Every once in awhile, a genuinely novel idea comes up in economics, and you would think that given the generally impenetrable, contradictory, and confused commentary emanating from far and wide about our current situation, now might be a propitious time for a truly new idea to arise. Parenthetically, I do not wish to single out any particular source or category of publications as blameworthy for disappointing commentary. It seems universal, from the ed and op-ed pages of our most distinguished papers to (most) magazine backgrounders, and even to the relatively few snippets of academic economic commentary that have emerged. All seem equally at a loss for a coherent explanation of what’s happening.
In other words, we need some new ideas, or at least one.
I actually have a nominee.
I credit the reliable David Warsh of Economic Principals for first bringing this to my attention. The essential concept is simple: Every debtor/creditor transaction involves the negotiation of two critical terms, but economic literature has focused on only one: The interest rate.
That is to say, as far as macroeconomics is concerned, the Fed’s key job in terms of maintaining relative equilibrium is to focus on interest rates. But the other key variable we’ve ignored is that of collateral. Or, stated differently, leverage. How much collateral is the debtor putting up? How much leverage are they relying upon?
For this insight, in turn, Warsh credits John Geanakoplos, a professor of economics at Yale since 1994. (Interestingly for our purposes, Geanakoplos also served 5 years in the early 1990’s as Managing Director and Head of Fixed Income Research at Kidder, Peabody, which, until it flamed out in the wake of the Joseph Jett scandal was an innovative firm, particularly in the greenfield territory of CMO’s.)
Here’s the gist of the theory (emphasis mine):
For at least a century, economists have been accustomed to thinking of the interest rate as the most important variable in the economy – lower it to speed things up, raise it to slow them down. Yet especially in times of crisis, collateral demands – alternatively, margin requirements, loan-to-value ratios, leverage rates or “gearing” – become much more important.
Everybody knows that when interest rates go down, prices rise. Less widely recognized is that when margin requirements go down – say, the down payment on a house – prices rise too, often even more. Without some form of control, leverage becomes too high in boom times, and asset prices soar disproportionately. When they crash, leverage crashes with them, and then prices suddenly are too low. This is the leverage cycle, Geanakoplos says, and the current crisis is the result of a particularly virulent specimen. Intervention can mitigate its worst effects.
Central banks, therefore, should rethink their priorities. The Fed should learn to manage system-wide leverage, reining in on it in ebullient times and propping it up in anxious times, in order to prevent the worst outcomes. Leverage cycles happen not because people are stupid, or because they ignore danger signs. It’s in the nature of competition to drive leverage to unsustainable levels, whereupon it collapses, with various effects.
I find this fascinating on several levels.
For one thing, it partially explains why the dot-com bubble didn’t bring the entire global financial system to its knees. Stock margin requirements have always been essentially 50%, not zero money down. As well, of course, that was limited to one industry in (largely) one geographic territory, not the national housing market.
Second, it has potential implications for our professional judgment and behavior when we act for debtors and for creditors. I will leave you to be the conscience and the brains of your own professional conduct, but just a thought.
The key point is that in certain circumstances, it’s the collateral terms and not the interest terms that assume overwhelming importance. If you want a memorable "hook" to understand this, look no further than The Merchant of Venice. Geanakoplos writes:
“Who can remember the interest rate that Shylock charged Antonio? But everybody remembers the pound of flesh that Shylock and Antonio agreed upon as collateral. The upshot of the play, moreover, is the regulatory authority (the court) decides that the collateral level Shylock and Antonio agreed upon was socially suboptimal, and the court decrees a different collateral -a pound of flesh but not a drop of blood.”
What, you should be asking by now, are the implications of this for getting out of our current predicament?
As hard as it may be to stomach, if you believe (as do I) that getting "underwater" homeowners to have a real stake in continuing to pay their mortgages, so as to staunch the bleeding of foreclosures, bank writeoffs, deteriorating or unguessable values of "toxic" or "legacy" CMO’s and CDO’s, and all the follow-on destruction that causes, we may need to swallow deeply and simply absorb big writedowns on those underwater mortgages in order to give the homeowners an incentive to keep paying.
Again, Geanakoplos has written about this:
Despite all the job losses and economic uncertainty, almost all owners with real equity in their homes, are finding a way to pay off their loans. It is those “underwater” on their mortgages — with homes worth less than their loans — who are defaulting, but who, given equity in their homes, will find a way to pay. They are not evil or irresponsible; they are defaulting because — for anyone with an already compromised credit rating — it is the economically prudent thing to do.
Isn’t it against the interest of bondholders to have "cramdown" writedowns of the value of the collateral in the form of homes with underwater mortgages? In a perfect world, it would be, but we’ve traveled a long way from that perfect world. Consider:
For subprime and other non-prime loans, which account for more than half of all foreclosures, the best thing to do for the homeowners and for the bondholders is to write down principal far enough so that each homeowner will have equity in his house and thus an incentive to pay and not default again down the line. This is also best for taxpayers, who now effectively guarantee the securities linked to these mortgages because of the various deals we’ve made to support the banks.
