Bubble Economics

This is a response to a friend who wanted to know what I read and where I got information about an economics discussion (which had continued far too long) following a post he made which was a letter he wrote to the Republican National Committee re: why he was no longer playing with them. Among the respondents was one particularly ignorant man who had far too any misconceptions to list here, but to whom my previous post relates.  My friend, opining that I had sliced and diced him, then asked: Mike. What are you reading? You have been cutting xxx xxxxx a new one for days now, and this is the stuff about which I wish to know. What are your books?

My response:

    This is largely just off the top of my head, xxx, I was a Government/Economics/history (World and AP US) for 20 years after leaving the NAVY, which, bless the GI Bill's heart, put me through two BAs and a MS in management. What stuns me is that absolutely nothing I've told that guy is obscure or difficult to grasp or to document. I just noted this morning that he's a mortgage broker. He isn't the first person in that field that I know (I sometimes play golf with another one) to seem almost to be bending over backwards to deny the critical role that under-regulation of financial markets played in causing the bubble collapse. It's sort of like a pimp blaming hookers for his bad rep.

         The Clinton administration believed home ownership was a positive factor in a healthy economy at a time when many lenders (banks as well as independent brokers) axiomatically “red lined” (denied loans to) certain ethnic groups, based, not on their individual ability to pay, but on where they lived or their race, etc. The Clinton initiative - "encouragement" to stop this blatantly unfair lending practice - became an excuse (based on potential profit) to some, but not all, in the industry (banks, realtors and brokers) to simply sell/loan to anyone who walked through the door. Adding to this incentive for mortgage brokers especially, was the belief that these mortgages, risky or not, or a least a  majority of them, would be resold before any risk of default came back to the original lender.

        In truth, many of these mortgages were sold very soon after closing to other financial institutions as investments. (I pay you, then I get to collect the $200,000 (or more) in interest over the life of the loan!) By 2004, an early “what if” report came from economist Paul Kasriel of Northern Trust, a nationwide wealth management corporation.  It was probably the first report pointing to the potentially disastrous effects of a collapse in housing on financial institutions and dates to July 30, 2004. He noted that 60% of banks' earning assets were mortgage-related--twice as much as was the case in 1986. What made this so bad was the extra step, which was considering these for investment purposes, as real money -that is, that you could lay it down and when you picked it up later it would still retain the same value. Another "twist" was "bundling” these, essentially making one big instrument out of many mortgages, some "good” loans, some “fair”, and some really, really, bad (risky) loans issued to naive buyers who were told, in many cases by a realtor and mortgage broker in tandem, that the property  would continue to appreciate and they'd "be way ahead" in a year or two. Property values always go up, right? Yeah, until they don't. At the edge of the collapse you had some who "owned" (had mortgages on) several condos, bought as investments with almost no true collateral. When prices tanked, these folks were “upside down” (or “under water” either sucks) in three or four properties.

        Meanwhile mortgage loans of all levels of “quality,” for want of a more descriptive term, were being “bundled” as one financial instrument. These bundles had several tranches, or tiers, of loans, themselves bundled. These bundled promises to pay, like all securities sold as investments, were submitted to a rating agency and assigned a value rating, which is sort of like setting the odds that they’re worth what is asked, on a risk basis. These ratings go from rock solid guaranteed (AAA+) - “investment grade” - all the way down to D-. Anything lower rated than a Baa is generally considered speculative and not investment grade.  Although there might be a tranche of AAA loans in a given mortgage bundle, many had even more B, C, or even D rated (highly speculative, not investment grade) tranches also.

        Not to worry, though because all the owner and prospective seller of these bundles had to do was get the entire bundle rated as investment grade, (AAA or AA) irrespective of the shitty, high risk tranches which comprised as much as half or more of the bundle. Unfortunately, here’s where the guys who didn’t get punished nearly enough come in. Almost all financial investment products rated in the US are “risk assessed” and rated by Standard and Poor, Moody’s or Fitch, all of whom perform this service, supposedly a realistic, good faith, analysis of the likelihood that, as long-term investments, they are good investments for State pension plans, Municipal retirement plans, and even big individual investors or Brokers as resale paper.

        Sadly, S & P, anxious to keep the business of large commercial banks like Bear Stearns, Lehman Brothers and AIG (who insured a lot of these investments…..see the need for reasonable regulation yet?) rated far too many of these bundles far too high (fearing the bank would go down the street to Moody’s or Fitch?) and thus they were bought and sold as if they were gilt edge securities. The more these sold, the more even  sketchier, and lower quality, bundles hit the market, until one day, some guy, somewhere, said something like “Hey, what are we doing here? These aren’t worth anything close to what they’re selling for if housing prices don't always go up.

        The “bubble", which had peaked in 2006, began to “leak” by year’s end, and the worst hit on December 30, 2008, when the Case–Shiller home price index reported its largest price drop in its history. An example of what was contained therein is offered here to give a sense of scale: Median home prices in California’s Monterrey County, an already high cost of living area, were $799,500 in August of 2007. By November of 2008, 15 months later, they were $275,000, a drop of 65.6 %!   Sadly, this was reminiscent of Black Thursday, (October 24, 1929), when panicked sellers, having had similar “oh shit” moments, dumped nearly 13 million shares on the New York Stock Exchange (more than three times the normal volume at the time), and investors suffered $5 billion in losses. Almost immediately, persons who, for example, were paying on an $800,000 mortgage for a house now worth only $400,000, simply walked away, their mortgage now just more paper with little value.

        And, finally, back to the original question. While several good analytics have been made of these events, a fairly readable version is “The Big Short.” I’d read the book for understanding, then watch the movie. Much of what I told our “friend”, xxxxx, is mandatory 12^th grade Economics in Florida. It’s a 1 semester required course, which, sadly, still focuses too much on Micro and not enough on Macro, but a good course will discuss “trickle down,” “supply side,” The Depression, and, I hope by now, the background and causes of the Great Recession. I covered the economics of the depression in US History as well.

There is an Arab proverb which starts, “He who knows not and knows not that he knows not is a fool; avoid him.”  Sadly, for purposes of this discussion with xxxxx, we need go no further.

       Hope this answers your question. By the way, my late brother, Steve, always said you were a swell guy for a five string bass player. That last part was just gratuitous joshing; be well, my friend!.