Tag Archives: behavioral economics

No Free Lunch No Free Market

“The market is a human creation. It is based on rules that humans devise. The central question is who shapes those rules and for what purpose,” Reich concludes. “The coming challenge is not to technology or to economics. It is a challenge to democracy. The critical debate for the future is not about he size of government; it is about whom government is for.” [Robert Reich]

Bingo!  Adam Smith, in Wealth of Nations, offered the Invisible Hand – and economists have been grabbing it ever since. IF, they mused, if all buyers and sellers were truly free then markets would achieve equilibrium and all will be well.  Everyone will act in their own self-interest, and the competition induced will benefit all.  There will be an equilibrium price – for anything – when the demand and the supply are equal.  However, there’s always been a flaw in this argument.

The cracks begin showing when it’s noted that “price” and “value” are not the same thing.  Truly, there is a “market value,” i.e. the price at which an asset would trade in a competitive auction setting, but this isn’t a definition of value.  Value is a qualifier we assign to things that are beneficial, significant, advantageous, or useful. Let’s digress a moment and review why this differentiation between price (even market price) and value is important.

Finance works best when it acts as the conduit for moving capital from places of surplus to places of scarcity.  In the simplest possible terms, finance allows the money in someone’s savings account to be invested in someone else’s business enterprise.   The owner of the savings account benefits from the earnings; the owner of the business enterprise benefits from the extra cash to expand his operations.   Not to put too fine a point to it, but when finance doesn’t move capital from surplus to scarcity then it’s not finance – all too often it’s merely gambling.

Additionally we should note that the the system itself is a gamble.  If I put in a $1000 investment in Widgets International Inc. then I’m betting my shares will either pay dividends, gain in price, or preferably both.  And now to return to “value.”  I’m taking a risk with my money, but I’m also hoping to invest in something of value – perhaps WI Inc. manufactures the best product on offer which helps nurses prevent bed sores from afflicting their patients.  I have $1000 on hand (surplus), Widgets International Inc. needs to expand to meet the demand for its product (scarcity) and finance allows the conduit to work toward mutual benefit.

However, what if I behave as though my $1000 really isn’t surplus? What if I make a side bet that the price of Widget International will go down?  In this instance I am buying a “financial product” which has precious little to do with the product the company is manufacturing, a bit more to do with how the company is managed, and a great deal to do with how a hedge fund can be used to “manage wealth.”   Or, to put it another way – to reduce risk.  Money (capital) slathered about in an effort to reduce risk isn’t part of that conduit for moving capital from surplus to scarcity, and it (as we’ve seen) is fraught with consequences.  The word “behave” is the key term.

If the concepts of price and value are problematic in a discussion of American economics, then our Economic Man as described by Adam Smith is also at issue:

“Economic Man makes logical, rational, self-interested decisions that weigh costs against benefits and maximize value and profit to himself. Economic Man is an intelligent, analytic, selfish creature who has perfect self-regulation in pursuit of his future goals and is unswayed by bodily states and feelings. And Economic Man is a marvelously convenient pawn for building academic theories. But Economic Man has one fatal flaw: he does not exist.” [Harvard]

The “convenient pawn” became the cornerstone of neoclassical economic theory.  The theory elevated the pawn, and the pawn returned the compliment by rationalizing everything from child labor to global out-sourcing.   The Magic Market would “equalize” everything, and all would be well.  In fact, there is no such thing as a free lunch, and there is no such thing as a free market.

In fact, if we skip the jargon (such as a trader saying “I make markets”) what we understand is that traders in the financial sector are sales personnel who have products to sell to prospective buyers.   Last time we looked those sales personnel, the buyers, and the sellers were all human beings – or human beings managing various and sundry enterprises.  Even if  trading is  computerized, someone – some human being – had to program those computers, which still have no innate capacity to count beyond 0 to 1.  There are some benighted souls who believe that if we have just enough “self monitoring,” and more elegant algorithms those messy, inconsistent human beings will no longer screw up the financial markets.  Again, we’d have to ask, “Who is writing those algorithms?” And,  how much “self-monitoring” is good enough?   There are markets, but they are certainly not free of human beings – humans being the brokers, the agents, the buyers, and the sellers.

“Who shapes the rules, and for what purpose?”

We have rules for all manner of human transactions.   When sharing a meal we don’t eat the mashed potatoes with our hands. When getting an invitation with an “RSVP” we don’t wait until after the event to respond.  A soccer match is played with only 11 on each side.  The FAA has rules for take offs and landings to minimize the risk of collisions.   And we have rules for financial markets.   Why? Because a market is simply a transaction between two human agents – buyer and seller – no matter how computerized.

