A currency union can't survive by combining less competitive, smaller economies with more competitive, larger economies without a common fiscal/borrowing system and/or labor mobility across the territories. Before long, the currency follows the bigger more competitive countries, and the smaller less competitive ones are left with an ever decreasing ability to produce/compete/grow, thus resulting in employment loss, decreasing growth and ultimately stagnation. The only way out for these countries is to: (1) catch-up in competitiveness (not possible in the short-term), (2) for the smaller countries to coordinate salary deflation across public and private sectors at the same time (not possible outside of a brutal dictatorship), or (3) to devalue and adjust prices via the currency mechanism. In summary, the competitive adjustment needs to happen via the relative prices (if currency is fixed) or via the currency if its floating.
As such, the Euro's survival looks very bleak, unless Greece, Portugal, Ireland and Spain (And Italy) can catch-up in competitiveness... or most likely - they'll get out of the German straight-jacket.
I wrote two posts earlier on this:
http://jtolosa.blogspot.com/2010/05/euro-clock-is-ticking.html
http://jtolosa.blogspot.com/2009/04/spain-new-argentina.html
and its surprising to me how long it takes for the general consensus to agree to the above reality - which has been lived over and over again during the last 40 years.
The European dilemma was exacerbated because so much credit flowed into these weak countries which was put to work in unproductive assets, thus creating debt that was ultimately not able to be repaid (due to the asset bubble and the reality of the lack of competitiveness), thus, advancing the day of reckoning.
No matter how far the can is kicked, these countries will need to get out of the Euro because we were not all created equally competitive... and the difference in competitiveness needs to be reflected in relative wealth at some point... and the only democratic and equitative way of pushing through the difference in wealth (without people noticing) happens to be an exchange rate.... let exchange rates float, and the market dictate how rich or poor countries become... fixing currencies with larger and more competitive countries is like creating a vision of an oasis in the middle of the very dry desert...
Showing posts with label Finance - Economics. Show all posts
Showing posts with label Finance - Economics. Show all posts
Tuesday, June 14, 2011
Monday, September 6, 2010
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).
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).
Sunday, August 29, 2010
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...
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...
Tuesday, May 11, 2010
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.
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.
Monday, April 19, 2010
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.
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.
Thursday, April 30, 2009
True Economic Growth Starts with the Right Education and Incentives
We are finally getting rid of a culture where our best and brightest were going into activities that were directed at creating fake-non-long-term economic growth….
Is financial engineering fake economic growth? Not to the extent that it finances real economic growth (i.e. expand the possibilities of real growth to occur)… however, most of the financial engineering we experienced during the last number of years wasn’t really directed to productive economic growth, but, rather incented to provide quick intermediation fees (and augment the % of profits that the financial industry had in our economy) regardless of the economic outcome… this is/was deplorable and I hope it stays in the mind of various generations to come (although I also believe that financial memory is rather short)… None of this would have happened if we had not allowed “Economic Intermediation” (be it in the financial industry, in the real estate industry, any industry to be paid on a fee-based, no-skin in the game, I’ll be gone and I-would-have –spent-all-the-money-by-the-time-you-go-bust-and-realize”)…
If an intermediary is wise enough to recommend the purchase of a particular asset, they should be paid the majority of their work based on the results of that recommendation (why is this so crazy!!)…
Here is a recommendation: Create a payment structure where they make a killing when they recommend something that works out, but, they don't earn anything when they recommend something that flops (perhaps something to cover basic costs).
Now, don't lock them for too long of a time for this payment structure to work (i.e. if the recommendation goes bust after a “rational” period of time, they should have already cashed out under the assumption that there were other forces beyond the recommendation itself that brought the asset down).
Last point - we should always look at performace / profits / growth over a 10 years period - financial industry profits never were what they were back then - if we subtract all the losses today, we see that just like everything - there is always reversion to the mean.
Is financial engineering fake economic growth? Not to the extent that it finances real economic growth (i.e. expand the possibilities of real growth to occur)… however, most of the financial engineering we experienced during the last number of years wasn’t really directed to productive economic growth, but, rather incented to provide quick intermediation fees (and augment the % of profits that the financial industry had in our economy) regardless of the economic outcome… this is/was deplorable and I hope it stays in the mind of various generations to come (although I also believe that financial memory is rather short)… None of this would have happened if we had not allowed “Economic Intermediation” (be it in the financial industry, in the real estate industry, any industry to be paid on a fee-based, no-skin in the game, I’ll be gone and I-would-have –spent-all-the-money-by-the-time-you-go-bust-and-realize”)…
If an intermediary is wise enough to recommend the purchase of a particular asset, they should be paid the majority of their work based on the results of that recommendation (why is this so crazy!!)…
Here is a recommendation: Create a payment structure where they make a killing when they recommend something that works out, but, they don't earn anything when they recommend something that flops (perhaps something to cover basic costs).
Now, don't lock them for too long of a time for this payment structure to work (i.e. if the recommendation goes bust after a “rational” period of time, they should have already cashed out under the assumption that there were other forces beyond the recommendation itself that brought the asset down).
Last point - we should always look at performace / profits / growth over a 10 years period - financial industry profits never were what they were back then - if we subtract all the losses today, we see that just like everything - there is always reversion to the mean.
Tuesday, April 21, 2009
Spain - the new Argentina
Its always the same - pegged, fixed, converted currencies - people/countries want the benefits and not the downside, people/countries believe the hype, don't think about the consequences.
Argentina dollarized its economy in the early 90's in an effort to defeat inflation and start a new wave of liberal economic policies with the intenation of modernizing its economy. Inflation was defeated, capital flowed in, the economy grew, etc.... and people believed the hype, the country enjoyed the benefits.... but, with all those capital inflows, new credit to individuals, AND rising prices/purchasing power (standard of living) comes a responsibility; the country requires to create something with that and invest the money (not spend it), become more productive (to produce more with the same tomorrow), and save for bad times... Argentina spent a lot of money (albeit there was significant investment), did not become more productive (albeit technology modernized various industries), and did not save much money... this is a simplification of the problem - but I simply want to make a point and a comparison to Spain...
Spain went through its own dollarization (its Euroization) -> a country that was running large country risk spreads, with lack of credit (on a relative basis) suddenly found itself in a miracle - just by changing its currency, money started flowing into the country, there wasn't a currency spread anymore, credit to individuals started flowing -> it was a new beginning for Spain -> prices for assets increased, salaries increased, there was a newfound purchasing power -> what a miracle! why didnt they do it before?... the country did create many things with that though -> today Spain is a very competitive country in a number of industries (even outside Spain), including banking, infrastructure, and green energy... however, I am not sure they did everything they had to do -> did they save enough?, did they become more productive?... I am nobody to judge, maybe they did... but, I think they are in real trouble now - a la Argentina... the economy and their wealth grew in a currency that can't adjust now via a devaluation or monetary policy (just like Argentina's price level/economy could not adjust via their currency or monetary policy) - so, it neeeds to adjust via the price level itself and unemployment... its a choice Argentina had -> devalue and shatter asset values/credit or maintain the currency and suffer deflation, and send the country into a deep recession with very high unemployment..
What could Spain had done? Don't believe the hype -> you become richer by truly producing more goods and services that (1) are a necessity at home or (2) that are needed/wanted elsewhere in the world... you don't become richer by borrowing against higher value assets and then spending in non-productive things...
The basic point of this writing is this: The adoption of a more stable, more respected non-national currency brings very valuable beneifts to a country - it allows foreign capital to trust the unit of account/store of wealth/medium of exchange in that country more (so more capital can flow in), it allows for longer-term credit to flow (because the threat of devaluation, inflation is decreased (never eliminated, because there is always the risk that the country would need to abandon the currency altogether)), and because of that new capital -> asset prices will increase, which then allows for more credit (and you get the idea)... there is no new wealth created solely by this -> the nationals of that country need to use that opportunity to invest the funds in productive assets, they need to become more productive relative to the world, they need to understand they need to save because bad times will always arrive... Its all too common for countries throughout history to not get this (or to not have their leaders (during good times) emphasize this enough.
