(For previous posts in this series, see here.)

The real estate boom fueled by the easy availability of subprime mortgages was a classic pyramid phenomenon, entirely dependent like all such phenomena on an endless stream of new buyers coming along willing to pay the inflated prices. When the crash came, as it inevitably does with all schemes that are based on expectations of permanent and rapid price increases, it turned out to be financially advantageous for many people who had taken these loans to declare bankruptcy and simply abandon their homes and walk away, since the money they owed was often more than the house was worth. Some became homeless as a result, but others who had bought these properties more as investment vehicles did not fare too badly. Many had put no money of their own as down payment so they had essentially rented the houses for a few years, often at below market rates.
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(For previous posts in this series, see here.)

The current so-called subprime mortgage crisis is a result of a real estate boom fueled by a combination by ignorance, greed, lax standards and oversight, and outright criminality.

Unlike art or precious stones, in the case of a house, the value can be determined within a fairly narrow range. Knowing the neighborhood, the size and state of repair of the house, historical pricing patterns, etc., one can assess the value of a house fairly accurately. Barring sudden unforeseen events such as finding oil on the property or the discovery that some major new construction is going to occur nearby, or that the house has been built on a toxic waste site, the price of property tends to be fairly stable and predictable.

When it used to be the case that the banks that loaned you the money to buy a house held on to the mortgage themselves, there were built-in checks and balances to prevent the unrealistic pricing of homes. After all, foreclosing and selling a house is a costly and tedious business that banks would like to avoid, so it was in their own interest to ensure that the buyer could afford the house so that default was highly unlikely. It was also in the bank’s interest that the house was being bought at a reasonable price, with a down payment, so that the bank was lending substantially less money than the house was worth so that they could sell it easily in the unlikely event of a default. That was indeed the case when we bought our own house nearly twenty years ago. There were careful checks of the title to make sure the ownership was not challenged, a valuation of the home by an independent appraiser to make sure we were not paying too much, and we had to demonstrate, using tax returns and the like, that we had the steady income that we claimed we had and that it was sufficient to pay the mortgage. The fixed-rate mortgage payments themselves were high enough so that they covered the interest and also part of the principal, so that the money we owed the bank steadily decreased over the time of the loan.

But those days are long gone. Now the banks that loan you the money to buy your house resell your mortgage within days in the secondary market. Since the banks that initially provide the money for the house purchase do not hold on to the mortgage but quickly sell them, this does not require them to look too carefully into what they are financing. Indeed it is better not to do so at all, since the banks make their money at the point of transaction, so that the more mortgages that pass through their hands, the more money they make. This lack of close scrutiny also encourages the emergence of unscrupulous mortgage brokers who make their living on the basis of the number and value of the mortgages they broker between buyer and bank. Hence it is in their interest to obtain as many mortgages as possible for as high a value as possible. This encourages them to inflate the prices of the houses being bought and sold (in which they are aided by appraiser accomplices) and to inflate the incomes of the buyers so that they become eligible.

In order to make even more buyers eligible, buyers with poor credit histories (i.e., those labeled ‘subprime’) were also offered adjustable rate mortgages with no down payment and low teaser interest rates for the first few years so that they could afford the payments, at least initially. Furthermore, they were offered mortgage deals in which the monthly payments were interest only (in which case the money owed never decreased) or, incredibly, did not cover even the interest, so that as time went by the borrower owed more money, not less. The net result of the latter practice was that the value of the mortgage often exceeded the value of the house by substantial amounts.

Why would buyers accept such terms? These practices enabled them to afford to live in a more expensive house than was otherwise possible for the few years during the initial low-interest period and they thought they could sell and move on before the higher rates kicked it. Those who hoped to make the house their permanent home could hope that they would be either earning more money in the future to make the higher payments affordable or were told that they could refinance to a fixed rate mortgage at better rates in a year or two, before the low initial interest rates ended.

As a result of all these dubious lending practices, more people became ‘eligible’ to buy more expensive homes and home prices naturally started going up as a result of the increased demand for them. As long as the real estate market was booming and prices were rising, overextended buyers felt they always had the option of selling the home at a higher price than what they bought it for, thus paying off the mortgage loan with a tidy profit left over. Everyone would be happy. As a result, no one was looking very closely at the underlying value of the properties. There was no incentive to do so, and in fact it was discouraged. Why do that and destroy the dream?

Next: The end of the dream

POST SCRIPT: Lewis Black gives TV executives some good advice

(For previous posts in this series, see here.)

