Scott's random rants....the economy how we got here

"How a man in a cave in Afghanistan caused America
to overreact and commit economic suicide"

Lets' go back to early 2001.   The Tech bubble had already popped and the economy was in a mild slow down.   The Tech heavy Nasdaq composite was off its highs of 5000 with no bottom in sight.   The bull market of the late 1990's was fueled by ever increasing productivity improvements in businesses and factories due to the ever increasing application of computers in all areas of industry.  No doubt speculation in the market was driven by the speculators' ability to borrow funds on margin from their brokerage house to buy stocks.   Federal regulations allow speculators to borrow money from their broker in equal proportions to their own capital.    If you have $1,000 in your brokerage account, you can open an margin account and use that to borrow an additional $1,000  from your broker.   This was called "50% margin" or a leverage of 2:1.   Even thought Alan Greenspan and the Fed knew there was ramped speculation in the stock market or "irrational exuberance" towards the end of the Tech bubble, the Fed did not exercise its power to change the margin standards to reduce the amount of borrowed money that was chasing stocks higher and higher in the late 1990's.  So Alan Greenspan's first big mistake was not to slowly raise margin requirements as the "irrational exuberance" became more and more obvious to everybody.   Greenspan had the key to stopping the "irrational exuberance" bot chose not to use it.   

This is an important fact since the 1920's stock bubble was disproportionately fueled by borrowed money.  However back then speculators could borrow several times their capital for speculation in the market.  In the 20's you could borrow $100 for only $10 in personal capital.   The leverage ratios back then could have been 10:1.   After the stock market crash, excess leverage was assigned as the main cause to ballooning stock prices and their subsequent credit crash leading to the great depression.   This then lead to the Federal Reserve being given the power to set margin ratios for the stock market, as a braking function.   Some brokers will set margin requirements higher at their own initiative for more speculative investments too, since they are on the hook if their customer goes belly up and cannot pay their debt obligations.  The moral of the story is that America learned from the fact that excessive leverage in the stock market can lead to instability and an economic crisis.  

Fast forward to the falling stock market of 2001 and remember the fact that some towel head in Afghanistan crashes two commercial airliners in the world trade center.    The Fed now reacting to the on-going slowing economy from the Tech bubble and potential panic situation from the 9/11 attacks, floods the system with liquidity and keeps interest rates low to prop up the economy.  Low interest rates are kind of like an antibiotics for an economy with an infection.   They can help the patient get well.. 

Due to globalization and the rise of China, inflation in the United States was held in check.  This prompted the Federal Reserve to maintain an easy money policy to promote growth since excessive inflation was no where to be seen.   In response to the 9/11 attacks, government increased deficit spending on  the George Bush's private war in Iraq, in revenge on "the guy who tired to kill his Dad", and new agencies to protect us from terrorism.      The resulting trade deficits were being circulated back into US debt by the foreigners looking for a place to invest their excess billions.  

As interest rates fell, residential property became more affordable to many more people.  The theory being, when interest rates fall, then the interest portion takes up a smaller proportion of your mortgage payment.  It is even possible to afford an even larger mortgage principle if you wanted to upgrade properties.   As interest rates fell people could afford to "keep up with the Jones" and buy ever larger McMansions.  Prices rose steadily as the demand for housing increased due to lower interest expenses, and increasing purchases of "investment properties".   Ever increasing home prices created a speculative demand push inflation spiral that increased home prices in many markets to double digit growth rates.    People were now buying two or three properties, which they would rent, and wait for the inevitable price appreciation to double or triple their down payment investments.  The ideal situation would be to rent the property for the mortgage payment and wait a few years and triple or quadruple your down payment.   Other people were also afraid that spiraling properties would shut them out of the market later, so they bought what they could as a hedge against the rising prices.   The advent of mortgage equity withdrawals allowed speculators to "double-down" and buy more properties using the appreciation from older properties to finance the down payments on new properties.     This really trumped up the leverage ratios.   In a could of years an appreciating market a good real-estate speculator might have leveraged his original down payment to control properties costing 20 to 30 times his down payment. 

The real estate speculation game was really pretty easy at the time and you had a lot better leverage than in the stock market.   Think about it.   Put 10% down and you can borrow the other 90% from your bank.  That was a 10:1 leverage ratio, just like the stock market of the 1920's.   Put 20% down and you still have 5:1 leverage.  You could only get that kind of leverage before in the stock market in the 1920's.   If your real estate appreciated 10% a year, then your 10% down payment was at least doubling every year.    That is a 100% annual return for the first year and not a bad investment at all.   No wonder the real estate market was on a tear! 

