Foreclosure Myths

Barron's recently published their proposed plan to solve the housing financial crisis: "Mortgage Relief for Everyone." Here is the four step plan summarized:


I've been reading a lot of this kind of nonsense in the popular press but was a little flabbergasted such a proposal was coming from a free market publication and was compelled to reply. They actually printed the letter below:

Dear Editors:

I must respectfully disagree with all four points of your plan. First, low, subsidized financing is what turned real estate investment into a financial asset akin to an option on a bond. Low mortgage rates recapitalized housing based on the debt service required to buy overvalued housing assets on the margin. The temptation of easy financing caused buyers to view housing as a sure thing with quick turnover. But all one-sided gambles soon end and now we’re saddled with a severe balance sheet problem where incomes and rents are insufficient to service outsized mortgages.

By reducing lending rates your plan merely addresses the balance sheet insolvency problem by artificially inflating the servicing of mortgage debt. This is like a little hair-of-the-dog to cure a hangover. But in the case of an asset bubble, this can only prolong the pain because your plan merely seeks to maintain these overvalued assets, while a functioning housing market going forward needs to correct them. Equity returns on overpriced housing will continue to be negative and buyers will choose to put their funds elsewhere, if they’re at all sensitive to yield. I, for one, do not want my most important asset to have a negative return for the next 5-10 years and I certainly wouldn’t borrow money at any rate to buy such overvalued assets.

It’s necessary to return housing prices to some rational level consistent with personal incomes and implicit rents. It’s time to manage the losses, not deny them. The only other option is to inflate incomes until the real value of housing equals the depreciated nominal value of mortgage debt. But this comes at the cost of all other investment alternatives, especially savings. It would also sacrifice the credibility of the dollar – an economic risk that may be incalculable.

This kind of fuzzy thinking can only be cleared up if we burst a few myths about foreclosures. Let's say someone bought a house at $600K with 5% down plus closing costs and financed the rest with a $570K loan. After a 25% decline in housing prices that house is now worth $450K and the owner is looking at a $150K loss of which his/her equity is only $30K. Does this person want to avoid a foreclosure? I think not. If fact, they're begging to push that $120K loss off on somebody else - i.e., the banks and investors who underwrote the mortgage-backed securities - and walk away.

These investors and lenders in turn would also like to push the loss off on somebody else - say, back to the original owner or the taxpayer. This argument about saving peoples' houses is really an argument on how to stick them with a really bad housing investment for the life of their mortgage. This may sound like just deserts, but how are these buyers, many of whom came from the lowest income brackets, going to save for the future when an overpriced house sucks all their disposable income down a black hole? They are going to be even more dependent on government benefits in the future. This was not the way to promote "an ownership society." The political rhetoric about "helping poor folks stay in their houses" is no benevolent altruism. The better route would be to let people foreclose and then manage the losses across the financing chain. The sooner housing falls to a realistic level, the better off our economy going forward will be. And inflation is definitely the stupidest route out of this cul-de-sac.

In the next housing phase, where most homes will be looking like a capital loss rather than a gain, we need to return prices to an economically rational level ASAP. Housing is paid for out of incomes and rents. There is a reasonable multiple of income, usually roughly 4x to borrow against for residential home purchases. There is also a reasonable multiple of gross rents that imply a fair housing value. Living in a world where there is no rational connection between these fundamental cash flow values and the price of the underlying real estate means we will be living with a dysfunctional market for a long time to come. There's only one thing worse in real estate than owning a house you don't want - having it own you.

Why Blue Needs Red (and Vice-Versa)

Pundits and casual observers have come up with all sorts of ‘theories’ to explain the red-blue divide in our politics. But the voting evidence tells a different story than the exit polls and media narratives. There are many cross-cutting divisions in our politics, but the red-blue divide is best explained by three coinciding factors: lifestyle, party and ideology. Since the 1960s the lifestyle differences between urban and rural have become aligned with liberal and conservative ideologies. This alignment has then been amplified by partisan electoral strategies and governing platforms that target these divisions. The result is that rural communities have become more conservative and Republican while urban communities have become more liberal and Democrat. Suburbs are now the tipping point, or battleground, if you prefer. Both election campaigns were well aware of this and Obama had considerably more resources to campaign in the suburbs nation-wide than did McCain. Money and the economic crisis is what delivered the election to Senator Obama.

