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Subprime mortgages, bailouts and the undead

A market failure occurs when markets operate so inefficiently that participants suffer losses.  Another bland statement: the reasons for a market failure are obvious in hindsight.  The 'Subprime Mortgage Crisis' is a spectacular market failure.  It is similar in its dimensions and profile to the Savings and Loan Crisis which occurred between 1986 and 1995 and unwound 1000 banks with assets of over $500 billion.
        Make no mistake - it is a crisis. Since 1998, more than 7 million borrowers bought homes with sub-prime loans. One million of those homeowners have already defaulted on their loans The crisis is likely to get worse. Financial analysts predict that at least a quarter of these people - some 2 million families - will default and face the financial pain and psychological grief of losing their homes over the next few years.
        A bailout occurs when the political costs of allowing a market correction are too dangerous.  The S & Ls were bailed out and the taxpayer bill by 1999 was around $157 billion in 2007 dollars.  The Subprime mess has not run its course. In May 2008 the most promising congressional proposal - when the smoke and mirrors get put away - guarantees up to $300 billion in loans to keep people from losing their homes.
        The word "bailout" is politically charged and legislators are pedaling backwards as hard as they can to avoid saying it.  So the bailout is not a bailout and it is being constructed with plausible deniability. There will be painful participation by borrowers, lenders, and government surrogates. Taxpayer money will not be used because of fees collected by Fannie Mae and Freddie Mac from the loan originators; Fannie Mae and Freddie Mac are federally chartered but not federal.  Mortgage loans may be written down.  Borrowers may have to split any capital gains with the government if they sell their homes.  The Federal Housing Administration, although guaranteeing $300 billion in loans, will not have to use taxpayer money because of all the fees being collected.   
        The final default rate among up to 500,000 sub-prime borrowers is anybody's guess.  If half the dollar amount of all the loans go into default, that would make the Subprime bill about as big as the S & L tab.  Unsaid is who pays if all the fees collected don't cover the defaults.
        Blame, or avoiding blame, is important when something like this hits the fan.  The easiest targets are the victims.  But of course, they are not victims.  They are shiftless no-account losers who had no business applying for a loan when they knew damn well they couldn't pay it back when their ARMs readjusted.  Serves them right for also buying slogans like "the Ownership Society" or assurances like "home prices only go up". 
        That is the general sway of public opinion - these delinquents are adults.  Even if they can't make heads nor tales of the fine print of a contract, the basic features are well within the understanding of anyone eligible for even a subprime loan.  It was wishful thinking and therefore irresponsible to take out the loan.  There is little belief in innocent victimization from "predatory lending". 
        That attitude is pretty durable as you travel up the food chain.  Brokers will talk about their slim margins and the ingratitude of the deadbeats now in danger of losing their homes.  Investors will be amazed and indignant at any suggestion that they should be asked for forbearance.  How do you keep the entrepreneurial spirit alive if you ask investors not to take the financial recourse to which they are entitled?
        The geniuses who jury-rigged the bundled, traunched and differentially rated securities out of a vast sea of questionable debt are genuinely surprised that the ropes of sand dissolved.  But it's all in a days work and they are ready to move on.
        But the Fed and the politicians are paying attention.  The Fed is throwing money into the sputtering engine of the economy as fast as it can bail.  Ben Bernanke, Chairman, is a very keen student of the Depression and knows what not to do.  He is not raising interest rates such as the federal funds rate or the discount rate.  He is finding every excuse to pump money into a money supply ready to go limp.  He is also coming to the rescue of some very big fish like Bear Stearns but the trickle-down of the great stream of money is not confined to the investment banks.
        Franklin Roosevelt was inaugurated - the first of four times - on March 4, 1933.  He set a record for requesting and signing a flood of new legislation in the next 100 days that still stands.  He was able to do this in large part because the congress was running scared.  If they gave the president what he wanted, they could blame him for the failure.
        The dynamic today is certainly not the same.  There is essentially no credible leadership from the executive.  But the Congress is still very vulnerable to being labeled do-nothing in the face of catastrophe.  In spite of the articulate thunderhead of verbiage from the letter writers and bloggers, the vote-getters recognize an incipient populist backlash when they see one.  And both the Fed and the Congress do not want the very real prospect of economic collapse to come home on their watch - no matter the scorn of the pundits and free traders.

