Every newspaper I open, and every news broadcast I see, the
last few days, more or less morbidly or hysterically predicts "a recession," the
end of the world, a terrible disaster for America, and all that. The economy is
a shambles, of course, since unless it is a shambles the news anchors have
nothing to hyperventilate about. If it bleeds, it leads, whether it's a human
body or a vast abstraction we call "the economy," which is really nothing but
the sum total of every economic transaction everybody in the country does every
day. What they foregt to say is that in a $14 trillion economy like ours, even a
$140 billion write-down for bad loans only writes down 1% of the value of the
current-year economy, and a far smaller fraction of the hundreds of trillions of
dollars of total asset value in America.
A "recession," acccording to generally accepted economic ideas,
happens when an economy has a negative growth rate (that is, it shrinks) for two
or more consecutive fiscal quarters. Production goes down, employment goes down,
incomes go down. A slowdown from a growth rate of 3% to 1% is not a recession. A
true "recession" is when the growth rate falls below 0%, and the economic
activity in June is actually less than it was in May.
There haven't been many true recessions in the United States
for a long time, although there have been some long slowdowns that felt like
recessions to the people who got cut back or laid off. Economists debate whether
the 2000 recession that followed the burst of the dot.com bubble was a true
recession, or the 1990 recession triggered by the junk bond crisis and real
estate speculation. They were slowdowns, yes, but whether they rose to the level
of True Recessions is an open question.
Americans, though, have come to assume that we have some sort
of divine right to have an ever-booming economy, and ever-rising personal
incomes, and the press waxes fervent as it predicts a catastrophic disaster at
any hint the boom might quit booming as loud as it was.
There is a business cycle. It is natural. Sometimes, there is
more economic growth. Sometimes, there is less. And then there is more again.
And then there is less again. And while this isn't quite mainstream economic
theory, I think it goes something like this.
Us humans are herd animals, and we like to buy stuff. So we see
our friends and neighbors buying stuff, and we rush out to buy some stuff too.
Every ten or fifteen years this creates a stampede of us herd animals to buy
houses, which drives the price of houses up. Those who bought the house stuff
early can sell to the stampede and make lots of quick and easy money. The rest
of the herd sees this, stampedes even faster, buys more houses, assuming that
the price of houses will keep going up and up and up and they can make tons of
easy money too! Well, it can't last, and it never does. After a year or two, the
market runs out of people who have the money and credit and gullibility to keep
bidding up the price of houses, and then sales drop off, prices drop off, real
estate agents become waiters, the people who bought at the top of the market
have lots of buyers' remorse. Some can't pay the bill and get foreclosed.
This time, it was a little worse than usual, because the
"financial products industry," the banks and other lenders who want to sell you
a little money now for a lot of money later (it's called a "mortgage") figured
out that by doing some neat card tricks called "creative financing" they could
convince people who couldn't afford to buy a house that they really could afford
to buy a house, and along the way a lot of lenders started believing in their
own snake oil. Last summer, I was getting cold calls offering me loans up to $3
million at just 0.5% interest, and, of course, the calls got a lot colder when I
said, "Sure, I want a $3 million home loan at 0.5% interest only for 40 years,"
at which point the loan broker starts sputtering.
So, lured by "teaser rates" of 2% or 3% or less for a year or
two to "get them into the house," and "adjustable rate mortgages" (ARMS) that
misrepresented the real long-term cost of a home loan, a couple million
financially unsophisticated people bought houses they couldn't afford. And a few
hundred thousand real estate agents, brokers, loan officers, loan brokers, and
lending institutions, including some really big ones, jumped on the gravy train,
then bundled the subprime loans and sold them off to big and allegedly
sophisticated institutional investors who failed to do their own due diligence,
and now get to eat the crow.
