Wednesday, December 30, 2009

On 'extend and pretend' and 'walking away on your mortgage'

Felix Salmon links to articles that show real-world examples of why it’s really just better to walk away than it is to try to deal with evil and/or incompetent mortgage servicers.

What we’re seeing here is the mortgage equivalent of credit-card sweatboxes: servicers who make sure to drain homeowners’ savings before they foreclose, since they know that they won’t chase homeowners after foreclosure, even in recourse states. By holding out the promise of a modification tomorrow, they make sure to squeeze every ounce of blood out of the homeowner before finally snatching the home away anyway.

So this is what I’d like to ask Megan McArdle, and others who like to extoll the moral virtues of paying one’s debts: just how much of your life’s savings should you give these snakes before they take your house

My take on it:
1. Are servicers the real culprits to go after when you’re trying to renegotiate a mortgage? I don’t know how it works in the US, but my gut feel is that these servicers work for the MBS investors. You need to go after the MBS investors if you want a renegotiation. Unfortunately, investment banks have made a real mess, and it now seems impossible to reconstitute who really owns what in MBS.

2. This may devious on the part of the banks who really may still have a way to renegotiate their loans, but extending a loan for as long as they can before they foreclose may be the only way to get back as much of their money as they can. With borrowers having paid no money down on the mortgage, extending and seeing how long borrowers will pay before defaulting is probably a belated way for banks to mitigate their loss. And with many borrowers having no prospects to pay the loan at all going into the future, many banks probably see a renegotiation as the real ‘extend and pretend’ option. The devious part of it though, is that if the banks already see a default down the line, they should just take their losses and foreclose now (and eat their losses) rather than trying to squeeze every last penny from borrowers who have already lost their jobs.

3. In the case of borrowers having no ability to pay the adjusted rates on their ARMM mortgages, but still have paying jobs, banks will need to be coerced to renegotiate. Here, nationalization seems to be the solution. A promising arrangement would probably be to impose a restructuring along the lines of rent-to-own. There have been good discussions on this so far.

4. In the case of borrowers who have the ability to pay their mortgage and only want to walk away, or do a renegotiation, because they are now underwater, the stance should still be ‘a deal is a deal’. Everybody who enters into a contract stares at the prospect of loss. That is why a contract is there, so people adhere to their agreements regardless of what happens after they close the deal. I maintain my position in a previous post.

To prevent this kind of mess of ever happening again, going forward, all mortgage securitizations should have recourse to the originator, and all mortgages should have personal recourse to the borrower. Take away all incentives to game the system.

The global economy is the one true macro

Nick Rowe set up an interesting discussion on the pitfalls of using micro concepts to approach macro issues. He rightly argues that macro is different from micro. When you look at the economy as a whole, every micro trade that clears the market involves two parties whose gains or loss from the trade merely offsets each other. Therefore, policymakers cannot generally improve macro conditions, by changing the rules to increase gains for one party, because mostly it will also result in a loss in another part of the economy. Here are Nick’s main points:

If I cut the price of apples, holding money incomes constant, holding all other prices constant, then consumers are better off in real terms. They can afford to buy more goods, and if apples are a normal good, they will spend some of their increased real income on buying more apples...

This "income effect" is total rubbish in macroeconomics. If there are 100 apples sold, and I cut the price of apples by $1, then consumers of apples are $100 richer. But producers of apples are $100 poorer. No effect on aggregate real income. Real income is the quantity of apples. It's GDP! And money income is the price of apples times the quantity of apples....

A fall in the price of apples, relative to the price of other goods, means consumers will substitute away from other goods and into consuming more apples. That makes sense in micro, where we draw the demand curve of apples holding the prices of other goods constant. But in macro, where the price of all goods is on the vertical axis, it doesn't make any sense at all. If the prices of all goods fall, what are they substituting away from? And why?....

