Tuesday, March 24, 2009

Thoughts on the Economy

I haven't really shared too many of my thoughts on the recession and it's causes, so I'm putting up this post, just to give a little more of my take on it all. It might be a little rambling, but bear with me... If nothing else, jump to the end and read the last little bit. That's probably the best part...

Working at Legal Aid, I see a lot of people who have been most affected by the the situation, whether through loss of job, foreclosure, debts, or other hardship. It's a really tough, sad situation. I am frequently a last line of defense for people, and a lot of times there's just nothing that can be done to help. It's a frustrating thing, especially because so often the people who are coming in are really victims of the system. Sure, there are occasionally people who are spending beyond their means, and who have gotten into hard times as a result. But the vast majority are not in that situation. A lot of people were coerced into making bad deals.

The phrase "toxic asset" has been used a lot to describe the bad investments that are held by all of the financial companies. One of the things that I feel gets overlooked is what these toxic assets are: bad deals. These are loans that were made that buyers can no longer afford to pay on (or are predicted to default on, even if they're still paying). They were often loans made at ridiculous rates (10% or higher), with adjustable rates (that only adjusted up), large balloon payments and other mechanisms designed to strip equity from homes and ensure that buyers were paying out far more than they would normally have to. These were largely targeted to subprime buyers, but a lot of the same mechanisms made their way into prime mortgages too.

The thing is, these are loans that were sold. The banks were willing to lend money, and wanted to do so at the highest rates possible. To that end they designed a series of products that unfairly targeted buyers, that were designed to increase rates over time, and make sure buyers weren't paying off principle (and thus were paying even more interest). If you want to know more about these products, I could go into great detail. Basically though, they were very carefully constructed to confuse the heck out of people to make sure rates stayed as high as possible.

Further complicating the matter was that the banks that made the mortgage almost always immediately turned around and sold the ownership of that mortgage to a different bank. The selling bank was getting a good deal because they were getting paid upfront. Sure, it wasn't the entire value of the mortgage, if they stuck it out over the long term, but they were getting a big chunk, and none of the risk. So for the selling banks, volume was the key issue. The more of these mortgages they could make, the better off they were. So they sold and sold and sold, and did very little to make sure they were being smart about their sales, because they knew they wouldn't face any of the risk.

At the same time, the buying bank thought they were getting a good deal because this was a "secure" investment (they'd own the home if things fell through) paying off at a very good rate (10%+ is very good), and they usually had other protections (this is where we get into credit default swaps and the like, which I know less about). Another of the great things about being the purchasing bank is that you couldn't be held responsible for anything the selling bank did wrong. There are, in our laws, "safe harbor" provisions that provide that a purchaser for value (the second bank) can't be held responsible for the fraudulent acts of the seller (the first bank), unless they knew about the fraud. Those laws meant that purchasers didn't want to know anything about the riskiness of the mortgages they were purchasing, since if they did maybe they could be held responsible. So neither the first bank nor the second bank cared about the risks they were facing.

Making things even worse was that this whole system was greased by brokers, who connected the first banks and the home buyers. Brokers made all of their money by commission, so the more volume of mortgages they sold, the more they made. Plus they got paid kickbacks by the banks to make sure people took out higher rate loans. So if you could get an 8% loan, your broker would lie and tell you he could only get you a 10% loan, and then he'd get as much as half the difference (I think I remember seeing half... don't quote me on that. Whatever the amount, it was a big kickback).

Anyway, between the banks and the brokers, home buyers were sold heavily on these mortgages. People who already had homes were convinced to refinance, and often lost a lot of equity as a result. People who didn't have homes were put into mortgages much worse than they should have gotten. And people who had no business owning homes were coerced into making bad deals (often because brokers flat lied, both on the documents and to the buyers... I have so many stories... Yes, some people were willfully blind, but not the majority I've seen).

