Something is Wrong!

A headline in the New York Times, “Walk Away From Your Mortgage!”

Why not?

The best remedy for the current economic malaise?

Since there is too much debt, let’s all just walk away from our debt.

And, if the New York Times is printing such material, then it must be OK! Right?

As we “recover” from the Great Recession we see pockets of problems all over the place. Things just don’t fit together the way they used to. And, what we are doing to combat these problems doesn’t seem to be relieving the suffering. The whole world seems to be dislocated.

There is too much debt outstanding. No one disagrees with that, but how do you get people and businesses and governments to start spending again when they are desperate to reduce their outstanding debt?

Other headlines this morning point to the problems in commercial real estate. In “Delinquency Rate Rises for Mortgages” we read that “More than 6% of commercial-mortgage borrowers in the U. S. have fallen behind in their payments, a sign of potential troubles ahead as nearly $40 billion of commercial-mortgage-backed bonds come due this year.” (See http://online.wsj.com/article/SB20001424052748704130904574644042950937878.html#mod=todays_us_money_and_investing.) Also, “Further Slide Seen in N. Y. Commercial Real Estate” points to the fact that 180 buildings totaling $12.5 billion in value, are in trouble in Manhattan. (See http://www.nytimes.com/2010/01/08/nyregion/08commercial.html?hp.)

But, the problems don’t seem to be just in commercial real estate. The New York Times article cited above states that at least one quarter of all residential mortgages in the United States are underwater and that 10% of the mortgages outstanding are delinquent. Another round of foreclosures and bankruptcies seem to be on the way.

Which brings us to the banking system: here the difficulties bifurcate depending upon size. If you are really big you seem to be doing very, very well these days. In fact, it seems as if the “good ole daze” have returned for these bankers. Risk-taking and speculation in the carry trade abound. Simon Johnson, an economist at MIT issued a warning on CNBC yesterday morning that the next phase of the financial crisis could be just beginning and this gets back to the risk-taking of the six major banks in the US whose combined balance sheets exceed 60% of United States GDP.

If you are smaller, however, your problems are immense. The smaller banks are carrying the burden of the commercial real estate problems and consumer debt and mortgages still present these banks with problems because these loans represented “Main Street” and were not all packaged and sold to investors in Finland. Remember there are 552 banks, all small- and medium-sized banks that are on the FDICs list of problem banks and this is expected to grow this year before declining, generally do to actual failures.

There are more dislocations throughout the economy that point to persisting problems. For example, in manufacturing, since the 1960s the unused capacity of United States industry has continually declined from peak usage to peak usage of that capacity The latest peak utilization of capacity still saw that about 20% of the industrial capacity of the United States remained unused. Unused capacity for the past thirty years seems to average around 23% to 24%.

We see unused capacity in the labor force as well. Since the 1970s under-employment of labor has grown quite consistently. Attention is focused upon the unemployment rate, but this measure does not include those individuals that have left the labor force because they are discouraged and those that are only working part time but would like to work more. We have seen estimates that 17% to 20% of the employable people in the United States are under-employed. Another dislocation that is not comforting.

Then we hear about the problems in state and local governments. Reports indicate that there are more than 30 states that are currently experiencing fiscal difficulties. We hear most about California and New York, but there are many other states particularly in the west and southwest that are having real problems. One estimate is that the states will have a combined budget shortfall of at least $350 billion in the fiscal years of 2010 and 2011. And, this doesn’t even get to the difficulties that are being faced by local governmental bodies.

And, there are the dislocations being created by the federal government. Budget deficits for the next ten years have been placed in the range of $15 trillion. The United States is fighting in three wars throughout the world. The government is passing health care legislation that has been justified fiscally by postponing start dates of programs from three to five years. There is climate control efforts being considered along with regulations, like anti-pollution controls, that will just exacerbate the economic and fiscal problems of the country. Then there are other changes in the rules and regulations that apply to industry that will further change the playing field and create greater uncertainty about what management’s should do.

There is the problem of unemployment, the number one issue among the American voter. (And, you thought the number one issue was health care or pollution or terrorism or the war in Afghanistan.) But, there is a dislocation problem relating to federal government stimulus programs.

For fifty years or so, the federal government has attempted to stimulate the economy to put people back to work in the same jobs that they were released from. The government has sought to put unemployed people back to work in the steel industry, in the auto industry, and in other jobs that are the backbone of American industry (according to the labor unions and others). As a consequence, the steel industry lost competitiveness, the auto industry lost competitiveness, and so do many other industries.

