comments by Paul Bissett on business, economics, energy, optimism, and survival
“It is to me a new and consolatory proof that wherever the people are well-informed they can be trusted with their own government; that whenever things get so far wrong as to attract their notice, they may be relied on to set them to rights.”
—Thomas Jefferson to Richard Price, January 8, 1789.
This article in the Wall Street Journal by Edward Pinto describes the fuse that was lit by the 1992 GSE Act. Mr. Pinto chief credit officer at Fannie Mae from 1987 to 1989, so has some knowledge of this act and its impacts on the underwriting process of loans securitized by Freddie Mac and Fannie Mae.
Groups like ACORN were invited by House Banking Committee Henry Gonzalez to -
draft statutory language setting the law’s affordable-housing mandates. Interim goals were set at 30% of the single-family mortgages purchased by Fannie and Freddie, and the Department of Housing and Urban Development has increased that percentage over time.
This eventually led to zero percent down mortgages, the (continued) bailout of Freddie Mae and Fannie Mac, and our current credit difficulties. Make no mistakes about it. The economic problems that we suffered over the last 18 months, and continue with today, have their roots in Congressionally-mandated actions to rewrite the standards for credit-worthiness to help facilitate home ownership.
While these were (are) admirable goals, the road to economic hell is paved with good intentions.
I read Paul Krugman’s columns on a regular basis. A frequent topic of his columns is his perceived need to pursue Keynesian solutions to our current economics problems. Keynsesian solutions propose that government should spend liberally during times of economic troubles in order keep the economy operating efficiently until such time that private segment spending and investment can “get back in the game.” Public spending should act as a governor to business cycles, spending more in times of recession, and spending less during economic booms. This article (and this one and this one) suggests that the Obama administration erred in not being more aggressive in their stimulus efforts, and that the economy will suffer without more deficit spending by the government.
It may be an extreme act of hubris to critically comment on the rhetoric of a Nobel Prize winner in Economics. However, he seems to ignores the fact that public stimulus can come in two forms, one through direct government spending (e.g. spending on infrastructure) and transfer payments (e.g. unemployment benefits), and the other through the monetary policy of the federal reserve.
There are several problems with direct governmental spending to support Keynesian goals. First, is that it takes a long-time to get bills through Congress, so by the time the money actually starts flowing, the economy has typically worked through its issues. Second, Congressional priorities are typically not the same as those priorities required to get the economy back on its feet. Thus, the money is inefficiently spent with respect to helping the economy. Third, a true Keynesian spending program would be reduced when the economy is doing well. However, Congress has yet to reduce real spending during any period since 1960 (see chart.)
A much better approach to stimulate the economy is through the monetary operations of he Federal Reserve. As this previous post suggests, the Federal Reserve has made a huge bet on monetary stimulus, to the tune of $13 trillion, far in excess of that requested by Mr. Krugman. This stimulus continues today, and is not just through low interest rates (which may be leading to asset inflation in other countries through the dollar carry-trade), but also through direct purchases of mortgages from Freddie Mae and Fannie Mac (and here). This stimulus is huge. In addition to the direct Federal Reserve purchases for these bonds, the government guaranteed 98% of the residential mortgages in the third quarter, providing an “off-the-balance sheet” stimulus that is not included in any of the accounting for governmental or federal reserve actions.
Mr. Krugman obviously knows the importance of the continued easy money policy of the Federal Reserve. However, it is not clear to me why Mr. Krugman continues to write on the importance of another direct stimulus effort from the government, which would only be a small fraction of what the Federal Reserve and off-the-balance-sheet efforts have already committed to the economy. An expansion of direct spending seems to be more of a political desire for increased top-down control of the economy, than any true desire for more economic stimulus.
The Summary – The housing market continues its pricing decline, but it looks like it may be the beginning of the end for the downward spiral in pricing. An historical analysis of the Tampa, FL market suggests that median home prices may have reached inflation-adjusted parity with home prices in 1994. This price parity for the median home in Tampa is $161,000 in today’s dollars, 44% below the peak in median pricing of $287,500 in September, 2005. This compares well with the estimate of actual average sales transaction prices in Tampa of $160,530 in January by the ERA Polo Real Estate Group.
