A Good Podcast on Housing

Well timed for the week that we've spotted our first short sale in the neighborhood, "This American Life" (which you should listen to all the time anyway because it's great) did a really wonderful comprehensive one-hour show on the housing crisis. It should be mandatory listening for, well, everyone. Not only did they cover all aspects of the crisis, but they did so in a way that was both accessible to non-nerds and yet not dumbed down to ignore important details.

Last post I ranted about the issue of over-exposure...that is, in our attempt to own our own houses, most Americans are totally over-exposed to housing price changes with no diversification within the sector (real-estate); the equivalent of borrowing a million dollars and then investing it entirely on a single internet stock. (After a bubble bursts, it's a lot easier to see how stupid an investment idea is; I think an important lesson we all have to learn from the housing crisis is that if we're going to directly connect real-estate to the global financial system, the chaotic, non-linear, unpredictable nature of the financial system is going to infect housing prices.*)

A trend that you'll spot over and over when you look at the current financial crisis and how we got here is intermediation - that is, the ability of Wall Street to take something, process it like a TV dinner, and then send it back out to someone else. The effect of this "financial engineering" (financial processing might be more correct) on our system is about as healthy as eating heavily processed food is on our gut.

But John Bogle puts financial processing in the right perspective: Wall Street's profits are the fees they take on transactions. To the extent that their profits have grown faster than GDP (that is, their growth cannot just be explained by taking the same cut from more general economic activity), we can see that Wall Street is taking a bigger slice of the pie than they used to. Finance-geeks will give you all sorts of lines about increasing efficiency of the market, but this is crap; if the financial-sector's profits grow faster than GDP, they're simply keeping more for themselves.

Financial processing is how they do it. When you listen to the slice-and-dice game that financed the housing bubble, with a mortgage getting passed on over and over, you have to remember that the parties involved didn't just do it because they wouldn't be bearing the real risk. They did it because they got paid every time they made a transaction. Wall Street had a few years of huge profits, and those profits were a slice coming out of everyone's mortgage payments. Someone did get rich off this whole mess.

Another Case of Food Processing

A caller on Marketplace Money wanted to know what to do about his auction-rate securities. If you don't follow this kind of thing, basically the investment banks convinced very reliable long-term municipal borrowers like the NJ turn-pike authority to set their bonds up in an auction-like scheme where the bonds were constantly resold each week. (Normally the bond would be 30-year fixed rate, someone would buy it, keep it for 30 years and everyone goes home. Life is boring for 30 years.)

The rationale for this scheme was: by re-auctioning the bonds, the turn-pike would constantly be getting "the latest" interest rates, which were at the time very low. (When interest rates are down at 1%, it's basically impossible to convince anyone to buy a 30-year bond at that rate.) The theory was that by making a municipal bond look variable-rate instead of fixed-rate, the borrower could get the lower current variable rate (1%).

Investors in this were told that this was just about the same as holding cash, but for slightly higher interest; since the auction is every week, you can always sell your bonds off in the next auction.

If you get higher interest, you're always taking a risk, so it's good to know what that risk is. It turns out the risk here is that the entire auction system would break down when the investment banks who ran the system ran out of money. The poor caller needed to sell his bonds ASAP (his short-term funds were in the bonds) but the auction system had ground to a halt so he couldn't find a buyer. In the long term he's not going to lose any money; the odds of the Turnpike-authority defaulting is very, very low. But he needs his money now!

(These are long-term bonds that are resold in the short term...so you can get your money now if there is an auction, or you wait 30 years if there isn't.)

Now you could say that this investor was chasing higher returns without knowing the risks, but I think we need to look at the roll of the brokers and investment banks. This poor guy got these bonds through a broker, who gave him some "good advice" - look at this clever way you can make more money. Look how clever we (the investment bank) is in creating this new trick to improve returns. Look how kind we are to let you in on this little secret. (Implicit message: returns are higher because not everyone knows about this. Truth: there are nerds on wall-street who control such large piles of money that if it's worth knowing about it, they know about it and buy it before you ever find out.)

There's a conflict of interest that was present in the dot-com bubble burst that's present here both in the housing crisis, and in all of the other instruments (like auction-rate bonds) that have started to break down as a result of the stress the housing crisis has induced. And that is the conflict of interest between profits for Wall Street itself and profits for the investors who are one set of Wall Street's clients (and the borrows who are the other)!

Auction-rate bonds turned into a deal that went ugly for both the investors and the borrowers. One might speculate that the only group for whom the deal was any good was the investment banks who ran it and got to collect transaction fees all over the place, without having to carry any of the risk themselves.

Good Advice

So if there is a common thread to this rant, it is: don't trust "advice" - see that any party that makes its money on transaction fees has an incentive that goes against your best interests. This would include:

• Real estate agents. (See Freakanomics regarding agent selling practices for their own houses vs. client's houses.)
  
• Mortgage Brokers. (See This American Life for poor recommendation on Mortgages.)
  
• Stock Brokers. (See the dot-com bubble.)
  
• Investment Advisers. (See the recent 401k kick-back scandle)
  

Of course if you believe any of what I've written, it does beg the question: why are you listening to some cranky blogger on the interweb?

* That's actually a bit disingenuous of me - real-estate has been subject to bubbles for hundreds of years; but connecting real-estate to hedge funds certainly doesn't make things better.