This effort to stimulate the economy and put people back into the jobs that they had lost has contributed greatly to the increase in the unused industrial capacity and to the increase in the under-employed in this country. The effort to constantly maintain a low unemployment rate by putting people back into the jobs they have lost has resulted in a massive slide in the competitive position of the United States.

The point of this discussion is my concern with the huge dislocations that now exist within the country. Things are out-of-whack and it is going to take us quite a while for us to get things back together again. Yes, we can try and “force” the economy back into a position of higher employment and greater capacity utilization, of lower debt burdens and greater solvency. But, this would just postpone, once again, the need to realign the country to deal with the pressures of the 21st century.

Something has changed, however. The United States is now facing a more competitive and hostile world economy. The government may not be able to “force” the economy back into its old mold.

Are Derivatives the Problem?

Bob Shiller, the Yale economist, has gotten a lot of press in recent days supporting the use of derivatives and arguing against the use of the efficient markets model in understanding financial (and non-financial) markets. I am supportive of what he is trying to say. In this post I present my reasoning for this support…you can go to Bob’s articles in the Wall Street Journal and elsewhere and his upcoming book (along with his many other books) to get his view.

First, human beings are innovators. They are problem solvers and are constantly pushing the edge trying to come up with something new that makes things better.

The problem we are dealing with here is risk. People, investors, don’t like risk. They are constantly trying to reduce risk in their lives…and they are willing to pay to reduce risk.

And, this is the essence of derivatives. Derivatives are risk reducing tools that can be used to hedge cash flows and thereby protect individuals from assuming more risk than they would like. People will pay for this…derivatives will get invented.

Answer me this…will a large number of people pay someone to invent a tool for increasing risk? The answer to this is no! People don’t pay people to build speculative instruments. The expected return to speculation is zero or less. Now how much will you pay for someone to create a tool that can provide you with an expected return of zero or less? Right…nothing!

People will pay innovators to build instruments that help to reduce risk because they are receiving value by being able to reduce the risk. Now this does not mean that people will not use these risk reducing instruments to speculate with. Hedging is providing a cash flow to offset the movements of all or part of another uncertain cash flow. Speculation means that you are taking an uncovered position…that is, you are working with only one of the cash flows.

So, like other innovations, derivatives have been created for a positive reason…but can be used in ways that increase risk. Like cars…or drugs…or nuclear energy plants. All these can be used in positive ways…but they can also be used in other ways as well.

Conclusion: derivatives will continue to be used, created, and, at times, misused. Financial innovation is with us and will continue with us. My experience supports the view that only a minimal amount of regulation will be effective to control the use of derivatives because part of innovation…is to get around the rules. That’s life!

My second point has to do with the efficient market hypothesis. People who support the efficient market hypothesis argue that market prices reflect all the information that is available to the market at a particular time. That is, market prices are correct. In essence, everyone in the market knows what information is available, what that information means, and how that information is translated into market prices…for all time. At least, there is a well informed group of arbitragers that know these things so that “on the margin” market prices can be made “right”.

In the world I live in, individuals have to deal with incomplete information…especially about the future. That is why uncertainty exists and why people have created probability theory as a way to deal with incomplete information and the resulting uncertainty. For prices to be “correct” and for markets to be “efficient” we need complete information which means no probability distributions for we will have certainty. I can’t believe that everyone in the market, given what information is available, knows what the price of every stock will be at every period of time in the future.

When we have incomplete information markets cannot be efficient because we don’t know the exact models to forecast the future with and we don’t know the appropriate probability distributions that surround our forecasts. As a consequence, our risk management models, as well as our risk management controls, have been inadequate. As such, our hedges have contained more risk in them than we had anticipated and our speculative positions have provided way more risk that we had assumed. Thus, our financial structure has been out-of-line with where we thought we were and our financial system has been more fragile than we thought.

My third point concerns the incentives present in an economy. People will use the instruments that are available to them in ways that are consistent with the incentives that exist within the economy at a given time. For example, in the past, the price of a house may have appreciated over time but this was not the real value of the house. The real value of the house was the flow of services that people received over time…it was this which made the house a home. What people acquired was the flow of housing services…not the stock…not the house itself. This was because the house was not going to be sold…at least not for a long time into the future. In this sense the price of the house was only important at the time of purchase.