Based on my experiences in Argentina, I'm not liking the current situation in Spain and the choices ahead of it (albeit with more influence with the European Central Bank than Argentina had with the Fed).
Argentina dollarized its economy in the early 90's in an effort to defeat inflation and start a new wave of liberal economic policies with the intenation of modernizing its economy. Inflation was defeated, capital flowed in, the economy grew, etc.... and people believed the hype, the country enjoyed the benefits.... but, with all those capital inflows, new credit to individuals, AND rising prices/purchasing power (standard of living) comes a responsibility; the country requires to create something with that and invest the money (not spend it), become more productive (to produce more with the same tomorrow), and save for bad times... Argentina spent a lot of money (albeit there was significant investment), did not become more productive (albeit technology modernized various industries), and did not save much money... this is a simplification of the problem - but I simply want to make a point and a comparison to Spain...
Spain went through its own dollarization (its Euroization) -> a country that was running large country risk spreads, with lack of credit (on a relative basis) suddenly found itself in a miracle - just by changing its currency, money started flowing into the country, there wasn't a currency spread anymore, credit to individuals started flowing -> it was a new beginning for Spain -> prices for assets increased, salaries increased, there was a newfound purchasing power -> what a miracle! why didnt they do it before?... the country did create many things with that though -> today Spain is a very competitive country in a number of industries (even outside Spain), including banking, infrastructure, and green energy... however, I am not sure they did everything they had to do -> did they save enough?, did they become more productive?... I am nobody to judge, maybe they did... but, I think they are in real trouble now - a la Argentina... the economy and their wealth grew in a currency that can't adjust now via a devaluation or monetary policy (just like Argentina's price level/economy could not adjust via their currency or monetary policy) - so, it neeeds to adjust via the price level itself and unemployment... its a choice Argentina had -> devalue and shatter asset values/credit or maintain the currency and suffer deflation, and send the country into a deep recession with very high unemployment..
What could Spain had done? Don't believe the hype -> you become richer by truly producing more goods and services that (1) are a necessity at home or (2) that are needed/wanted elsewhere in the world... you don't become richer by borrowing against higher value assets and then spending in non-productive things...
The basic point of this writing is this: The adoption of a more stable, more respected non-national currency brings very valuable beneifts to a country - it allows foreign capital to trust the unit of account/store of wealth/medium of exchange in that country more (so more capital can flow in), it allows for longer-term credit to flow (because the threat of devaluation, inflation is decreased (never eliminated, because there is always the risk that the country would need to abandon the currency altogether)), and because of that new capital -> asset prices will increase, which then allows for more credit (and you get the idea)... there is no new wealth created solely by this -> the nationals of that country need to use that opportunity to invest the funds in productive assets, they need to become more productive relative to the world, they need to understand they need to save because bad times will always arrive... Its all too common for countries throughout history to not get this (or to not have their leaders (during good times) emphasize this enough.
Based on my experiences in Argentina, I'm not liking the current situation in Spain and the choices ahead of it (albeit with more influence with the European Central Bank than Argentina had with the Fed).
Sunday, April 5, 2009
Why are we protecting creditors? We are creating moral hazard.
I've been writing about this mortgage situation for close to 18 months now (and probably thinking about it for 24 months). Something that i've been asking myself since all these bailouts started is about the lack of questioning of the implied protection the government has given creditors.
There has been a lot written on those "bailouts" that basically protected shareholders (who rightfully were taking risks). However, there hasn't been enough written on the fact that all those capital injections are basically making creditors whole.
Maybe I am being naive (in that it probably doesn't really work that way), but, why don't we simply let the market run its course (with the banks?). In other words, if a bank is to fail, its shareholders lose, and its creditors lose... the government takes over and in a very fast transaction it puts it back into the market - there will obviously be a bid for the assets of that bank... here's the caveat - the bid will have two concepts: 1) how much debt would they be willing to take on and 2) how much capital will they put in.... the highest bidder takes the institution... and bingo, by default... the new debt level is known...
I am guessing it can't be that easy - creditors would have the right to sue (claiming that through a bankruptcy process they would've taken control of the bank (rather than unilaterally having to cede control)...
Regardless, the point here is that we talk about moral hazard on the equity side, but, one of the biggest moral hazards we might be creating happens to be on the credit side.
There has been a lot written on those "bailouts" that basically protected shareholders (who rightfully were taking risks). However, there hasn't been enough written on the fact that all those capital injections are basically making creditors whole.
Maybe I am being naive (in that it probably doesn't really work that way), but, why don't we simply let the market run its course (with the banks?). In other words, if a bank is to fail, its shareholders lose, and its creditors lose... the government takes over and in a very fast transaction it puts it back into the market - there will obviously be a bid for the assets of that bank... here's the caveat - the bid will have two concepts: 1) how much debt would they be willing to take on and 2) how much capital will they put in.... the highest bidder takes the institution... and bingo, by default... the new debt level is known...
I am guessing it can't be that easy - creditors would have the right to sue (claiming that through a bankruptcy process they would've taken control of the bank (rather than unilaterally having to cede control)...
Regardless, the point here is that we talk about moral hazard on the equity side, but, one of the biggest moral hazards we might be creating happens to be on the credit side.
Sunday, March 15, 2009
The Chinese complain... are you serious?
The Chinese Premier is asking the US to comment on the quality of the more than $1Tr US Government Bonds that the Chinese own. He is worried that the US won't make good on the paper, and they can be left holding the bag. Worse yet, as the largest owner of US securities, the Chinese's alternative of selling (before they fall) looks like an impossible task (as they would crash the market themselves before they can get out).
What's pretty foolish about his comments is the fact that the reason the US is precisely in this predicament is that the whole world was willing to lend it money (all its savings) for a really long-time, thus creating the conundrum so referred to by Greenspan. All this capital that was flowing in financed huge current account deficits - basically it supported our building of homes and high-level of unproductive consumption (until it reached the limit last year).
At a very high level -> it did also benefit places like China -> a significant amount of our trade deficit was with China, so in essence, they were sending us money (USD to purchase US IOU's) that we then recycled back to them by importing even more, which they then sent back to us for more IOU's. Essentially, China lent us $1Tr so that we could buy its goods, so that their people can be employed, their industry can grow, they can get more competitive, etc.
Under normal circumstances, their currency would have appreciated, and trade would have been less... but, they were managing their currency - they prefer to lower their own citizens standard of living, their purchasing power, in exchange for providing more jobs, more factories, more production as they develop.
The real irony of this post is that the Chinese now want to sound like very serious financial managers who had bought an investment very focused on its return -> whereas we all know that the reason they bought that investment was to allow for a devalued USD vis a vis the Renminbi and to allow us to keep buying their cheap stuff.
They should certainly not be the ones worried nor publicly complaining about the risks on US Debt -> if there is any risk in it, a lot of the blame sits with its largest buyer.
What's pretty foolish about his comments is the fact that the reason the US is precisely in this predicament is that the whole world was willing to lend it money (all its savings) for a really long-time, thus creating the conundrum so referred to by Greenspan. All this capital that was flowing in financed huge current account deficits - basically it supported our building of homes and high-level of unproductive consumption (until it reached the limit last year).
At a very high level -> it did also benefit places like China -> a significant amount of our trade deficit was with China, so in essence, they were sending us money (USD to purchase US IOU's) that we then recycled back to them by importing even more, which they then sent back to us for more IOU's. Essentially, China lent us $1Tr so that we could buy its goods, so that their people can be employed, their industry can grow, they can get more competitive, etc.
Under normal circumstances, their currency would have appreciated, and trade would have been less... but, they were managing their currency - they prefer to lower their own citizens standard of living, their purchasing power, in exchange for providing more jobs, more factories, more production as they develop.
