Month: March 2009

  • Unintended Consequences

    “In Europe in the Middle Ages and into the Early Modern period it was often the law or custom that a man who raped a woman was forced to marry her. This law was frequently turned on its head by couples who could not otherwise get married—because of differences in their social status, for example. The man and woman would stage a rape, which would produce a social imperative requiring them to marry.”

    Retrieved from “http://cs.calstatela.edu/wiki/index.php/Courses/CS_461/Museum_of_unintended_consequences/Rape_as_a_marriage_proposal“
     
    Over the next week, the rhetoric surrounding the Obama Budget proposal is going to escalate.  There’s just no escaping it.  But the way your Congressional Representatives vote will have much more to do with the pressure you put on them than anything they say to each other in their dueling press conferences. 
     
    I’d like to point out a couple of things in hope that maybe you will be encouraged to contact the Representative and Senator from your district and offer your opinion.  First, there are unintended consequences to every action.  The bigger the action, the greater the consequence.  Past actions and inactions on the part of our government have contributed greatly to the current economic crisis.  The wrong actions now will make it much much worse.
     
    By the way, my son asked the other day, “What is economics anyway …” and I found that off the top of my head it was surprisingly difficult to answer him.  I wanted to talk about money, resources, labor and profit.  But it’s much simpler than that.  Economics is the science of production, distribution, and consumption of goods and services.  The economy is not about “money”, money is a tool used by the economy to make the transfer of goods and services easier.  Which makes all the current conversation kind of weird because we keep talking about the problem as though money is the economy. 
     
    We are indeed having a money problem though.  For a more thorough discussion of our monetary and banking system, please see my previous blog “Lives in the Balance”.  And we aren’t just having a money problem, we are also having a problem of reaction to the problem.  It’s the old horse versus barn-door paradigm.  (If you agree with me now, you can skip straight to the end, recommend me to all your friends and just leave me a great comment.  If you don’t know what I’m talking about, hang in there for the long version.)
     
    Four years ago, monetary agents were lending money to each other, to companies, to consumers, and borrowing from foreign entities to make that happen.  We as a nation and an economy were encouraged in this behavior by a philosophy developed and articulated by Ayn Rand called Egosim.  She was a free-market prophet who declared that any state interference in the affairs of “the producers” is not just good economic policy (a debatable proposition at best) but an immoral act designed to prevent the capable from fully realizing the fruits of their labors while breeding a class of leeches who subsist on the ill-gotten largesse which the government has stolen from the aforementioned Producers.  Alan Greenspan was a friend and student of the late Ms. Rand and has publicly proclaimed his allegiance to her ideas since his first public appointment.
     
    He believed in and wrote policy to support a “supply side” economy.  From this philosophical perspective arose such cloying cliches as “a rising tide lifts all boats”.
     
    Ms. Rand’s position was that given free-rein, the Producers would create better, more efficient, more effective and less expensive products.  Government regulation would lead to inefficiency and waste.  Her magnum opus “Atlas Shrugged” makes this point vividly as the poor beleaguered capitalists are forced into less and less sustainable positions until they are finally convinced that they’ve lost the war.  The book ends with the hero flying West to Colorado to the last enclave of free-market culture where all the great men have fled to produce for themselves alone and to enjoy an unfettered life.  Beneath the wings of the jet, the lights literally go out as the electric grid fails and all the land is swallowed in literal and figurative darkness. 
     
    So we’ve had 30 years of economic policy designed to avoid that scenario.  Has it produced the intended result?
     
    In actual fact, Producers are no more immune to stupidity, shortsightedness, and greed than anyone else.   Instead of creating products that are better, cheaper, more efficient, and more durable, we’ve seen entire industries push the “planned obsolescence” envelope until consumers are willing to accept that the products we buy will be outdated within a few months and unsupported within a year or two.  Remember the Maytag repairman of the old commercials?  What company can you think of today that’s actively marketing it’s products as “built to last?”  What car company today is producing vehicles that get better gas mileage than the ones that rolled off the line in the 80′s?
     
    Advertisers have designed clever campaigns to convince us that we need newer, brighter, shinier, things that our grandparents would have slapped us for buying.  New _______, again?  What’s wrong with the old ones?  
     
    And as a group, we’ve been complicit in all this materialistic frenzy.  Oh, maybe not you personally, but well, yeah, probably you too because it’s pretty damn hard to live in America without thinking that I NEED something that I no more need than I need a hole in my head.  And if I’m in that boat, I’m pretty sure I’m not alone because I’ve been frugal from years before it got to be cool to be frugal.  The bottom line of all this is that our consumer debt in 2007 hit 100% of our gross domestic product.  It took from the Great Depression until the 1980′s for consumer debt to exceed 50% of GDP, but we have gone and shot the moon, baby. 
     
    You know what that means?  There is no money left in the pocket of the consumer to spend.  All the economic gurus tell us that the way to get out of a Recession is to Spend.  But I really must repeat it again since there appear to be so many politicians and talking heads who didn’t get the memo, consumer debt exceeds our Gross Domestic Product.  We don’t HAVE anything left to spend. 
     
    Now, I want to be transparent about something else before I come down to the end of this writing.  Ten years ago, five years ago, I was worried about the size of our national debt.  I thought it was a moral outrage and I couldn’t believe that no one seemed to care.  I remember a particular conversation with a very good friend (Republican at the time but has since transferred to the dark-side as a registered Independent), in which I argued passionately that the National Debt was out of control.  My otherwise responsible friend quoted to me as the concluding argument a line that came straight from Greenspan, “debt is not a problem because our economy is growing, and it will continue to grow for all the foreseeable future. We’ll grow our way out of this debt.” 
     
