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Sticky Interest Rates

Much is made in economics of “sticky wages” that prevent the price of labor from falling to meet the quantity demanded and thereby provide full employment. But the root cause of our prolonged recession is not insufficient consumer demand or overpriced labor; it is due to mortgage debt that is excessive compared to borrower income and house value. Reducing wages would cause even fewer people to be able to afford their mortgage and exacerbate a cycle of foreclosures, falling house prices, lower consumer spending, and lower business investment. It is more appropriate to say that “sticky interest rates” are the cause of our current economic problems.

The housing bubble left behind elevated mortgage debt that continues to sap consumer spending and business risk taking. Savings are increasingly directed to the safest of investments, causing interest rates to fall to historically low levels. Although this benefits higher credit quality borrowers, those with poor credit or equity are unable to refinance.

Yet these are the same borrowers who are constraining the economy through the fear of their default and their lower spending patterns. I would guess that 1 in 4 Americans fall into this category. Some of these chose high-risk mortgages, but many were simply unfortunate on when and where they bought a house.

The reasonable approach would be to modify the borrowers who can’t refinance at current low market rates. Unfortunately, creditors became believers in risk management only after the bubble burst and are now zealots who are inappropriately applying underwriting standards and risk based pricing to their existing high risk borrowers. These borrowers can’t possibly meet the new standards – some never could, and never should have gotten the loan. But poor past credit standards are largely a sunk cost that can never be recovered.

The purpose of loss mitigation is not to meet a return on capital target or low default rate; it is simply to minimize losses. Workouts do not require an additional investment of capital – that investment choice was already made (it was a bad one). If 3 out of 4 loans in a workout program re-default, then it was a success merely by preventing one of the four loans from causing a loss. Cutting losses by 25% doesn’t sound great, but on the bottom line it is similar to increasing profits by 25%. The correct questions are if any additional loans could have been saved, and if the optimal workout program was chosen. The cost of workouts is usually small compared to the cost of default.

 If we are trying to mitigate losses on high-risk mortgages, then we can extend the term, forgive principal, and/or cut the interest rates. Extending the term is fine, but if a mortgage originated in 2006 has a 30-yr term, then most of their current payment is going to pay interest. Extending the term at the same interest rate won’t reduce the payment much. Forgiving principal will certainly reduce defaults, but it will cost the creditor a lot, create a moral hazard incentive for new delinquencies, cause creditors to limit future lending for fear of more forgiveness, and anger everyone who didn’t get forgiven.

Consider the components of a mortgage interest rate and how they now apply to high-risk borrowers:

• Risk-free profit: Short-term LIBOR & US Treasury yields are near zero.
• Inflation risk: Low by most measures.
• Refinance option: High-risk borrowers can’t refi regardless of market rates.
• Origination costs: Sunk costs, if they haven’t been recovered by now…
• Servicing: Defaults have much higher servicing cost than performing loans.
• Credit risk: Very high potential credit losses.

 The credit risk component of the interest rate is admittedly extremely high. But consider that the higher the interest rate, the higher the mortgage payments, and the more likely it is that the borrower will default. If one were to charge an interest rate proportionate to the borrower’s risk, then they couldn’t possible afford it and would certainly default. One should be happy to continue to get the current credit premium.

When I add up the components of interest rate on a high-risk borrower, I come up with a modification interest rate of 1-2%. I like 1% because it grabs headlines and should spur action. Is this how I want to invest my savings, on 1% crummy mortgages? No way. But if I already own the crummy mortgages, then it sure beats paying 50+% in losses every time one defaults.

One can easily make the 1% mortgage a quid pro quo by making the modification a 1-month ARM. That way the borrower is taking the risk of higher future interest rates in exchange for lower interest rates today. Since the Fed says they want to keep rates low for at least the next two years, this isn’t that bad a bet. And when rates do start going up, hopefully employment and house prices will too.

