Market-Based Management®

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.

This is NOT another Great Depression

Times are not good, but pundits should really stop talking about us being in another Great Depression. Sure there is a banking crisis on, but they have happened before. Sure the government is doing silly things like bailing out industries and passing ineffectual “stimulus” packages. However, the government reaction to the current crisis is by no means comparable to the combined stupidity of the Hoover and Roosevelt Administrations. When the Great Depression hit, the government sprung into action (especially Hoover who is often wrongly labeled as doing nothing). Unfortunately, the government proceeded to take the worst possible actions. Below is a list of three broad categories of actions taken, which, if they did not make the Depression worse, certainly prolonged it:

1.Higher Taxes: The Revenue Act of 1932 raised taxes across the board with the top rate going from 25 to 63 percent. The law also doubled the estate tax and raised the corporate rate to 13.75 percent. Subsequent revenue acts in 1935, 1936, and 1940 added further increases with the top rate eventually reaching 79 percent. Although corporate taxes only rose to 22.1 percent, the 1936 Act provided for the taxation of undistributed profits (those not paid out in dividends). Furthermore, the 1940 Revenue Act created a 50 percent top rate on “excess” corporate profits. Despite these draconian tax measures, the hikes produced little in the way additional government revenue, nor did the nation achieve any significant gains in the way of decreasing inequality.

2.Higher Tariffs: Passed in 1930, the Smoot-Hawley Tariff raised tariffs on 20,000 items to record levels. Foreign governments retaliated with tariff hikes of their own, and world trade contracted an astronomical 66 percent between 1929 and 1934. Both U.S. imports and exports declined dramatically, and the breakdown of international comparative advantage took a heavy toll on the world’s total economic activity.

3.Tight Credit: Although it is difficult to characterize the government’s confused monetary policy in the 1930s in a single paragraph, the end result was that the money supply contracted by about one-third, which led to deflation. Furthermore, as government had pressured businesses not to cut wages, deflationary pressure on wages manifested itself in massive unemployment. Rather than easing rates, the Federal Reserve raised interest rates, while insisting that banks hold higher reserves. Those banks that did not fail (and prohibitions on branching meant that thousands did) ceased lending.

With the disasters above in mind, let us take a look at what is being done now:

1.No (or fewer) Higher Taxes: Congress has apparently lost its stomach for higher taxes, and talk has shifted away from raising taxes and towards postponing any pending rollbacks of the Bush tax cuts. Even if taxes were to be “unlowered,” then the top rate would revert to the old rate of 39.6 percent, which, while steep, ain’t 80 percent. At 35 percent, American corporate taxes are already some of the highest in the world, so there is not much room for them to go higher. Furthermore, the stock market slump has promptly silenced most calls for an increase in the 15 percent capital gains tax, which would—at worst—revert to the old rate of 20 percent in 2011.

2.No Higher Tariffs: While valuable free trade deals with South Korea and Columbia are on hold, no Smoot-Hawley-like tariffs appear in the works. In fact, the one solid thing to come out of the recent G-20 Summit was a pledge by member nations not to raise tariffs. Even if nations do begin to raise tariffs, unlike in the 1930s, the World Trade Organization (WTO) exists to moderate disputes and hopefully prevent the catastrophic trade wars of the 1930s. U.S. tariffs are low and will likely remain that way. Despite the tough anti-trade rhetoric of the presidential campaign, it is likely just rhetoric. When a campaign pledge to renegotiate NAFTA caused concern in Canada, Ottawa was essentially told privately that it really was not serious.

3.Ample Credit: Rightly or wrongly, the Federal Reserve and the Treasury have provided ample liquidity to financial institutions. Despite cries that the credit market has “seized up,” inter-bank lending remains high. Banks are willing to extend credit to those with good credit ratings—just not as much to those who should not be lent money in the first place. Although the current crisis springs from many causes, a major implication is that the repackaging and backing of mortgages created an unnaturally high mirage of widespread credit worthiness, which (considering that these mortgages were backed by valuable assets—as in homes) was perhaps not altogether unreasonable. Yes, many banks are in trouble, but the credit will be there to stave off most collapses, while drastic deflation (despite huge drops in demand) is unlikely to materialize.

Of course, there is much to write about this subject, which is complicated and even not fully understood. However recessions happen. They can be sharp and quick or long and shallow. The deciding factor is often government reaction. The Great Depression did not just happen, poor policies took a recession and stretched it out for 11 to 20 years (depending on who you talk to). So while we complain about the bailouts, it is important to remember that much dumber things have been tried in the past. The current economic slump maybe painful, but it will not be another Great Depression. Markets are tremendously creative and resilient forces. They will always fix themselves—as long as they are allowed to.

