Here’s Another Nice Mess You’ve Gotten me Into…

For the past 20 years, my company has been designing mission critical software for some of the most recognized brand-name companies in this country. During that time, I have been privy to hundreds of business plans, and have seen many examples of ventures, and can identify prominent features that were common to the plans which succeeded, and other features which were common to the ones which ultimately failed. Prior to founding the company, I have held very visible economic posts in leading Wall Street investment banks, and as commodity economist for one of the nation’s leading producers of consumer goods. So I am considered well experienced and well qualified to comment on our current economic situation.

The prominent proximate causes of our current economic situation all can be grouped into one: unsupervised speculation on a grand scale using other people’s money. Used to be that local S&L institutions accounted for the majority of home lending. Little S&Ls like Mr. Potter’s in ‘It’s a Wonderful Life’ would assess the credit worthiness of a local homeowner or farmer, and lend its capital to fund the endeavor. They knew the borrower, and could keep tabs on his ability to repay. It was the S&L’s money, so if the borrower faltered, the lender could step in immediately and sell the property and recoup their assets, or help the borrower to make good on his load. More importantly, the lender, because his own money was at risk, took particular care to see that this was a good investment for him! Over the past 20 years or so, somebody got the idea that the banks and S&Ls could bundle those loans, and sell them on the open market. That would allow the S&L to make more loans with the proceeds, and if the market for these mortgages were liquid enough, the investment banking community could make money trading those packages of loans.

Once upon a time, the investment banks were all private partnerships: Bear Stearns, Goldman Sachs, Merrill, Paine Webber, Kidder, Drexel Burnham, Lehman Bros, – all of them were partnerships, capitalized exclusively by the wealth of the partner-owners. Starting roughly in the 1980s, those partnerships began to disappear, as the enterprises needed more capital to fund the expansions of their forays into the capital and private equity markets. Junk bond trading added leverage to the mix, and soon these guys were making money like never before. There was so much money to be made that lucrative arrangements were made withthe traders, who carried home at the end of each year, a significant portion of their profits, aided by the leverage and access to capital provided by their employers.

Enter stage left, the government. Under the Community Reinvestment Act, passed under President Carter, and later augmented by President Clinton, the government embarked on a program to extend home ownership to people with lesser amounts of capital. The mortgage packages referenced earlier that were sold by the local S&L institutions were guaranteed by Freddie Mac, and Fannie Mae. And, as a matter of fact, the executives of these quasi government entities had their compensation arrangements changed, so that they were paid based on the volume of loans they processed, rather than on the profits of their institutions. The Fed made the cost of capital cheap by keeping interest rates low.

So now we have a perfect storm:
A whole new class of buyers are enabled and rush to buy houses with cheap, almost guaranteed mortgages using other peoples’ money.
This creates a significant inflation in the value of houses.
The housing inflation attracts speculators like sharks who buy multiple houses to flip them for a profit – using other peoples’ money.
The housing inflation prompts other homeowners with a little more capital to take out homeowner loans and buy Cadillacs or whatever- using other peoples’ money. They are enabled by the artificial and temporary increase in the valuation of their homes.
The S&Ls and making money hand over fist- lending money to anyone who can fog a mirror, then flipping those mortgages through Freddie to the investment banks – laying offtheir risk to other people.
The investment banks are trading up a storm and making a ton of money- using other peoples’ money. And so are the traders- using other peoples’ money.

And even us guys sitting in the bleachers are pleased as punch to see the value of our houses soaring. We’re high-fivin’ each other at our kids’ soccer games and at cocktail parties – all thinking about how smart we were….

Until housing prices peaked, and Bear and Lehman failed. (Technically only Lehman failed. Bear was ‘rescued’ by a shotgun marriage.) Those events brought about the credit spasm in September 2008, and have set the stage for further disasters to come.

The credit crisis has now spread into other industries – housing, investment banking, banking, mortgage, automotive, applicance, etc. And now that the housing market is 20-50% below where it was just a few years ago, there are many houses ‘under water’- that is worth less than the money advanced to buy them. In some cases, homeowners are abandoning their houses rather than pay their mortgage.

The key question now is how to untangle this mess.

Should unwise buyers be protected? The arguments for this are that liquidating the houses under water at fire sale prices would depress other adjacent housing values, and that these are the least able to afford a foreclosure.

Should the mortgage holders be protected? The arguments for this are precedent, and the rule of contract law, which is the basis for business transactions around the country and around the world.

Should BOTH be protected? Should the government use taxpayer funds to bail out certain holders. This will cause a huge burden on the treasury, and on the obligations of our children and grandchildren. And it would set a very bad precedent.

Choices 1 and 3 will inevitably lead to a longer and more protracted, though not as deep housing slump. Choice 2 will lead to a sharp decline in housing prices, as a large ownership migration takes place almost immediately. But all other things being equal, there should be a sharp rebound in housing values once the flush is completed. But then again, other things rarely ARE equal.

A similar quandry is being faced by the GM bondholders at this moment. Should they step aside and settle for a small percentage ownership of GM, or should they assert their right of precedence in the liquidation of GM?

I hope they choose the later. Because if they do not, it will deal a cruching blow to our credit markets. If they are steamrolled into abrogating their rights under the debt covenants they hold, the markets appetite for corporate bonds will dry up like a raisin in the sun. Already the treasurer of Indiana pension funds is thretening to unload and refuse to buy the bonds of any company with a union presence. That would be a VERY disturbing omen!

Trending Articles