The common fad is to discuss workouts in terms of Net Present Value (NPV sounds sophisticated to people in DC, and naive to people in finance). If only people really understood the mouthful they say with “NPV”. It assumes an accuracy of prepayment, default, and loss severity models over a variety of different workout alternatives. It assumes an accuracy on future house price and interest rate paths. It sounds good in theory. In practice, the NPV estimate will be incredibly rough. People will tend to choose assumptions that favor whatever outcome they desire anyway. Complexity doesn’t equal accuracy. Complexity does equal operational disaster, at least in the mortgage servicing world. 

If we want to solve the mortgage, housing, and general economic problems then we need to “un-sticky” mortgage interest rates. We don’t have to do 1%, or even 2% modifications. We don’t have to do it to all delinquent borrowers. But we do have to do something.

Texas Healthcare Tort Reform

In 2003 a bill was passed that capped non-economic damages at $250k. I don't know the devil in the details, but that sounds reasonable to me. I often hear people claim that outrageous lawsuits are a big part of rising health care costs. But I read experts who claim that lawsuits only effect total costs on the margin. This topic will heat up with Gov. Perrry's presidential candidacy.

Here's what I found, from Health & Human Service's Medical Expenditure Panel Survey.

Texas health care premiums aren't lower than the national average, or than many neighboring states. Tort reform doesn't look like a silver bullet to our health care costs. If tort reform is enacted nationally, I'm not expecting my insurance premiums to be materially different.

Maybe insurance companies allow states to cross-subsidize each other, and Texas is a victim of that - but I doubt it. Much more likely is that the cost of Texas' large percentage of uninsured's emergency procedures is borne by those who do have medical insurance.

IBGYBG Federal Budgets

If someone has a proposal to balance the budget then let's see it. But it has to be for next year, and it has to be specific. None of this stuff where the changes don't hit until many years into the future (IBGYBG = I'll be gone, You'll be gone), by which time future Congresses will have over written your budget with their own. No across the board percentage cuts, or freezes, or vagueness about eliminating tax loopholes and waste. Tell everyone exactly what you want to do now.

I know many conservatives want a balanced budget now, but then the specifics get dim. From what I know of their values and ideology, I think I can build a proposal. They might want to cut Social Security - but at least for the next year, that isn't much of a problem anyway (probably no problem if we had full employment). And they might want to cut Medicare too. But the political reality is that old people vote, and making significant cuts to Social Security's or Medicare's current recipients would get them booted out of office in the next election. So let's take these off the table for 2012. Likewise, conservatives tend to like national defense, so I won't cut that.

But conservatives really don't like the government providing assistance to individuals, and they don't like regulations that impede on business. With that in mind, I've tried to construct what I think a conservative balanced budget would look like, starting from Obama's current 2012 budget (some Republican leader said Obama didn't have a budget - took me 5 seconds to find it on the Internet, along with details from every Cabinet level department).

If we cut pretty much all benefits to needy individuals, except for Social Security, Medicare, and veterans, then we get close to balancing the budget. That means no federal money for Medicaid, food stamps, unemployment benefits, student loans, subsidized housing, etc. I also eliminated several government departments that they either don't like, or find unnecessary. That lowers the deficit from $1,042 billion down to only $110 billion.

Potential Conservative Balanced Budget Cuts:

There aren't any big ticket items left to cut, so one would need to cut a lot of little things from programs like highway funds, medical research, defense, etc. to reach the last $110 billion. As a reference point, the military in Iraq and Afghanistan is budgeted to cost $118 billion in 2010.

It is worth pointing out that many of the programs that provide assistance to individuals such as unemployment benefits and food stamps (SNAPS) are "automatic stabilizers" meaning that their payouts automatically increase the weaker the economy gets. If our economy were stronger, many of the programs would naturally shrink. These programs help people when they need it most, though media and politicians rarely attribute our higher government spending to programs which require no extra approval by the President or Congress. It also means that they cost the government the most when tax revenues are the weakest and therefore exacerbate deficits.

