Crisis of Confidence

I listened to an abridged version of Jimmy Carter’s “Crisis of Confidence” speech today. He spoke of how we needed to renew our confidence in each other… start believing in America again. This was in response to the recession in the mid to late 70’s. I have noticed a slough of television and radio ads recently that convey a similar message, but with a contemporary twist. They try to convince us that the solution to our current crisis is to simply get out, spend more money and feel better about ourselves. The problem with both the speech and the recent ads is this: you can’t just tell people to feel better and have it happen. You can’t tell people to regain their confidence and expect to see a surge in national pride.

The real solution is real simple. It is stupid simple. People feel better about themselves when they accomplish things. The government has been hooked on one-time, short-term stimulus in the form of Cash for Clunkers and home buyer tax rebates. Buying new stuff only makes people feel better for a short time–until the luster wears off.  Instead of blowing our money on these band-aid programs, why not fix some bridges? Rebuild a few schools? Increase government support of small business lending and daycare so people can start businesses and go to work.

I see some of this going on, but not on the level necessary to really spark something.  These projects need to be under taken on a scale that requires the employment of more than the current force of workers.  Then, as the economy begins to recover, we can dial these efforts back.

Americans are industrious and always have been. We are people of action. Sure, we can be inspired by movies like Rudy or a good rock song. But, long term confidence is inspired by accomplishment and success. We need to do things to get our confidence back, not just talk about it.

Debt Threat

This update on the American Bankers Association website focuses on the level of debt we, as a country, may be taking on. Currently, the United States is considered a AAA rated debt. That could be in trouble if our sovereign debt rises too far.

Government debt can seem a bit nebulous as a concept.  However, there are two basic pitfalls to increasing national debt.  One, the debt could grow so large that we actually owe more than we are worth.  Two, the payment on that debt could grow so large that we don’t have enough cash to pay it.

The real impact of too much national debt is debatable. One way to look at it is that we can continue taking on debt forever.  This is only really possible if  the economy continues growing.  An economy that grows fast enough will cause the relative size of our national debt to shrink. However, if we take on debt at a faster rate than our economy grows, the debt level will outstrip our GDP. At that point we will literally owe more than we are worth as a nation. This is not a game-ending scenario, but it makes further borrowing difficult. As a rough analog, think of all the home owners who are underwater on their mortgages. It is a tough situation, it can be handled, but the borrower must be extra careful.  If, in this situation, we had a national emergency that required debt spending… bummer.  There may not be anyone left with enough confidence in our nation’s ability to repay it.

Another perspective is that the interest payments on increasing debt will soak up too much of the country’s gross revenue, harming our economy.  Granted, if government debt holders reside in the US, interest payments do go back into the economy as they are paid out.  On the other hand, if these payments increase to a significant percentage of revenue, there are other consequences. According to the Congressional Budget Office, our AAA debt rating is in jeopardy at an 18% debt to revenue level. But, who cares about debt rating, really?  The bigger problem is how to pay the money.  What could we do as a nation if 1 out of every 5 dollars we generate did not go to debt payments? One way to make the payments is to print money. This drives up inflation.  The other way to make the payments is to cut government spending in other areas.  Good luck.

There is a happy medium.  Increase debt and its corresponding payments slower than the economy grows.  Or, sand-bag some debt growth and save some room for tough times, when more debt is needed.  As we sit, we already had a heightened debt level when this recent recession hit.  Now, that debt level is creeping higher.  It’s not new territory, but it is still dangerous.

Independent Value Scale

I’ve read some recent internet traffic (OK, Twitter traffic) about research into an independent value scale.  This seems like an interesting concept on the face of it.  After all, prices within countries are set, but relative values can be obscured by international monetary exchange rates.  This complicates trade.  Re-valuing goods and services using a money-independent scale would eliminate this effect and better clarify relative values.  However…

Money is a value scale.  It takes any input of labor, materials, whatever value-add, and translates it into a common unit of exchange.  Trading goods and services for other goods and services creates a big problem: finding the exact mix that satisfies both sides.  By utilizing money, the relative values of goods and services can be determined and translated into an accepted medium of exchange.  No hunting and waiting for perfect trades or negotiating values to barter.

When this concept is applied in different countries, different monies develop.  They are different value scales, but function the same.  So to talk about an independent value scale is to talk about a new, international currency.  If this new currency is used to express the value of goods and services across the world, then each international money would necessarily develop an exchange rate with it.  This is because prices in each country’s home currency would fluctuate occasionally.  (I’ll call the units of a new, independent value scale Independent Units, or IUs.  Not very creative, I know.)  Versus a fixed, or floating, IU value, exchanges would need to be constantly recalculated.  But, would international trade be made easier with a common, international value scale to compare goods and services?  Let’s look at that.