One thing we did learn during the debacle of 2007-2008 was that some investment houses were selling products on which they could calculate a price but they were incapable of determining the product’s value. In some instances the artificiality of the product and its distance from anything tangible, such as a home mortgage, made it impossible to determine what the product was actually worth.  All too much of the Stuff had a “market price” but turned out to have no value in the last analysis.  Thus the demise of Lehman Brothers.

There are some questions at the intersection of economics and politics in 2016:

  • Do we want an unfettered market for financial products? Do we want rules advantageous to the sellers of products in the financial markets? Do we want rules advantageous to the buyers in financial markets? Do we want rules which protect the general public from irresponsible or anti-social behavior on the part of the buyers and sellers?
  • Do we want those who write the rules for the transactions in the financial markets to have the interests of the general public in mind?
  • Do we support agencies which enforce rules designed to restrain the behavior of buyers and sellers in the financial markets?
  • Do we encourage investment or speculation?
  • Should our system of taxation reward work or wealth?

We can focus down on a single issue illustrative of the general regulatory environment – this past July a Senate Committee was taking testimony on a proposed rule that investment advisers place the client’s interest first when deciding upon investments in retirement accounts. One member of the panel offered that the rule would “cost” the investors some $80 billion because financial firms would simply raise fees to make up the profit differential if they couldn’t put their own interests before the interests of their retirement account clients. [Litan pdf]  However, what didn’t go unchallenged was that the study cited by the panel member was financed by the Capital Group, a corporation which definitely stands to benefit if the proposed rule from the Department of Labor is not implemented. [BostonGlobe]

The question highlights the element of freedom:  Is the investment adviser free to purchase elements in a portfolio which enhance the profitability of his firm, or must the adviser give first priority to those investments which will best serve the clients’ interests?  Is the client free to assume his agent (investment adviser) is acting in his or her best interests?  Is the client free to know how investment portfolio decisions are made?  It isn’t a question of whether or not the “market” is “free,” it’s a question of who is free to do what.

Consider for a moment a situation in which a large employer has selected a financial advisor to manage its retirement program.  There are three human agencies at play: the employer, the employees, and the financial advisors.  And, because there are human beings involved we should assume that these relationships are contractual. If the financial advisors are placing their own interests above those of the retirees, then must the employer seek to break the contract? Under what conditions and at what expense?  Are the employees free to take their contribution elsewhere? But, what of the employer’s contributions?   In the rarefied theoretical academic version of a Free Market this would never happen – all the pawn would march neatly across the board. However, this isn’t a theoretical academic version – this is real life – and if the financial advisor is “free” to act in his or her firm’s interest, what happens to the contributions of the employer and the employee? If they act in their self interest then they must cut ties with the advisors.  If the adviser is “free” to act in his or her self interest the employer and the employees lose value in their retirement investments; if the employer and employees are “free” to act in their own self interest the adviser loses the account.   We are left asking: Who is going to write the rules of our economic game? Or to put it in economic-political terms:

“The most important political competition over the next decades will not be between the right and left, or between Republicans and Democrats. It will be between a majority of Americans who have been losing ground, and an economic elite that refuses to recognize or respond to its growing distress.”  [Reich]

References/Recommended Reading:  John Lanchester, “Money Talks: Learning the Language of Finance,” New Yorker, 8/4/2014.  Craig Lambert, “The Marketplace of Perceptions.” Harvard Magazine, March-April 2006.  Michael Blanding, “The Business of Behavioral Economics,” Forbes, August 2014.  Adam Ozimek, “The Future  Irrelevancy of Behavioral Economics,” Forbes, September 2015.  Dan Ariely, “The End of Rational Economics,” Harvard Business Review, July-August 2009.  Paul Krugman, “How did economists get it so wrong?” New York Times Magazine, September 2009.  Noah Smith, “Finance has caught on to behavioral economics, Bloomberg View, June 2015.  Robert Litan, Senate Subcommittee on Employment and Workplace Safety, Senate HELP, July 21, 2015. (pdf) Annie Linsky, “Warren…Brookings Institution,” Boston Globe, September 29, 2015.  Robert Reich, “How the pro-corporate elite has rigged the system against the rest of us,” Alternet, September 29, 2015.