So, will it be a battle that’s always going to be fought to a win-lose rather than win-win result? Last time country rubes, next time city slickers? The majority of the voters voiced their displeasure with this distraction and both candidates did their best to campaign on their bipartisan credentials.

But here’s the rub. The split between rural and urban values differs across many political issues and policies. These differences are eminently legitimate and beneficial to our national identity. However, our mainstream media and most of our commercial culture is heavily biased in one direction. These media industries are based in urban America and tend to reflect urban values. This is not necessarily malicious, but the reason we have few conservative reporters, TV news analysts or Hollywood script writers is because these professionals have predominantly come to reflect their urban liberal preferences.

“So,” liberals might ask, “what’s the problem?” The problem is that broad swaths of the country are founded on more traditional, conservative values. These Americans may enjoy entertainment fare from the city, but they have no desire to embrace the same values and lifestyles. Many of these traditional values are also shared by urban and suburban dwellers, but the small towns of America provide the roots from which American culture spreads its many diverse branches. Rural areas also offer a respite from the rat race, the impersonal and stress of urban living. They provide the necessary link to nature, our neighbors, and the land.

I would argue these traditional values provide an important touchstone for our national culture that promotes the diversity and colorful experimentation that goes on in the more fluid, progressive, urban environment. Americans are not really black-and-white conservative or liberal – they are tolerant and traditional. Our liberal ideology emphasizes the tolerant while our conservative ideology emphasizes the traditional. If either of these were to be snuffed out I'm sure we would be poorer in soul and spirit for it.

Big Business + Big Labor + Big Government = Universal Health Care?

If history is any guide, Rahm Emanuel has revealed the Obama administration’s strategy to cajole big business into supporting universal health care as the foundation of a New New Deal (See the WSJ: “Emanuel Sets a Challenge,” Nov. 19). The strategy implies a radical expansion of the Federal government’s commitment to social insurance mandates. National unemployment insurance and public pensions, the harbingers (or Trojan horse) of the social welfare state, were passed with similar political strategies in almost every developed democracy during the crises at the end of the 19th century and in the 1930s.

Today, corporate CEOs’ first preference is to remove rising health care costs from their income statements and the attendant liabilities from their balance sheets. Their second preference is to have somebody else pony up to help pay for it. The Democrats’ gambit is to close off the first option and leave the second as the only alternative to doing nothing. Obviously the political architects believe the triumvirate of big business, big labor and big government can steamroll universal health care over special interest opposition. This at a time when the electorate has expressed the lowest approval ratings in history for large public institutions – a level of mistrust that applies to both parties’ stewardship.

Of course, these special interests include individual taxpayers, consumers, and anyone unaffiliated with the big three, which means small business, entrepreneurs and the self-employed--who’ll all get flattened in this scenario. Every taxpayer will be subsidizing the inefficient provision of corporate and public health care and we’ll be told it’s for our own good. The only possible consequence of mandates is the loss of consumer choice and control needed to contain costs. This makes little sense in an expanding world market for private health care. Costs are best reduced by maximizing consumer choice and providing incentives to economize all around. Social insurance should only play a limited role in cases of catastrophic illness or accident. It looks like it’s time to pay attention to what change in Washington will really mean.

A Failure of the Free Market Model?

It's quite heady reading the international press these days. The proclamations of the demise of free market capitalism are proliferating like kudzu. The formerly sober Nikolas Sarkozy has been one of the most vocal in pronouncing a New World Order (based on the French model, one presumes), while talk of a New New Deal is all the rage on this side of the Atlantic. This past weekend's G20 meeting in Washington DC was a lovefest of cooperation and self-congratulation, even if George Bush wasn't quite bussed on the cheek.

But perhaps we should all take a deep breath.

Exactly what do these folks from around the world think brought them together? Was it good fellowship and neighborly concern? No. It was an interdependent network of international capital and product markets. We inhabitants of earth have just rediscovered that our fates are inextricably intertwined! But it's the global capital and trade markets that have accomplished this wondrous feat.

It's market specialization and free exchange that make the candlestick maker dependent on the watchmaker dependent on the shoemaker dependent on the banker dependent on the lawyer dependent on the farmer dependent on the grocer and so on in an endless web of interdependency. Interconnected capital markets combine one woman's savings with another man's labor and both become better off - without ever even sharing a hug. Such interdependence makes cooperation more rewarding and conflict more punishing.

