November 2008 • VIEW Issue 8: Last month (Oct. 2008, Issue 7, Article), I addressed failures of our media to disclose critical germane facts and analysis surrounding the “bail-out”. This month I’ll address how we got into the economic mess we’re in and why the current “fixes” probably won’t do the trick.
Let’s start with some economic reality therapy. Our economy has a normal cycle every four to seven years or so. That is, it oscillates between a high and a low like a wavy line. It seems whichever party is in office on the down swing, tends to get the blame. Conversely, whichever party is in office on the upswing tends to claim the credit.
Back to the causes: In its simplest form, on the upswing, consumers buy more stuff. Suppliers expand capacities and inventories, hire more people and buy more stuff. This all works well until the wave tops out. People buy less stuff. Suppliers still at high output, realize their inventories are growing. Then come the plant closures and layoffs. Then people don’t have jobs to earn money to buy lots of stuff. So they buy a lot less stuff.
Make no mistake; while the normal cycle is predictable, it can be exacerbated, extended or shortened by other economic factors. In the case at hand, low interest rates and easy access to loans increased the demand for real estate and the price of the real estate rapidly increased. As the prices increased, home buyers and investors jumped in to ride the wave upward.
All was fine and good on the way up. Then the market topped out and the loans began to default. Savvy real estate investors sensed the top of the wave and began to sell. Massive selling dumped a glut of property on the market and prices slipped like California ocean front cliffs after a heavy rainstorm. When the loan defaults began to mount, the mortgaged properties were worth far less than the balance of the loan. Henceforth, the banks were facing huge losses.
At the same time, in the stock market, bank and other financial stocks soared until the wave topped out. When the banks began to suffer losses, their stock price also tanked, precluding them from effectively selling more stock to raise capital.
A bit of background: the word mortgage or “death promise” is a derivative of the word morgue. In short, loans were given to people who couldn’t make the payments. People that couldn’t ordinarily afford the mortgage thought they could during good times: Interest rates were low, and introductory rates were too good to be true.
In the words of George Carlin, “There are good rules and there are bad rules. Running with the scissors – good rule Mom! No singing at the kitchen table – bad rule.” There are good “rules” or guidelines of lending, also know as the Five C’s.
Back to the five C’s of credit. What are they?
1) Character – Have the prospective borrowers consistently and reliably repaid in loans the past?
2) Capacity – Despite their desire to pay, can they make monthly payments given current paycheck and other obligations?
3) Capital – How much are they worth? How big is the prospective loan relative to what they already have?
4) Collateral – If they are unable to pay, what assets can they use to settle the debt?
5) Conditions – Is the economic environment conducive of repayment and preservation of the asset they are financing ?
Character: Res ipsa loquitur (Latin: the thing speaks for itself). Or, in the words of Dr. Phil, “The best predictor of future behavior is past behavior.”
Capacity: The banks peddled loans that didn’t really reflect the actual cost by offering “low introductory rates” or the infamous sub-prime.
For example: a mortgage payment that was normally $1,000 per month was offered at $500 per month for the first year. Guess what happens in month 13? Duh!
Moreover, when interest rates were very low, ARM (or Adjustable Rate Mortgages) were the loan of choice. The problem is, as the interest rates increased, so did the monthly payment).
Capital: Many of the loans equaled to or exceed the value of the property.
Collateral: The value of the homes were inflated due to the buying spree. When the market “tanked” (corrected itself for the overpricing) the house was worth less than the outstanding loan balance.
Conditions: Interest rates were at an all time low. Ergo, they would probably go up. Unemployment was low. The stock market indexes were growing far beyond sustainable growth paths. Nobody wants to be the party pooper, but let’s face it; almost all economic indicators were too good for too long, which translates into: what goes up, must come down. This sort of reminds me of when I’m merging onto Highway 33 approaching the “Y” when there’s a lot of traffic. There’s always this one moron in a car that zooms down the right and cuts in at the last second.
I’m guessing most people don’t want to default on a loan, and most banks don’t want to “boot” people out of their homes. That’s a lose-lose scenario. That’s why we have rules.
Recently, Alan Greenspan, former Federal Reserve Chairman, testified in front of a congressional committee. His revelation was that the banks failed to protect their long-term well-being. I infer from this statement, the banks self-preservation was an adequate protection in the past that didn’t hold true this time. My take: there was a major leadership failure. So why would any experienced manager who has lived through the Savings and Loan fiasco of the 80s let history repeat itself? I don’t know either. My hunch is the quest to placate insatiable stock holders and managerial bravado, the catalysts.
Oh yeah, I almost forgot about the executive bonuses. A few of the ol’ boys from Lehman Brothers walked out the door with over $100 million dollars in bonuses days before the company collapsed. If that’s leadership, for just a second, I’m more inclined to ascribe to the chaos theory or be ruled by “the masses” our forefathers warned us about.
Enough banter from me. In summary the causes were:
• Borrowers weren’t properly qualified and money was lent to people who couldn’t afford to repay the loan.
• Borrowers did not read and comprehend how the expiration of introductory terms and variability in interest rates affected their obligation.
• Loans weren’t properly collateralized.
• Corporate greed and myopia put short-term profits in front of corporate health.
So why won’t the current fixes work? Picture a bucket of water with a few holes in it. The water level steadily declines. I know, let’s put some more water in it to stem the losses. The reality is, the bucket is defective; adding more water isn’t going to fix it. Back to realityland for a moment. The same institutions and leadership who caused the problem are the same ones receiving the cash to recapitalize themselves. If that’s not bad enough, the banks are hoarding the money and not lending it out, further hampering the economic recovery. That’s worse than looting during the riot. It’s adding injury to insult.
Here’s the public policy failure: Rewarding the leadership, employees, and shareholders who made or allowed poor choices. And now the really bad news: Those of us who made prudent financial decisions are paying for it.
• Our elected officials have underestimated the cost and will come back for more money. It will likely be cleverly disguised as an economic growth and protection package.
• Other failed industries will ask for their poor decisions to be borne on the back of the American tax payers.
• The “overhaul” or new rules promised to prevent a reccurrence will create more bureaucratic cholesterol and probably won’t effectively prevent the Déjà vu.
• Take a more behavioral approach: Do not rescue: make the leaders, employees, and shareholders live with the consequences. Why the shareholders? If you’ve ever seen Dante’s Inferno, the highest level of hell is for neutrals. If you ask for behavior A and you reward behavior B, you’ll keep getting B. Duh!
• Change the lending disclosure statement to include a worst case scenario for a loan payment.
• Have property appraisals state both a current value and normalized baseline growth value. (If the market weren’t distorted, the value would likely be X.)
Here’s What I think: The folks that got booted out of their homes already felt the pain by not reading the fine print, I’m guessing they won’t do that again. Problem solved (for this generation...).
Upside: Taxpayers indirectly pay in the form of a harsher and longer recession. The direct pain is felt by the parties that were the proximate cause. Besides, it sends a message: You make your bed, you lie in it.
Downside: We’d have to listen to all the whining from former employees and shareholders that they were innocently injured and how their pensions were hosed. My response in advance: get in line behind the former employees and investors for Enron.
How about the quality journalism: Why not ask the whiners what their responsibility was in the deal?
– Jefferson Pinto, CPA, MBA
Jefferson Pinto is a retired CPA , holds an MBA from one of the finer accredited universities in this country, and is the VP of corporate operations for his day job.
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RELATED ARTICLE: Economy: 'Heads I Win, Tails You Lose,' Apr 2010, #25
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