If one worker tried to sell his apples for a higher price than the other workers, he might be unemployed. Nobody would want his apples. But then there would be an excess demand for other workers' apples, and an excess demand for their labour. There is no way the labour market/apple market as a whole could be in excess supply, because on average, the price of apples must equal the average price of apples...

And if people want to hang onto their money, rather than buy apples with it, the demand for apples, and the demand for labour, will be deficient. A deficiency of aggregate demand has got nothing whatsoever to do with a deficiency of income. Income is always sufficient. It's always the same as goods sold. A deficiency of aggregate demand is a deficiency of peoples' willingness to get rid of money. The "Paradox of Thrift", and the "Paradox of Toil", are merely corrupt versions of, or way-stations to, the Paradox of Money. Each individual can increase his stock of money by buying less; but in aggregate they fail, but cause unemployment as a side-effect.

I commented that when you have an open economy in a globalized environment, the micro assumptions can hold, and macro assumptions of a closed economy break down.
1. If you make apples $100 cheaper, domestic producers can potentially sell more apples, regardless of the level of demand domestically. It becomes a substitute to apples (or oranges) everywhere else in the world.
2. Hence, even if there is an excess supply of apples in the domestic market, it can still (potentially) sell as much output as it wants.
3. And even if the “paradox of thrift” holds in the domestic economy, the excess supply of apples could clear elsewhere in the global economy. (It also helps if your government controls the value of your currency, which in actuality is an integral part of what you trade in a globalized economy).

Nick replied: If you are talking about a small open economy, (under fixed exchange rates, with a common currency) you are absolutely right. In fact, I would say that SOE macro isn't really macro at all. It's micro. The only true macro is closed economy, and therefore global macro. But if we have national currencies, then I think there are some aspects that can only be handled from a macro perspective.

This reminded me of a post I made in August last year, which argued that national monetary policies (especially of small open economies) were becoming more and more insignificant in a globalized environment. Now that capital mobility is global…
1. If one country hikes its interest rate to contain domestic inflation, it can attract more capital from overseas, nullifying the hike. Similarly, if the country cuts rates to spur investment, capital might leave the economy for better rates elsewhere.
2. An aggressive money supply policy in one country can spill over excess liquidity into the global system, spreading inflation globally.
3. One country’s active currency management policies artificially inflates/devalues free floating currencies.
4. Because of points 1, 2, and 3, one Central Banker’s monetary policies to cure domestic unemployment might be rendered ineffective.
5. Financial crisis that start in one country can easily spread to other economies….

My speculations of a global central bank were rightly trashed in this forum over at EconomicsUK. But nonetheless, there seems to be a disjoint in economics theories as they are applied in a global setting. More importantly, there is a lack of coordinating institutions that would ensure the fair administration of monetary transactions worldwide. We don’t even know how to make them work, if there is a way to make them work.

Globalizing trade and financial flows without the corresponding globalizing of human capital movements has only led to repeated global imbalances. Because governments are still local (or national, for that matter) they still adhere policies that will result in what is good for their local populations. it is they, after all, who are stuck with the net gains and/or losses from globalization. A gain is made for them if a country creates more jobs, decreases its cost of capital, and maintains a stable inflation rate. So a local/national government will do what it can to achieve these aims, no matter if the gains from these aims end up being offset by a loss in another part of the world.

We either need to get rid of nation-states altogether, or we enforce stricter rules on nations participating in global trade.

Monday, December 28, 2009

The scalper economy and the fall of small business

In my previous post, commenter Min clarifies why I think an increasing money supply causes a higher rise in prices of scarce resources relative to other goods.

Hedge funds to me are the main reason for the difference. In both equilibria (prior and post monetary loosening), scarce resources remain constant. Expanding fiat currency makes the scarce resource artificially more expensive, relative to other goods. If you take scarce resources that have a stable demand, oil for instance, because it is a necessary component in many activities, many investors could 'rationally expect' that holders of oil will be able to profitably sell it to the market when they take delivery.