Oddly enough, that great altruistic theory of state socialism accomplishes the exact opposite. In socialist societies people become isolated and suspicious, business relationships become arbitrary, honesty and transparency become clouded. People and nations cease trading to become self-sufficient. And everyone becomes poorer in a dangerous downward spiral.

So, tell me now: Are we truly going to abandon free markets and embrace statism? Are we going to be governed by who we know and what favors we owe? Will we abandon accountability and responsibility to survive on the whims of politicians? Will we pretend to work, while they pretend to pay us?

Come now, ...not bloody likely.

2008: Not an Ideological Realignment?

Interesting article in today's WSJ on the recent election, putting it in historical context. (article here - subscrip req'd)

Ms. Marisco basically compares the 2008 election with other realigning elections, specifically FDR's win in 1932. She also gives a good comparison of 2008 to 1980, arguing that both elections resulted from the failures of the previous administrations. (I'm not sure FDR wasn't also running against "4 more years of Herbert Hoover.")

In any event, the 2008 election indicates a repudiation of government failures, which implies a desire for competence, not expansion of incompetence. The calls for a New, New Deal are misguided in so many ways, as I have argued previously.

Like Reagan, the shift of independents to Obama is motivated by the candidate and his ability to reassure voters of his competence and leadership qualities. Ideology and positions on the issues are a completely different matter.

How We Vote?

Read an absurd op-ed in the NYTimes yesterday titled, "What is Your Vote Worth?" criticizing the Electoral College system, again. I reprint here it in full:

“The conception of political equality from the Declaration of Independence, to Lincoln’s Gettysburg Address, to the Fifteenth, Seventeenth and Nineteenth Amendments can mean only one thing — one person, one vote,” the Supreme Court ruled almost a half-century ago. Yet the framers of the Constitution made this aspiration impossible, then and now.

Under the Constitution, electoral votes are apportioned to states according to the total number of senators and representatives from each state. So even the smallest states, regardless of their population, get at least three electoral votes.

But there is a second, less obvious distortion to the “one person, one vote” principle. Seats in the House of Representatives are apportioned according to the number of residents in a given state, not the number of eligible voters. And many residents — children, noncitizens and, in many states, prisoners and felons — do not have the right to vote.

In House races, 10 eligible voters in California, a state with many residents who cannot vote, represent 16 people in the voting booth. In New York and New Jersey, 10 enfranchised residents stand for themselves and five others. (And given that only 60 percent of eligible voters turn out at the polls, the actual figures are even starker.) Of all the states, Vermont comes the closest to the one person, one vote standard. Ten Vermont residents represent 12 people.

In the Electoral College, the combined effect of these two distortions is a mockery of the principle of “one person, one vote.” While each of Florida’s 27 electoral delegates represents almost 480,000 eligible voters, each of the three delegates from Wyoming represents only 135,000 eligible voters. That makes a voter casting a presidential ballot in Wyoming three and a half times more influential than a voter in Florida.

This system, along with the winner-take-all practice used to allocate most states’ electoral votes, creates the potential for an absurd outcome. In the unlikely event that all 213 million eligible voters cast ballots, either John McCain or Barack Obama could win enough states to capture the White House with only 47.8 million strategically located votes. The presidency could be won with just 22 percent of the electorate’s support, only 16 percent of the entire population’s.

The authors here (a sociology grad student and two graphic designers?) adopt the logic of reductio ad absurdum to argue their case, though one wonders if they are even aware of it. They assume modern definitions of political equality mean “one person, one vote,” and then argue this principle was thwarted by the framers of the Constitution. Then they cite the remotest mathematical possibility as proof of the absurdity. They seemed to have missed the point by a mile.

Our democracy has established the principle of “one person, one vote,” but the concept of political equality and justice are not violated by the Electoral College, the Senate, or the apportionment of House seats. The objective of a social choice mechanism, which is what voting is, is to arrive at a result acceptable to the majority of voters while adhering to accepted notions of equality and justice. A direct vote with a simple majority does not necessarily accomplish this as it would strongly favor the tyranny of absolute numbers, which may only affirm the narrow interests of that majority. In other words, high population states and regions would dominate our national politics. Is this fair or just? Not to those in small rural states.

Furthermore, when that majority is geographically based, as it is today and often has been in our past, the incentive for inhabitants of regions that are persistently dominated is to secede from such a tyranny. Such secession movements are fairly common, especially in today’s world. (Just ask a Québecois.)

