March 29th, 2013

A Simple Explanation of the Housing Boom

A friend really liked my Discounting entry because he saw in it a simple explanation of why we aren't on the gold standard. Which is funny, because I _was_ talking about the gold standard, but mostly by way of pointing out some things about banking history in the US that I thought was a relevant metric for understanding the decision making being displayed by the troika. He wanted to know if I could explain the housing boom. I will try.

Once upon a time, in order to borrow money, you had to show that you satisfied a lot of criteria: good _C_haracter, _C_ollateral, _C_apacity to repay, maybe some other stuff, too. If you wanted to buy a house, they wanted you to have some "skin in the game", that is, they wanted you to put up a significant fraction of the value of the house, they wanted you to demonstrate income (to prove capacity to repay) that was enough to pay the bill and live a decent life, and they wanted to know you were the kind of person who paid your bills (you've been paying them for a while, type of thing).

Then, in a fit of efficiency, we decided since "credit scores" were almost as good at predicting who would repay as the 3, 4 or 5 or whatever Cs, then we only needed to look at the credit score, maybe _ask_ you what your income was (but you didn't have to prove it). And as long as the house was worth enough, we wouldn't even make you put up a down payment. Etc.

This was okay. It was a lot more fragile than the previous system, but it also let a lot of people borrow who _would_ repay, but had trouble convincing borrowers of that under the previous regime. It worked well, it was a lot cheaper.

Ordinarily, when a lot of money is being loaned out, it becomes harder to get: either interest rates rise, reducing the desire for it and/or other restrictions are placed on credit. Interest rates rise when the Federal Reserve says they rise. Other restrictions are placed on credit when regulators insist on that happening. Neither one of those things happened as we were coming out of the recession of the early 2000s, and we went from a time period of easy money designed to help us recover from the recession to an inflationary boom. But it didn't _feel_ inflationary, because the inflation occurred in "assets": that is, house prices went up, but other things not so much, and people weren't concerned, _because they could just keep borrowing more money_.

So, you have to ask yourself: who were the suckers loaning the money? I get that the regulators (at the Fed, which should have raised interest rates, and at the various banking regulators, where they should have insisted on raising lending standards and stopped the ratcheting up of housing appraisals) didn't stop it, but shouldn't the suckers have wised up? Rather than the money coming from Savings & Loan deposits (you put your money into a savings account and the bank loans it out to your new neighbor to build a house on the vacant lot, type of thing), the money was coming from investors who were searching for a marginally higher return (rate of interest) in an extremely low interest rate environment (see how that very low interest rate policy has all kinds of nasty effects in the wrong environment?). The investors bought packages of pieces of mortgages that insurers and/or ratings agencies promised would NOT go bad not ever never could not happen. The investors believed the guarantor, in other words (sort of like people who put their money in banks that are known to be in trouble, but offering a higher rate of interest on CDs, because they figure they'll get bailed out no trouble).

The investors actually did start wising up. They really did. But the brokers who created the packages made so much fucking money in commissions on these things that they worked long hours and swore to all kinds of false things to convince people to buy variations on the scheme, scam, etc. -- and then they had to find people who were willing to build houses/take out mortgages on (commit to making the payments, in other words) for the other side of the deal. They beat the bushes to find new suckers to invest and new suckers (or fraudulent straw buyers) to sign up for mortgages.

Want to know who to blame? Think of this as Agatha Christie's _Orient Express_: there's a whole cast of bad guys. People who knowingly paid too much for a house believing they could make money selling it quickly. People who signed up for mortgages they couldn't afford, believing they could somehow make it work with another mortgage (a home equity loan, etc.). People who bought securities that packaged up all that future heartache. The brokers who figured out how to make the machine spew out ever bigger chunks of money for them to buy drinks for hot chicks in NYC bars. Greenspan for being old and stupid and fundamentally cowardly. Bush for being a cynical blowhard who didn't care what happened to the Republican party after he finished his second term. A whole bunch of regulators appointed by Bush who sat around and looked at porn on the internet, rather than go after criminal behavior at the banks (but don't blame the career people under those guys, because the staff was cut to the bone and then discouraged from taking the obviously correct actions).

The houses got built as a _side effect_.

Think about that for a while. What else could we do as a _side effect_ if we could only get the right kind of delusional thinking going at a high level? Or for that matter, as an _intended_ effect, if only we were really prepared to do Big Things like, well, insert favorite infrastructure project here.

Two quotes from _A History of Central Banking in Great Britain and the United States_ (not a review)

from p 364: "The belief in a "golden age" of competition and flexibility seems to have been built into the human psyche along with honesty, good workmanship, and respectful youth."

