Thinking About This Mess

So another day on Wall Street, another 300 plus point drop. This keeps up much longer and I'm going to start thinking that is the norm.

However, a little more seriously, I'm looking at what the Bush Administration intends to do. Essentially, it wants to pump a lot of, what will ultimately be, taxpayer money into saving people who are getting hit by the market downturn. Specifically, they (meaning the Administration and the Democrat-controlled Congress) want to spend about $700 billion (more on the credit card I suppose, since as I recall, Bush and the Congress have collaborated to create a huge budget deficit already) in order to buy up bad mortgages from failing institutions.

My question is why?

Yes, I understand that if they go under, it will be economically bad. But the plan that seems to be floating out there is going to do very little to either A) undo the mess, B) prevent it from happening again or C) punish those who got us into this mess in the first place.

Now, the financial situation, from my lay point of view, was sort of inevitable. There is always going to be a downturn, especially when it comes to housing. It just is un-realistic to think that prices would never fall, that defaults would never happen, or that the value would continue to go upwards. The sub-prime loans were a bad idea, that too many people bought into, and that too many presidential administrations did nothing to ensure that they would remain monitored.

Consider this, subprime lending only became available when the laws in this country were relaxed in regards to usury. What is usury you may be wondering? In TV shows, its what a loanshark deals in regular basis. Originally, usury meant the charging of interest on loans. For centuries, the practice was banned in the Catholic Church (and as an interesting histotical side note, one of the reasons why the great banking houses were Jewish originally, i.e. the Rothschild family). However, in the U.S., the concept of usury evolved into situation where the interest on the loan exceeded the permissible rate. In California, its anything over 10%.

In 1980, at the tail end of the Carter Administration, Congress passed a law called the Depository Institutions Deregulatory and Monetary Control Act in 1980. One of the things which this law did was it eliminated interest rate caps for a number of types of credit loans, including mortgages. In the 1990s, Wall Street started to securitize (or making them tradeable on the market) mortgages. Since they could use them as securities, it was a way to make more money. The more mortgages, the more securities available to sell or trade. So the mortgage companies started to look for more people to loan money.

However, they ran into a problem. With interest rates as they were in the 1990s, there was already stiff competition for people with good credit. However, despite the 1980 Act, there was still a relatively large and untapped pool of people to market subprime mortgages.

Now, it should be noted, that subprime mortgages were meant to be used by people who could not get a traditional mortgage. These are people who have bad credit histories, credit scores of below 620, and people with bad debt ratios (i.e. more than 45% of their income goes to servicing debt).

The Department of Housing and Urban Development estimated that in 1994, there were approximately 70 lenders who did subprime mortgages. By 1997, that number had more than tripled to 270. In 1993, subprime mortgages represented approximately $20 billion dollars in loans made. By 2000, the number had reached $140 billion and was continuing to rise.

With the increase in subprime lenders, there was also an increase in subprime mortgages being written. And the more that these companies got into the business, it seems, the more addictive it became for them. While this was happening, two administrations (Bush and Clinton) failed to recognize the potential problems that this could cause.

In addition to an overall expansion of subprime lending, there began to be a shift in how subprime loans were made. According to one report, the shift became most noticeable in 2006. Prior to that, subprime lenders were competing by making rates more attractive (i.e. not requiring such high interest rates to people who had blemished credit histories). However, begining with the mortgages in 2006, it appears that there was shift in the guidelines and a lowering of standards even further to allow more people to qualify for the loans.

Why did they do this? The answer is simple: profits. Prior to 2006, and specifically in 2004, interest rates on mortgages hit their lowest levels in decades. For people with good credit, that was a great. They could get mortgages at very low rates of interest. For people with bad credit, it was even better. They could get mortgages that were not usurious (or at least not as bad had been previously). The people who is was bad for was the corporations making the loans. For every dollar they loaned, they were making less than on previous years. Therefore, they needed to do somethign which would increase their profit margins. Their solution: raise the interest rates on their loans, but decrease or make exceptions to the requirements for people taking out the loans.

Let's see. A desire for ever increasing profits. Mixed that with predatory lending practices targeting people who have demonstrated they can not be trusted with credit in the first place. Sounds like a great plan to me.

What did this lead to? Increase home values (because so many people had access to money they were able to bid up the prices of real estate), increased profits over the short-term (looked great on their balance sheets) and lots of people owning property that they did not really have the money to support.