The real irony of this post is that the Chinese now want to sound like very serious financial managers who had bought an investment very focused on its return -> whereas we all know that the reason they bought that investment was to allow for a devalued USD vis a vis the Renminbi and to allow us to keep buying their cheap stuff.
They should certainly not be the ones worried nor publicly complaining about the risks on US Debt -> if there is any risk in it, a lot of the blame sits with its largest buyer.
Saturday, February 28, 2009
A simple way to understand what we are living
We used money to consume and build houses. (period) What is the problem with that? A lot of the money used for those purposes wasn't ours, it was lent, and when money that is lent is used for things that won't produce future income, there is the risk that we would reach a point where we won't have enough income or production to pay it back. And it was no different at the national level than what it was at the individual level because ultimately the national level is simply the sum of all the individual pieces.
Where was the money coming from? Well, at the individual level, it was obviously coming from financial institutions. At the national level, it was coming from private and public internationals - our capital account supported the huge deficits on our current account for a really long-time. These imbalances usually lead to a drop in the currency value or to less interested internationals in lending to that type of country... or at the individual level to banks simply not lending to the individual, but, that didn't happen.
The US is the reserve market, the reserve economy, and the dollar is the reserve currency of the world and the world has a need to "export" their way to development. So the money kept coming, also supporting the dollar. A huge imbalance was created internatoinally that led to one of the biggest bubbles in history in real estate (Residential mainly, but, also including commercial) and essentially to a bubble economy as well -> consumption (a measure of GDP) was enabled by significant borrowings / cheap credit. If those borrowings/cheap credit had not been there, then GDP would not have increased at the same rate - same for housing if the international money had not been there. This is the "conundrum" that Alan Greenspan was talking about when he was raising rates but rates for long-term borrowing was not increasing (international money kept pouring in).
The other point that I want to make has to do with employment and production. The full-time employed work-force is probably the best measure to understand the health of the economy. Those that work provide for themselves and for those that don't work (just like a one-income generating families have one person providing for all the others).
The economy is measured by the value of all the goods and services produced in a particular year, and these goods and services are generated by the full-time force. Like individual families, there are two healthy ways to consume and one unhealthy -> two healthy: from current income or savings, the unhealthy -> by borrowing. During a long-time we used the unhealthy ones - borrowed to consume and invest in non-productive assets. Its as if a corporation borrows money and then uses it to pay lavish dinners, airplanes, beautiful deks, and others -> none of these would provide the repayment methods necessary to pay the debt back.
How we get out of this mess is a totally different topic, and a very complex one - at a high level, however, we go back to the first point -> we became overlevered -> the borrowings did not go to improve our production capacity but rather to unproductive uses, and it got to a point where our productive assets could not generate enough income to pay for the debt. Something's gotta give - either the debt is reduced to sustainable levels (by production) or the production value (relative to the debt value) has to increase.
Where was the money coming from? Well, at the individual level, it was obviously coming from financial institutions. At the national level, it was coming from private and public internationals - our capital account supported the huge deficits on our current account for a really long-time. These imbalances usually lead to a drop in the currency value or to less interested internationals in lending to that type of country... or at the individual level to banks simply not lending to the individual, but, that didn't happen.
The US is the reserve market, the reserve economy, and the dollar is the reserve currency of the world and the world has a need to "export" their way to development. So the money kept coming, also supporting the dollar. A huge imbalance was created internatoinally that led to one of the biggest bubbles in history in real estate (Residential mainly, but, also including commercial) and essentially to a bubble economy as well -> consumption (a measure of GDP) was enabled by significant borrowings / cheap credit. If those borrowings/cheap credit had not been there, then GDP would not have increased at the same rate - same for housing if the international money had not been there. This is the "conundrum" that Alan Greenspan was talking about when he was raising rates but rates for long-term borrowing was not increasing (international money kept pouring in).
The other point that I want to make has to do with employment and production. The full-time employed work-force is probably the best measure to understand the health of the economy. Those that work provide for themselves and for those that don't work (just like a one-income generating families have one person providing for all the others).
The economy is measured by the value of all the goods and services produced in a particular year, and these goods and services are generated by the full-time force. Like individual families, there are two healthy ways to consume and one unhealthy -> two healthy: from current income or savings, the unhealthy -> by borrowing. During a long-time we used the unhealthy ones - borrowed to consume and invest in non-productive assets. Its as if a corporation borrows money and then uses it to pay lavish dinners, airplanes, beautiful deks, and others -> none of these would provide the repayment methods necessary to pay the debt back.
How we get out of this mess is a totally different topic, and a very complex one - at a high level, however, we go back to the first point -> we became overlevered -> the borrowings did not go to improve our production capacity but rather to unproductive uses, and it got to a point where our productive assets could not generate enough income to pay for the debt. Something's gotta give - either the debt is reduced to sustainable levels (by production) or the production value (relative to the debt value) has to increase.
Wednesday, December 17, 2008
We are all Argentines now
Argentines have Italian blood, and in the best Italian tradition, they also learned that there are better stores of value than their own national currencies.
We are all Italo-Argentines now - Ben Bernanke has just acted on his speech which delivered the nickname Helicopter Ben (and that nobody took too seriously back in 2002). The United States of America's Central Bank has just declared to the world: we want to be a Banana Country, please follow us. It is this new Central Banker's belief that you can rescue an economy by printing your way out of trouble, in other words, that you can rescue an economy by inflating your way out of trouble. I believe its always been about establishing a balance between Keynesian economics and Friedman economics, but, not sure how much even Keynes would agree with this one. Last I checked, inflation was bad for the economy, and inflation is created by excess money pursuing too few goods. We have a problem of too few goods, and it is the countries' belief that by printing money, there will be an incentive to buy more goods, thus produce more goods... or worse yet that the additional money will pursue the same goods, thus increasing the nominal value and growth of our economy... The problem is that those that produce goods, and those that buy goods are not producing/purchasing not because of a lack of confidence but because of an excess of debt - so, Bernanke will essentially will be inflating us out of our debt.
My friends, before we know it, when all is said and done about this episode we will all be Argentina - and when the whole world plays the same trick, we will all go back to the age when Gold was a currency not a commodity... because when something has a fixed supply, it will always have an upward value bias against those things that don't, especially when there is an intent to augment the supply with a free hand. There might be deflation in the short-term, but, salvaging this crisis will simply mean funny money and significant inflation in the future.
We are all Italo-Argentines now - Ben Bernanke has just acted on his speech which delivered the nickname Helicopter Ben (and that nobody took too seriously back in 2002). The United States of America's Central Bank has just declared to the world: we want to be a Banana Country, please follow us. It is this new Central Banker's belief that you can rescue an economy by printing your way out of trouble, in other words, that you can rescue an economy by inflating your way out of trouble. I believe its always been about establishing a balance between Keynesian economics and Friedman economics, but, not sure how much even Keynes would agree with this one. Last I checked, inflation was bad for the economy, and inflation is created by excess money pursuing too few goods. We have a problem of too few goods, and it is the countries' belief that by printing money, there will be an incentive to buy more goods, thus produce more goods... or worse yet that the additional money will pursue the same goods, thus increasing the nominal value and growth of our economy... The problem is that those that produce goods, and those that buy goods are not producing/purchasing not because of a lack of confidence but because of an excess of debt - so, Bernanke will essentially will be inflating us out of our debt.
My friends, before we know it, when all is said and done about this episode we will all be Argentina - and when the whole world plays the same trick, we will all go back to the age when Gold was a currency not a commodity... because when something has a fixed supply, it will always have an upward value bias against those things that don't, especially when there is an intent to augment the supply with a free hand. There might be deflation in the short-term, but, salvaging this crisis will simply mean funny money and significant inflation in the future.
Tuesday, November 18, 2008
A special point about doing business or the creation of wealth
There are a lot of "exchanges" in society that can potentialy create value, but, they not always happen due to miopic thinking by one of the parties.
The first point in a business exchange should always be about creating value - can we combine our assets/strengths in a way that we can create value for a third party? If value is created, then it should be shared between those creating it - the problem is that necessarily the question about splitting the value comes up and it ususally leads to conflicts that then eliminate the possibility for an exchange.