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Filed under Economy, financial regulation

Cliffs, Hostages, and Charts: Passing S. 3412 is good policy

The one element of the current fiscal flap which has attracted most people’s attention is the expiration of the Bush Tax Cuts, and the reversion to the tax rates of the Clinton Administration.  Senate Majority Leader Harry Reid (D-NV) commented today:

“It took four months, but Republicans are finally realizing the way back from the fiscal cliff has been right in front of them all along.  In July, the Senate passed legislation to give economic certainty to 98 percent of families and 97 percent of small businesses – to every American making less than $250,000 a year.  For four months we’ve been one vote away from a solution to this looming crisis.  And for four months, House Republicans have refused to act.  Instead they have held the middle class hostage to protect the richest 2 percent of taxpayers – people who have enjoyed a decade of ballooning income and shrinking tax bills.”(Senator Harry Reid, 11/29/12)

The bill to which Senator Reid is referring is S. 3412, passed in the Senate on July 25, 2012 on a 51-48 vote.   Interestingly, Senator Dean Heller (R-NV) voted against the bill.  The bill has since languished in the Republican controlled House of Representatives.

To restate the obvious, since the end of July 2012 the Congressional Republicans have made it abundantly clear that they will not accept any tax increases on the upper 2% of American income earners.

Every pundit from Bangor to Chula Vista has opined about the various political implications and ramifications of this GOP position.  If we step away from the Chattering Cable-ites momentarily, we can see that tax policy is (1) a rather blunt instrument by which to manipulate economic behavior, and (2) while a reversion to the Clinton area rates is advisable, there really is more that can be done to better secure fiscal stability.

With all due respect to the mathematicians who have crafted all manner of elegant algorithms to predict economic behavior — even if the entire transaction is computerized there is still a very human element involved.  An algorithm is written with a human purpose.  In this case it might be to automate the purchase or sale of particular “things” at a specific price.  The essential problem with capitalism is that prices are determined by human beings who pre-judge the value of the “things” in terms of their own desires and motives.  The motive might fall anywhere along the spectrum from pure speculation to pure long term investment strategies.

Given this context, consider momentarily the currently popular Republican refrain that if marginal tax rates are “too high” investment will be stifled and economic expansion constrained.   The essential economic question at this point is not how many petulant plutocrats does it take to impede any political action in regard to tax rates — but, at what marginal rate does tax information become a significant factor in the investment decision?

As the chart from the IRS indicates, the marginal rate of taxation on the highest income earners has dropped since the mid 1960’s.  The taxation on capital gains is now below 20%.   The next question: What is the statistical relationship between marginal tax rates and investment?

The Congressional Research Service (pdf) studied the relationship between top marginal rates and private savings ratios and created these illustrations of the data:

If the data points look a bit scattered — it’s because they are.  The CRS drew the following conclusion:

“The bottom charts in Figure 3 show the observed relation between the private fixed investment ratio (investment divided by potential GDP) and the top tax rates. The fitted values suggest there is a negative relationship between the investment ratio and top tax rates. But regression analysis does not find the correlations to be statistically significant (see Table A-1 in the appendix) suggesting that the top tax rates do not necessarily have a demonstrably significant relationship with investment.”

Translation: While the charts tend to lead the eyeballs toward seeing a negative relationship, when we actually crunch the numbers the results could just as easily be the result of good old fashioned chance.

There is a place for anecdotal evidence from financialists whose self interest dictates the championing of lower marginal tax rates as a significant factor in their investment decisions, however it’s not in the midst of a rational argument about economics.   Therefore, investor extraordinaire Warren Buffet’s question remains valid:  ‘If I called you in the middle of the night and told you I had the best investment opportunity ever seen in the world — would you ask me about the tax rate?

This ragged relationship between effective rates on capital gains and the returns investors receive as a percentage of GDP is illustrated below:

The first points to note are along the pink line (circa 1996) when the average effect tax rate on capital gains was 25.5% but the trend line for realized gains was going up.  The ‘conventional wisdom’ held for the period between 1996 and 2000, at which point the trend lines no longer support the contention that lower average effective tax rates mean greater realized gains.  Between 2000 and 2004 the average effective tax rates decline, but so do the realized gains, and from 2004 until the last data available from the Tax Policy Center in 2007 the tax rates remain essentially the same but the gains increase.  Go Figure?  What we could conclude with more certainty is that the tax rates and the realized gains aren’t operating in tandem, and there’s more to “economic decisions” than considerations about marginal tax rates on capital gains involved.   Again, Buffett is probably right.

If reducing the effective tax rates on capital gains isn’t a sure fire way to increase earnings and entice yet more investment, then what about tax rates in general?  That doesn’t quite work either as illustrated by the following chart from Business Insider:

… and we know what happened in 2007 through 2008.  If a relationship cannot be demonstrated between lower capital gains taxes and the gains coming from economic growth AND we cannot demonstrate a relationship between overall marginal tax rate reduction and economic growth, WHY are the Republicans so intent on preserving the tax breaks for the top 2% of the nation’s income earners?  George W. Bush may have stated more truth than he meant when he quipped during the 2000 Alfred E. Smith banquet attendees, “This is an impressive crowd. The haves and the have-mores. Some people call you the elite. I call you my base.”

