Home Prices Should Not Go Up

The collapse of home prices in the United States is a major cause of the financial sector's current woes and the severe economic decline we are currently suffering. I do not dispute that. But I do dispute the notion that using government money to attempt to stabilize or increase home prices is the correct policy response.

Home prices declined because they were far too high to begin with. They got so high because fancy mortgage products enabled people to buy homes that were more expensive than they could actually afford. And people bought homes that were more expensive than they could afford because they assumed (wrongly) that they could refinance on more advantageous terms sometime later or sell the house at a price higher than they paid for it. The government exacerbated the bubble by encouraging the GSE's (Fannie Mae and Freddie Mac) to subsidize the mortgage market, thus making it easier to borrow money for a home purchase.

There are many reasons why government policies designed to prop up home prices are a bad idea. The first one is that low home prices are a great thing. Like milk, gas, and healthcare, housing is something everyone needs. The lower it costs, the better. It is pretty straightforward to understand why the approximately 1/3 of Americans who do not own homes would benefit from lower housing prices. Of course, many Americans own their homes. And they seem to want their homes to be worth more money. But if you think about it, the vast majority of homeowners do not realize any benefits when home prices rise. Higher home prices mostly make people feel wealthier; owning a more expensive house does not result in more money in someone's bank account unless she is willing to sell that house and begin renting or buy a smaller house. Most homeowners, however, aspire to live in their homes for a long time or to move up to a bigger and better house when they can afford to do so.

The government has enacted many policies designed to make home ownership more affordable: tax credits for first-time home buyers; an aggressive policy of printing money to buy mortgage-backed securities from financial firms designed to drive down mortgage rates; and propping up Fannie Mae and Freddie Mac to make it easier for Americans to obtain mortgages. These policies may make homes more affordable for people in the near term. But they also create more demand for housing and result in higher home prices: people are willing to pay more for houses because interest payments on their mortgages are lower and they can receive tax incentives for buying.

Unless the government is going to continue to plow money into the housing industry forever, these policies are creating future problems. If the government cuts these subsidies, housing prices could fall, perhaps drastically. Because current policy encourages people to buy homes today at artificially high prices, we might have a whole new wave of people who owe more on their mortgages than their houses will be worth in the future. This might create yet another economic crisis. And it would ensnare a whole new group of homeowners who managed to escape the current crisis and are fortunate enough to be able to buy a new home today.

Another unfortunate consequence of policies that prop up home prices is that they result in resources being diverted from more economically productive industries toward home construction. Building bigger and better homes is nice. But it does not result in a more productive economy. (It does lead us to consume more energy, however). By increasing the demand for homes - and the resources that go into home construction - we take resources from other industries that create economic progress and make America more competitive.

The dangers of a housing bubble are clearer than ever. The United States needs to stop feeding a new one and let housing prices decline to a natural equilibrium. Although this may upset some banks and those homeowners who are planning to sell, it will benefit the broader economy by reducing the risk of a future housing collapse and increasing our economy's productivity.

TARP Repayment: Good News, But Banks Still Have Government Money

Today the Treasury announced that 10 large banks would be allowed to repay funds they received under the T.A.R.P. program. This is good news for the American taxpayer. However, it hardly signals some sort of "all clear" for these institutions. Banks that repay T.A.R.P. money are not necessarily operating without massive amounts of government financial assistance. Remember that the T.A.R.P. represents only a fraction of total government support to the financial sector. The Federal Reserve, through a variety of other bailout programs, has lent billions of dollars to Wall Street. Perhaps this has received less attention because reporting on it is so difficult: the Fed refuses to disclose who it has loaned to and on what terms. Meanwhile, the F.D.I.C (and ultimately the taxpayer) continues to guarantee billions of dollars of debt issued by some of the very same banks that have repaid T.A.R.P. funds.

If every single bank were to repay every dollar ever lent through T.A.R.P., Wall St. would still have lots of government money. And the government would still be on the hook for massive amounts of bank liabilities if some of these institutions ever become insolvent in the future. It remains unclear when and how the Fed and the F.D.I.C. will untangle themselves from these arrangements.

