(no subject)

[steuard]

I've had trouble looking away from the turmoil in the financial markets this week. Between the possibility that the economy could plunge down a cliff and the possibility that we're going to be collectively saddled with a trillion dollars of new debt, it's awfully likely that something tremendously significant is happening. Unfortunately, I don't know nearly enough about the underlying issues to have any good sense of what the "right" response might be, individually or as a society. A couple of thoughts, in no particular order:

• I am surprisingly bothered by the notion that when the dust settles, some people will have gotten rich off of these subprime loans. I can accept that the government may have to step in and bail out the economy in this situation, but if the corporate executives who made these high stakes gambles waltz off into happy retirements with golden parachutes I know that I'll resent it. Perhaps the right way to handle that is to combine extreme government spending with extreme government enforcement: have federal, state, and local law enforcement go over every aspect of the subprime mess with a fine toothed comb and throw the book at people for every little infraction that contributed to the disaster. I'm a little disturbed to realize that I'd feel better about those golden parachutes if the profiteering executives and predatory lenders had to enjoy them from prison.


• This is sort of situation is precisely why I've long been skeptical of extreme privatization and deregulation. The government is going to stick its nose into issues like banking and retirement, we just have a choice of when and how. If we leave markets entirely free without regulation, we'll get occasional major busts when competition for the highest immediate profit leads to erosion of standards and collective stupidity, and the government will be politically forced to step in to bail the rest of us out. If we privatize retirement investing, there will come a time when a major market drop leaves half a generation of the elderly destitute, and the government will be forced to step in to make sure the elderly don't have to live on cat food. The alternative is to set up some level of government involvement in advance, in the hopes of making government involvement more predictable and more fair. It's a tough balancing act to do that without stifling the positive effects of free markets, but I think it's still a better choice.

Comments

[ukelele.livejournal.com]

I need to point out that "subprime" doesn't necessarily mean "bad". As I understand it, it means that you wouldn't have qualified by traditional criteria -- but traditional criteria may well have been too conservative. One of our mortgage loans is subprime, but that doesn't mean that we can't afford it, that anyone was lied to or manipulated, etc. It just means that we couldn't get a conventional loan package because what kind of 20something can scrape up a 20% down payment in greater Boston? Shyeah.

I cannot say that we have gotten rich off our subprime loan, as really we're in quite a lot of debt now ;). But we have gotten a house off of it.

[zathrus.livejournal.com]

Yes. I read something Patri linked to a while back about how the mortgage thing happened, and the start of it seemed pretty reasonable. It seems that some (many) lenders kept going in that direction, long past anything reasonable. And then investors did complicated financial things in back rooms, and everyone ended up involved one way or t'other. Not all subprime loans are bad -- but way too many were. And a friend of mine went into the mortgage business in large part because he could speak Spanish, and saw a great many Hispanics being exploited by unethical lenders getting them into high-interest-rate loans they couldn't afford and couldn't understand. We are in a good position to figure out what's going on with our mortgages, and figure out what we can handle, but we are far from representative.

Newt

[ukelele.livejournal.com]

Yeah, my impression is very much that people realized we had all these sophisticated financial tools kicking around that we didn't previously, and this gave us new ways to price and allocate risk, and that meant that old standards really *were* too conservative, but then we didn't have any idea what the hell we were doing with these tools because it's not like many people actually understand them, so we went too far the other direction. Add a special sauce of the outright unethical and you get all kinds of fun.

[steuard.livejournal.com]

Oh, I'm not annoyed at individual homeowners (though the folks who falsified their loan applications do trouble me and probably bear some of the blame for how things have turned out), and getting a house doesn't sound like "getting rich" to me. Thanks for the clarification on "subprime", too: I'm not that knowledgeable about housing markets, and I was using the term as a vague shorthand to refer to the current mess in general (as I've often seen it used in the press, I think).

My frustration is mainly based on the impression that banks should have known better: if you don't particularly understand the risk characteristics of a new financial tool, it seems insane to bet your firm's solvency on it (much less the global financial system). And encouraging people to take out loans that they honestly couldn't afford isn't right (I've read stories about some lenders or mortgage brokers out here in California routinely inflating applicants' stated income and assets, perhaps without even telling them).

