Posts tagged ‘interest rates’

## Bubble Prices are not Wealth

Conservative sites are running with this story:

OBAMANOMICS IN ACTION: Typical US Household Worth One-Third Less Than Under Bush

Seriously?  The bursting of the housing bubble, which actually began under Bush, is Obama's fault?  Because that is what likely drove middle class household worth down (while the Fed-sponsored asset boom in financial instruments drove up wealth of the top 1%).  I suppose one could say that the Republicans sponsored a bubble that helped the middle class while Obama is sponsoring a bubble that helps the wealthy.

I won't say this stuff is meaningless to the economy, because clearly they affect people's perception of wealth and thus spending and optimism.  But sound long-term economic growth has got to come from stable and rational monetary policy that allows interest rates and financial assets to find their correct level.  Getting political mileage out of bubble pricing of assets only creates incentives for politicians such that they will never stop fiddling with interest rates and credit.

Boeing reported a net pension deficit of $19.7 billion at the end of 2012. The discount rate is based on the yields of highly rated corporate bonds—double-A or higher—with maturities equal to the expected schedule of pension-benefit payouts. Moody's decision last summer to lower the credit rating of big banks hurt UPS and other companies by booting those banks out of the calculation. And because bonds issued by some of those banks carried higher yields than other bonds used in the calculation, UPS's discount rate fell 1.20 percentage points. This is obviously not a wildly productive use of corporate funds, to divert ever-increasing amounts of money to pay people who are no longer producing. But at least corporations are acknowledged the problem (I will give credit where it is due -- thanks to accounting rules and government regulations that force a fair amount of transparency here). It is interesting to note the Boeing example, where their expected rate of return on pension funds fell from 6.2% to 3.8%. Compare that to corrupt government entities like Calpers, which bravely faced this new reality by cutting its discount rate from an absurd 7.75% to a still absurd 7.5%. This despite returns last year around 1%. By keeping the number artificially high, Calpers is hiding its underfunding problem. An interesting reform would be to force Calpers to use a discount rate equal to the average of that used by the 10 largest private pension funds. ## Looking for Something to Short? Here's a Suggestion: Via Zero Hedge and the WSJ: The$604 million issue from consumer lender Springleaf Financial, the former American General Finance, will bundle together about $662 million of loans secured by assets such as cars, boats, furniture and jewelry into ABS, according to a term sheet. Some loans have no collateral. Personal loans haven't been a part of the mainstream ABS market since securitizations from Conseco Finance Corp. in the late 1990s, according to Michael Dean, co-head of Fitch Ratings' ABS group. That market dried up as the recession hit and, under the weight of bad subprime loans, Conseco filed for bankruptcy in 2002. Springleaf's issue comes as prices on traditional issues backed by auto loans, credit cards and student loans have soared as investors pile into debt with extra yield over Treasurys. As those yields fall, ABS investors have been giving unusual assets that were previously shunned a second look.... The 190,627 loans in the Springleaf deal have an average FICO credit score of 602, in line with many subprime auto ABS. But the average coupon of 25% on Springleaf's personal loans is above that on even "deep subprime" auto loans, probably because there is no collateral for 10% of the issue, an analyst said. Bonus points for AIG's involvement in this offering (btw, now that AIG has repaid obligations to taxpayer, expect a corporate name change in 3..2..1..) We had a credit bubble in part where the market likely under-priced certain risks. Bubble bursts and risks take their toll. Economy floundered. The Fed reduced interest rates to zero. Frustrated with low interest rates, investors have begun seeking out risk, likely driving down the price of risky investment. Repeat. ## Well, I Was Wrong I have been a stock market bear for some months now. I don't really think the US economy is going to double dip on its own, but I felt like Europe and Asia would bring us down. Well, I simply underestimated both the Fed's and the ECB's willingness to goose financial assets. If the Fed and ECB are going to inflate our way out of, uh, whatever it is we are in, then I certainly don't want to be holding bonds, particularly at these absurdly low interest rates. Stocks are not as good of an inflation hedge as some hard assets, but they are a hell of a lot better than most bonds. I'm certainly not going to buy back in the current euphoric highs, but I am giving up on trying to predict that market based on fundamentals. It seems that fundamentals are a suckers game, and you better not be timing the market unless you have an inside line to government policy, because that seems to be what drives the train. PS- I wish Milton Friedman were still around. QE was as much his idea as anyone else's. I wonder what he would have thought of the results, or of this particular implementation. ## Risks of QE So far, I have mainly been concerned about inflationary risks from quantitative easing, which is effectively a fancy term for substituting printed money for government debt (I know there are folks out there that swear up and down that QE does not involve printing (electronically of course) money, but it simply has to. Operation Twist, the more recent Fed action, is different, and does not involve printing money but essentially involves the Fed taking on longer-term debt in exchange for putting more shorter term debt on the market. Scott Minder in the Financial Times highlights another potential problem: In 2008, just before the first of two rounds of quantitative easing, the Federal Reserve had$41bn in capital and roughly $872bn in liabilities, resulting in a debt to equity ratio of roughly 21-to-one. The Federal Reserve’s portfolio had$480bn in Treasury securities with an asset duration of about 2.5 years. Therefore, a 100 basis point increase in interest rates would have caused the value of its portfolio to fall by 2.5 per cent, or $12bn. A loss of that magnitude would have been severe but not devastating. By 2011, the Fed’s portfolio consisted of more than$2.6tn in Treasury and agency securities, mortgage bonds and other fixed income assets, and its debt-to-equity ratio had dramatically increased to 51-to-one. Under Operation Twist, the Fed swapped its short-term securities holdings for longer-term ones, thereby extending the duration of its portfolio to more than eight years. Now, a 100 basis point increase in interest rates would cause the market value of the Federal Reserve’s assets to fall by about 8 per cent, or $200bn, leaving it insolvent, with a capital deficit of about$150bn. Hypothetically, a 5 per cent rise in interest rates could cause a trillion dollar decline in the value of the Federal Reserve’s assets.