Usury

To a foreigner you may charge interest, but to your brother you shall not charge interest, that the LORD your God may bless you in all to which you set your hand in the land which you are entering to possess. (Deuteronomy 23:19,20)

I usually try to avoid Biblical quotations, but this time I just could not resist. To be honest, I do not really agree with the quote. I am, after all, a fixed income trader whose career hinges on the usefulness to society of lending money at interest. I include it here to make a point: throughout history, the charging of interest has been a controversial topic. Some argue that it leads to investment and progress. Others argue that it is immoral and contrary to scripture. I would argue that the controversy stems from the fact that while it does lead to economic progress in the majority of instances, there are also times when lending can be predatory and immoral. Lending money to a small business at 9% sounds like a good deal for everyone. But lending money at an annual rate of 25% to a single mother who is struggling to put food on the table does not result in economic progress. Rather, it results in richer guys getting richer and poorer people staying poorer.

So, I was quite disappointed today when the Senate killed a proposal by Senator Bernie Sanders, Independent from Vermont, to put a cap on the rate banks charge credit card customers. Unfortunately, Congress lacks the will to inhibit the type of irresponsible lending that financially cripples families and leads America further down a seemingly never-ending hole of bad debt.

In general, I oppose Congressional interference in business matters. But today an exception to that rule should have been made. Taxpayers are currently propping up Wall Street banks for the good of the country, or so we are told anyway. It is perfectly reasonable for that assistance to come with some strings attached. One very good string would prevent bailout recipients from engaging in a practice (usury) that exacerbates the very same problem (a debt crisis) that the bailout money is intended to resolve.

I would have liked Sander's proposal even more had it only applied to bailout recipients. That way the problem of interference with free markets would be irrelevant. But either way, it is very disappointing that our government has again failed to protect American families because the interests of banks got in the way.

Breaking the Law

I finally got around to reading some of the Emergency Economic Stabilization Act of 2008. I was a bit surprised - even a little impressed - by the level of specificity written into the bailout legislation. Yes, Congress did grant wide discretion to the Treasury Department. But the discretion was not boundless. The law does not give the executive branch of government the authority to spend $700 billion as it wishes; Timothy Geithner cannot go around buying whatever he wants. Rather, "The Secretary is authorized to establish the Troubled Asset Relief Program (or "TARP") to purchase . . . troubled assets from any financial institution on such terms and conditions as are determined by the Secretary, and in accordance with this Act . . ."

That may not sound like much, but in light of recent actions by Treasury, I would like to delve a little deeper into that straightforward instruction. Anyone who has taken a basic accounting class can tell you that an asset is something a company owns. It is worth something greater than zero. It can be a factory, a troubled mortgage bond or a patent. But it cannot be a liability. An asset cannot be something that will result in the company having less money in the future. (I apologize if this sounds obvious, but I promise I am going somewhere here.) When a company issues a share of stock, a preference share, or a bond, then a new liability is created. That LIABILITY is not an ASSET. Indeed, an asset is the opposite of a liability.

Ok, now take another look at the excerpt from the TARP law. It gave Treasury the authority to purchase assets. But not liabilities. So then how in the heck did we taxpayers end up spending billions of dollars on common shares and preference shares? The best answer I can come up with is that the Treasury Department decided it was above the law. I will refrain from expounding on the importance of democracy and adherence to the system of government outlined in the American Constitution. Suffice it to say that certain Treasury officials apparently believe they have more important concerns and that I respectfully disagree.

The law does contain a definition of the term "troubled assets." They are assets related to mortgages or "any other financial instrument." I'm sure the Treasury Department could find a lawyer to argue that therefore assets can be liabilities. However, even if that argument were to succeed, the Treasury would still be operating outside of the law because Congress specified how the Secretary must go about acquiring these assets (also know as liabilities to creative types). The Treasury is instructed that any publicly traded institution that sells assets to Treasury must also give the government a warrant or equity stake designed "to provide additional protection for the taxpayer against losses from sale of assets." In other words, the government must demand equity stakes as an additional compensation for buying troubled assets. But if the government is only buying equity stakes, then it would be impossible to receive any "additional protection" from equity stakes. It is therefore impossible to adhere to the law without the government acquiring more than just preferred shares or common stock. Any way you cut it, both former Treasury Secretary Hank Paulson and current Secretary Timothy Geithner broke the law by using TARP money to buy equity stakes instead of troubled assets.

