Rational Actors: What We Knew

I have blogged in the past on our decision to rent our house out (rather than sell it) and just a little bit on the ideological food fight over human decision making going into the crisis. Before the crash, did lenders and home buyers act rationally (according to perverse incentives) or did they simply lose their minds? I can only provide insight into one tiny transaction within the housing boom, the one I was involved in.

Why did we buy the house? What were we thinking? In hindsight it is clear that the correct decision would have been to defer buying the house to avoid the 25% decline in asset valuation. But when we bought in 2006* (near the top of the market), what did we know?

• We knew we wanted a house. We were old enough, and had rented for long enough that we wanted to try it the other way.
• We knew that we would have to live in the house for at least 4 or 5 years just to break even on high transaction costs related to housing purchases. We had no intention to sell the house on a shorter time frame. (In hindsight we ended up leaving after 4 years - a bit earlier than expected.)
  
• We knew the house was unlikely to appreciate in value. We were aware that the rent-to-mortgage ratio was pretty far out of whack, and we believed that house prices couldn't really go up any more. In other words, we had no speculative interest.
• We "knew" that high housing prices were sustainable. Before Washington DC, we had lived in Boston, and I had worked in San Francisco, two markets with sustained unusually high housing costs. So it didn't seem implausible to us that in the suburbs of Washington DC, housing prices could simply remain high.
• We knew that we could get decent financing with a manageable fixed long term interest rate, and that this was desirable. We put down a very large down-payment. We had no expectation of strategic default at all.
• We knew that there had been rapid turn-over and price appreciation (a "boom") in the housing market over the last few years, with crazy things going on (bidding wars, no inspections, etc).
• We knew that there were tax incentives to pay a mortgage rather than rent, and we could do a monthly-cost analysis to show that we'd get a reasonably good deal (in terms of monthly payment) despite rent-to-mortgage ratios.
  

We did not know that underwriting criteria had so totally fallen apart; stories of NINJA loans and liar loans were not mainstream and the Giant Pool of Money was two years away. And we had no idea why Wall Street would make loans that would not be repaid (nor did we realize that this they were doing such a thing).

We also did not think that Washington DC was likely to suffer a real-estate bust they way Texas did in the 80s; it seemed that the government was hiring lots of people and would keep on doing so and that the housing build up was reasonably permanent, similar to other high-priced east coast cities. The notion of a nation-wide, rapid, steep housing crash wasn't on our radar; we didn't recognize that the volatility in housing prices we were seeing was, in fact, real volatility.

So putting it all together: our purchase of the house was not speculative. We expected flat home values and tolerable expenses, and we were willing to accept that to not rent. We had no sense of the price volatility that a house might display.

Better Late Than Never

I started reading finance books after we bought the house; before the house purchase, my strategy was "save money for the house." It was only after the house down-payment was paid for that I started to ask "what else to save for."

So one of the questions I have to ask is: had I read all of the books first, would we have avoided buying the house? Upon writing up our assumptions, I think the answer is "no". In particular, simply making a case that houses are tied to interest rates and interest rates can be volatile would not have scared us off. Houses are illiquid and expensive to sell, so we would have expected a rate spike (even a serious one) to only slow the market down, not murder it. The missing piece of information was the huge exposure to ARMs and deteriorating lending quality. It's not that this information wasn't know-able back then, it's that we didn't know about it.

If you want to categorize this transaction, the best label is probably "information asymmetry".

* This is not meant to be a "cry-me-a-river" post regarding the house; we are very, very lucky that we were able to absorb the loss without having to put our career and life plans on hold. Many others are not so lucky.

Rent This House - Pay No Tax

In past posts I have tried tried to describe the math behind keeping the house as a rental. Main points:

• Consider all expenses when calculating whether rental pays. Property tax is a big one!
• Consider return on equity; if you have equity, you need to earn more than you would by selling and putting the money you get in a bank. (Of course, the banks will give you 0.0001% now, so that may be moot.)
• Consider high transaction costs - it's just not cheap to buy and sell real-estate. In our case, we considered the market dislocation as driving up transaction costs (in that we'd have to have the house on the market for a while).

Well, it's April and the tax man is upon us.* Here is what I have learend:

1. Losses on the rental property (there are a lot of up-front expenses; since we rented in October we're definitely in the red against those up-front costs for 2009) do not lower taxes on your regular work-type income. So we just "carry the loss forward" - that is, we can use our loss to pay less taxes next year if/when we make some money on the house.
2. We have to depreciate the house - that is, we claim for tax purposes that it loses about $3000 of its value as an asset every year. This produces another "loss" for tax purposes.

If we have a good year with the house, we will still make less than $3000 in profit, so it turns out that due to depreciation, we will probably never have to pay taxes on the house.

To explain this second point in more detail: think of your rental house as a business; the business "buys" a house and thus has an asset. The IRS requires you to treat that house as losing value over 30 years. (This is silly because you will almost certainly be able to sell your house for more than $0 in 30 years, but hey, I only work here.) Your business recognizes a "loss" every year of a little bit, and thus you are less profitable to the IRS than you are in real life. (Clearly you didn't lose any real money to depreciation.)

There is a flip side: when we go to sell the house, the price we paid will be lowered by all of that depreciation. We paid $400,000 for the house (plus closing costs), so the odds of us making money on selling the house are approximately zilch. But for tax purposes, the price we bought at will appear lower for every year of depreciation.

(The IRS calls this "recapture" - the idea is that we really did think the house was trending toward $0, so when we actually sold it for more than $0, we were surprised that we made that unexpected money. Again, this strikes me as very silly indeed, but I'm not in charge.)

The final piece of the puzzle: if we have accumulated "losses" with the IRS every year (it's possible, because depreciation will be larger than our profit margins) we do get to use those losses against selling. So when it finally comes time to sell the house, the taxes on any gains (should they, due to some freak accident, exist) will be made larger by depreciation but smaller by losses carried over.

Does this affect the net calculation of whether it pays to rent a house out? I don't think it really matters substantially. It does change all of the numbers a little bit, but the way I see it, there are enough unpredictable factors (how long will you be renting, what will future interest rates be, what will the rental market bear) that the unknowns dwarf the imprecision of calculations done without correct tax treatment.

* You should really not treat anything I say on this blog as professional advice. The best thing to assume is that I am a computer programmer who is woefully under-informed in financial matters, because, well, I am a computer programmer who is woefully under-informed in tax matters.

I'm Only Happy When It Rains...

On On the Media, Adam Davidson describes the difficulty of explaining anything financial on the Planet Money podcast. And this has to be a concern to all of us for a simple reason: we (the tax payers) got totally looted this time around, and if we can't even understand the arguments about how to fix the problem, Congress isn't going to "fix" the systemic problems in our financial system in a manner that works out well for us. Simply put, if we can't understand it, we're going to get looted again.

So what do we do when we find explanations like this? Friedman is arguing that people buying homes at of market were acting rationally, the bankers weren't acting irresponsibly due to their paychecks, and that regulation, not deregulation caused the crisis. His arguments are more nuanced than I am describing; I am phrasing them a bit more bluntly to draw out how ludicrous they are. Mike Konczal takes apart point three here.