That's an amazing sentence.

p 381 in Wood, a quote from Stefan Zweig, Die Welt von Gestern pp 336-37 [The World of Yesterday]

"[A]nd thus hordes [of Bavarians] went over [to Salzburg] with wives and children to indulge in the luxury of guzzling as much beer as their bellies could hold....But the happy Bavarians did not know that a terrible revenge was approaching. For when the [Austrian] crown stabilized and the mark plummeted downward in astronomical proportions, the Austrians went over [to Bavaria] from the same railway station in their turn."

I'll probably come back to this latter quote and the section around it in another not-a-review post, if I get around to taking on the Cyprus-should-exit-the-Euro argument, a subset of all the thus-and-such-should-exit-the-Euro arguments, in turn an argument against any effort at monetary union. But not right now, because T. wants to watch Angry Birds Star Wars level videos to learn how to play the Cloud City levels.

_A History of Central Banking in Great Britain and the United States_, John H. Wood

Finally, a review!

I got this from my library system (not ILL -- internal request through the Minuteman network; the book itself belongs to Newton Free Library, which seems like the library that has _all_ the books I request, which probably means something) and I may yet buy the thing. It is in print and reasonably priced (around $30 on Amazon, B&N online, etc.) but not available as an e-book through Amazon. It was written and published before the bust and the period it covers ends around 2000 or so.

The author has been an economist for Quite Some Time now and admits to having changed his mind about a few things, and he's spent a bunch of time at various components of the Fed, so there's a lot of reason to believe he knows what he's talking about.

It's a slow read, because there is a lot to think about. I think the more familiar you are with the time/place covered (let's call it 18th century and onward), the more sense you'll be able to make of the book itself -- it assumes you already know about the wars that presented such stresses to the financial systems of the participants, for example. I have zero formal training in economics, and thus don't know the names of a lot of really basic ideas (the Phillips Curve, for example -- I mean, I know that term _now_), however I have decent rough understanding of the domain and various schools of thought within it, so a lot of my slowness involves matching the unfamiliar terminology to the familiar idea. If you don't recognize the underlying ideas, you're going to be in a lot of trouble here.

That said, it's a great book and a really interesting one. Wood _has_ opinions but he's (mostly) not embedding them in the frame, which is very refreshing. I think he has had a great deal of experience navigating discussions with people who maintain long-standing different perspectives and that enables him to structure the exposition as objectively as I could imagine.

If you've played any of the online games I've pointed to (or just read my reviews of them), you know the basics: money supply, price level, unemployment, interest rate/cost of money, and perhaps even pertinent regulatory targets like reserve requirements. Whether you are Jane Doe or Banker Jane Roe or Businesswoman Zoe, you care about all these things even when you cannot name them, because you have to figure out how you're going to make it through the day/week/month/year and pay for the stuff you need. Your life is more difficult if you cannot predict what you are going to be paid tomorrow/next week/next month/next year, or what you will have to pay to buy food, ditto, or you don't know the value of what someone owes you will be etc. Inflation can make life easier for debtors, if they have incomes which ratchet up more or less with the price level (inflation makes your debt go away!). Deflation can make life great if people owe you money and you're sitting on a liquid pile of the stuff. Prices which don't change (very much) don't necessarily directly benefit one group or the other -- except by making those predictions so much easier to make.

Central bankers exist at the nexus of domestic (in-group) price stability and foreign (out-group) markets (exchange rates). They _try_ to keep these things from moving around too much, but as Wood does a fantastic job of displaying over and over and over again, this isn't very easy, and as soon as you add additional goals (like, say, full employment or financing a war) it becomes hair-raising. Worse, other places' price problems get transmitted to you via the exchange -- and vice versa.

Central bankers have a variety of tools to try to keep all this sloshing around from turning into a destructive flood (or drought). All of those tools have limitations. And Wood ably depicts the use of those tools and the limitations of those tools, and how changes in the global rules of the game have strengthened or weakened various strategies -- and how history gives us clues as to what to expect, but the gap in time means we _forget_ and repeat our mistakes. Particularly in the 20th century discussion, he incorporates a nuanced understanding of the intersection of politics, economics and central banking.

If you've ever sat around and wondered how we ever got in the habit of giving our money to someone else to hold onto and then writing checks against it, Wood has the story right here. If you've ever wondered about just what it is the FOMC does, Wood has (some of) the story here as well (he assumes a lot of knowledge). If you've ever wondered why the government has a monopoly on creating money (and prosecutes people who introduce competitive money), you'll have a much more solid understanding after reading this book. It's not that that's what the book is about -- it's that all of those things are around the edges of central banking.

I even think this book constitutes a solid grounding for understanding why the Euro exists, even tho people across the political spectrum in the United States think it's an incredibly stupid thing. If you're up for 400 pages (really: this book isn't a third end notes. There are some footnotes, but it's basically 400 pages of exposition) about monetary, fiscal and etc. policy, I doubt you could do better (altho I know what I'm going to read next on this topic, because I found something with a very favorable review by the author of this book).