    The two problems with that line of thinking were that 1) it REQUIRED unabated growth and 2) it REQUIRED no increase in debt.  You’ll never outgrow something if you can stretch it to fit at each new size.    But as I said, my friend has since seen the light so clearly that I haven’t even been tempted to go back and say, “I told you so.”
     
    Now that we are in trouble, I’m hearing absolutely unbelievable calls for “fiscal restraint”.  People who had no problem with government spending five years ago have suddenly found religion, only now the times are different and they are dead wrong.
     
    The only way out of this mess is to spend, and the only place left for the money to come from is the government.  Private investment is dead.  Consumer spending is dead.  That only leaves government spending. 
     
    I don’t want you to think I’m exaggerating, but I’m afraid some of you won’t believe this next statement unless you go look it up for yourself, so I implore you to go, look it up.  The ONLY markets functioning today are those being guaranteed by the government.  If government spending stops, even those markets can’t function.
     
    It’s too late to lock the barn door, the horse is out.  The only way to get the horse back in is to keep the doors open!  It’s way past the time for a “jump-start”, pumping a few hundred dollars into the pockets of taxpayers isn’t gonna do it.  It’s way too late to tell banks to “shore up their capital position” (let me translate that for you, the newly energized regulatory agencies have been telling banks that they are increasing the capital requirement - banks are being required to hold MORE MONEY IN RESERVE! – you cannot LEND more if you are being required by regulators to RESERVE more.)  Sorry for shouting, <deep breath>.’
     
    The time to increase reserves was about 7 years ago when the markets started going off the charts.  That’s the same kind of common sense as “buy low, sell high” but although it’s easy to understand on paper, it’s hard to do in real life.  Instead of telling banks back then that they needed to increase their reserves, they lowered the capital requirement on the five largest banks and the actions that followed brought the unintended consequence of a broken economy.  
     
    Losers panic and sell low or get carried away and buy when things are at their peak.  Decreasing capital reserves in 2003 was like waiting until a certain attractive stock hit $800 a share and then deciding to buy.  Increasing the capital reserves now is like holding that $800 stock until the price drops to $3 and then selling it.  
     
    The unintended consequences of restraint now are pretty clear to see if you’re one of the little guys who was already struggling back when the people calling for restraint were telling us that the crisis was all in our heads and that we were just a nation of whiners.  Distressed banks forced to raise their capital requirements become insolvent banks with the stroke of a regulator’s pen.  An economy that’s barely limping along on Federal guarantees becomes “road pizza” (Tucker’s phrase) if the spending stops. 
     
    If you have never done it before, I urge you to use your Internet Savvy skills and find the web address where you can email your Congressman and tell him or her, “Please don’t fall for the rhetoric.  Now is not the time for the government to stop spending.”  And even more than that, if you are the kind of person who already has your Congressial Rep on speed-dial, I strongly urge you to find one person in your life who hasn’t been politically active and ask THAT person to please make a call or send an email.  We need to speak loud enough to be heard over the roar that’s been created in and around Washington by the sound of the voices of people who love to hear the sound of their own voice but are saying utter nonsense.   
     
    If in our current climate government spending stops, or even slows down, we’re all going to get a front row seat to a new show in town called “What Made the Depression Great.”
     
     

  • Below the Brown Bag

    I’m determined to brown bag my lunch to save money.  And I’m getting tired of bologna sandwiches (even though I’ve only taken them once.  It doesn’t take much bologna to do that for me.) 

    So here’s my plan.  Make vaguely casserolish dinners of which there will be ample leftovers and I’ll take the leftovers to work in my Tinkerbell Lunchbox. 

    This is not working as well as I’d hoped.  In fact, it’s not working at all.  My boys have suddenly developed a powerful liking for vaguely casserolish meals.  Tonight, I made manicotti, and I cleverly planned far far ahead.  I cooked and stuffed two boxes of noodles.  Surely there would be left-overs.  After the feeding frenzy, I went in to survey my reward.  There were three noodles left.  Not bad, I could do three noodles for lunch.

    Then I heard Michael say, “This stuff was really good, I’m gonna have seconds.”

    And that was the end of that. 

    Maybe next week.  They will be on Spring break with their Dad.  I’ll have my opportunity for leftovers then.  But it sure will be quiet.

     

  • Lives in the Balance

    Are you getting tired of hearing about the banking crisis?  The money crisis?  The mortgage crisis?  Are you getting tired of hearing someone’s opinion about it?  Are you tired of people “debating” by throwing big words at each other more designed to keep the viewer confused than to define and clarify the problems much less evaluate solutions?

    I think we all get it that the banking crisis affects ordinary people.  I don’t think any of us really get a sense of which government actions (or inactions) might be helping and which might be hurting.  I’m not going to try to persuade you to support one course or another, but I do want to explain some of the words we hear if we watch the news and hopefully shed light on what the debate is all about. 

    As I analyze a company for it’s financial strengths and weaknesses, I look at two documents (well, okay I look at a whole lot more, but these two are central).  I look at an income statement and I look at the balance sheet.  The current banking crisis is a crisis of the balance sheet.

    Let’s say I win a smallish lottery and I want to use my winnings to start a bank.  I have $10,000 of my own money.  I get a charter from the government and I’m in business.  The first thing I do is go to all my friends and tell them I’ll pay them 3% on the deposits they make into my bank.  Let’s say I have 9 friends, all of whom also have $10,000 so when they make their deposits.  My bank now has $100,000.

