If We Can't Help, Let's Just Get in the Way...

William Kristol's hopefully vain exhortation today in the Washington Post Online today sickens me.  The general idea is that since Obama and the Democrats have the electoral mandate, they are in the driver's seat legislatively, so what they Republicans should do is simply get in the way as much as possible.  This is particularly true as they have nothing to actually add to any debate in terms of new ideas or solutions.

It's this type of political BS that hurts us the most.  It does not matter what side it comes from.  It reminds me of a kid on the playground that would only disrupt a game if it could not be played by his rules, refusing to actually take part in the game.  It's just as childish.

The role of the minority party should be to be that of overwatch and alternative, minding what is good for both party and country, not just party.  They should provide oversight keeping the majority honest (if possible) and provide alternative solutions to what the majority is proposing.  If they are so intellectually bereft as to not have any alternatives, then they either need new leadership, a new mission, or should just shut up.

...And the Supply-Siders Certainly Don't Get It!

Phil Kurpen of Americans for Prosperity posted this little ditty on the Fox News Blog (yes, I'm trolling) today arguing simply that the way out of the current crisis is to increase the savings rate, because it's the debt itself that is the problem.  The argument is that the current standard of living is built on unsustainable, and generally bad-for-us debt and we should all just stop spending and save our money instead and this whole problem would go away, because, it's a just a big Ponzi scheme anway.

What's a big Ponzi scheme?  I'm not sure, and I don't think he really knows either, but aparently Bernanke, Paulson, Obama and Bush are all in on it.  However, it's a very timely reference, as is the reference to Maddoff, as irrelevant as they are.  The problem is that in a Ponzi scheme, someone is actually skimming the money from the top, which why it always fails Mr. Kurpen fails to show how this is so.

Regardless let's consider this proposal.  We are currently in a recession brought on by the banking crisis (and probably some other stuff too, but let's keep it simple for now).  The banks stop lending, so consumers and businesses that use credit for big-ticket items can no longer get that credit for those goods. As sales drop, businesses adjust and start to lay people off and invoke salary freezes and in some cases salary cuts.  People become nervous for their jobs, and start to save money by scrimping.  Businesses see this pullback and a new wave of layoffs occurs, and/or different industries are effected.  This is a recession. It's self- propagating.  Businesses cut back in response to consumers and vice versa.  As a result of this process, the economy actually shrinks.

There is a point below which the economy won't shrink (theoretically) but since the US is a service economy now and no longer a manufacturing economy, our economy could take quite a pounding before it reaches some level where the recession stops (note that I did not say equallibrium).  I'm not sure that anyone really wants to find out where that is; (some may say they do, they clearly have not thought it through) we would call that a depression.

Given this scenario, how does saving money effect this process? IT WOULD MAKE IT WORSE! Removing additional money from the economy by saving will simply make the recession worse.  Now the supply-siders will come back and say that the additional savings will allow the banks and businesses to invest that money.  However the argument fails on its face for two reasons: First there is nothing that guarantees that the banks will loan the money when they get their hands on it (as Paulson found out to his dismay).  Second, for every dollar saved, at least one dollar is removed from the economy.  Businesses rely on dollars that are in the economy, not in banks, beause if it's in the consumer's bank account they are not out spending it on goods and services.

So let's all just think twice when we hear this type of simplistic thinking.  I've been hearing it a bit lately, as it seems to be quite popular with the more conservative Republican crowd as a way to take the Obama administration to task.  Just say "No" to this type of thinking.

The Financial Mess—who’s Fault is it? –Part One

[Instead of simply complaining about who does not "get it" I've decided to explain my reasoning behind who the real culprits are for our current financial situation. I originally planned to make it one big post, but it was becoming unwieldy, so I've decided to break it up. Please enjoy and feel free to comment]

 

A review of the press surrounding the current economic woes will reveal a bevy of culprits. Borrowers are at fault for either buying houses that they cannot afford, lying on their loan applications, or speculating on the housing market. Mortgage brokers are at fault for selling loans to people that could not afford the loans, and offering "teaser rates" that did nothing but get the borrowers in trouble. Underwriters are at fault for actually writing the loans, and ignoring traditional industry guidelines regarding "low" down payment loans. Fannie and Freddie Mac are at fault for suborning this behavior by purchasing many of these "bad" loans. The "big" banks are at fault for creating new financial instruments out of these loans and then foisting them off on unsuspecting investors (including other "big" banks). The SEC is at fault for ignoring the whole thing (among many other crimes during this process).

 

And so it comes to pass that whatever your bias is, you can find someone to blame for the "credit mess". Conservatives blame the individual, and liberals can blame either the government for not doing its job, or the "evil" corporations that allowed this to happen. However, in order to get a clearer idea of where the blame actually belongs, we need to take a close look at how the process worked. While intelligent people can differ in opinion, it is simply not possible for any one of the failings stated above to have created the mess that we are in. In fact given the way the markets work, theoretically all of those things could have happened and we would not be in the condition we are in today. What I will do here is follow the loan though its life and show where things went wrong.