What changed? In recent years in too many cases the price of the house became more important than the flow of services. Why? Because in many cases, houses were “sold” every two or three years. People with teaser interest rates, or whatever, that reset every three years, “sold” their house to themselves because the game was to refinance the house using the inflated house price to get a better mortgage rate. Living in the home was not the essence of the deal…speculation on the house price was the focus…and this was seen explicitly in the many “speculative” deals that arose at this time. And this was the essence of the asset-based securities used to support these transactions.

Also, remind me sometime to tell you about my friend that ran a mutual fund who avoided moving into dot.com stocks until the year before the stock market bubble burst. He did not move into these securities until he saw that too much money was leaving his fund…going into funds showing better results because they had invested in dot.com stocks. And he made the front page of the Wall Street Journal when the bubble burst and his “late-in-the-day” bets…collapsed.

Finally, my last issue has to do with the government. Unfortunately, in many cases, government policies can dominate the economy; government policies can create the incentives that people respond to. And, although the government may not mean to, it can create incentives that are detrimental, at least over the longer run, to the health of the economy.

If you have read many of my posts, you know that I believe that the Bush43 tax cuts, the war on terror along with other events that inflated the spending of the government, and the Greenspan “low interest rate” policy set the scene for the bubble in the housing market, the exponential increase in credit over the past eight years, and the overwhelming increase in leverage. The incentives that were created during this time put more and more pressure on business executives to take speculative positions and finance these positions with more and more leverage.

Who was responsible for the behavior of these business executives? Like my friend that ran the mutual fund…even those that were relatively conservative in their business decisions…ultimately found themselves forced into positions where they had to take on more risk than they would like. Competitive pressures “forced” decision makers to respond to the current environment that existed in the market place. After-the-fact they seem to have been overly greedy. After-the-fact they appear to have been insensitive to the risk they were taking…careless even. And now, people and politicians have dumped on them for their mis-guided behavior. The politicians that created the environment many years ago…although they might have lost the election…walk away defending their legacy in other areas. This is one of the difficult things about economics…results often trail, by many, many years, those policies and programs that were their cause.

Yes, I agree with Shiller that derivatives are here to stay. And, I agree with Shiller that many new kinds of derivative securities will be invented in the future. I just wish that we could invent a derivative that would allow us to hedge against bad policy making in Washington, D. C.

The Mortgage Market and Incentives

This post is a follow-up to my post of July 27, 2008, “It’s All a Matter of Incentives.” The major concern I was trying to express in that post was that “Incentives are the cornerstone of modern life” (Freakonomics, p. 13) and that Congress and the Administration need to be careful with the incentives they set up because people will not only respond directly to the incentives they set up, but will also attempt to circumvent these incentives if there is economic justification to do so. It is a reality of the situation that this latter behavior may produce results that are contrary to what Congress and the Administration hopes to achieve.

I stated that “The subprime mortgage market is the premier current example” of this type of situation where good intentions have gone awry. These good intentions are captured in the first type of incentive that contributed to the creation of this market: “There were the social and political incentives to develop this market to allow more and more Americans to achieve the ‘dream’ of owning their own home.”

For a long time, owning one’s own home has been the ultimate hope of the American middle class. This dream has been pictured in stories, novels, radio shows, movies, and TV. Supporting this dream has been a foundation stone to the community of politicians. Throughout most of the 20th century politicians have created programs that encouraged and fostered home ownership from the creation of Savings and Loan Associations, dedicated to home finance for the middle classes, to the Federal Housing Authority and other programs developed in the 1930s, to the programs to help GIs after World War II attain their own homes. Helping Americans obtain their own home has been the bedrock of politics for a long, long time.

The effort to create a derivative security that would allow more funds to get into the housing market came about in the late 1960s and early 1970s. This move to create a derivative security with mortgages as the underlying asset was politically driven. The issue was this: insurance companies and pension funds have lots of money to invest in longer term assets. Mortgages are a longer term asset. But, mortgages are held on the balance sheets of depository institutions and when these institutions are fully lent up there are no more funds to support housing ownership and housing construction. How, the question was asked, can mortgages become acceptable assets for insurance companies and pension funds to invest in? At this point investment bankers were brought into the process to help the politicians in Washington, D. C. create an instrument that depository institutions could use to sell the mortgages they previously had held and sell these instruments to those that had so much money available for investment in longer term assets. This would thereby free up funds for the depository institutions so that they could go out and lend more to the housing market spurring on home ownership and home construction. This would result in an economic and social environment in which elected politicians could get re-elected.