Because hedge funds who are merely looking for arbitrage profit enter into the bidding along with bidders who are actually end users, they make pricing for the scarce resource artificially more expensive. This serves to crowd out the smaller businesses who may not have the economies of scale to be able to earn back what it will cost them to buy the scarce input. Think of it like scalpers crowding out potential concert goers with lower income.

As fiat currency becomes more and more a policy tool, it becomes more and more perilous to conduct regular commercial business activities. But it provides more opportunities for arbitrage, as an expanding currency lifts other investments, such as equities and properties. Funds pile on these risky investments, as they rush out of traditional bonds and savings accounts, whose nominal yields are at zero but whose expected real yields are negative due to the policy’s induced inflation expectations.

It now becomes more profitable and more logical to engage in speculative financial activities as opposed to real economy industrial activities. Now are you still wondering why we are getting more of these rather than more small businesses starting up? Bernanke, be careful what you wish for. You just might get it.

Friday, December 25, 2009

An open letter from a drug dealer

This is an open letter to the general public, on behalf of people like me involved in the human well-being enhancement industry. You generally know more us more for the disparaging term “drug dealers”. I am writing this letter to you to air our side of the equation, and to remind everybody that we too act within market constraints.

You see, most of us in the well-being enhancement profession generally deal with sophisticated consenting adults who know exactly what it is they are doing. They come to us, transact profitable economic trades, because they have specific rational and logical objectives. They may come to us to help them deal with an emotional loss, they may have to deal with recurrent depressions, a sense of unbelonging, or simply they want to improve their current state of mood. We have perhaps been involved in a lot of improved marriages, much-quickened health recoveries, improved character of public events and gatherings, and in the general perceived intelligence and talent of people who make use of our products. Society needs what we provide.

Indeed, we would not exist if it were not for the continuing patronage of our willing clients. We are simply providing a service that our drug users demand. And don’t forget too that consumption of our products consists a tiny percentage of the total transactions that people engage with us. That is, the people we transact with may not always be the end-users of our service. They may in turn around and supply this useful commodity to others also in need of our value-enhancing contributions. This then leads to a much wider net of general well-being enhancement, not to mention opportunities for our own clients to also make boatloads of money. Remember, too, that we are not paid to look after the general health of our clients.

Now don’t judge us if we, due to our dealer job, will have the ability to know which users would be willing to pay more just to get a sufficient supply of our products. Our decision to then price our products accordingly is nothing more than just a reaction to the market forces that everybody else adheres to. Remember, we could be wrong and we end up losing a much-needed user. But this comes with the risks of doing business.

After all, we’re just ordinary businessmen also doing God’s work. Our thanks go to Goldman Sachs, as well as to Henry Blodget, for helping us get our thoughts in order, to make our case much clearer to you, the general public. Goldman Sachs remains our most admired company, and we continue to mine its employee rolls in search for potential new lucrative transaction opportunities.

Thursday, December 24, 2009

Can there be financial black holes/debt deflationary spirals?

There is an interesting discussion sparked by Nick Rowe over at Worthwhile Canadian Initiative about financial black holes. Here and here.


Nick Rowe asks: Like physics, modern macroeconomic theory predicts the possibility of "black holes"…. If the economy gets too close to a black hole, it can't escape, and is sucked into a deflationary death-spiral. If nominal interest rates are at or near zero, and so at their lower bound, any deficiency of aggregate demand causes increased deflation, which in turn causes increased expected deflation, which in turn causes higher real interest rates, which in turn reduce aggregate demand, which in turn causes increased deflation...and so on. The price level and real output should both fall to vanishing point. Money in a black hole should have infinite value, yet nobody will buy anything with it….

So where are they? Why can't we see them? We sure have sailed our macroeconomic spaceships close enough to the boundaries of predicted black holes plenty of times. Why didn't any economy ever get sucked into one, and collapse into an infinitely valuable pinpoint?

