Thursday, October 2, 2008

Are we getting anywhere with this?

Since my last post was about the enormous debt that we've incurred as a country, here's a quick observation on where some of that money is going. We'll spend around $40 billion (!) this year in the war on drugs, and by the government's own standard, we're accomplishing nothing! We're also around a million and a half people for drug offenses, and yet drugs remain cheap, legal, and popular. Bjorn Lomberg, founder of the Copenhagen Consensus Center, estimates that spending $200 million per year could prevent 300,000 deaths from heart disease in developing countries. Basically by distributing aspirin based medication. He doesn't mention it, but I would think that the people this would help are older and probably wiser, and exactly the kind of people you'd want to help in these regions. The drug war seems to be something that everyone hates, and yet no one will stand up and say something about because they are afraid. Maybe in a time of national crisis like this, we can find the courage to speak out.

Time to Save

I just read an article in the NYT that detailed the fear of the credit crisis affecting Silicon Valley. Apparently Apple has lost around 16% of it's market value, as investors believe that people won't spend as much money on things like Ipods and Iphones over the holiday season. I think that they very likely won't. And shouldn't. But is that the end of the world? With the government nearly $10 trillion in debt, and with all of us about to face an explosion of Social Security, Medicare, and Medicaid expenditures that will make the current crisis seem like the broken light bulb you fix in your house just before the roof falls in, we probably shouldn't be buying that extra Ipod or that new TV. On the other hand, as long as government keeps saying that it has everything under control, why should we worry?

Wednesday, October 1, 2008

Value II

Speaking of value, Paulson is claiming that the reason these mortgage-backed securities are untradeable is because no one knows what they’re worth, and therefore can’t price them. His original plan claimed to use the the $700 billion as a method of “price discovery”, whereby he would set a market price for these securities. Which is a crock of shit.

Why does he think he knows better than all these firms (who deal with this every day), what the market value of these securities should be?. Paulson is an educated man. He knows better. Therefore, he has to be lying.

But watching CNBC today, with all these people throwing ideas around , and the market reacting every time someone important opened their mouth, it occurred to me that the real reason that the market for these securities is non-existent is not because no one has any idea what they are worth, but because no one has any idea what they’ll be worth tomorrow!

If the government is going to go in and buy $700 billion worth of securities, then that will change what they are worth today. But because we have no idea what the government is going to do, we have no idea what these things are worth.

If Congress and the President would simply say that no bailout is going to happen, then people could move forward with figuring out what things are actually worth. And the corollary, of course, is that if we just bail companies out all the time, arbitrarily, then their value will tend to be arbitrary and capricious.


We’ve been hearing a lot about how these mortgage-backed securities are becoming nearly worthless. You might ask yourself why this could be. If these securities are being sold for 20 cents on the dollar, does that mean that 80% of people are being foreclosed on?

No, it doesn’t. But it brings up an interesting point that I think we should be talking about. And that is the concept of value. Part of the problem is that firms are unable to value these securities properly, which is a problem, because you can’t trade securities if you don’t know what they’re worth.

But whatever they’re worth, we know they are worth a lot less to the mortgage holder than they are to the homeowner.

Why is this? Well, if a bank forecloses on a home, they don’t have any use for it. It doesn’t generate income for them. The are not in the business of renting houses, or investing in real estate, or really even very good at selling them. Other people do these things, but not banks.

As an analogy, pretend your friend, the neuro-surgeon, wanted to buy a set of neuro-surgical scalpels. These scalpels cost $10,000. For some reason he needs to borrow money from you to buy them. You agree to lend it, but require him to sign a document saying that if he doesn’t pay you back on time, you get the scalpels.

Sure enough, he nicks someone’s medulla-oblongata, incurs a lawsuit and a judgement, and has to declare bankruptcy. You get the scalpels. But, like a bank with a house in suburbia, they don’t do you much good. You’re not a surgeon. You could use them for cutting cheese, but that’s a pretty expensive cheese knife. So you decide to sell them.

But when you do, you quickly realize that the potential market for this set of scalpels is pretty small. There just aren’t that many neuro-surgeons out there. And most of them already have knives. Of course, eventually you’ll find someone that will pay close to $10,000, but it could take years. Since you need the cash now, you end up selling them for $3500.

How much were they worth to you? $3500.

But how much were they worth to your friend? $10,000.

And the thing is, this is real value. When you took possession of them, they immediately lost $6500 in real value. Why? Because, as they say, value is in the eye of the beholder.

