## Monday, September 29, 2008 ... //

### Bailout rejected

The Democrats mostly supported the intervention while the Republicans mostly opposed it. I watched the proceedings in the U.S. Congress and my reaction is: wow.

See also: Lawrence Summers: Taxpayers can still benefit from the bail-out, Financial Times
These guys have a lot of courage if not irresponsibility. Not too shockingly, Dow drops by 7% (by 778 points, biggest absolute drop in history), S&P 500 by 8.8%, and Nasdaq by 9.1% (and oil by 10%). On the "previous" black Monday, in 1929, Dow dropped by 12.8 percent so these quantities (but not others!) seem to be comparable by now. ;-)

Some of the Republicans have already claimed that the GOP with its loud "No" was reacting to Nancy Pelosi's partisan speech: well, I must tell you, that's a pretty bad policy to decide about the world economy according to an emotional reaction to an irrelevant bitch.

While I generally don't like interventions as a matter of principle, fundamentalism in these matters is simply a bad approach. Even though greed, irrationality, and panic is behind the bizarre developments, it doesn't mean that people should use the same values - greed, irrationality, and panic - to design the future.

In my opinion, the testimonies of virtually all of the liberals and conservatives who opposed the bill were populist and ill-informed in character. If someone says that "ordinary people" are innocent in this situation, he's simply neither a right-wing politician nor a realistic one. These problems began because many financially unsubstantiated mortgages were allowed for people who couldn't naturally afford them.

These transactions always had two sides, not one: the insufficiently liquid borrowers as well as the banks. Whenever they agreed about a mortgage that wasn't sensible, greed and irrationality played a role even though the detailed reasoning why the transaction was a good idea was, of course, different for the two sides. In the case of the lenders, political correctness has surely contributed, too. Without political correctness, the bankers would immediately know that most of those people were simply not wealthy enough to afford certain houses.

At any rate, the housing prices grew more than they should and people who were dangerously in debt were "owning" many of these houses. The housing bubble has inevitably burst and the trend has reverted.

But all these events belong to the past. They are part of the initial conditions of a physics problem that the lawmakers were supposed to solve today. I am afraid that their solution is incorrect.

Another opinion that baffles me is the belief of many of the lawmakers that the sentiments and events on Wall Street do not influence the "ordinary people", whatever is the definition of this bizarre, Marxist-sounding category. I view this opinion as a stunning misunderstanding of the economy. Whether someone likes it or not - or finds it politically incorrect or not - the banks, millionaires, and billionaires are much more important for the life of the whole U.S. and global economy than generic, "ordinary people".

It may surely sound as a very decent idea to try to punish the people on the Wall Street for the sick state of the financial system but what many people don't realize is that such a punishment will also (or especially) punish the "ordinary people". Some of them are also guilty - like those who have borrowed something they shouldn't have (and cheated when they described their financial situation) - and many of them are innocent.

A proper rational solution requires economics expertise rather than cheap populist and ideological references to "constituents" who have no idea what's going on and what will happen in different scenarios either. Bernanke is one of the leading U.S. experts in economic crises and Paulson has an extensive - and successful - experience with managing big financial institutions: his present job is not too different. Their calm and professional comments made much more sense than the comments of the passionate lawmakers.

I enjoyed e.g. the debate between Ron Paul and Ben Bernanke - they clearly agreed about most things even though their final, binary answers were different - but most of the other lawmakers simply didn't look like high-quality politicians to me.

While I am an enthusiastic advocate of the free markets, I believe that there exist several basic macroeconomic numbers whose reasonable values have to be controlled by the Feds and the administration. The value of money (whose time derivative is called the inflation) and the overall confidence in markets are among them. Just like the government has to guarantee that money is not counterfeited (if the system depends on the money, and the present world does), they must make sure that the money's value (and the accessibility of loans, which is closely related) is not compromised by other means. There exist certain assumptions that are necessary for capitalism to work. It is similar to the evolution of biological species: it works almost automatically but the physical laws must guarantee certain essentials of life.

Let me use the most general, non-technical description I can find: it is absolutely clear that if the confidence in the capitalist system itself goes to the trash bin and if most of the "assets" that have flooded banks and institutions become "toxic", unquantifiable, and unexchangeable, capitalism can't work well simply because capitalism depends on a certain degree of confidence in the system, in its players, on a well-defined value of assets, on easy enough trade, and on the positive value of most companies' actual assets - much like life depends on constant laws of Nature, well-defined numbers of copies of DNA molecules, the ability of living creatures to move, and the "alive" (as opposed to "dead") status of most animals in Nature that haven't yet been eaten or recycled. ;-)

Once we're talking about scary scenarios - where capitalism may become disrespected or even replaced by something else - I am surely in favor of interventions that should otherwise be as market-friendly as possible (and the reverse auctions etc. in the plan were surely highly market-based). You know, Central Europe can offer you many examples of situations in which the capitalism and freedom itself were replaced by something fundamentally different for many decades.

