The Irvine Housing Blog, a website tracking the real estate crash in Irvine, California, offers an intriguing explanation for what caused the meltdown. This posting is my spin on what they've written.
The Irvine blogger points his finger at the transformation of housing finance from a business of transactions between banks and their local customers into an industry involving a series of faceless entities and the international bond market. The Fed's monetary ease after the 9/11 attacks was merely the spark that fell onto a dry, tinder-strewn forest floor.
To understand what happened, we have to take a look at the mortgage banking system and how it changed over the past 30 years. Prior to 1980, most people got their mortgages from a savings and loan association, also known as a "thrift." These local institutions gathered deposits at a regulated rate, and lent the money out at a higher rate. The difference, or the spread, paid for costs, profits, and the occasional default. No one ever called it exciting, but the livin' was easy. "Take it in at 3%, lend it out at 6%, be on the golf course by 3 o'clock." As an icon of the easy-livin' 1960s, the so-called 3-6-3 rule was right up there with Dean Martin, the '66 Mustang, and the three-martini lunch.
The end of the good old days
Then it all changed. In 1971, the U.S. abandoned the gold standard and allowed the dollar to "float" against other currencies. Money could now flow freely around the world, seeking the highest rates of return. In the background, inflation was heating up. And then then it really took off after 1974, when the Arabs cut off the flow of oil and quintupled the price. That, along with the floating of the dollar, drove a silver stake through the heart of the banking system as we once knew it.
By the mid-'70s, ordinary people started abandoning banks and thrifts for other investments that paid more. Why stick your money into East Nowhere Savings & Loan at 3% when you could buy a Treasury bill for 5%? Worse yet, East Nowhere's great assets -- those solid home mortgages written in the '50s and '60s that hardly ever defaulted -- were now a lead weight around its neck. Somewhere between the second and the third martini, it dawned on East Nowhere's bankers that if their mortgages were paying 6% while they had to offer 6.5% to keep deposits, there'd be no more Cadillacs and no more country clubs.
Regulators and politicians were also behind the 8-ball. If you told East Nowhere S&L that it couldn't pay more than 3% on savings when any common fool could get 5% somewhere else, it would run out of money to lend. Then construction would stop, and the economy would go into the tank. If you allowed East Nowhere to pay whatever they wanted for deposits, there was still the matter of all those old mortgages on the books that weren't yielding enough to pay the S&L's light bill, let alone the president's club dues.
Facing death, the S&Ls reach out to Wall Street
It didn't take long for bankers to switch to iced tea for lunch and brush up on Finance 101, namely the need to pay close attention to the duration of your assets relative to the duration of your liabilities. If the average mortgage lasts for seven years but your average savings deposit sits for six months, and all the regulations keeping things stable have been blown away, you've got a big alligator swimming in your pool just waiting for the right moment to strike.
Some of the S&Ls crossed over to the dark side and made stupid, risky loans in their search for better returns. Remember the commercial real estate bubble of the 1980s and the S&L bailout of the early 1990s? Other S&Ls took the high road and hopped on a bandwagon called "securitization." Oh, they'd still make loans just as they always did. But instead of holding them, they'd turn them into bonds and sell the bonds.
Voila! Duration matching could be someone else's problem. The customer would keep sending mortgage payments to East Nowhere Savings & Loan, blissfully unaware that the money was being passed through to the holders of bonds based on his and other mortgages. East Nowhere would be the"originator" of the loan, taking a fee for finding the borrower, checking his references, and handling the paperwork. It would also be the "servicer" of the loan, taking another fee for collecting the payments and managing the escrow accounts, along with the occasional foreclosure.
But someone else would be the "holder" of the loan. That someone else could be anyone from an insurance company in Portland, Oregon to a Saudi prince looking for a place to park his petrodollars. There was no need for the lender to know the borrower. The bond indenture would suffice, thank you.
That, in essence is what happened to mortgages after 1980. A couple more wrinkles that matter: It's not East Nowhere S&L that actually issues the mortgage bonds I just mentioned. Instead, East Nowhere sells its mortgages to Fannie Mae or Freddie Mac, two gigantic corporations created by the federal government to turn mortgages into bonds. Freddie and Fannie create the bonds. Oh, and East Nowhere competes for originations and servicing rights with "mortgage banks" like Countrywide Financial and Ditech.com (owned by General Motors, which cut its teeth by having financed car loans). Maybe you've noticed that just about all of the S&Ls have gone away? They've been outgunned by the big boys.
Mortgage bonds: Theory vs. practice
From essentially 0% of the market in 1980, the "securitized" share of mortgages has grown to about two-thirds of the pool today. On the surface, it's a great idea. Holding mortgages is a financial activity. Originating mortgages is a sales activity. Servicing mortgages is a matter of computers and data processing. Capitalism is all about specialization, and it only stands to reason that a salesman left to sell is going to be a better salesman than one who also has to worry about duration mismatch and escrow accounts. Everybody's happy! Why, it's a classic win-win-win-win solution!
Yeah, right. The more wins, the more losses. They never tell you about the risks until it's too late.
What's missing from this picture? Checks and balances. In days gone by, the East Nowhere S&Ls of the world had good reason to lend carefully. If you hold onto a 6% mortgage and the borrower defaults, you'll lose at least two or three good loans' worth of profits by the time it's all over. Not to mention being the evil banker who took some poor guy's house away. Your shareholders won't like it very much, and neither will the regulators. And you know what? In days gone by, some of the S&L bankers actually lost sleep over debtors who fell behind. Don't tell anyone, but some of them had a heart.
But what if a payment stream stops going into a mortgage bond? Phone calls get made and wheels turn. But it's not the same. The guy who wrote the loan has long since been paid. The servicer makes even more money off the foreclosure. The poor busted debtor gets evicted by some corporation with nothing but letters in its name and a calculator in its chest. As for whoever got left holding the bag for those bonds, well, what's risk all about, right?
On Main Street they call this "irresponsibility." On Wall Street, the financial geeks call it "moral hazard." I call it "magical thinking" or "not giving a shit." Call it what you will, but in today's securitized mortgage business this mentality is everywhere you look.
