A Falling Market is Not a Thief - Part I

It must be a hard wired human trait that we believe nearly every misfortune or crisis that we encounter is the first, and worst...and never our fault.

So I am on the couch with wife, two kids, and hound, and the spouse is watching Oprah. Suzie Ormond is the guest, advising a crowd of people who are in financial trouble due to the recession. A guest has lost his faith in government(!) and the economy after losing half his life savings in his 9th year of retirement at the age of 65. He wonders what he and his wife will do. It is with amazement that I listen to Ormond, Oprah, and the crowd chalk the crowd's problems up to greedy criminals who "caused" this catastrophe. Even my wife balks at the theme -- that we are all victims of a drive by shooting. Oprah says the bad guys cheated and "won," and that is "UnAmerican."

It is easy to understand the emotional desire to equate financial losses as theft. It allows you to mentally defer personal responsibility, and even better, demand "justice" from higher authority. It provides a greivance and a sense that the law should make you whole. But this idea is both flawed and dangerous.

The current economic crisis is actually not that difficult to understand. Fundamentally, it is a housing bubble that -- like all bubbles -- has burst. It was not driven by nefarious, crooked "wall street" criminals. It was a broad-based, international, overheated market that caused home prices to rise so quickly and for so long that people lost appropriate valuation of real estate. In addition, a combination of factors culminated to undermine the broader economy. It is a warning tale of the law of unintended consequences more than true crime.

Real Estate has historically been a "boom-bust" market. Prosperity drives demand for homes that are relatively long lead production items -- demand can easily outpace supply when it takes years to plan, zone, acquire, and build housing developments. Prices for existing homes rise, and builders start new projects. Prices accelerate as demand for materials cause spot shortages. By the time the market is sated, there is almost always a glut of houses...causing prices to fall as supply exceeds demand. It has happened repeatedly for as long as man has bought and sold buildings.

The current boom was partially heated by public policy decisions -- historically low mortgage rates, and community development rules loosening credit standards for sub-prime buyers. Banks developed new tools to mitigate the high foreclosure risk of these subprime loans -- mortgage backed securities (MBSs). These are basically bonds backed by a large number of mortgages. The idea being that while a single loan carries a risk of failure, a thousand such loans dilutes the impact of a few foreclosures. Being subprime, MBSs had the added benefit of paying much higher interest than the prime rate. The paper is also backed by the collateral of the houses themselves -- and in a heated market, the houses were perceived as appreciating assets. The result was a huge increase in demand for houses (due to easy access to low cost loans) and a huge new secondary mortgage market. Clearly a recipe for a bubble.

But the thing that made this bubble so much more pervasive than previous busts is the gradual infiltration of MBSs into nearly all financial institutions. Fifteen years of constant growth in housing values, plus the advantage of <4% spreads between prime and subprime mortgage backed securities caused massive investment in these high yield, theoretically low risk securities. Everyone was buying them. Domestic and global corporations of all stripes used them to to pad their earnings. Average investors purchased Real Estate Investment Trusts (REITS) for their portfolios, as they paid higher yields than regular corporate or government bonds, and were perceived as less risky than stocks.

The need to feed this market created huge incentives for lenders to expand the potential pool of homebuyers to provide new securities to package and sell. This required offering increasingly risky loans to eager homebuyers who were willing to overpay for homes they could not otherwise afford. Home equity loans, Jumbos, balloon loans, interest only, etc. Buyers accepted these loans in the hope that increasing home values would provide equity, and the upwards ride would never end. The government backed giants, Freddie Mac and Fannie Mae served as a safety net, willing to buy packaged securities no matter what the risk.

Investment Banks purchased huge amounts of MBSs, which they then used as collateral for other financial transactions -- often leveraged up to 50 to 1. They sold insurance (credit default swaps) against default of the mortgage securities -- effectively profiting twice -- while doubling their risk.

Everyone got what they wanted. Consumers got houses, and those who saw their homes greatly appreciate used their windfall equity to borrow money for new cars, vacations, additions/upgrades, and other houses. Federal, State, and Local Governments achieved their policy objectives of broadening the homeowner class, and got to reap the new tax revenue to finance billions in unrelated policy objectives from education to childrens healthcare to public works. Homebuilders and suppliers provided massive employment, and every bank and corporation involved in the buying/selling of securities turned huge profits that were then distributed to shareholders and employees -- creating a broad economic boom that carried the Dow past 14,000. What's not to like?

Well, a funny thing happens when supply exceeds demand. More in Part II.