Nationally, the supply and demand of new homes also appears to have reached a balance. New home starts in February of 358,000 is within 6% of new home sales 337,000. For homebuilders, this suggests a possible end to the downward spiral in pricing for their new products. However, it does not necessarily suggest an end to the downward pricing pressure of existing homes, as foreclosures, job losses, and general insecurity in the employment market continue to pressure existing home prices.
The building industry may see a pricing bottom here, but the potential supply of homes will probably exceed new home demand for some time to come. Times will continue to be challenging for the home real estate market, but the phase of speculative excesses appears to be at an end. Hopefully the next phase will be one of recovery, but it will depend on the general economy to right itself.
On to the Numbers -
In the spring of 2008, I put together the following graph and calculations based on the Case-Shiller Index (CSI). I was trying to decide what to do with our house in Tampa, as we were moving to Oregon.
(The spreadsheet used to create this graph may be found in this hyperlink.)
We had listed our house in Tampa in January 2008, but by February we were receiving very little interest. We were wondering whether we should lower the price to help generate its sale. In retrospect, I wish I had done this “back-of-the-envelope” calculation in the Fall of 2007, as I might have listed our house at a lower price to begin with and perhaps sold earlier at a higher price.
In any case, it is a pretty straightforward calculation that charts the CSI versus time (blue diamonds). I regressed time versus the index from January 1987 to April 1994, which appeared to be a period of stable pricing. I projected this forward in time (pink line) to create a basic long-term trend. I then regressed time versus the index between September 2007 to March 2008 to create a short-term trend (blue line).
As is pretty evident, the pain in the housing market predicted from this short-term/long-term relationship suggested that things would get much worse. We quickly lowered the price of our home to sell it as soon as possible (and had contract within two weeks).
Remarkably the trend since February 2008 has pretty much followed the blue short-term trend line, with a little jog during the credit crisis of the summer of 2008. The question now is whether the pricing in the housing market will continue to fall.
The top of the Tampa market was September 2005, and the median asking price of a house at this time was $287,500. A fall back to the pink long-term trend line would yield a median price of $107,200. However, the CSI is a nominal pricing index, and none of the values have been inflation adjusted. Since 1994, there has been some real inflation in the cost of building a home beyond the speculative increases in price. In addition, there have been other factors impacting the cost and pricing of new homes since 1994 beyond the most recent speculative excesses. These include increasing median square footage and upgrades in finishing costs (e.g. granite counter tops) that are beyond the norm of the typical 1994 new home. These factors would yield a rise in the price of a new home based on true costs differences that would need to be considered when trying to find a “bottom” in the median home price today that removed speculative excesses.
Rather than trying to account for all of these factors, let us try a quick addition of inflation to the trends to see if we can surmise a possible end to the median home pricing declines. Average inflation in the CPI over this period was 2.7%. Let us assume a 3% inflation rate in the pricing of homes from May 1994 and add it to our Long-Term Trend (Long-Term+Inflation; red line). This new inflation adjusted trend line shows a crossing with our blue short-term line at $161,221 during March 2009. Recent sales in January 2009 averaged $160,530 (ERA Polo Group), suggesting we are close to the inflation-adjusted price parity with the median home sold in 1994.
However, it does not suggest a complete end to the pricing declines. The woes of the general economy will continue to impact the housing market. Pressures in the employment market will translate into continued pressure in the housing market, reducing overall demand, and possibly increase supply through short-sales, foreclosures, and relocations.
I am going to put the summary upfront – Ben Bernanke, the Federal Reserve, the Treasury, Congress, and the President are all making a bet. They’re betting that they can stuff enough money in the financial system to forestall a total financial and economic market meltdown. To a large extent, they seem to have succeeded. But is it enough?
The short answer is probably yes. The money released and committed will cover the expected reductions in available capital when compared to the Great Depression. The longer answer (not covered here) is that the devil will be in the details of how the money gets put into the hands of those that can create jobs, income, and wealth.
My biggest concern is that re-regulation of the financial (and other industrial) markets combined with large government deficits may reduce the efficiency of this money that has been stuffed into our financial systems. This would cause the money to flow into higher prices (inflation) rather than job and wealth creation. An easy money policy combined with a highly regulated business environment is a recipe for stagflation.
Now for the numbers – The total government monetary action in this financial crisis is approaching $13 trillion. This does not include the deficit spending by the administration, but just the amount of money that has been made committed by the Federal Reserve, FDIC, and Treasury. This amount of money is nearly equal to GDP. Is there a reason for so much cash?
Perhaps. Let’s take a look at some debt statistics from today and the Great Depression.
Figure 1
Figure 1 shows Total Debt from the period of 1929 to 1940. At the beginning of that financial crisis, Total Debt to GDP started at 170% and climbed to 270% by 1932. This rise in the ratio was caused mainly by the drop in GDP by 57%, as Total Debt had not climbed but rather had fallen by 9% (Figure 2).
Figure 2
Figure 3 shows the growth in total US debt from 1975 to 2008 in relation to GDP . The Total Debt (Public and Private) to GDP ratio climbed from 160% to 370% during this period. Remarkably this was during a period of dramatic GDP growth, and thus represents a true growth in the amount of debt used to fuel Total GDP growth. In short, there has been a real growth in the use of leverage over this period.
Figure 3
So what does this say about current easy money period? It is a well-known fact that Ben Bernanke is a student of the Great Depression period and is determined not to exacerbate the current problems with a tight money policy. A look at Figure 2 shows that the greatest decrease in relative debt was in the Private Money, Individual category. Within that category the greatest percentage decrease was in Commercial and Security Margin debt. A tight money policy during this period caused a negative feedback into economic growth that helped accelerated job loss and wealth destruction. Interestingly the percentage fall in GDP matched the fall in this Debt category during the period 1929-1932.
Total Debt between 1929 and 1934 fell 13%. A similar fall from the 2008 Total Debt of $52.6 trillion would remove $6.9 trillion from the economy. It could be said that the government has replaced over $4.2 trillion of the expected loss of financing, and is committed to another nearly $8 trillion, if needed. This should seem to be sufficient to keep the economy from a suffering the crippling loss of capital seen during that Great Depression period.
One difference is that the 2008 Financial Debt appears to be a much higher fraction of Total Debt during this period than the previous period at 33% versus 11%. A similar fall of 60% of this type of Debt would remove $10 trillion from the Total Debt. The current total commitment of $13 trillion would appear to cover this worse case scenario in the reduction of available capital.
What does this all mean? Well, it means that the Fed has stepped up to backstop the loss of credit that might occur in a financial crisis. And it does look like they have provided enough when compared to the Great Depression period.
The only thing now will be whether the money flows through the system to those who require the credit. The actual money flows into the economy will be controlled by re-regulation of financial markets, congressional legislative agendas, and government fiscal policy. The financial fire appears to be out, let the rebuilding phase begin.
General Electric closed today (3/5/2009) at 6.66. An apocalyptic number? Odd, isn’t it. What is the market telling us?
I don’t think it is saying capitulation. The volume is not there. There is something different about this market. This is not a dramatic catharsis that like the proverbial phoenix gives rise to a beautiful new bird that flies again. This is the grind, the mashing of metal against metal that suggests something is seriously wrong with the machine.
Since Election Day the DJIA has dropped from 9,625 (11/4/2009) to 6,594 (3/5/2009), down 31%. This in a market that was already down 32% from an all time high of 14,093 in October 2007. Its not supposed to happen like this. And I don’t think the administration is listening. Or if they are, maybe they are hearing something different.
Federal Reserve Balance Sheet - Wall Street Journal
Between the 1929 and 1932, the DIJA fell nearly 90%; and by 1933 GDP had fallen by 45%. There were a lot of bad policy mistakes that were made during that time that contributed to the continued decline in economic activity. The current Federal Reserve appears willing to add trillion of dollars of debt on its balance sheets to avoid the monetary mistakes of the past. However, Congress and the White House seem to have taken a different message from the previous crash and the current one, and seem bent on trying to antagonize capital holders and businesses in ways that have not been seen since Roosevelt.
However, when you consider the market is down 51% from its high, half of which is during the time since a new administration was elected, it would appear that there is a new vote happening. This vote is in the markets and business investment and it is going in a direction that is opposite the one expected by our political leaders. Can they hear it?
I like visiting Europe. The continent has a different flow and feel to life. Life seems to move a bit slower, and people tend to have lower expectations about the “stuff” in their lives.
On the flip side, it seems to be more expensive to live, which maybe feeds into the lower expectations on the stuff. Economic classes also seem to be more rigid, and upward mobility seems to be a far away dream for millions of inhabitants. Look a bit deeper and services like health care and education, while free, tends to be rationed fairly extensively.
So I like visiting Europe, but would I want to live there?