The value of the dollar and you

Gallup Poll reports that in April 2008, 29% of Americans identified the declining value of the dollar as an economic "crisis".  This was second to 42% who identified rising gas prices, roughly the same for healthcare costs and problems in the housing market, and more than rising food prices, a drop in real wages and job losses.  Gallup emphasized that this concern was not about inflation but about the dollar exchange rate against other currencies:  "However, given that Americans rarely seem to focus on international economic issues, it is somewhat surprising that the declining value of the U.S. dollar receives the second-highest percentage of "crisis" mentions (29%)."
        It is surprising because no matter which way the dollar swings, it will hurt some groups and delight others.  Winners and losers will switch when the pendulum swings the other way.  Because of this shifting balance of winners and losers, politically, the issue is usually a wash.  For example, traveling overseas or buying imports becomes more expensive.  But our goods become relatively cheaper and easier to sell.  This supports jobs and growth in any business that sells goods or services abroad.  Also, seemingly wide variations from expected or "normal" exchange rates seem to self-adjust over time.  The current dollar exchange rate is identified as a "crisis" because it is correctly perceived as making a high-profile pocketbook issue worse.  A weak dollar is probably contributing to the high price of gas.
        The dollar is said to be relatively weaker than other popular currencies - especially the Euro - because it takes more dollars to buy (exchange) those units of foreign currencies than it did before.  As with any other commodity that can be  bought and sold, the easiest way to understand the price or exchange rate of a currency is in terms of supply and demand.   
        The exchange rate between one currency and another is the reflection of a running popularity contest.  The availability of cool and necessary things to buy that are priced in a currency will make that currency more valued relative to another. Inflation in the home country of a currency will make that currency less desirable. Lower interest rates in the country will make investment returns (from bonds, CDs, treasury bills) lower - a big reason for capital to "flee" from a currency. Perceptions of the strength of an economy in general will be reflected in the exchange rate of a currency. 
        For generations, the strength and size of the American economy has made US Treasury bills, bonds, and notes the most popular place to park cash in the world.  These T-bills are IOUs of the US government.  The US has never defaulted on interest or principal payments on any of its debt.  US credit is so high that T-bills are referred to as "risk-free".  The allure of such an investment has made it possible for the US to borrow almost without limit - and it has.  The national debt – the dollar amount of those IOUs – was $9.3 trillion in May 2008. 
        It is easy to imagine from a common sense point of view, that a lender might finally decide that it is too risky to lend that sweet guy any more money.  The exchange rate may be a reflection of some reluctance to lend.  Another reason not to lend is that Interest rates are being artificially battered down by the Fed. The returns will be higher somewhere else.  Grain, movies, Boeing jets and US debt are some of the coolest things we sell.  So lower interest rates and doubts about US debt are reasons NOT to exchange Euros for dollars, and our dollar's popularity sinks.
        One class of assets that may have higher returns when interest rates are low is commodities. Commodities are products that may be nature-based like precious metals, grains, unprocessed foodstuffs ... and crude oil.  The undifferentiated product is sold in very large units called contracts.  The contracts are packaged in many ways into securities and are bought and sold every day on commodities exchanges.   
        The three usual reasons to buy these securities are to hedge, to invest, and to speculate.  Hedging is done by the actual customers of the product: food processors, factories, mills, oil refineries.  In a volatile marketplace, these manufacturers need to protect their supply and they need to be able to depend on a stable price over a defined period of time.  They can do that with these contracts.
        Wealthy investors keep a broad portfolio of investments that vary in the degree of risk and expected rate of return. CDs and  other interest-bearing accounts are relatively low risk with a low rate of return.  Individual stock holdings or mutual funds  would be expected to yield more but are riskier.  Commodity accounts are among the riskiest investment holdings and can yield fantastic returns.  But the overall investment strategy of broad holdings of varying risk is tried and true.  Right now, interest bearing accounts in dollars are not especially appealing.  Just by comparison, commodity offerings are more  attractive.  This extra attention and demand is enough by itself to increase the price of commodities like oil.
        Speculators gamble on hunches of particular prices going up or down over a short period of time.  Speculators are responsible for huge amounts of money going in and out of the market.  This can make price movements dramatic and unpredictable over that narrow time horizon.
        There is another reason for an increase in the price of oil.  Because of the historical soundness of the dollar and the gargantuan size of the pool of dollars, crude oil is priced and traded in dollars on the international market, even among trading partners that are not American.  But the dollar is now weaker relative to the currencies of these international trading partners in oil.  To make up for the relative lost value of the dollar, the price of oil - in dollars - must rise to reflect the value of the oil traded, even if the trade is not with Americans.
        The value of the dollar reflected in international currency exchange rates is a legitimate concern for American consumers.  It makes all imports, and especially oil, more expensive.  And the price of oil, in particular, makes the price of everything that is transported by oil-burning engines more expensive.
        The remedies for a weak dollar are well-known but come with their own hazards and contradictions.  Indicators of a strong  economy - rising GDP, declining unemployment, shrinking inventories - will restore confidence in the dollar.  A smaller outstanding debt usually helps to increase someone’s credit-worthiness and their appeal as a borrower.  Allowing interest rates to rise would bring capital flooding into US securities, thereby strengthening the dollar.  Having cool stuff for sale at attractive prices would be a reason to acquire US dollars.  But, There Is No Such Thing As A Free Lunch.  Every one of these  "remedies" comes at a price.