We don’t need to go into the details of the construction of the mortgage-backed security because that is not the thrust of this post. All that needs to be said is that over the next fifteen years, the market for mortgage-backed securities became the largest part of world capital markets and the dull-as-can-be mortgage became one of the stars of the speculative universe. This latter point is most memorably captured in the book by Michael Lewis, “Liar’s Poker”.

The point: “For every clever person who goes to the trouble of creating an incentive scheme, there is an army of people clever and otherwise, who will inevitably spend even more time trying to beat it…” (Freakonomics, p. 25) The politicians saw to it that the incentive scheme was created…and then human nature took over. And, as they say…the rest is history.

The creation of the subprime market (and others) is just an add-on to this story. The political desirability of such a market is that funds for home ownership could be pushed down below the middle class into segments of society that had not, previously, had access to mortgage funding. With this innovation more and more Americans could live the dream and politicians could walk away knowing that they had contributed to building a better America…and, the best thing was that it cost the taxpayer nothing…or, at least, as originally conceived it cost the taxpayer nothing. Now the incentives spread from mortgage brokers, to depository institutions, to other financial institutions and to the rest of the world. This scheme really worked…and more and more people wanted to get their piece of what they saw as an expanding pie. This ‘new world’ of finance was different from what existed before. This ‘new world’ would continue to grow and grow.

The problem is that the subprime mortgage worked only in periods when there was inflation in housing prices. The scenario is described in an article in the New York Times about IndyMac, the failed mortgage lender. “Executives at IndyMac, like many other people on both Wall Street and Main Street, apparently never dreamed that home prices might fall. To the contrary, IndyMac made many loans on terms that implicitly assumed prices would keep rising.” The bank lent to people that were below standard in terms of credit quality and did not require “documentation to verify their income and assets.”

“As long as home prices continued to go up, the company’s strategy was very lucrative for executive, employees and shareholders…the boom perpetuated an insatiable hunger for mortgages and…the sales culture took over, and the sales division really drove the company. (See, http://www.nytimes.com/2008/07/29/business/29indymac.html?ref=business.) But, if the market provided positive returns at the beginning, the positive returns drew more and more people into the practice and the added competition drove away the returns and resulted in the participants taking on more and more risk in an effort to make their efforts work.

This was the intended focus of my earlier post, to show how incentives can create further incentives and lead people to chase positive returns by seeking an edge over their competitors. In addition, it is important to document how politicians, chasing a particular outcome, can create incentives that end up resulting in behavior just the opposite of what they desire to achieve.

And, the beat goes on. Splattered all over the July 29 newspapers, we see the news that politicians are still attempting to shore up the housing and mortgage markets. (New York Times: http://www.nytimes.com/2008/07/29/business/economy/29place.html?ref=business; Wall Street Journal: http://online.wsj.com/article/SB121727042664390535.html?mod=todays_us_money_and_investing; Financial Times: http://www.ft.com/cms/s/0/056c8604-5ce1-11dd-8d38-000077b07658.html?nclick_check=1.) Hank Paulson, US Treasury Secretary issued guidelines on the development of a covered bond market. Covered bonds are a form of secured bank debt that gives investors recourse to an issuing bank’s balance sheet and a pool of collateral, usually high-quality mortgages or public-sector loans, if the bank is unable to repay its debt. The reason for this…”to increase the availability of affordable mortgages.”

The role or roles of the Federal Reserve? First and foremost, the Federal Reserve is responsible for the amount of inflation in an economy. Inflation is everywhere and at every time a monetary phenomenon. I believe this. Where is the measure of inflation or potential inflation captured? I believe that Paul Volcker is right when he says that the most important price in an economy is the price of a country’s currency in foreign exchange markets and this captures market expectations of inflation, both current and in the future. The Federal Reserve must not have a bifurcated policy directive…price stability and economic growth. It cannot serve two masters. We see this particularly in the behavior of the Fed over the past seven years as it relinquished its independence and under wrote the inflation in the housing sector so as to support the administration’s economic policy. A central bank cannot do this.

There are two secondary roles that the Federal Reserve plays. The first of these is to help the financial markets avoid a liquidity crisis. This function the Fed performed admirably in March and April of this year. But, once the crises period has been passed, the Fed needs to back off. The second role is to see that the banking sector remains solvent. This responsibility has to do with the capital requirements in effect in the banking system. All other roles that can be assigned to the Federal Reserve must be carefully weighed and considered before they are implemented. I hope this clarifies where I position myself on some of these issues.