These payments to individuals tend to be immediately spent rather than saved, which is an argument for their efficacy over tax cuts as a stimulus. One could argue that they do nothing to stimulate investment - although without consumer demand in a recession, higher private investment is illusive anyway. Conservatives would argue that the government support of individuals in a time of crisis removes the urgency of the incentives for the individual to find work and support themselves, thereby lengthening the duration of the economic slow down.  People who like these programs tend to like them even more in a recession. Those who dislike the programs tend to hate them in a recession. They are politically polarizing programs. 

Note that this is not a budget proposal that I personally support; it is far too draconian for my taste. I've created these budget cuts as an example that has detail, substance, and immediacy. It also helps identify the scale of cuts required if we aren't willing to touch Medicare, defense, or raise taxes. People can see where the cuts are coming from, and with a little help, the consequence to individuals. Any politician or pundit who advocates a balanced budget, or even large spending cuts, should provide this kind of detail. Otherwise they are just playing games.

Balancing the Budget One State at a Time

Many people are concerned about all the tax dollars that go to DC and are spent there. Not surprisingly, $5.55 of Federal spending occurs for every $1 of tax of revenue that is raised there. What other states are feeding at the Federal trough? 

Here's Federal spending per dollar of tax revenue (for 2005, more recent year available):

 

This is back in 2005, so maybe some of these differences are due to housing booms or recessions. So I looked at the data going back to 1981. Although there was some variation from year to year, the patterns were pretty consistent. New York and New Jersey paid more than they received every year. California paid more in 20 out of 25 years and averaged receiving 92 cents for every dollar of tax paid. Most of the deep South never paid as much as they received. Nor has South Dakota, Montana, or Idaho. Alaska hasn't in 20 years.

Some states have a lot of poverty, which may explain why they are on this list. Some may have a lot of retirees that receive Social Security and Medicare (some retirees are pretty wealthy, so maybe it is a push). Some states are more likely to have large military bases due to their location (i.e. Hawaii). Other states may tend to get agricultural subsidies. And some states have a lot of corporate headquarters located within them. Every state has an explanation.

Sometimes sharing money across state boarders is good, so that if one state that is in trouble (recession, disaster) then they can be helped by other states. But in the long run, we hope that we all pull our weight. We should identify who isn't and correct it.

Many state governments make a big point of saying that their spending has to be balanced. Imagine if we balanced the Federal budget for each individual state. The states that typically vote Democratic should be all for that. The states that are strongly Republican should be very worried. Not just the citizens in those states, but the businesses that directly or indirectly rely on government revenue. Many Republican states should probably look a bit less to DC for where the Federal money is being spent, and a lot more within their own state borders. It likely that large cuts in federal spending will tend to hit Republican states harder than Democratic states.

It would be informative if we could see data like this for many more cohorts. By city, by occupation, by industry, by age, by family size, etc. Even for each individual family, a list of taxes paid versus federal spending received (hard to do, since the benefits of many expenses are shared). But if we did this, people might discover that they only need to look in the mirror to discover why we have a Federal deficit. If we start from that point rather than blaming liberals in DC, then our politicians would have an easier time balancing the budget.

If you are interested in looking at the data for yourself, visit the tax foundation's website.

Your Dollar is Worth More Today

Your US dollar is worth more today. How can that be? Look at the change in value today of various things on the financial markets (in US dollar terms): S&P 500 down 6.7%, Euro down 0.7%, Oil down 6.5%, Wheat down 3.9%, Lumber down 3.1%, Copper down 4.6%. Even Frozen Orange Juice Concentrate was down 5.2%.

What went up today? The US dollar went up against not only the Euro €, but also the Canadian $, the Australian $, and the British £. The 10-year US Treasury bond increased by 2% today (causing yields to fall). That doesn't sound like a world that is worried about the US government defaulting.

Gold went up 4.2%, and silver up 2.3%. The Yen, in dollar terms, was up 0.5%.

