Monday, September 22, 2008

The Financial Mess

What a mess we've gotten ourselves into! Just weeks before one of the most significant presidential elections in history the economy went into melt down. The candidates can really do little except suggest what they might do and perhaps criticize what the other candidate might do. There is a danger in saying too much (McCain has been more vocal about what he would do) and saying too little (I think Obama has taken the right balance here, but perhaps he could say more). The current president is in his final months in office, which means he has little clout. The one person who seems to have some clout at this moment, and by all reports is doing a good job is the current Treasury Secretary. Both candidates seem to agree on this and praise his leadership while suggesting the need for oversight.

What is the cause of this? Greed, yes I think there's some greed here, but greed is the driving force of capitalism -- which makes McCain's populist rant against greed sort of odd. Is it hubris, I think this is the more likely cause. Without hubris greed can do little long term damage, but when we think we can do what we want, when we want, even if we don't know what we're doing, well -- that's hubris. And I think hubris is different from cockiness. Cockiness is being outwardly self-assured, but that attitude expressed might cover a more thoughtful demeanor underneath.

John McCain has called himself a strong proponent of deregulation. Now, we've all experienced red tape! It can get overwhelming at times. But as we have seen (and McCain seems to acknowledge) with out some rules things get out of hand (yes I know I'm theologically a non-creedal type). Obama has been an advocate of broader government oversight, but the question is -- what kind?

As for the promises both candidates are making?

McCain's continued promise to continue the Bush tax cuts, which turned the Clinton surplus into a record deficit, seem problematic. There are some parts of that tax policy that will have to be addressed -- for instance the inheritance tax, which expires in 2010, will return to previous levels in 2011. That will have to be looked at to bring it up to date -- though I can't see it being totally eliminated. Considering what we're entering into, McCain's declaration that he'll cut taxes and then balance the budget through cutting earmarks is pretty silly. Back in California Arnold Schwarzenegger promised to balance the budget without raising taxes by cutting the fat in the budget. Well, the amount of fat found was pretty small. It was a choice of cutting into essential programs. And you know this debate about pork is an interesting one. What is one person's pork is another person's necessity. If a congressperson or senator doesn't bring home some bacon to our state, we'll get rid of them. And I'm sure that John McCain has brought some home to Arizona -- if not then he's not been representing his state very well.

So, back to the financial mess. I'm not an economist, so I'm trusting that there will be some steady hands on the wheel. I'm pleased to see that the leaders of both parties are involved. I'm expecting that the final bill won't be to any one's liking in all its details, but it will, hopefully, put us on the right track.


Anonymous said...

I am not a securities expert, but like so many others I have an opinion.

The major source of the current financial crisis for both the investment banks and the insurance companies, from my perspective, was the introduction of high yield mortgage backed securities into the securities system without anyone exerting any significant effort to see that the new securities were all that they were held out to be. The new instruments were created in a hurry to meet demand on an unprecedented scale. With everybody along the chain of creation have absolutely no incentive to insure quality in the creation of the underlying mortgage loans, and no responsibility in the event the securities or their component mortgages should turn out to be unsound. The instruments on their face were reasonably profitable, and would allow an account manager at an investment bank, securities brokerage house or insurance company, to park huge sums of money with little apparent risk, and a promised steady return.

Everyone was feeding from the trough and everyone got fat while the house of cards was growing. And anyone who counseled against the new, indisputably profitable, securities would be deemed unwise and would not advance up the success ladder among big money account managers.

As with any new product, someone needs to investigate the item, see where the potential risks are and either improve the product to eliminate the risk, or disclose the risk and build into the pricing a factor to account for the risk.

In times past a bank or credit union would expend great effort and caution to see that their mortgage loans were made to a good credit risks and based on a solid appraisal of the homes to be used as mortgage collateral. Each foreclosure affected the bank's bottom line and the bank manager's job.

With the advent of big-time trading in multi-billion dollar securtized mortgage instruments an unquenchable demand grew for saleable mortgage loans paying significant interest and collateralized by good old realiable home mortgages. Small mortgage brokerage companies sprang up all over the place to create (and sell) the mortgages which were snapped up even before closing - thus insulating the broker from personal risk in the event of default. The mortgage brokers made money, the title companies who insured the property titles and conducted the loan closings made money, the appraisers who vouched for the values of the real estate made money, and major mortgage institutions who put together the bundle of mortgage loans and sold them for huge profits made money.

Add to this the weight of adjustable rate mortgages which would eventually adjust to an unbearable interest rate if the borrower did not refinance quickly. Also add to this the burden of high interest home equity loans where homeowners borrowed out the balance of their equity, and often beyond their equity (on the premise that their home would one day rise in value to match their loan obligations.

Yet, underlying all of this was a continuing but uncritical perception that the new mortgages were no different from the old mortgages, made by local banks and credit unions who were ultra cautions in assuring that their borrowers were credit worthy and the mortgaged homes were sound protection against default.

