Wednesday, February 25, 2009

When the Pictures Don't Fit

Here are a couple of stories for you.

A. A country, hugely in debt, is pouring money, like gasoline on a fire, onto energy suppliers who have national, or at least organizational, objectives to destroy the United States, or the entire western world. This debt-crazed country of our story has sufficient reserves of the materials needed to supply it at current levels of usage for five hundred years. What does it do?
1) It denies entrepreneurs the opportunity to develop those resources, thus forcing the country to continue its dangerous imports.
2) It invests in technologies that are, at best, likely to provide the equivalent of 5-10% of the need.
3) It penalizes people through taxes and fees for their use of this material, claiming that a higher claim than national survival is the danger of climate change.
4) The government justifies its policies in the same of an ideologically driven pseudo-science, "global warming," justifying its scorn for a common-sense solution to a dangerous risk in the country's current accounts balance, and in, as well, in its geopolitical stances. The latter are perverted almost unimaginably by dependency on foreign sources, forcing the country to back tyrannical regimes, engage in fabulously expensive wars, and to act as the world's most pompous hypocrite.

Yep, the subject is oil, coal, gas, and nuclear power. America -- that's us -- has enough in shale, offshore, Arctic, coal, nuclear and gas to power our system for half a millennium -- far longer than most societies have existed. The Roman Empire, for instance, had just about had it after 350 years.

Why would our elected representatives, including our latest President, make such strange choices regarding energy production? Or justify them with such fabulous lies?

Let's wait on that for the second story.

B. A country, deeply enamoured of home ownership, looked the other way when its government decided to force the financial system to absorb mortgages issued to a large group of people who could not afford the payments, a dramatic violation of market principles. Even so, the ultimate costs could have been avoided by consulting with Congress on taxing authority to pay for what was transparently a political program. This taxing authority was not sought. It is this writer's opinion that either Clinton or Bush could have gotten that authority -- who doesn't love home ownership for everybody? They chose not to risk political capital, preferring to risk the entire capitalist system instead.

However, by one of those tulip market miracles, the financial system absorbed this worthless paper, and grew at an extravagant rate. Then, as we all know now, and with very little warning (at least from the popular press), defaults on these subprime mortgages exploded. This disaster created a far graver risk, still largely unreported in the United States, though easy to find out about in, say, The Asia Times. That risk was much bigger, on the order of several magnitudes, than the original value of the subprime mortgages. Why? Because part of the financial system's fabulous growth has been powered by securitizing those mortgages (both the good with the bad), and then creating a variation of financial instruments called derivatives. This variation, called a credit default swap, was a form of insurance. What these young geniuses were doing is known on the street as "laying off the bet," a familiar tactic for bookies.

They rationalized a potentially fabulous risk by firmly believing that, based on the evidence, housing prices never go down. As such,the large apparent risk (that payoff on these swaps would be ten to fifty times greater than the value of the subprime market) was actually negligible. The market in credit default swaps became substantially greater than the value of all of the housing stock in the United States. About that payoff effect on widespread defaults: because there is a market in derivatives of credit default swaps, themselves a form of derivative, the risk of payoff goes up exponentially. With defaults on, say, a million mortgages, it's as though there had been ten million defaults. Multiply for effect on your own. Hint: Start with 12 zeros. The government reacts by:

1) Lowering interest rates
2) Offering to pay off the subprime mortgages
3) Forcing banks to reduce the value of the subprime mortgage's principal or to reduce interest payments.
4) Throwing a trillion dollars at the banking system with almost no strings attached.

Of course, what this amounts to is a vast, new intervention in a once free market. Value is no longer possible to determine. Chaos enters in. This latest political intervention is the worst so far, but what started it was a benign policy from the 1970s, greatly extended under both Clinton and Bush, of giving a break to people who couldn't afford mortgages. The policy essentially expected the market to subsidize otherwise untenable risks. This "political market" in mortgages exploded in value from a few billion to trillions by 2001. Hey, there's never any shortage of constituents for either party. Worse, as the years went by, these trillions became based on housing prices that were, frankly, a speculator's fiction. You know what happened next, or found out when you tried to sell your own house.

In the last two years, as housing values began to reflect actual demand instead of speculative hopes, they rapidly declined. Valuations began to go below the value of the principal on the mortgages held on them. The banks were totally screwed. Even though much of that was self-inflicted, blame is really out of court. With the whole system at risk, blame has to come after the fix, requiring people who caused the problem to fix it. Let them serve prison terms later. Unintended consequences of often good intentions, if only for good profits, had spun the economy out of control. Accusations are a waste of time and money. Why the urgency?

