Thursday, October 30, 2008

The “Housing Market” - The Greatest Fraud of All

As the financial crisis has unfolded over the past few weeks, many high profile leaders have had their faith in a market driven economy shaken. Even Alan Greenspan had to admit in testimony before Congress that the assumptions behind his economic policies were wrong. He now says he made a mistake in believing that banks “operating in their own self-interest, would do what was necessary to protect their shareholders and institutions.”

Actually, I think markets work well when the conditions for them are allowed to exist. But we are seeing the unmasking of one of the greatest economic deceptions of all time—the claim that in the United States a market determined home prices. The “invisible hand” that Adam Smith envisioned setting prices in a marketplace is suppose to be just that—invisible. Smith’s economic model rested on the assumption that many buyers and sellers acting in their own self-interest and without government interference would negotiate fair prices for scare commodities.

But lets count the ways the so-called “housing market” has failed to meet these conditions.

Government subsidies for homeowners – For decades the federal government has taxed homeowners at a lower rate than renters. It accomplishes this by allowing payments for home mortgage interest to be deducted from income. Homeowners can borrow up to the entire equity in their house and spend the money on whatever they want—cars, vacations, college tuitions—and the interest paid on the loan is tax deductible. Renters are not allowed to deduct interest paid on loans. The effect of this policy is that homeowners are taxed less as long as they remain in debt. That makes owning a home intrinsically more valuable than just having a place to live.

Government-backed loans eliminate lenders’ risks-The point of Freddie Mac and Fannie Mae was to encourage banks to loan private money to purchase homes by promising public money if the loan went bad. This policy effectively privatized gains and socialized losses. The result is a moral hazard that subverts the functioning of the market. Banks can loan money under the most outlandish of circumstances because they have everything to gain and nothing to lose.

A single person sets interest rates – The Federal Reserve Chief dictates interest rates. It’s no accident that Alan Greenspan had the nickname “Maestro” when he ran the Federal Reserve. Rather than allow market processes to determine interest rates he orchestrated market movements by dictating the rates himself. Allowing the judgment of one person to determine something as fundamental as the cost of money on such a grand scale is the antithesis of a free market.

Of course the government had good reasons for these policies. Congress decided that communities benefited from widespread home ownership. In other words a social good resulted if more people owned homes rather than rented. But government manipulation of markets to achieve a social goal is the definition of socialism.

That is where the great fraud arises—the creation of a socialist system for home ownership but labeling it a “free market.” The claim that no regulation is needed for mortgages because the market will operate is absurd. Socialist systems need regulation; otherwise the moral hazards are too great. The government appears to have no plans for ending the mortgage interest deduction, ending bailouts of failed lenders, or ending Federal Reserve control of interest rates. If it continues to use these policies to manipulate home prices its needs to be intellectually honest. The government should admit that fact that the housing market has been socialist for decades and adopt appropriate regulations to protect the public.

Friday, October 24, 2008

Irony in the Financial Crisis

How much should the government pay for the bad mortgage-backed securities that the banks no longer want? I find a profound irony in that question. A problem in the current financial crisis is that no one knows what many of these securities are worth. Settling on a price that will solve the problem is tricky. If the government pays too little the bailout could fail and the banks will go under anyway. If the government pays too much banks will reap enormous profits at the expense of taxpayers and have little incentive to change the lending practices that resulted in this mess.

The reason no one knows a fair price to pay is that the securities in question are too complicated for anyone to understand. The irony is that the complexity was intentional. The securities were designed to make it difficult if not impossible for anyone to know their underlying value.

Much as been written during this current financial crisis on the question of whether free market capitalism is dead. But the mortgage industry during the past few years was anything but a free market. The idea behind a market is that fair and accurate prices will result from negotiations between buyers and sellers acting in their own best interests. But, for consumers to act in their own best interest, they need to understand the agreements they enter.

Corporations have put enormous effort into making contracts so complex the normal rules of the market do not apply. The premise behind my book, The Two Headed Quarter, is that financial companies can mislead consumers without lying by presenting numbers in such complex ways that rational decision-making becomes impossible. Bob Sullivan’s book Gotcha Capitalism exposes how companies use complex contracts to cheat consumers out of money with hidden fees and surcharges. The idea throughout corporate America is to find deceptive yet still legal methods for taking as much money as possible from consumers without them noticing.

Now there is no money left in the consumer’s pocket for the corporations to take. But, it turns out that a constant flow of money from the consumers is needed or the system falls apart. This was never a “market” in the ordinary sense of the word; it was a Ponzi scheme.