A reader, Doc Merlin, comments :There is no such thing as a deflationary spiral. I have never ever seen it happen, never watched it, never seen it talked about in history. However, we have seen multiple times, INFLATIONARY death spirals…..Deflation is its own cure, because as prices drop, people will naturally want to consume more.

My own take, I can think of 4 variables which can help prevent the prevalence of black holes
1. growing population
2. growing productivity
3. growing trade
4. constant influx of new technology or products

An economy with high indebtedness, that cannot be paid for due to a lack of all 4, can probably experience a so-called financial black hole. In other words, my take on it is that we have so far avoided any instances of deflationary spirals because the world has always been growing somehow somewhere. And now, due to the gains from globalization, countries that may have otherwise experienced a slowing down of points 1 or 2, may compensate for it by an increase of point 3. Also, because globalization has increased the economies of scale for a lot of market innovations, it has enabled point 4 to remain constant.

However, there can be no escaping a market saturation, once a hitherto unmarketed-to geoeconomic area has been fully integrated to the global economy, and eventually trade growth will slow. So too, as a country’s population attains some affluence and occupational specialization, family rearing takes a back seat and even population growth slows down. Hence, the constant source of economic growth that we can expect going into the future, both at the business and at the macro level, will be to increase productivity or to introduce new technology or new products. These do not always come cheap. Debt, therefore, becomes more common among firms, and tolerance for larger portions of it become the norm.


As debt becomes accepted as a necessary growth booster in the commercial arena, so too its prevalence become natural in the consumer arena. If businesses can borrow in anticipation of earning the cash to pay for it, why can’t an individual too borrow, if he believes the investment outlets available to him will enable to him to earn the necessary cash to pay it off.

So what we have is an economy, one that might be experiencing a stagnant population growth, a slowing productivity growth (due to constant misallocation of resources to endeavours that turn out to be counter-productive) but experiencing an increasing indebtedness among its population. I need not recount here how the increasing tolerance for debt plus "irrational exuberance" became strong factors in causing the credit crisis.

Now how can an economy pay for its collective debt obligations when the time comes, when there is a lack of growth in any of the 4 areas? This is where modern monetary policy theory comes in, to induce firms to invest (or induce households to purchase housing and durables)

Nick Rowe (talking about Keynes): Keynes is not sure whether an economy can escape the black hole of a deflationary spiral. If it does escape, it can only escape via the effects of an increase in M/P. And it will be more likely to escape if M/P increases due to a rising numerator M than a falling denominator P. Because falling P may create expectations of further deflation, which would further reduce aggregate demand.


Well and good if the increase in money supply does the job and avoids the debt deflationary spiral. However, this purely monetary theory does not consider a relatively more modern occurrence – the existence of hedge funds and other investment pools. These funds exist solely to arbitrage away any inefficiencies that are introduced to the market, both by the market itself, and by the government. So if money supply is increasing, it is actually creating an imbalance in the economy. It makes whatever scarce resources there are to become even more expensive. And hedge fund managers, being the arbitrage machines they are, try to profit by buying whatever resources they can identify that would have stable anticipated demand. These are therefore bid up more than they should.

So what happens to the business, the households, the economic actors who are meant to revive the economy via the increase of productivity or the introduction of new technology or new products? Their costs of production rise. As if it were not already risky to embark on costly new business endeavours, via a rising debt, in an economy with stagnating populations and saturated markets, you now have to do it in an environment where your cost of inputs may have been bid up beyond what it is could be profitable to turn up a finished product.

Thus, a focus on reviving the economy, and on preventing a deflationary spiral, via a monetary easing, has ended up introducing a new complication for the players necessary to turn the economy around. It has ended up spoiling the conditions necessary to spur more active market activities.

What happens then if no one is left to try to increase productivity or introduce new products and technologies? You go back to the possibility of a financial black hole.