The Asset Allocation Question

For years, many of the most trusted experts in personal finance have instructed American families to allocate their savings to a mix of stocks, bonds and money market instruments. The percentage that should be allocated to each sector, according to widely accepted theory, mostly depends on the investor's age, wealth, willingness to accept risk, and expected future income stream. But one factor has been conspicuously absent in the determination of investors' asset allocation decisions: valuations are not considered. If stocks are bubbly and bonds are cheap, the investor still funnels as much money into stocks as he would if the valuations were reversed. Two assumptions that underlie this approach to investing are that markets are generally efficient (meaning stock and bond prices are close to fairly valued given the amount of information available to the investing public) and that the average investor cannot beat the market.

Recent events have got me thinking a lot about this. This approach has wreaked havoc on the retirement savings of millions of Americans. So I took out a book I had not read since college: "A Random Walk Down Wall Street," by Princeton economist Berton Malkiel. The book is one of the most influential arguments for the efficient markets theory and the implications for personal investors. The basic message is that investors should not attempt to pick stocks or time the market.

Most of the research I have seen supporting the efficient markets theory (and the notion that the average investor cannot beat the market) focuses on the futility of stock-picking. "A Random Walk Down Wall Street" is no exception. It convincingly argues that people should not attempt to pick which stocks will go up and which will go down; they should just buy index funds with low fees. A small number of experts keep stock prices in line and earn profits doing so; but most people should not attempt to beat the market.

However, Malkiel only touches on the subject of asset allocation. Malkiel cites data showing that equity only mutual funds hold a larger percentage of their funds in cash (mutual funds almost always have a fraction of their funds in cash to meet liquidity requirements) at precisely the wrong times. He concludes that "mutual-fund managers have been incorrect in their allocation of assets into cash in essentially every market cycle during this period [1970-2002]." This is a weak argument. Equity only mutual fund managers are not in the business of allocating assets between equities and cash (and are often legally prohibited from investing significant amounts of money in bonds). They are in the business of buying stocks.

Consider the state of affairs in the United States. The vast majority of Americans and institutions invested a relatively fixed percentage of their savings into equities regardless of valuations. Despite the advice of people like Malkiel, a lot of that money is invested in funds with flexibility to pick stocks (as opposed to index funds). So, there are a lot of dollars out there chasing "cheap" stocks. Because so many people are chasing the same cheap stocks, it is very difficult to outperform the maket. But very few funds are able to sell stocks and buy bonds. Most of the money is literally stuck in the equity markets because investors believe they need to allocate some fixed percentage in stocks. There might just not be enough money out there that is actually managed by people with enough flexibility to keep stocks at fair levels relative to other asset classes.

I suspect that the very good research about the efficiency of the stock market has been wrongly applied to asset allocation in general. Although it may be difficult to pick which stocks are winners, it may be possible to intelligently allocate more or less money to certain sectors of the financial markets based on valuations like yields and P/E ratios. Much more research needs to be done on this point. But many studies have suggested that simple metrics like P/E and P/B ratios can be used to beat the market.

For years Americans have been instructed to invest with a blind faith in the ability of the stock market to turn money into more money when given a long enough time horizon. Recent events ought to at least trigger a serious academic reevaluation of the notion that Wall Street is able to keep the markets near their fair values. Perhaps it is time to rethink the philosophy of investing so much of our savings in the stock market regardless of fundamental valuations.

Equity Stakes

Speaking to a Congressional panel today, Treasury Secretary Geithner advanced the idea of converting the government's preferred equity stakes in banks into common equity. Preferred stock is actually more like debt than stock because companies pay a fixed coupon to holders of preferred shares. By converting preferred shares to common equity, the Treasury hopes to reduce the liabilities of troubled banks and thus improve their capital position. The media, along with many politicians, have correctly identified this as a risky idea. But most of the scrutiny has focused on the thorny issue of how the government can effectively control large ownership stakes in corporations. Fears of nationalization and government interference in private markets have been at the heart of the debate about converting government stakes to comon equity.

