Housing: The Decision - Government or No Government

Finally somebody has said it like it is - Home Prices in this country are supported by the government and if government were to leave the mortgage market to private enterprise, the availability of credit to buy homes would suffer significantly and thus (like for any other asset) prices would fall in tandem with the adjusting of the credit availability.

This is what Bill Gross said after visiting Washington DC last week:
"The private market was nowhere to be found because they charged too much (during the last 12 months, when gov't has been responsible for 95% of mortgages). It was the cost of private origination and securitisation, perhaps more than any other factor, that justified government involvement. Prime, but non-conforming, mortgages (jumbos, insufficient down payments) were being purchased by PIMCO in the hundreds of millions of dollars every week, but at yields of 6, 7, and 8%. If that was the risk/reward tradeoff, compared to FNMA and FHLMC yields at 3.5–4%, how could policymakers pretend that the housing baton could be quickly and cost-effectively passed back to the private market? Few, if any, could afford a new home at those interest rates. If you were a believer in the dominance and superiority of private markets, how could you deny the signal that markets were sending – that the risk was too high given the substantial losses of recent years?... Americans now know that housing prices don’t always go up, and that they can in fact go down by 30–50% in a few short years. Because of this experience, private mortgage lenders will demand extraordinary down payments, impeccable credit histories, and significantly higher yields than what markets grew used to over the past several decades. Could an unbiased observer truly believe that housing starts of two million or even one million per year could be generated under the wing of the private market? In front of Treasury Secretary Geithner and the assembled audience, I said that was impractical. Let me amend that to “ludicrous.”.... Having grown accustomed to a housing market aided and abetted by Uncle Sam, the habit cannot be broken by going cold turkey into the camp of private lending. The cost would be enormous in terms of yields – 300–400 basis points higher than currently offered, crippling any hopes of a housing-led revival to the economy."


I believe the adjustment we just went through is the first phase of what could be another large adjustment if the government decided to get out of mortgages.  The adjustment in home prices is a reflection of removing all the loans that should not have existed in the first place: liar loans (no doc), no down payment loans, reverse amortization loans, interest option, among others - these loans were permitting people to buy homes they could not afford and because there was new demand for every particular price point, asset prices went up - we all felt rich, we all spent more, we all got more indebted, ultimately society created this bubble.   
 
The second phase could be equally hurtful or worse - if government stopped guaranteeing mortgages, mortgage rates would go up significantly, and with them, demand for homes at any particular price point would also drop significantly.  I don't think government will leave the mortgage market (guarantees, mortgage interest deduction, etc) for this specific reason.... which then leads to another question -> how can we create the right incentives as a society to stop so much investment into dead assets - i.e. homes.  Homes don't deliver any economic growth - outside of providing an abode to those that do - at least not in the same fashion as investment in assets that are tied to the production of goods and services.  The other negative effect of homeownership - in periods like today - is that it removes flexibility from the labor market.  Owning a home does not allow people to move to find work as easily as if they were renting.  Obviously owning a home provides many positives for people, famiilies, and society, yet this last argument is purely an economic one.
 
Going back to the beginning of the article - politics are playing a big part in the public's perception of the economic reality today - are future deficits good or bad? did an increase in government spending do any good for employment and growth? what would tax cuts do relative to spending? etc... and I have seen a lot of people denounce Fannie and Freddie and the government's involvement in the housing industry and a call to allow the private market to run its course... I question if these people are also willing to put the country into another 20-30% adjustment of home prices and the carrying risks to the financial systems that go hand in hand with that.
 
In the end, at a minimum, we should do everything we can to not allow ourselves to fuel these types of bubbles going forward because as we have seen its almost impossible to get out of them (at least in an optimal fashion).

Deflation vs. Inflation Discussion

Lately, arguments on the future prospects of the economy have turned very confusing - so many people worried about the growing deficit and debt, and the potential implications on the currency and high inflation and yet so many other people calling for more deficits and monetary easing due to the fears of deflation.  Aren't these two monetary phenomena diametrically opposed? and if they are, how can the market be arguing for the two extremes at the same time?

The answer is yes - they are opposed, and yes, the market has a right to be arguing for both at the same time. At a high level - very significant (fiscal and monetary) measures that could create some serious inflation need to be taken (or better said, need to be expanded) to make sure we don't fall into a deflation trap.  Japan has been taking measures for twenty years that would spark fears of hyperinflation and lead to devaluations in most countries, yet, despite those measures, after all these years, its still dealing with falling prices and an appreciating currency.

In simple terms - I've beaten this horse to death - we borrowed significant amounts of money and invested them in non-productive assets.  There is no difference between us having invested all the mortgage debt we took out (close to $10Tr to be exact) in homes or in statues (ok, there's a slight difference - we can sleep and eat in our homes, where we wouldn't be able to do it in statues)... yet, while we spent all that money in statues, we still owe the money - but our productive capacity to repay it is less than what its supposed to be...  Since we owe so much money with limited productive assets to pay back, our individual decisions point to our savings to pay all that money back - which then puts the economy at risk, which leads companies to invest less, to get leaner, which leads to potential contraction and to potentially lower prices - starting a downward spiral... that also leads to an appreciating currency (because of the falling prices, which makes exports less competitive, despite all the printing of money)... that's the deflation trap we need to do everything to not fall into, its a very bad situation....