But can we even understand what they are arguing about? What are these capital minima, and why do we care?*

Rainy Day Funds

As part of our personal finances, we maintain "rainy day" money - that is, money that just sits in a boring old FDIC insured bank account for the sole purpose of having money on hand if something bad happens, like I lose my job or the car gets hit by a meteorite.

Now we have a friend, let's call him Joe. Joe has a good job that pays a lot of money, and Joe has expensive taste. He pays for his car, mansion, caviar, champaign, and Armani suits using credit cards, mortgages, car payments, etc. In other words, Joe has a ton of debt, but he also has strong cash flow coming in to pay that debt. He swears he has the situation "under control".

Joe has a rainy day fund too! But...his rainy day fund is only $5000. We keep telling Joe "that's too low". What if something happens?

Unfortunately Joe's high paying job was in banking, and he was laid off last year. The $5000 of rainy day money wasn't even close to being able to absorb the avalanche of debt he was faced with. In fact, it got a lot worse; since his house went down in value, he can't sell his house to make back the money he owes on the mortgage. Clearly $5000 wasn't enough.

Rainy Day Funds for Banks

You can think of reserve capital as rainy day funds for banks. Every time a bank makes a loan, they are required to put a little bit more money into the rainy day fund, just in case the loan goes bad. The Friedman and Konczal are arguing about what effect the government minimums on the rainy day fund had.

Konczal's argument is an important one to understand, and it is basically this:

• If banks are going to have the minimum rainy day funds the law will allow, then banks are trying to live on the edge, and the law has to assume that bankers are crazy.
• If banks are going to have larger rainy day funds than the law will allow, then you can't blame the law for being "too lenient" because the bankers are choosing their own (larger) rainy day funds and thus it is the banks own decision that is right or wrong.

In other words, you can't claim that banks are grown-ups who can manage their own finances and then blame the law when banks fail.

This begs a question: why wouldn't banks set up larger rainy day funds to avoid failing? The answer is that banks profitability is measured relative to their rainy day fund - that is, relative to their capital base. Thus the closer to the edge a bank runs, the more relatively profitable it is as a business.

I would argue that there is also assymetric risk (something that deserves its own post). Basically if the bank is more profitable, the bankers might get higher pay, their stock options might be worth more, they might get a bigger bonus pool. But if the bank fails completely, once the bank is bankrupt, life doesn't get worse for the bankers if it is more bankrupt. If the bank fails gently (is insolvent by $1) the result is the same for the bankers as if the bank completely implodes and needs a huge taxpayer bailout.**

One more thought: while I think Konczal is right to point out the flaws in Friedman's logic regarding regulation, I consider the capital requirements (rainy day arguments) a little bit silly; the rainy day requirements that would have been necessary to keep a bank functional in the face of the crisis at hand now would have been so high that anyone suggesting them would have laughed the idea out of congress or the boardroom. The requirements would have been too large for banks to function at all.

The heart of the problem isn't banks having inadequate reserves for a crisis, the heart of the problem is the banks making an astounding number of loans that will never be paid off. It's the equivalent of Joe buying the state of Florida on his bankers salary; no amount of rainy day savings is going to protect against that.

* Regarding whether bankers who made money by doing deals regardless of whether they failed may have had incentive to do stupid things, and the mentality of home buyers in 2006, I'll leave that to you to judge - human nature is what it is.

** That result under Bush and Obama appears to be that the bankers get to keep their jobs, which is astounding.

So...How Did We Get Here?

Housing wise, it's been a good four years. Let's review:

• Housing prices are down about 25% where we used to live, more so in less fortunate parts of the country.
• The economy is on its ass, with high unemployment and poor growth.
• Interest rates for consumers are very low - if you have money in the bank, you're not getting much for it.
• Credit for businesses is hard to get, see also poor growth.
• The Federal Bailout Agency^H^H^H^H^H^H^H^H^H^HFederal Government has spent all kinds of money on the crisis* so when we come out of all of this, our national total national debt is going to look at lot more like Italy's than it used to.

You might ask yourself: how did I get here?

Let's trace backward. The problems we have today come from two sources:

1. The results of a housing bubble. The housing bubble represents a massive mis-allocation of resources. Simply put, we spent the Bush years (I don't want to call them the "oughts") building houses we didn't need; this hasn't set us up for future growth, rather it was squandered investment.
2. The bursting of a credit bubble. There's a lot less credit than their used to be, which makes it hard to invest in new growth.

These bubbles are actually interlinked; since most people finance their houses, house prices are tied to housing credit (that is, cheap mortgages). So really we had a mortgage bubble that is now hitting us twice: it hurt our real economy by misdirecting investment into houses, and it hurt our banking system by creating a lot of bad debt.

How did we end up with a mortgage bubble? The answer to that is: financial alchemy.

Simply put: Wall Street banks discovered that they could turn lead (sub-prime mortgages and other low quality debt) into gold (AAA-rated CDOs) because the credit rating process wasn't very good. Banks could stuff their securities with "thin file" borrowers (borrowers with a good credit score but short credit history) and low-score borrowers and the average was good enough for the pool to be acceptable.

Wall Street made money on these transactions from the difference in the cost of raw materials (crappy mortgages) and the price of the finished product (high-grade AAA debt). This explains the strong pressures for lower lending standards: the worse your mortgage, the less the bank has to pay to buy it; if they can still manage to turn it into a CDO, they make more money by lowering their cost of supplies.

You can think of this as painting lead bars in gold paint because the gold inspector only looks at the bars, rather than testing them more carefully. Get the cheapest lead you can to make the most money when you resell your fools-gold.

The banks building these CDOs would have done quite well by this strategy except for one problem: they kept their own defective product. In trying to answer the question: were they malicious or were they incompetent, this pushes me to suspect gross incompetence; if you know you are making a truly defective product, the last thing you want to do is keep it. If nothing else, I think the CDO losses being eaten by the major banks indicate that they didn't realize the scope of the mess they were making.**

So to summarize: Wall Street discovered they could make money by financial alchemy, and the raw material was housing debt; this demand for housing debt as raw material drove down the cost of financing and thus drove up the price of houses, which caused a building boom. (You gotta love how commodities markets react to prices.) When the whole thing fell apart, we're left with too many houses, too much bad debt, and not a whole lot of money. Not a whole lot of money unless, of course, you received bonus payments for creating CDOs.

* I am very critical of the Fed and Treasury's handling of the crisis, which I think has created moral hazard and burned fiscal and monetary resources without either fixing real problems for "main street" or addressing any kind of long term problems. This approach has been consistent under both Bush and Obama.

** This doesn't make their actions even remotely acceptable; but I think the issue is important when we consider how to prevent this from happening next time. Regulations to stop "bad guys" aren't going to help; we need regulations that stop the amount of damage that can be done by "dumb guys who have our money".

Why Did We Keep The House?

(I am just now finishing up this post, which I realize has been sitting half-written for months now.)