Well, I would prefer to sign a few papers and print a couple of otherwise unphysical and meaningless pieces of paper (such as banknotes). If I could have prevented the Great Depression after 1929, using a time machine and the present knowledge of economics, I would have done it. However, it is likely that the best solution would have to start years before 1929 just like the best solution to the current mortgage-related crisis would start already in 2003 or so. ;-)

The Feds and the administration should be in charge of the macroscopic degrees of freedom: there are still millions of more microscopic degrees of freedom left to the invisible hand of the free markets that naturally adapt to the external environment, including the macroeconomic parameters.

Because there is a feeling of an evaporating credibility of the markets that leads to dropping stock markets and increased volatility, something should be done about it. It's bad that the people who are actually important in the financial system (and wealthy) don't have a meaningful representation in the U.S. Congress. The body seems to be full of people who think that it doesn't matter whether anyone trusts any stocks, banks, funds, lenders, borrowers. But they're wrong. It matters a lot. More precisely, it probably doesn't matter for them because the number of jobs in the Congress is unaffected by the economy and their financial situation is arguably independent of the stock markets and banks, too. But the voters (including pensioners, investors, small businesses, large businesses, consumers, and charities) may live in a different world.

Let's hope that their mistake won't have excessively dramatic consequences.

#### snail feedback (12) :

These problems began because many financially unsubstantiated mortgages were allowed for people who couldn't naturally afford them.

Well, that maybe makes for an interesting story to tell, but it's false. Homebuyers do not qualify themselves for mortgages, lenders do. Furthermore, literally every such loan includes a deed of trust, or similar provision, that gives the lender recourse to seize the underlying asset in the event that the borrower fails. If the borrower is subprime there is also the requirement that they purchase mortgage insurance to guarantee the repayment of the loan and protect the lender.

After all that it's the borrowers fault that the industry is in trouble? Sounds like blaming the victim to me.

Something smells.

Dear donimo,

this sleight-of-hand of yours meant to remove all responsibility from the borrowers can't pass the basic logical scrutiny. The very existence of this "crisis" proves that you are wrong.

If the existence of the borrower's income in the future were not needed at all, the lender could buy the house himself and he would earn at least as much as he earns if he lends the money. ;-)

It's easy to see because given your assumption, the borrower wouldn't really bring any positive thing (at least not a guaranteed positive thing) into the whole transaction and its realization.

A deed of trust (or insurance) is a helpful policy but your suggestion that it is a sufficient gadget to insure all the players against all possible future risks has been falsified by the evidence. ;-) It simply can't work if too many borrowers become illiquid and too many equities drop below zero. And when the market becomes sour, which it often does, it is a rule, not an exception, that it begins to influence all of them simultaneously.

The deed of trust is unusable because the equities drop below zero faster than they can be sold in the real world (with excessive supply) and the mortgage insurance is unusable because the insurance companies that were hired to insure too many bad borrowers are going to collapse once the equities begin to drop.

Clearly, such a thing wouldn't occur if the loans (at least a vast majority of them) were based on the actual ability of the borrowers to pay rather than some shaky forms of "insurance" that clearly don't work if they're used by too many people.

It seems to me that you have learned no lesson from the mortgage crisis and you are eager to repeat the basic mistakes again.

Sorry but a deed of trust is clearly not a sufficient guarantee for lenders to avoid the risk, and the more lenders incorrectly believe that it is sufficient, the more unnatural state of the market they create and the more serious problems arise once their unsustainable assumptions are shown to be invalid. Do you really need to see more than what you're seeing to understand that I am right and you are wrong?

Best
Lubos

Of course that in many cases, it was the lenders who incorrectly calculated the risk. For example, they didn't realize the basic things sketched above, namely that a deed of trust becomes useless once the real estate market begins to drop and the excessive supply of houses emerges.

But in many cases, their result was wrong because they were misled by the borrowers. In some cases, the lenders had a hierarchical structure.

The "direct representatives" of the lender who communicated with the borrower knew that the borrower wasn't ready for the mortgage but the "top officials" of the lenders who actually calculate the risks already got incorrect information about the borrowers' solvency.

At any rate, the ultimate "microscopic problem" is the inability of many borrowers to pay the loans. These transactions wouldn't happen without them so I don't understand how they could possibly be innocent.

It may also turn out to be wrong and unjust to call them "victims" because many of them actually won't lose anything at all and they had housing for free. They're at least as much "sinks" of all the help that's coming now as the bankers.