Naturally, everyone will tell you they're honest. What are personal delusions and corporate P.R. departments for, anyway? Borrowers will haul out the usual excuses, some of them good and most of them embarrassing. The originators will claim to have followed the rules, checked the references, and so on. The securitizers will tell you they've got their eye out for fraud. The bond buyers? Ah, the bond buyers. They're my favorite, because if anyone should have known better, and in fact did know better, they're the ones.
The bond buyers will sing a song of prudence, advising you to look at historical data showing miniscule mortgage default rates. Catch one of them on their second after-dinner drink (the three-martini lunch being a relic of more carefree days), and they'll tell you something else: Fannie and Freddy are too big to fail. The bond buyers could afford to ignore credit quality. By and large, they work for big pension funds, mutual funds, and insurance companies. Their job was to pretend that the mortgage bonds were solid. Given that Uncle Sucker is there to bail them out, were they wrong?
There's no welfare queen like a corporate welfare queen
In other words, if the shit really hits the fan, the federal government will rescue the bondholders. The alternative is to see the whole financial structure collapse, and trust me, no one wants that. We have no choice; they've got us over a barrel. We bail them out, or there's a second depression. Really. The Federal Reserve refers to this as the "implicit government guarantee" on Freddy and Fannie's securitized mortgage bonds. All $5+ trillion worth, no matter how crappy the collateral. You see, the securitization business might be efficient, but it's more efficient in more ways than one. It is a remarkably efficient buck-passing mechanism, and it's a remarkable efficient vehicle for fraudulent dealing.
The bottom line is this: The bag holder is the same dude who got stuck with the bill for the S&L "crisis" of the 1980s. He is Uncle Sucker. And don't kid yourselves, every penny that Uncle Sucker pays out comes from you and me. No matter how careful we were with our money. That is what "moral hazard" is all about: the ability to stick it to millions of faceless suckers who you'll never meet and who'll never meet you. If you managed your personal finances in a responsible manner, you'll wake up with someone else's hangover. The people who threw the party? Worry not. They've been paid.
Monday, October 1, 2007
Sunday, September 30, 2007
Seattle, Prince Prospero & Jim Cramer
Edgar Allen Poe set one of his stories in medieval Europe during the plague. The pneumonic form was so virulent that it could kill within a half-hour of the first symptoms showing themselves, often on the face as a sort of Masque of the Red Death.
THE "Red Death" had long devastated the country. No pestilence had ever been so fatal, or so hideous.
But there was a man with a castle, and he was immune.
The Prince Prospero was happy and dauntless and sagacious.
One night he threw a big party, as if to show the world how safe and clever he was.
The external world could take care of itself. In the meantime it was folly to grieve, or to think. The prince had provided all the appliances of pleasure. There were buffoons, there were improvisatori, there were ballet-dancers, there were musicians, there was Beauty, there was wine. All these and security were within. Without was the "Red Death."
Meanwhile, his lunatic of a brother, Jim Cramer, transported to the 21st century as if by magic, ran amok in the land, warning of the Red Death. He was both scorned and feted for his powers of observation. His shrieking candor was bracing, brave, and dangerous.
Don't you dare buy now. Don't you dare buy a home now. You will lose money.
Then he retreated to Prince Prospero's castle, where he had been invited to join the festivities. It was a rainy night in the Pacific Northwest, and the pestilence was nowhere to be noticed.
Bob Toll told me that Seattle was up. ... Seattle's okay.
Was all truly well? A letter arrived at a reveler's doorstep. It was from a real estate agent in Magnolia, one of the castle's finer neighborhoods. It showed that in July 2007, inventories had suddenly doubled while sales had not changed. A gasp was heard, quickly stifled.
When the echoes had fully ceased, a light laughter at once pervaded the assembly; the musicians looked at each other and smiled as if at their own nervousness and folly, and made whispering vows, each to the other, that the next chiming of the clock should produce in them no similar emotion; and then, after the lapse of sixty minutes, (which embrace three thousand and six hundred seconds of the Time that flies,) there came yet another chiming of the clock, and then were the same disconcert and tremulousness and meditation as before.
One Sunday, the reveler ventured forth to two open houses in his neighborhood. Welcome, one agent said. It's nice to have some company. He was showing a beautiful home, professionally staged by a professional staging company. The price had been cut twice, most recently from $750,000 to $700,000. Based on what similar houses rent for, it ought to sell for about $375,000. No one's even stopping to look, the agent said. Sales are down more than one-third. The market topped out right around Memorial Day. Magnolia is full of people with one-year ARMs ready to reset, he added. But maybe things will come back next spring.
The other house was advertised for $585,000, recently cut from $600,000. If it had been on the market last spring, its agent said, he'd have set the price at $625,000 and it would have sold immediately. But it's not spring. This year's pool of buyers is exhausted. Wait until January, and they'll start trickling back.
Both realtors were subdued but not depressed. Yes, things are slow. The outlying areas of Seattle will suffer the most, and California is getting what it had coming. The reveler agreed. Magnolia is forever, he said, but I hope you've saved some of the money you've been making. Yes, one agent said. I'll be able to put food on the table. People are always going to have to live somewhere. We have cycles, the other agent said, mentioning that he's been selling real estate for more than 30 years. We've had a good ten-year run here. It's not the end of the world.
The reveler recalled his friend from across town. The house across the street has been for sale all summer. Started at $350,000 and is now at $300,000. I wonder how low it will go, the friend said.
It was then, however, that the Prince Prospero, maddening with rage and the shame of his own momentary cowardice, rushed hurriedly through the six chambers, while none followed him on account of a deadly terror that had seized upon all. He bore aloft a drawn dagger, and had approached, in rapid impetuosity, to within three or four feet of the retreating figure, when the latter, having attained the extremity of the velvet apartment, turned suddenly and confronted his pursuer.
