as vehicles to keep government subsidized housing debt out of the federal budget deficit and thus avoid a budgetary procedure that allowed Congress to challenge appropriations for the Vietnam War), but the core of Kling’s argument is that over the course of seventy years the government created a regulatory environment that elevated mortgage lending above other forms lending (commercial lending for example). All that being said, I do not want to make out that the article is a government-bashing blame game; the article is an impartial look at the incentives created by regulatory structures. As a society and through a free and fair political process, a majority decided that we valued housing enough to subsidize it. Unfortunately, the realities of economics dictate that when you subsidize something, you tend to get too much of it.

The Mortgage Mess Explained (Sort of)

I get a lot of questions in class regarding the current mortgage mess and subsequent credit crisis. While I try my best to answer, I think the honest truth is that no one really knows what exactly has happened and whatever the truth is often distorted by pundits and ideologs. So here it goes—my best effort to explain this mess the best I can, and, as always, corrections and knowledge sharing is more than welcome.

One thing must be made clear—the mortgage market is not a free market—it is pricked and prodded at nearly every point by government activity that has distorted the process. True, there is much involvement by private entities, but we shall see how their actions merely responded to incentives offered by government manipulation of the market.

So it all begins with depositors leaving their money with the bank. Since deposits are insured by the Federal Deposit Insurance Corporation (FDIC), depositors need not do due diligence on the financial institution they leave their money with and don’t care if the latter make silly loans. Flush with cash from reassured depositors, the banks look to loan it out. Say Joe Schmo wants to buy a home, but Joe has lousy credit (we will avoid the usual credit points system and just give Joe a CCC rating). If Joes was a company looking to borrow money, then the bank may think twice, but there are no worries with the mortgage—Joe may not even have to put any money down—just pay the fees and Joe has his loan. Why would the bank do something so foolish? Because, it is not foolish. The bank doesn’t have to hold onto the mortgage and wait for Joe to default. In fact, the bank probably wants to get rid of Joe’s mortgage as fast as possible. Luckily for the bank, there is always a willing buyer for troublesome mortgages like Joe’s. Fannie Mae and Freddie Mac (two technically private entities chartered by the federal government) will buy the mortgage from the bank. The bank now has more money to lend out to the Joe Schmo’s of the world (who also may or not be real estate speculators) and also has the incentive to repeat this cycle over and over again.

However, Joe’s mortgage does not stop with Fannie and Freddie. Fannie and Freddie take Joe’s loan and combine it with other mortgages to create mortgage-backed securities, which they then sell to investors. Fannie and Freddie then use the money to buy more mortgages from banks who loan the money out again. So what self-respecting investor would buy a security backed by shaky mortgages? The answer is a conservative investor adverse to risk. “Huh?” you say, “why would a conservative investor buy something backed by a bunch of mortgages taken out by folks with lousy credit?” At this point the investor neither knows nor cares about Joe and his credit. When Fannie and Freddie sell a mortgage-backed security to an investor, they guarantee the mortgage payments. As far as the investor is concerned, the mortgage-backed security is sound as a pound. It was for this reason that mortgage-backed securities proved popular with traditionally risk adverse financial institutions such as insurers (like AIG) and hedge funds. Since a mortgage-backed security guaranteed a stream of interest payments, investors found all sorts of uses for them. A common use was as an interest rate swap, where a company looking to hedge against cash flow difficulties would swap its cash flow for the guaranteed stream of interest payments from the mortgage-backed securities. In short, mortgage-backed securities appeared to be a great way for companies and financial institutions to hedge against risk.

Unfortunately, what looked to be a firm foundation ended up being made of sand, because behind all those “good as gold” mortgage-backed securities lay Joe Schmos with rotten credit. The problem was that when credit rating agencies looked at mortgage backed securities, they didn’t see Joe and his CCC credit but guaranteed financial instruments which gleamed AAA and imparted this shine to the institutions holding them.

So what happened? Many of the loans had been made at adjustable, rather than fixed, rates. Since many folks had borrowed much more than they should of, even a small increase in interest rates meant big increases in mortgage payments. Not surprisingly, more and more people began defaulting on their mortgages as rates increased. Conventional wisdom had held that this would not be such a big deal for the holders of defaulted mortgages. After all, the house could always be sold to cover any losses. However, the prolonged slump in the housing market meant homes sold at greatly reduced prices or not at all. Entities such as Fannie and Freddie found themselves held to guarantees that they could not meet. Deprived of their guaranteed interest payments from mortgage-backed securities, investors (and the credit rating agencies) began to see what really backed the securities—homeowners with poor credit living in much depreciated housing.