As the economy continues to expand, the Federal Reserve will eventually seek to normalise monetary policy, resulting in higher interest rates. In this scenario, the central bank could find that the market value of its portfolio has declined to the point where it no longer has enough sellable assets to adequately reduce the money supply and maintain the purchasing power of the dollar. Given US dependence on foreign capital flows, if the stability of the dollar is drawn into question, the ability of the US to finance its deficits may falter. The Federal Reserve could then find itself the buyer of last resort for Treasury securities. In doing so, the government would become hostage to its printing press, and a currency crisis or runaway inflation could take hold.

George Dorgan observes, on the pages of Zero Hedge, that European countries are taking even large balance sheet risks.  The most surprising is the Swiss.

## Not A Sign of Good Health

Swiss government bonds are trading at rates that imply a negative interest rate.  The German government is issuing bonds with interest rates of zero that are actually trading above face value.

This is really bad news.  Investing in these securities is effectively the equivalent of putting money in one's mattress -- it means that investors don't perceive any money-making uses for their money better than paying paying financially strong governments to keep it safe for a while.   I am far from an expert on banking regulations, but my first guess on this is that this is at least in part a function of bank capital requirements that effectively require banks to put a lot of cash into government securities no matter how bad the return.

Germany and Switzerland certainly are providing some value in creating a safe haven for capital, but I wonder if in the long-run this is anything but destructive, shifting wealth and investment out of the private economy and into investments with no return.

## The Perfect Example of Politics over Policy

I don't think you could find any better example of paying off one's political constituents at the cost of out groups than this:

Congressional Democrats and the White House have agreed to pay for a bill to freeze student loan interest rates for a year by raising taxes on so-called S Corporations, according to a top Senate Democrat and senior House and Senate aides, but Republicans said the tax increase may ensure the bill’s defeat in the Senate.

Apparently, the taxpayer-subsidized rate of 3.4% on student loans is set to go up to a less-subsidized 6.8% in a couple of months.    So to keep this subsidy rolling, Congress is proposing to tax S-Corporations, mainly used by entrepreneurs and small businesses  (disclosure:  including mine) to avoid double taxation of business income.

I don't think its possible to come up with a real policy reason that money should be taken away from entrepreneurs and given to 18-year-olds so they can overpay for college, especially since most of the subsidy for student loans is captured by universities that have simply raised tuition to soak up each successive college subsidy program.  Note that Congress is instituting a permanent tax hike on entrepreneurs in order to give just a 1-year break (ie through the next election) to students.

But this is the perfect political bill.  It takes money from a group likely to be lost to the Administration in the next election anyway (e.g. entrepreneurs and small business people) and transfers it to a group that is very likely to vote for Obama if it votes at all, but needs to be energized to get to the polls.  The Obama Administration was obviously watching the Occupy movement carefully, and noted that much of the angst seemed to be aimed at student loans.

Expect similar payoffs to other constituencies over the next few months.  Oops, here is one already.

## Government Mal-Investment

A reader sends me this editorial from Jerry Jordan at IBD.  It discusses a topic that is one of my favorites - government mal-investment.  By a thousand different mechanisms, from direct investment (Solyndra) to artificial interest rates to monkeying with price signals to economic rule-making (e.g. community banking, ethanol mandates) the government is shifting capital and resources from the allocations a well-funcitoning market would make to optimize returns and productivity to allocations based on political calculation.  We rightly worry about deficits and taxes, but in the long run this redistribution of investment from the productive to the sexy or politically expedient may have the largest long-term negative implications -- just look at what the management of the Japanese economy by MITI (touted at the time as fabulous by statists everywhere) did to that country, with the lost decade becoming the the lost two decades.

It is hard to excerpt but here is how it begins

It usually surfaces with an entrepreneurial adolescent deciding it would be a good idea to sell lemonade at the curbside to passersby

Parents, wanting to encourage the idea that working and making money is a good idea, drive around to buy the lemon, sugar, designer bottled water, cups, spoons, napkins, a sign or two, and probably a paper table cloth.

Aside from time and gas, the outing adds up to something north of $10. At the opening of business the next day, the kids find business is slow to nonexistent at$1 per cup. So, they start to learn about market demand and find that business becomes so brisk at only 10 cents per cup that they are sold out by noon, having served 70 cups of lemonade and hauled in $7. The excited lunch-time conversation is about expanding the business. A stand across the street to catch traffic going the opposite direction; maybe one around the corner for the cross-street traffic. The kids see growing revenue; the "investors" see mounting losses. There is a strand of economics, we'll call it the K-brand, that sees all this as worthwhile. They add together the$10 spent by the parents to back the venture and the $7 spent by the customers and conclude that an additional$17 of spending is clearly a good thing. Surely, the neighborhood economy has been stimulated.

To the family it is a loss, chalked up as a form of consumption. If this were a business enterprise it would be a write-off. In classical economics it is a "mal-investment."