The sad thing is that this is all so predictable. It happened
just fifteen years ago, in the last real estate run up. It happened seven years
ago, in the dot.com bust, after hundreds of thousands of people invested
billions and billions of dollars in internet start-ups, some with no cash flow,
some with no products, on the assumption that anything to do with the internet,
quite a novelty then, would make them rich. It happened in 1636 in the
Netherlands, in The Great Tulip Mania, when many thousands of Dutch invested
enormous sums of money in exotic tulips and bulbs, the price of which kept going
up, until finally there was nobody left to keep bidding it up, and the house of
cards and flowers fell down.
As always, the motivation is Avaritia, Greed, the third
of the Seven Deadly Sins, the innate human desire to get something for nothing,
or at least for cheap, a big profit for little or no effort.
What really happens is that we, the great collective "we," have
some money and credit. We see the housing market taking off, so a lot of us jump
in, hoping for a quick profit. The rest of the herd sees us jumping in, and
follows like the proverbial lemmings over the cliff, bidding the market up
higher and higher, until everybody who has enough money or credit to buy an
overpriced house has done so, and no one is left to bid things up any more, and
then it all comes down. Suddenly, millions of people are left with little cash
and over-extended credit, so they have to cut back on their spending on
everything.
As people cut back on spending, retailers don't sell so much
stuff, so their revenues and profits fall. They cut back hours and lay off
workers. They don't order as many goods. So manufacturers have to cut back
production, cut back hours, and lay off workers. Unemployment increases. And we
have a recesson. Or at least a major slowdown.
In a nutshell, our pent up cash and credit (demand) chases
supply. Retailers, manufacturers, and home builders, ramp up production (supply)
to meet the demand. Finally, that pent up reserve of cash and credit is
exhausted, and supply now exceeds demand. Retailers, manufacturers, and home
builders, have to cut back on the excess supply, because there isn't enough
demand left. Slowdown happens. Maybe recession happens. The herd of Consumers
(that's us) have to rebuild our cash and credit reserves, pay off some loans,
which takes a few years, before we can start buying all that stuff again. After
awhile, we accumulate some more cash and credit, consumer spending begins
increasing, retailers place more orders, manufacturers ramp up production, and a
new boom begins.
Neither Republicans nor Democrats want to face an election and
a recession at the same time, so a bipartisan task force quickly agreed to mail
out $600 tax rebates to every taxpayer, whether they actually paid taxes or not,
in order to put money in our pockets to spend to keep retailers and
manufacturing orders jumping in order to stimulate the economy. This it the
Great $150 Billion Tax Cut of 2008. I don't know whether Democrats quite
realize the enormity of what they've done yet, but they blinked. They admitted,
at least tacitly, that tax cuts really do stimulate the economy, after years of
claiming they don't. Staring the recession monster in the face at election time
is a wonderful reality check.
What to do?
There is probably no way to prevent the boom and bust cycle
from ever happening again, because it is in the nature of us humans to follow
the human herd, and to want something for nothing, or at least quick and easy
profits from a speculation. The deadly sin of Greed is hardwired into our genes.
But there are four very simple things that could be done to prevent this kind of
subprime real estate bubble and bust from happening the way this one did.
1. Ban Teaser Rates. They don't deceive
sophisticated buyers, but they do mislead unsophisticated, subprime buyers into
believing they can afford houses they really can't afford. I would propose an
absolute ban on teaser rates - you pay the full interest rate on the loan from
the day the first payment is due. This is called "full and fair disclosure." If
the lender wants to lure you with 3 months of no payments, fine, but then it's
the full 6.7%, or whatever it is. If you can't make the payment, then you can't
afford the house.
2. Ban ARMS - Adjustable Rate Mortgages - In the Subprime
Market. Allow subprime borrowers access to fixed rate loans, only. This
prevents them being deceived or mislead, even by themselves, about their ability
to afford the house. This will make it a little harder to qualify subprime
buyers for home loans, but it will make it a lot harder to qualify subprime
buyers for houses they can't afford and will later lose to foreclosure.
3. Create The Tort of Negligent Lending Practices
I usually take a dim view of new ways to sue, but I think this is justified.
