Economics is called “the dismal science” for a reason. The desire to study the production, distribution, and consumption of goods and services is not widespread – you might rather surf the web for videos of cute kittens, or collect rare beer cans from breweries long gone. Lionel Robbins in a 1932 essay said economics is “the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.” That of course means that, however boring, and those cute kittens aside, this is the stuff of everyday life. The available resources are almost always insufficient to satisfy all wants and needs, especially as the free-market system in the western world continually generates new wants, which turn into new needs, which create new scarcities. There are runs on new video game consoles after all. Thus we get into a matter of choices, as they are affected by incentives and resources. This is the stuff of most people’s lives.
Do you want that nice house on the hillside at the edge of the city with the cool view of the city lights? Can you afford it? Did you buy it, or more precisely, did you arrange one of those subprime mortgages where you really didn’t have to come up with much of a down payment, where you could pay interest only, or less, just adding more each month to what you eventually owe? No one checked your income, to see if you could make the payments, and maybe you decided the adjustable rate thing was the way to go – low payments now that bump up in a few years, when maybe your ship will come in, or when you can sell the place at a big profit as housing prices always go up and move on to something even more snazzy.
You’re in trouble. Think about that word – Middle English morgage, from Anglo-French mortgage, from mort dead (from Latin mortuus) + gage – a conveyance of or lien against property (as for securing a loan) that becomes void upon payment or performance according to stipulated terms. It’s about death – you kill the loan, by paying it off, or it kills you. Guess what? Your ship is not coming in – few ever do – there is no buyer willing to purchase your place and provide you much of a profit, if any. And what you owe each month on the loan is about to double. Now what?
Of course you are not alone, and that is the problem. Times have been good, housing prices rise and rise, lenders were eager to rope in new business, and as long you figured you could refinance again or sell at a profit before your costs jumped, this was a no-brainer. Buy the big house.
But it was Subprime Nonsense as Daniel Gross explained –
In the last couple of weeks, the conventional wisdom surrounding debt – housing and corporate – has changed. For the last several years, lenders and investors have believed that a) debt doesn’t go bad, so it’s OK to commit to huge chunks of debt without asking too many questions; b) lenders can insulate themselves from bad debt, in the unlikely event it should appear, by packaging and selling loans as securities; and c) sharp professional investors who buy and trade these securities, often using debt themselves to increase returns, can protect themselves from losses through the use of newfangled securities called credit derivatives. Events of the last few months have proven that a, b, and c are wrong when it comes to subprime housing debt. That realization, in turn, is leading lenders and investors to wonder whether they’ve also been laboring under false assumptions when it comes to subprime corporate debt. (They have!)
As mentioned earlier, this is the perfect storm. In fact, it’s tulip mania again, as in the Netherlands in the first part of the seventeenth century, as you might recall –
In 1623, a single bulb of a famous tulip variety could cost as much as a thousand Dutch florins (the average yearly income at the time was 150 florins). Tulips were also exchanged for land, valuable livestock, and houses. Allegedly, a good trader could earn six thousand florins a month.
By 1635, a sale of 40 bulbs for 100,000 florins was recorded. By way of comparison, a ton of butter cost around 100 florins and “eight fat swine” 240 florins. A record was the sale of the most famous bulb, the Semper Augustus, for 6,000 florins in Haarlem.
By 1636, tulips were traded on the stock exchanges of numerous Dutch towns and cities. This encouraged trading in tulips by all members of society, with many people selling or trading their other possessions in order to speculate in the tulip market. Some speculators made large profits as a result. Others lost all or even more than they had.
Some traders sold tulip bulbs that had only just been planted or those they intended to plant (in effect, tulip futures contracts). This phenomenon was dubbed windhandel, or “wind trade”, and took place mostly in the taverns of small towns using an arcane slate system to indicate bid prices. (The term windhandel is similar to the recent term vaporware: both have much the same metaphor.) A state edict from 1610 (well before the alleged bubble) made that trade illegal by refusing to enforce the contracts, but the legislation failed to curtail the activity.
In February 1637 tulip traders could no longer get inflated prices for their bulbs, and they began to sell. The bubble burst. People began to suspect that the demand for tulips could not last, and as this spread a panic developed. Some were left holding contracts to purchase tulips at prices now ten times greater than those on the open market, while others found themselves in possession of bulbs now worth a fraction of the price they had paid. Allegedly, thousands of Dutch, including businessmen and dignitaries, were financially ruined.