Rights and Entitlements

Every functioning government -- from county to federal -- provides some measure of services to the public in addition to security.

Citizens give up property, generally in the form of taxes, to finance these services. The most vehement of libertarians will argue that the government should not get involved in service delivery, but it is rather simple to understand why a government does so. An individual can build a driveway to his mailbox, but isn't going to finance a modern road of any consequence. Nor will corporations finance the volume of roadways necessary to create a functional modern society. It must be collective action in the form of government. And this is just one example.

There is an entire body of law that governs collection and spending of revenue for the public good, and from a policy standpoint, you can debate the relative merit of every government program. But the systems are established in public law, and are therefor legitimate...though frequently wasteful and inefficent.

The hazard for the American public is not that government programs exist, but in the rhetoric that claims such programs must exist. This is the road that generates misguided statements like Americans have a "right to healthcare." The advocate makes this claim to undermine the debate over the merit of government funded healthcare, implying that there is some ordained or natural human right to get treatment for illness, and that government must establish programs to enforce this natural (rather than electoral) mandate.

In a state of natural liberty, this is obviously not so. Healthcare is a human invention -- we are not born into it anymore than we are homeowner's insurance. Healthcare qualifies not as a right, but as a potential "entitlement." Through the legislative process, government decides that citizens (and in some cases any person in the US) should be provided a service or payment, and finances its distribution. This is elective public policy that can be established, extended, and hopefully reduced or eliminated as required, though the last seems a rarity. The law may entitle you to the service, but there is no "right" to it, except as determined by law.

In the case of entitlements, the only "right" involved is Equal Protection -- that once passed, the law applies equally to all people. This establishes that the laws creating entitlements are general to all people, even when providing different levels of entitlement based on criteria (income, age, family size, etc.) Civil Rights govern the application of entitlement law -- they do not justify it.

When a politician states that people have a "right" to any entitlement, hold onto your wallet. Entitlements should be considered according to their costs and benefits, not as gifts of nature.

It seems like a rarity for Americans to spend any effort thinking about what they believe. The lack of rigor is apparent in the simplest terms that infiltrate our political vocabulary. Any American can give you an example of his "rights" but can offer no definition of a right, or an articulate explanation for how it is derived.

As a short term assistant professor of American Politics, I lived the mantra of most rookie profs -- to stay one day ahead of the class. I also discovered the truism that one of the easiest ways to understand a subject is to be forced to teach it. Having to explain Locke to 19 year olds was humbling -- but eye opening as well.

A second order effect to being forced into a nominal understanding of Locke led me to significant thought about why I believe as I do. Convenient for the lazy and somewhat uncommitted, I was able to crib from the intellectual bedrock of the Constitution. For the first time I was able to mentally grasp the distinction between liberty and rights.


Liberty is inherently an absence of constraint -- you do what you want, when you want...and devil take the hindmost. It is a condition enjoyed by all creatures from plankton to homo sapiens. The issue with this natural liberty is that it overlaps, and we come into conflict over things and places (property) -- when all have equal claim to everything, violence ensues. In a civil society, people sacrifice some portion of their natural liberty to a collective body politic in exchange for security -- specifically to settle disputes over property, and protect their lives (a form of property) -- both from local violence and outside threats. The remainder of this freedom is considered civil liberty. Relatively simple and straightforward.

The concept of "rights" stems from the idea that the constraints on natural liberty are limited -- and some areas are beyond the powers of government to infringe. In addition, these constraining laws must apply equally to all. Spelled out in the first ten amendments, these limits are complex and subject to interpretation, but the concept is clear.

Laws are the means by which government implements its authorized constraints on liberty. Despite the protestations of the ACLU and libertarians, the rub rests not so much in government infringing our rights, but in people claiming "rights" which are nothing of the sort. More to follow on this.

The Uncommitted Pundit

The title of choice for this blog was the Lazy Pundit. It should have been no surprise to this correspondent that it was a title already taken. And why not? With consideration it became apparent that punditry and laziness are synonymous. Isn't the energetic pundit considered an academic? The academic requires research, study, and careful annotation in the development of an argument. The pundit does not.

For the pundit, logic and consistency are largely optional, and there is no accountability in opinion. Credentials offer more amplification than gravity. The artful turn of phrase makes the argument. Or perhaps it is the sheer outrageousness of the position. Whichever.

So as a "feed the mayo to the tuna" idea guy, laziness is given. So it is the Uncommitted Pundit. Commitment is unnecessary in the beginning, when obscurity is certain, and there is comfort in the mirage of Internet anonymity.