Making Money the Old Fashioned Way

This would be hilarious were it not also tragic (HT: Coyoteblog). PickupPal is an internet site that allows would be carpoolers to meet online and coordinate travel plans. Drivers post when and where they are going, while passengers post where they want to go and how much they are willing to pay. Sounds like an ideal win-win situation—the folks save money, gas, and reduce congestion. However, not everyone was thrilled with PickupPal, and an Ontario bus company sued alleging that PickupPal operated as an unregulated transport company. The bus company won. The Ontario Highway Transportation Board fined PickupPal $11,000 Canadian dollars and ruled that ridesharing is only legal if it is between home an work, does not cross municipal boundaries, and is with the same driver each day (who can only be paid no more frequently than weekly).

While prosperity springs from multiple sources, at its core lies the amount of freedom that people have to exchange with one another. When this freedom is circumscribed by legal boundaries, then society is almost always worse off. Of course, while we as a society may wish to limit some exchanges (arms dealer and terrorist for example), restrictions like those placed up PickupPal are both silly and destructive. The bus company is better off, but the good people of Ontario now have a slightly lower standard of living. We may laugh at this example, but all over the world consumers have their choices by similar legal boundaries. Paradoxically, most of these laws are championed by “consumer advocates,” who advocate for consumers by limiting their choices. Needless to say, companies are more than happy embrace laws that protect them from additional competition. While the title of the article is “I’ll Never Let Canada Live This Down: Evil Carpool Startup Fined,” I cannot help but think that we will see PickupPal sued south of the border soon. Cities and states won’t stand for the loss of revenue or the lucrative practice of selling taxi cab monopolies. The excuse will be lame—probably something having to do with quality or the service will be blamed for the inevitable traffic fatalities or some sort of carpooling serial killer—but it will come; and we will all end up a little poorer.

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.

Follow the Box!

This is neat. The BBC has installed a GPS transponder in an ordinary cargo container box and will follow it around the world for the next year. The project is meant to highlight the explosion in global trade that has fueled so much economic growth since the 1950s and done so much to raise living standards. Anyway, the box is on its way—bound for China full of delicious Scots Whisky. It will be interesting to check in from time to time to see where it is going next, and, perhaps more importantly, what it is carrying.

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.

Creating Jobs by Breaking Windows

Like anyone who grew up playing with GI Joes, I still find military hardware neat—an enthusiasm tempered only by the massive costs involved. Most folks are familiar with the mental model of “guns or butter,” but this idea was plainly lost on the BBC in this article on the two new aircraft carriers to be laid down in Scotland. According to the BBC, these two great efforts will “create” thousands of jobs. Simply put, they will do nothing of the sort. True, we will observe thousands of Scots heading to the yards, but what we will not see are the thousands of others who would have been going to work somewhere else, had a portion of society’s scarce resources not been redirected towards these floating behemoths.

While a society certainly needs protecting, and the freedom of the seas is essential to global prosperity, such projects do not “create” jobs—they simply redirect them from somewhere else. Economists classify the BBC’s mistake as the fallacy (sometimes parable) of the broken window. In the fallacy of the broken window, some punk kid breaks a baker’s window. A bystander quickly remarks that the damage is a good thing, stating authoritatively that the breaking of the window will boost employment by providing work for a glazer. What the bystander does not see are all the other things the baker may have done with the resources now dedicated to re-glazing. You are probably thinking that this makes perfects sense (and that is because it does). However, as you listen to the news coverage of the aftermath of Hurricane Gustav or even the presidential race (politicians love to talk about “creating” jobs), I can guarantee that some candidate or pundit will count the devastated homes and commit the fallacy of the broken window. The fallacy of the broken window is translated into MBM through our mental model of opportunity cost. Opportunity cost defines the cost of something not as mere dollars and cents, but whatever else could have been done with the time or resources at hand. Every “created” job must be paid for with another job (or jobs) somewhere else. Unfortunately, the victims never know what has happened to them, nor do they see the broken window that has put them out of work.

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.

Not from the Onion but it belongs there

At first I thought Don Boudreaux over at Café Hayek had a hold of my leg with this post about the Onion Futures Act of 1958—until I noticed that he had linked to this Wall Street Journal article and a quick Google search turned up that there really is an Onion Futures Act of 1958. The Onion Futures Act bans futures trading in onions, and came into effect after onion farmers blamed “moneyed interest” and “speculators” for volatile onion prices. The act still remains on the books, and (as far as I know) no other bans on commidity futures exist. So with folks blaming oil prices on “moneyed interests” and “speculators,” what would a ban on oil futures do to the price? Of course onions ain’t oil, but since no other commodity has suffered the same ban, it remains the only example we have.

Despite the ban, onion prices continued to remain volatile. Actually, they became even more volatile after the prohibition of futures trading. Contrary to what had been believed, onion futures trading had actually helped to stabilize prices. Futures are an excellent hedge on risk and a valuable knowledge process. They encourage traders to do their homework and collect and vet mounds of information on what might be the future price. This allows consumers and producers to plan on these prices and respond accordingly. Hopefully, decision makers will come to understand the valuable knowledge provided by futures market and not repeat the onion mistake.