    Now my bank is losing money because I have to pay the people who have made deposits.  So I also go looking for people who have a need to borrow money.  I tell them that if they’d like a loan from me, I’d like to see some proof that they will have income to pay it back, I’d like to know that they have character to pay me back, and if they meet my criteria, I’ll loan them the money they need and they’ll pay me back, plus they’ll pay me 6% interest. 

    My balance sheet now has three entries. 

    The $90,000 which my friends deposited are called my LIABILITIES.  Those dollars are liabilities because my friends can come to me at any time to withdraw their money and I have to be ready to give it to them. 

    The $10,000 I put in is my EQUITY.  That’s the amount of money I have a right to draw out for myself. 

    Liability + Equity =  This is the amount of money I have to lend and they are both shown on the same side of the balance sheet.

    On the other side of my balance sheet is the money I’ve loaned out which I call my ASSETS.  The loans I’ve made are assets because they are paying me money, 6%.  The difference between the 6% I’m earning on my assets and the 3% I’m paying for my deposits is my profit which is added into my equity.  In my first day on the job as a banker, I met a guy, Joe, who wanted to borrow $100,000 to buy a house.  I loaned it to him and that’s my entry on the other side of the sheet.  

    So that’s the simplest balance sheet ever.  Three entries, Liability + Equity ($100,000) = Assets ($100,000).  And it all balances. 

    The most complicated bank in the world right now is Citigroup.  You can google Citigroup financial statement and find their balance sheet online.  They end their fiscal year on Dec. 31 and the top entries I googled show the balance sheet through 2007.  At that time Citigroup showed Liability (2,074,033,000,000) + Equity (113,598,000,000) = Assets (2,187,631,000,000).  Everything balances. 

    Now what happens when something goes wrong with an asset.  Say, Joe, who borrowed that $100,000 for the purchase of his house.  Six months later he comes back to me and says, “I’m sorry, I lost my job, I can’t repay the mortgage.”  When Joe and I made our agreement up front he pledged his house as collateral for his loan.  So now that he can’t pay his loan, I own his house.  In ordinary times, this isn’t a problem because the house has value, I sell the house to someone else, and I’m back in business.  But these aren’t ordinary times.

    There are literally millions of Joes out there who for one reason or another can’t pay their mortgage.  The supply of houses far exceeds the demand for houses.  And because of that I can’t sell the house for more than $80,000.  I have a balance sheet problem. 

    $10,000 + $90,000 = $80,000.

    If I sell the house now, I will be $20,000 in the hole.   I’d be bankrupt.  I’ve lost all of my equity plus I’ve lost $10,000 of the money that people deposited in my bank.  These assets which are worth less now than they were worth when I did the loan, are called Toxic Assets.  Though a lot of different people have weighed in with opinions about the banking crisis, the debate going forward is over this critical problem.  How are we going to deal with these toxic assets?

    1. Bad Bank – this is a concept used with some considerable success in Europe.  When a bank gets into trouble because of toxic assets, the Bad Bank buys the assets for just a little less than their face value but more than the market says they are worth.  The banks love this plan.  They lose a little, but they keep their bank and stay in business.  In essence, this is the Paulson plan as it was proposed last Fall.  Remember the title of that plan was “Toxic Asset Relief Plan”.  TARP as it was talked about and sold to Congress and the American Public was a Bad Bank Plan.  Those toxic assets would be purchased and HELD until some time in the future when the price of houses would rebound, then sold.  The taxpayer foots the cost for now, but gets money back in the end when the sale is made. 

    2. Another way we could deal with toxic assets is to wipe out the bank.  We say, sorry, you didn’t verify Joe’s income, you didn’t verify Joe’s assets, you loaned money based on a false appraisal so you loaned more money than the asset was worth and now Joe can’t pay, you screwed up – see you in bankruptcy court. 

    Remember that amount of money Citigroup shows as it’s liabilities?  The amount that depositors have in the bank?  If the bank’s assets are insufficient to cover the bank’s liabilities, then the bank is insolvent.  It’s technically bankrupt.  Some people are calling for exactly this option.  Let the banks fail, they say this is the way that markets regulate themselves and that the markets should be allowed to do just that.  

    If Citibank is bankrupt, the American taxpayer is on the hook because the Federal Deposit Insurance Corp (that’s us) has guaranteed depositors up to $250,000 each that they won’t lose their money.  At Citigroup alone that’s close to a trillion dollars.  But even worse than the taxpayer being on the hook for the insured deposits, is the fact that “institutional investors” and other big companies who have their money in Citigroup would lose.  Institutional investors means mutual funds, IRA accounts, money markets … the money that Americans are relying on for retirement.  Companies who bank millions of dollars with Citigroup would not be insured and would lose everything.  Allowing Citigroup to fail means that in addition hundreds and possibly even thousands of small, medium, and large businesses  would have their capital wiped out, they would also fail. 

    Then the cost to the tax payer becomes the cost of life in the Great Depression – we have 20% unemployment or higher, and a whole generation lost to that giant flushing sound.  Economists are concerned that not only the largest banks, but potentially hundreds across the country are potentially insolvent.  (I’ll come back to this question further down.) The fear is that if even one of the biggest banks goes down, all the rest will follow in a cascade of failure that would not only crash the US Economy, but would ripple around the globe. 

    3. The third main proposal is that we nationalize the banks.  This is the policy preferred and implemented by the International Monetary Fund around the world.  We are not the first country to get into a banking crisis.  The IMF says that the longer the crisis is allowed to continue, the more costly it will become.  So their recommendation is nationalize as early as possible.  Use government money to bring the balance sheet even (which if the banks fail we will have to do anyway) and then as soon as they are stable, we sell them back into private hands.  There have been countries who successfully employed this strategy and only owned the banks in question for a matter of hours.  It’s a big hit to the taxpayer, but it’s a known hit, it ends the crisis, and we can get back to economics as usual on Monday morning. 

