If Einstein were asked to solve the wrong problem, even he would come to the wrong conclusion. It is my opinion that this is what is happening to the powers that be in the U.S. Federal Reserve and Treasury. Yes, there was a housing bubble, which preceded the current economic problems, but it is NOT the root of the problem. Until they realize that, they are not going to come up with the correct resolution to the current problems.
What we are experiencing is a continuing bursting of the “Internet” bubble. I don’t mean Internet bubble as in .com stocks increasing in price in the stock market; I’m referring to the “Internet” in the sense of a new “Industrial Revolution.” It created a huge wave of new technologies and communication channels creating a type of bubble in the overall economy. It created an enormous amount of new investment opportunities, many of which weren’t really that great to begin with. To compound the problem, the new technology brought us online brokerages. Therefore, not only were there an abundance of new investment opportunities, it was substantially easier for the average person to enter the investment arena…. and viola, you have the makings of a stock market bubble. When grandma and grandpa were suddenly day trading NASDAQ stocks, it should have been easy to see that something was wrong. As always though, we heard the “but this time it’s different” defense. This was just the beginning of the problem, however. As a result of this bubble bursting, we get everybody pointing fingers at public companies and their management, and we get knee jerk regulation to solve the perceived problem, which were never really the problems to begin with. As one example, mark to market regulations came back to haunt us quickly and escalate current problems, possibly having pushed this from a manageable situation to an unmanageable one.
Let me use the tulip mania scenario to try to describe what I think happened. Most of you have probably read about the bubble created in the market for tulip bulbs in Europe in the 1600’s. Tulips became more valuable in the minds of many people than sanity could justify, and prices for tulips soared beyond anything we could probably even fathom in a bubble today. Obviously it finally burst, and people’s fortunes were destroyed when the house of cards fell. Let’s consider a further scenario that might have followed. If there was an exponential increase in the quantity of tulip bulbs that people want to plant, you might find that the fertilizer market suddenly starts to boom as well. Substantial increase in demand for fertilizer would start driving the prices in that market up also. When the tulip market finally did burst you would probably have many investors who still had some level of liquidity. If these people became accustomed to making easy money or to having a high net worth, they may have started looking around for another market that shows potential gains similar to what the tulip market once provided. They realize the fertilizer market has been booming, everybody throws their money into this new booming market and we are off to the races again. Nobody ever stops to think that the fertilizer market was booming BECAUSE of the tulip market, not independent of it. Ultimately, as time passes, fertilizer prices collapse as investors find they don’t own anything but a worthless pile of shit… It looks like they just got sucked into a second bubble, when it was really just part of the first bubble to begin with. Then to compound the problem even further, investors with all this crap try to start convincing others that there are other uses for it, in order to keep the market booming. They try to convince you that it’s a sign of affluence that you have it on your shoes, they try to convince you its good to rub on your skin, they convince you that its still good to plant those worthless tulip bulbs in and they try to convince you that it makes a great additive in your food…and for a while it works and fertilizer prices stay stabilized. Then one day everybody wakes up and realizes that “none of this shit makes any sense” and prices finally collapse. Suddenly everyone is screaming for regulations against fertilizer food supplement companies, as if they were the root of the problem, having forced them to eat shit.
So that’s how this started and led to a bubble in housing prices. When people were making money hand over fist in the .com stock market boom, there was a huge jump in perceived net worth…some real, some just on paper. Just like the Jeffersons, everybody starts “Movin’ on up” and housing prices start booming. When the stock portion of the bubble came to an end, investors that didn’t want to face the fact that the gravy train may be ending started looking for other booming markets. At that point, real estate was the only real game in town and tons of money flowed into the real estate markets. Since the real estate gains left many people feeling like they still have a higher net worth, it kept them from pulling as much money out of the stock market as they probably would have otherwise, so the stock market never fully corrected to the long term historical trend-line after the NASDAQ bubble burst. So we still have inter-dependence between the two bubble markets, in the end the housing bubble was helping support stock prices, keeping them elevated above historical trends.