There was a sharp cry -- and the dagger dropped gleaming upon the sable carpet, upon which, instantly afterwards, fell prostrate in death the Prince Prospero. Then, summoning the wild courage of despair, a throng of the revellers at once threw themselves into the black apartment, and, seizing the mummer, whose tall figure stood erect and motionless within the shadow of the ebony clock, gasped in unutterable horror at finding the grave-cerements and corpse-like mask which they handled with so violent a rudeness, untenanted by any tangible form.
THE "Red Death" had long devastated the country. No pestilence had ever been so fatal, or so hideous.
But there was a man with a castle, and he was immune.
The Prince Prospero was happy and dauntless and sagacious.
One night he threw a big party, as if to show the world how safe and clever he was.
The external world could take care of itself. In the meantime it was folly to grieve, or to think. The prince had provided all the appliances of pleasure. There were buffoons, there were improvisatori, there were ballet-dancers, there were musicians, there was Beauty, there was wine. All these and security were within. Without was the "Red Death."
Meanwhile, his lunatic of a brother, Jim Cramer, transported to the 21st century as if by magic, ran amok in the land, warning of the Red Death. He was both scorned and feted for his powers of observation. His shrieking candor was bracing, brave, and dangerous.
Don't you dare buy now. Don't you dare buy a home now. You will lose money.
Then he retreated to Prince Prospero's castle, where he had been invited to join the festivities. It was a rainy night in the Pacific Northwest, and the pestilence was nowhere to be noticed.
Bob Toll told me that Seattle was up. ... Seattle's okay.
Was all truly well? A letter arrived at a reveler's doorstep. It was from a real estate agent in Magnolia, one of the castle's finer neighborhoods. It showed that in July 2007, inventories had suddenly doubled while sales had not changed. A gasp was heard, quickly stifled.
When the echoes had fully ceased, a light laughter at once pervaded the assembly; the musicians looked at each other and smiled as if at their own nervousness and folly, and made whispering vows, each to the other, that the next chiming of the clock should produce in them no similar emotion; and then, after the lapse of sixty minutes, (which embrace three thousand and six hundred seconds of the Time that flies,) there came yet another chiming of the clock, and then were the same disconcert and tremulousness and meditation as before.
One Sunday, the reveler ventured forth to two open houses in his neighborhood. Welcome, one agent said. It's nice to have some company. He was showing a beautiful home, professionally staged by a professional staging company. The price had been cut twice, most recently from $750,000 to $700,000. Based on what similar houses rent for, it ought to sell for about $375,000. No one's even stopping to look, the agent said. Sales are down more than one-third. The market topped out right around Memorial Day. Magnolia is full of people with one-year ARMs ready to reset, he added. But maybe things will come back next spring.
The other house was advertised for $585,000, recently cut from $600,000. If it had been on the market last spring, its agent said, he'd have set the price at $625,000 and it would have sold immediately. But it's not spring. This year's pool of buyers is exhausted. Wait until January, and they'll start trickling back.
Both realtors were subdued but not depressed. Yes, things are slow. The outlying areas of Seattle will suffer the most, and California is getting what it had coming. The reveler agreed. Magnolia is forever, he said, but I hope you've saved some of the money you've been making. Yes, one agent said. I'll be able to put food on the table. People are always going to have to live somewhere. We have cycles, the other agent said, mentioning that he's been selling real estate for more than 30 years. We've had a good ten-year run here. It's not the end of the world.
The reveler recalled his friend from across town. The house across the street has been for sale all summer. Started at $350,000 and is now at $300,000. I wonder how low it will go, the friend said.
It was then, however, that the Prince Prospero, maddening with rage and the shame of his own momentary cowardice, rushed hurriedly through the six chambers, while none followed him on account of a deadly terror that had seized upon all. He bore aloft a drawn dagger, and had approached, in rapid impetuosity, to within three or four feet of the retreating figure, when the latter, having attained the extremity of the velvet apartment, turned suddenly and confronted his pursuer.
There was a sharp cry -- and the dagger dropped gleaming upon the sable carpet, upon which, instantly afterwards, fell prostrate in death the Prince Prospero. Then, summoning the wild courage of despair, a throng of the revellers at once threw themselves into the black apartment, and, seizing the mummer, whose tall figure stood erect and motionless within the shadow of the ebony clock, gasped in unutterable horror at finding the grave-cerements and corpse-like mask which they handled with so violent a rudeness, untenanted by any tangible form.
And now was acknowledged the presence of the Red Death. He had come like a thief in the night. And one by one dropped the revellers in the blood-bedewed halls of their revel, and died each in the despairing posture of his fall. And the life of the ebony clock went out with that of the last of the gay. And the flames of the tripods expired. And Darkness and Decay and the Red Death held illimitable dominion over all.
Saturday, September 22, 2007
The Fed Cuts Rates, and Rates Go Up. Huh?!
Or so asked Peter Viles, the L.A. Times's real estate blogger, on Friday, Sept. 21st, three days after the Federal Reserve reduced its symbolic "discount rate" by 0.5%.
I suspect we'll be hearing the same question with increasing frequency over the next year or three, as the Fed’s attempts to "cut interest rates" have the opposite effect. Fact is, Americans don't have much of a clue about the Federal Reserve. That's the main reason I created this blog: to explain what the Fed can and cannot do.
If you scroll down and read those "Basics" postings, you'll see that, when the Federal Reserve "cut interest rates" on Sept. 18th, what it really did was create enough new money to drive the overnight ("federal funds") rate down. Traders reacted by sending rates on 10-year Treasurys from 4.35% to 4.70%. Mortgages are closely tied to the yield on 10-year Treasury notes*, so the increase was quickly reflected in higher mortgage rates.
You see, creating new money is a bit like having sex without a condom: long after the (take your pick: glow, anger, resentment, boredom ...) has worn off, all kinds of other things might happen. This time, the financial traders whose trades set interest rates (other than for those overnight inter-bank loans) took a look at the situation and decided the following:
Let's talk about interest rates. What you pay for a loan consists of three components. The first is a real return to the lender of 1-2%. The second is an expectation of inflation. The third is the default risk investors perceive when they make a loan (or buy a bond, which is essentially a loan made by someone else).
