I have been meaning to write this for sometime. One of the most underreported aspects of the American economy is the loss of jobs and the decrease in middle class wealth and income. These are long term issues that preceded the bubble and still exist today.
Let's start with the loss of jobs. The reasons are obvious. Technology and globalization. It would be possible to write an entire book about how technology in the long term eliminates jobs. Some argue that technology increases productivity and therefore wealth and income and it has from time to time and in some parts of the economy. But the long term trend is inescapable. From small manufacturers, to farming, to large scale agriculture, and now to services.
The impact on globalization on US jobs is obvious to us all. Impacts started with manufacturing and have extended to low value services and now extends to professional services such as accounting and computer science.
Next combine the loss of jobs with loss of wealth and income for the middle class. The main drivers of this are also long term. First the competition for jobs due to job scarcity drives wages down. The reduction of the power of organized labor has hurt all US workers. Some claim that the unions were too powerful but that was clearly not the case. The unions never had that much power. But while they were viable they supported wages and benefit levels for non-union workers. Almost all gone now.
All of this would eventually lead to a reduction of consumer spending. This was avoided for awhile. First wives entered the work force in the 70s and 80s. In the 90's there actually was a peace dividend and the subsequent economic growth and asset appreciation (housing and stock market) supported consumer spending.
By 2000 all of these short term influences had been spent. Jobs were still being lost and wealth and income was beginning to become concentrated. But we had two bubbles in the 2000's that disguised the longer term trends. After the Internet bubble we had a jobless recovery. We would likely have fallen into a long recession but then we had even a bigger bubble. The bubble was not just housing. It was an overall asset bubble, a credit bubble and a leverage bubble. All of this excess spending saved or created jobs.
Now that's over and the longer term trends have re-emerged.
I would not be surprised if the unemployment rate stays over 8% for 5 to 10 years.
I would not be surprised if we had a Depression with offical unemployment at 15%.
There are government policies that can improve this situation but they will seem so radical to the American voter that they will not have a chance for success until it gets much worse.
Friday, September 16, 2011
Sunday, April 17, 2011
Macroeconomics - a political science
Before I continue on the remaining topics let's pause to talk about the field of macroeconomics. Macroeconomics is a political science. It is not a scientific body of knowledge where there are truths, facts, theorems, or problems with correct answers. It is a body of knowledge about values not truths and in this regard it is like other areas of philosophy such as morals and ethics. It is unlike related areas that are often lumped in with macroeconomics like microeconomics or finance which do contain certain facts, theorems and valid, proveable equations.
When you hear an pronouncement or opinion from an economist ask yourself whether the speaker acknowledges that their views or based on their values.
One tell-tale sign is their terminology. If the speaker talks about economic growth or GDP as the measure of a countries economic well-being then the speaker is likely a conservation economist. If the speaker talks about unemployment, poverty levels or middle class income as a measure of a nations well-being then the speaker is likely a liberal economist.
Since the two sides have basically different values they will measure the economy in different ways using different tools and different statistics. They can barely have a conversation since they don't see the world the same way at all.
When you hear an pronouncement or opinion from an economist ask yourself whether the speaker acknowledges that their views or based on their values.
One tell-tale sign is their terminology. If the speaker talks about economic growth or GDP as the measure of a countries economic well-being then the speaker is likely a conservation economist. If the speaker talks about unemployment, poverty levels or middle class income as a measure of a nations well-being then the speaker is likely a liberal economist.
Since the two sides have basically different values they will measure the economy in different ways using different tools and different statistics. They can barely have a conversation since they don't see the world the same way at all.
Wednesday, March 23, 2011
Bubble and Meltdown - the agency problem
The agency problem was best explained in Stiglitz's book Freefall. In general the agency problem occurs when a economic player is making decisions with other people's money. The agent may not make the same choices as the priniipal who actually provides the money.
In the mortgage mess it seems that everyone was an agent.
