Decision Tree

I’ve been wanting to write about the election for some time now. This election has been a difficult one for me, not because I’m feel like I’m choosing between two different competing values among the two candidates, but because there seems to be so much wrong with both candidates and both parties right now. I really don’t see how to vote.

What’s worse is that I see no evidence of real good anywhere across the political spectrum at this time. The way our current financial crisis is being handled does not bode well for the way future crises will be handled, crises that we know are coming, such as Social Security, Medicare and unfunded government pensions. For the first time in my life, I fear for the future of the United States, and would not be surprised to see it cease to exist as it currently does within my lifetime.

But in order to talk about the current election, to try and make a decision about it, one needs to discuss the most serious issue of our time, the housing/finance crisis.

Housing Supply

Let’s begin at the beginning here. The government has had competing interests in intervening in the housing market. On the one hand, government intervenes by telling people where to place their houses via zoning laws, and how to build their houses via building codes. These laws are ostensibly designed to make sure that houses are built in safe places using safe methods.

But more often they’re used to lock out newcomers. There are several reasons why old-timers in a city or town may want to lock out newcomers: to prevent overpopulation which can change the nature of a city or town, cause traffic problems, or environmental problems. Then there are also budgetary concerns. New families bring with them children whose costs of public education invariably exceed the tax revenues they pay into the town (more here). Therefore, towns are encouraged to take measures to slow population growth.

Some measures used by towns to slow population growth are obvious, such as minimum lot sizes, which over time eat up available land, and ensure that only very expensive houses do get built on available land. Others are more subtle. When a town offers a tax deferral for an elderly couple living in the house they raised their family in years ago, what they’re really doing is preventing a new family from raising their family in that same home. What looks like an act of kindness toward some old people is in fact a measure designed to keep children from moving into town.

But it bears mentioning that there are people who oppose development for development’s sake. Environmental concerns are most typically cited, but fears about changing the character of a town, or of increased traffic are also cited. In some cases, such as the wetlands act passed by congress in the early 1990s, large swaths of land are taken off the market for development. In a place like eastern Massachusetts where I live, which is all pretty much land fill in what used to be swamps, such a law can have an enormous impact on the price of housing.

But often times people seem to be anti-development for its own sake. Where I live, in Belmont, MA, there is a campaign afoot to “Save The Maple Forest“. The “Maple Forest” that they are trying to save consist of a few scraggly acres of trees, nestled in among office parks and highways. A developer wants to put a retirement community in there. So it’s housing that won’t have any children living there, meaning it will be a net positive for the town tax-wise. And because they’re retirees living there, they shouldn’t have much of a traffic impact during rush hours either. It would seem that people object for its own sake. I can’t claim to understand it, but their objection does have an effect on the cost of housing, whether they are effective in stopping the project or not.

Housing Prices

Of course, restriction of supply increases the price, whether we’re talking about housing or widgets. And with demand ever increasing, in this case as measured by population growth, prices get sent ever upwards. Hence comes in our second government objective: to create “affordable” housing. In other words, having manipulated the supply of housing, they now seek to manipulate the price.

There are a few ways that the government seeks to affect the affordability of housing. One such way is to directly instruct developers to build cheap housing. This is done in exchange for the building permit enabling them to build higher priced housing. But opportunities to get affordable housing built by such methods are by definition, few and far between. The best way then, to alter the price of housing isn’t to do so directly, but indirectly. By affecting the affordability and availability of the debt financing a home purchase.

The most direct and obvious way that this is accomplished is by means of the home mortgage interest credit. This credit enables you to in effect pay for your interest on your mortgage with pre-tax dollars. That discount then enables the home buyer to take on slightly more debt with which to be able to buy slightly more home. But even this won’t have much effect in the long term. Eventually, the restriction on housing supply combined with increases in the population density of urban areas prices people out of homes within commuting distance of the urban center, even with the tax deductions. Therefore, more drastic steps are needed.