For all of Senator Reid’s efforts to move the Congressional Republicans into the real world of average Americans, nothing has worked thus far to convince them to abandon frivolous pledges from scions of anti-tax activists, which at this point serve little purpose other than to widen the income gap, and to deplete the capacity of middle income earners to generate the aggregate demand necessary to stimulate the economy.

It really can’t be argued that all economic decisions are dictated by human behavior, but neither can it be successfully asserted that an economy is not essentially a very human institution.   There are reasons well beyond the political optics of S. 3412 for Republicans to give serious consideration to pass the bill in the House of Representatives; it’s good economic policy.

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Filed under Economy, Heller, Reid, Taxation

Attacking Free Enterprise?

It seems as though anyone advocating (1) the regulation of the derivatives markets, (2) the oversight of banking operations, and (3) the reduction of student loan rates is ATTACKING FREE ENTERPRISE… or at least that’s the impression given in the Romney advertising to date.  This might be just as good a time as any to explore what we mean by Free Enterprise in our capitalist system.

Let’s start with what Free Enterprise is NOT.  It is not a license to sell anything to anybody for any reason.  I am not at liberty to sell an unidentified liquid mixture labeled “baldness preventive” if it contains nothing but some water and lanolin. I am not at liberty to promote the sales of flammable pajamas for infants.  I am not at liberty to sell you portions of bridges I do not own.   In short, American Free Enterprise comes with some restrictions which prevent the greedy from exploiting the gullible.

If we move beyond the realm of quotidian consumer products, I am not free to sell you shares in the Reese River Steamboat Company — a river only in the Nevada sense of the term which has been known to flood, but is more often noted by small bridges along Highway 305.  I am not free to sell you my shares in Exxon-Mobil, Inc. because I don’t actually own any.  I am free to borrow some shares of XOM, and short sell them.  Here’s one of the best explanations of short selling I’ve seen so far:

“Assume you want to sell short 100 shares of a company because you believe sales are slowing and its earnings will drop. Your broker will borrow the shares from someone who owns them with the promise that you will return them later. You immediately sell the borrowed shares at the current market price. When the price of the shares drops (you hope), you “cover your short position” by buying back the shares, and your broker returns them to the lender. Your profit is the difference between the price at which you sold the stock and your cost to buy it back, minus commissions and expenses for borrowing the stock.”  [InvestorGuide]

Simple enough — you sell stocks you’re borrowing at a high price, and then buy them back at the newer lower price.  There’s a little rhyme which urges caution in these short sale transactions:  “He who sells what isn’t hizzen, Buys it back or goes to prison.”  There are, however, naked shorts — which do not come in boxer or brief forms — and in these transactions the seller doesn’t have the securities in hand.  The SEC has some serious rules to prevent short sellers from manipulating the market and artificially driving down prices, “requiring that short sellers and their broker-dealers deliver securities by the close of business on the settlement date (three days after the sale transaction date, or T+3) and imposing penalties for failure to do so.”   Back to, “He who sells what isn’t hizzen, Buys it back or goes to prison.”

I am not free to get information about a company that almost nobody else knows  and then use my knowledge to buy or sell Octopus Inc. shares accordingly.  People make frowny faces about “insider trading.” The SEC prosecutes.

In short, even in some of the most complex or technical kinds of financial trading, I am not free to satisfy my greed by taking advantage of  your gullibility.

Vultures and Ventures:   All business enterprises require financing.  The financing depends on the size of the enterprise.  Some individuals start companies by themselves, or by borrowing from family and friends.  Some get start up money from a local bank.  Some get start up funds from very big banks; some rely on Venture Capitalists.  The “venture” investors risk their money on enterprises which they believe will eventually thrive.  Some businesses make it — others don’t — Heaven Help ‘Em they are taking some serious risks.   Some firms  make it, like First Solar, others beset by Chinese “dumping” go the way of Solyndra. [CNN] So, what’s the difference between a Venture and a Vulture?

Vultures do perform a service.  In nature they are part of God’s Own Building and Grounds Department.  However, in financial realms they’re more like raptors than the much maligned Cathartidae.  There were plenty of raptors in the air in the 1980s, the era of the Leveraged Buyout. They’re still hunting.