## The True Cost of the Education Bubble

I hinted at it in my last post, but have addressed it in more depth in my column this week at Forbes.  A brief excerpt:

The theme from all these failures is distorted signals and corrupted communication.  People, no matter how savvy, cannot possibly research every nook and cranny of the economy before making an investment.  They make decisions, therefore, based on signals – prices, interest rates, perceived risks, and the profit history of other similar investments.  If these signals are artificially altered or corrupted, bad decisions that destroy wealth and growth will result.

Which brings me back to education.    I will tell you something almost every business owner knows:  We business owners may whine from time to time that banks won’t lend us money, but what really is in short support are great people.  Nothing has more long-term impact on an economy than amount and types of skills that are sought by future workers.  That is why everyone accepts as a truism that education is critical to economic health.

Unfortunately, there is good evidence that our education policies have already done long-term harm.   The signals we send to kids making their higher education plans have disconnected them from reality in a number of fundamental ways, causing them to make bad decisions for themselves and the broader economy.

## China Bubble Bursting

I don't have time today to link all the evidence, but the combination of crashing real estate markets and the Chinese government jamming liquidity into its banks tells me the China bubble is bursting as we speak.

This is an interesting test of the Austrian view of depressions vs. the Keynesian / Krugman / Thomas Friedman / MITI view of government-orchestrated prosperity.  If the latter are right, then China is doing more right to keep their economy going than any country in history and you should go invest all your money in Chinese real estate.

However, if one believes the Austrian model about government-enforced mis-allocation of capital and labor leading to bubbles and crashes; if one believes that the technocrat-beloved MITI was largely responsible for the Japanese lost decade; if one believes that the US govenrment through articially low interest rates and government-directed reductions in underwriting quality helped create the housing bubble -- then the mother of all crashes is looming in China.  Because no country has done more to reallocate resources and capital based on the whims of a few technocrats  and well-connected industrialists than has China.  After all, this is why Thomas Friedman loves China, that it does not rely on the judgement of millions of individuals to allocate capital, but instead on the finger pointing of a few at the top.

## Ka-chunk Ka-chunk

That is the sound of the printing presses running 24/7.  Because that appears to be how we are funding all of Obama's spending right now (source)

When folks say they are not worried about the deficit, because folks still seem eager to buy our debt (as evidenced by the low interest rates) note that the general public has been a net seller of US debt the first 2 quarters of 2011.  In fact, the only buyer has been Uncle Sam himself, buying up the debt with newly minted cash (or electrons, really).

One other interesting issue, the Fed seems to have been soaking up the money supply in the early days of the recession, before the high-profile business and financial failures really got things moving downward.

## Bank Regulation

This article by Mark Perry seems right to me -- the lightest touch (and probably the most effective) approach to bank regulation is to return to a regime that puts its major emphasis on capital requirements.

We can talk all day about causes of the recent financial crisis, but in my mind the root cause was taking real property with a volatile underlying value (e.g. homes) and leveraging the absolute crap out of it.   In the initial transaction, home buyers were allowed to come to the table with less and less equity, until deals were being cut with more than 100% debt.  This stupidity was a true public-private partnership, as the government kicked off the party and encouraged its growth via various community development policies as well as policies atFannie and Freddie, but private originators as well as home buyers eagerly jumped into the fray.