Such fears are valid. But they should not be the focus of the debate. First of all, the government already has control over bailout recipients. Many banks would be bankrupt without government assistance. If the government wants to interfere, it can already do so simply by threatening to cut off funding. So fears of nationalization or excessive government interference are moot. Second, and most importantly, the real problem is that common equity is much riskier than preferred equity. A preferred share must pay a fixed coupon to the investor unless the company suspends the dividend it pays to common shareholders. In other words, preferred share holders get paid before common equity holders. Preferred stock holders also fare better if bankruptcy occurs and the firm is liquidated. Congress and the media should be giving more attention to how the conversion would increase the government's probability of losing money. The Treasury has already put trillions of taxpayer dollars at risk to help banks. Converting preferred shares to common equity will exacerbate the problem.

A Better Plan

The American economy is going through a profound restructuring. Less money will be spent on home construction in the future. American car companies will be smaller in the near term. The financial sector will employ fewer people. Such restructurings are painful because they are associated with layoffs and bankruptcies. But there are many ways for the government to mitigate the effects of this economic correction without risking trillions of dollars on bailouts. Below I outline a 5 part approach to coping with the current economic crisis and the financial sector's problems. Compared to the Obama administration's approach, this plan devotes less money to the financial sector and more money to the social safety net and job creation.

1) Restore Confidence: The most efficient way to restore confidence is to greatly expand unemployment benefits and the affordability of health care. Compared to many other developed countries, the United States has a weak social safety net. Parents who are worried that their children may lose access to medical treatments have every reason to drastically cut spending, causing an especially severe economic contraction. If Americans were more confident that they could maintain a decent standard of living, economic activity would be higher. This policy does not mean that we have to adopt a European style economy. The U.S.A. can skip the restrictive labor rules found across the pond because they hamper economic growth. We should just borrow the good stuff (the safety net) and we should do it as soon as possible.

2) Fight Unemployment: There are millions of unemployed Americans out there right now who want to work. Many businesses are shrinking. Eventually, other businesses will expand to fill the gap. But that can be a slow process. In the meantime, the government should use this excess supply of labor to modernize American infrastructure so that the country enters the next global economic expansion on a competitive footing. We need more stimulus money.

3) Maintain Price Stability: The Federal Reserve has done a good job fighting deflation so far. Under Bernanke's direction, the Fed has expanded the monetary base to help prevent a dangerous drop in prices. However, the Fed should be more cognizant of inflation risk. Bernanke ought to be more conservative in the assets he acquires during this monetary expansion because he may need to sell the assets quickly - thereby reducing the monetary base - to fight inflation. The Federal Reserve should conduct monetary policy. It has no business assuming massive credit and interest rate risks.

4) Ensure That There Is A Viable Financial Sector: This does not mean that huge banks need to be bailed out. The economy will benefit if a competitive group of healthy financial institutions exist to provide credit to people and businesses. The government can intervene if such a group does not exist. But that intervention should not take the form of pumping cash into failing banks. Rather, the money should be used to better capitalize the healthiest banks. Such a policy has a higher chance of ending in full repayment to the government and in an expansion of credit.

5) Impose Harsher Terms On Bailout Recipients: Many commentators argue that some banks are too big to fail. One argument for saving failing financial institutions is that their failure would be catastrophic to other institutions, setting off a dangerous chain reaction. I would like to see more evidence on this point. But even if one does assume that a firm's failure would be intolerably harmful to the economy, it does not follow that the government needs to spend billions of dollars to save investors in the firm. The government can guarantee the failing firm's obligations to customers and counterparties, but allow bondholders and equity investors to suffer losses. While discussing such an approach, market commentator and fund manager John Hussman wrote:

"Ultimately, if a financial institution is not capable of surviving without large and constant infusions of public capital, the stockholders and bondholders of that company – not the public – should be responsible for the losses incurred. . . . [T]his can be achieved without customer losses or a disorganized Lehman-style unwinding." (Here's the link.)

In conclusion, the Obama administration needs to rethink its approach to the current economic crisis. More money should be spent on the social safety net and building infrastructure. Less money should be spent on saving investors in financial institutions. Both can be accomplished without stifling the free market and without financial market chaos.