In the classical leveraged buyout the takeover firm uses loans to accomplish the buyout of a smaller company, and then uses both the assets of the “acquiring company” AND the assets of the “acquired company” as collateral for the deal.   A private equity firm takes the acquired company “private” while it is re-organized and prepared to be offered once more as a “public” corporation.  This is the part wherein most of the bodies are buried.  Departments may be closed, factories shut down, management reorganized, pension funds offloaded, etc. The guiding principle here is Efficiency.

Now we have a problem, because “efficiency” to one person may not have the same meaning for another.  If one espouses the Shareholder Value school of corporate finance, then that company which maximizes value for the Shareholders is the Most Efficient Company.  The higher the share price the better the company.   Enter the issues:  Is this definition of efficiency really the best policy?

At bottom this is a management question.  If Octopus Inc. believes it can manufacture and market the best quality ink for ball point pens by purchasing the best quality ethylene glycol (another reason not to suck on your pen!) AND it takes its position as The Quality Manufacturer seriously, then it’s not really being efficient if the ingredients could be had more cheaply — at the risk of a slightly inferior product.  If Octopus Inc. were the target of Dewey Graspe & Grabbe, would it really be better “economically” should the new management be more “efficient” and procure inferior but cheaper ingredients?

If Octopus Inc. had a very low personnel turnover rate because it offered a good pension plan and paid the best wages in the pen manufacturing sector, and therefore had fewer “customer returns” due to dysfunctional pens, is it more “efficient” to reduce personnel expenditures by eliminating the company sponsored health plan or offloading the company’s pensions?  If we adopt the “efficiency” standard of the Shareholder Value School the answer is Yes.   If we apply another standard including the value of the company to its community, its reputation in the manufacturing sector, its contributions to the overall economic well being of its region — then the answer might very well be No.  Not only is the overall evaluation of a company problematic under the constrained definition of “efficiency” underpinning the Shareholder Value school, but there’s another glitch to be considered:  What’s the Value?

There’s a time and place to meander through the weeds of EMH (Efficient Market Hypothesis) variations, rational markets, and behavioral economics — and this isn’t it.   However, we do need to remember that the Shareholder Value school assumes that the higher the share value the “better” the company.   But, what factors inform the share value?

The stock market does place a price on the equities offered by any company, but does the price reflect the value?   What if our hypothetical Octopus Ink, Inc. has a current share price of $10 per share?  If it were to lay off 200 experienced workers and replace them with 150 inexperienced workers, and the “market” rewarded the firm by pricing the shares at $12, does the price increase really reflect more “value” in the company?

If the answer to the last question is something like, “Hmmm, could be, but maybe not…” then we need to assume that the value of a firm isn’t merely mathematical nor is it just a mirage created by social, cognitive, and emotional factors either.  Taking this one step further, if we aren’t ready to assign value based on price alone, then it’s difficult to argue that the Shareholder Value model is completely informative.  If it’s not completely informative then we’d be better off erring on the side of caution and not assuming that Shareholder Value is the be and end all of economic activity.

Re-enter the Raptors.  Let’s lay off the melancholy and  maligned vultures for the moment and concentrate instead on the private equity Raptors.  If an “efficient” economy is one in which shareholder value is the primary goal of investment, then we’re wedded to a system in which the equities markets determine how we evaluate our economic activities.  Wall Street takes over Main Street and reformulates it in its own image.

What we need to decide, and the election of 2012 is as good a time as any, is if we want to be a nation in which we know the price of everything, but have a more difficult time determining the value of anything.  This is not to attack the notion of “free enterprise,” but to establish the ground rules by which we conduct our transactions.

When freedom becomes license there is the least liberty.  If we minimize our vision of what is valuable by reducing it to a price tag bestowed by mathematical models or a Manic Mr. Market, then we have automatically reduced our economic horizons.  If our “free enterprise” tradition devolves into a free-for-all market in which the greedy are “free” to prey upon the gullible, then we will have exchanged our economic system for economic chaos.  No one would be so foolish as to equate chaos and liberty.

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Filed under 2012 election, Economy, Politics, Romney

Philosophical Stuff: Mortgage Modification in Nevada and the Moral Hazard

There’s always a point at which ideology and reality meet, and if we’re seeking a rational solution to Nevada’s economic problems then reality must inevitably trump ideological concerns.  Nevada governor Sandoval is at this crossroads, and has chosen to direct his administration to explore ways to assist homeowners facing foreclosure.  [LVSun]

One of the problems with supply side “invisible hand” ideology is that it offers only a One Size Fits All to economic issues.   For example, the NPRI’s objections to Governor Sandoval’s suggestion are underpinned by the Moral Hazard argument:

“First, it’s unjust to use taxpayer dollars to subsidize the entities — the individual who can’t pay his mortgage and the bank that made or bought the loan — that are causing the problem. Now, this money is coming from the feds, so at least Sandoval isn’t spending state money. But this interference is still going to make things worse.