Real rates of return change very little over time, and because the Federal Reserve can create dollars out of thin air if it chooses, interest rates on government bonds have no default component. So, when long-term rates went up after the Federal Reserve "cut interest rates," it was because bond traders decided that inflation is more likely to rise because of what the Fed did, and because of what the Fed might do in the next few years.
How about the dollar? Why did it fall after the Fed's announcement?
Start by imagining that you're the chief financial officer for a big corporation. As part of doing business, you have a bunch of cash. You have to figure out where to put it; you'll want it to be readily available, but while it's sitting there you'd like it to earn the best possible return. If you see the Fed cutting American short-term rates, you might want to buy safe short-term bonds that pay in currencies other than the dollar: for example, Euro-denominated, 90-day bonds issued by the German government.
If this sort of thing happens often enough -- not just among corporate CFOs, but among all of the entities that trade currencies -- the value of the dollar will fall. Currency traders are constantly evaluating various issues, with differences in inflation and interest rates being at the top of the list. In recent years, U.S. rates have fallen while rates elsewhere have risen. More recently, the U.S. mortgage crisis has caused many traders to think the Fed will turn to inflation to reduce the burden of debt accumulated in the past several years.
That's why you've been reading that the Euro, which was worth about 85 cents in the late 1990s, is now priced at $1.41. It's why the Canadian dollar, which was worth around 65 cents a few years ago, now trades for as much as the American dollar. I'd hate to be one of those hotels in Victoria, British Columbia that had been making such a killing from the Seattle-based tourist trade, but I sure wouldn't mind being a European traveler to the United States right now.
The bottom line is this: The Federal Reserve does not, and cannot, set mortgage interest rates. The Fed can "influence" long-term rates by creating and destroying money, and by using some other powers. But that influence is more limited than most Americans believe. Financial markets, not the Fed, set long-term rates through the trading of bonds. And if bond buyers have a motto, it is this: Actions speak louder than words.
-------------------
* Wanna know why rates on 30-year mortgages are based on 10-year Treasury notes? There are three ingredients in that particular stew.
The first is the nature of a bond, Treasury or otherwise. It pays interest every six months and the principal at the end. If you haul out your trusty calculator and do the math, when you consider that the cash flows are paid to you at different times and that the biggest nut (the principal) is paid at the end, the "average maturity," or duration, of all the cash flows on a 10-year bond is 7 years.
That leads us to the second ingredient: It just so happens that the average dwelling gets sold every seven years. Call it a 30-year loan if you want, but chances are that it'll turn over in seven years. As a result, the interest rate is going to look a lot like a 10-year bond because of that bond's seven-year duration.
But why Treasurys? Ah! That's because most mortgages are backed by bonds issued by two federally-chartered companies, Fannie Mae and Freddie Mac. The government doesn't guarantee their bonds, but most buyers think Freddie and Fannie are "too big to fail" and thus would be bailed out by Uncle Sucker anyway. That's why the pricing (and its reciprocal, the yield, or interest rate) of Fannie and Freddie ("agency") bonds is based on Treasurys.
I suspect we'll be hearing the same question with increasing frequency over the next year or three, as the Fed’s attempts to "cut interest rates" have the opposite effect. Fact is, Americans don't have much of a clue about the Federal Reserve. That's the main reason I created this blog: to explain what the Fed can and cannot do.
If you scroll down and read those "Basics" postings, you'll see that, when the Federal Reserve "cut interest rates" on Sept. 18th, what it really did was create enough new money to drive the overnight ("federal funds") rate down. Traders reacted by sending rates on 10-year Treasurys from 4.35% to 4.70%. Mortgages are closely tied to the yield on 10-year Treasury notes*, so the increase was quickly reflected in higher mortgage rates.
You see, creating new money is a bit like having sex without a condom: long after the (take your pick: glow, anger, resentment, boredom ...) has worn off, all kinds of other things might happen. This time, the financial traders whose trades set interest rates (other than for those overnight inter-bank loans) took a look at the situation and decided the following:
- Federal Reserve Chairman Bernanke intends to inflate the U.S. out of the mortgage crisis by creating a lot of new money.
- Short-term rates -- which the Federal Reserve can control -- will fall, reducing returns on deposits of U.S. dollars sitting in banks here and around the world.
Let's talk about interest rates. What you pay for a loan consists of three components. The first is a real return to the lender of 1-2%. The second is an expectation of inflation. The third is the default risk investors perceive when they make a loan (or buy a bond, which is essentially a loan made by someone else).
Real rates of return change very little over time, and because the Federal Reserve can create dollars out of thin air if it chooses, interest rates on government bonds have no default component. So, when long-term rates went up after the Federal Reserve "cut interest rates," it was because bond traders decided that inflation is more likely to rise because of what the Fed did, and because of what the Fed might do in the next few years.
How about the dollar? Why did it fall after the Fed's announcement?
Start by imagining that you're the chief financial officer for a big corporation. As part of doing business, you have a bunch of cash. You have to figure out where to put it; you'll want it to be readily available, but while it's sitting there you'd like it to earn the best possible return. If you see the Fed cutting American short-term rates, you might want to buy safe short-term bonds that pay in currencies other than the dollar: for example, Euro-denominated, 90-day bonds issued by the German government.
If this sort of thing happens often enough -- not just among corporate CFOs, but among all of the entities that trade currencies -- the value of the dollar will fall. Currency traders are constantly evaluating various issues, with differences in inflation and interest rates being at the top of the list. In recent years, U.S. rates have fallen while rates elsewhere have risen. More recently, the U.S. mortgage crisis has caused many traders to think the Fed will turn to inflation to reduce the burden of debt accumulated in the past several years.
That's why you've been reading that the Euro, which was worth about 85 cents in the late 1990s, is now priced at $1.41. It's why the Canadian dollar, which was worth around 65 cents a few years ago, now trades for as much as the American dollar. I'd hate to be one of those hotels in Victoria, British Columbia that had been making such a killing from the Seattle-based tourist trade, but I sure wouldn't mind being a European traveler to the United States right now.