So, we will undergo all the practices possible to not fall into it - printing money, providing economic stimulus, etc (if our politics allow it after the elections) - which will ultimately lead to rampant inflation (too much money chasing too few goods) and currency debasing... yet its something we need to do to not fall into the trap above...

that's how we can be talking about inflation and deflation at the same time... we need to take inflationary measures to not fall into a deflation trap.  this is all the result of the bubble we all lived through - facilitated by the Fed for so many years, as to how they let it become this way - its a function of another posting...

Of Basketball, of John Wooden and of Life

I played basketball when I was young, I played a lot of basketball, at a competitive league, in school - elementary, middle school, JV, varsity; I spent hours on a daily basis on a basketball court. I don't play anymore, in fact I haven't played competitive basketball (other than pick-up games) since I turned 18 years old (I went to a Division I university, one with a pretty good basketball program - not that I would've had a chance in Division III anyway).

I always look back and think about what that time investment gave me... and today I believe it gave me a lot. Beyond the physical exercise and the camaraderie, competitive/organized basketball provides a lot of very good things for later in life. It taught me to be unselfish, to understand how far true teamwork can take you, it gave me enough experiences to understand that sharing success with others is better than sharing success by yourself.   It teaches you the meaning of competition - that feeling of having an opponent yet knowing that their excellence is nothing more than a goal/target for yourself to improve; and for when that success is reached it then means so much more.   It teaches you that actions have reactions- both in the good sense and the in the bad sense; the unwritten code of behaviour that says that everything we do is not in a vacuum and that it has consequences.  Lastly, among so many other things, it teaches you that hard work gets you closer to any goal you may have, there is no such thing as a free lunch, hard work is as necessary in life as it is on a basketball court.


I could write for hours of the many things that basketball gives players or coaches...but, I want to get to John Wooden, the legendary UCLA coach who yesterday died four months before his 100th birthday. While I never met him and never saw him coach (I was born the day before he coached his last game at UCLA - winning the national championship against Kentucky on 3/31/75), I've read about him and followed him for quite some time. I always struck me how a nice and humble person had been so successful, in fact the most successful college basketball coach (arguably on any sport) of all time. Just scratching the surface of his thoughts provides a lot of insight as to how this man was so successful in trade and in life - I would say as successful in LIFE as anyone can be, here are some of his quotes:

• Success is peace of mind which is a direct result of self-satisfaction in knowing you did your best to become the best you are capable of becoming.
• Don't measure yourself by what you have accomplished, but by what you should have accomplished with your ability.
• If you're not making mistakes, then you're not doing anything. I'm positive that a doer makes mistakes.
• It isn't what you do, but how you do it.
• Never mistake activity for achievement.
• Success comes from knowing that you did your best to become the best that you are capable of becoming.
• Failing to prepare is preparing to fail.
• Be more concerned with your character than your reputation, because your character is what you really are, while your reputation is merely what others think you are.
• The main ingredient of stardom is the rest of the team.
• You can't live a perfect day without doing something for someone who will never be able to repay you.
• Consider the rights of others before your own feelings, and the feelings of others before your own rights.

He also shared thoughts from his father: "The Seven Point Creed"

• Be true to yourself.
• Make each day your masterpiece.
• Help others.
• Drink deeply from good books, especially the Bible.
• Make friendship a fine art.
• Build a shelter against a rainy day.
• Pray for guidance and give thanks for your blessings every day.

He wrote various books, which will become more popular now... and perhaps his main one was based on something he instilled on his UCLA players: the Pyramid of Success (which also has an application for life) - the attributes required to be a winner on the court and in life.
 
I have no doubt John Wooden would have been successful in anything he set out to do - he was successful as a husband, father, grandfather, friend, basketball coach, author, lecturer, among others.... in the same way he would have been successful as a CEO or even as a politician (maybe not, he was too nice , :)). 
 
May he rest in peace and may his teachings and examples which are applicable on the court as off the court (for basketball as in life) serve various generations in the future.

The Euro - the clock is ticking.

As I established a year ago - its a matter of time for the less competitive countries in Europe (Spain in my example) to run into trouble within a common monetary system with more competitive countries.  The inflow of money that comes with the anchoring of the monetary unit combined with the missallocation of credit (to non-productive uses) or simply the expenditure of that money ultimately leads to a situation where the country becomes uncompetitive, and will ultimately lose its ability to grow out of a recession. 

Spain, Italy, Greece and Portugal (and Ireland) are in that predicament and no matter how much the ECB and its sister countries "throw" at the problem (i.e. to cover debt maturities in each one of these countries), its a problem that has no easy solution.  The only way to solve the lack of competitiveness for these countries is to coordinate salary deflation across its public and private sector to regain the competitiveness it needs.  Since we know from history and reason that is not possible, there is only one ending to this story: devaluation (and in most situations)  default.