Let's go back to the Savings and Loan crisis in the late 1970's and early 1980's because this is an important event leading up to today's problems.  The Savings and Loan (S&L) industry was thrown into a tailspin due to the high inflation and interest rates of the late 1970's.    In an era of stable inflation banks and S&L's lent money for the mortgages themselves.   They were able to attack short term deposits. paying a lower interest rate than they would get on their long term loans, such as mortgages.   This game worked for quite awhile, at least until inflation in the 1970's skyrocketed.    Unfortunately for the banks and S&L's, the depositor's money was only tied up for the short term; either in daily deposits or for up to a few years in certificates of deposit.   The mortgages they wrote were however for up to 30 years.   As soon as inflation rose, banks and S&L's had to pay the ever increasing prevailing interest rates, or they would loose their deposits and their source of funds for loans.   Soon the banks and S&L's were paying more in interest to attract deposits than they were earning on the old mortgage loans they had outstanding.    This put them in a serious financial bind resulting in the Savings and Loan crisis.    Being the holder of a mortgage is not really a good situation, in my opinion.    If interest rates rise, then people do not pay off their mortgages early and you get stuck with the below market interest rates.    If you make the loan in high interest times, then when interest rates fall, you will not benefit from the above market rates since people will pay off their expensive loans and refinance.   Holders of mortgage securities.take the risk of rising interest rates, but lose the benefit from falling interest rates. 

The end result of the S&L crisis was that lending institutions had to learn manage the "duration" of their loan and deposit portfolios to minimize their risk to interest rate changes.   When the duration of the loan and deposit portfolios are equal then the institution would be hedged on their interest rate risk.   However, since individuals are not ready to make a 30 year deposit at their local bank or S&L, these institutions had to find investors who were willing to tie their money up for a long period of time.  This lead to the development of the mortgage backed bond market.  Basically these mortgages would be bundled up and sold in lots to groups of investors that would take the long term interest rate risk for the banks and S&L's.   There was always a market for long term bonds from pension funds, bond mutual funds, and hedge funds.      

The banks and S&L's eventually turned into mortgage origination and servicing centers, and let the real financing be done by the mortgage backed bond market.    Unfortunately with the decoupling of mortgage origination and the end source of the financing, it was increasingly fraught with mismanagement, lax lending standards and even fraud.   The borrow and lender were so decoupled, that the lender really had no idea how credit worthy the borrowers were and how much the properties held as collateral were really worth.   As soon as a unscrupulous mortgage broker unloaded his questionable pool of mortgage debt on the bond market, it was somebody else's problem to worry about.

So you know the rest of the story.   The artificial wealth that comes with easy credit and debt has simply evaporated.   The collateral for the mortgages evaporated.    People started to understand how credit unworthy many borrowers were.   Of course the government helped the situation by putting unqualified people in houses by having programs to increase home ownership among unqualified buyers.   

What I cannot understand is that our "wise and learned"(?) economic leaders stood by and watched as the bubble formed and did nothing to contain it.  In fact they helped fuel the fire.   It seems when assets are inflating in price there is nothing remotely to be concerned with, but when assets fall in price then they seem to be all concerned.    The Government is really clueless about the whole situation.   The Government helped fuel the fire by having HUD encourage Fannie Mae to make subprime loans to increase home ownership to the poor, and by giving capital gains tax breaks on home sales.   Now with the markets collapsing and people saving to pay off debts, the Government wants the drunken consumer to never get sober and keep spending mindlessly money that they do not have. 

What can we learn from this mess? 

The leverage available to the general public for speculation has to be limited.    Just like in the stock market, where you can no longer use excessive leverage, the real estate market needs to have clear rules to prohibit bubbles originating from too much leverage.    In the 1920's you had Joe the plumber speculating in stocks, and in the the 2000's Joe the plumber was speculating in real-estate.  The problem and the end result will be the same, they just speculated with different assets in 80 year intervals.   Home ownership is a risky proposition, and just like investing in stocks, is not for everyone.    In Germany where all finance matters are more conservative than in the US, you can't buy a house for less than 20% down.   Most mortgages are much shorter in duration, and there are clauses in the loans to discourage early payoffs of the loan with interest penalties.   Most German mortgages carry clauses that if the market price falls, then you might be required to put up more money on the loan to bring the equity back up to 20%.  That would be essentially a margin call, like in stocks, on the real estate market. 

Mr. Nader blames the securities markets, but they were in fact only put in business by the Federal Reserve's easy money policy, the government's approval of ever inflating asset prices, and the millions of citizen speculators who dabbled in real estate speculation.      

These are historical economic times.   They only happen once every eighty years.