Basically, everything that you could use is cheaper today. Commodities fell, and so did currencies of countries that produce commodities. In my opinion, every nation in the Euro has a higher chance of default (albeit still very low) than the US because of the contagious banking problem there - in spite of what S&P thinks.

The economy is slowing, and so too may corporate earnings. Even after the past week, US stocks are still expensive in terms of their price relative to the 10-yr trailing average of earnings (CAPE). The S&P 500 would have to fall another 16% to hit the 100-yr average CAPE, or another 69% to hit the lows we saw in 1932 and 1982. 

Anything that is a medium of exchange or store of wealth is worth more today. Anything whose value is based on utilitarian aspects is worth less. Our dollars are worth more today. But that doesn't feel good if you own something besides dollars, Treasury bonds, gold, or silver. If the fear continues, people will continue to sell assets and hold dollars and precious metals. That would cause lower consumption, lower sales, lower profits, and lower employment.

People aren't consuming, they aren't investing, and they aren't even really saving. They hoard mediums of exchange in order to preserve their wealth. This is the essence of deflation. We had a very deflationary day. It is the opposite of inflation; our currency now buys more. That sounds good at first, but now you see that deflation really sucks. 

Solution to Mortgage & Housing Markets

I keep kicking this around and improving it. Attached is my latest version. Now if I could just get a policy maker interested. Or even someone to explain why it won't work.

Download Solutions for the Mortgage and Housing Markets

The Real European Bailout

Lots of angst and anger over the Greeks being bailed out. But the Greeks didn't get bailed out. They got bailed in by having to buy €42 billion of their own bonds back. The Greeks get a lower interest rate and get some of their debt forgiven in 20 years. But for now, a nation that has no cash has to fork out more cash.

So who got bailed out? Large European banks. No doubt many German banks. They probably devised the plan to begin with. Granted, the banks will have to take a 21% haircut on the valuation of their Greek bond portfolio. But that isn't nearly as big a haircut as required to discount the bonds to market value. Notice that the deal in essence forces Greece to buy back some of their bonds - including from banks. That is the real beauty of the plan - for the banks.

It is a masterful bit of spin, so that many people believe that the Greeks are the beneficiaries and the European banks are the victims of the deal. The real problem is that this deal didn't solve much. Greek default is just as likely as before. And since Greek banks hold huge amounts of Greek debt, a default in Greek sovereign bonds would make all Greek banks insolvent. The same holds true in the relationship of most European banks to their nation's bonds. If the government defaults, then so will the banks. And European banks hold huge amounts of each other's public and private debt. So a default for one is a default for all. 

Which is why the US dollar will probably get stronger. If your currency is the US dollar, and the dollar gets stronger, then all else being equal (and it never is), everything looks cheaper. Stocks, commodities, oil, and even gold will look cheaper from a dollar perspective. But they will all look more expensive if you are holding Euros.

How to Fix Budget Politics

After seeing Congress' solution to our debt ceiling and the Eurozone's solution to their much likelier bond default, I think we will all welcome being governed by a new breed of super intelligent chimps. Rise of the Planet of Apes may look utopic, not apocalyptic.

I see little interest in solving our economic problems. But there is huge interest in blaming the problems on the other party. I see no one that offers even an implausible economic policy - even one that would be politically untenable in the hyper partisan environment. (for my economic policy proposal, see here).

If 'None of the Above' was a candidate in the next elections, it would win in a landslide. But that is no more helpful than waiting for super intelligent chips. Instead, let's pressure every candidate for Congress (and the President, lobbyists, and other experts) to declare exactly how they want to tax and spend. The CBO can create a fairly detailed 2-page list of government spending programs and tax choices to be made in the next year, and estimate what the deficit will be based on the numbers input.

This tax and spend list won't be for the next 10-years, which is a favorite political trick which pushes all the pain to distant years. That is utterly irrelevant since future Congressmen will make their own decisions anyway. All I want to see is the budget preferences for next year. And the list won't allow someone to make across the board caps or changes, or to do a "me too" on someone else's bill or list. If someone wants to be a copycat, then they have to figure it out and fill in each line. And they will need to understand each line so that they can answer questions from constituents and lobbyists.