The "invisible hand" of Adam Smith assumes that prices are set by the market forces of supply and demand. There are free market fundamentalists that still believe that this "invisible hand" actually works to set prices so that supply and demand reach equilibrium. And this does work fairly well for consumer commodity products and services.
But it assumes that the buyers and sellers are rational actors, they are making rational decisions in their own best interest and that they both buyers and sellers have the same information. The agency problem is that if the buyers and sellers are agents and are not making decisions in the interest of the real buyer or real seller then the invisible hand simply isn't there. This is only one problem with the invisible hand. There are others which we may get to.
Contrast the players involved with the housing and credit bubble with the Bailey Savings and Loan system. In this system a local bank lent money to a developer - as a construction loan. Some of the money came from their depositors but some of the money was the bank's own money. The ratio between the depositors money at risk and the bank's own capital is leverage and the leverage was probably around 10 to 1. The banker would make the construction loan based onthe developer's past performance, their credit worthiness and the bank's assessment that the housing that was built could be sold. The developer had to put some of their money at risk as well.
When the contruction was complete the developer would sell the homes. The home buyers would get mortgages from the same bank. The bank would assess the value of the house, the credit worthiness of the buyer and would expect the buyer to put some money at risk - at least 20%. The homes are sold and the construction loan is repaid.
The banks hold the mortgage, collect fees and interest and pass on some of the interest (always at a lower rate) to their depositors. The difference in the interest rates results in profits to the bank less reserves for the possibility of some defaults. But even in the case of default the bank is protected since they assessed the value of the house and the buyer had 20% of their money in the house. Only if the value of the house decreased more than 20% was the bank at risk.
Now compare that simple model with the model used during the credit and housing bubble.
Since most of the players were agents and not principals they due diligence of assessing the overall housing market, the specific home assessment, and the credit worthiness of the buyer, the developed, the mortgage broker and the Wall St. bank were all neglected.
The buyer borrowed money from the mortgage broker.
The mortgage broker borrowed money from the Wall St. bank. They paid the money back when they sold the mortgage to the Wall. St. bank.
The Wall St. bank borrowed money from institutional investors and the ratio of money at risk to their own capital wasn't 10-1 it was 35 or 40-1. They paid the money back when the sold the mortgage securities to their investors.
And the agents became rich by paying themselves large salaries and bonuses while they put their corporations and the shareholders - the real principals at risk.
So when it all fell apart the shareholders or Countrywide Financial, Citigroup, Lehman Bros, Bear Stearns, Bank of America all went south but the executives walked away with their bonuses intact.
In the mortgage mess it seems that everyone was an agent.
- The buyer obtained 100% mortgages and therefore had little or no money at risk.
- The mortgage broker sold the mortgage to a Wall St. bank. Their risk was limited to the short time they held the mortgage.
- The Wall St. bank combined the mortgage into securities and sold the securities. Their risk was limited to the short time they held the mortgage.
- The rating agencies had no money at risk.
- Often the buyers were fund managers, pension fund managers, bond fund managers, hedge funds, etc. They had little or none of their own money at risk. In fact some of the bond fund managers were obligated to buy high yield bonds.
The "invisible hand" of Adam Smith assumes that prices are set by the market forces of supply and demand. There are free market fundamentalists that still believe that this "invisible hand" actually works to set prices so that supply and demand reach equilibrium. And this does work fairly well for consumer commodity products and services.
But it assumes that the buyers and sellers are rational actors, they are making rational decisions in their own best interest and that they both buyers and sellers have the same information. The agency problem is that if the buyers and sellers are agents and are not making decisions in the interest of the real buyer or real seller then the invisible hand simply isn't there. This is only one problem with the invisible hand. There are others which we may get to.
Contrast the players involved with the housing and credit bubble with the Bailey Savings and Loan system. In this system a local bank lent money to a developer - as a construction loan. Some of the money came from their depositors but some of the money was the bank's own money. The ratio between the depositors money at risk and the bank's own capital is leverage and the leverage was probably around 10 to 1. The banker would make the construction loan based onthe developer's past performance, their credit worthiness and the bank's assessment that the housing that was built could be sold. The developer had to put some of their money at risk as well.