    Bankers hate this solution.  They lose control of their banks, they lose their jobs, they lose their big bonuses.  As a tax payer, I kind of like this plan.  I figure this is the only plan in which the bankers feel as much pain as I do.  I’m angry that they loaned so much money to people who obviously can’t repay their loans.  So I want them to suffer too. 

    4. The final option under debate is somewhere in the middle.  In this option instead of pouring a trillion into Citigroup, a trillion into Wells Fargo, a trillion into B of A … as they all go bankrupt, or we nationalize them, we pour a few billion into them to shore up the balance sheet.  We implement rules and regulations that say things like, “in exchange for taking public money, you will limit executive pay, you’ll go to a lending process where you verify the borrowers’ assets down to the last penny and you look at his credit history all the way back to 4th grade when he borrowed that dime from Jennifer for his milk money.  You’ll imporve the rigor of teh appraisal process and you won’t ever ever ever lend 100% of the value of a home (that way if the price of homes does fall, there’s at least a small cushion to protect the bank from losses.”

    This last option is the plan the Obama Administration has come up with.  Some economists fear that its not enough and that we are postponing the inevitable.  They are saying that the Toxic Assets on the balance sheet are more toxic than the banks are representing.  If the money that’s being poured in only brings the balance sheet into balance, or worse, if it doesn’t balance it, there’s no money to lend and businesses will continue to fail or down-size which hurts domestic production which means that the toxic assets become more toxic as more people lose their jobs and home prices continue to fall. 

    But there are other economists who side with the banks and say that the situation really isn’t as bad as it looks on CNN, the assets held by the banks do have value and if we just give them time, they will appreciate back to a level that allows the bank to sell them for enough to cover liabilities and the crisis is over. 

    The biggest unknown in the whole mess is the value of these toxic assets, just how toxic are they.  That one piece of data would tell us in an instant whether the banks truly are insolvent.  Banks are saying it’s not that bad, economists and the market are saying that they fear its far far worse than the banks have been willing to admit. (We can figure out what the market thinks by looking at the price being paid for Citigroup stock.  They have 113 million shares of stock outstanding.  On Friday, Citigroup stock closed at $1.74 per share = $196,620,000.  Compare that to the balance sheet which says that the stock-holder equity is $113 Billion and you can see the problem.  The market thinks that if Citigroup had to pay all its stockholders today, those stockholders wouldn’t get much of anything.)

    And that’s where part 2 of the Obama plan comes in.  The nation’s 19 largest banks have been given until the end of April to complete a collateral “stress test”.  This means that they are to evaulate their assets under certain assumptions, (unemployment rates, falling housing prices, etc) and determine whether or not they would be continue to be solvent under these asumptions.  If they aren’t, they would have 6 months to either raise their capital elsewhere, or the Government would step in and purchase (Nationalize) a certain percentage of the bank.  

    There is room for debate on all these questions.  I’m sure we all have an opinion about what might work and what the impact of failure would be on ourselves and our families.  What I hope is not that I’ve convinced you, as indeed I have not attempted to convince you, which plan is the best for America.  What I hope is that I’ve explained the options well enough that with a little more research you’d feel confident to let your Congressional Representatives and Senators know what you are hoping they will do. 

    * * * * * * * * * *

    Money Savers:

    In the midst of the national preoccupation with getting a good deal – have you changed anything about your own spending habits?  Are you saving money now in ways you weren’t a year ago?

    Here’s what I’ve changed recently:

    Cancelled cable television, signed up for basic Netflix plan.  Monetary savings = $50 per month and ironically, I think I’m watching more television programming now.  I like that there are no commercials, I can see an hour long program in 40 minutes.

    Staying out of bookstores.  I have only bought two books since Christmas, a couple of discounted paperbacks at Walmart which I’ve read, loaned to a friend and will put in a care package for troops in Afghanistan soon. 

    Brown-bagging my lunch.  I’ve slipped on that one lately, been going out to lunch with my friends.  But I grocery shopped this morning and I’m set now for two weeks of lunch in a ziploc bag/box in my Tinkerbell lunchbox. 

    What are you doing?

  • More Sexy Money Talk

    How many people think that the Community Reinvestment Act and the liberal Congress who forced banks to lend to poor minorities without a clue how to handle the responsibility of homeownership is the true cause of the mortgage crisis?  How many people think that Fannie Mae and Freddie Mac were taken down by the overwhelming number of poor people who defaulted on their mortgage?  There are so many myths floating around out there that it’s hard to know what’s really going on.  Have you heard these?

    MYTH 1 – CRA caused it.

    As a banker required to pass annual tests on the Community Reinvestment Act and at least 20 other Banking Laws and Regulations covering the A to Z’s of lending, it’s amazing to me how many people feel free to blame CRA for the mortgage crisis when they obviously have no idea what CRA is or what it forces banks to do (or not). 

    Here’s the myth:

    “Congress imposed sanctions and fines on banks that did not lend to a sufficient number of minority customers, regardless of their creditworthiness or ability to repay a mortgage. Banks found themselves having to make these subprime loans.”

    Here’s the truth:

    CRA does not require a bank to lend money to anyone who doesn’t qualify for the loan, period.  The Community Reinvestment Act doesn’t fine banks or punish them for failing to lend.  What CRA does is keep a scorecard of the amount of local activity a bank performs.  When and IF that bank ever desires to merge with another bank, a low CRA score can result in the Fed refusing to approve the merger.  That’s it.  That’s all it says. 