The Recession that wasn't

A high school senior can tell you that a recession is two consecutive quarters of negative GDP growth. That would be a shrinking economy for six months as measured by a single indicator, Gross Domestic Product.  So six-tenths of one percent growth in GDP means that you can not use the first quarter of 2008 as the starting point of a recession.  Other non-news is that 7 1/2 million seems to be a pretty durable average for the number of Americans unemployed in the last year.  There were 650,000 homes in foreclosure in the first quarter of 2008.  Forty-seven million Americans are without health insurance and 40% of them are in households that earn $50,000 a year or more.  Former Fed Chairman Alan Greenspan says, "This is an awfully pale recession at the moment."
        The Business Cycle can be a marvelously complicated econometric model.  A simpler idea is that we have good times and bad times and graphing GDP over time gives an illustration of these recurring cycles of good and bad times.  The apex of the good times is the peak.  The bottom of the cycle is the trough because of the shape of the U.  If the duration from peak to trough is at least six months, then that is a recession.  That downhill slide can also be called a contraction.  The uphill climb from trough to peak is an expansion.  If the trough was unpleasant enough, it can also be called a recovery.
        Depression is no longer a useful descriptive term and currently has no technical meaning.  That jersey number was figuratively retired after The Depression with a capital D.  No policy maker will ever admit that new bad times are a Depression until the unemployment rate exceeds the 26% nadir that was seen in 1933.  Even the word 'recession' causes a great deal of fidgeting.
        Does it matter when and where the "R" threshold is definitively crossed?  Probably not.  Close is good enough when you're in the woods without a flashlight.  The fiscal policy guys and the monetary policy guys don't wait for an engraved invitation.  Whatever this regime is, whether it's a "bumpy stretch", a "rolling readjustment" or a "recession", it is not the sort of climate that gets people re-elected.  When an election rolls around and skies are cloudy, the best advice is to look busy.  Activist fiscal policy would be to pass a fiscal stimulus bill and send out tax rebate checks.  Increased spending authorization by congress and the president is also classic Keynesian medicine to counter a ... whatever you call it.
        Monetary policy is directed by the Fed and Mr Fed, Ben Bernanke, is looking very busy indeed.  The current Fed Chairman is not elected.   He's appointed to a four-year term by the president.  Ben is doing his best but he has reason to be anxious.  Blaming him for the sorta-recession may be like blaming Hoover for the Depression - not quite fair.  But the common denominator for both of them is that the unfortunate accidents happened on their respective watches. The body has their fingerprints on it.  The buzz is, a new presumptive Democratic president will not re-appoint Bernanke in 2010 and he will compare poorly to Alan Greenspan and his 18 year bi-partisan reign under four presidents.
        In stormy weather Bernanke is an easy target.  The Chairman of the Fed is the nexus and focal point for monetary policy.  Structurally he is first among equals on the Fed Board of Governors.  But traditionally and in fact he is 'more equal than others'. The Fed Chairman is often called the second most powerful person in the nation. 
        We've learned a lot since 1929.  We will not deliberately limit credit.  We will not allow the money supply to shrink.  The Fed has been lowering interest rates with alacrity. The Fed has only stopped short of shooting money onto the sidewalk through a fire hose to inject liquidity into our world.
        The monetary and fiscal remedies are credible, tried and true.  They will have an effect.  They may even have an effect on GDP and forestall the tell-tale dip into a technical recession.  There is a lot of misery and dysfunction that is immune to the trickle-down magic of a rising – or non-falling – GDP.  That is the cruel blowback of the power of names.  As the fear of recession recedes, so may the political will to help the many mired little boats that do not rise with the tide.