Its the same between employees and owners, debtholders and equityholders, or even between rich and poor in society.
Having an understanding of the concept of fairness and transparency helps the negotiating parties to pie-enhancing situations in a way that both parties are better off doing the transaction than not doing it. Of course, different views of fairness or of relative contributions could also hamper the value creating initiatives.
The first point in a business exchange should always be about creating value - can we combine our assets/strengths in a way that we can create value for a third party? If value is created, then it should be shared between those creating it - the problem is that necessarily the question about splitting the value comes up and it ususally leads to conflicts that then eliminate the possibility for an exchange.
Its the same between employees and owners, debtholders and equityholders, or even between rich and poor in society.
Having an understanding of the concept of fairness and transparency helps the negotiating parties to pie-enhancing situations in a way that both parties are better off doing the transaction than not doing it. Of course, different views of fairness or of relative contributions could also hamper the value creating initiatives.
Sunday, November 9, 2008
From Smith to Keynes to Smith and Back
I was reading the other day an Argentine columnist that was arguing that there are two (not necessarily invisible) hands in the economy - one that guides individual decisions into collective good (Adam Smith)...But, that sometimes can lead to collective harm (as the excesses we havejust witnessed) and then another (somewhat discredited for the last 20years) visible hand that is required to bring things back into normalcy-> John Maynard Keynes (and The General Theory of Employment, Interestand Money) and his concept of having government spending replaceconsumer spending...
The piece that Krugman wrote today is more or less arguing the samething and providing some background to what we are living... Goldman didan excellent summary of the liquidity trap we might be going into (whichKrugman points in his article)... Which then connects the dots -> insituations with high real interest rates, the fed can be effective bylowering nominal interest rates, but, when real interest rates can onlygo to zero or negative, monetary policy completely loses significance(Japan in the 90's and the situation we might be in today), so you needfiscal stimulus...
It all comes back to policies of this administration and Fed: 1) we will deeply regret driving that budget deficit higher and higher (that ismoney badly needed right now), and 2) Bernanake should have never cutrates the way he did in 2007, he needed them now.
When Consumers Capitulate By PAUL KRUGMAN
Published: October 31, 2008
The long-feared capitulation of American consumers has arrived.According to Thursday's G.D.P. report, real consumer spending fell at an annual rate of 3.1 percent in the third quarter; real spending ondurable goods (stuff like cars and TVs) fell at an annual rate of 14percent. To appreciate the significance of these numbers, you need to know thatAmerican consumers almost never cut spending. Consumer demand kept rising right through the 2001 recession; the last time it fell even fora single quarter was in 1991, and there hasn't been a decline this steepsince 1980, when the economy was suffering from a severe recessioncombined with double-digit inflation. Also, these numbers are from the third quarter - the months of July, August, and September. So these data are basically telling us whathappened before confidence collapsed after the fall of Lehman Brothersin mid-September, not to mention before the Dow plunged below 10,000. Nor do the data show the full effects of the sharp cutback in theavailability of consumer credit, which is still under way.So this looks like the beginning of a very big change in consumerbehavior. And it couldn't have come at a worse time.It's true that American consumers have long been living beyond their means. In the mid-1980s Americans saved about 10 percent of theirincome. Lately, however, the savings rate has generally been below 2percent - sometimes it has even been negative - and consumer debt hasrisen to 98 percent of G.D.P., twice its level a quarter-century ago. Some economists told us not to worry because Americans were offsettingtheir growing debt with the ever-rising values of their homes and stockportfolios. Somehow, though, we're not hearing that argument much lately.Sooner or later, then, consumers were going to have to pull in theirbelts. But the timing of the new sobriety is deeply unfortunate. One istempted to echo St. Augustine's plea: "Grant me chastity and continence,but not yet." For consumers are cutting back just as the U.S. economyhas fallen into a liquidity trap - a situation in which the FederalReserve has lost its grip on the economy.Some background: one of the high points of the semester, if you're ateacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to dothe right thing by saving more can leave everyone worse off. The pointis that if consumers cut their spending, and nothing else takes theplace of that spending, the economy will slide into a recession,reducing everyone's income.In fact, consumers' income may actually fall more than their spending,so that their attempt to save more backfires - a possibility known asthe paradox of thrift. At this point, however, the instructor hastens to explain that virtueisn't really vice: in practice, if consumers were to cut back, the Fedwould respond by slashing interest rates, which would help the economy avoid recession and lead to a rise in investment. So virtue is virtue after all, unless for some reason the Fed can't offset the fall in consumer spending. I'll bet you can guess what's coming next. For the fact is that we are in a liquidity trap right now: Fed policy has lost most of its traction. It's true that Ben Bernanke hasn't yetreduced interest rates all the way to zero, as the Japanese did in the1990s. But it's hard to believe that cutting the federal funds rate from1 percent to nothing would have much positive effect on the economy. In particular, the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away,yet mortgage rates and the interest rates many businesses pay are higher than they were early this year.The capitulation of the American consumer, then, is coming at a particularly bad time. But it's no use whining. What we need is a policy response.The ongoing efforts to bail out the financial system, even if they work,won't do more than slightly mitigate the problem. Maybe some consumers will be able to keep their credit cards, but as we've seen, Americanswere overextended even before banks started cutting them off. No, what the economy needs now is something to take the place ofretrenching consumers. That means a major fiscal stimulus. And this timethe stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn't spend. Let's hope, then, that Congress gets to work on a package to rescue the economy as soon as the election is behind us. And let's also hope thatthe lame-duck Bush administration doesn't get in the way.
The piece that Krugman wrote today is more or less arguing the samething and providing some background to what we are living... Goldman didan excellent summary of the liquidity trap we might be going into (whichKrugman points in his article)... Which then connects the dots -> insituations with high real interest rates, the fed can be effective bylowering nominal interest rates, but, when real interest rates can onlygo to zero or negative, monetary policy completely loses significance(Japan in the 90's and the situation we might be in today), so you needfiscal stimulus...
It all comes back to policies of this administration and Fed: 1) we will deeply regret driving that budget deficit higher and higher (that ismoney badly needed right now), and 2) Bernanake should have never cutrates the way he did in 2007, he needed them now.