    There is NO Federal or State Banking Law anywhere that ever requires a bank to loan to anyone who doesn’t qualify for the loan.  On the other hand there are multiple organizations including the Federal Home Loan Bank, FDIC, Federal Reserve and others that come in regularly and evaluate the collateral for the loans any given bank has on the books.  If that collateral is weak, the bank IS fined, given strict supervision guidelines, or can find itself taken over by the Fed with it’s collateral sold for pennies on the dollar to another more solid bank.  That’s a pretty strong disincentive for banks to loan money to weak borrowers. 

    Banks are subject to anti-discrimination laws.  So if, for example, a bank has a habit of approving loans to green people at an interest rate of 5%, but only approving loans to equally qualified purple people at an interest rate of 10%, the bank can be fined and have it’s CEO Spraypainted Pink in the Public Square. 

    Every year regulators come and look at a random sampling of loans made by a particular bank.  The regulators bring their own calculators and hole up in a back office with food they also bring themselves in hermetically sealed containers lest someone from the bank accidentally befoul the process by offering them a sandwich (I’m exaggerating – a little).  They spend weeks glaring at everyone suspiciously and asking a lot of questions. 

    The idea that the regulators come in and fine banks who fail to lend to a certain number of minorites is good drama, but it’s not true.

    MYTH 2: Fannie Mae and Freddie Mac did it.

    “This crisis started in our housing market in the form of subprime loans that were pushed on people who could not afford them. Bad mortgages were being backed by Fannie Mae and Freddie Mac, and it was only a matter of time before a contagion of unsustainable debt began to spread. “

    Oh really?  The market share of Fannie and Freddie. in the years 2004 to 2007, never came close to its level before the junk market took off. According to data from the Federal Reserve Board, Fannie and Freddie securitized $315.2 billion worth of mortgages in 2002, accounting for 50.1 percent of the new mortgage debt that year. In 2006, they securitized $276.0 billion in mortgages, giving them a market share of just 34.8 percent.

    When you look at the Subprime Market, Fannie and Freddie had even less of an impact.  Between 2004 and 2006, Fannie and Freddie went from holding a high of 48 percent of the subprime loans to holding about 24 percent, according to data from Inside Mortgage Finance. 

    And did they relax their standards so much that they were brought down by the high default rates of the loans Fannie and Freddie purchased?  The data is available at the Fannie Mae site.  The Serious Deliquency chart includes everyone who is 90+ days late on a single family home loan, or 60+ days late on a multifamily home.   These are very conservative data because not all these homes will get to foreclosure, but they are the ones most likely to go there.  The serious delinquency rate is 2.4% on Single Family and .30% on multifamily homes. 

    That’s a rate at or below the historical default rate.  Compare that to data from Moody’s Investor Services which announced last month that 42% of all subprime loans are seriously delinquent and that as many as 50% of all subprime loans could be in default by the end of the year. 

    It’s starting to look like Fannie Mae and Freddie Mac are the only good news out there. 

    MYTH 3: It’s less risky to play with money than have unsafe sex.

    In spite of the fact that Fannie Mae and Freddie Mac have very low default rates, they’re in trouble.  So how is that?  Their woes are easily explained if you understand the twin dangers of exaggerating the size of your equipment and swapping sex partners. 

    The executives at Fannie Mae and Freddie Mac, just like all the big boys, got paid based on how many times they scored.  Now as I pointed out above, for several years straight, they weren’t scoring.  They were in fact losing market share hand over fist.  They were losing because in spite of the rumor that they were cheap and easy as the crack whore on 4th and Main, they actually had standards.  But they were talking the talk like, well, like one of those rappers who really came from a nice middle class family with a nice home, made straight A’s, walked the dog, and had a curfew, who writes lyrics about blood, guns, needles, and wife-beating.

    Most of the loans Fannie and Freddie were buying were Prime loans made to people with substantial downpayments, excellent credit, stable employment histories … boring vanilla people.  Which means boring vanilla returns on investment.  So the accounting geniuses at the two agencies cooked up a scheme to make it look like they weren’t boring.  In fact, they cooked up a scheme which seriously misrepresented the size of their … ahem … portfolio.  Congress thought they were regaining the share they’d lost, and the execs at the top got nice sexy bonuses. 

    Then they got audited.  And once they were naked it was kind of hard to pretend anymore. 

    That’s when things get really weird.  See in the mortgage investment world, everyone is subject to everyone else’s … portfolio.  They got hooked up together in a kind of mutually assured destruction pact called credit default swaps.  Credit Default Swaps work like a big net.  Company A sells bonds.  Company B buys them.  But someone at Company B gets a bad feeling that MAYBE Company A might not be as solid as the financial statement implies.  So Company B goes to Company C and says “Hey, I have a $100 bond from Company A, I’ll pay you 3% a year for every year I hold it if you’ll guarantee me that you’ll pay me the face value if Company A fails.”  So far, that’s straight insurance right? 

    Well, Company C agrees to insure that bond.  THEN Company C, which doesn’t own anything related to Company A goes to Company D and says, “Hey, I have an interest in the health of Company A.  Would you insure that they are good?  I’ll pay you for that service.”  So now, Company C is hedged.  If Company A defaults on the bond, C will pay B but D will pay C so Company C has a net loss of 0.   

    So every one is happy.  A has money, B has a bond, C has a hedged bet.  And when you look really close you see that eventually the circle closes when A buys a bond in D and starts the process all over again.  