Why do I think this is important? Because if we could find a way to keep people in these home that are being foreclosed on, we would be maintaining a lot of their actual values, instead of handing them over to banks that have no use for them. This bailout proposal actually takes our tax money, and uses it to buy mortgages from banks who are kicking people out of homes which, in most cases, have far more value to them than to the banks!

If we’re going to bail out anyone, why don’t we bail out the homeowners?

I can hear the objections now:

“It’ll take too long to work out!” How, exactly, is taking the time to do something right worse than do the wrong thing right now?

“It’ll set a terrible precedent!” Of course it will. Do we want people to think that the government will bail them out if they do stupid things? Of course not. But is this a worse moral hazard than allowing multi-billion dollar financial companies think that the government is going to bail them out? I don’t think so.

I don’t know how you would administer something like this. Maybe the government could require people with foreclosures to go through a pseudo bankruptcy proceeding where they would have their debt restructured, but would be allowed to stay in the house if they kept paying the restructured amount. There is a very interesting discussion of this whole issue here.

The point is that you maximize the value of the underlying asset (the home) when you leave it in the hands of the person who values it most. In almost every case, this is the homeowner.

I’d love Secretary Paulson to explain how buying $700 billion of homes from banks at 60 cents on the dollar from banks that value them at 20 cents at the dollar, and charging it all to taxpayers who are being kicked out of homes they may well value at 80 cents on the dollar makes any sense at all.

The only possible explanation is that the world as we know it will end if we don’t get this done tomorrow. Bush might refer to this as a “Market of Mass Destruction.” I’m going to need some better documentation this time.

This Just In! CNBC May Be Biased!

I was watching CNBC for a minute today, and the cheerleading for some sort of bailout was embarrassing to watch. The Wall Street Journal and The New York Times are not much better, both characterizing the failure of the bailout bill as a failure of Congress. If you didn’t know any better, you’d think that your representative’s only job was to vote yes every time the house leadership and the president told them to. Haven’t we been ripping them for doing just that before we invaded Iraq?

The bill was flawed. Most economists believed it would do little or nothing, and that’s not much for $700 billion. To pretend that this was not debatable is ludicrous. I applaud those members of Congress who had the courage to vote no. I was shocked that enough of them did. I doubt that they will be able to resist again.

Secretary Paulson has been wrong every step of the way so far. He is now asking for at least $700 billion to hand over to Wall Street financial firms, one of whom, until recently, he worked for! He hasn’t explained how this is going to work (at least not in any satisfactory terms) and he refuses to entertain alternative plans. He can not have considered this one for more than a week before proposing it, and yet, in the face of opposition from the public, and widespread skepticism from every expert quarter, he refuses to admit that there might be another way. Or that nothing would be preferable to this.

But he has our president firmly behind him!

This is the very definition of hubris*. If this bill passes, and does nothing but saddle our children with another back-breaking debt, we will look back and ask ourselves, “How could we be so naive? After everything this administration has told us, how could we be so taken in? Will we ever learn?”

Maybe not.

*Edit...You might say that it's hubris for me to claim to have all the answers. You would be right.

Thought on the Crisis

It’s becoming pretty obvious that the people who are going to have to legislate a solution to the current crisis are either very simplistic in their understanding of a complex system, or are pandering to people who are. More likely a combination of both.

There are two opposing and extreme viewpoints that I seem to be hearing a lot of. The first is that government can dictate financial activity effectively, and the second is that the free market must be allowed to work.

In the first instance, we have a complete denial of the unintended consequences that can flow from rash action, examples of which are abundant in recent financial news. The second is based upon the fallacy that a free market currently exists.

Free markets are economic models. They are useful for predicting things in certain situations, but they don’t actually exist in the real world. And even the most hardcore libertarian wouldn’t want them. There are markets which exhibit different degrees of freedom or political control, but there are no truly free markets.

When you introduce rules into a marketplace, they will affect different people or entities differently. It’s at this point that you have to begin to make value judgements on the fairness of these rules. And so I believe that you absolutely do have to balance the interests of those who will be affected by the externalities of this crisis against the impulse to let the institutions that got us here simply fail.

With that said, handing over $700 billion dollars to an official of the same administration that told us to trust it on Iraq because we couldn’t wait for more evidence seems like pure insanity. The moral hazard, precedent, and transformation of the financial system that this “solution” will precede is not something that we should rush. Senator Barney Frank’s pronouncement that we don’t have time to debate whether it’s good or bad is an example of the worst kind of leadership. We do have time, and we must.