These more drastic steps mostly involve legislation instructing banks to make loans to people whose credit histories are questionable, or who lack a proper down payment. The down payment part is key, because in most of the country, mortgages are non-recourse, meaning that a bank can only collect the house in the event that the borrower stops paying down the loan. So in the event that the value of the house decreases to less than the value of the loan, the bank is stuck with the loss. This is an important point, that we’ll come back to later. The point here is that without a down payment, the bank is not insulated from and has no recourse in the event that the price of the house decreases to less than that of the mortgage and the borrower defaults.

So the federal government passed legislation like the Community Reinvestment Act, which set targets for banks to make loans to those seeking affordable housing (and activists sued banks who didn’t comply, accusing them of racism and whatnot). In order to make those loans, banks had to lower their lending standards. So no more 20% down, no more income verification. Needless to say, making these kinds of loans is reckless, and incidentally, raises the price of existing housing, as now unqualified borrowers are competing for the same homes that the qualified ones are competing for. The result is a snowball effect, whereby people who otherwise want to take out responsible mortgages find themselves priced out of the market, and now need to take out liar’s mortgages and the like, in order to be able to afford the house that they previously would have been able to afford honestly. Thus begins the cascade.

Finance and Banking

The best place to start here is at the Great Depression, which is when most of the banking regulatory infrastructure was put into place. Some of the regulatory infrastructure made imminent sense, such as setting loan reserve ratios that the banks had to comply with. Other regulations made little sense, such as those limiting banks from entering adjacent industries such as insurance, or from entering more than one state. The idea that they had was to limit contagion, but what they wound up doing was limiting banks from adequately diversifying. Thus one particular class of bank ran into trouble first, in the 1980’s. Namely, the Savings and Loans (SNLs).

Now I should preface this part of the discussion by that I am no expert on banking regulations, and I will thusly treat this subject with relatively broad brush strokes. But the gist of what I have to say here is correct.

The idea of the Saving and Loan bank is that ordinary people put their money in as deposits, and earn a certain amount of interest from the bank. The bank in turn lends out that money against hard assets such as houses for mortgages. Again, this type of bank was the product of regulation. The thinking behind the regulation was that if you had banks whose activities were limited to main street, then they would not be susceptible to the contagions flying around Wall Street. Of course this was correct in a sense, except that the bank had a structural mismatch that was bound to screw it up sooner or later.

The mismatch, specifically, was that you were making long term loans with short term deposits. This was bound to have an effect when an economic downturn hit, and people needed to draw down their savings, which the bank of course didn’t have because it had loaned it out as a mortgage. The answer, of course, was that the SNLs needed to be able to offload their loans, and invest in things other than mortgages. While the latter piece led to the SNL crisis of the 1980’s, it’s the first piece that we’re concerned with here.

In order to offload their mortgages, the SNLs needed someone to offload them to. Therefore, around the same time as these other New Deal structures were put into place, the Federal Government created the Federal National Mortgage Association, better known as Fannie Mae. The idea of Fannie Mae was to have an entity for the SNL to sell their mortgage to when they needed cash and could no longer service the loan. Because Fannie Mae was a part of the government, they had a strict mandate to buy only the safest loans.

During the Johnson administration, Fannie Mae was turned into a private bank in order to remove it from the balance sheet of the Federal Government. And two years later, the Federal Home Loan Mortgage Corporation or Freddie Mac was created so that there would no longer be a monopoly on the secondary market for mortgages in the United States.

Just to be clear, both entities were now, basically, semi-private. They were what’s known as Government Sponsored Entities, and while it was never explicitly stated, it was always implied that these entities would not be allowed by the Federal Government to fail. This meant that there was very little perceived risk in doing business with these two entities.

This would be fine were these two entities to continue servicing the loans they purchased form their respective banks. But they too would run into the same problem as the SNLs, namely, they would run out of cash with which to buy mortgages. So they needed to turn these mortgages into tradeable securities, like bonds. Such securities are called Collateralized Debt Obligations, or CDOs.