The bottom line is this: The Federal Reserve does not, and cannot, set mortgage interest rates. The Fed can "influence" long-term rates by creating and destroying money, and by using some other powers. But that influence is more limited than most Americans believe. Financial markets, not the Fed, set long-term rates through the trading of bonds. And if bond buyers have a motto, it is this: Actions speak louder than words.
-------------------
* Wanna know why rates on 30-year mortgages are based on 10-year Treasury notes? There are three ingredients in that particular stew.
The first is the nature of a bond, Treasury or otherwise. It pays interest every six months and the principal at the end. If you haul out your trusty calculator and do the math, when you consider that the cash flows are paid to you at different times and that the biggest nut (the principal) is paid at the end, the "average maturity," or duration, of all the cash flows on a 10-year bond is 7 years.
That leads us to the second ingredient: It just so happens that the average dwelling gets sold every seven years. Call it a 30-year loan if you want, but chances are that it'll turn over in seven years. As a result, the interest rate is going to look a lot like a 10-year bond because of that bond's seven-year duration.
But why Treasurys? Ah! That's because most mortgages are backed by bonds issued by two federally-chartered companies, Fannie Mae and Freddie Mac. The government doesn't guarantee their bonds, but most buyers think Freddie and Fannie are "too big to fail" and thus would be bailed out by Uncle Sucker anyway. That's why the pricing (and its reciprocal, the yield, or interest rate) of Fannie and Freddie ("agency") bonds is based on Treasurys.
Sunday, September 9, 2007
The Five Stages of Real Estate Grief
I posted a version of this on the L.A. Land blog the other day. Ha!
Crisis Basics - It's the Real Estate, Stupid
The economic history of the last 35 years has been one of a series of financial frauds, each bigger than the last, amid a backdrop of stagnating industrial production and, along with it, a declining standard of living. Those failures unleashed an ethic of every man for himself. In a country that actually makes fewer and fewer things, the results have been predictable: paper entrepreneurship on an escalating scale.
The 1970s gave us Penn Central, Continental Illinois, and stupid farm lending. The 1980s gave us the Latin debt crisis and the S&L debacle. The 1990s gave us the dot.com frauds. The '00s almost gave us the theft of Social Security, but that was stopped at the last minute by what was left of the Democratic Party. Instead, we got Door #2, the residential real estate bubble.
Of course, there is also the Iraq War and the failure to deal with climate change, but those will have to wait for another time. The wolf at today's door is in residential real estate, where we've seen a speculative bubble in prices, fueled by reckless credit. While any discussions of "the residential real estate market" need to be tempered by recognizing the local nature of housing, the granting of credit is a national, even international phenomenon and therefore we can deal with this as a systemic fraud.
Something else: the crisis really isn't one of house prices but rather one of bad loans. It's the lending crisis that threatens to bring down the whole American economy. Prices are certainly an issue, but it's the inability of borrowers to service their loans that makes this the problem it is. Lenders abandoned their standards, allowing borrowers to abandon their prudence. It couldn't go on forever, so here we are.
Wasn't it the borrowers' fault, you might ask? To which I would reply, yes, of course it was. No one forced anyone else to borrow two or three times what they should have for a mortgage, relative to renting. But ultimately, the responsibility lies with he who is holding the wallet: the lender. So, if there is to be a bailout of any kind, we must be sure to reclaim the spoils from the lenders. All of them. Right up to, and including, the half-billion dollars worth of bonuses and stock options received by Angelo R. Mozilo, the reckless pig who runs Countrywide Financial, America's largest mortgage originator. Not to put too fine a point on it.
I digress. Housing prices peaked about a year ago, on average. Because markets are local, prices peaked before that in some places. Elsewhere (Seattle being an example) they're supposedly still rising. There isn't a Dow Jones House Index, so that's as close as we can get. But when the history of this meltdown is written, I think the top of the American housing market will be pinned in 2006.
Since then, we've seen growing signs of distress in credit markets. In the words of Creedence Clearwater Revival:
I see the bad loans a-risin'
I see trouble on the way
I see earthquakes and lightnin'
I see bad times today.
Chorus:
Don't shop around tonight,
Well, its bound to take your equity
There's a bad loan on the rise.
I hear hurricanes a-blowin'
I know the end is coming soon.
I fear rivers over flowin'
I hear the voice of the foreclosure auctioneer
Chorus
Hope you got your things together.
Hope you are quite prepared to move to a trailer park
Looks like were in for nasty weather
One CMO is taken for a thousand bad loans
Chorus
Okay, it doesn't rhyme. But you get the point. One month ago, it all came to a head. In August, credit markets locked up and the stock markets fluctuated while the sharpshooters in New York, Frankfurt, London, Tokyo and Hong Kong looked to see what the big central banks would do. On cue, Germany's Bundesbank, America's Federal Reserve, and some others stepped in to spread some quicklime on the rotting corpse, in the form of creating some money and reducing interest rates. Will it work? Call me a skeptic. To find out why, keep reading.
The 1970s gave us Penn Central, Continental Illinois, and stupid farm lending. The 1980s gave us the Latin debt crisis and the S&L debacle. The 1990s gave us the dot.com frauds. The '00s almost gave us the theft of Social Security, but that was stopped at the last minute by what was left of the Democratic Party. Instead, we got Door #2, the residential real estate bubble.
Of course, there is also the Iraq War and the failure to deal with climate change, but those will have to wait for another time. The wolf at today's door is in residential real estate, where we've seen a speculative bubble in prices, fueled by reckless credit. While any discussions of "the residential real estate market" need to be tempered by recognizing the local nature of housing, the granting of credit is a national, even international phenomenon and therefore we can deal with this as a systemic fraud.
Something else: the crisis really isn't one of house prices but rather one of bad loans. It's the lending crisis that threatens to bring down the whole American economy. Prices are certainly an issue, but it's the inability of borrowers to service their loans that makes this the problem it is. Lenders abandoned their standards, allowing borrowers to abandon their prudence. It couldn't go on forever, so here we are.