That’s why I’m with Mark Thoma on this. Fiscal policy is a better policy alternative than monetary policy. Nick Rowe himself doesn't seem to side for more use of monetary policy (though he argues, correctly in my opinion, that it is not useless). But support should be going more towards helping build the market by focusing investment on industry-specific concerns, not on quantitative easing that goes nowhere and just increases business complexity or everyone. help industry rebuild itself. That’s what China is doing more of, and Western economies are well-advised to do the same.

Tuesday, December 22, 2009

Why are we even encouraging strategic defaults?

Felix Salmon has a post up, arguing about reducing the shame of default. He seems to be advocating that more people with underwater mortgages default on the mortgage, both as favour to themselves and to teach errant bankers a lesson. He says “If there’s less shame attached to default, we will end up with exactly what we want — less badly-underwritten credit, a more solvent society, and much less tail risk. We went far too many years believing without really analyzing the proposition that credit is nearly always a Good Thing.”

Well, that not only seems unhelpful but can only make things worse. What we need to be doing is shaming bankers, the ones who misled the people who shouldn’t be borrowing into taking out loans they have no hope of paying, so the bankers find a way of renegotiating these mortgages. We shouldn’t be reducing shame of default of the borrowers.

What would happen to the financial system once everyone no longer has shame of default? More defaults leading to more underwater mortgages leading to more defaults, all the way down to financial armageddon. Why stop at mortgages? What about all other indebtedness backed by any sort of asset that may have gone down in value? Stock loans? Equipment loans? People have also been known to borrow against these. And not paying debts because banks didn’t do their jobs properly could be just one step away from not paying taxes because the government isn’t spending your tax money correctly. Is that next?

Pls. let’s bring the talk back on how the mortgages can be realistically and orderly fixed. Nationalize the guilty banks, fire the errant bankers, institute the needed financial reforms. Threats like making personal defaults more common seem attractive at first, but they will only lead to more pain down the road. If defaults become at all common, it won’t be long before we forever say good-bye to any notion of providing credit to anyone.

Monday, December 7, 2009

To save globalization, we need to first rein in globalization

Back in August of last year, before the Lehman bankruptcy, and before the beginning of the financial meltdown , I tried to summarize how I saw, from my perch in the world, the world had fared in terms of globalization, and what specific long-term trends had gotten us to where we were. This was close enough to what became more or less a common consensus.

I then speculated as to what was to come next. With the exception of further financial meltdown due to the fall of Lehman, I could say that we are more or less on this path I foresaw.

My speculation was an optimistic one, optimistic in the face of the growing uncertainty of the third quarter of 2008. I remain convinced that the stage we are in is part of a longer-term secular global rebalancing, and we will eventually stabilize at a new more balanced equilibrium.

I just want to reiterate that this global rebalancing will be the greatest source of growth, as well as the greatest challenge, for capitalism in the coming decade. The developed world needs to rebuild its manufacturing base, while the developing nations need to develop a thriving consumer economy. Much capital investment for production needs to be rebuilt in the developed countries, while much more advanced distribution chains and financial networks need to be established in the developing nations.

Developed countries need to rediscover the original source of their development – a strong and vibrant producer economy that provides ample employment for their domestic consumers. Developing nations need to do the mirror image – to develop a domestic consumer base that will enable their local manufacturers to thrive even in the face of a slowdown in the rest of the world.

For these rebalancing efforts to continue advancing towards their objectives, two requirements need to be addressed. First, the capitalist investors and business men in the developed countries need to be assured that their investments will not be endangered by undercutting from foreign competitors organized only for maximum producer efficiency. Second, the capitalist investors and businessmen in the developing countries need to be assured that the government will provide enough safety nets for their local populace, such that a more consumerist mentality will take root, and that the government will be there to help them in the crucial but likely costly project of enriching the locals, to enable them to become more active buyers of their end products.

The success of this global rebalancing will probably lead to this much longer-term result. But to achieve this result, which I consider the final end and epitome of globalization, we need to do the ironic thing first. We need to rein in globalization at this time.