A read of the opinion pages across the political spectrum seem to converge on a similar theme with the current administrations budget plans. Krauthammer, Brooks, Krugman all seem to point to grand plans by the administration to address social engineering on a scale not seen since Roosevelt or Johnson. Others see similar impacts through the nationalization of the banking industry.
If you look at the current federal deficit as a percentage of GDP as well as the total federal outlays as a function of GDP, we seem to be approaching a federal budgetary perspective of Western Europe. In the last 10 years, US government expenditures has increased from 34% to 40% of GDP, rapidly approaching that of the European Union at 47%. As the fraction of direct government expenditures to GDP increases, more of the total services provided for everyday life will be directly supplied by the federal government. This will have dramatic consequences for future expectations of governmental services. In short, the more people that become dependent on government for services, the more they will expect and demand that those services continue, until the service itself becomes a right.
The current crisis certainly calls into question the rhetoric of smaller government. But we should not confuse the rhetoric with the facts of increasing governmental expenditures over the past decade. The growth in federal services over the last administration does not suggest that the Bush years were built on pinching pennies. Real (inflation-adjusted) governmental expenditures increased more than 24% from 2000 to 2008 (probably higher because I am not sure if the this Census Bureau has updated their figures for the TARP program). It has been suggested that California is our first looks at the results of continually growing government expenditures at the expense of a sane fiscal policy. One has only to review California’s 10.1% unemployment and $41 billion deficit to get a sense of what a “European-azation” of our federal budgetary policy may accomplish for the rest of the US.
Does this mean that we will drift towards a more European America? I hope not. When I think of Western Europe economies, I think of slow growth, high unemployment, and strongly regulated industries. This is not consistent with the ideals and work ethics of many Americans.
I want the ability to create a future for my family based on how hard I work and how well I make my choices. I would probably accept some restrictions and regulations for public safety and the infrastructure investments necessary for greater economic gains, i.e. a rising tide will raise all ships of opportunity. However, limit my abilities to generate a future for my family based upon my work ethic and intelligent choices, and I will have serious issues with the people in charge.
Such limitations can come from tax policy, regulation, or even energy regulation via a cap and trade system, for this is a hidden tax on economic activity (an expected $646 billion). Given the current leanings of the Congress and the Executive branch, some limitations will probably happen. If the net result of these new policies leads to anemic growth (~1-2%), persistent high unemployment (~8-10%) and high inflation (~3-5%), then our journey to a European America will be nearly complete.
You just can’t make this stuff up.
Fannie Mae posted a $25.2B Q4 loss, full year loss of $58.7B. Freddie Mac is expected to post a similar, if not greater loss.
In response, Freddie Mac’s Chief Executive David M. Moffett said that they would take steps to “rebuild our house” including … efforts to reduce foreclosures and boost financing of affordable mortgages. This is social engineering, not rebuilding the balance sheets and income statements of a public company.
These organization were once implicit political beasts that made money by borrowing cheaply as “government-sponsored entities” and leading in the housing market. The tax on these entities for this implicit guarantee was excess lobbying donations to both Democrats and Republicans, and the use of the profits to fund “affordable mortgages”, i.e. sub-prime mortgages.
Now the gloves are off and they are explicitly owned by the government under conservatorship, with the backing of $400B since September of last year. Their new goals are to stabilize the housing market by making mortgages more affordable and forestalling foreclosures.
According to the Wall Street Journal -
Fannie’s government-appointed CEO, Herbert Allison, said: “It’s not about maximizing returns on equity or profits. It’s really about being of use to the country during this very difficult period.”
The administration is taking the approach that slowly pulling the band-aid off the patient (i.e. the housing market) will reduce the likelihood of shock. In the process they are pumping the patient full of expensive life-support drugs (capital injections and regulatory “cram-down” contract changes) that are doing great damage to the vital organs (i.e. our financial, credit, and legal systems).
For those of us who lived through the eighties and nineties and got to watch the Japanese government try to spend their way out of a balance sheet recession, this path seems to be a poor approach to our problems. The Japanese Nikkei average peaked at 38,916 in December, 1989. Yesterday it closed at 7,510. A -80% return over 20 years. This period in the Japan was replete with “zombie” banks, zero federal reserve interest rates, and huge government deficit spending. I don’t think this is the model we want to follow.