After the NASDAQ bubble, the Fed comes along and tries to compensate for the bubble bursting and proceeds to stimulate the economy by lowering interest rates. It was probably the right approach to the problem and the solution everyone was screaming for, but the real estate market was already providing some perceived relief, for the interim, so you had two areas boosting the economy. The tangible one, larger money supply with decreased rates, amplified the effect of the perceived one, driving housing prices even higher. Which brings us to the point that the current Fed sees as the root of the problem…housing bubble and subsequent leverage in sub-prime paper. Their root of the problem puts a market value baseline in stocks and real estate, which they are trying to support, MUCH HIGHER than the equilibrium of the long-term trend in prices.
So, back to the bubble in real estate prices. By 2004, I knew more people who claimed to be mortgage brokers than I knew who were homeowners. Doesn’t this sound like grandma and grandpa day trading NASDAQ? Almost everyone who could have, should have, or justifiably wanted to buy a property or refinance one had done so with the Fed Funds Target Rate at 1%. We now also have several times the normal amount of mortgage companies and commission based brokers chasing what is now an empty pool of potential business. Once again, we have a scenario where the gravy train is coming to an end and nobody wants to face the music. Instead of letting the bubble unwind itself then, the market becomes even more aggressive to protect brokerages and stockholders. They hire more commission based mortgage brokers to hit the markets even harder, push for regulations to ease non qualified home owners getting approved for loans, getting people who just refinanced to do it again and wrap their credit card and auto loans into it…. in essence, make a market where there is none. Stock and Real Estate investors were demanding, after all, that these companies keep the gravy train going, with no regard for any future recourse. Since the government always bails us out, why shouldn’t taking higher risk be the norm, right? Now, subconsciously I think investors know something isn’t quite right, and still want to protect themselves, so we start getting some crazy new derivatives designed for hedging purposes, which nobody really understands. Of course these derivatives are all built around bubble prices being the baseline pricing instead of around normal market conditions…. so they are doomed as a hedge from the beginning. And it seems the derivatives are all the products of companies most likely to fail should the derivatives turn out to have been necessary. Would kind of seem similar to Houston buying hurricane insurance from an insurance company with its entire assets to cover claims tied up in Galveston Island property. Which pretty much brings us up to the present.
The succession of bubble markets in the past 10 years has created a huge wave of increased leverage. If there is always a market presenting huge gains, and the government steps in one way or another to protect a bubble if it does burst, why not take more risk, and use higher leverage to generate higher returns. In fact, it became necessary to do so to keep giving investors the returns on their stock investments that they had become accustomed to in the bubble markets. This leverage is still part of the whole “internet bubble” scenario. As companies de-leverage back to normal risk ranges, the stock market needs to come down to historical trends, the real estate market needs to drop to historical trends and investors need to realize that booming markets are not in fact the norm. This huge decrease in leverage is like a huge decrease in the money supply. And if investors seek to borrow money from a smaller supply, what should happen to interest rates…. they should go up to create equilibrium and liquidity in the markets.
Instead, we get artificially low rates, weaker U.S. Dollar (which has actually helped some) and higher oil prices. Yet the Fed is surprised when they inject a huge some of money into the banking sector, expecting it to provide liquidity to the markets, and instead watch the banks put it all straight into their reserves. If we saw rates go up to equilibrium, we might see investors pull money out of a declining and overpriced stock market and put their money in the banks with the new better risk reward ratio resulting from the higher interest rates…. wouldn’t that provide liquidity at least to the commercial banks? Certainly deposits provide more liquidity than the company’s stock price, which is mostly irrelevant. Then maybe we could get back to rational markets, where the stock market is booming because the economy is booming, instead of the economy is booming because the stock market is booming. If we have to manipulate the stock market to keep the economy booming, we are putting the cart before the horse. You might have a much better view from the cart, but eventually you’re going to lose control of the horse.