So now the Bush Administration, as well as both major candidates, want to bail everyone out. About the best that can be said for Senators McCain and Obama is that they both agree that none of the bailout money should be used to pay for CEO/executive compensations for getting us all into this mess. The initial plan proposed by the Bush Administration was best summed up here.

Now, where will we get the money to do this bailout? Well, it will have to be borrowed, since the government does not have nearly three quarters of a trillion dollars lying around (which by the way means that every taxpayer is on the hook for approximately $2,300). What will it do? Well that is a good question

Part of the argument which is going on now in Congress is exactly what should happen with the bailout. (If only half as much thought had been put in the PATRIOT ACT... but I digress).

Reading some of the interviews that are going on, its interesting to get some of the mindset of the Bush Administration people who are doing the talking. For instance, when asked about limiting executive compensation, Secretary of the Treasury Hank Paulson declined to consider that as part of the package. As he stated, if such language were included in the bailout package, "institutions aren't going to participate ...this won't work the way we need it to work,...." apparently because it will be viewed as punitive. It almost seems to me as if he is saying that the drowning man won't accept a lifeline because it means he will have to let go of the thing that is dragging him down.

Besides, if the entity accepting help under the bailout needs help, isn't that an indicator that something is wrong in the first place? When did we start rewarding failure as if it were success? Apparently, the Bush Administration wants to pretend as if nothing the financial houses did was wrong, because to admit to that might leave the door open to.... a modernized, comprehensive regulatory system that makes sense! Horror! Regulations are bad... and must be abolished to allow market freedom which will benefit everyone in the end. ... Except of course when the Republicans want to tinker with the market to protect their friends.

Which takes me to my next point. The people who owe the money on the mortages. They are just as complicit in this financial mess as the executives on Wall Street. Not partly. Equally. They sat across a table from someone and had a chance to review the terms. As long as they were all included, and all the necessary discolsures were made, they had a choice. Subprimes were always a gamble. They had to hope that the value of their property would increase enough to help them refinance or that they would continue to be making enough money to meet their loan payments. Many people, including myself, looked at subprime mortgages when they had an opportunity to buy property. Many people, including myself, walked away from subprime mortgages because they were simply too economically risky.

Why then should we reward these people by keeping them housed? All it will do is continue to artificially inflate the value of real property. This in turn will make it harder for people to put together sufficient capital necessary to get a prime mortgage, at a good rate.

In fact, part of the proposal put together by Congressional democrats includes a provision which will allow bankruptcy courts to refashion mortgage terms in order to avoid foreclosure. Apparently, to the Democrats, contracts are really meaningless until an outsider has a chance to reform the terms which the parties previously agreed to in good faith? Apparently, according to the Democrats, we should reward people for not taking into account what the terms of the contract means before signing. We should encourage people to not consult an independent financial or legal advisor, and instead just tell them to go ahead, fail, the government will come and bail you out just like the Republicans do for the executives on Wall Street.

From my point of view, the mortgage industry enhanced this mess by not realizing that they were going to get the profits which they hoped for and instead sat down to reformulate the terms with the customers. Instead, they just kept letting properties go into foreclosure, leaving them with worthless mortgage securities to trade. At the same time, too many of the people who took out these mortgages did not pay attention to wath they were doing. They did not do what was necessary to keep up with the mortgage payments. They were not proactive enough to get things done.

The Chairman of the Federal Reserve says that there will be a recession if we do not bail out the mortgage industry. I am not in favor of a recession, but if all we are going to do is spend money to save the people who put us in this mess, without providing for real reform and real consequences to both Wall Street and the subprime defaulters, then it might not be a bad thing. Otherwise, we are just artificially inflating the markets... and inflation which will come back to hurt us even more later.

Unpopular Thoughts

I have been watching the news, as I usually do. I have been seeing how the housing bubble has hurt people when they come to my office and I try to help them.

And when I can, I do.

But then I see what Congress and other legislatures are trying to do with the foreclosure the problem. Now, on an emotional level, I can sympathize with this. However, on the other hand, I look around and see no reason why we should be bailing anyone out.

The system that we have right now is broken. If it wasn't, then the economy would not be in the state that it is in. However, propping up the institutions that helped to cause this problem seems to be me to be counter-productive.

Not only does it seem to be counter-productive, but it denies people who have been waiting, needing a down-turn in the housing market, the chance to enter. The idea that the government will now start bailing out individual homeowners who failed to protect themselves by obtaining mortgages which were essentially gambles is an economic reward to them. It also will also keep the prices which, were inflated because of the lax rules for lending, unnecessarily high which makes it harder for young adults and new families to buy their own property.