When the contruction was complete the developer would sell the homes. The home buyers would get mortgages from the same bank. The bank would assess the value of the house, the credit worthiness of the buyer and would expect the buyer to put some money at risk - at least 20%. The homes are sold and the construction loan is repaid.
The banks hold the mortgage, collect fees and interest and pass on some of the interest (always at a lower rate) to their depositors. The difference in the interest rates results in profits to the bank less reserves for the possibility of some defaults. But even in the case of default the bank is protected since they assessed the value of the house and the buyer had 20% of their money in the house. Only if the value of the house decreased more than 20% was the bank at risk.
Now compare that simple model with the model used during the credit and housing bubble.
Since most of the players were agents and not principals they due diligence of assessing the overall housing market, the specific home assessment, and the credit worthiness of the buyer, the developed, the mortgage broker and the Wall St. bank were all neglected.
The buyer borrowed money from the mortgage broker.
The mortgage broker borrowed money from the Wall St. bank. They paid the money back when they sold the mortgage to the Wall. St. bank.
The Wall St. bank borrowed money from institutional investors and the ratio of money at risk to their own capital wasn't 10-1 it was 35 or 40-1. They paid the money back when the sold the mortgage securities to their investors.
And the agents became rich by paying themselves large salaries and bonuses while they put their corporations and the shareholders - the real principals at risk.
So when it all fell apart the shareholders or Countrywide Financial, Citigroup, Lehman Bros, Bear Stearns, Bank of America all went south but the executives walked away with their bonuses intact.
Tuesday, March 1, 2011
Bubble and Meltdown - part 2
Been away for a couple of weeks. Before I move on to the other topics one more thought on the Giant Pool of Money.
One of the reasons given for a government policy of fiscal restraint is that huge government borrowing will "crowd out" borrowing by business. The idea is that as the deficit and national debt grows the US goverment will have to issue more and more T-Bills and Bonds and will soak up all available fixed income investment money. Over time the investors will require higher and higher interest rates not due to the risk of default but due to the risk of USD inflation. As the interest rate rises on US government bonds then it will also have to rise on all USD corporate bonds. USD corporate bond holders face the same risk of USD inflation plus the credit risk.
But after a decade of huge deficits it hasn't happened. Even before the meltdown US government bonds had low yields and after the bubble, the bail-outs, the 2010 stimulus and the 2011 tax deal 10 year bonds are currently yielding less than 4.00%.
Why?
I believe the answer may be the Giant Pool of Money. The supply of money available for fixed income investment continues to increase. The money is concentrated in foreign central banks, balance sheets of the largest corporations, US banks and the super-rich.
If interest rates on US government and investment grade USD corporate bonds stays low then this may be an indication that the Giant Pool of Money is a decisive factor. Stay tuned.
One of the reasons given for a government policy of fiscal restraint is that huge government borrowing will "crowd out" borrowing by business. The idea is that as the deficit and national debt grows the US goverment will have to issue more and more T-Bills and Bonds and will soak up all available fixed income investment money. Over time the investors will require higher and higher interest rates not due to the risk of default but due to the risk of USD inflation. As the interest rate rises on US government bonds then it will also have to rise on all USD corporate bonds. USD corporate bond holders face the same risk of USD inflation plus the credit risk.
But after a decade of huge deficits it hasn't happened. Even before the meltdown US government bonds had low yields and after the bubble, the bail-outs, the 2010 stimulus and the 2011 tax deal 10 year bonds are currently yielding less than 4.00%.
Why?
I believe the answer may be the Giant Pool of Money. The supply of money available for fixed income investment continues to increase. The money is concentrated in foreign central banks, balance sheets of the largest corporations, US banks and the super-rich.
If interest rates on US government and investment grade USD corporate bonds stays low then this may be an indication that the Giant Pool of Money is a decisive factor. Stay tuned.