If a loaf of bread in the US is valued at 10 IUs, we can easily compare that to a loaf of bread anywhere else in the world–for instance a loaf in France that costs 15 IUs.  If these two countries want to trade breads, we know how many of each are needed for an even trade.  But, there is a basic problem.  Prices within countries fluctuate regularly.  The loaves are priced and purchased within each country with the home currency.  So, the home currency value of each loaf would be translated into IUs.  Then, the values of the loaves would be compared in IUs to determine the correct number to be exchanged for an even trade.  The newly acquired loaves would be priced and sold by translating the IU value back into the home currency.

Without an independent value scale, the loaves’ home currency values would simply be translated into the trading country’s currency and the relative value would be immediately known.  The use of an independent value scale adds another layer that is unnecessary.  Home currency to notional IU exchange rates would fluctuate just as much as exchange rates between any two currencies.  So exchanges would need to be calculated twice in order to complete a simple trade.

Unless an independent value scale becomes an international money… it’s just another layer in the way of trade.  And, aside from recent conversions to the Euro in Europe, I don’t see many countries scrambling to give up their money.

Homes for Goats

These two stories, one from The Wall Street Journal and a similar story from NPR, highlight the current economic plight of goat herders in Mongolia. Although thousands of miles away from the United States, the herders’ story closely mirrors real estate troubles here in the US.

In both cases, loans were made based on rapidly increasing asset values. In some cases, miscommunication between borrower and lender lead to bad loans. Due to undesirable changes in the market, defaults rose significantly. In the midst of mounting loan loses, banks there are acting to protect depositors’ money. Once collateral assets are liquidated to make payments or mitigate loan losses, the borrowers may be left with no way to earn a living. For those who have lost their livelihood, the skills they have do not necessarily translate from the broken industry to a new industry. But there is a story behind the stories. It is the parable of primary, secondary and tertiary demand.

How could such a simple thing as demand affect an entire marketplace, much less an entire economy? For our goat herders, demand for sweaters 2,000 miles away in the West did them in. That demand picked them up, propelled them to the (economic) clouds and dropped them to their fate. In the goat herders’ world, they lived in the realm of tertiary demand. It is a cruel, cruel world. It is one in which fate is dictated by demanders two markets removed. Playing economic connect-the-dots with the demand chain is crucial to predicting what may lie ahead. To understand their predicament, let’s look at an example from the opposite side of the demand chain (and opposite side of the world).

Recently here in the US, as I’m sure you’re aware, residential home prices went down. But, lot prices went down even more. And land prices, in some areas, went to nil. In the residential real estate market, homes are in primary demand. They are the end product; the user level good. In most transactions, buyers expect a finished product when they buy a house. Aside from the roofing, flooring and other physical attributes of a home, buyers expect to obtain the ground beneath it and, perhaps, a little extra around the sides. The ground itself is considered a piece of the finished home. Like exterior siding, it would be odd to spot a house in a neighborhood without. As the ground is a part of the house, demand for it will depend on the demand for homes. How does the demand for homes affect the price of lots?

Lot demand is secondary. When demand for homes falls, builders must sell off their excess inventory before building new ones. As they are not building new homes, they do not need new lots. Builders may also have an inventory of lots not seen on the market–a shadow inventory of lots held for new construction. Until they work through these lots, they will not be buying. In order to sell remaining homes in a market of less demand, home builders may lower prices. But, home builders are only competing with other home sellers. Lot developers are competing with other lot sellers and with home builders who have excess lots. So, where home demand has dropped off, lot sales will nose dive. While home sellers can lower their prices just enough to sell homes, lot sellers may have to lower prices enough to lure the interest of those who don’t need their product. Further, when builders need lots, they will determine the amount they can pay based on the differential between the expected price of a new home and the cost to build it. Whatever amount is over the cost and less than the expected sales price is what they can pay for a new lot. Ouch. It’s worse for land.

Land demand is tertiary. To avoid repeating the above, I’ll make this simple. Land demand is dependent on home sales as well as the exhaustion of both inventoried and marketed lots. To make it worse, just has builders inventory lots, lot developers inventory land. So, land sellers must compete with other land sellers and with lot developers who already have land. The problems compound a little here. You see, it costs money to develop lots just as it costs money to build homes. As the builder is fitting lot cost into his price-less-cost-to-build model, lot developers are doing the same thing. The expected sales price of their lots less the cost to develop is what they can pay for land. Recently, in some areas, that equation equalled zero. In rare circumstances, that equation yielded a negative. Land with negative value. It is a cruel, cruel world.