When Consumers Capitulate By PAUL KRUGMAN
Published: October 31, 2008
The long-feared capitulation of American consumers has arrived.According to Thursday's G.D.P. report, real consumer spending fell at an annual rate of 3.1 percent in the third quarter; real spending ondurable goods (stuff like cars and TVs) fell at an annual rate of 14percent. To appreciate the significance of these numbers, you need to know thatAmerican consumers almost never cut spending. Consumer demand kept rising right through the 2001 recession; the last time it fell even fora single quarter was in 1991, and there hasn't been a decline this steepsince 1980, when the economy was suffering from a severe recessioncombined with double-digit inflation. Also, these numbers are from the third quarter - the months of July, August, and September. So these data are basically telling us whathappened before confidence collapsed after the fall of Lehman Brothersin mid-September, not to mention before the Dow plunged below 10,000. Nor do the data show the full effects of the sharp cutback in theavailability of consumer credit, which is still under way.So this looks like the beginning of a very big change in consumerbehavior. And it couldn't have come at a worse time.It's true that American consumers have long been living beyond their means. In the mid-1980s Americans saved about 10 percent of theirincome. Lately, however, the savings rate has generally been below 2percent - sometimes it has even been negative - and consumer debt hasrisen to 98 percent of G.D.P., twice its level a quarter-century ago. Some economists told us not to worry because Americans were offsettingtheir growing debt with the ever-rising values of their homes and stockportfolios. Somehow, though, we're not hearing that argument much lately.Sooner or later, then, consumers were going to have to pull in theirbelts. But the timing of the new sobriety is deeply unfortunate. One istempted to echo St. Augustine's plea: "Grant me chastity and continence,but not yet." For consumers are cutting back just as the U.S. economyhas fallen into a liquidity trap - a situation in which the FederalReserve has lost its grip on the economy.Some background: one of the high points of the semester, if you're ateacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to dothe right thing by saving more can leave everyone worse off. The pointis that if consumers cut their spending, and nothing else takes theplace of that spending, the economy will slide into a recession,reducing everyone's income.In fact, consumers' income may actually fall more than their spending,so that their attempt to save more backfires - a possibility known asthe paradox of thrift. At this point, however, the instructor hastens to explain that virtueisn't really vice: in practice, if consumers were to cut back, the Fedwould respond by slashing interest rates, which would help the economy avoid recession and lead to a rise in investment. So virtue is virtue after all, unless for some reason the Fed can't offset the fall in consumer spending. I'll bet you can guess what's coming next. For the fact is that we are in a liquidity trap right now: Fed policy has lost most of its traction. It's true that Ben Bernanke hasn't yetreduced interest rates all the way to zero, as the Japanese did in the1990s. But it's hard to believe that cutting the federal funds rate from1 percent to nothing would have much positive effect on the economy. In particular, the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away,yet mortgage rates and the interest rates many businesses pay are higher than they were early this year.The capitulation of the American consumer, then, is coming at a particularly bad time. But it's no use whining. What we need is a policy response.The ongoing efforts to bail out the financial system, even if they work,won't do more than slightly mitigate the problem. Maybe some consumers will be able to keep their credit cards, but as we've seen, Americanswere overextended even before banks started cutting them off. No, what the economy needs now is something to take the place ofretrenching consumers. That means a major fiscal stimulus. And this timethe stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn't spend. Let's hope, then, that Congress gets to work on a package to rescue the economy as soon as the election is behind us. And let's also hope thatthe lame-duck Bush administration doesn't get in the way.
Monday, March 17, 2008
Bear Stearns 10.5 years after
Bear Stearns is no more today, it was sold for $2 a share to JP Morgan, at 33% of its price in 1985. I had my first job at Bear Stearns, and there I started learning of the intricacies of the capital markets. More than 10 years have gone by, and I have come and gone through five other jobs, gone back to school, seen bubbles come and go... but seeing Bear go down makes me put a lot of things into perspective.
First, careers, just like investment returns, needs to be seen/measured/understood not in days or years, but, decades. It is almost surreal to see that the work of 85 years (at BSC) could be taken down in a matter of days (although it was really the work, bad decisions of the last three years - or the foray, or the manner in which they embraced the opportunities in the mortgage industry).
The Fed is scrambling now in what I think is the most important questioning of the world of fiat money created in the early 70's. Credit expanded like it never did before these last few years, and with credit, the economy also went along, and with it asset prices. The problem is that asset values need to be supported by real incomes, real earnings, and if these are based on credit, which ultimately also has a limit, then we have a problem.
In the simplest way of explaining what I mean - more money was lent than there is and people that lent it are asking for it back... there is simply no equity that can support the real value if all the credit is called back.
Human self-interest and greed can take down in one day what responsible behavior builds in over 100 years.
The saddest part for me will be what "Bear Stearns" will represent to my kid when in 20 years he asks me about my first job decision... it will mean either nothing to him (probably) or have a negative connotation....
First, careers, just like investment returns, needs to be seen/measured/understood not in days or years, but, decades. It is almost surreal to see that the work of 85 years (at BSC) could be taken down in a matter of days (although it was really the work, bad decisions of the last three years - or the foray, or the manner in which they embraced the opportunities in the mortgage industry).
The Fed is scrambling now in what I think is the most important questioning of the world of fiat money created in the early 70's. Credit expanded like it never did before these last few years, and with credit, the economy also went along, and with it asset prices. The problem is that asset values need to be supported by real incomes, real earnings, and if these are based on credit, which ultimately also has a limit, then we have a problem.
In the simplest way of explaining what I mean - more money was lent than there is and people that lent it are asking for it back... there is simply no equity that can support the real value if all the credit is called back.
Human self-interest and greed can take down in one day what responsible behavior builds in over 100 years.
The saddest part for me will be what "Bear Stearns" will represent to my kid when in 20 years he asks me about my first job decision... it will mean either nothing to him (probably) or have a negative connotation....
Thursday, December 6, 2007
Taking two sides of the same coin...
Ben Stein pointed the other day to the fact that Goldman had been shorting mortgage securities at the same time that it was underwriting them (and selling them to institutional investors). I pointed out that there is a clear conflict of interest in this and that it would create waves.
The NYT came out today with an article on how bad the situation for the securitizations from the street in 2006 are currently and points to the fact that many of them were actually hedging agaist a downfall (or being short) at the same time that they were underwriting them.
One big bank that saw the trouble coming, Goldman Sachs, began reducing its inventory of mortgages and mortgage securities late last year. Even so, Goldman went on to package and sell more than $6 billion of new securities backed by subprime mortgages during the first nine months of this year.
Of the loans backing the Goldman deals for which data is available, nearly 15 percent are already delinquent by more than 60 days, are in foreclosure or have resulted in the repossession of a home, according to data compiled by Bloomberg. The average default rate for subprime loans packaged in 2007 is 11 percent.
In any case, the bankers argue, buyers of such securities — institutional investors like pension funds, banks and hedge funds — are sophisticated and understand the risks.
Wall Street officials maintain that the system worked as it was supposed to. Underwriters, they say, did not pressure colleagues on trading desks or in research departments to promote securities blindly.
Goldman Sachs also moved early to insulate itself from potential losses. Almost a year ago, on Dec. 14, 2006, David A. Viniar, Goldman’s chief financial officer, called a “mortgage risk” meeting. The investment bank’s mortgage desk was losing money, and Mr. Viniar, with various officials, reviewed every position in the bank’s portfolio.
The bank decided to reduce its stockpile of mortgages and mortgage-related securities and to buy expensive insurance as protection against further losses, said a person briefed on the meeting who was not authorized to speak about the situation publicly.
Goldman, however, did not stop selling subprime mortgage securities. The bank, like other firms, retains a piece of the securities it sells. A Goldman spokesman said the firm was not betting against the mortgage securities it underwrote in 2007.
Like Goldman, Lehman Brothers also started to hedge its huge inventory of home loans in the second quarter of this year, concerned about poor underwriting standards. But Lehman also continued to sell mortgage securities packed with shaky loans, underwriting $16.5 billion of new securities in the first nine months of 2007. About 15 percent of the loans backing these securities have defaulted.
As has been pointed out in the past - there was a clear link between Wall Street and sub-prime originators. Wall Street found (smart and/or dumb) liquidity for exotic instruments that were backed by mortgages and the originators had no problems finding ever higher yielding mortgages.
I am guessing this will have interesting tails...
The NYT came out today with an article on how bad the situation for the securitizations from the street in 2006 are currently and points to the fact that many of them were actually hedging agaist a downfall (or being short) at the same time that they were underwriting them.
One big bank that saw the trouble coming, Goldman Sachs, began reducing its inventory of mortgages and mortgage securities late last year. Even so, Goldman went on to package and sell more than $6 billion of new securities backed by subprime mortgages during the first nine months of this year.
Of the loans backing the Goldman deals for which data is available, nearly 15 percent are already delinquent by more than 60 days, are in foreclosure or have resulted in the repossession of a home, according to data compiled by Bloomberg. The average default rate for subprime loans packaged in 2007 is 11 percent.
In any case, the bankers argue, buyers of such securities — institutional investors like pension funds, banks and hedge funds — are sophisticated and understand the risks.
Wall Street officials maintain that the system worked as it was supposed to. Underwriters, they say, did not pressure colleagues on trading desks or in research departments to promote securities blindly.
Goldman Sachs also moved early to insulate itself from potential losses. Almost a year ago, on Dec. 14, 2006, David A. Viniar, Goldman’s chief financial officer, called a “mortgage risk” meeting. The investment bank’s mortgage desk was losing money, and Mr. Viniar, with various officials, reviewed every position in the bank’s portfolio.