This debt backed by property that was already too highly leveraged was thrown into portfolios that were themselves highly leveraged, and then further leveraged again through CDS's and other derivatives.  And then the CDS's were put into leveraged portfolios.  I would love to figure out the effective leverage in the AIG portfolio.  For ever $1 million in real property that secured the mortgages they insured, how much equity did they have? A thousand bucks? Less? These investors felt protected by diversification that didn't really exist. The felt safe with AAA ratings from agencies who really didn't understand the risks any better than anyone else did. They relaxed assuming everything was watched by government regulators who were in way over their heads. But more than anything, they felt protected by history. The system of putting mortgage risks into tranches, such that the top tranches could only be affected by default rates consider then to be wildly improbable, had never to that point failed to deliver its promise. Default rates had always stayed withing expected norms. And this is the most dangerous risk -- the risk that something will happen that has never happened before. Default rates that seemed impossible suddenly became reality. Tranches that were untouchable suddenly were losing large chunks of their value. Sure, there were warning signs, but at the end of the day what happened was that events occurred that were worse than people had thought was the worst case scenario (there is a whole body of interesting behavioral study on how humans tend to overestimate their understanding and underestimate the width of a probability distribution). As new financial products are created and the economy evolves and the government pursues new forms of interventions in commerce, new failures can occur that have never happened before. And never has there been invented a micro-regulatory approach that guards against new-type failures (they don't even do a very good job against old-style failures). Capital requirements are the one approach that guard against catastrophic failures even for unanticipated risks. It can be argued that this will raise the cost of capital, at it is true interest rates at any one point of time would have to go up. But one can argue that the low interest rates of the 2000's greatly understated the true cost of capital, and that those additional costs were paid in a sort of balloon payment at the end of the decade. I am still thinking this through -- I don't think any regular reader would be mistake me for someone who favors regulation in general, but I am coming around to some extent on the notion that banks are different. I would ideally like to see a self-policing market where companies that choose to cut equity too fine just go bankrupt. But the reality of the political-financial complex today is that this never happens -- costs of large failures are socialized, and executives who made bad choices get fat gold parachutes and Treasury jobs. Postscript: I have arguments all the time about whether the financial melt down was mainly caused by government or private action. Was it a public or private failure.? My answer is yes. One thing that those of us who promote private action over public can never repeat enough is this: Our support for private action does not mean that private actors don't screw up, that there are not bad outcomes, that people don't make bad decisions, etc. They do. Lots of them. When these constitute outright fraud, there should be prosecution. For the rest of the cases, though, libertarians believe that in a free society there are automatic corrections and sources of accountability. Make a bad product - people stop buying it. Sign a union contract with wages that are too high - you go bankrupt. Treat your workers shabbily - and the best of them go work for someone else. Take on too much risk - you will fail and lose all your capital. The problem with our financial sector is not that it is not regulated -- it is the most regulated sector of the economy. The problem is that, as always happens, there has been substantial regulatory capture. There has been an implicit deal cut by large financial institutions - regulate me, but in return protect me. In a sense, as is typical in a corporate state, large corporations and government have become partners. As a result, many of the typical checks and balances on private action in a free economy have been disrupted. In effect, certain institutions became too big to fail, and costs of failure and risk taking were socialized. That is why the answer is not one or the other. Certainly the massive failures were driven by the actions of private actors. But they were driven in part by incentives put in place by the government, and their stupid behavior was not checked because traditional private avenues of accountability had been neutered by the government. This is why the recent financial crisis will always remain a sort of political Rorschach test, where folks of wildly different political philosophies can all find justification for their position. ## Paul Krugman Weather Forecasting Paul Krugman has become pretty famous for being able to peer into the complex economy and find something to justify whatever he is promoting. Higher interest rates, lower interest rates, more growth, less growth, unemployment, or boom times all simultaneously are proof of whatever theory he currently holds (which, in turn, is generally exactly the theory required to support actions by the Democratic leadership). In the same way -- hot weather, cold weather, drought, wet weather, mild weather, lost of hurricanes, a lack of hurricanes -- are all simultaneously the proof for man-made global warming. Whatever the weather currently is, someone can use a government grant to build a model to prove that it is due to anthropogenic global warming. Thus this story -- Global warming causing freezing. ## Nothing To See Here, Move Along Kevin Drum, echoing Paul Krugman, looks at rising interest rates on Treasuries and decides that there is nothing to see here, move along. You will all be relieved to know that these rising interest rates have nothing to do with a couple of trillion dollars in new government borrowing, and the effect that this borrowing (and wild money printing) might have on • Inflation • Sovereign risk • Supply and demand for credit Boy, do I feel better. PS - And remember, if interest rates do start exceeding historical norms, Krugman will discover that it is Bush's fault. ## Prices Matter The other day I was having a discussion with a smart, well-informed woman who tends to be a bell-weather for Democratic talking points. When asked about the recession, I said something like this: The story for banks, corporations, and people are all the same -- everyone has too much debt, everyone took on too much in expectation of things going up and up. With flat or even down expectations, everyone is now trying to clean up their balance sheet. They are spending less, building equity and reducing debt. And the economy is going to slow as a result, no way around it. I went on to say that I was not only opposed to the stimulus bill in particular, but I was offended that the government would try to interrupt this deleveraging process. The government had essentially made the decision that if individuals won't spend, then the government will take their money in the form of taxes and spend for them. And if no one wanted to have debt, the government would go about and take debt on in the name of everyone. She responded that she thought it was ironic that after the government had worked so hard for so many years to tell people to save more, and that they are only doing it now when it was counter-productive. Forget for now the whole Keynsian "saving is counter-productive" argument, and focus for a minute on the government communication effort around individual debt. There is no doubt that to the extent that the government has verbally communicated on individual debt, is has generally been to encourage savings and not take on expensive consumer debt. But verbal communications are generally the least effective form of communication in the economy (Ralph Nader and his theory that we are all zombies to corporate marketing notwithstanding). In fact, markets don't communicate via words. They commucate with price. Prices are the giant semaphores of the free market, and they are extraordinarily powerful communication tools. Do people drive less or turn down their thermostats after Jimmy Carter gives a fireside chat about energy conservation in his little cardigan sweater? No. People conserve more when prices go up. When gas prices go up, prices are telling consumers that gas is now scarcer vis a vis demand, and it may be time to conserve. The same goes for every other thing we buy. In fact, the only things we actually run out of (water in a drought, electricity during summer brownouts, gasoline in the early 1970s) are all commodities where the government interfered with and/or severely restricted the ability of retail prices to move with demand. In these cases, the government tends to substitute public exhortations for pricing signals (for example, you can't