Let's create a statutory cause of action against any lender, including banks and
private lenders, that knowingly sells a loan the lender knew, or should have
known, via the exercise of due diligence, the borrower couldn't pay for. This
should allow the buyer, and anyone who buys the loan from the original lender,
to sue the original lender for damages flowing from the act of "negligent
lending." The financially sophisticated lenders should have a duty
not to sell loans they can't repay to financially unsophisticated
subprime borrowers, and this duty protects not just the subprime borrower, but
the bank itself, its investors, the investors it sells its loan bundles to, and
ultimately the entire US and global ecoomy from the consequences of a subprime
lending crises caused by the lenders' neligence.
This should (we hope) inhibit lenders from selling loans to
people who can't afford them. And while it will somewhat restrain the creativity
of banks and other lenders, and make it harder for people who can't afford the
mortgage to buy (or refi) the house, that is exactly what it should do.
It should inhibit lenders and borrowers from doing foolish things to themselves.
4. Ban Different Interest Rates for Rich and Poor
Borrowers. This may be the most the most controversial, and may fly in
the face of free market theory, or free market ideology, but here we go.
If you're a prime borrower with lots of income and good credit,
you get the lowest interest rate, because you have a low risk of default. If
you're a subprime borrower, with low income and marginal credit, you get the
highest interest rate, because you have a higher risk of default. But this
practice of charging poor people more for the loan than the bank would charge a
rich person is very perverse and counter productive, because by making the
loan more expensive for the subprime borrower, it increases his risk of
default, and by charging a higher interest rate, it forces the poor person
to pay more for the same house than the rich guy would pay.
In very rough numbers, if Rick Rich buys a $200,000 house with
5% interest on a 20-year mortgage, he's going to pay about $100,000 in interest,
for a total price of $300,000 for the house. But if Perry Poor buys the same
$200,000 house with 10% interest on a 20-year mortgage, because he's a higher
credit risk, he's going to pay about $200,000 in interest, for a total price of
$400,000 for the house. The same house costs Perry Poor $100,000 more than it
would cost Rick Rich! - thus charging the guy who can best afford it less,
and the guy who can least afford it more. A lot more.
The practice of charging higher interest rates to poor people,
and lower interest rates to the rich, makes it much more expensive for
low-income people to buy the same house, contrary to the public policy of
encouraging people to buy and own their homes. It's almost as if you went to the
grocery store and the clerk said, "Well, you're rich, so that gallon of milk
will be $3." The next guy in line, he says, "Naw, you're poor, so that gallon of
milk is $4." What if gasoline was $3 a gallon for the rich, and $4 a gallon for
the poor? We wouldn't take this discrimination for a minute in the grocery
store, or at the gas station, but we do it all the time in the home mortgage
business (and the auto loan business). One might even say that it is a form
of invidious discrimination against the poor, a price premium they have to
pay simply because they are not rich.
If we want, as a matter of public policy, to encourage and
enable low and middle income people to buy and own their own homes, a form of
savings, for most people their single largest investment, then perhaps we
should make it easier for them to do so by not charging low income folk more to
buy the house than it would cost a rich person.
If we were to require that a lender charge the same interest
rate to all home buyers, regardless of their wealth or poverty, and thus
spread the risk of default among the entire pool of loans, high-income buyers
who can afford it would pay slightly more, but low-income buyers would pay less
than they do now, thus making homes more affordable, and, most importantly,
reducing their risk of default and foreclosure in the subprime market by
not charging the low-income borrower a higher price because he (or she)
has less money. The slightly higher interest rates would be offset by
slightly lower home prices, and might bring a little more affordability to the
housing market, which in some cities is out of reach for even middle-income
people.
Perversely, banks and other lenders, by charging higher
interest rates (and, therefore, higher payments) to subprime borrowers,
increase their risk of default and foreclosure, which is exactly the
problem that the higher interest rates are supposed to insure against.
Thus, the lender creates a problem, and then charges the borrower more money (a
higher interest rate) to pay for the problem, thereby exacerbating the problem
the borrower pays for and the lender created!
Tose four, simple, changes, might go a long way to restore
faith in the home mortgage business, and to prevent this kind of subprime
mortgage crisis from happening again in ten years.