I've heard people characterize the cause of the mess as "lenders assuming that housing prices would always go up". That can't be literally true (nobody would be that nuts), but my sense is that a lot of firms were eager to cash in on high returns in the short term while pushing the inevitable day of reckoning as far into the future as possible. ("Maybe it will eventually go away, or at least be somebody else's problem by then.")

[ukelele.livejournal.com]

The media have been totally sloppy about it. Annoying.

And I share your frustration about the banks. I get that average people might not 100% understand all this stuff, especially if you're being lied to, but you'd think financial companies would have both the incentive and ability to manage risk appropriately.

As for "nobody would be that nuts", certainly the media narrative around here echoes the "people believed housing prices would always go up" theme; of course, as already stated, the media are sloppy, but certainly the housing market around here was incredibly overheated and a lot of people took out loans that only made sense under the assumption that their property values would always go up. Again, it seems like *lenders* ought to be smarter than that, but who knows.

If it's any consolation, everyone has now gone completely overboard the other way :P. We had to actually drop me from our refi application last week because my credit (700+) wasn't high enough. Yeah.

[ukelele.livejournal.com]

Oh, and I found this interesting: http://www.marginalrevolution.com/marginalrevolution/2008/09/mindles-dreck-i.html . The really interesting part is when he lays out an argument that there *is* an incentive for some major financial companies to invest in poorly-understood instruments.

[jminnis.livejournal.com]

Keep in mind that one major problem is the half-assed privatization of Fannie May and Freddie Mac. The market gave them a pass on a lot of things because of the government backing. The government was asleep at the wheel in terms of monitoring them. Because of this, Freddie and Fannie became the dumping ground for bad mortgages. I suspect that a lot of companies would have behaved better if they hadn't been planning on foisting off any problems on the US treasury.

I'd also say that this is another fine example of the danger of tying executive compensation only to short term stock prices for the company. If an executive gets multiple million dollars for hitting a particular stock price in a given year, there's a huge incentive for them to fudge the books or do other things to make it happen. You'll notice that pretty much all of the major company collapses have that aspect of executive compensation (and that aspect of executives working to meet their compensation goals) tied to them.

[beth_leonard]

*nod*

Also part of the problem is that mutual fund managers get *annual* bonuses for beating the market in any given year. There is tremendous pressure to "beat the market" which is hard to do without leverage. In an up year, they leverage more so annual returns are better than "market" returns, but it means that when the market starts falling, even slightly, their problems suddenly compound much much more quickly. However, if you make a $2M bonus 4 years in a row and $0 bonus for bankrupting your mortgage-backed-securities mutual fund in the 5th year, as an individual you still come out ahead.

The investors in said funds however...

There's a reason Jon and I start with market indices as the base layer of our portfolio. Of course the market as a whole is (was) over-weighted in financials, so that's not so great on a day like yesterday.

--Beth

[steuard.livejournal.com]

I recall that Patri has talked in the past about people looking for better weighting schemes for stock index construction than market capitalization. Weighting by market cap gives investors extra exposure to overpriced companies and less to underpriced ones, exactly the opposite of what you'd want. The claim was that practically any other weighting method would be better (number of employees was one example) simply because you aren't mixing the weighting variable directly with the reward variable (or something like that). I'll be interested to see if those ideas eventually take off.

[jminnis.livejournal.com]

This is a very good point, an one which I had never really thought about. I've never heard of a fund that does anything like this, though.

[jminnis.livejournal.com]

I think that it would rock if mutual fund managers got paid their bonus in shares of their fund, which they could only cash out 10% per year for the decade after the bonus is awarded. Something similar could be done with executive compensation.

I invest in market index funds and individual stocks. I avoid managed funds like the plague.