Healthcare in America

     People care about the state of healthcare in the US.  Of course, they may not be talking about exactly the same thing when they express their concerns.  Ninety percent favor some kind of change to the system, either fundamental change or a complete overhaul.  Two thirds think that government should guarantee health insurance for all.  By a factor of two to one, people feel that providing health insurance for all is more important than keeping costs down.
        That is probably the most you can say at a global level.  If you dig deeper, perceptions of the problem separate most clearly among certain large groups defined by their economic stake.
      There are 47 million uninsured in the US, about 16% of the population.  Most elderly people are covered by Medicare so the uninsured are younger than 65. Twenty percent of the uninsured are children.  Only 13% of the uninsured are white;  22% are black and 36% are Hispanic.  Of the uninsured, the head of the household in 64% of those families works full-time, all year.
        Americans feel that access to healthcare is more important than controlling its cost but only 16% are uninsured.  One can speculate why people put such value on wide access to healthcare.  They may be close to effected individuals and understand their personal circumstances.  They may deplore the vulnerability of children or minorities.  There may be a well-developed civic sense that healthcare is as important as education for the vitality of a community.  Most likely, people recognize their own vulnerability as their benefits are threatened by rising premiums.
      Shareholders and business managers recognize the growing cost of healthcare as one of the biggest threats to their bottom line.  Firms make a strong argument that unavoidable costs of a company’s healthcare benefits pose an irresistible assault on the competitiveness of that company.  Jobs are lost as companies move offshore to countries that provide no expensive benefits to their workers.  The link to national economic health is undeniable.  What is the indicated reform:  To disassociate healthcare from job benefits entirely?  To shift the additional cost burden to the worker? 
        Medicare and Social Security have protected seniors from poverty and lack of health care. By their own reports seniors 65 and older are generally satisfied with their Medicare coverage.  But Medicare recipients have to pay premiums and co-payments.  They have to pay 20 percent of costs above the allowable rate.  Preventive care, dental care vision and glasses are not covered.  Premiums and co-payments – including the shared dollar amount for the costs of prescription drugs – are increasing.  The costs of non-covered services are not inconsiderable and are also increasing.
      Prescription drugs are a weak link in both Medicare and private insurance plans.  Many people who depend on expensive prescription drugs buy them in Canada.  Canada produces more generics of brand name drugs years before they are available in the US because of differences in their patent laws.  Patented medicines are also cheaper in Canada because their prices are controlled by a federal review board that caps their price below the average prices in seven other countries (“international peers”).  This differential has been addressed somewhat by changes in Medicare.
        The insurance industry just adopted a new benefit standard for so-called Tier 4 drugs.  Tiers 1 through 3 have progressively higher but fixed co-pays, typically $10, $15 and $25.  Tier 4 drugs are the most expensive.  They are the most intensively managed because of potential side effects, variable dosage requirements and the complexity of the treatment regimen.  That they have no effective substitutes also puts them into Tier 4.                
        Consumers will have to pay a percentage of the cost rather than a fixed co-pay for these drugs.  Twenty percent of a lot will still be a lot.  This change will add hundreds or thousands of dollars to out-of-pocket costs for many.
        An obvious criticism of the Tier 4 plan is that it is a dramatic departure from what insurance is supposed to do.  The insurers are shifting potentially catastrophic costs to a minority of insured (sick people) to lower premium costs for a majority (healthy people).  This is upside down to the traditional mission of pooling risk to protect everyone from individual calamity.
        The squeeze that will ultimately make the difference is on the middle class.  In 2004, a third of the uninsured were in families making more than $50,000 a year.  Employers are shifting healthcare costs more and more to their employees – higher premiums, lower benefits, cutting dependent coverage or ending coverage entirely.  Or people lose their coverage due to changing circumstances such as divorce, job change, or moving. In the face of that they may face impossible obstacles to restoring their former protection – single-party premiums, pre-existing conditions. 
        As more and more people are priced out of any coverage at all – or worse – as more and more join the ranks of the poor, the political will to address these issues in a comprehensive fashion will magically appear.  But then the change will not be incremental.  It will be breathtaking.