Our goat herders are living in that world. The value of their goats depends on the demand for cashmere wool by manufacturers. That demand for cashmere is dependent on retailers’ purchases of wholesale sweaters and the inventory of cashmere held by manufacturers. The demand for those wholesale sweaters is dependent on consumer purchases and the inventory of sweaters held by retailers. When consumer demand in the US slips because of an economic downturn–linked to residential real estate, it turns out–the value of goats plummets. Goat herders are left with loans they cannot repay and are faced with the specter of losing their goats and, potentially, their homes.

What has this parable taught us? In life, you need to evaluate your role so you can be prepared to deal with it. Are you in a position of primary, secondary or tertiary demand? In other words: are you the sweater, the wool or the goat?

The Economic Gain Doctrine

In this story at CNN Money, Les Christie discusses the tax consequences of debt forgiveness and foreclosure.  Sometimes, but not always, you can be liable for the balance of your mortgage if it is forgiven in the course of a foreclosure or deed in lieu.  In short, if you lose your house, you could owe taxes on it as well.

It doesn’t seem fair, and there are some safeguards against it, but the concept behind this double whammy is simple.  If I remember correctly, and that is questionable, the concept is known as the doctrine of economic gain.  Plainly put, if you have an economic gain, the government taxes you on it.  This is the basis of the income tax in a nut shell.  But, how can this lead to you owing taxes on a loan?  I’ll explain.

First, the basics.  When you go to work and earn a paycheck, that is income to you; it’s an economic gain.  You received money, you got to keep the money, you pay taxes on the money (remember the order of events, it becomes important).  Most people understand this and are OK with the concept.  Now, unlike normal income, loan money is not taxed.  It is not an economic gain because you have to pay it back.  You received money, you did not get to keep the money, you do not pay taxes on the money.  Since you have to pay it back, loan money is never really your money, so it can not be an economic gain.

The reason why forgiven debt can be taxed is because the borrower retains use of the money.  You received the money, you got to keep the money, you pay taxes on the money.  When debt is forgiven, it transforms from “never really your money” into “income” or economic gain.  It doesn’t matter that the borrowed money was used to buy a TV or a car or a house, the borrower whose debt is forgiven has retained the use of the money.

In a normal, appreciating, real estate market, a foreclosed home can be sold to cover the balance of a debt.  In our real estate market, this is not always the case.  Often, repossessed homes do not cover the loan balance.  Other scenarios that could result in a remaining loan balance are short sales and deeds in lieu.  The remaining loan balance, if forgiven, could become income to the borrower.  If this is taxed, our IRS will take its payment in cash.  That is a tough hurdle for someone who just lost their home and likely doesn’t have much money saved.

There is hope.  One way to avoid paying taxes on forgiven debt is to reaffirm it.  You can tell the bank you want to repay the difference.  Of course, you will have to continue making payments on the remainder, but it may be easier than coughing up the cash to make a big lump-sum payment of taxes.  Bear in mind that there are consequences for every action.  It may be worth while to ask questions if paying the mortgage is getting tough.  A tax or mortgage professional should be able to explain the tax impact of a specific short-sale, foreclosure or deed in lieu scenario.

The Fed Doesn’t Get It

This story from ABC news relates that the fed needs to do research into preventing future speculative bubbles.

In the article, Donald Kohn, the central bank’s outgoing vice chairman is quoted as saying: “Many central bankers and economists, myself included, were a little complacent coming into the crisis.”  You think?  Two obvious, in hindsight at least, forces drove the real estate market to all-time highs.

First, At a time when housing values were skyrocketing (In May of 2005, the FDIC published this report showing that in 2004 alone, US average housing prices rose by 11%) mortgage rates were the lowest they’d been in 30 years.  My question is: how could you NOT speculate in real estate?  The reality is that most people did not.  However, when you can borrow funds with an interest rate lower than the expected rate of appreciation in the financed asset, you can make money buying houses by simple arbitrage.  For those among us with a thirst to make a quick buck, the temptation must have been overwhelming.  Indeed it was, considering the pickle we’re in now.