One can never underestimate how the power of greed, the thought of making a lot of money quickly, can cause otherwise rational people to lose their senses. A friend of mine works for the white collar crime division of the Cleveland police and he can tell story after story of sensible middle-class or wealthy people, the kinds who could be your neighbors, who are professionals and cautious in most of their dealings, becoming the victims of some racket run by charming men and women. These people often did not even need the money they thought they would quickly make. In each case, it was greed that overcame their judgment, coupled with the desire to feel that they too are smart investors with access to valuable information that the general public did not know. Conmen and conwomen know exactly how to prey on such people.

Greed is also what fuels bubbles. The so-called ‘dot com’ craze of the late 1990s is within recent memory of most of us, where privately-held internet companies would go public and sell stocks, whose values would then skyrocket literally overnight. Initially some people made a lot of money and this soon attracted more naïve investors who assumed that the good times would always last. But they never do and in 2000 the inevitable crash came, wiping out nearly 80% of the paper value of people’s investments.

While most of us are not the kinds of financial high rollers who get invited to participate in such IPOs (Initial Public Offerings), it is easy to get sucked in by the general enthusiasm and try and get in the game later, when the savvy investors have already made most of the money to be made. It may be hard for us to comprehend how people could get so unhinged that they forget the basic rules of investment and fall prey to speculation. But I can see how other naive people like me could easily get sucked in and invest their savings thinking that there was easy money to be made.

As economist Burton Malkiel says in his chapter on bubbles in his book A Random Walk Down Wall Street (1999):

Not all investors in the bubble companies believed in the feasibility of the schemes to which they subscribed. People were “too sensible” for that. They did believe, however, in the “greater fool” theory – that prices would rise, that buyers would be found, and that they would make money. Thus, most investors considered their actions the height of rationality as, at least for a while, they could sell their shares at a premium in the “after market,” that is, the trading market in the shares after their initial issue. (p. 43)
. . .
The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze. It is not hard, really, to make money in the market. . .What is hard to avoid is the alluring temptation to throw your money away on short get-rich-quick speculative binges. (p. 53)

During the dot-com boom in the late 1990s, I would read almost every day of yet another internet company that would have an initial release of stock and of those who bought them finding their investment doubling or tripling within days. Even I had the vague feeling that by not participating in this boom, that I was somehow losing out, that I was falling behind by standing still. I felt a tug, a temptation to ‘get in the game’. But I did not actually invest during the dot-com boom because not only do I not understand the stock market, I do not even like the principles on which it works, where bad news for ordinary people seems to mean good news for investors.

For example, I recall the day in July 2005 when terrorists struck the London underground trains, killing many people and causing panic in the financial markets. Brit Hume of Fox News said that when he heard the news, the first thing the occurred to him was that it would be a good day to invest in the stock market, to take advantage of the sudden drop in stock prices due to the tragedy. I was stunned by that shameless display of callousness and greed. I simply cannot imagine thinking like that, to eagerly look forward to tragedy and disaster as opportunities for making money. It seems ghoulish to take advantage, however indirectly, of the misfortunes of others. And so I cannot bring myself to directly ‘play the market’, as they say, although my retirement accounts are presumably being invested by someone who is playing such games, so my hands are by no means clean.

But it is not only big investors who can fall prey to that kind of hype. If you find it hard to imagine that normally level-headed people could go nuts over things like tulip bulbs, recall the idiotic Beanie Baby craze of the 1990s. The prices of those cheaply made and nondescript toys started rising insanely as certain of those stuffed animals, sometimes for no discernible reason other than a rumor that they would become scarce, suddenly became highly sought after items. Ordinary people started lining up at stores on rumors of their availability and started paying far more than what they could afford for things that they thought would become collectors’ items. The idea of an everyday item (a small, mass produced, cheaply made stuffed toy!) becoming a valuable investment vehicle was bizarre. This was such an obvious mass hallucination that I could not believe it was happening before my very eyes. Clearly reality had to prevail at some point and that bubble also crashed, leaving some people with huge quantities of Beanie Babies that they could not sell at even the list prices.

But while the Beanie Baby example was illustrative in the way it caused some people to spend more money than they could afford, it has had nowhere near the devastating impact that the current sub-prime mortgage bubble debacle has spawned. Once again, as with the tulip bulbs or Beanie Babies or the earlier dot-com bubble, the problem begins when the price of an item gets divorced from reality.