Attempts were made to resolve the situation to the satisfaction of all parties, but these were unsuccessful. Ultimately, individuals were stuck with the bulbs they held at the end of the crash – no court would enforce payment of a contract, since judges regarded the debts as contracted through gambling, and thus not enforceable in law.
Now it’s housing. It would have been wise to have read Extraordinary Popular Delusions and the Madness of Crowds, written by the British journalist Charles Mackay in 1843. Ah, no one reads such things.
But Friday, August 10, the Associated Press reported this – “Wall Street closed out a difficult week with a mixed finish Friday after the Federal Reserve injected billions of dollars into the banking system to calm markets torn by worries about evaporating credit. The Dow Jones industrials, down more than 200 points during the session, ended with just a 31-point deficit and managed to post a gain for the week.”
In short, so many odd loans had been made to people who might or might not be able to make the payments, payments that kept shifting and would soon jump dramatically higher, and those loans had been repackaged and sold in blocks and resold again and again, and often purchased on margin – and the collateral for the original individual loans was now not rising in value or even holding steady – that no one knew what anything was worth any longer. Investors bundled together mortgages, including some subprime loans, and sold them off to institutional investors – hedge funds and mutual funds. These buyers were hoping for the steady flow of income from homeowners making their mortgage payments. Oops.
No one was financing anything until this was straightened out. You want to float a bond issue to expand your business, or buy that little company that would compliment your enterprise? No dice. Everyone was spooked. Who was holding a major position in some financial instrument that might or might not be worthless? Who knew what they had? It was a credit crunch, or a crisis in liquidity, or what you will. The trigger for the chaos in the market was that Thursday the French bank BNP Paribas said that it was freezing three funds that invested in United States subprime mortgages because it was “unable to properly value their assets.” The assets might be tulip bulbs. It was hard to tell. That day the Dow fell almost four hundred points.
It was falling again Friday, but the Federal Reserve stepped in and added nineteen billion dollars in liquidity Friday morning, then another sixteen billion, then finally three billion –
The New York Fed, which carries out the central bank’s market operation, announced a three-day repurchase agreement of mortgage backed securities and then two more of the so-called “repo” moves to inject liquidity into the market. The Fed’s maneuvers came after the fed funds rate, the amount banks charge each other for overnight loans, ticked above 6 percent again Friday – well above the Fed’s target of 5.25 percent and a sign that credit was becoming harder to obtain.
The Fed stepped in after the same occurrence Thursday, injecting $24 billion in temporary reserves to the U.S. banking system. In a repo, the Fed arranges to buy securities from dealers, who then deposit the money the Fed has paid them into commercial banks.
Add that up – that’s sixty-two billion pumped in to keep the whole shebang from freezing up. The Feds will cover the tulips. They had to, to “facilitate the orderly functioning of financial markets.” The Dow closed Friday at 13,239.54. It closed at 14,000.41 on July 19. So the Dow is now down about 761 points, or 5.4 percent, from that record close. If you have investments or a 401(k) you just lost a big chunk of change. Who knows what your mutual funds or pension plan is holding? It might be tulip bulbs. Sell now, and hold the cash.
And if you have one of those whiz-bang mortgages – well, this fall as a big batch of subprime mortgages written in 2005 and 2006 begin to reset their rates. Is that you?
This will not end soon. The odd thing is that the Dow Jones industrial average ended the week up 57.63, 0.44 percent, at 13,239.54. Standard and Poor’s was up too for the week. The Nasdaq composite index ended up 33.64, or 1.34 percent. Perhaps it could be worse.
What the heck happened? Floyd Norris in the New York Times says it was a new kind of bank run –
A few generations ago, savers responded to financial panics with runs on banks, and even healthy institutions could fail if they could not raise enough cash quickly enough.
For a long time, that all seemed to be safely relegated to the past. But now the runs are back – and this time the targets are not banks but the securities that have replaced them as the prime generators of credit in the new financial system.
“Our current system of levered finance and its related structures may be critically flawed,” said William H. Gross, the chief investment officer of Pimco, a mutual fund company. “Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment.”
Yeah, yeah – there was the “bank run” scene in that 1946 Capra movie – Jimmy Stewart, in the snow, at Christmas time. But Norris reminds us of real life – the “Panic of 1907” was halted only when the J. P. Morgan persuaded banks to stand together and halt the string of closings by lending money to threatened institutions. There was a fix – “That led to the creation of the Federal Reserve, as Congress recoiled from the notion that the country’s financial health had relied on the wealth and wisdom of one private citizen.” In spite of the theories of the economic conservatives, sometime the government does have to jump in a do something. The invisible hand of free market doesn’t fix everything.