By financially rewarding those who are in or near foreclosure, you incentivize other homeowners to flirt with foreclosure and punish those who pay their bills on time. In turn, this depresses home prices, which hurts every homeowner who is doing his best to make on-time payments.”

This argument makes sense, but only superficially.  Yes, people should be responsible for paying off their bills and contracts.  Yes, some individuals made some irresponsible decisions in terms of financing, or refinancing, their homes. Therefore, why should there be any collective response to their individual problems?  To address this question we need to take on some of the illusions of the Almighty Market.

When we strip all the tangential issues away from the troubles in the housing market what we find is that depressed home values have some homeowners “underwater,” if not already drowning in debt.   We’ve come to speak of  value, cost, and price when speaking of the housing market as if these were synonymous.  They aren’t. 

The Basics

The differences in terminology aren’t merely semantic or academic, they go to the core of what we’ve come to believe about how capitalism should work.

For example, the value of a home is not only its market price but also incorporates the protection it affords the family, including the quality of life which can be attained while living in that residence and location.  Part of the value of a home includes the quality of the neighborhood schools, the proximity of parks and recreational facility, and the networks of social relationships in the community.

The cost of a home isn’t measured purely in dollars and cents either.  Paying off the mortgage is only one part of a home’s cost.  There are expenses for insurance, upkeep and maintenance, and improvements which must also be considered in the total cost of a residence.

Now we’re down to the price.  In terms of the housing market, the price of the home is the best offer from an immediate buyer.  So, how does classical capitalism explain how the price is determined?  Back to Econ 101:  The market price is established by the interaction of supply and demand; and, the equilibrium price is that achieved when the demand is equal to the supply.

Here’s where the rubber starts meeting the road.  If the ‘best’ price is one that can be derived algebraically from quantified inputs like how many houses are on the market, and how many people want to buy them, then we would probably not have created the Housing Bubble in the first place.   However, we did have a housing bubble, just as we had a Stock Market Bubble, just as we had a Dot.Com Bubble, just as we had the Savings and Loan bubble, just as we had a Tulip Bubble, just as we had a South Seas Bubble…

We’re Forever Blowing Bubbles

Why? Without getting into all the particulars of each Bubble created, and then pricked, by our markets, they do have one thing in common: A Failure of Judgment.  If we look back to the Housing Bubble we can see failures on several fronts.  Potential homeowners were attracted into the market by a political decision predicated on the Ownership Society as perceived by the Thatcher government in Great Britain:

“She thought the housing would be better maintained, but more importantly she thought that homeowners would become more responsible citizens and see themselves as having a real stake in the future and in the quality of life in their communities.” [Cato]

U.S. policy since at least 1992 advanced the “better citizens through home ownership” theory.  This amalgam of political and economic theory led to the promotion and marketing of the “Everyone Needs A White Picket Fence Around Their Own Subdivision Home” construction boom.  Construction companies were attracted into the housing market with low interest rates for construction loans; banks got into the act with mortgage origination, more banks got into the act with mortgage servicing, yet more banks got on stage in the secondary mortgage markets, bankers enthusiastically joined in the game securitizing the secondary mortgage instruments, joined again by those making sideline bets on those securities, and we Bubbled right along. Where did the judgment fail?

Let’s take one step back before moving this argument further:  In the bad old days a person buying a home got a 20% down 30 year fixed rate mortgage.  In other words, the loan ratio was 80-20, with the homeowner having a 20% stake in the actual ownership of the residence.  Also, in those bad old days, there was more knowledge than information in the pipeline, and we need knowledge to make good judgments.

Before the housing booms (and busts) in the 1980’s and the 2000’s, local bankers and homeowners were practicing the principles of an Ownership Society.  The local banker knew more about the prospective mortgage seeker, knew perhaps not only the amount of his or her income but also may have had a better sense of the permanency of that employment.  Underwriting standards were higher because the bank, which might have kept a significant portion of the mortgages on its own books, had an ownership stake in the process.

The problem in the early 2000’s was that the knowledge accrued by homebuyers and mortgage providers in a previous era was dissipated and diluted into statistics about “units” and “trends” and inserted into algorithms which sought to reduce that knowledge into formulaic whiz-bang fast fodder for investors.  It was the economic version of observing statistical trends on the productivity of horses and applying the conclusions to automobiles.