CDO’s bundle up mortgages, car loans and the like, and then float them on the public market as if they were bonds. They get a credit rating, and they pay a coupon. But unlike a bond, mortgages can be paid off at will. So basically, the bank backing the CDO agrees to resupply the CDO with any mortgages that get paid off early. All in all, it works as planned. The book Liar’s Poker provides a good history of the formation of CDOs in the late 1980’s.

So far, so good. Now let’s tie it all together.

Tying It Together

So in 1995 the Clinton administration started to make revisions to the Community Redevelopment Act, offering housing credits to Fannie Mae and Freddie Mac for buying loans that were considered subprime. The idea here was to encourage homeownership. The result, was disastrous.

Now, banks could issue loans to anybody, disregarding the traditional rules about creditworthiness and down payments and the like, knowing that they had someone to offload their debts to, someone whose obligations were government guaranteed (at least by implication). The result was a flurry of new mortgage instruments, designed to get people in houses by hook or by crook. This flood of new entrants to the housing markets caused home prices to rise dramatically in many markets, which in turn made ordinary people who previously would never have considered such exotic mortgages to seek them out. On top of that, speculators in some markets, specifically California, Nevada, Arizona and Florida went on building sprees to try to satisfy the new demand, mostly because these were areas where government would let developers build more.

The next problem is that the CDOs are sold throughout the world to a variety of institutions, including, Fannie Mae and Freddie Mac. In the case of Fannie and Freddie, this is literally a case of them eating their own shit. In the case of everyone else, it was a case of believing that these CDOs has the full faith and credit of the United States Government behind them. Buying CDOs became like buying treasury bonds but with a higher rate of return. Who wouldn’t want that?

So these toxic instruments spread fairly quickly throughout the banking system. It was fine so long as the loans underlying them were performing, and so long as the asset values supported the loans. But should one of both of these things change, the holder of the CDO was poised to be in big trouble. The first one is obvious, if the CDO stops paying its coupon or cannot pay its entire coupon, then the owner of the note is screwed. The second condition is less obvious.

Most businesses of any sort take on debt to finance their operations, banks being no exception. And most of this debt comes with what are called covenants, which are conditions that the debtor must meet in order to continue to be able to borrow the money. Without meeting said conditions, the borrower typically must return what they borrowed. This is done as insurance against a change in creditworthiness of the borrower. Unfortunately, these interlocking agreements can cause a domino effect if enough of these loans need to be recalled.

Typical loan covenants involve asset ratios, detailing how much the borrower must have in assets to keep the loan. For a bank, a loan they make to a customer such as a mortgage is an asset to them. But if the value of those loans gets written down, then they in turn may be required to return the loan they made from another institution. So why would the value of a loan get written down? Because the value of the underlying asset becomes less than the value of the loan. None of this is much of a risk when a bank requires a borrower to own 20% of his home outright, or when home values increase at phenomenal rates like 15% per year. But when the bank is issuing “no money down” loans and real estate prices decrease, the bank finds itself in a world of hurt.

The accounting rule (FAS 157) requires that the value of the loan be written down to reflect the value of the underlying asset, even if the loan is still performing. This means that if real estate prices drop, a highly leveraged bank can find itself needing to repay its loans even if all the liar’s loans they made perform as planned. The problem, of course, is that not all such loans will perform as planned.

So when a handful of no money down loans that were issued at teaser rates suddenly flip to market interest rates go bad, the housing market begins to tank. Why would such loans go bad? They go bad because the “owner” was never an owner in the first place. Having never put any money down, he never had a stake in the property. He was probably a renter before taking out the mortgage, he was functionally a renter (who just received a big rent increase) while he “owned ” his home and paid a mortgage, and he will go back to being a renter after he hands the house keys back to the bank. What this means is that not only has a previously owned home gone back onto the market thus increasing supply, but a previously credit worthy borrower has left the market. Thus the supply of homes has increased, and the demand for them has decreased. It doesn’t take very much of this activity to send housing prices backwards. And even a slight shift backwards can cause massive writedowns at the lending institutions, causing those institutions to be in violation of their covenants and unable to pay back the loans that they took out themselves. Being in default on their loans means that the guy who loaned them the money now has to write down the value of the loan (asset) on their books, and thus begins a financial contagion that threatens to engulf the globe.