Next: The subprime mortgage bubble.

POST SCRIPT: Ricky Gervais in Extras

Comedian Ricky Gervais, who created the original The Office, has a new comedy series called Extras, where he works as an extra and tries desperately to ingratiate himself with the stars in order to get a break or at least a speaking role. This gives the show the chance to have famous actors as guests for each episode.

In this scene, we see him with Patrick Stewart.

(For previous posts in this series, see here.)

My first real awareness that my understanding of what constituted sound economics and business practices was orthogonal to how Wall Street viewed it came in the 1990s when company after company sought to increase its stock price by slashing its work force, thus increasing its profits (at least in the short term). I recall that the head of Eastman Kodak at that time fought this expectation that he too follow suit. His argument was simple: His company made products that were in demand, was price competitive, and was making good profits. Why should he get rid of good, loyal, experienced workers, the very people who had made the company successful, for no good business reason but merely to drive up the stock price? I thought he made complete sense, which just shows how much I knew. Outraged stockholders quickly organized his ouster and replaced him with a new CEO who did what they wanted, which was to ruthlessly reduce the payroll, in the process throwing tens of thousands of people out of work. But those actions did drive up profits in the short term, and the stock price rose, which is all that Wall Street cares about. The fate of the Kodak CEO was a warning to other CEOs that they had better not even think about putting the long-term health of the company or its employees above the short-term profit needs of the stockholders.

What seems to have happened that is driving this trend is that the line between appearance and reality in the financial sector has become increasingly blurred. For example, it seems to me that a company’s stock price should reflect its actual performance. So when it releases its annual report that says how well it did the previous year, its stock should rise if the report is good and fall if the report is bad. But that is not the way it works anymore. We are told sagely by analysts that what Wall Street cares about is not the data-based present (what some of us like to call ‘reality’) but expectations for the future. The measure that is used to determine stock price is how the report compares with what ‘experts’ and ‘analysts’ predicted it would say. What determines a stock price now is what analysts expect will be its profits in the future. We have moved from reality-based economics to crystal ball economics.

And therein lies the problem. It seems to me that the more one is separated from actual data, the more shaky the structure becomes. Once you shift the focus away from actual data to predictions about what future data will be, you have started playing a different game, that of appearance and expectations, and this can swiftly spiral out of control, where prices can start to rise based on unrealistic expectations, and then the rise itself seems to retroactively give substance to the expectations, which in turn fuels expectations of even greater rises, which causes even greater price rises, and so on. In short order, one has an accelerating price spiral where the relation of the price to the actual value of the commodity has been severed.

In some cases, fixing the actual value of a commodity is not easy and the price does become the value. This is true where rarity is an important factor is setting the price, such as in gold and precious stones. Art is another such commodity. Clearly the value of a painting by Rembrandt is not based on the raw materials used and the hours he put into its creation.

But apart from such specialized situations, in most situations we do have a rough idea of how much something should rationally be priced at based on some measure of underlying value, such as the cost of raw materials and labor, the cost of similar items in the market, and historical price patterns. When the prices of such things start outstripping the underlying value by wide margins, then we are heading for trouble because of the creation of ‘bubbles’. As Eric Janszen defines it in the February 2008 issue of Harper’s Magazine (p. 39): “A financial bubble is a market aberration manufactured by government, finance, and industry, a shared speculative hallucination and then a crash, followed by depression. . .A better, if ungainly, descriptor would be “asset-price hyperinflation” – the huge spike in asset prices that results from a perverse self-reinforcing belief system, a fog that clouds the judgment of all but the most aware participants in the market. Asset hyperinflation starts at a certain stage of market development under just the right conditions. The bubble is the result of that financial madness, seen only when the fog rolls away.”

The most famous historical example of a bubble (perhaps because it seems so extreme now) was the tulip bulb craze of 1636 where the price of tulip bulb ‘futures’ (i.e., the price expected in the future) skyrocketed, with reports of a single bulb selling for as much as a fashionable house and garden in Amsterdam! The problem with such bubbles is that they are like a Ponzi scheme in which the really savvy investors who get in early make a lot of money. The later people make money only as long as the prices keep rising rapidly because of the arrival of new investors (also known as ‘suckers’) willing to buy at inflated prices, thinking that prices will continue to rise. The need to maintain the illusion of unstoppable growth makes people reluctant to prick the bubble by bringing it into contact with reality, by asking awkward questions about the actual value of the commodities being bought and sold. But of course, rapid price increases are unsustainable and it is only a matter of time before the madness passes. In the tulip bulb bubble, by 1637 people started realizing that these tulip bulb prices were unrealistic and that they had been had. The tulip bulb market then came crashing to the ground, and people left holding these future contracts took a devastating financial hit.