In my previous post I tried to at least enumerate the costs of renting the house rather than selling it. The rent checks have to cover not only the mortgage but also property tax, maintenance, and return on equity.

(That last one is often overlooked: if you somehow still have positive equity in your house, then if you don't make at least some profit from renting, you're missing the money you would have made by selling and gaining interest on the cash you'd free up.)

And the short answer is: we are probably slightly behind when renting - that is, the cost of property tax, maintenance, mortgage, and a conservative return on equity* are more than the rent minus property management commission. (With the initial costs of getting the house ready, we're definitely behind but that's perhaps to be expected.)

So why did we keep the house? The short answer is: selling it would have been a lot uglier.

Before going on to the specifics, I have to rant about real-estate agent fees. The transaction costs to sell a house are 6%. I can't come up with words to describe how obscene that is. (Even if I could, I'm told that my mother is linking to this blog for the pet pictures, so I'll keep the language tame.) If you had a stock or bond that had a 6% commission to sell it, you'd throw it straight out the window and never look back.

(Wait - mutual funds did have commissions - these were "loaded" mutual funds, and had something like a 5% fee to buy in. They've gone the way of the dinosaur.)

Unfortunately with housing we're still stuck with high transaction costs - any strategy for managing housing investment has to take them into account. I don't think that FSBO represents a great way to save on transaction costs - if we announce FSBO, we probably have to accept buying agents, and even then we're going to get low-balled because the buyer knows we aren't paying that 3% on our side. For transactions to become more affordable, the cost structure needs to decline across the entire industry.

Besides the high basic transaction fee to sell the house, there was another factor: time on market. At the time of the decision, there were almost a dozen short sales in our neighborhood, many where the house was the same layout as ours. The short sale price (yes, many won't sell at all at that price) was perhaps $20k to $40k below "market", which was already really low.

Would we have been able to sell at market by waiting? Well, having let this blog post sit, we now have a historical data point. Our neighbors have been trying to sell their house. Personally I think they have over-priced it (it's easy to call your neighbor's house over-priced, hard to call your own...) but the operative number is over 200 days on market, or over $10,000 in lost rent.

With the great options of fire-selling (at least $20k loss), leaving the house on the market (at least $10k loss) and paying at least $15k in transaction fees, selling didn't pay.

Executive summary:

• We "make the mortgage".
• While this feels good, the net return on the house is probably a loss, when you go account for everything.
• The specific losses to selling in this environment would be worse.
  

* How do you know how much "return on equity" you should be getting? One simple way to figure this is to ask what you'd get back if you put the money somewhere else. I would suggest a conservative proxy, like: what would you get in an FDIC-insured savings account. It isn't fair to compare return on equity to a highly volatile investment like stocks. Sure you aren't making 6% on your housing equity, but then it is unlikely to plunge by 50% one year.

Who Drank the Spicy Soup

So there is one remaining question to answer: who drank the spicy soup? If the effect of securitizing all of this mortgage debt was to create more risk than we could handle, who ate that risk and ended up with a case of indigestion?

To quote top gun, the list is "long and distinguished". (Wikipedia has a chart but I'm not convinced it is accurate.

First: the investment banks.

• Lehman and Bear Sterns dropped dead. While their losses weren't huge, they didn't have the capacity to sustain much damage either.
• Merrill Lynch lost the most - almost $30 billion. I'm sure Bank of America feels good about that purchase. ("We want to be just like Citi - flat broke!")
• Goldman apparently didn't lose anything, although Goldman's financials can be opaque at best. They shorted the market at the last minute to offset losses - on the other side of that bet: AIG

Of course if the Wall Street investment banks are dumb, you know someone has to be dumber.

• UBS managed to lose $37.7 billion. They were one of the big suckers at the table.
  
• Citigroup lost $39.1 billion - their strategy of creating toxic waste, then keeping the toxic part didn't work well.
• Bank of America lost $7.95 billion. I believe this is the losses they earned the hard way, not the losses they "bought" by buying Merrill before Merrill's losses were fully disclosed. Note that they also own Countrywide - clearly BoA has a talent for aquisition.
  
• Washington Mutual and Wachovia both went under and were sold off (to JP Morgan Chase and Wells Fargo, respectively).
  

Finally we have the insurance companies. Since insurance companies "sit" on your premiums while waiting for something bad to happen, they are natural buyers of securities. Some insurance companies are crazy enough to try to insure financial products. Both MBIA and AMBAC had multi-billion dollar losses, but the big whale, the big sucker at the table was AIG, who have lost over $100 billion dollars since the crisis hit. Don't worry, though, you and I have their backs.

If you want a short list of suckers, basically it's:

• AIG, who bet wrong on sub-prime for the first half of the housing boom.
• Citigroup and Merrill Lynch, who were dumb enough to keep their own toxic waste. (Bank of America has managed to buy plenty of sick companies, so Citi and BoA are now the dynamic duo.)
  
• UBS, who bought toxic waste late in the game.

Of course, the real sucker is you and me, because it's our tax dollars bailing out AIG, Citi and BoA.

CDO Soup

We can understanding tranching via soup - it's the uneven distribution of risk and reward in a financial, um, mixture.

So what the hell is a CDO?

Well, recall in our soup example, we let the soup settle and ladle off the "really hot stuff". We can then sell spicy soup as not-so-spicy because we've put a disproportionate amount of the "hot stuff" into just a few bowls.

What do we do with the left-overs - those few bowls of soup so hot that no one can drink them?

Well, if you're Wall Street, this is what you come up with:

We'll just let the spicy soup settle for a day! Then we'll come back and it will have settled into: a really goddamn spicy bowl of soup at the top, and the rest will be drinkable. We can sell that.

That's a CDO*. We cut up and unevenly divide the remnants of what we already cut up and divided.

And if really want to push it to the limit, we'll take that settled soup and we'll let it settle again (no, really!) and try to ladle off some of that as a CDO-squared.

And if we really want to...oh wait, the whole financial system blew up. So much for the CDO-cubed.

* Technically a CDO is a tranched mixture of any pile of underlying stuff, but the ones that have gotten us in trouble are the ones that are a cut up mixture of mortgage backed securities.

Bob Vila Needs to Make More Than the Mortgage

Lori and I have entered a new phase of owning a home: we have rented it out. Lori began vet school this month, so we needed to relocate to Massachusetts). Rather than sell the home and buy a new one (or not), we rented the house and are renting a condo near school.

We ended up using a property management company. I spent almost two months in DC trying to rent the house myself and eventually gave up. Given the work that the management company did on the house, it is possible that we could have rented it ourselves. But the quality of applicants I screened on my own was...well...it wasn't good. What I've been told (and my experience bears it out) is that financially problematic tenants look for owner-landlords, thinking they won't be strict on financial criteria and/or won't do their homework. I did my homework, and what I saw was not pretty.