With such market pressures and profit potential for everyone involved, the construction of the house of cards was unstoppable. What few if any appreciated was that the new mortgage backed securities were little better than junk bonds. The credit worthiness of the borrowers was a crap shoot and the mortgaged homes were rarely worth even the amount of the loans. There was no protection against default, and, if home prices dropped even a little, the borrowers would be in a negative equity position thus creating a situation where economic common sense compelled them to walk away from the loans.

The human vices of greed and hubris may have contributed to the financial crisis, but these were fed by institutionally created and supported chimera.

Going forward, I would suggest (1) eliminate or greatly limit the availability of adjustable rate mortgages while converting all current adjustable rate mortgages into fixed rate instruments at some decent market supportable rate; (2) cap loan-to-value ratios at 90% unless supported by mortgage insurance or mortgage guarantees; (3) convert mortgage loans and home equity loans which place the total debt above 90% of the home value into unsecured debt (like a credit card - an add a few extra points on the interest rate).

But what do I know.

On an institutional level,

Anonymous said...

John, I think you give the individual too much credit. Its a little chicken and the egg.. you can't package up mortgages if you don't have mortgages to package up.

My quick thesis is the Community Reinvestment Act in 1995 required banks to lend to low income people. By 1998, they were being bundled with other loans in the packaged products. Fast forward to 9/11..and rates were falling, people were "nesting" rather than traveling, and everyone just got burned from stocks and wanted a new investment. People jumped into real estate because it always had "value" vs stocks that went to zero.

By 2003.. the snowball builds. People buy more homes, more demand, then they loan programs come off the shelf. Interest only, low documentation loan, stated income loans, etc. Add to this the financial pundits banging the table saying "real estate has never gone down since World War II". Remember this?

I will give you my shock statement.. that the individual has ALREADY been bailed out. Think about it.. someone buys a house for $200k, hoping to sell it for $300K. Instead the house value drops to $100k. The guy only makes $50K a year.. so he says, thats two years of GROSS income, just to pay for air. So he calls the bank and says.. bank, you can have the house, the keys are under the mat. And that has been happening! Granted.. there are tons of other examples.. and some very sad.. but there is a class of people who simply gambled and lost.

Quick thoughts on your ideas:
Most people are in their homes 7 years, so adjustables make a lot of sense in most cases.

I assume 90% at closing. Most areas have EASILY already lost that 10% in value. Also, requiring 10% down, you kick out virtually every low income person in the US from owning a home.. but maybe that is your goal.

Three- one, people will use credit cards to make #2 work. Realtors need that sale, so they will find a way around. The issue about moving debt is you have to find a lender to take it. Plus.. what value do you use? How often do you check the ltv? Also.. you would want to amortize that debt rather than just pay interest on it.

As a banker.. these are fun discussions. Personally I am kind of glad consumers are being squeezed b/c people have made HORRIBLE choices for a long time. Hopefully, people are finally getting serious about paying off debt.

Pastor Bob Cornwall said...

When George Bush came to office he pushed the goal of an "ownership society." In America we have held up the goal of private ownership as foundational to long term security. But over time, for many, that dream became less and less possible -- except that enterprising entities came up with ways of getting people into homes -- zero down, interest only loans. It seemed to make sense as housing prices climbed at 25 and 30 percent annually.

Take Santa Barbara, where I recently moved from, in 1998 the medium priced home was around 250 or 300,000. When I moved away 10 years later the medium priced home had come down to about 800,000 from over a million. So, you can see why it appeared attractive. Lompoc, where I was pastoring, the medium priced homes had climbed above 400,000 but the medium income was under 50,000 per year. A huge number of people had bought those zero down/interest only homes -- and now the bottom is falling out.

We waited for 25 years of marriage to buy -- and put down 10%. We have a mortgage we can afford -- as long as things go well with the church! But we stayed within our means.

Anonymous said...

"Also, requiring 10% down, you kick out virtually every low income person in the US from owning a home.. but maybe that is your goal."

Actually my suggestion was that this limitation would apply UNLESS the loan was insured (FHA, PMI, etc) or guaranteed (VA). If the borrower has questionable credit, then let that be on the table and taken into account as part of the transaction.

Also, I think my comment on converting excess mortgage debt to unsecured status was misunderstood. I meant that the holder of the debt is still stuck owing it, but the borrower gets the break in that the house payments would be modified to reflect a lower principal balance, and the house can still be sold or refinanced (hopefully at a lower interest rate or payment amount) showing a genuine 10% equity cushion.

The excess debt, which, unless discharged by gift (i.e., writeoff) or bankruptcy is still owed to the lender, would be accounted for separately by the lender. It could also be bundled off and sold. The writedown would have to be a one shot opportunity and it should be accomplished during some kind of an amnesty window.


Anonymous said...

John, its a valiant effort, but think again about you saying. Those who can least afford it will be the ones with the highest loan to values supported by tax payers. Isn't this what got us in trouble in the first place?

The other options are complicated and not sure how the heck it would all work. Who pays for the $350 appraisal? You are talking about MILLIONS of loans to be redoc'ed.

One top not discussed.. but eliminating foreclosures is an AWFUL idea. Locking someone in a house they can't afford does not work. I know that a controversial statement.. but wanted to throw it out there.