No Economy For Old Men

When I heard the Bush/Paulson measures to alleviate the mortgage mess and the ensuing proposals of the leading Democratic presidential candidates, I yearned for another time -- a time when notions such as caveat emptor, moral hazard, and sanctity of contract meant something. Unfortunately, these are becoming anachronisms and are being supplanted by the notion of "too big to fail". While government interference with the free market will, no doubt, moderate the incidence of foreclosures and the level of lender writedowns in the short run, it will, in the long run, encourage excessive borrowing in an already heavily leveraged economy and have negative implications for the U.S. dollar.

Paulson classifies the subprime mortgagees into: 1)those who would be in default even if the teaser rates were not reset, 2) those who would likely remain current on their mortgages if the teaser rates were frozen for five years but couldn't survive an immediate reset, and 3)those who are able to remain current on their payments even after the scheduled resets. He would allow the middle group to have their payments frozen for five years and then reset in hopes that the incomes of the mortgagees would have risen during that time to a level that would avoid default even at the reset rates. The Clinton approach would freeze at the teaser rate the mortgages of both the Paulson-designated group AND those who can afford all payments. I, on the other hand, would divide the universe of those who can't make their payments into two groups, those who were defrauded when they took out their loans, and those who were not. The first group should be made whole; the second should suffer the consequences of their decisions.

When a person mortgages his home, he is responsible for knowing the terms of the mortgage contract -- "caveat emptor" or "buyer beware." Ignorance of the terms of the mortgage is no reason to allow the mortgagee out of his contract unless the terms of the mortgage were not fully disclosed. If a mortgagee bets that when the interest rate is to be reset, he will either be able to sell his home for a profit or reset the mortgage at a low rate; and it turns out he is wrong, he should suffer the negative consequences of his decision -- "moral hazard." In the Clinton initiative, even those who can manage the mortgage payments after scheduled resets are entitled to a period of frozen teaser rates. If I were the mortgage lender I would expect no change in the terms. Otherwise, it would be an abrogation of the notion of "sanctity of contract". Why are these notions being suspended? Because the aggregate impact on the economy if they were strictly adhered to would be disastrous? We have seen how the notion of "too big to fail" has been invoked to "rescue" Donald Trump and Long Term Capital Management. Now subprime mortgagees can be added to this list.

How bad would the impact on the economy be if the subprime mortgagees are allowed to fail? Very bad indeed! There would be hundreds of thousands, perhaps millions, of foreclosures and forced sales of property. No one wants a foreclosure sale in his neighborhood. The negative impact on home prices and consumer confidence would be significant. A friend of mine, a highly respected economist, estimates that the historical relationship between the aggregate market value of U.S. homes and U.S. GDP has hovered around 100%, plus or minus 10%, in most years since 1950. In 2006, that relationship was 160%. An immediate regression to the norm would involve more than a 30% drop in home prices.

For purposes of illustration, let us assume that home prices nationwide decline 15% peak to trough during this cycle--a rare event indeed. The total market value of U.S. homes has been estimated at $21 trillion. The total debt against that asset is $11 trillion. A 15% hit to home prices would reduce owner equity from $10 trillion to $6.85 trillion, a decline of 31.5%. However, roughly $7 trillion of home value is in unmortgaged homes. Calculating solely for mortgaged homes, a 15% home value decline translates into a 70% reduction in equity. To put this into perspective, out of a total of 75 million U.S. homes, 50 million are mortgaged. If the owners of 50 million homes experience a 70% decline in equity, consumer confidence would plummet, which would start a vicious cycle of lower spending, layoffs, even lower confidence, etc. The probability of recession, now put at 50% by the most pessimistic Wall Street economists, would be close to a certainty, in my opinion.

There is roughly $1.76 trillion of subprime mortgage debt against roughly $1.96 trillion of home value. A 15% drop in home value would reduce equity from $200 billion to a minus $94 billion; so lenders would be on the hook for around $100 billion in writeoffs. Of course, a nationwide 15% decline in home value would result in a far greater decline in the value of homes used as collateral for subprime mortgages due to the impact of foreclosures. In this example, the total writedowns by lenders would be in the hundreds of billions, not just $100 billion.

Given this illustration, it is no wonder that the U.S. government is intervening in the free market process to try to stem the impact of falling home prices. I read that a large commercial bank has subprime mortgages at face value totaling 285% of equity. A fifteen percent writeoff of those mortgages would reduce equity by 42%. Two "venerable" financial institutions, Citicorp and Morgan Stanley, have had to shore up their capital by raising funds from Abu Dhabi and China respectively. The terms of the Citicorp deal, an 11% preferred stock convertible close to the market price of Citicorp common as of the date of issue, are those of a company in trouble. Deterioration in bank equity would mean less ability to lend unless further equity infusions were then available.

By the way, the S&P 500 Index is only off around 7% from its highs. Given the seriousness of the housing crises, I am surprised at such a limited response so far.

Why am I opposed to government intervention here? Am I a free market purist? I believe that the economy in the long run is better off when down cycles cleanse the excesses of the previous up cycles; and the housing bubble is a whopper of excess. Recessions are not pleasant; but U.S. citizens have weathered them in the past. If the U.S.intervenes and continues to bail out those who have made bad investment decisions, it will continue to have a deleterious effect on the U.S. dollar in the long run. It would encourage excesses in the future and indicate to the world that we are permissive and soft. We should remember that a significant portion of U.S. Treasury debt lies in foreign hands. A weak dollar means higher inflation and interest rates in the long run.