My choice – pull the band-aid off as quickly as possible. Have the FDIC take over the zombie banks, what assets can’t be priced, put onto the government books to collect the interest until they can be sold. Foreclose on the homes that need to be foreclosed. I feel for the people that can not afford their homes anymore. However, renting may be a better option. It will probably be cheaper in terms of their cash flow, allowing those individuals to repair their balance sheets until they can accumulate a sufficient down payment for a new home. A new home that can probably be purchased at a better basis than the home they are in at the moment.
This approach will probably cost about the same in the short term, but in the long term be much cheaper because a floor will be established in the asset market. This will reduce the current deficit financing being used to flood the mortgage market with cash. Once established, the asset floor will provide a level of certainty to the financial markets that will release the credit markets, and allow individual optimism to drive new wealth creation.
Without wealth creation, the hole we are in gets deeper and darker. If I was leading the current administration, I would want every decision to be colored by this thought, “how do we get people to create more than they consume?”. It’s that simple. If you are not creating more than you consume, you will have to be supported by someone, somewhere, at sometime. Any “investment” by the government in any activity or enterprise should be focused on getting people to create more than they consume.
Giving money to support mortgages and assets values to individuals via a nationalized mortgage market is not creating wealth, it is transferring it. In the end, you will run out of money.
Or the road to hell is paved with good intentions
So the housing market is to get some direct help. First, by recapping Freddie Mae and Fannie Mac with $200 billion. They are effectively creating at least $4 trillion in new mortgage money if the 20X leverage ratio for these monstrosities holds. More if the leverage ratio is allowed to increase (at the end of 2008 these ratios were 20X and 70X for Fannie and Freddie, respectively). This will continue the path of nationalization of the mortgage industry. Will someone please show me one example where the nationalization of an industry provided the long-term benefits it was meant to secure?
In addition, the administration will now back “cram-down” legislation. This will force the rewriting of mortgage contracts in a bankruptcy filing. The effect of this legislation will be to increase the mortgage spreads to treasuries, as issuers will demand more risk premium for issuing the mortgage. This will insure we will all pay more for our mortgages in the future.
A possible solution to the increasing mortgage spreads will be to “fix” mortgage rates. The administration will be able to do this because they will have effectively nationalized the mortgage market (see above).
Price fixing always fails in the effective distribution of goods and services. It creates winners and losers by subjective rules that have no relationship to individual incentive.
In this perverse case here, Congress forced Freddie and Fannie to underwrite sub-prime mortgages in an effort “increase” home ownership. This led to price dislocation (i.e. a bubble) from too many people chasing too few houses. The pricing bubble led to a misallocation of resources in the housing industry, which built too many houses because of the excess demand caused by the excess available credit.
A tremendous amount of those bubble home purchases are now underwater. And since the owners never could afford the homes in the first place, they find bankruptcy their only option to relieve them of their contractual obligations. The same people in government who set these homeowners up for failure now want to penalize the rest of the housing market with more expensive mortgages.
Look for this severe warning sign, price fixing of mortgages. Either explicitly via mortgage rates, or implicitly via a “credit worthiness” criteria outside of the true bill paying capability of the borrower that helps some buyers over others get mortgages from our national mortgage providers. If you see this happen, our troubles are just beginning.
I must be channeling the editorial staff at the Wall Street Journal. We must have both heard the same NPR show this Thursday morning. In this article they discuss the recent idea to limit mortgage rates to 4%.
They point to some of the problems with this proposal, but there are other problems with the government trying to qualify borrowers. The manipulation of lending standards at Freddie Mae and Fannie Mac for the purpose of trying to expand the ranks of home ownership are what got us into the mess in the first place. However, imagine if the government errs on the other conservative side of the credit markets (which is exactly what the federal regulators are doing to commercial banking right now). While interest rates may be 4%, very few people will be able to qualify, and the credit markets will remain frozen.
The Great Depression did not result from the Crash of ‘29, but rather the regulatory and monetary practices that followed in response. Price fixing and regulatory limitation of market are what produced 25% unemployment.
The recent economy was highly leveraged, which resulted in asset inflation. The over-leverage resulted from lots of reasons, not the least of which was poor regulation rather than the absence of regulation. The process of de-leveraging the economy will cause asset deflation and economic dislocation, but it does not necessarily have to cause extensive price deflation for other goods and services. Bad regulation, bad fiscal policy, and bad monetary policy will give us the exact problem they are trying to solve.