Friday, January 21, 2011
Bubble and Meltdown - chapter 1
Over the last year I have read 10+ books on the financial bubble and meltdown. Much of the story is well known but there are some aspects that I don't believe have received the attention they deserve.
Here are some under-reported aspects:
- The Giant Pool of Money
- The Agency problem
- How the bubble lead to misplacing of resources and lower rates of unemployment that were unsustainable
- How the wealth and income disparity leads to stagnation
- Repeal of Glass-Steagal
- Global imbalances in trade and savings
Let's start with the Giant Pool of Money. I can across this from a Podcast, This American Life, which is the number 1 podcast on Itunes. http://www.thisamericanlife.org/radio-archives/episode/355/The-Giant-Pool-of-Money. The basic idea is that there is a global Giant Pool of Money available for investing - much of it looking for fixed income investments, e.g. bonds. The Pool of Money is always increasing in the long term but in the years leading up to the bubble it really expanded. Part of this was due to the increased savings in Asia as millions of Chinese and Indian workers climbed out of poverty and saved a large percentage (at least compared to Americans) of their income. In addition the US trade deficit with China lead to the Chinese banks to accumulate billions in USD.
So we had a huge increase in money available for investing at a time when the fixed income investment of choice - US T-bills and Treasury notes had very low interest rates. So investment managers all over the world were looking for investments with a better rate of return and Wall St. invented new investments especially mortgage and asset backed securities that paid higher rates of interest. But even these new securites could not match the demand so Wall St. invented an alphabet soup of financial derivatives that we have all read about - CDO and CDS and then more deriviates based on the derivatives - synthetic CDOs.
We all know what happened next. In order to create more fixed income securities the mortgage brokers made very bad loans. They borrowed money from Wall St. to make the loans but then sold the mortgages back to Wall Street where they were packaged into asset backed securities and sold to global investors. Why did these supposedly well-informed investors buy securities that consisted of bad loans? One, they were rated AAA by the ratings agencies. Two, the feeling was that even if the loans went bad they loans were backed by strong collatoral, i.e. houses.
Of course what most of us missed was that the home prices were based on a bubble.
If you read what those in the industry said at the time it was "housing prices never go down" (even though housing prices have gone down substantially in the past). Looking back it is easy to understand that housing prices in the long term have to be linked to income and income for most Americans was stagnating. If you plotted housing prices and growth in income you would see a huge and growing gap.
These securities were very vulnerable not just to falling housing prices but even if housing prices stayed flat the borrowers would be unable to pay off their mortgages once the teaser rates expired nor would they be able to refinance. Had prices remained flat there would have been a large amount of foreclosures but when housing prices fell the number of foreclosures increased exponentially.
What drove the market for mortgages was not demand by consumers for houses it was demand for fixed income securities from the Giant Pool of Money. So mortgages were offered with no consideration as to whether the mortgage could ever be repaid. More on that when I discuss the agency problem.
The Giant Pool of Money tells Lehman, Bear Stearns, Citi, Merrill Lynch, Goldman Sachs - find us more securities. Wall Street works with the mortgage originators and makes them short term loans to make mortgages. Local banks make short term loans to developers. Developers build more homes and work with the mortgage originators to find buyers. The house is sold. The developer pays back the local bank. The mortgage originators sells the mortgages to Wall St. and pay back their short term loans. Wall St. finances all of this with short term loans in the form of CD and loans from the large banks. The mortgages are packaged into securities and sold to the Giant Pool of Money. Wall St. pays back their bank loans.
Everyone gets paid mostly in fees. The risk has moved from the local banks, the developers, the mortgage brokers and Wall Street to the Giant Pool of Money.
Except that there are always more loans to be made. More construction loans, more houses, more bad mortgages, and more risky mortgage backed securities some of which are not sold to the Giant Pool of Money but are held by the Wall St. banks.
So where's the blame? Well kind of everywhere. Every one in this chain is making mistakes. It may be that the least informed about the risks are the consumers and the Giant Pool of Money. Everyone else is simply trying to skim off fees and trying not to be standing when the music stops.