Best wishes
Lubos

Lubos, domino is not doing any sleight of hand. You're both right. But domino is more right. The reason for the increaced default risk is not that borrowers borrowed more than they could handle, the vast majority of the could handle it. The problem is that prices went up for everything else after oil prices skyrocketed, cost of living went up, but incomes stayed the same or went down. In the first half of the decade, inflation pretty much only affected the rich, but when energy prices went up the broader populous.

And, balloon interest rates were never meant to be repaid. The were simply pressure to make sure that flipper made their improvements quickly and sold. Increased costs and falling assets values meant that flippers couldn't sell fast enough or get value out improvements they made.

Even poor people have their own risk tolerances. They generally knew their budgets, and even probably even accouted for shocks. But they didn't expect costs to go up much more than their incomes for significant periods of time. That makes that mortgage payment more difficult and default more attractive.

(sub-prime is a small part of the problem)

And please see my post on Best and Worst Case Scenarios.

Here's my Best Case:

Nothing is done. Banks, afraid to lend to eachother and faced with watching their assets depreciate, loan to good borrowers with higher down payments or collateral and lower interest rates. Portions of loans with 6% or higher interest rates are refinanced at a lower rate, probably around 4%, on the existing value of the house or other collateral, the owner must pay the portion of the principal not covered by the current value of the house at existing terms, but the current rate is locked in. Owners deemed too risky at the new low rates default. Some banks holding mortgage backed securities that are dependant on the cash flows on the portion of the loan refinanced and on defaulted loans go bust. The assets of failed banks are sold off and the debts are nationalized. Inflation is kept in check, so costs of living do not increase relative to income, so default risk goes down. Commodity production increases to take advantage of recent rises in prices, continuously rolled over long positions on commodities are seen as untenable long term investments. Money is moved away from commodities, and prices of consumables fall. Default risk further decreases and some risky assets become valuable again.

And now the Worst Case:

Bailout happens. Inflation increases, but home values continue to decline and wages remain flat. Home owners, with budgets already crunched beyond expectations, are burdened with even higher costs of living and default risk increases greatly. Defaults increase and home prices fall more. The bailout causes the interest rate the government borrows at to go up, moving money away from businesses and causes banks to expect higher interest rates from home buyers, putting further downward pressure on home prices. Scared money also goes from home and business loan to continuously rolled over long positions on commodities, which people expect production not to increase for but demand to remain. Prices go up relative to income, and default risk goes up....

Credit markets freeze up within the next week and many businesses cannot meet their payrolls. Margin calls cannot be met and the NYSE shuts down for a week. Hardly anyone can get a mortgage so most home prices end up undefined rather than low. There is an emergency de facto nationalization of banks to keep the payments system moving... There is no one to buy up the busted hedge funds, so government and the taxpayer end up holding the bag. The quasi-nationalized banks are asked to serve political ends and it proves hard to recapitalize them in private hands. In the very worst case scenario, the Chinese bubble bursts too.

Here are Tyler Cowen's Best and Wors-- I mean, Good and Bad Case Scenarios.

And Commentary at Megan McArdle's

Dear Aaron,

you're just describing how a wrong mortgage that shouldn't have been created looks like but you seem to say that such a mortgage was OK. I can't believe that even after all these experiences we've had, you still seem to think that these mortgages were OK.

If someone becomes unable to pay e.g. if the oil price jumps 50% - which is certainly nothing impossible as we've known for many decades, not just in 2007-08 - he shouldn't start with such big investments. And everyone else should have discouraged him from making them, too.

And a lender, bank, or an insurance company may afford a few marginal cases from this category but it certainly can't promote them to a standard business because it is a path towards economic suicide (or assassination of the national economy). Is that really so difficult to see even on September 30th, 2008?

Buyers' market comes every decade or two. If someone (flipper, borrower, lender, or anyone else) literally relies on permanently increasing housing prices, it's just a terrible case of irresponsibility. It has always been. And the people who have made money - and increased the value of their houses - while running these risks should feel the moral responsibility to help to pay to those who were not as lucky because regardless of the luck, all of them were equally irresponsible.

When things are evaluated in a somewhat more controllable framework today, it is the irresponsible behavior, and not bad luck, that should be punished. Because the set of irresponsible people would be virtually impossible to locate, it's clear that this is not what the administration should actually try to do. It must use an approximation and the best approximation I see is that the irresponsible behavior was the behavior of the taxpayer, so it is the taxpayer who should pay. Blaming anyone "more specific" is just demagogy.