This leads me back to regulation. Seems we always start blaming regulation when markets don’t go the way we want them to. Well thought out regulation in advance can help create stable markets, but knee jerk regulation to try to avoid a scenario happening again isn’t very beneficial and often leads to new problems. If we hadn’t had new regulations concerning mark to market accounting, many of these financial firms would have had plenty of wiggle room to unwind their positions in an orderly manner as the stock and real estate markets corrected to historically normal ranges, and then slowly regain asset value. It forced companies to present potential losses on paper as a realized loss now. A regulatory change, because the old regulation got a finger pointed towards it as hindering real estate sales, allowed the sale of sub prime mortgages to flourish as if they were low risk assets. This temporarily fixed one problem, a slowing mortgage market, but created another one 10 times bigger. There are two things I’d like to point out about regulations:
1. If you tell your child not to stick his finger in the electrical outlet, and he continues to do it even after he was shocked once, it’s not the outlet manufacturer’s fault, it isn’t the home builders fault, and it isn’t the electric companies fault. You have a stupid child that continues to do stupid things, plain and simple. No amount of regulation is going to protect that kid. Someone did a very poor job of educating that child. You could seek regulations banning electric outlets, but that kid would probably just stick his finger in a light socket or something else…then you’ll try to regulate those. This kid is destined to be the guy in the news with his willy stuck in a Hoover, no amount of regulation is going to change his fate.
2. There is a reason why we can never regulate these things out of markets in a capitalist society in advance, and why regulating in hindsight will not work. Our markets are based on return on investment, and risk and pricing models aside, the companies that provide the best returns are rewarded, the ones that can’t keep up, die. The prosperous companies are usually the ones that find the loopholes in the current regulations, which provide them an excess return over the norm. In order to compete, all companies end up having to do business through this loophole and the loophole becomes the standard acceptable practice. Everybody is happy as long as the money is flowing in, and nobody wants to patch the loophole at this point because it would affect the profits of all companies in that particular industry or market sector, and ultimately it’s investors. Excess profits typically don’t last, and that industry will finally stall or burst and some investors will lose money at the end. That’s when we race to fix the loophole that is now moot and point fingers at managers who can no longer get investors excess profits over the norm. We come up with more regulations that create different loopholes and the process starts over again. It’s a regulatory process that leaves us behind the curve and always chasing our tails to fix problems that the free market system just resolved for us…. though we may not have liked the results and have residual issues to deal with from it. Again, I’m not saying regulation is bad, but if you over-regulate free markets, you push them into a narrow set of solutions to do business and they will always look for and test loopholes in the regulation which will provide them a competitive edge. This will happen no matter how much pre-existing regulation exists, like ants invading your home through a crack you never knew existed.
I finally came to the conclusion today that welfare is the American Dream. It’s not work hard, make good decisions and try to build up a nest egg for an early retirement. It’s all about living off the system, making bad economic decisions and then being rewarded further by the system for doing so. Take lots of risk and let the system reward you by making you whole again after you fail. I can get a house, a paycheck and a college education that way…. but I won’t choose the latter, that would defeat the whole philosophy. I’m sick of hearing people sugar coat a large portion of the cause of this housing crisis and whine about keeping people in their homes. I’m not talking about those who were truly victims of fraud, or those that had some outside crisis independent of their home purchase that put them in foreclosure…yes, I think those people deserve help and to keep their homes. Many of these people, however, didn’t deserve to be in homes in the first place. They had poor credit, a sub-adequate income to pay a mortgage, they bought houses at the peak of an obvious housing bubble, and they got adjustable rate mortgages when the Fed Funds rate was at 1% and interest rates had almost literally nowhere to go but up. But, they say, we need to keep these people in their homes? What about the group of American’s that did the sensible thing and delayed their pursuit of home ownership and the American Dream until a more economically reasonable time. Now, money is scarce to loan this group for a home purchase in the future and they are likely to have a loss in income due to inflated taxes to make sure those who made bad investment decisions can stay in the homes they couldn’t afford in the first place. The American Dream for these people is now further out of reach. We need to place more blame on those who made the bad investment decisions if this cycle is to ever stop. They made stupid investment decisions and they are going to be rewarded for it at everyone else’s expense. It wasn’t bad regulation that caused the problem, it seems that fraudulent lending activity was evident in just a small portion of the loans that were written. Nobody put a gun to their heads and said you have to make this purchase now under these terms. Many of the companies who wrote and invested in these loans, though also a stupid investment decision, at least WERE being pressured by shareholders to continue providing a stream of profits as if we were still in a booming market…in essence, someone WAS pressuring them to make their bad decisions.