    The amount that a Credit Default costs depends on how much risk the other companies think is involved in the company in question.  When the books at Fannie and Freddie were questioned, suddenly no one knew how much they were really worth even though they knew they were worth something.  Now, if I’m Company C, I’m not going to agree to insure you if I think I really might have to pay, or if I am willing to insure it it’s going to be for a lot more money.  Instead of 3% I’m going to ask … 40% or 60%.  And no one in his right mind is going to pay that kind of protection money.  Even Tony Soprano would have had a tough time selling that deal. 

    If Company B which is in the habit of buying my bonds can’t get insurance for my bonds, Company B is not going to buy any more bonds.  So now, I’m Company A and I need some money.  I have a boatload of loans on my books and I know the money will come in eventually, but today my payroll is due so I need money today.  And no one will loan it to me because they think that maybe I’m only a tease.  

    That’s what happened to Fannie and Freddie.  Their trouble had nothing to do with poor people getting loans, their problem was with wealthy gold-chain wearing, smack-talking CEO’s who wanted to be a little more wealthy.  So last September the Federal Finance Housing Authority, stepped in like Richard Gere in Pretty Woman and paid $100 billion for the exclusive right to Fannie Mae’s services.  Good for Fannie, not so good for everyone involved in insuring Fannie. 

    And now we’re at the part of the blog where I usually try to come up with a cool conclusion, but the truth is that we’re not at the end of this story yet, and might not get there until sometime in late 2010.  It’s like a soap opera.    Tune in tomorrow for the next installment …  

  • Truth in Lending

      yertle moneyWhen my kids were really little, we had a favorite story that I read every night for weeks.  Dr. Seuss’ “Yertle the Turtle”.  Suess was a genius ahead of his time.  He thought he was writing a lyrical little bedtime story about the exploitation of power, when he was in fact writing an allegory for the mortgage bubble of the 2000′s. 

    Seuss started with a pond, and so did we.  We started with a pool of money.  In all of history up until the year 2000 the entire sum of money held in the world added up to about 35 Trillion dollars.  That’s the total amount of savings in the US, Great Britain, China, Argentina, and the Congo plus the money in every other country.  35 Trillion.  Between 2000 and 2008 that pool of money doubled from $35 Trillion to $70 Trillion. 

    In Seuss’ story, Yertle, the leader of the pond, feels that he’s outgrown his little kingdom and he needs to rule more.  He reasons that he’s the leader of anything he can see, so the only thing he needs is to see more.  He demands that some of the other turtles climb up on a rock.  He climbs up on them and he’s a happier turtle.

    So if you’re a banker, or an investment firm, and someone makes a deposit with your company, it’s your job to find some kind of security you can buy that will provide a return on their investment.  If you are an investment banker in 2001 you find yourself in the unhappy position of holding a lot of deposits with no new securities to buy.  What do you do?  Traditionally, the investment of choice was US Treasury bills.  They were the safest thing in the world, and they provided a return.  Not a huge return, but something.  In 2001, Alan Greenspan made an announcement that drove the investors away from T Bills.  He said that for the foreseeable future, the US Federal Reserve would set the rate of return on T Bills at about 1%. 

    Investment bankers started looking for something that would provide a higher rate of return than 1% but would still be safe, and they spotted the American Dream.  Historically, U S mortgage default rates have been very low at about 2%.  So a bundle of mortgages, sold to an investment house, seems like it’s just as good as t-bills only instead of 1% they are paying 5-7%. 

    Just like Yertle the Turtle, the investment bankers are convinced that there’s something better over the horizon.  Yertle demands that more turtles come and climb onto the rock, on each other’s backs, to raise his throne a little higher. 

    Money pours in which is then in turn lent back to consumers desiring to purchase a home, or refinance the home they’re in.  Mortgage interest rates fall as lenders compete to get loans.  Housing prices rise, sharply, because there’s more demand.  And by 2003 everyone who wants a mortgage and can qualify under the historic risk guidelines has a house.  But remember, that global pool of money is still increasing at an exponential rate.  There are trillions more dollars looking for investments to buy.  People are calling the guys at Morgan Stanley and Bear Sterns saying, “Get me another $100 billion dollars worth of security and get it now.”  So Morgan Stanley and Bear Sterns are calling people at Countrywide and Fremont saying “find someone else to sell a mortgage to”. 

    Yertle the Turtle is the king of a pond, and a house, and a cat, and a cow, but he wants more, so he calls for more turtles.

    Telemarketing centers open and the average American renter starts getting 2 and 3 calls during dinner every night asking if they don’t want to get into a house, oh, and by the way, the rules have changed so if they didn’t qualify before, they certainly will now.  Traditional loans require that you document your income, that you have a certain amount of time on the job, that you have a certain amount of assets, that you have a down payment for your home … Under the new rules, you can have a stated income as long as you have verifiable assets in your bank account.  This is great news for self-employed people.  It’s also a way to pull in some people who are just outside the ring of qualification, but who would like to have a house. 

    But more money is coming in from the global pool and banks have to become more aggressive to get new loans on their books.  So they went to Stated Income/Stated Assets.  Basically, you tell the bank ”I’m a waitress, I make $40K per year, and I have $15k in my savings account.”  The lender gets an accountant to write a letter saying that it’s reasonable for someone in this industry to make that amount of money.  The lender isn’t asking for w-2′s or bank statements, just getting an accountant to say that it’s possible that you might be telling the truth.  Another wave of people get loans.

