25 September 2009

Banking as it Should Be: Cheap and Stupid

There was an article in yesterday's NYT talking about Adair Turner, who heads the Financial Services Authority (I've no idea what if anything that corresponds to here). Mr. Turner's thesis, which has crossed my mind on occasion and which I've also read elsewhere, boils down to this: the purpose of banks (defined as broadly or narrowly as you wish) is to be the Yenta.

The Yenta match makes. In the banking case, savers and spenders. That's it. That's all there is to it. And until the last decade or two, that was all there was to it. But then the banking industry, often called Financial Services, since it really encompasses lots of other actors, decided that just Yenta-ing was boring, and there could be ways to extract more funds from the match making exercise.

And thus was born the fiasco we are now living through. The only effect, and purpose, of LBOs and CDOs and MBSs ad nauseum is to increase the cost of matching savers with spenders. There is no more money available to spenders than savers can supply. The financial services players only extract greater amounts to gain all those profits.

Mr. Turner is only the latest, and I suppose most public and non academic, to broach the notion that banking functions should be cheap and stupid. Because they are. The so-called "innovations" perpetrated by the financial services industry serve only to line their pockets, not build a stronger more broad based economy and society. They serve only to narrow the base of growth recipients, and thus weaken the economy and society.

There is a reason that China has been able to come out of the dive better and faster than the USofA: since China makes stuff with their labor, it can consume its production in a broad swath of the economy and society. The USofA, on the other hand, has so narrowed the scope of its economy, that few gain anything from growth. That this was allowed, promoted even, by the Right Wingnuts should be used to string them up by a painful appendage.

For precedent, read up on Uruguay in the 1960's and 1970's. I've mentioned this before, but it remains a canary in the coal mine for the result of financialization/de-industrialization of an economy. Too bad that the Obamanauts won't listen to me.

13 September 2009

Steve Lohr Gets it Wrong

One of the good things about Sunday is the NYT, and the Sunday Business section. Lots of articles/columns/opinions, and not always a clear cut edge amongst them.

Today, I'll pick on Steve Lohr. Not because what he says is especially egregious, only because it is the latest in the continuing stream of words which miss the point. The avowed essence of the article lies in the title "Wall Street's Math Wizards Forgot a Few Variables", by which he means that the quants didn't get it right because they couldn't model the real world correctly, because the data weren't available.

Here is one quote:

The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn't sufficiently take into account was human behavior, specifically the potential for widespread panic.

The point is wrong. The point is that the data were available to model the root cause of the meltdown; the housing bubble. That root cause was the ratio of monthly payment to median income, and monthly payment to sale price. I know this data is available, because it was available in 1971. Banks and builders *chose* to make available a housing stock which was not affordable by the resident population's median income, using accepted ratios. They knew what they were doing, and the data were available to prove that they were gaming the system and its rules. Both they, the quants, and the regulators *chose* to ignore the data which would expose their fiddling. It was clear to me by 2003. Alas, I had no blog back then.

In 1971, I was a college senior, and one of my professors ("Buffalo" Bob Smith) made some money on the side as an economic/business consultant. The place was Springfield, Massachusetts; not exactly Manhattan or Boston or LA, just a middling New England town. Dr. Smith had mined (back then it took a bit more work to do, naturally) public data to create what he called "Shift and Share Analysis". This analysis was sold to one of the local banks, for the purpose of locating branches. I know this, because we discussed the analysis. The root of the analysis was plat level income data. In other words, in 1971, there was sufficient public data available to know what household incomes were, and what they spent it on.

The bone I have to pick with Mr. Lohr is that his article, whose conclusions are driven by the persons he chose to interview/quote, focuses not on the cause of the meltdown, but on the reactions of the bad actors who caused it. Nothing useful will come of their efforts, since their efforts are aimed at further gaming, rather than systemic reform. It is worth noting that earlier in the week the Times ran a story about these same folks securitizing life insurance policies, for their profit, of course. Never mind that doing so distorts the markets.

06 September 2009

Dr. Krugman Makes My Heart Go Pit-Pat

Paul Krugman does it again. His story in today's Times Magazine brings joy to my heart. Finally, a full-blown bullshit whistle against the Right Wingnut economists. But with all due respect, he does miss out on one point. And it's a very important point, why the behaviour of all those sub-prime and Alt-A home buyers was purely rational. It is the explanation of where the bubble came from. The bubble came from an increasingly unequal income distribution.