This effect gets magnified if you consider the CDOs. The CDO is a bunch of bundled mortgages. And seemingly every financial institution in the world has bought them. But now, with housing prices dropping in the United States, nobody knows how to value these loans, and nobody knows how many “owners” will drop by the bank when their loan rate resets and just hand the keys over, flipping the bank the bird. And frankly, there is no way to predict this either. Thus, these CDOs become effectively worthless on the open market. And if their market value is zero, then their holders have to write down their value, causing more non-compliance with loan covenants, pushing more institutions toward the brink.

And as if all of that wasn’t bad enough, the Federal Reserve has been adding fuel to the fire by lowering interest rates, and adding liquidity to the market in unexpected and inconsistent ways. This means that some banks which should be unwinding their holdings aren’t doing so in hopes of a bailout or of getting additional liquidity to be able to ride out the storm. Meanwhile, the currency loses value and is inflated, creating the potential for bubbles in other sectors of the economy down the road.

I hope that after reading all of this, you’re disavowed of the notions that this is all just a product of group psychology, or a temporary bout of market mania. This crisis is the consequence of serious and systemic market interventions by the government. It may seem strange to say that a series of events beginning with some neighborhood American NIMBYism created a snowball effect to the point where it took down world markets, but that is in fact what has occurred (and I’m not being a right-wing crackpot espousing this, see Paul Krugman in 2005). It will take a long time and a lot of effort to unravel it.

Some Conclusions About The Crisis

So what to do. Frankly, I’m not completely sure. I am sure of what NOT to do. I can’t vote for the people who caused this mess in the first place. That means most Democrats (yes, most Democrats), including Barack Obama, who worked for ACORN as an activist and sued banks for “discriminatory lending”, and whose buddy Deval Patrick was suing banks on behalf of the Clinton justice department. It also includes his buddies Barney Frank (Frank again) and Chris Dodd, both of whom deserve to be run out of Washington at the ends of pitchforks. I could be tempted to vote for McCain, but he’s decided it’s too difficult to explain to voters what’s behind the mess, and so instead he blames it on greedy capitalists, which only plays into the hands of the people who caused this mess, people who themselves are working overtime to blame this on unregulated capitalism (as if such a thing exists). And that’s assuming that Republicans like Bush and McCain haven’t contributed their fair share to the problem themselves.

Basically, democracy doesn’t work when people are only half paying attention. When those responsible for a crisis benefit from it, we know that nobody is really paying attention.

I suppose that leaves me with the Wiccan hating Libertarian, which I suppose ought to be registered as a protest vote against the Republicans from someone who ordinarily would be a supporter. It’s just all so disappointing right now. I suppose it has to get worse before it gets better, but I see no evidence that anybody really gives a crap about this situation right now. All I do see is political posturing and looting. What else to make of a bailout package that got rejected the first time, then accepted on the go around with lots of pork. Was the pork the missing magic ingredient that was going to make this recipe work?

All joking about prophecy aside, I seriously worry that the United States will cease to be within 20 years time. What it will look like I don’t know. But I’m sorely tempted to bury some gold bars in the basement just in case things head seriously south.

In the meantime, I have a few videos you should watch. You may have seen them elsewhere before. But they at least refute the McCain notion that this stuff really can’t be explained in the context of a campaign commercial. I’ve also collected a slew of links related to this subject. I will attempt to place them all within the context of the text I’ve written above, but I’ll put the remaining ones in a list below. And if you’re still reading this, thanks for sticking with me here. Let me know if you think I’ve missed anything.

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