It really boils down to education. For the average U.S. citizen these days, it really seems to pay to be stupid or uneducated. Until people are held economically responsible for their bad investment decisions, I don’t think people will actually realize they need an education in economics and finance. Why should they? Those who make irrational decisions get rewarded; those who make rational decisions get punished. Even though it’s probably going to be better at this point to economically bail them out than not, that still doesn’t make them right and it certainly doesn’t mean we have to act like THEY are the victims in this mess. Bail them out to better save the economy, but they should be held accountable some other way, hours of community service, a period of being in a marginally higher tax bracket or if nothing else at least send them back to High School and make them sit in an Econ class with a bunch of teenagers and then put their names on public list of LOSERS. They, however, should not be the reason for holding up rescue packages for the rest of the financial markets overall and they certainly are not martyrs.
Here’s the framework of a plan I haven’t heard mentioned. Force those in foreclosure to sell their homes at prices that will clear the market with fixed rate loan funding to private investors, on the terms that the sellers get a 3 year lease at prevailing rental rates from the buyer. As long as they make their rental payments, they remain in the home up to 3 years to get things in order. This allows private equity to provide most of the funds to free up the system. Make the homeowner being foreclosed on liable for any remaining balance on their loan from the selling price to whatever RTC style entity is setup through the Fed or Treasury. It will keep people from being homeless, and let the real estate market find its equilibrium pricing, and it removes default risk from the sub-prime paper everyone is holding. Then let the RTC entity negotiate the payoff of the remaining loan balances with those holding the mortgages, probably at a substantial discount. This would resolve price discovery for the paper, and not overly reward the lenders for bad lending practices. So the RTC type entity has accounts receivable of probably substantially more value than what they have paid the holders of the mortgages to cover any risk of default of the unsecured amount from the previous homeowner. Granted it’s unsecured funds at this point, but at least were dealing with just the amounts of the loans that are in excess of the estate market value independently. We remove home prices from the equation this way. Make the debt like student loans, in that they can’t wipe it away with a bankruptcy, and then pursue collections like any other creditor. Garner tax returns till the debt is paid off or whatever is necessary. The stock and real estate markets would equalize to equilibrium prices more quickly, we would free up the liquidity in the markets. It would let interest rates go up to equilibrium after the de-leveraging has decreased the money supply and help curb inflation from the commodity boom, without forcing the same default risks we have currently on ARMs if rates rise now. Worst-case scenario, at least taxpayers can feel like they are on the hook for supplementing the new buyers purchasing price in order to free up the markets, as opposed to bailing out the irrational purchaser while he gets to keep the bad investment he couldn’t afford to begin with. And, people might learn to spend as much time researching the largest purchase of their life as they do researching a $20 savings on a DVR knowing they won’t be bailed out of bad investment decisions. Granted, I threw this plan together in a few seconds without really thinking it all through and am not really proposing it as a viable solution as stated. I do however think there are alternate solutions we could find, if people would stop focusing on what they WISH would happen and start focusing on what the true underlying cause for problem was and what would truly solve the real problem we have at hand.
If they start trying to solve the right problem, they might come to a correct solution.