This is my game theory rationale for why a management company can pull better tenants. The agency cost is born by the landlord, who pays as much as first months rent in finders fees. The tenant pays nothing. High quality landlords and tenants are trying to find each other (or rather, if you are a high quality landlord, you want a high quality tenant, and vice versa). The agency cost acts as a selection signal - that is, if I am willing to burn my first month's rent on agency costs, I must believe that I will be able to sustain a high quality tenant in the long term, because my house isn't falling apart. High quality tenants know I am serious from this.

Since the finder's fee is real money, it's not a signal that can be faked easily by a landlord with a problematic house. But...why should the landlord pay the fee and not the tenant?

My answer is: asymmetric risk. As a tenant in a blue state, my landlord can't do much to me. His business is heavily regulated, the courts are sympathetic, and best of all, since he's sitting on property, he's a sitting duck for lawsuits. (That is, if he won't pay, I can get a judge to put his lien on his house.) I didn't realize how much leverage tenants had until I read the law as a landlord.

The landlord, however, is not in a great position. Give me a bottle of scotch and let me loose in your bathtub, and I can do damages to your house that will cost a full year's rent to repair. Against damage to an insanely expensive asset, a landlord has a few thousand dollars security deposit. And in terms of practical collections on damages, the tenant can skip town.

So it doesn't surprise me that the landlord pays for agency. It's worth a lot more to me financially as a landlord to have a good tenant than it is for me as a tenant to have a good landlord.

(As a tenant in Boston in 1998 I did use a broker, and it was structured where the tenant paid. Perhaps this is consistent with the brutally tight Boston housing market, where landlords can do pretty much whatever they want?)

So, Did You Make the Mortgage

The most common question I get asked when people here we're renting out our house is: do the rental payments cover your mortgage?

The short answer: yes.
The long answer: it's still definitely the lesser of two crappy housing options.

The problem is that the total cost of renting a house goes well beyond the mortgage. Besides the mortgage (which gives you a deduction against income tax on rental payments), you have property tax (a surprisingly big fixed cost), agency fees (in our case), repair and maintenance costs, and return on equity.

To focus on that last one: if you have positive equity on your home, it is not enough to get $1 more in after-tax rent than you spend per month in mortgage, maintenance, property tax, and any landlord-paid utilities. You are also losing the interest income on the money "tied up" in the house - your equity. If you would get cash out by selling, that cash could be sitting in a bank account returning...um...okay, so it wouldn't be returning squat right now, but in theory there is such a thing as interest.

I don't know what the long term outcome of renting the house will be. I do know that in the very short term, we're still in the red due to one-time costs to get the house ready to rent. (A lot of that stuff is repairs we could have done but put off as owner-occupiers.)

I will describe the trade-offs of selling vs. renting out in a future post.

Innovation and Commodification

There are fights going on in the banking industry right now that I want to rant^H^H^H^H call attention to. They are issues that most people probably don't know or care about, and yet they will affect our collective quality of life directly.

What do credit cards, mortgages, and over-the-counter (OTC) derivatives have in common? They are all products that are non-uniform - that is, each bank gets to make each product individually.

Defenders of deregulation would argue that the freedom to innovate in any way the banks can imagine is good for all of us, because the innovation leads to efficiency.

Despite having been raised by liberal socialists, I am sympathetic to this argument. I work in a highly deregulated industry (IT/computer tech) and would be at best grumpy if anyone told me how I could go about writing X-Plane.

But is that really the right analogy? I submit that banks don't fear the end of innovation - they fear the beginning of commodification, and we have a perfect analogy in the PC industry.

The computer hardware industry is, to put it bluntly, brutally competitive. It's not an easy part of the industry to make money in. Every year a PC sells for less money, but does more. Poor companies like Dell and HP are caught in the middle of that.

Okay - who are we kidding? No one is crying a river for HP or Dell, but being able to buy a laptop for under $500 is pretty awesome. There is no question that, from a price performance standpoint, whatever economic force is holding HP and Dell (and all of the other manufacturers) feet to the fire is yielding real dividends to consumers.

I believe that the force driving the price of PC hardware down is: commodification. Simply put, all PC hardware is like all other PC hardware. For any given product category, the ways a manufacturer can "innovate" is limited by the implicit rules of the PC ecosystem.

• RAM & Hard Drive: you can increase capacity, decrease latency. But you can't go changing around how the part fits onto the motherboard.
• CPU: you can increase the number of cores, you can increase speed. But you can't change what types of computer programs it runs.
• Graphics card: you can increase how many triangles you can draw. You can increase how much detail you can draw per pixel. But you have to do this via a standard interface.

When the specifications of a product become limited, it can be commodified - produced the same way by multiple manufacturers. Purchasers can easily change between suppliers, which puts intense competitive pressure on manufacturers to compete on the "commodified" axes (that is, the official ways commodities are measured).*

So let's take this back to banking. Look at things the banking lobby hates:

• "Plain vanilla" pre-approved consumer products. This would be direct commodification of anything in the consumer market. When the only thing banks can compete on is interest rate, interest rates are going to get driven down about as low as they can go. (The loss will come out of the banks margin on the product.) It's understandable why they don't like that.

• OTC vs. Exchange Traded Derivatives. This is complicated enough to warrant another blog post, but basically a derivative sold on an exchange is a standardized, commodified derivative, and the companies "manufacturing" the derivatives for trade make only the thinnest margin on large volume.

  By comparison an OTC derivative (a custom derivative made by a big bank for a company - think of it as getting a car designed from scratch instead of just going out and buying a Honda) is sold by one bank . There aren't any comparable derivatives to even check the price against! Which product do you think is more profitable?

Commodification is appropriate when we can quantify exactly how we want to select our products. Commodified memory works because we can standardize all but two variables: size and price. For a given class of memory, we can then buy the cheapest chips.

Could we do that for financial products? Yes! I reject the claim that exotic mortgages are useful for some class of buyers with special needs. If this were true, they would not have become the standard financing vehicle for several years. I think we know what most people want from a mortgage:

• Low up front costs
• Low monthly payment
• Low interest rate

In other words, when it comes to a mortgage, there is really only one variable: price. If that isn't a product waiting to be commoditized, I don't know what is.

If there is a single idea I want to leave you with, it's this: different kinds of innovation are good for different parties, and commodification channels that innovation into avenues that are good for the purchasers of a product. There is nothing anti-competitive about commodification. In fact, I would argue that it is anti-competitive not to have commodification.

Banks like the current system because they can offer products just different enough, just confusing enough, just opaque enough that consumers can't direct purchasing power toward the competitor who provides the best deal. Commodification would make these products transparent, and would make the market more efficient.

In a commodified world, banks would have to innovate, but they'd have to innovate on how to get us the best price on a mortgage, not on how to hide the fees in the hardest-to-find places.

* I would be remiss if I were to pretend that this always works out well. Five years ago, the commodity for CPUs was clock speed, rather than throughput, and the result was the market producing CPUs that ran very fast, but got very little done as they ran.

Is It My Turn Yet?

NAR wants us all to beg congress for an extension to the first time home-buyer's tax credit. That sounds good to me, but I wanted to punch up the text a little bit. Here's my version of the letter.