Wasn't it the borrowers' fault, you might ask? To which I would reply, yes, of course it was. No one forced anyone else to borrow two or three times what they should have for a mortgage, relative to renting. But ultimately, the responsibility lies with he who is holding the wallet: the lender. So, if there is to be a bailout of any kind, we must be sure to reclaim the spoils from the lenders. All of them. Right up to, and including, the half-billion dollars worth of bonuses and stock options received by Angelo R. Mozilo, the reckless pig who runs Countrywide Financial, America's largest mortgage originator. Not to put too fine a point on it.
I digress. Housing prices peaked about a year ago, on average. Because markets are local, prices peaked before that in some places. Elsewhere (Seattle being an example) they're supposedly still rising. There isn't a Dow Jones House Index, so that's as close as we can get. But when the history of this meltdown is written, I think the top of the American housing market will be pinned in 2006.
Since then, we've seen growing signs of distress in credit markets. In the words of Creedence Clearwater Revival:
I see the bad loans a-risin'
I see trouble on the way
I see earthquakes and lightnin'
I see bad times today.
Chorus:
Don't shop around tonight,
Well, its bound to take your equity
There's a bad loan on the rise.
I hear hurricanes a-blowin'
I know the end is coming soon.
I fear rivers over flowin'
I hear the voice of the foreclosure auctioneer
Chorus
Hope you got your things together.
Hope you are quite prepared to move to a trailer park
Looks like were in for nasty weather
One CMO is taken for a thousand bad loans
Chorus
Okay, it doesn't rhyme. But you get the point. One month ago, it all came to a head. In August, credit markets locked up and the stock markets fluctuated while the sharpshooters in New York, Frankfurt, London, Tokyo and Hong Kong looked to see what the big central banks would do. On cue, Germany's Bundesbank, America's Federal Reserve, and some others stepped in to spread some quicklime on the rotting corpse, in the form of creating some money and reducing interest rates. Will it work? Call me a skeptic. To find out why, keep reading.
Crisis Basics - The Fed & Interest Rates
Ask someone about mortgage rates, and chances are they'll tell you that they are set by the Federal Reserve. They'll be wrong. The Fed directly controls two very short-term interest rates. When it comes to mortgage rates, the Fed merely influences them. And only if it plays ball, which begs the question of who's influencing whom.
The Fed determines the "federal funds rate," the interest that banks charge each other for overnight loans. Overnight loans, you say? Who knew? Here's how it goes: Bank A makes a big loan on Tuesday, and as a result its cash on hand falls below legal requirements. Meanwhile, Bank B hasn't make any loans lately and has a big slug of cash sitting there, flaccid as a ... oh, forget it. Anyway, Bank A goes to Bank B and negotiates a short-term loan. Bank B is happy to lend, because it makes money on the deal. No one defaults on these loans. Ever.
These transactions are common, and the average of the negotiated interest rates is the fed funds rate. The Federal Reserve doesn't actually set the fed fund rate, but it controls it through its "open market desk." If the Fed wants the fed funds rate to decline, it will approach a bank and buy government bonds that the bank holds. The Fed pays for the the bonds by creating money in the bank's account which the bank can then lend. If the Fed wants to raise the fed funds rate, it sells bonds to the bank and the bank's lending reserve is reduced.*
The effect of these actions is to add or subtract money from the economy. Generally speaking, the idea is to create enough new money to keep the economy growing at its long-term potential rate, which most economists will tell you is 3% after inflation. If the Fed expands the money supply by more than 3% a year it's inflationary, and prices will tend to rise. If it adds less than 3% a year it's deflationary, and prices will tend to fall.
The Fed also sets the "discount rate." That one is usually window dressing. It's what a bank pays the Fed for a direct loan. Generally speaking, the Fed only makes direct loans if a bank is in trouble. You don't see a lot of troubled banks in the U.S., and you certainly don't hear about them. But the discount rate is widely understood as a symbol of what the Fed's doing with rates, so it gets a lot of attention.
In real life it's a lot more complicated than that, but I've just given you the basic idea. Now, here's what people tend to overlook.
1. When the Federal Reserve creates money, it's actually creating credit. The bank balance created out of thin air is done so that money can be loaned out. The Fed cannot create the ability to repay loans. If banks can't find enough creditworthy customers, it doesn't matter how much money the Fed created. And if people don't repay their loans, all the new credit in the world won't help.
2. Long-term interest rates are set in the market. Banks don't hold too many mortgages these days. Instead, home loans are turned into bonds, and the trading of those bonds are what sets mortgage rates. Mortgage bond rates exist in relation to U.S. government bonds, which are typically inflation plus a couple of percentage points. The bottom line: Buyers of bonds look closely at Fed policy and judge whether it's inflationary. If the Fed creates too much money, it will put upward pressure on all interest rates. Thus, the Fed doesn't determine mortgage rates, but rather it influences them by how much money it creates. Oh, and in any contest between the Fed and the bond market over long-term interest rates, the bond market wins.
Why care about all of this? Because, once you realize the limits of the Federal Reserve's power, then you can start understand what it can and cannot do in the current economic crisis. If you think the Fed can wave a wand and cut mortgage rates, all I can say is: think again.
--------------
* Besides buying Treasury securities, the Fed often creates money by using "repos," or repurchasing agreements. When the Fed creates a repo, it buys securities with an agreement to return them in a day or two.
What repos prevent banks from having to call in existing loans, forcing a shrinkage of business activity, or worse. In short, repos help prevent credit panics. But, as this excellent article explains, they're not immediately inflationary because money created by a repo is repaid quickly.
However, if the Fed keeps extending or replacing repos, they eventually do become inflationary. I think long-term rates rose after the Fed's "rate cut" in September 2007 because bond traders judges the Fed's behavior to be the first of many similar moves. What's temporary today -- a repo -- will eventually turn permanent. That's what the financial markets told us.
The Fed determines the "federal funds rate," the interest that banks charge each other for overnight loans. Overnight loans, you say? Who knew? Here's how it goes: Bank A makes a big loan on Tuesday, and as a result its cash on hand falls below legal requirements. Meanwhile, Bank B hasn't make any loans lately and has a big slug of cash sitting there, flaccid as a ... oh, forget it. Anyway, Bank A goes to Bank B and negotiates a short-term loan. Bank B is happy to lend, because it makes money on the deal. No one defaults on these loans. Ever.