Consider in the Bay Area that the median home price is $485,000 (incidentally the first time it has dropped below a half million in four years), in San Francisco itself it is $846,000. The average of the median incomes for counties closest to San Francisco is $88,718.88 (San Francisco: $79,423.00, San Mateo: $92,721.00, Santa Clara: $93,072.00, Contra Costa: $85,737.00, Alameda: $78,494.00, Marin: $102,866.00). So that breaks down to monthly income of $7393.24.

Now, if we take the medians (yes I know my average of medians is not perfect but if someone wants to send me better data, I will be happy to review my conclusions) of price and income, we see that a mortgage can run a family for the median price ($485,000) will require a monthly mortgage payment of $ 2,830.33. This assumes that they get the mortgage with no points, at a rate of 5.75% (which looking at FHA and VA loans might just be a pipe dream since the average rates that I am finding are 6.58% making the monthly payment $3,091.09.).

At either level, $2,830.33 or $3091.09, this does not seem to be too outrageous. But then consider what the family is bringing home each pay period. Each pay period, after the government takes its share, the people will have $2,685.37. Ooops, that is 52% of the median income if they can get the mortgage at the 5.75%. Whats that ? What about their savings that they use for a down payment? Unlikely considering that the average savings rate is -1% (that would be a negative number).

Want to buy a house in San Francisco or Alameda? In San Francisco, assuming the 5.75% 30 year rate, then it comes out to $4,937.03 (with a take home of $2,444.58 each pay period). Alameda homeowners could expect $4,214.12 (with a take home of $2,420.50 each pay period).

Even if people were to start saving up for down payments how much would they need to have in order to make enough of a dent in the mortgage? The rule of thumb for paying for housing is that a person should never spend more than 1/3rd of their income on their rent or mortgage. Now taking the medians for the Bay Area, that would mean spending no more than $1,772.35 per month on the mortgage. In order to do that, for a down payment, the family making the median would have to have a down payment of approximately $185,000.00.

Without resorting to crime, or having a trust fund etc to fall back on, this mythic median family would have $3,598.39 once it paid a rent that would put it living in some very dodgy area. Then after paying for luxuries like rent, car payments, gas, insurance, and food, as well as some saving for the future, they would have to put at least $1,000.00 a month a way. And that would mean all they would have to do is do that every month for 12 years. If they could put away $2,000 per month, they might get there in just over 6 years. (This is based on finding a bank willing to give a savings account with 3% interest).

So what is the point of this? Basically to point out that if we start saving people from the ravages of the market, it is going to end up prolonging other people's entry into the market. It will stabilize the prices at an inflated level. It will put more people in a situation where they cannot escape the rental market, thus increasing the power of landlords since will have essentially a captive market.

Of course, it is an election year. And the legislators want to look like they care. If they cared, what they would do is enact some reforms on the lending industry. They would actually regulate the markets in a way that made sense so that what happened in the last housing bubble is not repeated. But bailing out the companies that did this, bailing out the people who foolishly chose to gamble on their mortgages, is only going to end up hurting the next generation of homeowners.

Oil Profits In Perspective

So I was reading an article tonight while watching my beloved Giants struggle to support Matt Cain against the Dodgers. The article dealt with the testimony of some oil company executives before a congressional committee. The committee is looking into whether or not the oil companies are gouging the consumers.

Now, the oil executives made some good points. They do exist in a boom and bust business which means to an extent, they have to take the big profits when they can so that they can pay for future technologies. However, that arguments gets undercut when you look at what they have been doing with their profits (buying back stock to inflate their prices even further).

But apparently, here are some numbers for industry-wide profits and losses:

Pharmaceuticals - $ 48.2 billion

Military defense contractors - $15.2 billion

Oil - $123.3 billion

Ok, the dollar is weak, meaning we have to pay more for each barrel. And then there is the increased demand for oil from China and other emerging markets and that it going to skew the whole supply and demand thing. But, to make nearly ten times more than the military contractors, with a war going on no less, and maybe there is something a little shady going on here.

Of course, this is all for show. Congress and the Justice Department are never going to be able to do anything absent a smoking gun memo where the oil industry got together (a la the asbestos industry at Saranac Lake Conference) and fixed the prices. We live in a capitalistic society with all the good bad points of it.