Dear ________,
I am writing to express my strong support for Congress to extend the $8,000 first-time homebuyer tax credit through 2010.

Throughout this financial crisis, there has been one consistent, clear, and very American policy: if you did something really stupid in the last decade, whether it involved making non-competitive cars that no one wants or designing financial instruments that would lose most of their value while paying hefty bonuses to bankers, congress will bail you out, and the tax payer will fund it. Should housing be any different?

Reports show that home sales to first-time homebuyers increased by 25% in 2009 and now account for 50% of all sales. In addition, the tax credit is reducing the inventory of foreclosures that are sitting on the market, helping our neighborhoods and communities recover. Like the big banks, us home buyers did some really, really dumb things over the last few years, and this government-provided bail-out is helping us "recover" from our mistakes by making future, similar mistakes cheaper.

While I believe the market has improved, I do not think it has fully corrected itself. In order for that to happen, we will have to reach similar levels of bad lending policies (NINJA anyone?) and delusional optimism that housing prices only go up. While this level of psychotic optimism has been hard to find in today's difficult economy, the best way to assure continued housing activity is to extend and expand the credit and to do that NOW. Nothing says "do whatever you want, we'll pay for your mistakes" quite like a government back-stop on bad investments.

We can't wait until late in the year to see what happens. It might turn out that houses aren't worth as much as we paid for them in 2006.
Sincerely,
_______

Now where's the bail-out for grumpy-coffee-drinking-work-at-home-computer-programmers-whose-pets-are-running-around-the-house-like-animals?

Houses and Finance

You might have thought that my mad rants on finance were totally unrelated to a housing blog. But...it turns out that housing and finance do intersect, in some ways that have turned out to be pretty unfortunate for home-owners.

There are a few financial bloggers who I really like - Mike Konczal is one of them. He wrote a series of guest posts on the The baseline Scenario (another really good finance blog) that are of interest to home-owners who might be asking the question: "how did Wall-Street-style price-insanity infect my local neighborhood?"

The Limits of Arbitrage. This is an idea that has also been explored for stocks, but the basic idea is that if enough people lose their minds and start buying up the price of an asset, it may be impossible for sane, well-informed people to bet against them, making money while forcing the price down. There can be two reasons why people can't "bet against" the bubble:

1. There is no good way to make the bet. For example, if I believe houses are going up, I buy a house. But if I think houses are going to crash, it's a lot harder. If I don't already own a home, I can't sell a house.

   Since I can buy 2, 3, or 4 houses if I want, but I can only sell what I already own (1 house for most home owners) it's a lot easier to make the bet that houses are going up than going down.

2. If you borrow money to bet against an asset, you can go very, very broke. The problem is this: if you bet against asset X, you lose money every time asset X gains money. Your lender isn't going to lend you money once you've lost more than your own share. Put it together and a large enough rise in asset X means you're broke.

   For example: Google is at $100 and I think it's going down. I have $1000 and I borrow another $1000 and short (bet against the stock). I now am short 20 shares. If Google doubles in price to $200 then my initial $1000 only covers half of those shares. At about this time the bank is going to ask me to unwind the trade and give them back their money, because if things get any more out of hands, I won't be able to pay the bank back at all.

   Of course, this sucks for me - if Google later crashes down to $10, I'll never see my money - the bank forced me to sell at the worst time because I ran out of credit! Why does this matter? It matters because people can use credit to bet that an asset will go up. If they can't use credit to bet that an asset will go down (without risking the bank pulling the rug out from under them) then the amount of money betting on a rise (amplified by borrowing) will dwarf the bets on a fall, and the people betting on the price going down won't be able to "hold down" the price.

Phew. So what does this mean for houses and stocks? It means that even if smart, clever people could have predicted the bubble (some did, it remain arguable if enough did to make a difference) those smart people might not be able to keep prices sane because of structural problems with the markets. The only thing you can do is get out of the asset class entirely while the bubble goes by and wait for things to calm down. This is possible for stocks but more difficult for houses.

Prepayment. Mike is a financial engineer, so his articles can get technical, but I think prepayment is worth looking at. Cynics like me might accuse the banks of speculating on rising housing prices when they wrote all of these lame loans, but how do you make the link?

In The Giant Pool of Money NPR financial reporters explore the idea that with low interest rates and a lot of international capital, there was a huge desire for mortgage debt. In Infectious Greed Partnoy argues that often derivatives were sold to clients who didn't know what the hell they were doing.

So you can put together an argument and say "oh - the banks made subprime loans because hedge funds, insurance companies, pension funds, and other pools of money wanted the derivatives that come from subprime loans, and were too stupid to see the risk." But this doesn't explain a strange market inversion, where sub-prime mortgages were in higher demand than prime mortgages, creating incentives for brokers to push them. (A broker might make a higher fee on a subprime loan, but only because the originator set things up that way - e.g. the broker gets paid more for subprime if the originating bank wants that loan...why does the bank want a subprime mortgage?)

Here Mike suggests an answer: the prepayment penalty in a sub-prime mortage changes the very nature of what a mortgage is. One of the weird features of prime (normal) mortgages is prepayment. Owners pre-pay when interest rates fall (making a re-fi a good idea). This really sucks for the lender. If I offered you a CD that has a 5 year term but will drop to a 1 year term only if interest rates fall, would you accept it? Heck no!

(If I understand my financial engineering, mortgages have "negative convexity". Basically the longer a loan, the more its value changes with interest rates. But a mortgage's time span goes down when interest rates fall due to prepayment. So a mortgage is a loan whose duration is longer when interest rates are going up. Since a loan's value (to the lender) is inversely proportional to interest rates, this is about as bad as it gets: a loan that changes its value a lot when its value falls but only a little bit when its value goes up. If this seems totally one-sided, it is...this one-sided lender-is-hosed pricing comes directly out of the one-sided nature of pre-payment. Prepayment is heads-I-win-tails-you-lose, with the winnings for the borrower and losses to the lender.)

But if you can soak your borrower with a 4% penalty every time they prepay and encourage the borrower not to run the mortgage to its full 30 year duration (by having horribly high floating interest rates after the first few years) well....now we have something. We have a mortgage without this "negative convexity".

There's only one problem: it's a subprime mortgage - we might not get our money back. And now we can connect the dots. To the lender, a subprime mortgage has less interest rate risk but higher credit risk. And the credit risk of a mortgage has everything to do with housing prices. Ergo: the subprime mortgage as a speculative instrument exposing banks to rising real-estate prices.

(Of course we can see the problem now: as a way to speculate on housing increases, a subprime mortgage is a bit like selling a put option - you make a little money when you win but lose a lot when you lose. In the case of the mortgage, the most you make is the higher interest and prepayment penalties. The most you lose is a huge chunk of the mortgage. Which is exactly what has happened.)

Mixed Messages About Flying Under the Influence

When we bought the house 3 years ago it came with this totally awesome biplane made entirely out of Coors Light beer cans. I find it simultaneously wonderful and revolting.

I am very tempted to send it to Austin as a house warming gift...