The bank decided to reduce its stockpile of mortgages and mortgage-related securities and to buy expensive insurance as protection against further losses, said a person briefed on the meeting who was not authorized to speak about the situation publicly.
Goldman, however, did not stop selling subprime mortgage securities. The bank, like other firms, retains a piece of the securities it sells. A Goldman spokesman said the firm was not betting against the mortgage securities it underwrote in 2007.
Like Goldman, Lehman Brothers also started to hedge its huge inventory of home loans in the second quarter of this year, concerned about poor underwriting standards. But Lehman also continued to sell mortgage securities packed with shaky loans, underwriting $16.5 billion of new securities in the first nine months of 2007. About 15 percent of the loans backing these securities have defaulted.
As has been pointed out in the past - there was a clear link between Wall Street and sub-prime originators. Wall Street found (smart and/or dumb) liquidity for exotic instruments that were backed by mortgages and the originators had no problems finding ever higher yielding mortgages.
I am guessing this will have interesting tails...
Monday, December 3, 2007
The Government hand in "helping borrowers": what will the result be?
So the Government is laying out a plan to help the mortgage industry: they will coordinate with lenders and servicers to allow for more loan modifications to happen.
Here is Secretary Paulson:
Paulson has said rate freezes would not be offered to people who can afford the adjusted payment or those who, despite having made mortgage payments so far, have too little income and assets to do so in the future. Another issue was whether to exclude heavy borrowers who owe more than their homes are now worth.
Hope Now alliance members are close to agreeing on a systematic approach for dealing with resets on adjustable-rate mortgages, but they are still developing criteria for determining which borrowers will be eligible for streamlined refinancings and loan modifications
This reminds me of the kinds of market trampling that for which Emerging Markets get penalized every 10 years. Whenever the Government tries to have a direct effect on the market, fuel is added to the fire and ends up being counterproductive. The Government needs to make rules through which the economy plays; if rules are made and then changed, players don't play and the economy doesn't work.
Let's see what they are after here: They want to decide what kinds of loans should be modified in the market, because the market has only been able to modify 1%. Let's see, rational investors and borrowers (knowing that there is a 40% loss event if things go into foreclosure), have only been able to modify 1% of the loans. Is it because they are not cooperating and they need an intermediary or is it that there is simply no opportunity to rationally modify these loans?
I have no idea how they will be able to decide which borrowers are eligible to remain at their current rates and which ones not (without offering the option to everyone), not to say the drastic problems they would create to future incentives. Let's see, the responsible borrower that took out a fixed rate loan, or took out an ARM but has been making significant sacrifices to consumption patterns to afford the future payment, or somebody who refinanced just recently into a fixed rate loan, or somebody who took out the risky loan, but, simply can afford it... those don't get help. But, an irresponsible (or the victim of an irresponsible broker) borrower who took out an adjusting loan that upfront couldn't be repaid at the higher rate or those in the camp above but that are able to that fool the system into believing they can't pay, AND (to do justice to what they are trying to do) can pay at the unadjusted current rate, then, those are getting relief (or in market terms - significant returns on their (conscious or unconscious) gambles).
Market distortion: the government will always be there to the rescue...or investors beware if you are making very risky investments - it could be the case that the government will step in and decide exactly how many cents on the dollar you are getting back.
here is a frustrated borrower:
I’m no doubt opening myself up to charges of heartlessness. I don’t have a an ultralow teaser-rate ARM. My loan isn’t subprime. In fact, I knew exactly what I was doing when I bought an adjustable-rate product. I understood the risks and benefits. I’ll be able to afford the consequences of a rate increase.
Still, why should I be the sap who pays just because the above is true? The Journal’s primer suggests that only borrowers for whom a freeze would make the difference between staying in their home and defaulting would be eligible for a freeze. Those who either can afford their mortgages without a freeze or can’t afford their mortgage under any circumstances wouldn’t qualify. Good luck deciding who doesn’t need the help. I’ve just told you I don’t need it because I’m being honest and I’m not sharing any numbers. Would I like to continue paying the same interest rate for the next five years? Hell yes.
The decision to freeze an interest rate or otherwise modify a mortgage is appropriately handled by the borrowers and the lenders, and, in our current reality, the investors who bought the loans from the lenders. They’re the lenders now. They’ll act in their economic interests, whether that be freezing a rate or forcing a default. Anything else makes a total sham of the system of lending money so a borrower can purchase an asset which, in turn, is pledged as collateral against the loan.
I am simply very skeptical that this effort will succeed without creating huge distorsions in the credit incentives that will simply end up making matters worse.
Here is Secretary Paulson:
Paulson has said rate freezes would not be offered to people who can afford the adjusted payment or those who, despite having made mortgage payments so far, have too little income and assets to do so in the future. Another issue was whether to exclude heavy borrowers who owe more than their homes are now worth.
Hope Now alliance members are close to agreeing on a systematic approach for dealing with resets on adjustable-rate mortgages, but they are still developing criteria for determining which borrowers will be eligible for streamlined refinancings and loan modifications
This reminds me of the kinds of market trampling that for which Emerging Markets get penalized every 10 years. Whenever the Government tries to have a direct effect on the market, fuel is added to the fire and ends up being counterproductive. The Government needs to make rules through which the economy plays; if rules are made and then changed, players don't play and the economy doesn't work.
Let's see what they are after here: They want to decide what kinds of loans should be modified in the market, because the market has only been able to modify 1%. Let's see, rational investors and borrowers (knowing that there is a 40% loss event if things go into foreclosure), have only been able to modify 1% of the loans. Is it because they are not cooperating and they need an intermediary or is it that there is simply no opportunity to rationally modify these loans?
I have no idea how they will be able to decide which borrowers are eligible to remain at their current rates and which ones not (without offering the option to everyone), not to say the drastic problems they would create to future incentives. Let's see, the responsible borrower that took out a fixed rate loan, or took out an ARM but has been making significant sacrifices to consumption patterns to afford the future payment, or somebody who refinanced just recently into a fixed rate loan, or somebody who took out the risky loan, but, simply can afford it... those don't get help. But, an irresponsible (or the victim of an irresponsible broker) borrower who took out an adjusting loan that upfront couldn't be repaid at the higher rate or those in the camp above but that are able to that fool the system into believing they can't pay, AND (to do justice to what they are trying to do) can pay at the unadjusted current rate, then, those are getting relief (or in market terms - significant returns on their (conscious or unconscious) gambles).
Market distortion: the government will always be there to the rescue...or investors beware if you are making very risky investments - it could be the case that the government will step in and decide exactly how many cents on the dollar you are getting back.
here is a frustrated borrower:
I’m no doubt opening myself up to charges of heartlessness. I don’t have a an ultralow teaser-rate ARM. My loan isn’t subprime. In fact, I knew exactly what I was doing when I bought an adjustable-rate product. I understood the risks and benefits. I’ll be able to afford the consequences of a rate increase.
Still, why should I be the sap who pays just because the above is true? The Journal’s primer suggests that only borrowers for whom a freeze would make the difference between staying in their home and defaulting would be eligible for a freeze. Those who either can afford their mortgages without a freeze or can’t afford their mortgage under any circumstances wouldn’t qualify. Good luck deciding who doesn’t need the help. I’ve just told you I don’t need it because I’m being honest and I’m not sharing any numbers. Would I like to continue paying the same interest rate for the next five years? Hell yes.
The decision to freeze an interest rate or otherwise modify a mortgage is appropriately handled by the borrowers and the lenders, and, in our current reality, the investors who bought the loans from the lenders. They’re the lenders now. They’ll act in their economic interests, whether that be freezing a rate or forcing a default. Anything else makes a total sham of the system of lending money so a borrower can purchase an asset which, in turn, is pledged as collateral against the loan.
I am simply very skeptical that this effort will succeed without creating huge distorsions in the credit incentives that will simply end up making matters worse.
