Friday, September 19, 2008
Will the finance industry repeat the same mistake in the future? No, they won't make the exact same mistake again, but they are creative and will find new ways to make it. That is the foundation of the finance industry; it isn't very profitable without them in the short term, or very profitable with them in the long term. It is called separating fools from their money. The public good of finance is the allocation of capital to where it is best used. The private good is that it does better out of the hands of fools. Unfortunately, taxpayers are often left as the greatest fool.
Tuesday, September 16, 2008
What caused the speculative bubble in housing? People point to loans to the uncreditworthy, to low income households, low or no down payments, interest only loans, adjustable mortgages, low interest rates, loan fraud, appraisal fraud, and a myriad of other causes. While most of these were involved, the core problem was lending to people who could not afford to repay the loans. This was due to the failure to verify incomes and qualify the loans on fully adjusted market rates. Without the income to back up the loans there was no security for the loans other than the property and no constraint on prices other than the eventual shortage of speculators and funding for them. What caused the speculative bubble in housing was what caused the speculative bubble in stocks, the decoupling of prices from income. Without this decoupling, no bubble can form, with it, one is inevitable.
This was a lending problem. One must expect borrowers to deceive, to gamble, to look only at initial payments, and to do whatever it takes to acquire a speculative asset. Lenders possess the money and must be held to a higher standard. Lenders are normally much tighter in their lending, anticipating this, but the resale, repackaging, and securitization of loans separated the borrowers from the lenders and not only allowed deception and fraud but encouraged it. Adjustable rates with low teaser rates, interest only or interest optional features were designed to enable borrowers to obtain loans they could not afford. If borrowers had to qualify at full market rates there would be little need or want of them. A few might prefer them, but if they received them they would still be able to afford them, come what may. Lenders greedy for higher returns accepted, even preferred, higher risk loans to provide them, as long as they could hide it and pass it along to others.
Other factors, good or bad credit, rich or poor, high or low downs, affect the likelihood of default and that risk may be over or under priced, but these cannot affect overall prices greatly. If one is capable of affording the property but not willing, another can and will.
Why did this happen? Anytime incomes and prices can be decoupled, immediate and substantial short term profits can be made and are irresistable. Rationales are invented to justify these desires. Even though unsustainable and even though recognized as such, it may be rational to play the game and hope to leave ahead of the crowd. Instead of how much it costs, the question becomes how much gain is possible. Instead of asking whether one can afford to buy, the question becomes whether one afford not to buy.
Monday, September 15, 2008
What good is debt? How does debt benefit me? How does someone else's debt benefit me? Should interest not be tax deductible? Should mortgage interest not be tax deductible?
Debt allows one to convert income into assets and assets into income. This makes it a very useful financial tool in many ways. It allows the acquisition of assets without having to pay for them up front. It unlocks wealth that is otherwise trapped in assets. It allows consumption smoothing over time. It can transfer inflation risk from borrowers to lenders. It enables the debt market which provides another investment vehicle. It enables expansion of capital intensive business. Many small businesses are actually funded by loans on the proprietor's residence. It permits leverage to increase risk and return. It can be abused, but it can increase flexibility and power when well managed.
Without a deduction, borrowing to invest would make much less sense. Much lending would be driven to internal sources and much less money would be made available on the market without it. It would tilt investing from debt towards equities. Making some borrowing deductible and others not present another tax avoidance incentive since borrowing on deductible assets would then be diverted towards nondeductible assets. Treating individuals and businesses differently create another tax avoidance scheme. Real property is a productive asset despite assertions to the contrary.