Let's take the two extremes: Greece - has an uncompetitive private sector and a bloated public sector + unsustainable debt levels - it will simply default, leave the euro, and devalue.  For Spain the story is a little different - it has an uncompetitive (less in relative terms than the Greeks) private sector + a bloated public sector (less than Greece) + a sustainable debt level (At this pt).  So, for Spain, while its still liquid, the engine that generates profits in that country is dead (within the Euro) - its like a company with little debt, yet, it can't make money for the foreseeable future, so its wholly dependent on creditors (who are happy to lend the hot potato at above market levels, knowing that there are certainly places where they can unload the debt at a partiucular pt in time).  So, if Spain gets out of the Euro now, devalues, it might not have to default...however, reason and politics tell us that it will obviously stick it out and then devalue.

The lack of central taxing authority (to take care of most needs of the population) + the lack of mobility for people is what puts all the countries (who are not equally competitive) in this bind.  A solution for the lack of competitiveness in these countries would have been: (1) to have a central authority take care of basic people needs (i.e. so there is no country-specific political turmoil - think a US state), or (2) for unemployment to have a high bar as people can easily move to other places with more work (Again, think the US under a common language - or taken to the extreme - think Puerto Rico, whihc has about 4MM Puertorricans in the US).

The better question is what then remains of the Euro if these four countries leave?
Let's see where this story takes us, as its not easy to exit these monetary unions.

The trading / buyer beware culture that doesnt add anything to society

The unfolding events for Goldman Sachs exemplifies the grotesque trading culture that has invaded our banking system. Its probably better suited to generalize the behavior by calling the responsibles traders as opposed to bankers.
You see, the banking function is supposed to allocate capital from savers to investors (look for best uses). In doing that, it performs a key function in society and in the economy - providing the funds that ultimately fuel our economic growth. That function if combined by agents who are aligned with their shareholders (i.e. management who is aligned with its shareholders), can never be speculative in itself, because the future of the firm depends on its investment decisions. Clients become sacred, and the reputation of the firm is its most important asset to maintain its going concern value.
In the trading culture that has invaded Wall Street through periods of excess, the agent as a trustee of its shareholders has broken down, and thus the clients also lose value. Its a fee-based culture, buyer beware culture that would lend itself to excesses, bubbles and busts.
When "traders" are motivated by the turnover of transactions (because that's what generates fees) as opposed to their end result, and when the short-term gains are greater than the lost trust from their clients down the road, human greed will lead to situations in which there are a few fee-based unscrupulous winners, and a lot of losers (usually society as a whole, as an example - the current housing bubble).
Furthermore, this behavior doesn't add any value to society. The synthetic securities that were created didn't add anything to society - they didn't provide any funding to new industries or companies - they simply were financial creations that allow a double-sided bet. The bad part is that in these creations there is usually one side that has full information, whereas the other side is "searched for" in any corner around the world (even if they are accredited investors). These securities didn't really have a reason to exist other than making some fully informed parties very rich, and providing very good returns for their fee-based bankers in the middle. That industry grew to a size it should have never grown.
Another example of the fee-based, buyer beware culture that permeates every bubble (with a lot of fee-based middle men in the middle), we can also simplify the housing bubble. The allocation of capital to buy homes went from a simple party to party transaction (bank to borrower) to one in which there could be up to X layers in between the actual lender and a borrower (the transaction was essentially created by the middlemen, otherwise it would not have happened). Lets assume a future borrower was looking for a home and is enticed into buying a bigger home (with a bad loan) by a mortage broker (middlemen #1 - who collect a fee if a loan is made), who then connects that borrower to a bank (mmen#2 - who collects a fee for selling that loan to a Wall Street bank, only way they make the loan), who then sells the loan to Wall Street (mmen #3 - who collects a fee for packaging a lot of these loans), who then sells the loan to the end investor (in some cases, who never had full information about how loan was made). There could be examples of other transactions with even more middlemen (conduits that take loans from smaller banks to wall street, etc). We could keep on writing - like writing about the ratings agencies and how they were paid by wall street, providing clear conflicts of interest in their ratings.
The point is that whenever there are a lot of middlemen in the financial industry and its combined with perverse (and large) fee-based incentives, thats trouble brewing for the economy and society. In the housing industry, in the stock market, in the bond market, in the sovereign market you name it.
A lot of the profits that have been made by the financial industry in the past decade are not tied to real economic growth, but, rather to the bad intermediation that usually resembled gambling.
Its time we focus on those elements of the financial industry that help fuel real and sustainable economic growth in society. The % of profits that the financial industry takes should hold relevance to the economic output of that country. Whenever it gets out of whack, its probably that some danger is brewing - they are getting their profits from promoting gambling behavior outside of their basic function of channeling funds from savers to investors.