This is when the house of cards fell down. No longer able to simply make dodgy loans and sell them to Freddy and Fannie, the banks started being more careful about who they leant to. The tightening of credit led to even less home buying and further depressed the market, which pushed the value of mortgage-backed securities even lower. Meanwhile, at the other end of the spectrum, investors discovered the real worth of the mortgage-backed securities they held. Many venerable institutions suddenly found themselves writing off billions of dollars in assets, and some, like Bear Stearns, simply imploded. To make matters worse, the use of interest rate swaps meant that companies with no real connection to the mortgage market saw their cash flow hedges dry up. In the meantime, consumers started worrying about paying their mortgages and fiercely reined in their spending, which caused the economy’s aggregate demand curve to shift back (or to the left). The subsequent evaporation of demand is now driving down prices, eroding profits, and producing layoffs, which are, in turn, leading to more defaults and further depressing consumption. To be blunt, we are in for a very rough tide. However, barring nuclear war, things always get better over the long-term. The good news about sharp recessions is that they are often over the fastest. Furthermore, as I blogged about earlier, the government’s reaction has been nowhere near as pigheaded as in the past, but will more government oversight stop this from happening again? Probably not, the chief culprit behind this mess has been the government’s thirty year drive to encourage homeownership in America. While this is a worthy goal, it depends on cheap credit given to those who may not be entirely credit-worthy. Somehow, I do not think this policy will change anytime soon, and it will only be a matter of time before those on Capitol Hill call again for easy lending, and then we start all over again.

Markets Fail When You Make Them

Ok, I made a bad prediction in my previous post about gasoline coming to Georgia in the wake of Hurricane Ike. I know it was a bad prediction, because I drove to Atlanta Airport on Sunday and did not see a single gas station with petrol (although news reports say about half do). So why was I wrong, and why has the market appeared to fail? First of all, my prediction was based on the premise that the market would be allowed to work. Gas can be found in the Southeast—just not in Atlanta. Why did every station I saw in rural Mississippi and Alabama earlier this week have gas, while those in Atlanta did not? The answer is that it would be illegal to sell the gas available in the country or suburbs in Atlanta proper. The American gasoline market is not a single unified market, but a deeply fragmented patchwork of markets where federal clean air mandates dictate what types of gasoline (called boutique fuels) can be sold where. Because of its air pollution problems, only a special boutique fuel can be sold in Atlanta. After hurricanes Katrina and Rita, the federal government wisely suspended these fuel mandates and momentarily recreated a national market for gasoline. While this measure did have a temporary effect on air quality, it prevented many of the shortages that we now see today. Unfortunately, the feds did not follow this policy after Ike, but kept the mandates in place, which is the reason that Atlantans wanting to fill up either have to wait for scant fuel deliveries or dive to the suburbs or country.

Another curious going on is that when there is gas in Atlanta, prices do not appear elevated and are roughly on par with those before the hurricane. So why with all this scarcity, are gas stations charging prices close to pre-hurricane levels? The answer probably lies in the overt threats from state and federal officials that they will go after price “gougers” for selling gasoline at high prices. As I mentioned in the previous post, the Georgia price “gouging” law is fairly toothless and not even currently applicable (the governor has to declare a state of emergency for the statute to come into force). I erroneously believed that the benign nature of this law would not impede rises in Georgia gas prices and subsequently encourage conservation and supply. However, most gas station owners are either only vaguely aware of this or think the feds will get them instead. The effect has been a de facto price ceiling on gas prices in the Atlanta area, which gives motorists the incentive to snap up gas when it is available, rather than weighing much higher prices (say $8 a gallon) and buying only a few gallons at a time. This is exactly what I—and everyone else ay my neighborhood station—did when a gasoline shipment arrived. As a result, folks who would otherwise drive around with half or quarter tanks fill them up (and top them off) whenever possible. I am running with a full tank right now but would have left more for my fellow Atlantans had the price been higher. Unfortunately, the situation has unleashed my (and apparently everyone else’s) inner speculator.

Why there will be Gas in Georgia

With the approach of Hurricane Ike, I started to wonder if I should fill my gas tank prior to the inevitable disruption in the nation’s refining network. However, a quick google search revealed that Georgia (where I am) has a very tame anti-price “gouging” statute, which only comes into force when the governor declares a state of emergency (unlikely considering the state of emergency is in Texas). At the same time I noticed that those states neighboring Georgia (primarily Tennessee, South Carolina, and Florida) have more strongly worded statutes, and their public officials have been making noises about enforcing them come the inevitable spike in prices. In a market economy, prices provide the knowledge governing production, distribution, and consumption. If you monkey with this system by implementing a de facto price control in the form of an “anti-gouging” law, then you recreate the foolishness of the price controls of the early and late 70s. Of course, the full impact depends on Ike, but even if some shortages occur in Georgia; we will certainly fair better than our neighbors to the north and south.