The South Sea bubble that crashed in 1720 was another example of where stock prices rose wildly, and the rise itself fueled expectations of future rises, thus leading to an out-of-control spiral, again followed by a crash.

The Florida real estate boom and bust of 1926 was yet another example of a bubble where land prices sometimes quadrupled in a single year, driven up by speculators and naïve investors who felt that the only way prices could go was up and were thus willing to pay almost anything thinking they could make a future profit.

Next: More recent bubbles

POST SCRIPT: Mythbusting the Canadian health care system

One of the big propaganda efforts in the US has been the way the Canadian single payer health care system is falsely denigrated in order to perpetuate the lie that the US has the Best Health Care System in the World, when in actual fact it is bloated, expensive, wasteful, inefficient, inadequate, and corrupt. (See here for a series of posts on health care.)

Here is the first part of a series that combats the myths about the Canadian system.

(For previous posts in this series, see here.)

In the last post, I suggested that sending out checks for $600 to each taxpayer, especially those who don’t need it, and then encouraging them to waste it, hardly seemed like a coherent economic plan. Such a policy can only be understood as a subsidy to the business sector disguised as a benefit to individual taxpayers. We are merely conduits through which money is given by the government to Wall Street.

It was not always the case that governments responded this way. The US has met greater social and financial challenges before and responded quite differently, most notably the WPA (Works Progress Administration) program, begun in 1935 to get the country out of the Great Depression of 1929. “[T]he WPA provided jobs and income to the unemployed during the Great Depression in the United States. The program built many public buildings, projects and roads, and operated large arts, drama, media and literacy projects. It fed children, redistributed food, clothing and housing…About 75 percent of WPA employment and expenditures went to public facilities and infrastructure, such as highways, streets, public buildings, airports, utilities, small dams, sewers, parks, city halls, public libraries, and recreational fields. The WPA built 650,000 miles of roads, 78,000 bridges, 125,000 buildings, and 700 miles of airport runways. Seven percent of the budget was allocated to arts projects, presenting 225,000 concerts to audiences totaling 150 million, and producing almost 475,000 pieces of art.”

But those were days in which the collective good was more valued. Can you imagine that they even thought that spending money to provide cultural enrichment to the general public was a good thing? How quaint! Nowadays, we sneer at such an approach. What is considered good is not to have people be able to go to a library or a park or to enjoy a concert or play, but to get them to go to shopping malls. Nowadays, people are urged to not see themselves as part of a community, a social fabric, a collective. We are taught to see ourselves as ‘consumers’ whose only purpose is to accumulate private goods. When did that strange word ‘consumer’ come into vogue as a means of describing people? Its popularity is a symptom of how we are expected to see ourselves as merely voracious organisms, a species of bacteria, whose purpose is to eat up products to make the business sector happy. These days the purpose of a ‘stimulus package’ (as it is euphemistically called instead of the more accurate ‘let’s all waste money together’ plan) is to serve as a subsidy to business. The government wants people to use the money to buy junk they don’t need.

The notion that I, as an individual, have an obligation to spend money to ‘stimulate the economy’ strikes me as insane. I do not have to do anything of the sort. I have no obligation to goose up the economy by spending myself into the poorhouse, just because it is good for the stock market. As I see it, my obligations are to work productively, be a good citizen, serve my community, live within my means, and save for my family and the future – the kinds of things that Benjamin Franklin would have approved of. It seems blindingly obvious to me that the less I spend on unneeded goods and services, the better it is, both for my own financial health, the health of the community, and the long-term health of the planet. And yet, every muscle of government and business propaganda seems to be aimed at convincing people of the opposite. In a way one can understand that. When one is trying to convince people to so something that goes against common sense, one has to pull out all the propaganda stops. Thus the news media report with approval, and even glee, if people go on shopping sprees at Christmas. They are thrilled to tell us about people maxing out their credit cards buying gifts for all and sundry. They are downcast if people decide not to spend money they can’t afford.

The government is even being urged to call the $600 check a ‘bonus’ rather than a ‘tax rebate’ since studies indicate that people think of a bonus as ‘free money’ and are thus more likely to spend it, whereas a rebate is seen as your own earned money being returned to you, and is thus more likely to be saved.