These transactions are common, and the average of the negotiated interest rates is the fed funds rate. The Federal Reserve doesn't actually set the fed fund rate, but it controls it through its "open market desk." If the Fed wants the fed funds rate to decline, it will approach a bank and buy government bonds that the bank holds. The Fed pays for the the bonds by creating money in the bank's account which the bank can then lend. If the Fed wants to raise the fed funds rate, it sells bonds to the bank and the bank's lending reserve is reduced.*
The effect of these actions is to add or subtract money from the economy. Generally speaking, the idea is to create enough new money to keep the economy growing at its long-term potential rate, which most economists will tell you is 3% after inflation. If the Fed expands the money supply by more than 3% a year it's inflationary, and prices will tend to rise. If it adds less than 3% a year it's deflationary, and prices will tend to fall.
The Fed also sets the "discount rate." That one is usually window dressing. It's what a bank pays the Fed for a direct loan. Generally speaking, the Fed only makes direct loans if a bank is in trouble. You don't see a lot of troubled banks in the U.S., and you certainly don't hear about them. But the discount rate is widely understood as a symbol of what the Fed's doing with rates, so it gets a lot of attention.
In real life it's a lot more complicated than that, but I've just given you the basic idea. Now, here's what people tend to overlook.
1. When the Federal Reserve creates money, it's actually creating credit. The bank balance created out of thin air is done so that money can be loaned out. The Fed cannot create the ability to repay loans. If banks can't find enough creditworthy customers, it doesn't matter how much money the Fed created. And if people don't repay their loans, all the new credit in the world won't help.
2. Long-term interest rates are set in the market. Banks don't hold too many mortgages these days. Instead, home loans are turned into bonds, and the trading of those bonds are what sets mortgage rates. Mortgage bond rates exist in relation to U.S. government bonds, which are typically inflation plus a couple of percentage points. The bottom line: Buyers of bonds look closely at Fed policy and judge whether it's inflationary. If the Fed creates too much money, it will put upward pressure on all interest rates. Thus, the Fed doesn't determine mortgage rates, but rather it influences them by how much money it creates. Oh, and in any contest between the Fed and the bond market over long-term interest rates, the bond market wins.
Why care about all of this? Because, once you realize the limits of the Federal Reserve's power, then you can start understand what it can and cannot do in the current economic crisis. If you think the Fed can wave a wand and cut mortgage rates, all I can say is: think again.
--------------
* Besides buying Treasury securities, the Fed often creates money by using "repos," or repurchasing agreements. When the Fed creates a repo, it buys securities with an agreement to return them in a day or two.
What repos prevent banks from having to call in existing loans, forcing a shrinkage of business activity, or worse. In short, repos help prevent credit panics. But, as this excellent article explains, they're not immediately inflationary because money created by a repo is repaid quickly.
However, if the Fed keeps extending or replacing repos, they eventually do become inflationary. I think long-term rates rose after the Fed's "rate cut" in September 2007 because bond traders judges the Fed's behavior to be the first of many similar moves. What's temporary today -- a repo -- will eventually turn permanent. That's what the financial markets told us.
Crisis Basics - What Else Can the Fed Do?
In the preceding post, I implied that the Federal Reserve can't do a whole lot about the current economic crisis that's unfolding. It can create money to lend, but not the means to service the loans. It can influence mortgage rates, but it cannot set them. Not only that, but if it shows too much mercy and makes too much money, bond traders could decide that inflation's on the way and send interest rates soaring.
But there are wrinkles. Remember when I described how the Federal Reserve creates money by buying and selling government bonds to and from banks? Nowhere is it written that the Fed can only buy government bonds. If it wants to, it can buy mortgage bonds. Or corporate bonds. Or government bonds. Or options. Or futures.
The Federal Reserve, a/k/a Corporate Bailouts 'R' Us
In fact, the Fed has done all of those things at times. On October 20, 1987, the day after the Dow Jones lost 22% in value, Federal Reserve brought stock index futures in Chicago for the purpose of manipulating the stock market upward. This action wasn't revealed for several months; since then, a so-called "Plunge Protection Team" has operated to keep the U.S. stock market steady during periods of turmoil.
The PPT is controversial -- among other things, it begs the question of just how "free" U.S. markets really are -- but there's plenty of evidence that it exists. A long time ago, someone who I trusted told me that the Fed found a way to bail out some major insurance companies from their bad commercial real estate loans of the 1980s. God only knows how they did it, but I believed the story then and I still believe it.
And there are suggestions that in August 2007, the Fed started buying mortgage-backed bonds to keep the American mortgage market from locking up. I doubt we'll ever know for sure. As for whether it worked, the jury's out: mortgage originations collapsed by 50% in August, and September is anyone's guess.
The Fed: Meet your new landlord?
Want to get freaky? Well, one thing the Fed could do, at least in theory, is become a mortgage lender in its own right, most likely by refinancing existing mortgages at lower rates. A more plausible "radical idea" would be for Congress and/or the federal regulators to raise the limits on the mortgages that can be held by Freddie Mac and Fannie Mae, and encourage them to buy busted mortgages. (If that works like, say, Medicare Part D, the prescription drug benefit, they'd even forbid Freddie and Fannie from buying bad loans at a discount!) Then, as those loans go bad, the Fed would bail out Freddie and Fannie.
Voila! Problem solved! Not for the borrowers, mind you. They'd still be kicked out of their houses. But the lenders would be made whole. And isn't that the point of any bailout, to rescue the banks? This IS America. He's who's got the gold makes the rules, even if there's no gold.
For now, I think the Fed will stick to its more traditional tools: creating credit by buying government bonds and/or repos through the its New York open markets desk, and from time to time intervening to calm "disorderly markets." If there's a bailout, I think they'll try to use the traditional tools. If it goes out of control, I think they'll first try to consolidate the bad loans into Freddie and Fannie, and then bail them out.
Door #1: Frying Pan. Door #2: Fire.