Banks and other mortgage brokers no longer had a basis, required by federal regulation, for determining how much money they could lend. Under federal rules, banks have a capital ratio requirement. Nowadays (see below) it's set at a dollar in assets for each thirty dollars in credit extended. If a bank a) doesn't meet that standard, or b) has no idea of what its ratio is, bank management must stop lending money. What happened with the collapse of the subprime mortgage market was both a)and b). Defaults took many institutions below the standard; and dramatic uncertainty in the housing market made it impossible to assess the value of collateral, thus making credit nearly impossible to extend. To do so would have violated federal regulations of the banks.

Credit crunch! And the apparent absurdity of government reactions to it. Why are they absurd? If a whole class of people becomes entitled to violate a given market's principles, then the entire market will be held in contempt. A vast intervention in any market makes any value in that market suspect. Who knows what a house is worth today? Or a Citibank share?

And, it wasn't just mortgage holders and lenders, neither of whom would ever have been in that condition without Washington's political intervention in the supposedly intervention-free housing market. It was also young, smart bankers who invented financial instruments that a) were so complex that nobody could understand them, and b) would bankrupt the system if the primary assumption underlying them was not true.

It was also drastic alteration of the capital ratio, which had been 10/1 (10 dollars of credit for every dollar in assets). That historical, and historically successful ratio, was overturned by the Bush's administration, which raised it to 30/1, a perilous ratio that made transgressing it far worse for the banks. Instead of finding themselves at the brink of the expert slope at Aspen, bankers found themselves staring down at an abyss.

It was also a breathtaking Las Vegas atmosphere among buyers, who used houses and condominiums, previously regarded as the principal asset of a family, a lifetime purchase, as poker chips in a table game that has, for example, left the state of Florida with a quarter of a million new condominiums that have never been occupied. Last persons to hold the mortgages did not win.

And lastly, the political intervention itself was motivated by that same fundamental idea, i.e., even if poor mortgage holders couldn't pay off mortgages, the banks (or Fannie Mae or Freddie Mac) would profit by the increased value of the collateral at foreclosure.

However, the primary assumption for the game house rules in the mortgage market, and for Washington's political intervention, that housing prices would forever increase, turned out to be -- you guessed it -- false! Bang! went the markets! Boom! went the banks. Blooey! went your 401(k). Kapow! went your IRA. Kerplop! went your job future.

One can only stand in the light of absurdity so long before certain thoughts come to mind. Let's look at a couple of ideas.

About "representative government":
1) Representatives in Congress tend to look after the needs of those constituents who help them offset the expense of running for office. We have known for a very long time about direct investment in political campaigns in the United States by the Chinese, by the Saudis, by France, by England, and by many others, most of whom are on the list of America's largest creditors. It is no surprise either that the new President's principal economic advisors come straight out of the same "system" that's falling apart. The system put him in office.
2) In such a world, votes don't mean much except to confirm a group's wisdom in investing in a US Representative or a US Senator. Don't think that's true? The vast majority of voters want domestic development of energy. Who represents their interests in government?

About debt purchased by other countries
1) The Chinese and the Japanese hold over $1 trillion in United States government debt, and far more than that in US mortgage debt, including collateralized debt obligations. Oil producing countries hold an equivalent pile of US debt as well.
2) It is foolish to assume that holders of such enormous interests in the US government, and in US private property, will stand aside and passively observe while issues of U.S. government policy are decided. No, not their government policy -- our government policy, policy that's supposed to represent us, the voters, the official constituency of Congress and the White House.

If you want a conspiracy theory, here's one that actually seems plausible for story A, the oil story, and story B, the mortgage story:

1) The government of the United States, in its policy formulations, is essentially held hostage by China, Japan, oil-producers, and other major overseas bondholders. Don't believe it? When you use your charge card to buy gasoline, who lends the money to you? Yep, the Saudis, or some other oil producer, does. Think that won't have an effect in Riyadh or Mexico City when talk turns to trade and other niceties of international life? When you buy a 62-inch screen, who lends you the money? Yep, China does. Think they don't remember in Beijing?
2) Essentially, the ban on fossil fuel development in the United States from Congress and the White House represents the interests of foreign oil-producing countries. Let's say that again. American policy regarding fossil fuel development in our own country represents the interests of oil-producing countries overseas. You can't get around that. The last thing Saudi Arabia, Russia, Mexico, Canada or Venezuela want is a United States that's not dependent on oil imports. It has nothing to do with "green"; "global warming" is only an underpinning mythology whose primary function is to motivate a radically different policy. See Chapter 15 in Decline and Fall of the Roman Empire. No, Pope Alphonse, it's not "Green," it's just greenbacks.
3) The financial system in the United States is held hostage by a) bad debt issued in the name of social policy, a political mandate issued the White House and affirmed by Congress and b) bad debt issued by over-clever bankers to insure the very same bad social policy. The reason that mortgages held by people who should never have had them are being paid for by the United States government (i.e., you, sucker) is because if the subprime market goes into total default, the cost in the collateralized debt obligation and derivatives market will bankrupt the entire world. This is not an exaggeration.

