on the financial meltdown

[David Farber <dave () farber net>]

Since this is so long Mark's reply Mark is an OLD , in time not age,  
Wall Streeter who was involved with taking Apple public.

Dave

Date: Sun, 12 Oct 2008 13:00:36 -0400
From: Mark Stahlman<newmedia () aol com>
Subject: Re: any comment on this?

Dave:

Andrew is much better on telecom! <g>

Clearly "stabilizing" home prices is very important.  In addition,  
giving those people who are "under-water" on real estate need time to  
let all this happen.  This is pretty well known and in the headlines.

No one -- including the US Treasury -- actually knows what they will  
do with the $700B.  That's one of the reasons why it was so hard to  
pass in Congress.

We are in a FINANCIAL crisis and will probably be in one for 6-12  
months.  However, Andrew has failed to illustrate what the ECONOMIC  
consequences are likely to be.

The "problem" is the old rules are gone and new ones haven't been made  
up yet.  So lots of people are on the sidelines waiting to see what  
the new rules are going to be.

What I'm most interested in is the *permanent* changes in consumer  
behavior that this will provoke and how that will change the direction  
of the global economy.  Yes, it's way too soon to know.

Mark



Begin forwarded message:


From: odlyzko () dtc umn edu (Andrew Odlyzko)
Date: October 10, 2008 11:24:50 AM PDT
To: dewayne () warpspeed com
Subject: on the financial meltdown


Here is a little economic model that may shed some light on
what's happening to the financial system, why Paulson's recent
$700 billion plan may very well be the wrong solution, and why
the whole problem is very hard to solve.

Suppose your Aunt Millie and her husband retired two years ago
from their jobs in Palo Alto, and decided to move back to their
native Omaha.  They sold their little shack, bought for $50,000
many decades ago, for $1 million (two years ago being the peak
of the real estate market, and Palo Alto shacks being pretty
pricey even now).  Suppose the mortgage had been paid off a long
time ago, so she and her husband owned the house outright.  Now
by traditional measures (prices compared to household incomes,
say) that Palo Alto shack might have been worth $500,000 (as
Palo Alto is a desirable place to live, and there is very little
land that can be developed in the vicinity).  But with the runup
in real estate prices, it was valued at $1 million two years ago,
and she got that price.

After paying realtor's commission, capital gains taxes (the home
capital gains exclusion only covers $500,000 per couple), etc.,
they might be left with $800,000, say, of which they use $300,000
to buy a big house in Omaha, and put the remaining $500,000 into
a CD in a national Bank Too Big to Fail (BTBTF).  Note that
realtors and other agents got a large chunk, say $100,000 (just
to keep to round numbers), and the governments did not do too
badly either.

Now further let's suppose that your Cousin Jim, not knowing of
the relationship to your Aunt Millie, was the person who sold
the Omaha house to Aunt Millie, and bought her house in Palo
Alto, not knowing of the relationship, and not knowing he was
dealing with the same person in both cases.  Say he also owned
his Omaha house outright, and of the $300,000 he got, after
paying various fees, commissions, moving expenses, etc., (and
this is important, as the real estate bubble enriched many
people, not just the homeowners) had $250,000 left, of which
he spent $50,000 on some new furniture, and put $200,000 down
on that $1 million shack of Aunt Millie's in Palo Alto.  The
remaining $800,000 came from a mortgage from the Bank Too Big
to Fail (BTBTF), the bank that has Aunt Millie's $500,000.  Now
putting 20% down was absurdly conservative at the peak of the
real estate bubble two years ago, but it helps make the model
more realistic, in that BTBTF would have had other mortgages as
well, some from years ago, which supposedly have a lot of
homeowner equity in them.

Now the Bank Too Big to Fail (BTBTF) did not keep that $800,000
mortgate of Cousin Jim.  It sliced and diced it, and sold it off
(after mixing it up with other mortgages) to other institutions.
Say there were 4 tranches into which Cousin Jim's mortgage was
divided, each for a nominal $200,000, with slice A having first
claim on any mortgage payments from Cousin Jim (or from auctioning
Cousin Jim's Palo Alto shack if it goes into foreclosure), slice B
having second claim, etc.  (This is not a correct representation,
that's not how mortgages were packaged, but it has the key elements
of that wonderful "distribution of risks to parties able to bear it,
and enabling home ownership" machinery that was operating, so let's
go with it.)  And then those 4 tranches of Cousin Jim's mortgage
went on some wonderful trips, being further sliced and diced, having
their grades improved by credit rating agencies, etc.  And suppose
that by some miracle all the trenches ended up with BTBTF.  But
before they came back, perhaps $100,000 had been extracted from
them to pay the mortgage brokers, lawyers, Wall Street investment
banks, and of course the management of BTBTF, which showed such great
brilliance in minimizing risks and maximizing profits for BTBTF's
shareholders.  So now BTBTF has again the entire mortgage for $800,000
on Cousin Jim's house, but it is probably valued on its books at
$900,000, when you get down to it and examine all the financial
details.