The point behind all of this is to look at what went into developing these toxic assets. They aren't just bad investments because the people who took out the loans can't and won't pay - they're bad investments because they were created for the wrong reasons. These were mortgages designed and sold in such a way that they couldn't be paid off. The point to selling these mortgages wasn't to make money in the long term, it was to make money in the short term. The vast majority of them couldn't even properly be called investments, since there was so little chance at long term payoff. We're seeing now that these are toxic assets, and that's causing banks and insurance companies all sorts of problems. But the reality is that these were created as toxic from the start.
As far as "retaining top talent" goes, I don't have a lot of fear about losing it. I mean, if this situation is what the top talent got us into... I know that's a bit short-sighted, but I think the point is ultimately that we can't just trust that the people who have been identified as top talent truly are. Bonuses should be merited, not contractual. And when our top talent is letting us down, it's time to either retrain that top talent or replace it. Just because someone comes out of a premier business school or worked for a premier finance firm doesn't mean they've got a premier mind - it just means they were given a premier opportunity.
One of the big concerns is how much our economy has "shrunk". My economics classes are well behind me, but I wonder if using that word is appropriate. It seems like so much of the wealth that has been lost was just paper wealth that didn't actually exist in any sense other than perceived worth. There's a certain temptation to fall to a different extreme, in which the only "real" wealth is thought to be tangible - almost a Marxist ideal of the worker being the only one who really produces anything of value. I reject that idea, and I think investment is a very good and necessary thing, but that doesn't mean there isn't something to be learned here.

It's much easier to appraise the value of work than it is of investment, because an investment really only is worth anything when it is cashed in, whereas work creates something new. I think the point that needs to be made is that we need to be more diligent in our appraisal of the worth of investments. When you've just got paper wealth, it's easily erased (and easily expanded, which is largely the problem). Is there some sort of external check that can be placed on the evaluation of investments?

Did this section make any sense? I don't quite know... it kind of does to me, but again, I'm a ways out from my econ classes.
Finally, I think one of the biggest concerns is "where do we go from here". A lot of people are calling for all sorts of economic regulation. A lot of people are reacting very strongly against that call, and arguing against any regulation.

I think one of the important things to keep in mind is that ultimately this wasn't an economic failure so much as it was a moral failure. People were blinded by desire and induced by greed into unethical, impatient, and unwise decisions. Bad contracts were made, there was lots of fraud, people prized short-term gain over long-term growth, and any number of other problems. Some very specific regulations aimed at particular bad behaviors (like prohibitions on the yield spread premiums or specific types of fraudulent contracts) or trouble spots (like much more narrow safe harbor provisions) or designed to induce good behaviors (rewards for long-term investment, penalties for short term, etc.) could have a very positive effect.

I'm hopeful that targeting bad behaviors is something that a majority of people could get behind. We want to encourage people to approach our economy in thoughtful and creative ways, that see new options for growth. We just also need to make sure that responsibility, wisdom, patience, and ethics all play a bigger role in our economic life.

Now you, you'll graduate and you think you're going to move out now
I will congratulate you as soon as you pay your own way


Mike said...

Amazingly, I'm actually going to agree with you that much of the failure here was "moral". I'm wary of broad sweeping regulations, which tend to encompass more than they intend, but even as a quasi-libertarian I'm open to discussion of targeted regulation. Ultimately, though, I will defer to those who have greater economic knowledge than my single macroeconomics course gave me. Except that I will continue to rage against rampant deficit spending.

Jeff said...

What I wonder is this - why don't the new owners of the mortgages, now that it's clear that housing prices are declining and so having that mortgage turn into a house constitutes a loss, renegotiate the mortgages that are in trouble so that payments can continue? Seems like that's a win-win situation all around.

Maybe that's why I'm not "top talent..."

Matthew B. Novak said...

Jeff -

Each bank is treating the situation differently. What I'm seeing a lot of now is "repayment plans" where a bank gives a homeowner a couple months of what is essentially a test modification, and then if they make good on that, they give them a full modification.

Part of the reason not enough renegotiation is going on is because banks refuse to do it with people who are still paying their mortgages, and since just about everyone pays their mortgages if they can, the only people "eligible" for modification are people who don't have jobs. And if you don't have a job, it doesn't matter what your payment is, you can't afford it. So then those proposals get rejected.

Plus, the banks are often still thinking short term. Foreclosure gets them an asset where they previously had a potential liability. Banks only care about what looks good on their books. It's my understanding that there are serious accounting issues that go into these decisions, and that helps keep people focused on the short-term.