Information regarding the statistical probability of defaults in the Fixed Rate Era was unfortunately applied to the probability of defaults in a milieu of subprime, Alt-A, no-doc, adjustable rate, pick a payment, creatively financed, mortgages.  In short, we had Information about mortgages, but no Knowledge about how the new products were going to work.  Judgment fails without knowledge.

The failures of judgment can be set at the doorsteps of not only individuals who didn’t carefully consider the ramifications of their indebtedness in 2005, but also at the steps of the financial institutions which were promoting the direct opposite of ownership — liability.  At this point it’s probably a good  time to repeat the maxim that one man’s liability (debt) is another man’s asset, and by the time we got finished distributing the risk of all these liabilities we created a situation in the Fall of 2008  in which ownership was so diluted that it was all but impossible to discern who actually owned what.  We had lots and lots of “information” about the housing market, but frankly speaking, very little “knowledge.”

Prices, Impulses, and Peril

Now it’s time to ask another question relative to the Moral Hazard so feared by the NPRI:  Why would anyone “flirt with foreclosure” and risk punishing those who pay their bills on time?  Why would banks reduce their underwriting standards to accommodate the financial demands of those who would do so?

A simplistic, but unsatisfactory, answer is They Were All Greedy.  Indeed, they probably were, however even good old fashioned human greed has its limits, which are generally reached as soon as a human being perceives good old fashioned danger.  Why didn’t either side of the mortgage equation see the Danger Signs well before the situation became downright perilous?

The answer may come in two parts.  In the first part, people purchased mortgages they thought they could repay, given the information they had at the time.  Received wisdom, aka common sense, dictated that real estate values, which were defined as assessments or valuations and market prices, always increased.  People were lulled into believing that the market price of their property would increase, because that’s what it had always done before — in the bad old days of the Fixed Rate Era.  The idea that 1 out of every 180 properties in the Las Vegas, Nevada metropolitan area would face foreclosure was not just a Black Swan, but a four legged Black Swan with a teal blue head and pale green beak.

The second part of the answer is that bankers were also operating under the delusion that the statistics of the Fix Rate Era were applicable to the ARM Era.  However, there is another facet to this element of the discussion.  The promotion of adjustable rate mortgages and other financial products contributed to an overall decimation of actual ownership.

How does putting people into homes with 0% down payment “decimate” actual ownership?  Because — 0% means they had Zero actual ownership of the property.  The figures from the Fixed Rate Era showed that individuals who had from 0% to 5% ownership in properties were more likely to default than those who had 20%.   Worse still, homeowners were invited to take out home equity loans — “Pay for Educational costs, Medical expenses, Vacations…” which further eroded the actual ownership of the very real property.  Chickens do come home to roost, and they have in Las Vegas.

The recent CoreLogic report explains:

“released negative equity data showing that 10.9 million, or 22.7 percent, of all residential properties with a mortgage were in negative equity at the end of the first quarter of 2011, down slightly from 11.1 million, or 23.1 percent, in the fourth quarter. An additional 2.4 million borrowers had less than five percent equity, referred to as near-negative equity, in the first quarter. Together, negative equity and near-negative equity mortgages accounted for 27.7 percent of all residential properties with a mortgage nationwide. In the fourth quarter, these two categories stood at 27.9 percent.”

[…] Nevada had the highest negative equity percentage with 63 percent of all mortgaged properties underwater, followed by Arizona (50 percent), Florida (46 percent), Michigan (36 percent) and California (31 percent). The negative equity share in the top 5 states was 39 percent, down from 40 percent in the fourth quarter. Excluding the top 5 states, the negative equity share was 16 percent in the current and previous quarter.

Las Vegas led the nation with a 66 percent negative equity share, followed by Stockton (56 percent), Phoenix (55 percent), Modesto (55 percent) and Reno (54 percent). Outside metropolitan areas in the top 5 negative equity states, the metropolitan markets with the highest negative equity shares include Greeley, CO (38 percent), Boise (36 percent), and Atlanta (35 percent).

No surprise here, the numbers for the Las Vegas, NV area were among some of the worst in the nation.   Thus much for the “common knowledge” that real estate prices never fall.  We had all manner of information about the stock prices of home construction corporations, and copious amounts of data about bank equities, and even more information about default rates than anyone should have needed — but we didn’t use our judgment based on our knowledge of economic bubbles to avoid the Housing Bubble or its collapse.

The moral hazard argument might apply IF home owners and bankers KNEW that the products they were selling and purchasing were inherently dangerous, and were underpinned by dubious information and suspect analysis.  We certainly don’t want to reward irresponsible behavior, but the mortgage purchasers thought they were getting “good deals,” and the bankers thought they were spreading the risk so no one was imperiled — in the end the mortgage product purchasers were underwater, and the bankers had only succeeded in spreading a contagion to everyone in the entire financial sector.