[steuard.livejournal.com]

Yeah, I think we can pretty much all agree that an ill-defined patchwork of free market and government incentives is the worst of all worlds for a company. If the government didn't intend to guarantee Fannie and Freddie, they needed to make that abundantly clear all along. If they did intend a guarantee, that should have been out in the open from the start (and factored into the expected costs of the program when it was approved). As it was, the sudden switch from emphatic denials that there was a guarantee to emphatic promises of one (followed by acting on it) was yet another thing that's frustrated me about how this story has played out.

I also totally agree on executive compensation being tied to short term stock prices. I would have thought that the whole point of having a CEO would be to have someone looking out for the long term health and plans of the company. People react to the compensation structures they're given (just as my students react to the grading system I impose). So who exactly is it who's pushing for this short term focus? Are corporate boards run by day traders?

[pmb.livejournal.com]

It's important to note that Fannie and Freddie were originally a single government entity and did have explicit government backing. Then in the 80s, Reagan half-assed deregulated that one agency into two (for competition) on the theory that some free market was better than none.

[jminnis.livejournal.com]

Actually, the biggest step in deregulation was in 1968, when it was made a 'private entity.' It's taken 40 years, but the sin of half-assing the deregulation has definitely caught up with us.

where do I begin?

[dmyersta.livejournal.com]

The mortgage crisis (from everything I've read) is the result of a) the assumption that especially in places like CA and FL, the price of real estate will always go up, which is true in the long run, but not at the rates we've seen. This led to speculators in real estate which created an artificial bubble which has now popped, as all bubbles do. b) the average jane or joe not understanding the language the mortgage brokers speak and what they were signing, understanding only "Your monthly payment will be... Trust us!" c) banks making crazy loans (and not getting caught) making crazier loans (and not getting caught) making really super insane ridiculous loans that were guaranteed to default, expecting that someone else would pick up the tab. That's why they sold the loans within 10 seconds of making them.

As I understand it, there were also shenanigans like packaging loans with a high rate of default with loans that didn't have as high a rate of default and manipulating the statics to give a false impression of the actual risk in these loans and what created a crisis is that it was done in such a way that no one can tell which blocks of notes contain more bad than good and which are correct assessed in terms of risk, so all the people who have been buying our notes (foreign countries) are unwilling to continue buying them (and who can blame them?) until this is sorted out.

I think that the govt. giving *any* money at all to the mortgage lenders will merely encourage them to repeat this mess, perhaps even bigger because after all, it's no skin off their nose. They are gambling with taxpayers money now. I do not feel sorry for bankers who are in danger of losing their retirement packages. I do not feel sorry for banks whose books are flooded with non-performing assets.

In my opinion, the best thing that can happen is for the govt. to stay out of it ENTIRELY, let the banks take the hit, let the market correct itself and let this be a little blip rather than a prolonged, agonizing period of trauma.

I think the more govt. interference, the more likely we are to find ourselves in the situation Germany was in before WWII where people were paid on a daily basis and would spend their wages as soon as they got them because by the afternoon, their wages would be much less.

Re: where do I begin?

[steuard.livejournal.com]

In my opinion, the best thing that can happen is for the govt. to stay out of it ENTIRELY, let the banks take the hit, let the market correct itself and let this be a little blip rather than a prolonged, agonizing period of trauma.

I've been tempted by that same idea myself (let the reckless reap what they sew), but I've come to the conclusion that there probably is a real danger of catastrophic economic collapse in that case. If enough major banks fail and default on their debt to other banks and institutions, credit dries up: the other banks no longer have enough money to make new loans. Without available credit, businesses have trouble growing or sometimes even meeting operating expenses when their cash flow isn't 100% stable. And when those businesses can't make payroll, individuals suffer and stop spending, and the cycle intensifies.

Stupid nonlinear systems.

not every bank will fail

[dmyersta.livejournal.com]

Wells Fargo's mortgage lending department is doing great right now, for example. They avoided the crazy loans and now while others are having to back off, they are going gangbusters.

I think that what will happen is that as the available credit shrinks, business will come up with creative ways to grow and meet operating expenses and the price of housing will come back in line with the cost of goods/services/payroll and in a very short time 9-18 months, everything will have stabilized. OTOH - giving $$$ to the banks will prolong this "crisis" 5-7 years. Which to - will create much more pain and financial insecurity.