I bet that if each Congress member has to declare budget details for the next year, then they won't look all that different. Because once they have to go beyond glittering generalities and outrageous ideologies, the reasonable choices are pretty obvious. Once you have to declare the specifics to constituencies, the consequences make the divisive rhetoric politically untenable.

Calls for a balanced budget amendment will look silly if your proposal for next year has a trillion dollar deficit. Feigned outrage over the need to raise the debt ceiling will be recognized as crass and dishonest if your own budget preference would have done no better. Many congress members will actually learn something about the budget beyond reciting their party's talking points. And the public may actually learn how their government really taxes and spends, and stop believing propaganda. Or so I hope.

JGB Example

A corollary to the US is Japan 20 years ago. Japan had bubbles with numerous mal-investments and high debt levels. Since then Japan has slowly de-leveraged, with corporations hoarding cash in the absence of better domestic investment opportunities (consumption is low because wages are low). As the Japanese economy slowed, short interest rates fell to zero by 1996. The realization that the slow down was for the long run caused longer interest rates to gradually follow, with the 10-yr rates staying below zero after 1999.

Seems to me like that is where the US is heading. Some would say that Japan is nothing like the US; their population is older and shrinking, causing their consumer demand to gradually fall. And Japan is an export driven rather than import driven economy. Although the US population isn't shrinking, its growth is slowing as immigration slows (driven by worse job prospects and domestic policies). Japan has a strong currency because their export proceeds are exchanged into Yen for domestic investment. The US will have an increasingly strong currency as fears of Euro defaults drive money to safety.

In the absence of better low-risk investments, global savings will increasingly flow to the US and keep interest rates extremely low. China and developing nations simply don't offer enough liquid bonds an investments to satisfy global demand. The irony of bond experts who rail against debt is that, without debt, they would have no job.

Gold should continue to be a good bet, not for fears of US inflation, but for fears of Chinese inflation due to China's policy of an artificially weak Yuan. And for fears of default in Europe. Defaults in Europe would cause massive immediate bank insolvency in one country, which would then rapidly jump to much of Europe. At some point Europe will have to issue Euro-wide bonds for refinancing debt, which will basically be printing money. That may sound bad, but it beats the alternative of most banks in Germany, France, Italy, and Spain becoming insolvent, and causing the sovereign default of all those nation's bonds.

Someday China will hit a hard recession and the Yuan will no longer seem undervalued. Someday Europe will solve its problems by issuing new shared sovereign bonds. When that happens, gold's day will be done. But that some day isn't today or tomorrow.

Tax Lottery

and now for something completely different...

Everyone hates preparing, filing and paying their taxes. Many people love playing the lottery, in spite of odds worse than being struck by lightning (but no one expects to be struck by lightning). So put the two together. Here are the rules:

• 1 in 100 Federal tax returns get a $100 prize.
• 1 in 1,000 tax returns get a $1,000 prize.
• 1 in 10,000 tax returns get a $10,000 prize.
• 1 in 1 million get $100,000 (bigger prizes don't offer more incentive, but ruin lives).
• In order to win, your return must be filed on time and accurate.
• Accuracy of smaller prizes is checked by standard computer programs.
• Accuracy of larger prizes is verified by tax return audits.
• If someone selected for a prizes fails the accuracy test, then another winner is selected.

The cost of the proposed lottery would be roughly $400 million. Sounds like a lot of money until you consider that it would account for 0.01% of total federal spending. If that seems like too much, then drop some of the prizes. But I bet that the improvement in the accuracy and timeliness of tax return filings will more than pay for the cost of the prizes. Plus, it will add some excitement and even hope to the otherwise awful chore of filing your taxes.

If someone wants to be elected President of the US, then they should propose the tax lottery. All the pundits will hate it. But your average voter will love it.