Rent This House

We spent the last two days preparing pictures for our home web page. You can see the end result here.

As usual, the pets were immensely helpful!

We're ready for our close-up.



I don't want to go in the toaster!



After a big day on set...we get soooooo sleepy!

CC Is Tired


I am ready to help if you need me!

Ch-Ch-Ch-Changes

3 months without a post? 4 months? Quiet blogs sometimes indicate significant "stuff" in the lives of the posters. That's definitely true of my work blog (less posts = more code) and is true here too.

Here's the short of it:

• Lori got into Tufts vet school! She starts "real soon".
• We're moving to Westborough, MA.
• We'll be renting out our house here in Maryland.

So we're going a bit crazy right now getting the house ready to rent, getting the move organized, etc.

The of whether to sell or rent is a complex one, and it ties together the two themes of this blog (housing rants and financial rants) into one, um, über-rant. Comparing life as a tenant, landlord and home-owner is eye-opening too.

More to come soon - we're working on our showing pictures today, and I think they're coming out pretty good...it's nice to see that the house can look good when we get all of our junk out of the way. (Then we ask: why don't we always leave the house like this? Answer: we have too much stuff!)

Yet Another Way to Fund Housing

In a previous post I suggested that housing could be funded via equity instead of debt, an idea inspired from other economists and twisted slightly.  It's a somewhat impractical idea - at best the equity stake in a house owned by those other than the occupant would be split into tiny pieces and combined to make a "housing equity index"-style investment.  (The goal of slice and dice here is to emulate stock index funds and insulate passive investors from the occasional idiot home owner who destroys his own equity.  The goal is not to create tranches to change the risk curve like a CDO.)

The problem with this scheme is that the equity holders of the house would either have a say in how the house is managed (an annoying intrusion on home owners) or have no say (which means their capital is at risk).  This new scheme tries to work around this by keeping ownership with the occupant.

Derivatives As Insurance

Derivatives are like the force - they can be used for good or evil.  A legitimate use of derivatives is to offset one risk with the exact opposite risk.  For example, an airline (which is hurt by rising fuel prices) can use derivatives to cheaply set up an investment that goes up when fuel prices rise.  The result is that the airline's net exposure to fuel prices is smaller, which means the airline isn't as at risk to fuel price changes.  This use is a "hedge".

By comparison, derivatives can also be used to speculate - I can buy those same derivatives without being an airline - if fuel prices go up, I win my speculative bet - if they go down, I lose my money.

Derivatives that are used as a hedge are sort of like "insurance" - they provide compensation to the buyer when bad things happen.  If I buy a put option on the S&P, I have bought insurance against the stock market falling.  If the market falls (and I lose money from my stocks) the party who wrote the put will pay me - my insurance payout.  The cost of buying that put option was like a premium.

It should be noted that a derivative contract can be insurance to both parties!  If an oil company writes insurance on fuel prices going up and sells it to an airline, this is good for both parties. If fuel prices go up and the oil company has to pay out on the insurance, that's okay, they're printing money because fuel is expensive.  If fuel prices go down, they get to keep the premiums just when they need it.

(I mention this because A.I.G. has just cost us tons of money by writing insurance policies that came due using derivatives.  A.I.G.'s mistake was not writing the insurance - it was writing insurance that they didn't have the money to pay out.  What they did is equivalent to me starting to write insurance on an earthquake in California.  If it happens, I don't have the millions of dollars to pay out claims.  Maybe I could get a bailout and $165 million in bonus money...)

A New Kind of Home Insurance

So here's my scheme: home depreciation insurance.  The home owner agrees with a third party to:

• Pay the third party if the home price goes up and
• Receive money if the home price goes down.

This effectively lowers the market swings.  If I have a $400,000 house and buy a $200,000 depreciation policy, then if my house price falls by 25% I am only out $50,000, not the full $100,000.  (The other $50,000 "lost" is a loss for the third party.)  If the house goes up by 25%, I only gain $50,000, not $100,000.

In other words, I have given up some of the up-side of owning a home to avoid some of the down-side.  Given that a home is a single asset that is more expensive than most Americans savings, this improves the balance of the home-owners portfolio (which is normally over-weighted in non-diversified real-estate).

Homes are bought with leverage (e.g. I buy a $400,000 home with only $80,000 of my own money), to use the financial lingo.  Leverage (borrowing money to buy more of something that changes in price) amplifies the change in value of whatever you buy.  So our use of mortgage financing is making us all more susceptible to housing market price swings, relative to our personal income, savings, etc.  Depreciation insurance is an attempt to counter-act this problem, by letting the home owner "sell" some of the risk to a third party.

Who would be on the other side of the equation?  I can think of a few possible parties:

• Real estate investors who want exposure to house price appreciation but don't want to have to manage a rental property.*
• Pension fund managers who want to balance a series of asset classes that are unrelated (e.g. stocks vs. bonds vs. houses) to optimize return on volatility.
• Home owners who would consider buying a second home as an investment but don't want to buy less than a whole house worth of exposure.

* Buying a rental property to speculate in real-estate is a little bit tricky - the tenant and land lord have opposite incentives financially.  By comparison, in an owner-occupied house the owner and occupant are one in the same, so there is no conflict.  In other words, if you buy part of the appreciation of someone else's owner-occupied home, you don't have to be as worried that they'll scratch the hell out of the new wood floors.

A Different Way to Fund Housing

I have said before that buying a house is a little bit crazy.  If I went to the bank and said "I want to borrow four times as much money as I have, so that I can put it all in Amazon.com stock", the bank would laugh before they threw me out.

So...why will the bank let me leverage up 5:1 to speculate in real estate?  I am not a professional real-estate developer.  All my risk is concentrated in one property.  And owing that much on one property is terrible diversification.

We've seen two things happen at the same time which have changed the nature of home ownership in the US in a bad way.

• At least over the last 5 years, home owners were allowed to put a lot less money down - that is, they had higher leverage in buying houses.
• Home prices have become volatile.

Let's look at those two things in slightly more detail: when you write a loan that is backed by an asset, you want the owner (the person with the equity stake) to put enough money up that even if the asset goes down in value, its new value is less than the loan amount.  If you don't do this, the owner is "under water" and the loan isn't secured.  By making home owners pay a 20% down-payment, banks would protect themselves from a 20% decrease in house prices.  

That was a very wide margin back in the day, but the price swing we've seen of late is larger than that in some states.  Furthermore banks have been allowing down payments to get smaller, via piggy-back loans, seller-pays-closing costs, and all sorts of other weirdness.

I think these two trends may be related: the more houses are financed, the more housing prices are influenced by interest rates (because without cheap financing, the demand for housing goes down).  And the more houses are financed, the less housing prices have to change to put people under water.

it occurred to me that we don't have to use debt to finance housing.  I'd like to suggest a different model: equity mortgages.  (I realize that the logistics of this virtually impossible, but I still think it is interesting as a thought experiment.)

Under a "debt" mortgage (i.e. what we have now) the home owner owns the house, the house is collateral on the loan, and the home owner gains or loses all fluctuations in the price of the house.