Spontaneous Order Revealed

Spontaneous order is a key mental model in Market-Based Management and is loosely defined as the miraculous emergence of order from the seemingly chaotic interaction of billions of human beings. Adam Ferguson famously described it as "the result of human action, but not the execution of any human design." In MBM, spontaneous order represents our mental model of how the world works. That is, the world is made up of billions of self-interested individuals who provide for one another by pursuing their own self interests. If an individual or business fails to provide for others, then it will fail in providing for itself. I was acutely reminded of spontaneous order while viewing this short clip on the BBC. It depicts GPS tracking of ships, planes, and taxis (among other things) traveling in and around the British Isles within a 24 hour period. Not only is the clip amazing, but it serves a reminder that chaos is often not so chaotic.

When No One is Accountable

There is a fantastic post by former Treasury Secretary Larry Summers over at Creative Capitalism (HT: EconLog’s Arnold Kling) on the bubbling problems at Fannie Mae and Freddie Mack. I will let the post speak for itself, but for decades politicians have trumpeted the idea of public-private partnerships, as a sort of “third-way” where the supposed deficiencies of markets and government cancel one another out. Unfortunately, as evidenced by the growing troubles at Fannie and Freddie, this combination of conscience and profit is probably responsible for much of the trouble. What does one of these partnerships tell its private shareholders when there are no profits? It tells them that the company’s social obligations are to blame. What about when the partnership fails in its social obligations? The company explains that it has done so in order to fulfill its obligations to profit its private shareholders. As for the shareholders, should they keep an eye on the company’s books or question its debts and lending practices? Why bother, since the partnership’s debts are guaranteed by the government. In the end, we are left with a perfect storm of unaccountability—be careful of mixing two worlds, you may get the worst of both.

Creative Destruction Threatens Snail Shortage

Where have all the good snail collecting jobs gone? The answer appears to be nowhere—the problem is finding people willing to fill them. Snail gathering is hard work, but someone has to do it—otherwise Europe’s gastropod lovers (the French in particular) will go without escargot. Unfortunately, relatively high wages in France and the extension of protections to some species of snail nudged the French snail industry into slow decline some years ago. Fortunately, the demise of the Berlin Wall brought a flood of slimy molluscans from Eastern Europe, as impoverished villagers in Poland and Bulgaria proved only too happy to perform the dirty work and keep the escargots flowing.

That was until economic development in Eastern Europe brought better things to do, and would-be snail gatherers have moved on to more rewarding occupations. Now there is consternation in France that foreign supplies of snails may dry up and deprive Frenchmen of their beloved escargot. The pending snail crisis is an example of newer and better jobs crowding out the old—a process the great economist Joseph Schumpeter popularized as “creative destruction”. By providing greater opportunities, the rising tide of Eastern European prosperity is simultaneously destroying its snail industry. This is a telling reminder that, while we are bombarded with tales of this or that industry failing or moving oversees, the truth of the matter is this is often a symptom people of a country finding better things to do. At the same time I fear not for the French. I am sure they will get their snails from somewhere, as the nations of Eastern Europe pass the torch of snail gathering to peoples with lower opportunity costs, who will be delighted (and much better off) for receiving it.

The Importance of Vetting Knowledge

MBM talks a lot about collecting and sharing knowledge. However, we sometimes don’t stress the need to understand exactly what that knowledge means. Often what appears a clear connection is really quite meaningless. I was reminded of this by an article in today’s Arizona Republic (HT: Coyoteblog). The article complains that consumers are being “gouged” by faulty gas pumps. Apparently, about 9 percent of Arizona’s inspected gas pumps failed tests by the State’s Department of Weights and Measures. The article is full of innuendo and numbers implying there is something rotten in the state of Denmark (or at least Arizona). Despite the tone of the article, the fourth sentence begs some curiosity:

Half of those [pumps] were malfunctioning to the detriment of customers.