escape water use guilt ads in California). But these never work as well. It is the same with personal savings. The government in its verbal communications may have been saying to save, but what were its actions saying? The Federal Reserve followed a long-term policy over the last decade of keeping interst rates artificially low. Low interest rates send a clear and powerful dual message -- save less (because the returns are low) and borrow more (because borrowing is relatively cheap). Federal tax breaks from mortgage debt and Federal programs to provide looser credit with lower down payments to less qualified buyers made debt even more attractive vs. savings. And numerous federal programs helped encourage home buying, while local government zoning and anti-growth ordinances helped keep home prices going up and up. Every action the government took said "save less, take on more debt." Is it any wonder their actual verbal communication was ignored? ## So Just What Was the Omitted Intervention In a post earlier today on the mortgage market meltdown, I wrote: And that is what the argument usually boils down to - someone smart should have been watching them. But lots of smart people were watching all the time. You can see one such person featured in Lewis's article. Guys run all over Wall Street looking every day for some single digit basis point spread they can make money off of. But untold wealth was just sitting there for someone who was willing to call bullshit on the whole CDO/CDS pyramid game. These guys playing this game were searching for people to bet against them. And despite this, despite untold wealth as an incentive, and companies looking for folks to take the other side of their transactions, only a handful saw the opportunity. Thousands of people steeped in the industry with near-perfect incentives to identify these issues ... did not. What, then, were our hopes of having some incremental government bureaucrats do so? Usually, after this kind of crisis, there are lines of pundits and writers ready to suggest, with perfect hindsight, new regulations to avert the prior crisis. But, tellingly, I have heard very few suggestions. So in this context, I found these comments by leftish Kevin Drum, certainly no knee-jerk advocate of free markets, quite interesting: No argument on the greed and ideology front, but I'm curious: was there really anyone who made the right call on all this at a policy level? There were, of course, plenty of people who recognized the housing bubble for the idiocy that it was (Alan Greenspan notably not one of them), but were there any major voices making specific policy proposals to slow down the bubble? Or rein in the mortgage market? Or regulate the CDO/CDS market in a way that would have prevented some of the damage? I'm talking specifics here, not just general observations that the FIRE sector was out of control. Arguments about interest rates being too low count, if they were made for the right reason, but I'm interested mainly in more detailed recommendations. I don't have any big point to make here. I'm genuinely curious. There were many moments in the past few years when perhaps something could have been done, but what? And who was proposing serious measures that would have helped? Any major Dems? Economic pundits? Wall Street mucky mucks? Who were the unsung heroes? Help me out here. ## Michael Lewis on ... Whatever the Hell is Happening on Wall Street As usual, Michael Lewis is a great and informative read, trying to unravel the whole subprime mortgage / CDS / CDO bundle somewhat for laymen. The article does not excerpt well, but I would summarize it in saying he identified four mistakes by the financial world. The first two I would describe as real problems but not really new mistakes -- something similar could have been said about S&L's in the 1980's. These are: 1. A lot of subprime loans were issued to people with no freaking hope of repaying them, in an incredible general lowering of underwriting standards. (we all should remember, though, the government and the media was trumpeting this as good news -- increase in home ownership rates, blah blah blah). 2. People who bought these securities grossly underestimated the default risks, particularly in the crappiest tranches (securitized packages of loans are resold in tiers, with a AAA tranche getting first call on any payouts, and the tail end BBB tier getting high interest rates but who takes the first principal losses if the loans default). But Lewis highlights two mistakes that are in some sense brand new. These mistakes were effectively vast increases in leverage that acted as a multiplier for the subprime problem, while simultaneously spreading the problem into the hands of AAA investors who accepted the higher returns without paying too much attention to how they were obtained 3. Someone started scooping up the BBB tranches from various securities packages, bundled these together, and somehow got a ratings agency to declare that the top 60% tranche of these repackaged dog turds were AAA. 4. Credit default swaps, originally insurance policies on loan portfolios, turned into a sort of futures market on subprime mortgage packages. But, unlike futures markets, say in oil, where the futures trading volume are generally well under the total volumes of the underlying commodity flowing around the world, CDS values grew to as much as 100x the underlying commodity volume (in this case subprime mortgage securities). CDS's went from a risk-management tool to a naked side-bet. This is interesting stuff, and it was really only reading this piece that I think I started to understand #4 above (though if readers think I am describing this wrong, let me know). All of this leads me to a few thoughts: • Nothing about this convinces me any of these firms need to be saved or bailed out. Let them die. Maybe the guys who rebuild the industry in their place will be smarter and more careful. The country is going to face a recession whether Wall Street is bailed out or not -- too much (paper) value disappeared from consumer's net worths (or their perceptions of their net worth) for that not to be the case. I lived through Texas in the 1980s when the S&L industry went bust almost to the last institution. Nearly every one of the top 10 banks in the state went into FDIC recievership. • I have seen people observe that this is an indictment of capitalism because so many people made such bad mistakes. Sure. No one said capitalism is a gaurantee against stupidity, or even fraud. The difference is that the consequences of said stupidity and fraud have to be less in a free market system than if the same people had the power of cersion via government. In a free market, these guys will fail and be wiped out and get washed away. The people who they drag down may consider themselves to be innocent, but they participated of their own free will -- if they did not understand what they were doing, that is their problem. In a statist system, you still have mistakes like this, but they are infinitely more catastrophic, as the stakes in play are often higher. And the people who made the mistakes are never punished financially, because they are in charge of the machinery of state (or friends of those in charge). They make damn sure the power of the state is used to make everyone else pay for their mistake, kind of like ... this$700 billion bailout.
• Lewis seems to have a hypothesis that the main system change that allowed all this to happen was the shift in ownership structure from partnerships to publicly-held corporations.  And certainly you do get some added agency risks with this, though I find this explanation a bit shallow.  I do think that folks with money are going to approach Wall Street "experts" and rating agencies with a lot more skepticism for a long time, and that can't be a bad thing.
• The opportunity really exists for someone smart to start a brand new rating agency from scratch.  The only reason the current ones won't get wept away is simply that there are not many alternatives right now.  Warren Buffett should partner with someone well-connected with the new administration (Maybe Larry Summers, since there is no way he will survive a confirmation hearing with his men-are-from-large-standard-deviations-women-are-from-narrow-distributions baggage.)
• Lewis is unfair in depicting all the mortgage lenders as predatory.  I am sure some were cheats, but remember that as far as Congress, the Administration, the Federal Government, and the media were concerned, these lenders making subprime loans were doing God's work -- they were expanding home ownership and bringing the dream of owning a home to poor people historically redlined, blah blah blah.  It is only with hindsight that we demonize them for doing the wrong thing -- at the time, absolutely everyone on in the country was pushing them to do exactly what they did.  This is also why Democrats struggle to suggest a resposive regulatory package to this whole mess, as any real reform would have to address minimum underwriting standards, which in turn would have the direct effect of limiting lending to the poor, an outcome with which no Democrat wants to be associated.