 

Let's say it's June of 2006 and Mr. and Mrs. Jones, who are newlyweds, decide to buy a new home. They have good credit, but they are a little light on cash for a down payment. They have already been turned down for a "traditional" fixed mortgage because they don't have the money for a down payment, and the PMI (private mortgage insurance) would put the payment out of their reach. "No worries," says their mortgage consultant, "we can get you into that house." They happily agree and then close on their house. They end up with two loans. The first loan is a 30 year fixed interest loan for 80% of the value of the house. Their second loan, which is actually an equity loan is a 5/1 interest only adjustable rate mortgage (ARM), and they've got a great rate of 2.9%! The ARM will go up in 5 years to "normal" rates, but their mortgage consultant explains that by simply making larger payments, against that loan, "it shouldn't be a problem five years from now." They can also refinance the whole thing under one loan in five years, which should not be a problem given housing prices of late. Also, if they really have problems making the payments, they can always, sell, after all the way housing prices have been going for the last several years, they are certain to be able to turn a profit and get out of their house with a nice gain. This is a sub-prime loan.

 

To summarize: The Jones' have a house they really like, but they have to stretch to afford it. They are comfortable with this as they have seen that the housing market has been doing nothing but going up for years. They are comfortable that when their ARM comes due for an increase, they will be able to work it out.

 

So now that they Jones' are happy homeowners, they pay their mortgage to their underwriter, ACME corp. This income stream combined with all of the other mortgages they have issued represents a pretty nice income stream. The only problem is that ACME won't see its profit for many years, and the CEO is under pressure to grow the business today. So he puts together a group of mortgages, including the Jones' note and sells it to a secondary lender, Big Bank. Big Bank is happy to have the income. Plus, Big Bank has other things it can do with this mortgage to make more money.

[End Part One]

Time Magazine Doesn't Get It Either...

There is an excellent article in by David Fiderer in The Huffington Post today discussing the recent questionable history that Time Magazine engaged in with this piece.  Time seems to feel that lots of people were to blame, and that this must have been some type of "perfect storm" in order for all of these individuals to have caused the mess as it currently exists.

Both Time and Mr. Fiderer have overlooked how much the concept of risk drives the investment business.

Even the Economists Don’t Get It

Highlighting the sorry state of the field (some might still call it a science) of economics is in, The Washington Post Online published this opinion piece (registration required) today providing yet another suggestion for "saving the banks" without addressing the real underlying issues. Mr. Caballero, head of the Economics Department of MIT, has suggested that the US Government commit to purchasing stock in banks equivalent to two times the existing number of shares within the next five years. He contends that this would have several benefits; first, it would put a floor under the price of the stock. Second, it would allow (force?) the banks to raise additional equity privately, and somehow just by this act the market's negativity will reverse course and the market will rally.

While it's clear that Mr. Caballero means well, it's also quite clear that at the very least the market will not respond favorably in the event that this proposal comes to pass. Having a look at the last five days of trading when the market has been abuzz with bank nationalization talk should present a pretty clear picture of how the market will react to this type of program.

I'm also unconvinced that this type of program would actually help bank stock price very much. The bank would have to issue so many additional shares in such a short period of time (somewhere in the order of 10x the current number of shares) in order to prevent themselves from being nationalized that the price of the stock won't move very much. The reason for this is that the simple process of adding capital to an overextended bank does not suddenly make its Earnings Per Share number increase. Until that number increases, the bank shares will not go up—with one exception. That exception is housing prices stop plummeting and foreclosure rates return to normal. Why?

It's pretty simple really. The toughest part about being an investor, or day trader or banker even is controlling risk. It's easy enough to throw money at equities until something "hits" and then reap the profits if there is no risk to the funds that you are investing. In many cases even it's possible to lose more than you have invested if you are not careful. You control risk by knowing what it is that you have bought and understanding the possible scenarios arising out of that purchase, and pricing accordingly. Unfortunately, many of the RMBCDO (real-estate mortgage backed collateralized debt obligations) that the banks in trouble have purchased as investment instruments cannot be valued properly because the current housing situation and foreclosure rate makes it impossible to determine whether the underlying mortgages have any value or not. Therefore these CDOs have little market value where their "realized" value may end up much better.

Given that large banks still have an unknown number of these on the books, and the potential liabilities for these securities may be substantial, there valuation of the bank itself suffers. Additionally, they can't help improve their valuation by issuing loans and generating revenue because they have to keep as much capital as they can on hand to prevent another re-run of the massive de-leveraging that happened in 2007, again out of fear of what the housing market will do.

In the end, it's all about risk. Until risk is a known, or returns to known levels, the banks will be in trouble. JP Morgan and Citigroup seem to have seen this. They have ceased foreclosures and will be working with their borrowers per the Obama Administration's initiative. This initiative, if implemented properly (the details are still pretty non-existent) will hopefully put a floor underneath the housing market. When this happens, we will be well on our way towards recovery. Throwing more capital at the banks at this time will not solve the problem. By doing this, we would be trying to cure the symptom, and not the underlying disease.

 

[Stay tuned: I'm working on a much larger discussion of CDOs, risk and who I think has the most responsibility for the mess we are in]

Santelli’s “Tea Party”

Here's another reason not to pay too much attention to what the Talking Heads on the financial networks. It's pretty clear that this guy has no idea what actually got us into this mess, and is just trying to create news, which sadly, he has done. Mr. Santelli seems to think that the spending that will get us out of this recession will just magically appear if the government does not spend any money. Supporting the homeowners, and thereby propping up housing prices, could not possibly be a good idea according to this knucklehead. That might lead to something resembling a calculation of fair value for "toxic assets" which might then allow banks to either offload them or value them appropriately. That might lead to the horrors of more lending. That might lead to an end of the recession even!

But let's not get ahead of ourselves. We've got some kowtowing to the masses to do, and some hysteria to whip up.