Sunday, December 2, 2007
NYT: The answer to the mortgage mess: North of the Arctic Circle...
It is usually heard that brokers at origination point that misled borrowers into very risky loans, or that lenders funded these loans (knowing that they weren't putting the capital)... and we've heard about realtors, and rating agencies, and investment banks...and in summary, there was such a complex system to originate and sell mortgages that the simple eye would simply recognize early on that this would not have a happy ending...
but, as I have established in the past - the golden rule regulates markets and if there had been no "takers" for these loans, there would have been no borrowers either. For example, volume in these loans dried up significantly this year and it is not because borrowers suddently decided they had enough of brokers or unscrupulous lenders, it is simply because there weren't any more buyers for this paper. The market signals I get point lead me to believe that if there were liquidity for these loans right now, there would still be borrowers.
Because of this, we need to ask ourselves how that liquidity entered the system and if there were schemes that were created to amplify the liquidity.
Here is one example from Narvik, Norway (city of 18,000 people north of the Arctic Circle):
"Where all the bad debt ended up remains something of a mystery, but to those hit by the collateral damage, it hardly matters." "Above all, the residents want to know how their close-knit community of 18,000 could have mortgaged its future — built on the revenue from a hydroelectric plant on a nearby fjord — by dabbling in what many view as the black arts of investment bankers in distant places." "They allege that they were duped by Terra’s brokers, who did not warn them that these types of securities were risky and subject to being cashed out, at a loss, if their market price fell below a certain level." "The chief investigator of Norway’s financial regulator, Eystein Kleven, said Terra Securities’ Norwegian-language prospectus did not mention such payments, or other risk factors. Citigroup’s term sheet did provide information on risks, but Narvik got a copy only after it had signed the agreement."
The financial alchemy that started it all - the concept that risky collateral could be transformed into safe investments by packaging it creatively - went around the world looking for every single pocket of liquidity that existed - first it was smart liquidity (that probably pretty quickly figured the game) and then it used intermediaries to sell on dumb liquidity. Of course, the more complex the structuring got, and the more parties that were involved in a security (security enhancements, et al), the easier it was to sell (even to smart liquidity) - who could've know what was going on in the first place? it was almost impossible.
I come back over and over to the same point - market intermediares (smart), paid on a commission basis (no skin in the game), line up the necessary elements to connect the dots to generate those commissions... and there are usually (not so smart) dots in the map (although not necessarily in direct contact with those intermediaries).
but, as I have established in the past - the golden rule regulates markets and if there had been no "takers" for these loans, there would have been no borrowers either. For example, volume in these loans dried up significantly this year and it is not because borrowers suddently decided they had enough of brokers or unscrupulous lenders, it is simply because there weren't any more buyers for this paper. The market signals I get point lead me to believe that if there were liquidity for these loans right now, there would still be borrowers.
Because of this, we need to ask ourselves how that liquidity entered the system and if there were schemes that were created to amplify the liquidity.
Here is one example from Narvik, Norway (city of 18,000 people north of the Arctic Circle):
"Where all the bad debt ended up remains something of a mystery, but to those hit by the collateral damage, it hardly matters." "Above all, the residents want to know how their close-knit community of 18,000 could have mortgaged its future — built on the revenue from a hydroelectric plant on a nearby fjord — by dabbling in what many view as the black arts of investment bankers in distant places." "They allege that they were duped by Terra’s brokers, who did not warn them that these types of securities were risky and subject to being cashed out, at a loss, if their market price fell below a certain level." "The chief investigator of Norway’s financial regulator, Eystein Kleven, said Terra Securities’ Norwegian-language prospectus did not mention such payments, or other risk factors. Citigroup’s term sheet did provide information on risks, but Narvik got a copy only after it had signed the agreement."
The financial alchemy that started it all - the concept that risky collateral could be transformed into safe investments by packaging it creatively - went around the world looking for every single pocket of liquidity that existed - first it was smart liquidity (that probably pretty quickly figured the game) and then it used intermediaries to sell on dumb liquidity. Of course, the more complex the structuring got, and the more parties that were involved in a security (security enhancements, et al), the easier it was to sell (even to smart liquidity) - who could've know what was going on in the first place? it was almost impossible.
I come back over and over to the same point - market intermediares (smart), paid on a commission basis (no skin in the game), line up the necessary elements to connect the dots to generate those commissions... and there are usually (not so smart) dots in the map (although not necessarily in direct contact with those intermediaries).
Sunday, November 25, 2007
Optimizing Leisure Preferences - a Business Idea
I've always thought that there are significant inefficiencies around our leisure activities - be it plane flights, hotel nights, restaurante outings, etc... Seats, rooms, tables are given out to parties without necessarily there being optimal transactions between willing parties.
An example is somebody given a middle seat on a plane espite the fact that he/she would have been willing to pay an amount of money that somebody at an aisle or window seat would have been willing to receive in exchange for their seat, or significantly more price differences in a hotel due to the differing characteristics of each room, or in restaurant tables - why can't table X with a slightly better view of the sea at restaurant y be worth more than the other table? or theater seats, or sport seats (it is already widely practiced in sports stadiums - significant number of price levels according to quality).
There would be business models to solve this inefficiency albeit complex: 1) an online exchange to buy-up the better seats, rooms, tables, 2) service provided to corporations to map out their various levels of product (best to worst rooms), best to worst seats and to differentially price according to it...
Of course, there might not be enough incentives for business owners to achieve this since ultimately it could end up being the case that less money is collected by price discriminating among customers.
An example is somebody given a middle seat on a plane espite the fact that he/she would have been willing to pay an amount of money that somebody at an aisle or window seat would have been willing to receive in exchange for their seat, or significantly more price differences in a hotel due to the differing characteristics of each room, or in restaurant tables - why can't table X with a slightly better view of the sea at restaurant y be worth more than the other table? or theater seats, or sport seats (it is already widely practiced in sports stadiums - significant number of price levels according to quality).
There would be business models to solve this inefficiency albeit complex: 1) an online exchange to buy-up the better seats, rooms, tables, 2) service provided to corporations to map out their various levels of product (best to worst rooms), best to worst seats and to differentially price according to it...
Of course, there might not be enough incentives for business owners to achieve this since ultimately it could end up being the case that less money is collected by price discriminating among customers.
Mortgage Mess: Who's to blame?
Buyer beware? Lender responsibility? Investor responsibility?
Income is tightly correlated with the sophistication to understand what it being sold to somebody. Does the government have a responsibility to protect those that are less "able" to make the correct decisions, and if the government protects these people, where is the line drawn? (to not intrude into the decisions of those that are able to take their own decisions given full information and which make economies grow and markets move?) Perhaps the old liberal vs. conservative argument - should the government help some people and by establishing policies to help such people, do you then perhaps create an environment that is less conducive to growth (and thus end up with a smaller pie, and helping them less to start with).
Back to the mortgage market - I personally find it hard to believe that given the extent of the paperwork, and the size of the economic transaction, that these people were actually taken for a ride. I think it was wishful thinking (to buy a home knowing very well the risks inherent in the mortgage), the same wishful thinking that the experienced people went through - that home values would never decline, that refinancing is always an option (that led these people to take out these loans).
Why were minorities overrepresented in sub-prime pools - partly because of lack of education (taken for a ride) and partly because they are poorer and have worse credit on average (than non-minorities). Having said that (even if they were taken for a ride), it doesn't mean that they didn't make the decision (to buy a home or refinance) knowing that there wasn't a risk...
Income is tightly correlated with the sophistication to understand what it being sold to somebody. Does the government have a responsibility to protect those that are less "able" to make the correct decisions, and if the government protects these people, where is the line drawn? (to not intrude into the decisions of those that are able to take their own decisions given full information and which make economies grow and markets move?) Perhaps the old liberal vs. conservative argument - should the government help some people and by establishing policies to help such people, do you then perhaps create an environment that is less conducive to growth (and thus end up with a smaller pie, and helping them less to start with).