And there was the Depression, with a wave of bank failures, and that led to the establishment of deposit insurance – “With that, savers became convinced that they need not worry about the health of their bank, and bank runs vanished.”
And now, with “a new financial architecture” we may need a new tool. The new architecture relies more on securities and less on banks as intermediaries, and that’s a problem –
With the worth of those securities now being questioned – and no equivalent of deposit insurance – some who financed the securities want their money out, a fact that has created the 21st-century equivalent of a run on a bank.
Left to deal with the run are the institutions that were created to deal with the old system’s problems – notably the central banks like the Federal Reserve and the European Central Bank. But, in contrast to their close involvement with the banking system, these banks have little regulatory oversight of the securities that are in trouble and may not even know who is holding them.
At the heart of the new system was a decision to have loans financed directly by investors, rather than indirectly by bank depositors. Investors, ranging from hedge funds to wealthy individuals, had confidence in the arrangement because most of the securities were blessed as very safe by the bond rating agencies, like Moody’s and Standard & Poor’s.
The highly rated securities pay relatively low interest rates, but until now there were many willing to own them or to lend money to those who did own them. But there is no reason to hold them if there is any question about their safety – just as there was no reason to keep deposits in a bank that was facing a run amid rumors about its safety.
A result has been a freezing up of markets for many securities that, it turns out, were critical to the free flowing of credit. The problem first gained widespread attention when two hedge funds run by the brokerage firm Bear Stearns collapsed and a third Bear Stearns fund had to suspend redemptions as investors sought to get out even though there was no evidence that the fund was in trouble.
That third fund is the killer. Investors bailed out because no one knows what any of this stuff is worth. It may be fine, but who needs the worry?
The basis of the system was a belief that securities backed by bad credit could be very safe — so long as there were other securities that would suffer the first losses that came from defaults in pools of subprime mortgages or of loans to highly leveraged companies.
So far, none of those highly rated securities have failed to make their interest payments on time, but that fact is not enough to make anyone want to buy them.
They might be just tulip bulbs? Who knows?
So we get this –
On Tuesday, the Fed declined to lower the federal funds rate, saying that despite financial market volatility and a decline in the housing market, “the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.”
But that comforting outlook did not help the credit markets recover, or persuade anyone to buy the newly questioned securities – at least at anything like the prices people had assumed. No one wants to sell the securities at very low prices – and in many cases they have borrowed heavily against them. So the markets have dried up.
The Feds toss in money, but that’s not that helpful –
If the current panic is just that – unreasoning fear – then such cash infusions may be able to let the new financial system weather the storm. Money can be lent to those owning the dubious securities, obviating the need to sell. As they eventually turn out to be good, the loans can be repaid and all will be happy.
On the other hand, if many of those securities turn out to be as bad as people now fear, some of those loans will not be good, and there may be more financial failures.
Oh crap. No one knows. And the current tools for fixing things are the wrong tools –
The central banks, while clearly crucial to dealing with the loss of faith in the new financial system, lost influence under that system. Loans could be arranged by nonbanks, not subject to bank regulators, and the regulators were hesitant to impose rules that would not apply to all lenders. The lenders sold securities to finance mortgages that let people borrow at rates that – temporarily – were far lower than the Fed envisioned. That delayed the impact of the Fed’s attempts to raise interest rates in 2005 and 2006.
… If the American economy does continue to weaken, the Fed may feel forced to reduce interest rates sooner than it had expected, even if that move threatens to hurt the value of the dollar.
Prices in the futures market for federal funds show that just a few weeks ago investors thought there would be no Fed easing this year. Now they seem to think such a move is highly likely, and some expect it as early as next month.
But the Fed’s influence is limited when lenders are suddenly risk-averse. “The impetus of lowering interest rates may not help, if they don’t let you borrow in the first place,” said Kingman Penniman, the president of KDP Investment Advisors.
The new financial system is not the one the Fed was created to deal with, but it is the one it must try to handle.
Yep, economics is a dismal science.