More on the agency problem next time.
Here are some under-reported aspects:
- The Giant Pool of Money
- The Agency problem
- How the bubble lead to misplacing of resources and lower rates of unemployment that were unsustainable
- How the wealth and income disparity leads to stagnation
- Repeal of Glass-Steagal
- Global imbalances in trade and savings
Let's start with the Giant Pool of Money. I can across this from a Podcast, This American Life, which is the number 1 podcast on Itunes. http://www.thisamericanlife.org/radio-archives/episode/355/The-Giant-Pool-of-Money. The basic idea is that there is a global Giant Pool of Money available for investing - much of it looking for fixed income investments, e.g. bonds. The Pool of Money is always increasing in the long term but in the years leading up to the bubble it really expanded. Part of this was due to the increased savings in Asia as millions of Chinese and Indian workers climbed out of poverty and saved a large percentage (at least compared to Americans) of their income. In addition the US trade deficit with China lead to the Chinese banks to accumulate billions in USD.
So we had a huge increase in money available for investing at a time when the fixed income investment of choice - US T-bills and Treasury notes had very low interest rates. So investment managers all over the world were looking for investments with a better rate of return and Wall St. invented new investments especially mortgage and asset backed securities that paid higher rates of interest. But even these new securites could not match the demand so Wall St. invented an alphabet soup of financial derivatives that we have all read about - CDO and CDS and then more deriviates based on the derivatives - synthetic CDOs.
We all know what happened next. In order to create more fixed income securities the mortgage brokers made very bad loans. They borrowed money from Wall St. to make the loans but then sold the mortgages back to Wall Street where they were packaged into asset backed securities and sold to global investors. Why did these supposedly well-informed investors buy securities that consisted of bad loans? One, they were rated AAA by the ratings agencies. Two, the feeling was that even if the loans went bad they loans were backed by strong collatoral, i.e. houses.
Of course what most of us missed was that the home prices were based on a bubble.
If you read what those in the industry said at the time it was "housing prices never go down" (even though housing prices have gone down substantially in the past). Looking back it is easy to understand that housing prices in the long term have to be linked to income and income for most Americans was stagnating. If you plotted housing prices and growth in income you would see a huge and growing gap.
These securities were very vulnerable not just to falling housing prices but even if housing prices stayed flat the borrowers would be unable to pay off their mortgages once the teaser rates expired nor would they be able to refinance. Had prices remained flat there would have been a large amount of foreclosures but when housing prices fell the number of foreclosures increased exponentially.
What drove the market for mortgages was not demand by consumers for houses it was demand for fixed income securities from the Giant Pool of Money. So mortgages were offered with no consideration as to whether the mortgage could ever be repaid. More on that when I discuss the agency problem.
The Giant Pool of Money tells Lehman, Bear Stearns, Citi, Merrill Lynch, Goldman Sachs - find us more securities. Wall Street works with the mortgage originators and makes them short term loans to make mortgages. Local banks make short term loans to developers. Developers build more homes and work with the mortgage originators to find buyers. The house is sold. The developer pays back the local bank. The mortgage originators sells the mortgages to Wall St. and pay back their short term loans. Wall St. finances all of this with short term loans in the form of CD and loans from the large banks. The mortgages are packaged into securities and sold to the Giant Pool of Money. Wall St. pays back their bank loans.
Everyone gets paid mostly in fees. The risk has moved from the local banks, the developers, the mortgage brokers and Wall Street to the Giant Pool of Money.
Except that there are always more loans to be made. More construction loans, more houses, more bad mortgages, and more risky mortgage backed securities some of which are not sold to the Giant Pool of Money but are held by the Wall St. banks.
So where's the blame? Well kind of everywhere. Every one in this chain is making mistakes. It may be that the least informed about the risks are the consumers and the Giant Pool of Money. Everyone else is simply trying to skim off fees and trying not to be standing when the music stops.
More on the agency problem next time.
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