Back to the mortgage market - I personally find it hard to believe that given the extent of the paperwork, and the size of the economic transaction, that these people were actually taken for a ride. I think it was wishful thinking (to buy a home knowing very well the risks inherent in the mortgage), the same wishful thinking that the experienced people went through - that home values would never decline, that refinancing is always an option (that led these people to take out these loans).
Why were minorities overrepresented in sub-prime pools - partly because of lack of education (taken for a ride) and partly because they are poorer and have worse credit on average (than non-minorities). Having said that (even if they were taken for a ride), it doesn't mean that they didn't make the decision (to buy a home or refinance) knowing that there wasn't a risk...
In general, I don't support the supposition that on average, the customer was taken for a ride - its too much of an important transaction for anybody, no matter their financial circumstances to claim that it wasn't their fault. Make buyers very responsible for the decision and potentially we would not have had this extent of a mess.
Sunday, November 18, 2007
Mortgage Market: The actors in the crisis and their role
There were a confluence of factors and no shortage of actors, each with their own incentives, but, I will focus on a couple here as possible spark plugs for what we just saw happened.
Number 1
A belief by all actors in the system that home prices simply went up (and thus, that there would always be alternatives to a foreclosure - selling the home or refinancing).
This led to the creation of products that expanded the buck and focused on simply the initial payments to qualify a borrower. "Tomorrow is always better than today" - and the adjustment periods became shorter.
Also, additional risk layers (that permitted the borrower to take more risk- not necessarily tied to an adjusting payment- but to borrow more relative to the value of the home or borrow more from their own income to pay for the mortgage) were permitted for a low price (again, the belief that the risk of default was very low).
Investment Banks (nothing new)
The investment banks saw an opportunity to deliver paper to hungry investors (for yield) and simply looked for ways to deliver that yield - ever more risky assets ended up in paper that was sold to the market. It was then not the assets themselves but their structuring that let to the higher yield. Perhaps investors were not willing to take on higher yield in a risky asset by itself, but, if it was packaged in a particular way, then they were able to take it.
These two were not only spark plugs, but, they were necessary conditions for the feeding frenzy to continue (with one additional item - the appreciation of homes - for the party to continue homes actually had to appreciate in value).
While there were spark plugs and necessary conditions. There were other things that permitted to fire to expand so fast. Like the wind is to a fire, there was the channel itself - Wall Street needed paper with a higher yield to put into securities (because they were able to convince investors, for whatever reason, that it was good), well, "we know how to find mortgages" and by the way if you didn't like the yield I found you the last time (high LTV, high DTI), here is how we can find more yield (stated income, lower FICO)... So, what is the channel? it is composed of mortgage bankers, mortgage brokers, realtors (who were able to sell more homes), appraisers (who were able to make more appraisers), and others...
So, it was a great, great world - borrowers were able to get better and bigger homes, brokers and mortgage bankers made fortures, realtors sold homes like never before, appraisers had more business than ever (and btw, to remain competitive they needed to become more lax in their stds, because otherwise, the bank - who pays them would simply go next door - this is a different topic, how do you uphold your stds in feeding frenzies and still manage to do business, it is almost like losing in every direction, but, this point applies to everybody - brokers, bankers, appraisers, wall street and even investors), wall street was getting some fat fees, and investors were getting great yield.
Which gets me to the following point (which is already implied up there)... whenever
(1) a deep belief (that is contingent on certain (up to that point) illogical elements happening) is ingrained in a market (can be led by some of the players),
(2) that is linked to a (significant) profit opportunity among many dispersed players, and
(3) not everybody has the same information, and
(4) those with the most information are compensated based on commissions (not taking any risk or if they can control the risk - for example, mtg bankers taking equity out of their companies every year)
other necessary elements:
- hot potato based on risk - people believe that if you ever run into trouble, you can simply unload by selling
- belief that the private markets always come up with the optimal outcome and that they regulate themselves (i.e. excessive risk taking would come by the way of losses)...
- transaction based income for main players - no skin in the creation of the hot potato...
the results?
Investors: made yield for many years, hot potato was dispersed (although some took real risk)
Investment Banks: made money, transactions, profits during those years? hot potato write-off (the little of what remained)
Brokers: made money, transactions, no skin
Bankers: made money, transactions, pulled a lot of money out
Realtors: made money, transactions, no skin
Appraisers: made money, transaction, could lose their license.
Mortgage holders: they are the ones that are holding the two key assets: the homes (that can drop in value) and the mortgage (that they can potentially not be able to pay) - some however, got a mortgage that they would not have gotten otherwise and will still be ok...
Number 1
A belief by all actors in the system that home prices simply went up (and thus, that there would always be alternatives to a foreclosure - selling the home or refinancing).
This led to the creation of products that expanded the buck and focused on simply the initial payments to qualify a borrower. "Tomorrow is always better than today" - and the adjustment periods became shorter.
Also, additional risk layers (that permitted the borrower to take more risk- not necessarily tied to an adjusting payment- but to borrow more relative to the value of the home or borrow more from their own income to pay for the mortgage) were permitted for a low price (again, the belief that the risk of default was very low).
Investment Banks (nothing new)
The investment banks saw an opportunity to deliver paper to hungry investors (for yield) and simply looked for ways to deliver that yield - ever more risky assets ended up in paper that was sold to the market. It was then not the assets themselves but their structuring that let to the higher yield. Perhaps investors were not willing to take on higher yield in a risky asset by itself, but, if it was packaged in a particular way, then they were able to take it.
These two were not only spark plugs, but, they were necessary conditions for the feeding frenzy to continue (with one additional item - the appreciation of homes - for the party to continue homes actually had to appreciate in value).
While there were spark plugs and necessary conditions. There were other things that permitted to fire to expand so fast. Like the wind is to a fire, there was the channel itself - Wall Street needed paper with a higher yield to put into securities (because they were able to convince investors, for whatever reason, that it was good), well, "we know how to find mortgages" and by the way if you didn't like the yield I found you the last time (high LTV, high DTI), here is how we can find more yield (stated income, lower FICO)... So, what is the channel? it is composed of mortgage bankers, mortgage brokers, realtors (who were able to sell more homes), appraisers (who were able to make more appraisers), and others...
So, it was a great, great world - borrowers were able to get better and bigger homes, brokers and mortgage bankers made fortures, realtors sold homes like never before, appraisers had more business than ever (and btw, to remain competitive they needed to become more lax in their stds, because otherwise, the bank - who pays them would simply go next door - this is a different topic, how do you uphold your stds in feeding frenzies and still manage to do business, it is almost like losing in every direction, but, this point applies to everybody - brokers, bankers, appraisers, wall street and even investors), wall street was getting some fat fees, and investors were getting great yield.
Which gets me to the following point (which is already implied up there)... whenever
(1) a deep belief (that is contingent on certain (up to that point) illogical elements happening) is ingrained in a market (can be led by some of the players),
(2) that is linked to a (significant) profit opportunity among many dispersed players, and
(3) not everybody has the same information, and
(4) those with the most information are compensated based on commissions (not taking any risk or if they can control the risk - for example, mtg bankers taking equity out of their companies every year)
other necessary elements:
- hot potato based on risk - people believe that if you ever run into trouble, you can simply unload by selling
- belief that the private markets always come up with the optimal outcome and that they regulate themselves (i.e. excessive risk taking would come by the way of losses)...
- transaction based income for main players - no skin in the creation of the hot potato...
the results?
Investors: made yield for many years, hot potato was dispersed (although some took real risk)
Investment Banks: made money, transactions, profits during those years? hot potato write-off (the little of what remained)
Brokers: made money, transactions, no skin
Bankers: made money, transactions, pulled a lot of money out
Realtors: made money, transactions, no skin
Appraisers: made money, transaction, could lose their license.
Mortgage holders: they are the ones that are holding the two key assets: the homes (that can drop in value) and the mortgage (that they can potentially not be able to pay) - some however, got a mortgage that they would not have gotten otherwise and will still be ok...
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