In a healthy marketplace, buyers and sellers need each other. Sellers need satisfied customers willing to come back and give referrals. A small community-based business will not survive without repeat customers. Buyers need merchants that they can trust to provide reliable goods and contribute to quality of life in their communities. A business with contempt for its customers, that exists only to acquire as much money as possible, will eventually fail.

Failure is of course what has happened. But, what I find deeply ironic is that these corporations are now victims of their own deceptions. These corporations attribute their failures to customers who did not understand agreements designed not to be understood. Now these same corporations are shocked to discover that no one understands the agreements. The executives who created the complex securities don’t understand them, Treasury Secretary Paulson doesn’t understand them, Fed Chief Bernake doesn’t understand them, would be buyers don’t understand them. A security that cannot be understood cannot be fairly priced.

A mortgage is actually a simple idea. Over the long run it benefits no one to turn package mortgages into complex, incomprehensible, financial instruments. As the government moves forward to craft better regulations to prevent a future financial catastrophe’s it should consider going back to basics. A free market will work but only if the participants understand the agreements.

Sunday, October 12, 2008

The Deceptive Math of Financial Leverage

In physics a lever is a tool for obtaining a large torque (rotational motion) with a relatively small force. Anytime you use a screwdriver, a lug wrench, a jack, a crowbar, or a doorknob, you are using a lever. In each of these circumstances the rotations achieved would be nearly impossible without the lever.

By analogy, the leverage principle in finance is intended to magnify rates of return on invested money so that relatively small amounts of money can grow much faster than the actual rate of return on the investment. But in finance the tool used to obtain leverage is debt. Borrowing against an asset to fund an investment is financial leverage.

For example, a homebuyer who takes out a mortgage is leveraging the asset—the home—to increase the rate of return on the money used for the down payment. Suppose a buyer puts $10,000 down on a $100,000 house and finances the remaining $90,000 using the house as collateral. If the value of the house rises 50% to $150,000, the homebuyer now has $60,000 of equity in the house. The $10,000 investment has multiplied 6-fold even though the asset only increased 50% in value. Had the buyer paid $100,000 cash for the house a 50% return on investment is all that would have been achieved.

Investors in the stock market can also use leverage. An investor with a normal brokerage account is allowed to borrow up to 50% of the value of stocks owned to purchase more stocks. That means $10,000 can be used to purchase up to $20,000 worth of stocks. This is called buying on margin. If the stocks double in value to $40,000 the investor now has $30,000 in equity—a tripling of the initial $10,000 investment.

Leverage seems like a kind of financial magic. For many investment banks and hedge funds it was magic because these institutions were not bound by the normal rules that limit ordinary investors and homeowners. Stockowners cannot borrow more than 50% of the value of their stocks; homeowners cannot borrow more than the value of their homes. But, in the unregulated dream world of investment banking and hedge funds, there was no limit on the amount the managers could borrow against their assets. For example, by the time Lehman Brothers went bankrupt it was leveraged more than 30 to 1. It owed $30 for $1 in assets it held. Imagine a homeowner borrowing $3 million against a $100,000 home. That might sound crazy, but that’s effectively what Lehman Brothers did.

The motivation for investment banks and hedge funds to leverage their assets to such absurd levels is that it allows them to report fantastic rates of return for modest investment gains. Suppose a $3 million cash investment returns just 5% in a year so that the value is $3.15 million. That does not sound all that impressive. But, suppose the fund managers had only $100,000 in equity in that $3 million investment. The total equity after the 5% gain is now $250,000. The fund managers can now report a “return on equity” of 150%. That is an eye-catching number to report to investors, prospective customers and stockholders. The managers can reward themselves with bonuses for the their remarkable results. At the same time the appreciation of the actual investment was nothing out of the ordinary. It is a beautiful example of a two-headed quarter—using numbers to have it both ways.

But leverage has a dark side. Not only does it magnify gains it also magnifies losses. In the example above, if the $3 million investment loses just 3.3% of its value, the $100,000 of equity is completely wiped out. In markets with normal volatility, a 3.3% downward move is not unusual for a solid investment. The problem is that many of the investments were in mortgages, which are also a leveraged investment. Many of the subprime mortgages being called assets, were for homeowners who had no equity in their houses. Leverage was piled upon leverage. No wonder the banks have no idea what the mortgage securities they hold are worth. Homeowners with no equity have every incentive to walk away when prices fall. After all, when a homeowner invests nothing, there is nothing to lose.

In the same manner, the executives and fund managers had nothing to lose by taking on such absurd levels of debt. They pocketed huge salaries and bonuses for their financial “genius.” And it was an ingenious scheme—taking home the profits and billing the taxpayers and stockholders for the losses.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy