Trading tomorrow for today

By May 25, 2008Economy, Foreclosure, Realtors

There’s an awful lot of debate about who is to blame for the current foreclosure crisis and who should, or should not, be bailed out. Some folks are down right angry.

My father was a logic and philosophy professor. As a kid growing up I was allowed to do almost anything I wanted so long as I could make a valid argument for doing it. This was much harder than you might expect thanks to the many fallacies that rendered my arguments invalid in my father’s eyes. That my teacher said it was true didn’t make it so (the appeal to authority fallacy). But of all the fallacies that my father used to thwart my plans, the one I remember best is the post hoc ergo propter hoc fallacy – which says that just because something happened first doesn’t mean it CAUSED what happened next.

Subprime loans were the first to foreclose, but that isn’t enough to prove subprime lending caused this crisis. Speculation is correlated with foreclosures, but is it really the cause?

The truth is that there were a lot of things at play and we are unlikely to ever see a root cause analysis on the subject that would satisfy my father. But among all the arguments, I do see a theme… an ever increasing willingness to trade tomorrow for a better today.

Let’s take a quick look at a few of things I like to point to as potential causes of today’s foreclosure crisis, and see if perhaps you agree:

1. Federal Reserve effectively lowers reserve requirements in the early to mid nineties, likely in response to the housing crisis. Allow banks to lend a greater percentage of their deposits pumping money into the economy (and perhaps fueled the dot com bubble), but increased risk of bank failures.

2. Congress passes the Taxpayer Relief Act of 1997 allowing homeowners to exempt up to $500k ($250k if you’re single) in capital gains on the sale of a primary residence. Helps get real estate market restarted after a significant downturn, but highly incentivizes everyone to speculate with their primary residence.

3. After the dot com bubble collapses the U.S Federal Reserve lowers rates 11 times from 6.5% to 1.75%. According to Greenspan this didn’t help put money into the economy until the invention of the Structured Investment Vehicle, which essentially allowed banks to make highly leveraged investments by moving them off their balance sheet avoiding regulations. This helped free up credit to stimulate the economy, but encouraged riskier lending.

4. Lenders invent new products in ever increasing competition for new customers. All types of financial engineering are employed to lower payments – adjustable mortgages with teaser rates, negative amortization, high debt-to-income ratios, etc. All of which increase the loan amount a borrower can afford on a given income… at least to start. This created unprecedented demand for housing and increases in prices, but higher prices decrease home affordability, and low initial payments ultimately have to adjust upwards.

5. Counties and cities see unprecedented growth in revenue from building permits and property taxes and race to approve ever more development to fund the expansion of services. Yet over-development was one of the most cited causes of the last real estate downturns.

6. Rather than slowing development as demand falters builders continue building at record paces. Yet the Boston Fed found that declining prices play the dominant role in generating foreclosures.

7. And through it all consumer debt continues to rise as people increasingly make the decision to pay Tuesday for a hamburger today.

In each of these cases I’d argue that we have chosen instant gratification today without regard for the future. Perhaps every once in a while it would be better for us to trade a little pain today for a better tomorrow.

No Comments

  • Anonymous says:

    I fell into the trap . Friends and family saying you must buy now because in a few years will never be able to buy a house.  With banks leting you know its ok buy now and in two years to could refi and you be ok.  Well house prices went down about 60% and I lost my job after twenty eights years working for a great company that I thought .  Does this make me a bad person for having to give up my home back to the bank after I have used up my savings because its the moral thing to do.  I feel the bank failed me . The company I worked for failed me and I failed my self in trusting profesionals.

  • Sean says:

    Thanks for sharing that, I certainly don’t think you’re alone in those feelings. Sounds like you are taking to heart some hard learned lessons. Maybe if enough people do we’ll find a majority that are willing to sacrifice a little bit today for a stronger, less debt ridden tomorrow.

  • Dawn says:

    I just started reading your blog, so please pardon me if you have already posted on this, but “This American Life” on NPR did a wonderful program on this very issue. It talked about all of the different aspects that came into play in the industry itself and how each step fueled the next. If you haven’t heard it already it is worth a listen – I got it on their podcast. It helped me start to make sense of what is happening.

  • Noah says:

    Sean, dude,

    It is just human nature to get what you can when you can get it. Nothing will ever change no matter how many lessons you through at people. Where I live which is going through condo auctions every weekend, this same thing happened back in the 80’s. It is all a cycle. People will remember for a while, forget and then do the same thing again – maybe different people, but they will do it again. And believe me, when I see the cycle start again, I will be buying and selling but getting out before the cycle crests. Give it time.

    Noah@ShortOnChange.com

    http://www.ShortOnChange.com

     

  • Noah says:

    Sorry, after I proofed that, it should have read:

     

    Sean, dude,

    It is just human nature to get what you can when you can get it. Nothing will ever change no matter how many lessons you throw at people. Where I live which is going through condo auctions every weekend, this same thing happened back in the 80’s. It is all a cycle. People will remember for a while, forget and then do the same thing again – maybe different people, but they will do it again. And believe me, when I see the cycle start again, I will be buying and selling but getting out before the cycle crests. Give it time.

    Noah@ShortOnChange.com

    http://www.ShortOnChange.com

  • Anonymous says:

    I think you need to put in a little something about the bond rating companies.

    Yes, rates went down making loans attractive thru various financial vehicles and tools.

    But, I suspect some people that did receive loans probably wouldn’t have qualified for a Sears credit card.

    However, sub-primes loans, well, I think my dog was getting offers in the mail to apply.

    So, once a lending insititution had a ‘bundle’ (say 10 sub-prime loans with the value of each at 1 million dollars for easy math) of sub-primes loans they were allowed to package those into securities – Say one giant 10 million dollar security/bond backed by 10 one million dollar home loans).

    And the Bond rating companies pretty much rubber-stamped those AAA-grade. Then the security was chopped-up (perhaps sold as a whole if you find a buyer) and spread around the world.

    It worked until, I think, investor started to get a little spooked on what was actually backing-up the security – Sub-prime loans that are now racing into record defaults.

    Then people went – Well, if the bond companies rated those AAA what else did they rate AAa that isn’t….

    Ta-da – Credit Crunch.

    Who has what? Who knows?

    How much is this going to cost? Who knows?

    How many people are going to be in default? Who knows?

    Who saw some ‘record’ profits over the last years and some pretty high stock prices? Wall St. (financials)

    Who made the bad loans and placed bad bond-ratings on them in which everyone gets a little piece of the pie? Wall St.

    Who is paying for all this? You. Me. The tax-payer.

    Where does the instant gratification lie? Not with the tax-payer or people getting foreclosed on. I see Wall St. was rubber stamping – Instant Gratification on their bonds/securities backed by risky loans.

    If bond rating companies had not played the game in the name of the dollar that would have been another point at which someone should have said – Hey, maybe this loan shouldn’t have been made OR this bond should be rated a B-grade bond. Nope. Didn’t happen because it ‘hurts’ business.

    The in steps The Fed ‘using it’s power’ by helping save an investment bank (BearSterns) when The Fed is NOT charted to help investment banks (just commerical banks). This Fed action is completey unprecendented in it’s scope and all of this pretty much happened over the weekend when BearStearns failed. A weekend people.

    Nobody noticed or is concerned about this???? (No, I am not voting for Ron Paul either)

    I am not so sure I trust the people that msde the problem to have access to tax-payer money and Gov’t-backing of loans to solve the poblem. Why not just lock the fox in the hen house??

    (Oh, and more than likely all the lending companies will have to ‘raise’ rates in the future to ‘help’ offset some of these ‘costs’ which means, again, in the end you and me will likely pay more in the future. Great!)

    Doesn’t subprime mean – Not prime and therefore more inherent risk?

    Anyway. Coffee time!!!

  • Anonymous says:

    Just a little follow-up on what I said about The Fed intervention and why people might be concernced-

    Richmond, Va., Federal Reserve Bank President
    Jeffrey Lacker said the lending to securities firms that the central
    bank introduced in March may encourage risk-taking that leads to more
    financial turmoil.

    “The danger is that … the recent credit
    extension … might induce greater risk-taking,” Lacker said Thursday in
    a speech to the European Economics and Financial Centre in London. That
    “in turn could give rise to more frequent crises,” he said.

    From USAToday

  • Sean says:

    Thanks for your post. I agree that there is no way my point number 4 would have happened had the fed and other regulators not allowed the games that were played with securitization and special purpose investment vehicles.

  • Anon says:

    No. 4 is closest to the explanation, earlier comment hinted at it: the securitization of the mortgages. The fault lies squarely in the lax due diligence of the investors buying these mortgages. Of course the service firms did not help out either (bond rating etc) – they must have been asleep. It’s not like all financial institutions did this. Look at BofA: hardly any sub- prime crisis there. But, the lure of easy money had some, and then increasingly more, investors bidding up the value of these securities. This is called speculation, and is very healthy in a free economy as long as people act rationally. The investors that bought these mortgages fuled the cycle and is to blame in my view. A little bit of the blame is also to be directed toward those that bought in anticipation of higher prices and bought houses they could not afford. That’s fine if you are good at calculating risk and you have extra money to gamble with. But your house and gambling does not mix well. Hopefully housing costs will come down to a level where most that want to can afford to own a home, not primarily as an investment, but as a place to live. To earlier poster: it’s perfectly ok to walk away from your house and let the bank deal with it. I’m not sure which fallacy applies here, but in plain English, perhaps the argument was: “Well, everyone else is doing it!”

  • Nick says:

    For consideration as additional causes:

     

    – Transformation (and the government encouragement thereof) of the economy from one of production to one of consumption.

    This change was largly encouraged by the inclusion of consumption, and especially government expenses, in the GDP numbers which underpin many economic models of fiscal health at a national level. It’s much easier to outspend your revenue when that very spending inflates your abstracted well-being as a nation, and it’s totally inaccurate. The destruction of competative production as the primary means of national wealth will make it very difficult for America to emerge from a crisis of consumption ability.

     

    – Manipulation of the CPI

    It’s hard to understate the systemic, long-term, subtle, and very destructive consequences of changing the fundamental way the CPI is calculated to intentionally underestimate inflation by even ~4%, which the government did, primarily with product substitution and hedonic regression. This change enabled, and still enables, the Fed to create easy credit and ignore the inflationary results, and skews the financial markets to the extent that they rely on the incorrect data for long-term value approximations. When it becomes more widely understood, it will irreperably harm the US’s reputation as a transparent investment nation, and could destabilize our currency. And this is not even considering the systemic harm to every program indexed to the CPI to compensate for cost-of-living adjustments.

     

    – Lack of transparency and granular control of investments

    Many, many people put a lot of money into relatively opaque mutual funds which invested in all companies matching certain criteria, good and bad, regardless of their performance (eg: S&P500 index funds). This carte blanch has enabled big corporations all manner of excesses at the expense of investors’ long-term equity: executive compensation, chasing short-term returns with high-risk leveraged investments, selling MBS’s to “safe” funds, etc. This, I would guess, will be one thing which will change as fallout from the current correction; the market is ripe for an online company to offer much more granular investment control while retaining the benefits of mutual fund style aggregation, and someone will capitalize on the need. In the short-term, however, I would qualify this as another primary contributer to the current situation.

     

    Hope people find these points interesting. 🙂

  • Sean says:

    Anon said: “But your house and gambling does not mix well.”

    Yes, but with the incentive of $250-500k tax free thanks to congress is it really reasonable to think folks won’t take this gamble. The odds simply look to good to resist.

  • […] The answer is clear. It’s the same thing we’ve done with national deficits for years. Trade tomorrow for today, with a policy of “extend and […]

  • […] The answer is clear. It’s the same thing we’ve done with national deficits for years. Trade tomorrow for today, with a policy of “extend and […]

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