Thursday, January 5, 2012

Good Old Days?

Sure we are going through an economic crisis of monumental proportions; however, I'm tired about hearing how bad things are today, and how wonderful they were for the "Greatest Generation" who returned from World War II and lived in the America we all long for again.

Really? Consider the following and compare them to today:

1. Air & water quality- vastly improved environment-- remember choking smog and really polluted lakes and rivers. We now have a much greater emphasis on conservation and ecology than in the past. The whole US could have looked like Gary once did, if we hadn't paid attention to this problem.

2. Civil rights- tremendous advancements by any measure; politically, economically and socially. While discrimination hasn't been eliminated, and embedded poverty remains, a large Black and Hispanic middle class has arisen.

3. Women's rights- Advances made my women both economically and politically have been dramatic, including reproductive rights and employment and educational opportunities.

4. Gay rights-were they even mention at that time?

5. Social safety net in general much better- not only Social Security, but Medicare and Medicaid. Poverty remains but there are more services available for the poor, both from the government and the private sector.

6. Better access to elite colleges-- There no longer are same barriers based race, religion, gender,ethnicity, social class. Yes, costs are a barrier and the "greased skids" still exist, but there is more financial aid for the really disadvantaged and even well connected kids have to be really qualified to get into the top schools.

7. Auto safety- amazing improvements- safer cars, airbags, fuel efficiency etc.

8.Technology advances- just think about all the work savers and entertainment and recreational enhancements. Advances in electronics, mobile phones, PDAs, computers, the Internet and so on have significantly improved our quality of life.

9. Lower taxes- remember how high they were in the 50s and 60s?

10. Volunteer army- We don't worry about the draft now.

11. Cold War is over, along with threat of nuclear annihilation; albeit replaced by threat of terrorism.

12. Better quality housing-houses just seem to be better built than in the post war 50s,60s. Maybe not as well built as the pre-Depression era, but lots more amenities and space.

13. Crime has been dropping steadily for the last decade or more.

14. More open political process- No longer just for white protestant men. No more "smoke filled rooms", although I must confess I yearn for some of that some times. Money is a problem , but then it always was.

I'm sure I've left out other good examples so let me know.

My views are summed up in the words of the Carly Simon song, "These are the good old days".

It's the same thing in sports where they talk about how much better players were "back in the day" etc. Those players were no different then, and the old timers back then were complaining about them.

My thoughts are not all that original, just go see Woody Allen's movie "Midnight in Paris".

Maybe it's just age and memory as some have suggested, or just the way human nature is.

The point of this post is that if the positives were pointed out more often maybe people would feel a little better things than they do. Rather than dwelling on a steady diet of negativity and how bad things have gotten compared to how they used to be, let's not forget that in so many more respects things have actually gotten better; so enjoy them.


Wednesday, January 4, 2012

Root Causes of the Great Recession- A Tragedy, Part I

The financial crisis which led to the Great Recession was caused by the combination of misguided good intentions and "honest" greed. It had all of the elements of a classic Greek Tragedy. A Hero who is brought low by Hubris and Flaws, aided and abetted both by Villains and Allies.

The misguided good intentions was the imperative for everyone to own a home. The American Dream -(HERO). Home ownership is viewed as a worthy goal which gives people a sense of pride, stability and opportunity to build wealth for the future.

Why shouldn't all Americans have that opportunity? Since home prices only went up (HUBRIS), once a person started on the home ownership path their futures were assured; their kids went to better schools, they lived in more stable neighborhoods and they were a able to build equity for their future and perhaps for the their children. Essentially it was a way out of lower income status; that's why it was called the American Dream.

The problem was that buying a house is such a large expenditure that almost no one is able to do it with all cash.(FLAW) Therefore borrowing through conventional mortgage financing (ALLY) was usually the only way, and in all events the best way, to go. The Government (ALLY) long encouraged mortgage financing by among other things, allowing tax deductions for home loan interest payments, even after dropping tax deductions for all other non- business interest payments. Yes, older readers will remember a time when all interest was deductible; however that was eliminated for everything other than home loans when tax rates were reduced in the 70s.

Also, as I have told my law school finance class, buying a home using mortgage financing was the most common way ,and usually only way, for the average person to utilize the benefit (along with risks) from the customary business technique of leveraging. (FLAW)

A simple example of the benefits of leverage is as follows:

1. If you bought a house for $100,000 with all cash and sold it for $120,000, your return on investment was 20% - not bad, but not great.

2. However,if you bought the same house, but only put down $20,000 in cash (the prudent "old fashion " way), and got an $80,000 mortgage, when you sold it for $120,000, you just paid the bank back it's $80,000 loan ( which likely was less due to monthly amortization payments), and your return on your $20,0000 investment was 100%-- that's great. You then used that profit to trade up for a more expensive house. And so it goes - or I should say "went". (HUBRIS)

The "dark side" of leverage surfaced when home values dropped giving rise to the notion of "being under water" (the value of the home being worth less than what is owed under the mortgage).