    Then another wave of money comes to shore, and the rules have to be stretched again.  Finally at the peak of the lending frenzy in the summer of 2006 lenders were writing loans called NINA’s – no income, no assets.  If you had a pulse and a credit score, you could get a loan for a house.  Lenders were willing to do this because people have historically been known to do anything to keep the roof over their head and again, the default rate has only been about 2%.  They figured that in the worst case scenario, maybe 8-10% of those loans would default, but it wouldn’t matter because the price of real estate never falls so if the bank did get the house back it would be worth more than it was when it was sold so there’s no loss (except to the guy who bought the house and now has to go back to renting, but really he had his chance.)  

    The turtles down at the bottom of King Yertle’s throne are starting to feel some stress.  Their knees are shaking and their backs are aching, but Yertle doesn’t care.  He’s seen the moon rise higher than himself and he demands that more turtles come to raise him a miles above the earth. 

    American homeowners, especially the ones who couldn’t afford the homes they were sold, have reached their limit.  The credit cards are maxed out, they’ve refinanced to draw out the “equity” their homes gained through appreciation to try to borrow their way out of debt.  And for the first time in history, investment bankers are seeing something really scary.  The default rates on American mortgages are starting to rise beyond the worst case scenario predictions. 

    I haven’t mentioned the policies of the Bush administration, but they are important.  I know some of you will be unhappy that I have to bring this up, but you’ll just have to get over it.  The facts of history speak for themselves.  Two things happened in 2005 and 2006 that were critical to understanding what happened next.  First, a Republican Congress relaxed the net capital rule for the top 5 investment firms.  

    The net capital rule, established in 1975, allows the SEC to oversee broker-dealers who trade securities for customers as well as their own accounts. The rule requires that the firm maintain a debt-to-net-capital ratio of 12 to 1 or less.  If the firm reaches that limit they have to stop trading, so most firms maintain a much lower ratio.  Starting in 2005 that rule was relaxed to allow the five largest firms (that’s Lehman Brothers, Goldman-Sachs, Bear-Stearns, Merrill-Lynch, and Morgan Stanley) to lend at a ratio of up to 40-to-1.  They were allowed to lend obscene amounts of money based on the shaky premise that mortgage backed securities were just as safe as money.

    This was followed in 2006 by “bankruptcy reform”.  Under previous bankruptcy laws, if a family could no longer pay it’s bills, it could appeal to the court for relief and the courts had the power to restructure debt so that it was possible for the family to pay it back.  Under the 2006 Reforms, primary residences were taken off the table.  For the first time in my lifetime, a family in trouble had no way to get relief and repay their debt. 

    At the same time another significant event came from the consumer side of the aisle when the US Savings rate dipped into negative numbers for the first time since 1933.  American households, tapped to their limit spent more than they earned for an entire year. 

    Remember that the subprime boom began in 2003 with that wave of money that pushed lenders to offer ever more risky products to lure new borrowers into the market.  Many of those risky loans were the now infamous adjustable rate mortgages set to increase 2-3 years after origination.  As the mortgages reset, consumers could no longer meet their debt service from their regular income and had to cash out their savings to stay afloat. 

    As Yertle the Turtle reached Celestial Heights and basked with contentment in his kingdom, something he never expected to happen, happened.  All the way down at the bottom of the stack was a plain little turtle with a plain name, Mack.  Then plain little Mack, did a plain little thing. He burped and his burp shook the throne of a King.   

    With the savings gone, and no one interested in refinancing that house back down to a rational interest rate after the terms reset, that 8-10% worst case scenario default rate began to push 12-15%.  As more and more homes were lost to foreclosure the price of homes began to fall.  The same market pressures that pushed the bubble up, now pushed it down, and fast.  On average on every street with a foreclosure, the price of all the other homes on that street falls 9%.  Suddenly people who had never been at risk were upside down on their loans, they owed more than the homes were worth. 

    Being upside down meant if there was an emergency medical bill, or an unexpected layoff, the source that Americans turned to for their personal bail-out dried up.  More and more people defaulted, the backers of those mortgages had to make good on them, and the pool of money began to slosh wildly. (Market volatility)  Strong well-capitalized companies saw their stock value fall overnight to bargain basement prices because people started pulling so much money out of the market. 

    The problem now is that it isn’t just people at the very bottom, who should never have gotten a mortgage, feeling the pinch, it’s everyone. 

    And no matter how angry it makes me that people profitted to high heaven from all the bizarre deals written over the years, I’m very much afraid that if we simply let them go down, they will suck all the rest of us into the black hole with them. 

    This has been a very brief overview of what happened.  I’ve left out the incremental greed from appraisers who routinely were told “what was needed” in the way of valuation of property and mortgage brokers who profitted through payments (not disclosed to borrowers) paid to them by lenders for putting a borrower in a higher interest loan.  I’ve not mentioned the real estate agents who ”shopped” their clients in neighborhoods beyond the client’s reasonable reach because they were going to make between 6 and 10% of the purchase price of the home as their commission.  I haven’t touched on the number crunchers who kept churning out mathematical models based on 1990′s lending practices which bore little or no relation to the exotic mortgage products being offered after 2002.  I haven’t mentioned the bond ratings agencies who were offering AAA ratings to securities that they had no idea how to value because no one knew what was in them.  I haven’t touched on builders who decided there was not enough margin in affordable homes and built homes that on average cost more than 4 times the amount of the median American income.

    In the arc that formed between the middle class American trying to buy a house and the middle class Chinese trying to save some money there was a huge line of people who all made decisions based on wishful thinking and greed.  We may yet stave off a worldwide meltdown, but it won’t be a simple task, and it will be an expensive one.

  • A Crazy Liberal Idea

    I’ve been hearing and reading a lot of commentary quoting Ronald Reagan’s line, “Government can’t solve the problem, government IS the problem.”

    And I’ve been thinking about that.