Under an "equity" mortgage (i.e. what I am proposing) the hmoe owner owns part of the house, and the bank owns part of the house.  The home owner and the bank split gains or losses due to changes in the houses price.

How does this change things?

• A home owner can't be underwater; as a home decreases in value, the mortgage shrinks proportionally.  If you own 1/5th of your house, that is true no matter how the market fluctuates.
• A home owner has a smaller exposure to house prices.  If you put down a 20% down payment, you are exposed to house price changes only on that money.  Since the down-payment is put up in cash, you can think of this as speculating in house prices with some of your own money, but not the banks.
• Banks are exposed to both the upside and down side of house price changes.
• Banks are no longer exposed to default risk due to house price changes.  Because the owner can't be underwater, the home owner always has motivation to make payments.

These bullet points reveal a question: how does the mortgage get paid off?  In practice co-ownership of the house becomes very tricky.  Does the bank get to say whether you can renovate the bathroom?  Do you have to buy out the bank's share?  If so, do you have to do it on a schedule?  Can the bank sell its share to someone else?

I don' think equity mortgages are something we'll see any time soon, but I think they do illustrate some implications of debt-based housing finance that deserve closer inspection.

New Chandelier

Lori's parents were in town last week, and as always, did some really wonderful work on the house. Here is our old chandelier, which came with the house. If it looks sort of cheap, that's not because of the picture.



Lori's dad in action!



CC is alwys helpful, particularly when there are heavy things, electricity, and ladders.



The new chandelier:

Bob Vila Does Not Have $700 Billion

It's been a while since I've put up a good financial rant, but today deserves one, because these are special times.  I have a superb deal for you:

• You give me $700 billion in cash.
• I will give you $700 billion in bad mortgage bonds, toxic derivative products, and whatever fertilizer I happen to have in my garage right now.

Foo - I'm too late.  Uncle Sam is already signing you up for that deal.

Asymmetric Risk

At the core of the entire financial disaster is asymmetric risk.  Any time you have a situation where the party who takes a loss is different from the party who takes the gain, the party that takes the gain is going to try their hardest to make the transaction happen.  This asymmetric situation is everywhere:

• A home buyer who is not required to make a down-payment (zero percent equity) gets the up-side of a rise in housing price, but transfers the down-side risk to the bank.
• A mortgage broker that makes a commission on a mortgage but doesn't hold the mortgage makes money on the deal but doesn't get penalized if the mortgage goes into default.
• A bank that has FDIC insurance, but does not have to back up its risky investments with capital holdings gets the up-side of the risky investments but gets bailed out for the down-side. (See below.)

Fundamentally what we have is a situation where risk has been transferred (often using derivatives) from the party making a profit to a party that has insurance (whether real or implied) from Uncle Sam.

Grass Fires

Derivatives are the vehicle that makes this possible.  Basically a derivative is a contract that obligates parties to perform a financial transaction (one that will usually be really bad for one party) but does not require the party at risk to hold any money in reserve.

In the good old days, your bank took deposits from working people, loaned money out in mortgages to home owners, and kept the interest rate difference as profit.  Now since working people always want their money bank but home owners sometimes default, the bank had to keep a little bit of deposit money aside (its reserves) just in case; the size of that reserve has to be proportional to the risk of the home owners failing to make their mortgage payments.

Derivatives have no such capital holding requirements.  To see how insane this is, let's look at a "credit default swap" (CDS) - one of the most ludicrous inventions ever.  A CDS is basically insurance on a bankruptcy.  Here's how it works:

• You have $100 in General Motors bonds and are a little bit worried that GM might go under.
• I have $100 in treasury bills.
• We enter the following contractual agreement: in the event that GM does go broke, I will swap my treasury bills for your (now quite worthless) GM bonds.
• You will pay me some money right now to take this idiotic deal.

So basically what we have is bond insurance - you pay me a small premium, and in the rare event of a default, I insure you.  Now here's the rub: I don't have to keep the treasury bills locked away!!!  Heck, I don't even have to keep a fraction of them locked away.  I can go spend them on beer and pray that GM doesn't go broke.

Of course, this has some unfortunate effects.  Perhaps your GM bonds had a low rating because GM is in deep doo-doo.  But if you buy some insurance from me, you can "enhance" the credit of the bonds...GM bonds + insurance are a lot nicer than GM bonds.  But what happens if I, the writer of the insurance, go broke?  Your GM bonds instantly turn back into a pumpkin, so to speak.  At that instant, any other deals that made sense only if GM bonds are good is now quite screwed up.

And this is the nature of counter-party risk.  If you enter into a derivative contract and you need that contract to be valid for your business, you take on the risk of the other side of the contract going broke.

The experts told us that derivatives would spread risk and make the system more robust.  They were half right - derivatives definitely spread risk.  Derivatives on risk is like on a grass fire.

Selling Uncle Sam

Now we can start to see why Uncle Sam is considering spending $700 billion dollars to buy a huge pile of toxic waste.  If you have counter-party risk, it becomes in your interest to keep the other party alive.  Uncle Sam's umbrella of protection has been wrenched out from over the small depositor and home owner and extended to wall street through the mechanism of derivatives.

John Hussman has a great explanation of how you can hook Uncle Sam into insuring things that the tax payers really should not be insuring:

First, suppose that Citibank gets money from its depositors at a floating rate, and lends to mortgage borrowers at a fixed 6%. Now GM issues bonds yielding 7%, and enters a swap with Citibank, in which Citibank pays GM 5% fixed in return for floating. (Specifically, both parties agree on some notional principal, say $100 million, and each makes payments to the other, determined by multiplying a fixed or floating interest rate by that principal amount. The market for this sort of transaction is huge).

Well, now GM is paying an actual interest rate of floating + 2% (pay 7% to bondholders, get 5% from Citibank, pay Citibank floating). Meanwhile, as compensation for the credit risk it has accepted all around, Citibank earns a fixed 1% margin regardless of interest rate movements (pay depositors floating, get 6% from mortgages, pay 5% to GM, get floating from GM). Neat. And since Citibank is federally insured at the depositor level, and “too big to fail” at the institutional level, Uncle Sam is now a counterparty that effectively shares the risk in the case that GM or homeowners default. Similar transactions serve to swap risky corporate and mortgage borrowing into safe government agency paper issued by Fannie Mae and Freddie Mac.

The financial alchemy is in Citibank exposing itself to risk (and making money by doing so) without reserves.  Remember the good old days?  Well, in this transaction Citibank didn't put any money inside to cover the case where GM goes under.  (If GM goes under, Citibank is left writing mortgages at fixed rates while paying depositors a floating rate.  If interest rates go up, Citibank will lose money with every transaction.  But Citibank has no "nest egg" of cash stashed away to cover this case.)

Simply put, if you can get Uncle Sam to be counter-party to another entity, Uncle Sam has to protect the other entity.  And thus here we are, trying to bail out all of Wall Street.