Best
Lubos

Lumo, what you're suggest is a cash only economy. Tripling oil prices would make most investment untenable. It's certainly a possiblity. What happened was many things at once that were unexpected. And, the tax payer is everyone and pays no matter what, but who collects is another story.

Also, it's not actual defaults that are causing this it's increasing default risk and ridiculous leverage and speculation on the part of investers. It's not actual loan cash flows at risk that are the problem, it's borrowing on the expectation of receiving those cashflows or not. Likely what happened was that certrain types of debt were expected to pay off, and certain types of debt and interest were never expected. Investors were betting that certain principal payments over time would never be paid (they'be be received as a lump sum when the owner flipped rather than monthly) and that balloon interest payment would never come. The problem isn't the actual defaults, it's the were heavily levereged and betting that the bubble wouldn't pop.

The investors are just as culpable as the borrowers. Actually more so because the doubled down, over and over.

When you say that the things that happened were unexpected: Sorry to say but they were surely not unexpected for me.

For example, housing prices simply can't grow 15% a year, 10% or more faster than income, indefinitely because in a few years, the affordability drops to 1/2. It's just clear that an average house can't cost 50 years of average salary or something of this sort - which would happen with the insane rate.

So at some moment, a comparable drop to 15% must also occur. It seems clear to me that the long-term growth of housing prices can't differ from the growth of salaries too much.

I am not proposing any cash-only economy. I am saying that economic subjects at a sufficiently high level must always have their risks balanced and properly calculated. A single investor or borrower may take the risk and bet that the oil price will never double and transfer this risk to a higher entity.

This subject may transfer it to someone else, too. But whoever is at the top must have balanced risks.

If you're suggesting that whole parts of the system are going to collapse just if the oil price triples, then I tell you that those segments of the economy live in an immense risk because the probability that the oil price will triple sometime in 5 years is surely greater than one percent or so. There is absolutely nothing impossible about these scenarios. The price increase 10 times between 2000 and Summer 2008.

Once again, individual borrowers or investors may make a bet that a quantity will always have a positive sign (or negative sign) in the next 20 years but if too many people make the same bet with the same sign, it's a hell of a problem if they're wrong - and surely they can easily be wrong. It's bad that these people will get away with this mistake just because there were many of them and their failure would destroy the system.

Best wishes
Lubos

Lubos,

The effects of mortgage fraud on financial institutions and the stock market are clear. Fraudulent practices have become systemic within the mortgage industry and mortgage fraud has been allowed, unrestrained. It has placed financial institutions at risk and is having adverse effects on the stock market. Investors are losing faith and will require higher returns from mortgage backed securities. This will result in higher interest rates and fees paid by borrowers and limit the amount of investment funds available for mortgage loans.

How do I know?

Everybody knows:

http://tinyurl.com/5mehge

"When you say that the things that happened were unexpected: Sorry to say but they were surely not unexpected for me."

"It seems clear to me that the long-term growth of housing prices can't differ from the growth of salaries too much."

I totally agree. And that's why I waited for prices to come down in my area. Bought at decent and fixed rate. Bought well below what the lended want to lend. And I will be fine.

But that's beside the point. The crisis isn't about defaults, it's about betting that the default wouldn't happen with lot's of borrowed money.

Who Pays?

The taxpayer pays. The taxpayer always pays. No. Matter. What.

Everyone pays taxes and everyone is the taxpayer. When a blowup happens, it's the taxpayer who will pay. When there is economic destruction, the taxpayer pays. (And, conversely, when we pay taxes there is economic destruction… generally.)

Now that we've dealt that, who should they pay?

Should they pay borrowers, who didn't realize that living expenses might go up but their wages wouldn't, so they might want to default?

Or lenders who didn't expect the borrowers’ wages to stay low and prices to go up, leaving them less to make payments with?

Should we pay the flipper, who bought houses, hopefully with the intention of improving them and quickly selling? He didn’t know costs would go up and home values would go down, decreasing the return on his now costly improvements.

Or should we pay the lenders, who loaned to flippers at low rates, but put a ballooning interest rate on the loan so that the flipper would sell to someone else if he didn’t improve the property fast enough? He didn’t know that improvement costs would go up and tightening budgets would cause home prices to go down.

Or should we pay the banks, who bet that they would not see default risk go up, bet that they would receive sub-prime principal in lump sums, bet that they would not see sub-prime principal payments in installments after 2 years, bet that they would not see interest payments at ballooned rates, then borrowed on those bets and bet bigger?

I say know one, and my best and worse case scenarios show why. Inflation will not make people lend better and will increase default risk.

Basically what we seem to be doing is preventing the markets from lending at lower rates, as they should, and to safer borrows. The legislation we are getting will push rates up and keep borrowing criteria low.