For these non-prime mortgages, there is room to make generous principal reductions, without hurting bondholders and without spending a dime of taxpayer money, because the bond markets expect so little out of foreclosures. Typically, a homeowner fights off eviction for 18 months, making no mortgage or tax payments and no repairs. Abandoned homes are often stripped and vandalized. Foreclosure and reselling expenses are so high the subprime bond market trades now as if it expects only 25 percent back on a loan when there is a foreclosure.
As usual, a graphic can illustrate succinctly what a multitude of words cannot.
What this shows is the default percentage rate by month on the horizontal axis (0-2-4-6-8-10-12-14%) and the amount owed on all mortgages on a home divided by the current value of the home on the vertical axis, from 0% at the top to 100% where the green shaded field begins through 300% at the bottom.
The four different right-downward descending lines represent, from left to right, prime loans, ALT-A loans, option ARM loans, and subprime loans.
What’s notable to me in eyeballing this is:
- In the white area, where homeowners have positive equity, defaults are relatively low, even for the lowest-quality loans.
- At above 25% equity (75% loan to value), defaults are not material.
- But at about 150% loan to value (50% underwater), defaults go up dramatically, at all levels of loan quality.
- This suggests that if writedowns could occur, giving deeply underwater homeowners equity of at least 25%, much of the national and global problem could be resolved by hardworking people getting back to work to save their homes. Not too much further bailout needed. At least so it suggests.
And again, lessons for us in all of this?
First of all, I hope it’s simply been informative and eye-opening. The worst thing about all those liar loans may not have been the teaser interest rates but the no-downpayment scourge.
As I said earlier, your professional obligations, as you interpret them in your mind and your soul, will dictate the extent to which you will participate in negotiating and drafting highly-leveraged transactions in future. As a capitalist at heart, I imagine–with rueful confidence–that you will, by and large, negotiate and draft transactions with every last ounce of leverage your clients can negotiate. It is advisedly the Fed’s role, and not yours, to regulate the extension of credit in our economy. But you are not thereby exempted from telling your clients, in the immortal words, that "they’re a damned fool and they oughtn’t do it."
If you’re in a position of leadership in your firm, this would be the most opportune of times to re-examine your firm’s capital structure. What level of commitment are people in for? Are you over-leveraged, as a firm? What’s the level of "equity" that your partners feel you have in your firm?
This is not only financial equity, of course. But you know that.
Update (15 April):
A reader preferring anonymity (but a regular correspondent) writes:
Great post today. You made one assertion that is worth exploring. You
said that unlike the dot-com bubble (which was limited to one industry in
(largely) one geographic territory), the housing crisis is national in scope. I
thought you might find the following map of interest. According
to these data, 32 counties account for more than half of all foreclosures. Therefore,
the current housing crisis really isn’t national but instead is highly concentrated
in a few discrete regions.Therefore, not only is a mortgage bailout
sub-optimal economically it is also a hidden income transfer from most of
the country to a few counties (as well as an income transfer from responsible
borrowers to less responsible borrowers).32 Counties Account for 50 Percent of Foreclosures
As someone who has all four feet planted squarely in the "responsible"
camp—and whose primary residence is a Manhattan co-op, famously immune
from speculative fever because of both the vigilance of co-op boards and the
non-negotiable requirement of sizable down-payments and substantial post-closing
liquidity—I
am deeply sympathetic to our correspondent. Reckless economic behavior
is anathema to me even when I’m immune from collateral damage, and as a taxpayer,
here I’m not immune.
But I’m also a pragmatist at heart; I think most Americans are. So
let me quote from the conclusion of
Geanakoplos’ original piece, which suggests very pragmatic reasons to throw
expensive life-jackets at the underwater homeowners:
We know there are some who will be outraged at the idea that
their neighbors might get a break, while they — so much more responsible —
get nothing. To these outraged folks we say, you would benefit too. It is not
just your home values and your neighborhoods that will deteriorate if you insist
that your underwater neighbors not get relief; it is your tax dollars and that
of your children that will be needed to make up for the plummeting value of
those toxic assets held by banks, which we taxpayers now guarantee and may
soon own outright. It is your job that will be at stake when your neighbors
can no longer afford to buy goods and services, causing more companies to cut
jobs. So you need to act responsibly again, for your own sake and for the welfare
and future prosperity of the entire nation.
This type of cool, ratiocinated argument may come off as a bit
too close for comfort to those who defended the AIG bonuses as a trivial amount
of money in the larger scheme of things: That is to say, probably true,
but completely tone-deaf in terms of public outrage and more likely to inflame
than to cool passions. You have probably also heard the strained analogy
that just because your neighbor smokes in bed doesn’t mean you want to short-change
the fire department.
I honestly don’t know how to respond to or rebut the "morally
outrageous" argument since, as noted, I could easily be tempted to incline
in that direction myself.
The problem is that succumbing to that mildly vengeful instinct
doesn’t get us out of this. And at the moment, I want out. I
want out bad.
If anyone has a suggestion for what "out good" would look like,
I’m all ears. Barring that, I’ll take out bad.