Extending the Umbrella

Let's go back even further - how did we get here?  We have a policy in this country (the "American Dream") of subsidizing home ownership in the form of tax breaks and credit enhancement.  Basically Uncle Sam is willing to spend money to get you to buy a home by:

• Providing tax breaks for mortgage interest (which creates an incentive to borrow money, not save, and makes financing of houses effectively cheaper).
• Keeping interest rates low, which also makes financing cheaper.*
• Providing credit enhancement to borrowers (that is, guaranteeing mortgages).

To this last point, the Government does this both by writing guaranteed mortgages (FHA, etc.) and also by creating Fanny Mae and Freddie Mac - two companies that write mortgages.  Fanny and Freddie make mortgages cheaper by using their good credit rating to get cheap financing for home buyers.  Why would Fanny and Freddie have a good credit rating if their job is to make housing a little bit too easy to get?  Simple: we all assumed that the government would bail them out if things got ugly.  And of course, that is exactly what happened.  As a net transaction, Fanny and Freddie represent Uncle Sam backing up a huge number of home buyers on their mortgage.

So we have the government providing credit enhancement.  How can Wall Street profit off of this?  Simple: they need two things:

• They need a lot of people to buy homes and utilize that credit enhancement, so that it can then be transferred.
• Wall street then needs to find a way to transfer that credit enhancement from the individuals doing the borrowing to other parties, who will pay a fee for this.

Getting people to utilize the credit enhancement is pretty easy: offer them cheap financing. Offer them all the up-side of a market increase without the down-side by writing nothing-down mortgages.

You then write products that are tied to this sea of government-backed paper and you pull in Uncle Sam as a counter-party.  You sell this off with the wink-and-a-nod that the products are credit enhanced because you-know-who is a counter-party.  The huge chain of derivatives and "engineered" financial products spreads the risk all over the place, and thus spreads Uncle Sam's umbrella all over the place.

If Uncle Sam walks away and lets Wall Street go down, the chain of derivatives guarantees it hurts "main street", the little guy, for whom cheap housing was invented.  This is the true price of subsidized housing.

Only Pain Will Heal

Besides a huge credit mess, what we have is overproduction: too many houses and too many mortgage bonds.  The only way out is to stop making houses and mortgage bonds for a while. And this is where I have the greatest fear; falling prices for houses and mortgage bonds is the market's way of dealing with the extra product floating around.  

If the Government starts spending hundreds of billions of dollars to prop either, that is money spent on an inefficient and overproduced part of the economy, destroying real investment in future US growth.  But I fear that the debate in Washington is on who gets the bail-out, not whether there should be a bailout.

* I know, there is an immense amount of hand-waving in that statement and it isn't really supportable.  In fact, this whole rant scrambles cause and effect pretty thoroughly.  But I must point out that this is the nature of asymmetric risk; parties may not have known Uncle Sam would bail them out, but they didn't have to care, since they were in a position to make all the profit and take none of the pain.

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.

Housing: Why We're All Doomed

I don't think there's any even remotely good way out of the housing crisis - here's why:

For any market where the supply of housing can be increased, high prices are not sustainable. If a 3 bedroom house in Nevada is selling for half a million dollars, someone is going to go build another house in Nevada for less than half a million dollars, sell it, make a profit, and repeat until the price of housing comes down.

So for any market that isn't limited by available land, there's no sane way to prop up the price of housing. Anyone who took a mortgage based on bubble-level housing prices is simply screwed; when we (homeowners) buy a house, we are assuming market pricing risk ourselves. The only way out is to give up on equity (if there is any), stop payments, let the bank foreclose, and forget about your credit rating for the next decade. This transfers the market risk unceremoniously onto the investors who bought the mortgage.

(Requiring a real down-payment was the safety mechanism that kept these kinds of things from happening - of the people I know who bought a house, I don't think any of them actually put 20% down.)

Most of the "rescue" packages I've heard discussed on the media come down to some mix of either strong-arming lenders into accepting new financing terms or providing new financing. I have no qualms with strong-arming lenders even if it makes libertarians cringe. The libertarian in me says: buyer beware...investors should know that if their investment requires elected officials to stand by while citizens get the short end of the stick in an investment, someone is going to step in and do something populist. That's part of the risk of the investment. When you buy asset-backed whatevers, you should care about what the underlying asset is because that's the only thing protecting you. (Sure the house behind the mortgage has value, but having to foreclose to make good on the loan is an ugly solution.)

However I simply don't think adding additional financing is going to do a lot - we could hope to stem the wave of foreclosures but not the price change for anyone who bought a house at peak prices. If you're underwater, why would you want to accept fixed rate financing so you can protect your negative equity? I think it's a question of "how much is a credit rating" worth. Is a credit rating worth $50,000?

I'm not saying we shouldn't have additional loan help. In particular, I think that there needs to be disintermediation in the mortgage business (letting the people writing the mortages not own them has proven to be a bad idea). Securitization of mortgages has lowered their cost; if we are going to go back to traditional lending and we want to maintain credit costs similar to what we've had for the last twenty years, new investment has to come from somewhere.

Subsidizing housing prices seems like a non-option and unfeasible; not only would additional housing subsidies further increase the overall supply of housing (via new construction), but the scale of the problem is too large. Consider: by spending $150 billion we don't have, the government is putting a mere $600 in our pockets per person. How many home-owners are only underwater by $600 or only behind by $600? The rebate is a drop in the bucket, which is why it won't address housing problems at all. You can see how the market correction is beyond the scale of government intervention.

Stepping back, I come to a question more fundamental than "what went wrong" and "what should we do"...I want to know: should we even own our own homes at all?

When I plan my retirement savings each year, I try to diversify my investments - within stocks, I have an index fund to protect me from one company's downfall. Not all my money is in stocks, etc. etc. If I said "I'm going to put all of my life savings into Raytheon stock" you'd say I was an idiot.

But wait - look at my total set of investments. I have more money plugged into domestic property (in fact, into a single unit in a single neighborhood) than I have in all of my other investments combined!! That's not diversification at all? I am subject to an immense amount of market risk!

Home ownership is heavily subsidized in the US, and that's one of the reasons Lori and I bought - it's generally a better deal than renting. But this exposed us to huge market risk. I think one of the reasons that the housing crisis has hit so hard is that the nature of houses as a commodity has changed over the last thirty years. With the invention of securitization, REITs, etc. it's possible for speculative money to enter the real-estate market in a much bigger way and this means that the volatility of housing prices is going to resemble the rest of the instruments wall-street pedals. I think that, as a country, we didn't see our houses as dot-com stocks until it was too late.

(Here's my alternate approach: owner-occupied REIT coops. Basically the ownership rights (when you move, what you can do to the property) remain with the owner-occupier of the house. But the capital gains are owned collectively by all participants in the co-op.

(The owner-occupier would be forced to hold a larger stake in his or her own property, perhaps a minimum of 20%, so that the owner has a strong interest in maintaining property value.)

This would allow home owners to spread market risk across geographically diverse areas and/or different market profiles, or even sell off market risk to outside investors who want to buy it.