Systemic Problems Need Systemic Answers

It’s entirely too simplistic to insist that the Mighty Invisible Hand of the housing market will magically redress all the issues in the aftermath of the housing bubble collapse.  The Invisible Hand theory assumes a market with accurate information upon which reliable assumptions can be made.  In the recent housing catastrophe there was plenty of information, bits and pieces of data swirling through the bank computer algorithms, but there was obviously a paucity of knowledge about the actual condition of the economy.

The Invisible Hand works best when it’s guided by very human ones.  There is a large difference between a Free Market and an Efficient Market.  What the NPRI is implying is that an efficient market can replace human judgment with statistical manipulation, the “numbers will right themselves” if we are all just a bit more patient.  To argue that financial markets should be free of all government intervention is to ignore the fact that government is one of the financial market’s biggest customers.  Investment institutions on Wall Street were falling like dominos — some, like AIG weren’t “bankrupt” in the classic sense of the term, but they couldn’t prove to other financial institutions that they weren’t what is politely called “insolvent.”

When 10-K reports to the SEC were questionable at best during the Boom and Bust, and almost fraudulent at worst, or when balance sheets were composed of more fiction and hopeful thinking than accurate data, it would have been the height of folly NOT to have the financial sector’s biggest customer (government) step in to restore some sanity in the system.

It can be cogently argued that what failed during the last housing bubble collapse was NOT morality, but judgment.  Consumers, institutions in the financial sector, and government regulators, were all dancing to the same tune.  Unfortunately it was a Siren’s Song.  When we assume that an efficient market bolstered by elegantly scripted algorithms is a better system than relying on good old fashioned and very human judgment we are all headed for trouble.

As if to put a layer of icing on this notion, consider the study of the Housing Bubble Collapse of 2008 by the Cleveland Federal Reserve.  The study debunked ten simplified explanations, or myths, commonly cited as causal factors, and concluded:

“Many of the myths presented here single out some characteristic of subprime loans, subprime borrowers, or the economic circumstances in which those loans were made as the cause of the crisis. All these factors are certainly important for borrowers with subprime mortgages in terms of their ability to keep their homes and make regular mortgage payments. A borrower with better credit characteristics, a steady job, a loan with a low interest rate, and a home whose value keeps increasing is much less likely to default on a mortgage than a borrower with everything in reverse.

But the causes of the subprime mortgage crisis and its magnitude were more complicated than mortgage interest rate resets, declining underwriting standards, or declining home values. The crisis had been building for years before showing any signs. It was feeding off the lending, securitization, leveraging, and housing booms.”

Amen.  No single subject comprises the proximate cause of the entire debacle. No single facet of the situation posed a proximate cause of the collapse.  It seems to have been a failure composed of all the mentioned elements exacerbated by input from the processes themselves — or, again, a failure judgment in contrast to a failure of responsibility or morality.

If we now find the moral hazard argument to be (1) entirely too narrowly focused, (2) unconnected to the systemic issues inherent in the creation of bubbles, and (3) unhelpful in framing a systemic response to a systemic problem, then why not allow Governor Sandoval (or indeed any other agency of governance) to attempt to reintroduce some judgment into the possible solutions?


Recommended reading: Federal Reserve Bank of Cleveland, “Ten Myths about Subprime Mortgages,” 7/23/09.   CAP, “Housing Refinancing Reforms Still Needed,” 11/22/11.  The Economist, “Financial Economics: Efficiency and Beyond,” 7/16/09.  The Motley Fool, “A Stupid Idea That Deserves To Die,” 11/3/11.   Federal Reserve, “Re-Balancing the Housing Market: Lessons Learned,” 9/1/11.  FDIC testimony “Challenging Environment for FDIC Institutions,” 8/16/11.   FDIC, “The Challenge Posed By Short Termism,” 6/24/11.   Senate Permanent Subcommittee on Investigations, “Financial Crisis Report, (pdf) 4/13/11.  Brookings, “Developments in the Housing Market,” 12/12/11.   Brookings, “Telling the Narrative of the Financial Crisis,” 12/14/11. Brookings, “Geographical Differences in Price Changes and Negative Equity, 11/29/11.  EPI, “Wide Impact Of The Housing Slump,” 8/29/06.  CEPR, “Clearing the Air on Too Big To Fail,” 10/17/11.

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Filed under Foreclosures, housing, Nevada economy, Nevada politics, Sandoval