It's not as if the traditional Fed tools are without controversy. Indeed, most people, myself included, think the Fed is in something of a tight spot as it tries to calm stormy markets and head off a mortgage meltdown:
1. Is the Fed spitting in the ocean? The U.S. mortgage bond market is far bigger and more complicated than the U.S. stock market. Not only that, but it's closely connected to other financial markets: for corporate and government bonds, for options and futures based on the bond trading, for stocks of companies affected by interest rates and the servicing of loans. Putting aside the question of whether it's the Fed's business to bail out irresponsible lenders and borrowers by buying up mortgage bonds, there's a real issue of whether a Federal Reserve bailout would be a Pyrrhic victory.
2. What about inflation? This would be the likely cost of a Fed bailout of the residential real estate debacle. Let's make one thing clear: If a "successful" bailout meant wiping out debt or rendering it meaningless, the Fed can do it by buying it all back with dollars it creates out of thin air. The result, however, would be hyper-inflation. Those old mortgage bonds would be "paid off," but you wouldn't want to see the interest rate that a buyer of a newly-issued mortgage bond would demand in return for buying it. Does anyone remember the inflation of the 1970s? I do. It sucked. It was even a little scary.
That, in a nutshell, is the financial paradox that confronts the Federal Reserve: stand fast against a bailout and see a financial collapse, or give in to the siren song and watch inflation take off like a rocket. In a future essay, I'll translate this into the real economy where everyone works and plays. I bet you're on the edge of your seat. Hint: Put on your disco shoes. Stagflation's coming back!
But there are wrinkles. Remember when I described how the Federal Reserve creates money by buying and selling government bonds to and from banks? Nowhere is it written that the Fed can only buy government bonds. If it wants to, it can buy mortgage bonds. Or corporate bonds. Or government bonds. Or options. Or futures.
The Federal Reserve, a/k/a Corporate Bailouts 'R' Us
In fact, the Fed has done all of those things at times. On October 20, 1987, the day after the Dow Jones lost 22% in value, Federal Reserve brought stock index futures in Chicago for the purpose of manipulating the stock market upward. This action wasn't revealed for several months; since then, a so-called "Plunge Protection Team" has operated to keep the U.S. stock market steady during periods of turmoil.
The PPT is controversial -- among other things, it begs the question of just how "free" U.S. markets really are -- but there's plenty of evidence that it exists. A long time ago, someone who I trusted told me that the Fed found a way to bail out some major insurance companies from their bad commercial real estate loans of the 1980s. God only knows how they did it, but I believed the story then and I still believe it.
And there are suggestions that in August 2007, the Fed started buying mortgage-backed bonds to keep the American mortgage market from locking up. I doubt we'll ever know for sure. As for whether it worked, the jury's out: mortgage originations collapsed by 50% in August, and September is anyone's guess.
The Fed: Meet your new landlord?
Want to get freaky? Well, one thing the Fed could do, at least in theory, is become a mortgage lender in its own right, most likely by refinancing existing mortgages at lower rates. A more plausible "radical idea" would be for Congress and/or the federal regulators to raise the limits on the mortgages that can be held by Freddie Mac and Fannie Mae, and encourage them to buy busted mortgages. (If that works like, say, Medicare Part D, the prescription drug benefit, they'd even forbid Freddie and Fannie from buying bad loans at a discount!) Then, as those loans go bad, the Fed would bail out Freddie and Fannie.
Voila! Problem solved! Not for the borrowers, mind you. They'd still be kicked out of their houses. But the lenders would be made whole. And isn't that the point of any bailout, to rescue the banks? This IS America. He's who's got the gold makes the rules, even if there's no gold.
For now, I think the Fed will stick to its more traditional tools: creating credit by buying government bonds and/or repos through the its New York open markets desk, and from time to time intervening to calm "disorderly markets." If there's a bailout, I think they'll try to use the traditional tools. If it goes out of control, I think they'll first try to consolidate the bad loans into Freddie and Fannie, and then bail them out.
Door #1: Frying Pan. Door #2: Fire.
It's not as if the traditional Fed tools are without controversy. Indeed, most people, myself included, think the Fed is in something of a tight spot as it tries to calm stormy markets and head off a mortgage meltdown:
1. Is the Fed spitting in the ocean? The U.S. mortgage bond market is far bigger and more complicated than the U.S. stock market. Not only that, but it's closely connected to other financial markets: for corporate and government bonds, for options and futures based on the bond trading, for stocks of companies affected by interest rates and the servicing of loans. Putting aside the question of whether it's the Fed's business to bail out irresponsible lenders and borrowers by buying up mortgage bonds, there's a real issue of whether a Federal Reserve bailout would be a Pyrrhic victory.
2. What about inflation? This would be the likely cost of a Fed bailout of the residential real estate debacle. Let's make one thing clear: If a "successful" bailout meant wiping out debt or rendering it meaningless, the Fed can do it by buying it all back with dollars it creates out of thin air. The result, however, would be hyper-inflation. Those old mortgage bonds would be "paid off," but you wouldn't want to see the interest rate that a buyer of a newly-issued mortgage bond would demand in return for buying it. Does anyone remember the inflation of the 1970s? I do. It sucked. It was even a little scary.
That, in a nutshell, is the financial paradox that confronts the Federal Reserve: stand fast against a bailout and see a financial collapse, or give in to the siren song and watch inflation take off like a rocket. In a future essay, I'll translate this into the real economy where everyone works and plays. I bet you're on the edge of your seat. Hint: Put on your disco shoes. Stagflation's coming back!
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DENIAL: "Don't listen to those doom and gloomers. They're nothing but a bunch of jealous renters. Probably Democrats."
ANGER: "You traitors in the liberal media are driving down prices and killing the American Dream! And dammit, stop laughing at me!"
SADNESS: "I'll be ruined, I'll tell you! Ruined! Everything I've worked for will be gone! Just kill me now!"
BARGAINING: "Okay, maybe things got a little out of hand. If I take a 15% haircut, will you give me a bailout?"
ACCEPTANCE: "Honey, who knew that we'd be so happy in a trailer?"