See Adam Smith’s The Wealth of Nations (1776) –
Political economy, considered as a branch of the science of a statesman or legislator, proposes two distinct objects: first, to supply a plentiful revenue or product for the people, or, more properly, to enable them to provide such a revenue or subsistence for themselves; and secondly, to supply the state or commonwealth with a revenue sufficient for the public services. It proposes to enrich both the people and the sovereign.
That’s not exactly working out, is it?
[][][][]
As a footnote, you might take a look at Daniel Gross’ examination of the Rudolph Giuliani healthcare reform plan. This is what the government wants to do for you –
In this year’s State of the Union, President George W. Bush proposed a $15,000 standard deduction for health insurance, claiming a family of four making $60,000 would receive a $4,500 tax break to buy health insurance on its own. Giuliani would similarly offer a deduction of up to $15,000, which can be claimed by families that buy their own insurance. And, the New York Times credulously noted, “the money left over, he said, could be put into a ‘health savings account’ to be used to pay for deductibles or other uncovered medical expenses.”
The Kaiser Foundation found that in 2006, the average family premium was $11,480. That’s cutting it close, and Gross suggests no one seems to have an understanding of business customer-supplier relationships on a very basic level.
Issue one –
Institutions – say, the American Enterprise Institute, or a law firm, or Procter & Gamble – buy insurance on behalf of their employees. Human resource staffers, trained professionals whose job it is to evaluate these highly complicated plans, negotiate with insurers and buy in bulk. Or they hire consultants to do the same. They have to pick a provider that will cover all employees, from the CEO on down to the cleaning staff. In the end, they may make a large purchase: a thousand employees at $7,000 per insured employee adds up to $7 million in annual premiums. One of the ironclad rules of business is that those who buy in bulk tend to get discounts. Citigroup certainly gets insurance on more favorable terms than the First National Bank of Podunk.
Once insurance is in force, a zero-sum game commences. Every dollar the insurer pays out is one less it gets to keep for profits. So, insurers have powerful motivations not to pay legitimate claims. But when they’re providing insurance to a large group of employees at a corporation or institution, they also have powerful motivations to pay legitimate claims. If employees experience systemic problems with slow reimbursements and claims denied, insurers are likely to hear about it from the HR staff. Make life difficult for an influential employee, and an insurer can jeopardize the whole relationship. What supplier wants to alienate a huge customer like Microsoft? Of course, even given these circumstances, insurers have succeeded in passing along higher costs to corporate purchasers.
Issue two –
Bush and Giuliani, and advocates of their plans, want to change the dynamic. They want to turn what has been a wholesale, buy-in-bulk business into a retail business. They want to replace a bunch of giant, sophisticated consumers possessing limited bargaining power with a mass of unsophisticated consumers possessing no bargaining power. For some reason, they think you and I can do a better job negotiating with Oxford and Aetna than Wal-Mart and Coca-Cola can.
In theory, they argue, insurers will hasten to develop new products and services and slash prices to compete for the dollars of millions of insurance buyers. In practice, something else may happen. For an insurer, the utility of a customer – whether it’s an individual or a large group – is based on how many revenues and losses he produces. Say an insured person who has paid a $7,500 annual premium suffers an accident, which results in a $30,000 hospital bill. Worse, one of his children comes down with a chronic condition that requires $15,000 in annual, recurring costs. The insurer can pay the claims and sustain a loss. Or it can try to figure out ways not to pay. Or it can jack up premiums to such a level that the policy holder either becomes a profitable risk or can no longer afford to remain a customer. Alienate a single insured person and the insurance company only jeopardizes a single unprofitable customer relationship.
There’s not much to do then –
Fights between insurance companies and individuals are never fair. The overwhelming majority of individuals lack the resources, time, and fortitude to confront well-funded, profit-obsessed bureaucracies. Nor do they have human resource staffs or outside consultants that can act as advocates. Michael Moore can only make so many phone calls. Ah, but what about the vaunted power of the consumer to “negotiate” by taking his or her business elsewhere? Here, again, the individual can often be at the mercy of a brutal market. If you have a pre-existing condition or an adverse history, it’s not that easy to switch.
Consumer behavior can, of course, bring down the prices of all sorts of commodities, products, and services. But frequently, the magic works because a powerful, smart agent is acting on consumers’ behalf: a wholesaler or a retailer that buys in bulk. Wal-Mart’s customers can’t show up at factories and demand that the owner sell them a pair of shoes for $8. Wal-Mart can. Wholesale is always cheaper than retail.
And so it goes. Free-market capitalism is a bitch. And economics is a dismal science.
Just Above Sunset 