The problem of course is many low income people didn't qualify for most of the mortgages they were seeking. (FLAW) That became a serious problem when a disproportionate number of low income mortgage seekers were minorities. The Banks (ALLIES/VILLAINS), rightly or wrongly, were accused of discrimination, either outright or through use of techniques called red-lining. The result was the Government (THIS TIME A VILLAIN) put pressure on the Banks to make loans which they normally would be reluctant to make from a pure credit perspective. The Banks continued to resist making what they viewed as risky loans, except for a relatively small number of Community Reinvestment Act loans

Enter the subprime lenders (VILLAINS),along with their friends and abettors the mortgage brokers.(VILLAINS) For the most part subprime lenders were not conventional commercial banks. As such they were not as highly regulated as Banks, and with the help of mortgage brokers, were willing to make riskier loan for a higher return. They quickly dropped the conventional underwriting criteria of a substantial down payment, good credit history and sustainable income to service the debt.(HUGH FLAW) Many, if not most, low income borrowers could meet few or none of these customary underwriting requirements.

Nevertheless the Government, urged on by community activists (APPARENT ALLIES, BUT REALLY VILLAINS) were willing to allow these subprime lenders to operate with impunity and little or no supervision. Essentially the Government looked the other way or as Barney Frank so famously said , "let's roll the dice". Because, once again, they believed home prices never go down. And no, I'm not pinning the blame on Fannie and Freddie; they were more of big enablers who came relatively late to the game; no matter what some Republicans say.

I'll never forgot a New York Times article I read where community leaders were criticizing a belated crack down on subprime lending. In the article a civil rights leader in supporting subprime lending said,  "you may think a 30% default rate is high ( it's actually astronomical and got even higher), but I see the 70% as my constituents who now own a home".

Subprime lenders funding sources were not so much from depositors or federal reserve borrowings like banks, but rather from Wall St. securitization houses (VILLAINS) who were in the business of taking high return risks. (HUBRIS) They knew there was risk in making these loans, but thought that home prices only go up, and that through the technique of tranching (AAA,AA,A,B etc.) the priority of debt repayment, each tranche sold in the securitization would be priced according to its risk. (HUBRIS/FLAW)

The theory was securitization would diversify the risk over many investors with different risk appetites, and therefore was safe, or at least priced for the risk taken. (ULTIMATE HUBRIS AND FLAW). Of course Wall St would make big fees and profits in the securitization process.

The irony is that securitization rather than spreading and diversifying the risk, and by that I mean reducing its impact after loan defaults, actually spread the contagion and amplified the fall out when loans started to go into default. Investors panicked and the downward spiral began, leading to the Great Recession, the impact from which is still being acutely felt.

Remember, however, that those same Wall St. houses and Banks actually bought those now toxic AAA and AA rated mortgage backed securities. They thought they were safe, but they became toxic when defaults on the underlying subprime mortgage began. As the chairman of Morgan Stanley so inelegantly put it, "we ate our own cooking and it choked us".

Recall as well that the Government strongly encouraged the Banks to buy those securities by given them bonus capital credits under the Basel I Accords. (VILLAIN) They were super safe because of the AAA ratings given by the rating agencies (VILLAINS) and the fact that home prices never go down. It's easy to say now "what were they thinking",but there were not many who sounded the alarm.

Were those who operated these securitization greedy? Of course they were. Were they dishonest in a criminal way; apparently not. Remember greed is not illegal, only dishonest greed is illegal. So far the government (and fortunately it's the Obama administration) hasn't found actual criminal behavior, yet. Our legal system places a very high threshold of proof when it comes to criminal prosecutions. Sadly many erstwhile liberals appear to have forgotten that (did they leave their ACLU cards behind?) in their zeal to attack Wall St and the Banks.

Fortunately we are still a country of laws, and not lynch mobs, witch burners, human sacrifices or McCarthyites. To date the Obama administration, try as I'm sure they might, have not found greedy behavior which rose to the level of dishonesty, and therefore criminality.

If anyone was really at fault it was the Government. Many others were greedy and irresponsible, but it was the Government's policy of pushing home ownership for everyone, including those who were not credit worthy, and its Regulators' failure to rein in subprime lending by requiring (as it was authorized to do) customary underwriting compliance, which were the root causes of the housing mortgage crisis.

The subprime mortgage crisis set off the panic which lead to the broader financial melt down, which ultimately resulted in the Great Recession. Would we have an economic downturn anyway without subprime lending? Probably, but it would have been more of a correction than a collapse in home prices. Take a look at Canada which prohibited subprime lending. They fared pretty well through this crisis.

Subprime lending was a relatively new industry which arose to satisfy an agenda of those who felt that credit was not widely available enough and took advantage of our misguided goal of the American dream of homes for all-- whose prices never go down- alas.