The sad thing is that some people have actually bought into this notion that their proper role is to serve as engines to drive the consumer economy. In interviews, I hear people actually blather on about how they feel they should immediately spend their $600 refund check so that the economy benefits. They have swallowed the whole bogus story, hook, line, and sinker.

It seems clear to me that we have ceded control of the economy to the worst elements of the financial world, by taking it away from those who see it as serving the long-term well-being of people by encouraging sound business practices, and handing it over to people whose main goal is use money to make money, a financial pyramid scheme that depends upon the collusion of the government, a few big industries, and the financiers and other money people of Wall Street. We see now the government essentially using the money of ordinary people to bail out (and thus essentially reward) the scandalously risky behavior of the financial sector that has been driven by greed.

British comedians John Bird and John Fortune show in this satirical interview how the banking and finance sectors recklessly siphon away people’s money for their private benefit, confident that if things go badly wrong (as they have) the government will bail them out using public funds. The Northern Rock they refer to is the big British Bank that got into trouble due to the current subprime mortgage crisis and had to be bailed out by the British government.

Another example of how the government’s priorities are to maintain the profits of a few at the expense of the financial health of the many can be seen in its attitude to single-payer health insurance plans. There is absolutely no question that this would be not only provide overall better health services to the public at lower costs, but would also be hugely liberating for business. (See here for earlier posts dealing with this issue.) The employer-based health care system has to be the biggest albatross dragging down American business competitiveness. And yet, the stranglehold that the health insurance, pharmaceutical, and medical industries have on our government, and the huge profits made by them at everyone else’s expense, means that the current system continues without even a serious challenge to its existence, even as the economy gets dragged under. The ruthlessly exploitative health care industry has been helped in their efforts to preserve their lucrative cash cow by the Villager propaganda, endlessly repeated, that America provides the Best Health Care in the World and that Americans would never support a single-payer system. These are all completely unjustified assertions, but they are repeated unquestioningly.

Next: The rise of the ‘bubble economy’.

POST SCRIPT: Flight of the Conchords

Those two wacky musical comedians give a quick summary of the Lord of the Rings.

(For previous posts in this series, see here.)

Clearly I am not the only one that thinks that current fiscal and monetary policies are not only unsustainable but also immoral and that their priorities are completely out of whack. French President Sarkozy, following the discovery of the speculative trading and fraud that resulted in losses of $7 billion at one of France’s largest banks Societe Generale, also called for an end to this mad, reckless way of thinking, where short term profits trump everything else.

“The point of a financial system is to lend money for economic activities, which, in turn, generate profits,” Sarkozy told a gathering of French nationals at the French embassy [in India].

“It is not to go and speculate on different activities which create enormous flows and profits in a few hours,” he added.

“If one can make profits in a few hours, one can also make gigantic losses in a few hours as well. And it is time to realise that (we need) to insert a bit of wisdom into all these systems,” the president said. [Read more…]

(For previous posts in this series, see here.)

The current weird situation in which the stock market rises on what you or I might think is bad news can also be seen with labor figures. When reports are released that unemployment is low (which ordinary people would think is a good thing), the stock market tanks. When unemployment figures rise, the stock market also rises. Why? We are told that if unemployment is low, that means that workers are in demand and thus have more clout in negotiations and their wages are likely to rise. Again, you and I might think it is a good thing for working people to be earning more. But for investors, this is bad because rising wages means lower profits for companies and an increased possibility of rising prices, which means the possibility of inflation, which means that the Federal Reserve might raise interest rates to reduce the money supply and thus lower the risk of inflation. And we know the love affair that investors have with low interest rates. Hence the stock market goes down.
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One topic that I have tended to avoid in my blog posts is the subject of economics. This is because the ‘dismal science’ is one of those subjects where I feel a little out of my depth. Whereas I can make sense of events in many other areas of everyday life, even to the extent of making modestly successful predictions about what should occur, behavior in the world of business and finance tends to defy my expectations. For a long time, I thought this was due to my weak understanding of the basics of economics. But now I am wondering if it is because the economic world is, frankly, crazy.

I am beginning to worry that the modern US and global economy has become untethered from reality or even basic common sense. French President Nicolas Sarkozy seems to share my alarm when he recently said that we now seem to have a global “financial system which is out of its mind and which has lost sight of its purpose.”
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