Now suppose that the Bank Too Big to Fail (BTBTF) has on its books
just that mortgage to Cousin Jim, valued at $900,000, and standard
commercial loans for $1,100,000 to various companies, say a local
car dealer, restaurant, etc..  (Yes, $2 million is not enough
to make a bank too big to fail, it's not even enough to pay for
legal fees to establish a bank, but I am just trying to keep things
simple, BTBTF would have closer to $1 trillion on its books, but
then Cousin Jim's mortgage would be swamped by all the other accounts.)
And suppose that BTBTF has $200,000 in capital, and $1,800,000 in
deposits, Aunt Millie's CD for $500,000 included.  By conventional
banking standards, that is extremely conservative, 10% capital is
just great.  But these are not the usual times.  Real estate prices
have come down quite a lot.  Say they are down by 20% in Palo Alto.
(I have no idea of what the actual decline has been in Palo Alto.)
But that is just what realtors say, the market is pretty much
frozen, and if Cousin Jim had to sell his home today, he might
have to settle for just $600,000 in a quick sale.  And prices
are going further down.  So for the moment Cousin Jim is still
paying his mortgage.  He has his job (at least for the moment),
and he has hopes that the value of his shack will go back up to
to $1 million, or at least not go down below $800,000.  But if
it does go down further, and he is rational, he will hand the keys
over to the bank.  And then the bank might have to sell Cousin Jim's
shack for $600,000, which will leave it with a loss of at least
$200,000, and more likely $300,000, if proper accounting is applied
to all the financial maneuvers that had taken place.  That will
wipe out its capital, and possibly more.  But what if the price
the bank can get is even lower?

Until recently, the actions of government agencies, both in the
U.S. and other countries, seemed to be based on the assumption
that there would be only a modest decline in housing prices,
and so all they had to do was keep people from panicking.  If
Palo Alto housing prices only go down 20% from their peak,
Cousin Jim will keep paying his mortgage.  Perhaps a few of
his neighbors who got 100% mortgages with montly payments that
have just reset to levels they can't afford will walk away, but
if the effect is small (say BTBTF has only 10% of one of those
mortgages, and the total loss on that mortgage is going to be
$250,000, then BTBTF will lose $25,000, which is a painful hit
to its capital, but not fatal) then nothing serious will happen.

But now the general impression in the markets seems to be that
the housing price declines are going to be more serious.  Suppose
that prices go down to levels consistent with historical ratios
of house prices to incomes.  (And they could go down below that,
of course, historically this ratio has oscillated.  Note that the
situation is worse in many countries than in the U.S., since
those countries, including Ireland, had a more severe housing
inflation than the U.S. did.  The crisis started in the U.S., but
that could be the result of several factors such as (i) our investment
banks being the most leveraged, and (ii) our system being the most
transparent.)  What would that mean?

Over in Omaha, Aunt Millie and her husband might see the value
of their $300,000 home go down to $200,000.  (Inflation was generally
lower in the Mid-West than in California.)  That is not that much of
a problem, since they own that house outright.  They are probably
scared about that $500,000 CD at BTBTF, since the amount is over
the limit insured by the feds.  In practice, it seems pretty clear
that the feds will cover them for the entire amount, as several
countries have moved to do.  But in the meantime, they are probably
more than a little scared, and less willing to spend, helping push
the economy deeper into a recession.

But in Palo Alto, if the price of Cousin Jim's shack goes back to
the historical trend of $500,000, he will hand the keys to the bank,
sooner or later.  (Sooner if the recession kills his job.)  So where
does that leave BTBTF?  If it gets Cousin Jim's shack and has to sell
it, it will likely get only around $400,000 for it.

That means BTBTF is effectively bankrupt, since it has only $200,000
in capital, and the loss on Cousin Jim's mortgage will be $400,000
or $500,000.  Unless Paulson, using taxpayer money, overpays by an
absurd amount, there is no way that BTBTF can break even.  Yes, if
the free-marketer Paulson decides, in his wisdom, that the free market
is grossly incorrect, and that the Palo Alto shack is going to be
worth $1 million in a couple of years, he might pay $800,000 for
the mortgage on Cousin Jim's shack, arrange for it to be rented,
and sell it at the proper time for a profit for taxpayers, and great
glory for himself.  But any realistic price he pays for Cousin Jim's
mortgage, or pieces of it, will still leave BTBTF under water.
There is no way that BTBTF management can make the bank healthy
enough, unless either (i) real estate prices recover (which is
not absurd, rapid inflation, something that "helicopter Ben"
Bernanke had talked about in the past, might be resorted to by
the government), or (ii) BTBTF management take wild chances, like taking
all the cash in the till and wagering it on a roll of the roulette
wheel in Las Vegas (basically what the S&L's did in the 1980s,
when they were in a similar situation, and put lots of money into
crazily speculative investments).

Putting actual capital into banks (basically what Swedes did in the
early 1990s, and the British are doing now) seems to be the only
way to get the financial system moving.  That way management
(and unfortunately, since we can't start from scratch, it means
pretty much the same management that got our financial system into
the current mess) will have incentives to loan money in the
traditional ways, that sustain the normal functioning of the
economy, and not wager it in a casino.  But the amount of money
that would need to be put into banks for this to work will have
to be huge.  It would basically have to be enough to cover all
the losses on all the loans they have made (which we can't estimate
precisely, since we don't know how bad the recession will be, and
how many other bombs are going to explode.  This is in a way not
all that dissimilar from Paulson paying absurdly high price for
Cousin Jim's mortgage, but it would give taxpayers a better chance
to recover their money, and provide better incentives for bank
managers to behave prudently, yet perform their key function in
the economy.

Note that the fundamental problem we face is less the $200,000 that
the mortgage brokers, lawyers, Wall Street investment banks, and
management of BTBTF got out of the Aunt Millie and Cousin Jim
transactions.  It is rather the $500,000 that Aunt Millie and
her husband got for their shack above what the likely long-term
value of that shack is.  They did not do anything wrong,
all their actions were perfectly legal and moral.  But they were
the beneficiaries of the real estate bubble, and at least in the
short run they are likely to escape unscathed, and without any
blame attached.  In the long run, of course, they will have to
help pay for the cleanup, either through higher taxes, or through
inflation.

Sorry this is so long, but it seemed about the shortest model
that, even though grossly simplified, still showed what seem
the essential features of our current crisis.
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