Second, people were borrowing money simply to buy homes for profit and mortgage brokers were lending with no responsibility for if (when) those mortgages fail.  Normally, brokers filter qualified loan applicants and match them with loan products appropriate for their goals.  But, some brokers were motivated by loan fees to churn as many mortgages as possible, selling them off to investors immediately upon closing.  There was no connection between mortgage risk and broker income, no consequences for making bad loans.  Combined with flexible qualifications in more and more exotic loan products (many of which are clearly aimed at special borrowing circumstances and not general consumption) and the secondary market’s thirst for mortgage-backed securities, we had a very potent accelerant for the exploding mortgage industry.

This ability to easily speculate in housing had the same effect on that industry that speculation has in every other investment industry: it drove up prices.  But, these price gains were never sustainable.  In August 2004 and 2005 US Census press releases show that US median income did not change between 2002-2004 (incidently poverty increased from 12.1% to 12.7% in that time period).  Housing price appreciation was increasing faster than the median income.  If these trends were to continue in a linear manner, at some point people would no longer be able to afford homes.  What happens to a market when no one is buying?

Also consider the number of buyers who purchased before they had originally planned to due to enticing home value expectations, low loan rates and unusually easy access to mortgages.  This is the same acceleration of demand that we saw again recently driven by the Cash for Clunkers program.  When an otherwise stable level of demand is accelerated, it is not an increase.  It is borrowing future consumption and applying it to current supply.  The effect in the housing market was an increase in asset prices at the expense of future stability.

The fed may be able to mitigate some of the spike in asset values, which could soften the landing when the bubble bursts.  Consider that the near-term demand for home mortgages was elevated, but prices for mortgages did not show a corresponding increase.  An increase in mortgage prices (interest rates) would have raised the cost of buying homes by increasing monthly payments.  Without an increase in median incomes, home prices would have been reined in.  Unfortunately, that only works with standard mortgages.  The market was full of teaser rate, interest only, payment optional, stated income and any number of other assorted mortgages.  All of these loans allowed nearly anybody to afford nearly any home.  Tighter regulation of how mortgages were underwritten would have stemmed the flow of exotic mortgages and limited the buying frenzy in real estate.

Ironically, the government is currently tightening mortgage standards.  Now that the mortgage market is crippled with funds tied up in non-performing loans, their actions merely exacerbate the problems we have.  The one tool that definitely would have helped push our ailing housing market toward better health is lower interest rates.  Too bad they’re already at historic lows.

What me, blog?

I am sitting here watching Biggest Loser, thinking: I don’t know how this blogging thing works.  The idea for doing this has been in my head for a little while, though I have not been sure I would be able to contribute to a blog consistently and with any content that is worth writing about.  But, I’ve tried this before.

My first foray into this form of communication was the year of 2008.  I had posted a few blog entries during my second tour of duty in Iraq.  I am not a creative writer, but the military presented interesting content to me daily.  It was hard not to blog sometimes.  The folly,  humor and tragedy of life in uniform is something that will live with me always.  At a minimum, it gave me a new perspective on life.  Still, I’m not inclined to write about things, so I went through most of my days observing life around me and soaking in the entertainment.

Before getting called for my second tour, I was working as a credit analyst in the bank’s residential lending division.  My primary focus was financial and project analysis in support of development and spec construction lending.  Was I good at it?  It’s hard to judge myself, but I was starting to build my own portfolio of clients and present my own credits for approval.  Sadly, deployment put a stop to that.  The bank handed responsibility for my (small) portfolio to a new vice president.  He is doing a fantastic job.

Upon my return home, I jumped back into the fray of my primary career.  I am not in lending this time around.  My job now is to manage and sell the bank’s real estate owned–a position that did not exist until I returned and was given the job.  Credit analysis and lending was full of fun and challenge.  Managing and selling real estate presents entirely new challenges.  Watching how loans go wrong presents entirely new educational opportunities.  The nexus between loss mitigation and freeing up capital is a very large, very gray area.  I often find myself trying to translate the bank’s intentions and decisions into realtor-speak.  I am learning that there are seemingly innumerable facets of properties and transactions to track.

I have spent a whole year building the real estate owned position.  It is odd to be handed a job with little more than a general direction and no specific instruction.  My best learning technique has been to answer questions.  People throughout the bank, customers, realtors and friends make inquiries I don’t anticipate.  Every answer I find broadens my knowledge.

I suppose I will blog about this adventure: banking.  What do you want to know?  I will collect some of the questions and answers I have cataloged and dispense them here, for your entertainment and education.  It’s not rocket science, but rather a new perspective.