Price of gas at an all time high

The price of gasoline really is at an all time high, in case you didn’t know. The prior record was reached in 1981 when gas prices nationwide averaged $1.35 a gallon. To make a meaningful comparison, you have to adjust for inflation. Put another way, you have to translate yesterday’s prices into today’s prices. In the dollar value of March 2008, folks back then were paying the equivalent of $3.17 a gallon today.
        Don’t look for the price to go down any time soon. You don’t have to scratch very deep or look for a dark conspiracy to find the reasons why. They are relentlessly boring: Do you spring wide awake when someone says, “ya see, it’s just a matter of supply and demand …”?
How about refinery capacity? John Schoen of MSNBC said , “There hasn’t been a new refinery built in the U.S. since 1976, the result of extremely tight environmental restrictions, not-in-my-back-yard community opposition, and the high cost of new construction.”
        Refineries are the classic bottleneck. Refineries make crude oil into gasoline. You can have oceans of crude oil but without refineries you don't have a drop of gasoline to put in your car.
        Why not build more refineries? As the man said: For one, they are expensive. The prospects for future profits from such a large commitment are iffy at best. Why? It’s a high-tech operation to squeeze every drop of gasoline out of the crude and to be as environmentally friendly as possible. What’s the incentive?
        The dis-incentives away from a dependence on oil are growing every day. Owners of the aging SUV fleet are being punished for their extravagance. The Priuses, hybrids and new-tech cars are getting a long, serious second look. The press for bio-fuels and gas alternatives may finally lower the demand for gas. Increasing the supply will lower the price of gas. Concern about global warming may prove to be enduring enough to bring about institutional and technological change away from oil. Besides that, nobody wants to live near the new refinery so there are tremendous costs just in getting the site licensed and sanctioned, let alone building the thing. Tell me again, why should I build a new refinery?
        Remember OPEC? Mmmm..maybe not. The Organization of Petroleum Exporting Countries historically has had some influence over oil prices. During the 1973 oil crisis, the Arab members embargoed the countries of the west to counter their support of Israel. The disruption caused long gas lines in the US, a spike in prices, and uncertainty that lasted into the 80s. Since then, there have been oil gluts and the discovery of new reserves has diluted OPEC’s share of the world’s oil reserves. But we are not immune to oil shocks like the 1973 embargo.
        Recently, employees at a refinery in Scotland walked off the job for 48 hours. Nigerian production is down to 75% of its rated capacity because of rebel attacks. Workers at ExxonMobil Corporation have cut production to demand more pay. These events have an effect on markets that is way out of proportion to simple expectations based on actual supply and demand.
        Oil is a commodity that is traded every day on commodity markets around the world. These markets – precisely like the stock markets on which they are modeled – are subject to the same hysteria that can move prices without any regard to the actual physical health of the brick-and-mortar institution they represent. A spike in oil commodity prices – which theoretically may have some bearing on underlying supply – will translate instantly into an increase at the pump. The commodity prices are a real cost to the commodity buyers (refiners) because those are the prices they have agreed to pay – either today on the spot market or at some date certain in the future.
        Furthermore, the prices are “sticky”; what goes up does not necessarily slide right back down – at least not right away. As close as we are to the line – without new reserves or extra capacity – even minor shocks will send up prices. And perceptions and consumer behavior will take a while to turn prices in the other direction.
        When you scratch the surface, weird stuff crawls out of the woodwork. Another theory is that recent action by the Fed has inadvertently had an effect on oil and other commodity prices. The Fed, a.k.a. Federal Reserve System, is the mother ship and federal central bank to all the baby for-profit banks out there … ya know, like Citicorp and Wells Fargo. The Fed is also the watcher of credit and the guardian of the money supply. By reducing interest rates, the Fed may have made non-interest bearing investments, like commodities, more attractive. That raises their price. And that same action causes a “flight” from the dollar which pushes down the value of the dollar in the money exchange markets. Oil, which is denominated in dollars, must rise in price to compensate for that loss of dollar value. In a perverse way, this may be a ray of hope to those pining for low oil prices: commodity prices may be a speculative bubble which one day will pop.
        More sobering than the price at the pump is another ghost returned from the oil shocks of the 70s. This is what we know of oil in particular as a driver of cost-push inflation. Everything sold that must be transported by an internal combustion engine has the price of oil factored into it. This is only true of just about everything but most especially with food.
        Food is also laced with petrochemicals in the form of herbicides, pesticides, fertilizers and pharmaceuticals. And especially worrisome, some food stocks are being depleted because they are being converted instead to oil fuel alternatives. The rising price of food and the decreasing availability of food are something more than an annoyance; they add up to famine.