Update:  Just to be clear, as I have said before, this is about half of what happened.  There are really two stories, and usually authors focus on one or the other.  Story 1 is the steps taken by the Federal Government  (Fannie, Freddie, Community Reinvestment Act, mortgage interest deduction, low interest rates) that fueled the housing bubble and the expansion of credit to questionable borrowers.  It is described here, among other places.  Story 2 is the one above, how private firms decided not only to purchase these questionable loans made on bubble-inflated assets, but to leverage these assets up to staggering levels.

## A Last Case for Payday Loans

Well, we have upheld the ban on payday loans here in Arizona.

The payday-loan industry, which flourished this past decade on Arizonans' almost-insatiable need for quick, short-term loans regardless of their high interest rates, may have to close down in Arizona unless state lawmakers can be persuaded to ignore voters' wishes.

Voters last week overwhelmingly rejected Proposition 200, a ballot initiative financed and written by the loan companies to allow them to continue charging high interest rates on small loans. That decision placed Arizona among a growing number of states that have effectively shut down the payday lenders.

So, payday loans from company A to person B are really popular with both A & B, and the industry has "flourished."  But persons C, who don't participate in this market, have decided that, for their own good, A & B need to stop engaging in this behavior.  One such third party explains it this way:

Sen. Debbie McCune Davis, D-Phoenix, opposed Prop. 200 and has steadfastly fought payday lenders. She sees no need to let payday lenders continue to charge higher interest rates than other lenders.

Her and voter's actions have effectively limited payday loan companies to charging total interest and fees equivalent to no more than 36% annual interest.  OK, you say, this seems like a really high rate.  That should be enough, right?  Well, the problem comes with fixed costs and loan size.  Lets look at an example.

A typical payday loan size and term is about $400 for 18 days (pdf). A typical fee for such a loan is$50, which includes both fixed costs and interest.  Wow, annualized that is 250%.  Usurious!  So would you personally go out and get a payday loan?  No way! And that is why voters vote to ban them - they are not good for me personally, so they must not be good for anyone else.

But here is the problem.  How do you maintain a storefront and trained people and all the documentation and collection apparatus for less than $50? The same loan at 36% would allow a fee of only$7.20.  That barely even covers paying someone to originate the loan at the counter, much less pay interest and a risk premium.

Try going to the bank and getting a home loan or some other type of loan for only a $50 fee. Granted those loans are more complicated, but in turn you will likely get charged hundred and probably thousands of dollars in fees. There is a large fixed cost component to the act of lending which we tend to ignore on larger loans, but is there none-the-less. In fact, just try to go to a bank and get a loan for$400 at all.  They don't make them, outside of the credit card industry, which solves this problem in part through economies of scale and in part through cost-shifting costs to merchants, options not really available to payday loan companies.

And so far, we are only talking about fixed costs, not the underwriting risk of extending loans to about any person who wanders in the door and can sign his/her name.  Anyone remember sub-prime mortgages?  Maybe there is a justification for large risk premiums, after all, on loans to under-qualified borrowers.  Particularly when you consider that most payday loan customers could not qualify even for a sub-prime mortgage.

The best equivalent to a payday loan offered by banks is overdraft protection, where the bank will go ahead and pay out on checks where there are insufficient funds, though they will charge a $20-$30 fee per check paid.  As you can see, these fees are very similar in magnitude to those charged by payday loan companies, particularly when you consider that these fees are generally charged on checks that average about $150. Also, folks who get one overdraft fee usually get several in a row. People are willing to pay these fees because they are in fact lower than the fees of actually having a check bounce, which can incur similar fees from merchants as well as hurting one's credit. So, you just had to write three checks to get the power and water and telephone turned on, and you are pretty sure the money is not there in your checking account. You are facing$80 in bounced-check (NSF) fees or overdraft fees.  Now might you consider a $400 loan for a$50 fee?  Well, probably the answer is still no, you would put it on your credit cards.  But everyone doesn't have credit cards, or doesn't qualify for them, or don't have a lifestyle that allows for them.  Where do they go, short of Tony Soprano?

Update: A reader sent me a link to this report, comparing payday loan rates to overdraft protection, and finding them of similar magnitude.  The author calculates an average $28.61 overdraft fee on an average$155 bounced check yields an APR of 478%.  There is a fixed cost to lending, and small very short term loans cost a lot of money, no matter how you get them.

I will remind folks not to be fooled by 18% or 23% rates on credit cards and set that as the market rate for small loans.  First, this misses annual fees for the cards.  But more importantly, it misses merchant fees.  Merchants pay between 2.5% and 3.5% of everything you charge to the credit card companies.  This helps to subsidize rates and, particularly, subsidize the fixed costs of small lending transactions.

## Students Make $100 Financial Mistake: Very Alarming! This story comes from the Arizona Republic as part of the general effort to maintain the ban on payday loan companies passed earlier this year (their is a proposition on the ballot in November to overturn the ban). At least 5 percent of last year's freshmen at the University of Arizona obtained a payday loan, a figure the surveyor described as "very alarming." Arizona's Norton School of Family and Consumer Sciences conducted the survey, which measured the financial habits of 2,172 freshmen - about a third of the class - who enrolled in fall 2007. Student use of payday loans more than doubled based on a survey taken a year ago that included freshmen through seniors, said professor Soyeon Shim, the group's director. "As consumers, students shouldn't be using payday loans as a resort to deal with financial stress," Shim said. I wouldn't really recommend that students use this expensive form of ready cash, but I can't say I am particularly alarmed. How can any of us know what pressures they are under. In most circumstances, paying a 30% interest rate seems too high. But I know, from personal experience, there are times when short term liquidity is so valuable you might pay anything for it (just look - the American taxpayers are paying about a trillion dollars this year just for short-term liquidity). In fact, if students have a bad experience, it's probably better to learn a$100 life lesson in college rather than a $500,000 life lesson later flipping condos on interest-only loans. I personally had my own caveat emptor eye-opener with Columbia House Records in college. Nothing like getting stuck with a couple of over-priced America albums to teach financial horse sense. Muskrat Love... aaaarrrggghhh! Anyway, the effort to ban payday loans altogether is one of those elitist, snobby, holier-than-thou, we're smarter than you unwashed masses issues. Middle class homeowners who are upside down in their mortgages are not calling for inexpensive mortgages to be banned, they just want a government bailout. The government may spend a trillion dollars in the end supporting the mortgage market. But if poor people pay a high fee for a$100 loan, we have to ban the whole industry.

The fact is that there is always a demand for ready cash at high interest rates, and if you drive it under ground, people just go to Tony Soprano instead.

Oh, but you are not for banning payday loans, you just think the interest rates are too high, and that what is needed is government regulation of the rates?  Uh, OK, I'm sure that will go well.  Past government efforts to reduce the interest rate premium for risk have worked out really well *cough* mortgages *cough*.

But, if you are still thinking that you are much smarter in money management than people who go to payday loan stores and you really want to use the coercive power of government to force poor people to make the same decisions you would, here's this:

However, for those who think they are ever so much smarter than payday
loan customers, who are charged a lot of money for small liquidity
boosts, consider this:  Let's say you take out $40 each week from an ATM to keep you liquid and that the ATM fee is$1.50.  You are
therefore spending $1.50 or 3.75% for a one week liquidity boost of$40, which you must again refresh next week.  Annualized, you are
effectively paying 195% to get liquid with your own money.  For this kind of vig, at least payday loan customers are getting the use of someone else's money.

## Hey, Lets Look at More Financial Sector Charts!

OK, I know burn-out is setting in.  I certainly think that explains, in part, why the House voted for a demonstrably worse bill than they voted against the week before.  But John Moore has a number links to an interesting set of charts from the Milken Institute on the financial meltdown.

They hit on many of the things I discussed earlier, but put a greater emphasis on 1) securitization, and the effect it had on good underwriting standards and 2) on interest rates as a driver of the housing bubble.

Update:  And an interesting post on the link between credit default swaps and short-selling.  My personal view is that credit default swaps will someday be looked at like earthquake insurance -- nice premiums today, but too much systematic risk, too much certainty that in 10 or 20 years there will be an event that forces nearly every policy to pay simultaneously, wiping out the insurer.  You can't get earthquake insurance, and you nearly can't get hurricane insurance, and I think the default insurance market may go the same way.  Or, as a minimum, the price is going so high few people will buy it.  This is not a market failure, it is a market lesson learned and adjustment to reality.

Update #2:  Even more from economists on the rush to bailout.

## Restricting Credit to the Unsophisticated -- And Are You Really Any Better?

After years of arguing that expanded credit is critical for the poor, and attacking banks for "red-lining" poor and minority districts, the liberal-left of this country has reversed directions, and has decided that the poor can't handle credit.

No matter how much folks want to paint the recent mortgage problem as some sort of fraud perptrated on homeowners, the fact of the matter is that in large part, lenders lowered their income standards and a lot of those folks now can't pay.  While we have yet to see any specific legislation beyond bailouts, it is impossible for me to imagine any reaction-regulation that does not have the consequence (intended or not) of restricting credit to the poor.

But these restrictions are not limited to the housing market.  Many states, for example, are cracking down and even outright banning payday loan companies, often the last resort (legal) credit source before people turn to the loansharks.  First in Ohio (via Mises Blog)

If Ohio's 1,600 payday-lending stores want to continue operating past this fall, it
appears they will have to find something else to offer besides payday loans.

A hotly debated bill that effectively would spell the end of the short-term,
high-interest payday-lending industry in Ohio sailed through the Ohio Senate yesterday despite
pleas from lenders that their stores would close and 6,000 employees would be put out of work.

The Senate was unable to find a compromise that both satisfied payday lenders and
eliminated the debt trap that bill supporters said forced too many borrowers to take out new loans
to pay for old ones. So it did what the House did last month: dropped the hammer.

"I think everybody said there is just no way to redeem this product. It's
fundamentally flawed," Bill Faith, a leader of the Ohio Coalition for Responsible Lending, said of
the twoweek loans. The industry "drew a line in the sand, and the legislature kicked the line aside
and said we're done with this toxic product."

And perhaps soon in Arizona.  Yes, the interest rates are astonishing, though the dollars involved are seldom huge for the short life and small size of the loan.  And, as an extra added bonus, Tony Soprano does not send someone to break your legs if you don't pay (the Sopranos being the only alternative provider once payday loan companies are illegal).