So, forget about the President or Congress "doing good" with regard to those poor victims of evil bankers, the poor people who couldn't afford mortgages. The bankers were required to give those bad mortgages out by a President unwilling to ask the people to pay for what might well have been a popular social program. Congress and the White House are picking up the tab for nonpaying mortgage holders because a) they weren't willing to ask for tax authority to pay for their political policy of essentially giving homes to the poor (somebody has to pay the damn bill), and b) if the financial system goes down completely, all the political power in Washington won't help Republicans or Democrats.

Forget about the evil entrepreneurs who want to spoil the Rocky mountains by processing rock for shale oil. Congress is denying American entrepreneurs the right to develop our own energy resources because Representatives and Senators are, like the President, under the sway of the Chinese, the Russians, the Saudis, the Mexicans, the Canadians, and other oil-producing countries.

As P.J. O'Rourke memorably put it, Congress is a parliament of whores.

In this vast, no-wing conspiracy, stupidity begets stupidity. In the real world, this is generally the story of any conspiracy. And, as in the real world, Ponzi schemes usually end in bankruptcy and prison.

When the picture doesn't fit, in other words, you might try reframing it.

A good place to start would be to stop blaming the poor folks who bought houses they couldn't afford. We have no choice but to buy those houses for them, or from them. Otherwise, we will all be living in tents.

Another good place to continue would be to end the political intervention in the housing market and replace it with something Howard Samuels tried to do with the fake rental market in New York thirty years ago. The NYC rental market was also subject to a massive intervention in its free trade by rent regulations, dating to the 1940s, that strictly controlled rents for one class of people, and strictly controlled rent increases for another (the difference between rent control, now largely vanished, and rent stabilization, still in effect for a million apartments in NYC. As costs rose, throughout the 70s especially, a time of very high inflation nationwide, the margin between costs and rent declined radically. In fact, by the late 1970s, during New York's biggest financial crisis to that date, landlords were abandoning profitless buildings in the tens of thousands. Worse, to get something out of a building, they were often setting their properties on fire for insurance money. Arson was not a minority-driven quiet riot; it was property owners trying to get any return on otherwise worthless property. It was a grave emergency. Those old enough to remember the 1978 World Series may recall Joe Garagiola's running commentary on horizon-to-horizon fires in the Bronx, visible over the facade of the old Yankee Stadium.

Samuels, running for governor at the time, proposed that the state set a reasonable level of housing expenses to be 25% of gross income (seems fabulously low today). Based solely on income tax returns, and net income per renter, the state would rebate the difference between the deregulated, market rent and what the individual renter could afford to pay under Samuels' 25% formula. (This proposal was somewhat erroneously described as incomes policy, a complex program tried in Great Britain with not much success.) Samuels' objective was to allow the rental regulations in New York to expire, and to offset the dramatic impact on housing costs for many by a statewide tax program. His reason was uncomplicated. Nobody could afford to build if they weren't allowed to charge market rents. As time went on, the plan assumed that rising incomes would sharply reduce the number of renters qualifying for a subsidy. The legislature laughed the proposal away: "have to protect our constituents." The housing crisis went from bad to worse; recovery took another twenty years, and even then occurred only in luxury housing. We badly need something like this if the White House and Congress intend to extend the Community Redevelopment Act, and Fannie Mae and Freddie Mac continue to be encouraged to take on subprime mortgage risk.

Another, painfully obvious, choice is to tax consumption instead of income. America needs to stop borrowing money from China and Japan to buy their goods. And China and Japan need to start spending their own money on themselves. A value-added-tax, combined with a flat federal tax, would go a long way toward addressing the current, fantasy-induced chaos that puts both producer and consumer in the position of bankrupting each other. The VAT restricts consumption. Too bad. Americans need to save more money. This would provide a good incentive to do so.

Lastly, drill, goddamnit, before the only drilling in America is being done by our enemies. It may make you feel good to have clean hands, but nobody goes out of this world without getting a little dirty. Part of that is providing for your own energy requirements, if you can. The United States can.



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