Here is the story.

The story begins with a basic question: why would a bus driver in Stockton, CA buy a $400,000 house? That was the assertion made on one of the talking head shows in the last few days. I'll take it as apocryphal that a bus driver could only afford a $100,000 (say) house at the market rate for 30 years fixed, and would only take on the $400,000 house if he were Totally Nuts. Said bus driver is rational for a number of reasons.

First, house buyers are not buying a house at a price they can afford. They are buying a house at the monthly payment they can afford. This basic distinction has been missed by all commentators I have so far heard. It is a fact which I recognized when I was a graduate student in economics in the early 1970's. At that time, interest rates were high, home prices were driven low to meet the constraint of monthly income/payment. And those who bought then made out like bandits as interest rates declined, and housing prices rose in concert.

The asking price of housing at a point in place and time is not determined by the bus drivers. It is determined by banks and builders acting in concert, even if they neither realize it or will admit it. Rationally, banks and builders would only produce $100,000 houses if the income data (yes, they have such) says that's what can be afforded. That they chose instead to produce $400,000 houses was not because the data told them to do so, but because they chose to ignore the data.

It is a fact that house prices and interest rates are inversely correlated, and the fulcrum is median income. From median income comes median house payment. From median house payment comes the division between bank and builder. The interest rate does the division. That interest rate is not necessarily the one you read in the newspaper. As the Alt-A growing fiasco makes clear, the actual interest rate is partly in the hands of the home buyer. That is not a good thing. With median incomes stagnant, to within a gnat's eyelash, during the Bush years (I and II) ameliorated only a bit during the Clinton interregnum, the only way for bankers and builders to inflate house prices was to fiddle the interest rate down. And the only way for the middle class to maintain their standard of living was to live off the rising equity from their houses courtesy of the fiddle house prices. Without the perceived need to maintain consumption, and thus burn off increasing equity, this crash wouldn't be as bad as it will be. Had home owners not burned off the equity then, it would be available now to maintain consumption. But that is not to be, and is another story.

Why contemporary economists and pundits can't connect those dots is beyond me. For most, who are employed directly or indirectly by the finance industry, it is in their income generating self interest to remain ignorant. Why Krugman remains ignorant, I can't figure.

Second, back to our bus driver. He is shown a calculation by a real estate agent, which fits his maximum monthly payment into the $400,000 home. So far as he is concerned, it's a house he can afford. The agent just proved it to him. So he signs. Even if he's sophisticated enough to realize that he won't be able to afford it once/if the monthly resets, it's still a rational decision. In 2005, 2006 that is. And that's the key to understanding that the house buyers up to 2006, approximately, were acting rationally.

And here's why. Let's assume that our bus driver is a complete imbecile, but does know how to read and do simple arithmetic. He reads that house prices have been increasing. He knows that in a year or two he will have accumulated $100,000 (say) of equity in the house due to inflation in house prices. At that point, he knows he can sell the $500,000 house, take out $80,000 (say) net proceeds, which amounts to a tidy downpayment on a $300,000 house. Said $300,000 house, with tidy downpayment, could be financed with a conventional 30 year fixed with a monthly payment he can afford.

Why not just buy the $300,000 house now? Because he doesn't have the tidy downpayment that the real estate industry expects. In his current situation, he has to game the real estate industry's gaming of him (and his ilk). As has been pointed out, but not by Krugman in the current essay, the demand for home mortgages was not driven by home buyers, but by the banks, hedge funds, and other investors. Recall that Greenspan had forced down interest rates, and declared that they would remain down.

How to get greater returns, at low risk, for these holders of large amounts of money? This was the patient zero of securitization "innovation". It was the demand for these tranched instruments that caused the residential real estate industry to lure home buyers into their net. In order to get all that money, they needed ever more house buyers. But with median income stagnant, thanks to the Bushes and the Republican Congress, they had to fiddle the interest rate down in order to fiddle house prices up. The game was started by, and run by, the financial "innovators" not by the bus driver in Stockton. Don't blame the cat's paws.

So, in sum, the housing bubble was a purely rational reaction by home buyers squeezed out of income by the freshwaterists (you need to read the article). For those who bought early in the pyramid building and didn't burn the equity, it was an intelligent decision.