So, for those of you oppose payday loans, you are welcome to comment below about what a bad idea they are.  However, I challenge folks to criticize payday loans without simultaneously implicitly expressing disdain for the intelligence of payday loan customers, or trumpeting your ability to make better decisions for payday loan customers than they can make for themselves.

However, for those who think they are ever so much smarter than payday loan customers, who are charged a lot of money for small liquidity boosts, consider this:  Let's say you take out $40 each week from an ATM to keep you liquid and that the ATM fee is$1.50.  You are therefore spending $1.50 or 3.75% for a one week liquidity boost of$40, which you must again refresh next week.  Annualized, you are effectively paying 195% to get liquid with your own money.  For this kind of vig, at least payday loan customers are getting the use of someone else's money.

## More on the Teens as the New Seventies

For a while, I have been worried that the next decade may well be a return to 1970's economics, with bipartisan commitment to large government, ever-expanding government micro-management of... everything, growth-destroying taxes, and consumer-unfriendly protection of dead US industries.

Now, Megan McArdle points to an article that hints that the stagflation of the 1970's may be back as well.

Inflation and sluggish growth haven't joined in that ugly brew called
stagflation since the 1970s. They may not be ready for a reunion, but
they are making simultaneous threats to the economy and battling one
might only encourage the other.

Among a batch of economic readings today, the Labor Department
reported that import prices jumped 1.7% last month. The data included
troubling signs that consumer products, many imported from China, have
caught the inflation bug. The signs pointing to slowing growth included
a sharp deterioration in consumers' mood, as measured by the
Reuters/University of Michigan Surveys of Consumers, and a worsening
outlook for manufacturers, revealed in the Federal Reserve Bank of New
York's Empire State Manufacturing survey for February. The government
also reported that U.S. industrial production only increased slightly
during January, as colder weather elevated utilities output and offset
sharp declines in the auto and housing sectors. If indeed inflation is
teaming up with slower growth, it means big headaches for policy
makers, in particular Ben Bernanke. The Federal Reserve chief in
congressional testimony yesterday suggested that he is willing to keep
lowering interest-rates if the economy stalls. But, naturally, he will
have less room to do so if those lower rates would accelerate inflation
to unacceptable levels.

## Not a Bailout?

I was watching CNBC over lunch and saw that Alan Greenspan has criticized the President's plan for freezing the interest rates on some adjustable rate loans.  He argued, and I agree, that it is bad to mess with contracts and markets, and bad to stand in the way of a real estate bubble that needs to correct.  He said that if the government feels sorry for certain mortgage holders, it should give them cash.

I am not too excited about giving away cash to people who made bad financing decisions, particularly since I have successfully weathered a couple of tough years in my business brought about in part by rising rates on our businesses adjustable rate loans.  However, I am very much a supporter of being as open and up-front as one can be in government taxing or spending.  For example, I prefer direct payments to farmers rather than price supports.  I prefer a carbon tax to CAFE-type mandates.  In both cases, while both alternatives probably cost the economy about the same in total, the cost-benefit tradeoff is more clear in the first alternative.  Which is why, predictably, politicians usually prefer the second alternative.

All of this pops into my head because apparently the President's reaction was that he preferred his plan to a "bailout."  Huh?  How is his plan any more or less a bailout, except that the exact costs are more hidden and who pays the costs are more obscure.  The only real difference is that Greenspan's approach is probably less likely to set bad precedents for the future or to make mortgages more expensive for the rest of us, which the President's plan almost certainly will.

## Happy Birthday Leonhard Euler

Yesterday was apparently the 300th birthday of Leonhard Euler, one of the greatest mathematicians of all time and perhaps the greatest that the average layman has never heard of.

Euler is responsible for so much that is still important to modern mathematics it is hard to pin down his greatest achievement, but most will point to his famous equation that was sort of the unified field theory of mathematics, describing a relationship between all five of math's most important numbers:

$e^{i \pi} + 1 = 0, \,\!$
I learned something the other day that might be interesting to you business and finance folks out there -- the constant "e" was first described by Jacob Bernoulli when he was studying compound interest rates.

Jacob Bernoulli discovered this constant by studying a question about compound interest.

One simple example is an account that starts with $1.00 and pays 100% interest per year. If the interest is credited once, at the end of the year, the value is$2.00; but if the interest is computed and added
twice in the year, the $1 is multiplied by 1.5 twice, yielding$1.00Ã—1.52 = $2.25. Compounding quarterly yields$1.00Ã—1.254 = $2.4414"¦, and compounding monthly yields$1.00Ã—(1.0833"¦)12 = $2.613035"¦. Bernoulli noticed that this sequence approaches a limit for more and smaller compounding intervals. Compounding weekly yields$2.692597"¦,
while compounding daily yields $2.714567"¦, just two cents more. Using n as the number of compounding intervals, with interest of 1/n in each interval, the limit for large n is the number that came to be known as e; with continuous compounding, the account value will reach$2.7182818"¦. More generally, an account that starts at $1, and yields$(1+R) at simple interest, will yield \$"‰eR with continuous compounding.

In the 20th century, we have gotten in a mind set that math is this strange discipline that lives purely out in the theoretical either.  But we forget that a lot of modern math was invented to solve real-world problems.  Newton invented calculus (yeah, I know, I haven't forgotten Liebnitz) to solve planetary motion problems, and it turns out "e" was invented to work with interest rates.