The intent of the framers of the Constitution was not to insure some individual notion of fairness based on equal weighting on the outcome. Rather it was to develop voting rules that reinforce the cohesiveness of a disparate, voluntary union of states. This is critical in choosing a national leader who is meant to represent the entire nation and is insured by making the geographic distribution of votes across the states as important as the raw count of votes. (Besides, the EC only really comes into play when the popular vote is too close to make a clear determination.)

Our voting system has accomplished its objective more successfully than any other political experiment in world history. It has done this while also reinforcing the concept that every vote counts—and it does, just not in the way some people have wrongly assumed. It would be very wise for us to keep this in mind, because it is a strong union, not an individual sense of importance, that ultimately defends our rights and liberties.

Election at the Crossroads

Daniel Henninger has a good essay in the WSJ on what this "historic election" is really about - whether America will turn towards it's creative, innovative impulses or towards its security and protectionist impulses. He subtitles his essay, "Shifting America's animating idea from creation to protection." [Here, subscription req'd]

He concludes that an Obama presidency would

...transform the animating American idea -- away from creation and toward protection.

Many voters -- progressive Democrats, the asset-safe rich, academics and college students -- regard this as where America should go. They explicitly want America's great natural energies transferred away from unwieldy economic competition and toward social construction. They want the U.S. to reduce its "footprint" in the world. Monies saved by stepping down from superpower status can be reprogrammed into "investments" (a favorite Obama word) in a vast Euro-style hammock of social protection programs.

Economist Alan Reynolds estimates this would cost upwards of $4.3 trillion, and wonders where and how these funds will materialize. In a WSJ Letter to the Editor Nobel economist Vernon Smith provides the answer, which I quote in full here:

I think the answer to Alan Reynolds's excellent question and article ("How's Obama Going to Raise $4.3 Trillion?," op-ed, Oct. 24) is that Barack Obama is not going to raise $4.3 trillion, and he is not going to perform on his rhetoric. He excels as a rhetorician -- common to both the great and the least of past presidents -- but performance cannot run on that fuel. Inevitably, I think his luster will fade even with his most ardent supporters as that reality sets in. We also have seen luster fade time after time with Republican presidents. The rhetoric of a smaller and less invasive government always leads to king-size performance disappointments. This weakness is as central to the reality of our political economy as are its strengths. With all its foibles, its strengths become transparent when you compare it, not with our various idealizations, but with the litter of human experiments in political economy that have delivered far more suffering and murder than human betterment to the citizens of those economies.

Of course it is entirely likely that Mr. Obama will succeed in going for higher business, capital gains and income taxes, but it is an economic illusion to think for a minute that this will benefit the poor. All our wars on poverty have been lost by failing to help the poor help themselves. Higher business taxes, which ultimately can only be paid by individuals anyway, will simply export more economic activity to the world economy. Higher capital gains and income taxes will primarily reduce savings and investment at the expense of greater future productivity, which is at the heart of cross-generational reductions in poverty. A dozen countries, including the third largest economy, already have zero taxes on capital gains, and eight of them score high on the Economic Freedom Index and high in gross domestic product per capita.

I favor making all individual savings and direct investments deductible from income for tax purposes. In that world there would be no need to make any distinction between ordinary income and capital gains. By adding a negative feature to such a net consumption tax, the poor would not only receive redistribution benefit, but have an incentive to save and accumulate capital. Some poor will see this as an opportunity to help themselves.

We swung this way politically from 1965 to 1980. In France, they tried it under Mitterand from 1980 to 1988. Neither experiment worked out very well. It won't this time either. One would hope that it didn't have to be either/or on creation vs. protection, but advocates for either direction choose to ignore the trade-off. In Vernon's last paragraph he signals the way out - which is to help the poor help themselves by becoming integrated into the capitalist accumulation process rather than on the outside looking in, hoping an afterthought of noblesse oblige opens the door a crack.

My own response to Henninger's essay was to note that we are stumbling into making a simple error of risk management, which is rooted in human nature and what all this protection is about. For lack of clearer alternatives, we have convinced ourselves that the best protection against risk is national insurance pooling. Essentially, this says we're all in the same boat and we sink or float together. Yet, the best natural survival strategy against risk in this world is to be proactive, i.e. creative and productive, in the face of change. This strategy depends heavily on the incentive structures we face. Unfortunately, the cradle-to-grave welfare state reinforces all the disincentives to manage our fears and uncertainties effectively. Pray we pull back from that long slow decline into complacency and torpor.