    Hang in there because we have to go back to August 2007 for the beginning of this train of thought.  Remember the “Salmonella in Spinach” scare?  I remember it because my sister was one of the people who ate the tainted spinach and almost died of e coli poisoning. 

    Okay that’s the middle of the train.  Here comes the engine:

    Upton Sinclair.  In 1906 Upton Sinclair wrote “The Jungle”.  He intended the book to shock America with it’s graphic depiction of the struggles of poor working class people.  Sinclair’s childhood was a constant juxtaposition of extremes.  His alcholic father kept the family in constant povery, but he also had wealthy grandparents with whom he spent a great deal of time.  There was no middle ground, it was either feast or famine. 

    He became convinced that unchecked Capitalism would invariably lead to inhumane working conditions for wage earners.  His convictions and concerns brought him to write The Jungle in order to expose the middle classes to what their fellow human beings were experiencing just a street or two away.  He wrote of life in poverty, job insecurity, unfair and low wages, and unsafe working conditions.  But when America read the book, instead of finding compassion for the workers, the country found … rat sausage.  If there’s ever been a moment of collective national nausea, 1906 was it.  Sinclair said, “I aimed at the public’s heart, and by accident I hit it in the stomach.”

    We discovered that mouse droppings, chopped rat, body parts of the workers, and in at least one instance an entire human being unfortunate enough to fall into a rendering vat were ground up and packaged as food for human consumption.  Within months of the book’s publication Theodore Roosevelt authorized the Food and Drug Administration to conduct regular inspections of food and drug production companies.  

    Big Business hated the FDA.  They cried that the markets should be left alone because competition and the discernment of consumers would eventually regulate the businesses because of course no one would buy rat sausage if they knew that’s what it was.  But here’s what made Roosevelt persevere in spite of the outcry, the average consumer couldn’t see, and didn’t know what was going into the products being sold, so the mechanism of the free market was not enough to protect the public interest.  It was sound business for the meat packing companies to behave the way they did because they mazimized their profits which is the entire goal of business.  That’s the private side.  But on the other hand the public has a right to the information it needs to make good decisions about the products being sold in our markets. 

    Today some of the ”talk” I hear on the airwaves and in the office is an oft repeated line that Government should stay out of business lest it mess things up when it tries to become involved.  One of the mantras I hear is that things become more expensive, less efficient as a result of Government involvement.  On the other hand there is the question of whether I want to be sold rat sausage.  I rely upon government inspectors to make sure that the food I’m buying is safe.  I rely upon banking regulators to make sure that the financial products offered don’t have hidden poison designed to leech money from my pocket in excess of what I knowingly agree to pay.  I rely upon an entire infrastruction of inspection and regulation that I believe will protect me from such nasty surprises. 

    But from the election of Ronald Reagan in 1980 and coming forward, the number of people hired for inspection and regulation has been slashed dramatically.  Since 1972 the number of FDA inspections has fallen by 80%.  The number of inspectors employeed by the FDA has been cut 12 in the past 5 years.  With inadequate government resources to inspect the food, industries have hired private firms to fill in the gap.  And how’s that working for you?

    June 07 e coli in beef
    August 07 e coli in spinach
    Sept 07 e coli in ground beef
    Oct 07 salmonella in chicken and turkey pot pies
    Dec 07 listeria bacteria in milk products
    April 08 salmonella in jalapenos
      (and lets not forget the “stay away from the tomatoes, oh, just kidding it wasn’t the tomatoes after all” decision that led to tons of tomatoes being left to rot in the fields)
    Most recently in the headlines salmonella in peanuts shipped by the Peanut Corp of America. 

    The workers in the Peanut Corp of America plant have testified that they regularly saw mice, rats, roaches, and mold.  But just months before the outbreak which has killed 9 people and sickened about 20,000 others, that plant was judged to have a Superior Level of Food Safety.

    Judged by the FDA?  Nope.  Judged by a private for profit firm hired by the industry.  Does that seem like a good idea to you?  Anyone?  Wanna bet that the days of rat sausage are behind us?

    The next time someone at the watercooler lets off a little steam about the evils of government regulation, you might want to point out that the lack of regulation is what leads to companies selling us products that make us sick, kill us, or cause us to lose our homes.  I know it’s just a crazy whacko tree-hugging Liberal thing to say, but I’m in favor of a little more regulation, thanks.   

     

  • Do you know how to shop for a deal?

    I tend to think of myself as a good shopper.  I know how to compare, I know that it’s important to look for the fine print, check chipping costs, and make sure that the bargain-size costs less per ounce than the standard package (often it doesn’t).  But I’m constantly surprised by hidden charges and fees. 

    This morning I was reading the MSN Money columns and discovered this gem regarding air-travel:

    For airlines, one huge advantage of fees is that they don’t show up in most reservation systems when consumers are shopping for airfares. That’s because airlines aren’t required to advertise fees that only certain customers will pay, like those checking baggage. As a result, head-to-head price comparisons at booking sites like Expedia.com, Travelocity.com and Orbitz.com become more difficult, and prices listed in travel-agency computers won’t tell the whole story. What’s more, low teaser rates can lure fliers, even if the ultimate cost of the travel is higher.
     
    It’s possible, though a lot more work, to compare flights by calling the ticket counter at the airport and asking about the flight you need.  But other than that, it’s difficult to have any assurance that you are getting the lowest fare.  Airlines know we shop around and they know where we shop around so they’ve come up with this means of getting our business by advertising the lower fares and getting more money from us than we plan to pay. 
     
    What hidden fees have you discovered? 
     
    We need a consumer bill of rights that stipulates full disclosure of all fees before the purchase is finalized.