Faulty pumps are not good, and people getting ripped off is not good; but if half of the malfunctions cause detriment to customers, then what about the other half? Are some of the good people of Arizona getting a little free gasoline? Of course, I do not doubt the need for governments to standardize and inspect weights and measures (the practice dates to the Magna Carta (clause 35) in the Anglo-American tradition), but the little nugget on the impact of these inaccuracies tells us that this situation is probably happenstance or, at worst, neglect on the part of the pump owners. Interestingly, the article also mentions that it can cost up to $800 to recalibrate a pump, which considering the thinness of margins in retailing gasoline (only a few pennies on the gallon), is probably incentive enough to recalibrate infrequently—as opposed to deliberately fiddling the pumps. Furthermore, as the fine for a first time offense is only $300, it makes perfect sense for the gas station owners to have the state come out and do the inspections for them (paying the fine and fixing the affected pumps should be much cheaper than constantly re-calibrating of all of them). So, while malfunctions of 1 out of 11 inspected pumps causes us to quickly jump to conclusions, a little vetting of information reveals nothing more than perhaps the nature of pumps, happenstance, poor incentives, or the combination of all three—meaning only a few lines tell the whole story, and they don’t match the rest of it.

Entrepreneurs and Disaster

Last week ago, I was struck by this Wall Street Journal article recommended by Jamie Peterson at INVISTA. The article concerns the sprouting of entrepreneurship in the aftermath of the recent devastating Sichuan Earthquake in China (unfortunately, reading the full article requires a Wall Street Journal subscription).

Interestingly, entrepreneurs are often the first to swing into action following a natural disaster (the first trainloads of lumber for rebuilding arrived the very day after the Great Chicago Fire of 1871). However, sometimes the imposition of price controls and “anti-gouging” statutes quash these efforts by removing the incentives needed to induce the effort. Although price spikes following natural disasters are common, price controls only force the squandering of scarce resources within the affected area, while choking off flows of supplies from outside. If allowed to operate, the price mechanism usually forces prices back down fairly quickly and sometimes even gluts the market.

I wrote about this phenomenon a couple years back in the ABA's Journal of Natural Resources & Environment, and economist Russ Roberts has dedicated his latest work of economics-influenced drama to the topic. However, the overwhelming need for flexible markets following natural disasters is not the purpose of this post: it is that, despite decades of being told to despise entrepreneurship and other “bourgeois” values, in the wake of disaster, many Chinese discovered their inner entrepreneur. A lot of folks make silly comments like “markets are not compatible with _____ culture” (personally, I blame this false mental model on Max Weber’s attributation of capitalism to some vague notion of “Protestant work ethic”).

The Sichuan Earthquake reminds us that people are naturally entrepreneurial. Entrepreneurship is in our blood and no amount of cultural conditioning or even brute force can completely stamp it out (considerer the phenomenon of black markets). Of course, some countries exhibit greater levels of entrepreneurship than others, but this is because some countries do a better job of facilitating the human desire to benefit one’s self through the service of others. True, one’s inner entrepreneur maybe repressed by governmental, cultural, or overly bureaucratic corporate environments, but it is always there; and a little shove from within makes a much better catalyst than an earthquake.

The Heroic Entrepreneur

Most folks tend to think well of entrepreneurs. We cannot help but admire those who work two jobs to scrap together capital, while tinkering away in their garages or basements at night. Of course, the opinions of some tend to diverge after the erstwhile struggling entrepreneur transforms himself into something resembling a captain of industry, technology, or even coffee, but even the critics of free-market capitalism cannot help but offer grudging respect for the energy, effort, and chances taken by the entrepreneur.

While we admire the entrepreneur, we often forget that bygone entrepreneurs used to risk much more than bankruptcy or the other adverse effects of over work—they often put their lives on the line to provide goods or services for others. Nathaniel’s Nutmeg: How One Man’s Courage Changed the Course of History is the story of the first English traders who ventured to the East Indies (present day Indonesia). From rough seas, scurvy, and rotting ships to the literally “cut-throat” competition from the Dutch and native cannibals, Nathaniel’s Nutmeg details how entrepreneurs in search of fantastic profits risked, and often gave, their lives to feed Europe’s demand for spices. Ten pounds of nutmeg that cost less than one English penny in the East Indies would sell for two and a half pounds sterling in London—a markup of 60,000 percent! Of course, the King would take a reasonable cut, but there was little talk of windfall taxes on the lucky few who returned to fortunes and a lifetime of free drinks exchanged for tales of the East Indies.

The story itself centers on the tiny (about two and a half miles long) East Indian island of Run, which, although almost completely forgotten, used to be one of the most famous places in the world. One of the more inaccessible of the Spice Islands, it was here that English traders befriended locals and bought huge cargoes of nutmeg under the noses of the powerful Dutch East India Company. After years of being piqued by the cheeky English, the Dutch eventually attacked and seized Run triggering war between the two countries in the 1660s. At peace negotiations in 1667 (following two years of stalemate), the Dutch and English settled on an exchange of territories each had seized from the other. The Dutch would gain control of Run, while the English received what had been the disappointing colony of New Netherlands, which we now know as New York City and New York State. At the time, most observers thought the Dutch got the better of the bargain.