Monday, October 06, 2008

Drowned By the Anchor

Some people have been asking me of late why it is that such a small portion of the Mortgage market falling into default can bring down the entire economy. I'm not an economics genius but I know a few and am more than willing to henpeck their ideas in order to make my analysis of the situation seem more reasonable than it might have in the first place. I don't have a PHD but I assume that the shameless rape of another person's ideas in order make to make yours seem more plausible, if only by the manipulation of context and syntax, is the highest road to intellectual development. The same is most certainly true of religious zealotry and I can't imagine that higher education and the church differ all that much in their methods.

So I will attempt to make sense of how a relatively small shift in one area of the market can inject the kind of issues we've seen this month. The answer is not drastic shifts in actual money as one might imagine being necessary. The answer is quite reasonably uncertainty. The stock market and most other forms of trade based solely on the movement of money and not real goods, is simply like most markets a place for the exchange of risk from one source to another. Risk is the central theme of it all and is the means by which fortunes are made on Wall Street. For example if I have a company and want to try and make it bigger and better I need to invest money into it, if I invest all my own money I get all the profit but also take all the risk should my endeavor fail. If I offer a percentage of the business up for sale in the form of stock (or any number of other forms) I allow the business to be propped up on another person's money, in exchange for them sharing the risk, they also share in the possible profit. The end result is a positive one for the most part as a well examined risk is one that can be worth taking for the investor and the needed capital can be the thing that makes my business successful for both me and my investors. The problem is that when external factors to that arrangement constrain one or both parties from examining the risk they are buying, then the unknown risks make investment scary and scared investors don't invest.

To bring this into our mortgage 'crisis' scenario think of it this way; Fannie and Freddie by urging and by regulation sent a message to the lending community that they were willing to purchase any debt no matter how high the risk, as long as that debt contained the right quantity of people fitting the right physical description. That of course being an address in the poorest, least fortunate neighborhoods. In order to make the sales of these high risk assets worth while up the food chain, they had to be bundled with large quantities of low risk loans. When bundled together and sold over and over again from one lending institution to another the street level risk gets lost in a pile of numbers that average with other numbers repeatedly. The influx of loose cash on the housing market drove prices up as one would imagine. One of the things about the housing industry is that it has historically been a safe place to invest money for moderate growth over any period of time. In this case a drastic increase in capital without a corresponding increase in wages, meant that people were buying beyond their means. Functionally what we saw was a price increase driven solely by an increase in the number of people participating in the real estate market, not by actual economic growth or prosperity. All of this predicated on 'guarantees' issued by government backed lending institutions to buy all this higher risk debt.

But we know this already because you and I have a television or a radio and haven't heard anything but this for weeks.

But it's not a huge quantity of default. Sure a ton of people have loans that will be larger than the actual value of their homes for a very long time, but most are still making payments on those loans. Why then is the disaster afoot? It's simple really, the bundling of those high risk loans with other loans throughout the market and the sale of those bundled products repeatedly throughout the market have taken away any simple method for assessing the risk in any individual package of debt. With no firm way to assess risk there's no way to set a scale for acceptable loss, there is no way to set a fair price for sale. No one knows which packages of debt have the most high risk debt and which have the least. Nobody buys uncertain risk at a reasonable price. So thousands upon thousands of good loans are on the market for way below market price and people still aren't buying. Banks who responsibly wish to protect the real assets of their depositors are hesitant to lend money to other banks on the basis of the wild level of uncertainty in their real assets.

Bluntly, you can't see from the outside of these packages if there's more anchor than boat and nobody wants to take the risk. When people aren't willing to take risks businesses stop working.

How the government thinks they have any better shot at picking out the bad risk than the financial institutions holding the packages is beyond me.

Or maybe I'm reading everything wrong.


Mike said...

Does Dr. Ebeling read this? How about our Congressman?

Ombibulous said...

Dr. Ebeling, I would hope, reads more informed and knowledgeable work than mine. As for the Congressman, well I don't know what he reads, but then that might make him qualified to be VP.