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Wednesday, September 20, 2006

RE: Wealth Creation Technology

The great debate has now switched from whether housing is going to decline to what kind of an effect the housing decline may produce in the general economy. The housing section of SeekingAlpha is a good aggregator for this type of news. From today's listing, see this quick look at the NAHB outlook index (the lowest since 1991, which was when big swathes of CA saw strong declines in housing values), and a nice graph about the historical correlation between the NAHB housing index and the S&P 500 12 months later. If you will take a look at that, you can see why people are reasonable in expressing concern.

Yes, the economy is currently strong, but it is weakening and experience suggests that this weakening will continue. Granted, we don't have much of a historical correlation to a housing bubble this big. The last remotely comparable period we have is the period before the Great Depression, in which wealth was generated but it was also concentrated, followed by a period in which a great deal of wealth evaporated in a stunningly short period of time. Somewhat naturally, this is the historical correlation we are all hoping to see debunked.

Tim Iacono takes a critical look at the Chicago Fed's paper announcing that the housing boom occurred because of "wealth creation technology". Now I am not going to argue with the Fed, especially given that "wealth creation technology" is shorthand for lenders ignoring historical safe lending practices. There is no question that this has been done, and the Fed could have lowered interest rates to zero and not produced the housing boom we have seen if it had not been for "wealth creation technology".

I do disagree with the name chosen, because any time you lend on negative amortization you create wealth for the borrower only while the underlying market is accelerating. Perhaps the Fed was thinking about the brokers and loan officers, who most definitely generate upfront wealth for themselves when writing these loans. If so, I could wish that the nice folks who wrote this fine paper had consulted with the OCC, because the OCC has been firmly insisting (even while all this "wealth creation technology" was proliferating) that the defining characteristic of predatory lending is the pattern or practice of making home loans that the borrower clearly cannot repay without selling the home.

Up until I had read the Chicago Fed paper, I had thought that even the Fed agreed that predatory lending could not be designated a "wealth creation technology". Granted, it is profitable for the lenders, brokers and realtors, which is why it is a problem. The loan terms, however, not only cause the borrower to lose the home, but if done in great enough numbers in a locality, cause property values in that locality to fall. Predatory lending destroys wealth over a few years instead of creating it.

Indeed, the risks of "wealth creation technology" were of enough concern to the agencies to cause them to release a proposed interagency guidance in December, 2005 (which had been preceded by guidances related to high loan to value equity loans). It was more than controversial, because as banks pointed out, non-regulated lenders were going to offer these terms anyway. However, (see the previous link), some of the commenters were more than disingenuous in protesting the terms in the guidance that would have imposed a requirement to assess life-of-loan repayment ability, implicit recourse for sold portfolios, and a requirement that securitizers independently assess compliance. Interestingly, the Fed banks' comments were withheld from the public, but I suspect they had something to do with the risks of closing the barn door too late. It's not hard to guess that an awful lot of borrowers who had gotten these "wealth creating" loans previously would have been unable to refinance out of them into more traditional loans under the proposed guidelines, and this would have prevented some of these borrowers from consolidating their position.

Now there are times when home loans written with negative amortization are clearly not predatory lending, and that is when the borrower could afford to repay the loan if it had been written as a standard fixed amortization. In other words, if the borrower did not need the lower payments provided by the negative amortization or non-amortizing terms of the loan in order to qualify for the loan, the borrower is not going to be forced to sell the house to repay the loan. In these few cases, the borrower truly is taking out such a loan in order to invest his or her assets elsewhere at a profit. These cases are always under 5% of borrowers, however.

Thus, it is difficult when looking at the map of misery to believe that "wealth creation technology" resulted in areas in which 20% or 30% of borrowers were getting these "wealth creating" loans, and it is not hard to find a correlation with areas now seeing a rather sudden drop in prices. As soon as rapid appreciation stopped, a rapid decline was in the cards. Nor have we even begun to see the worst that this "wealth creation technology" will generate, because people are still refinancing their "wealth creation technology" loans at an incredible clip.

What's really cute about recent cash-out refis is that most of them have been done into a loan with a higher base interest rate, which is another hallmark of predatory lending. Normally predatory loans go through a few refis until the borrower has exhausted all equity in the home and is forced to sell, because as the borrower gets more and more in the hole, the borrower ends up more and more at the mercy of predatory lenders. Thus this "wealth creation technology" thing appears to be the Chicago Fed's new name for predatory lending. You can call it Little Green Footballs if you want, but it is still proven to destroy wealth and not create wealth.

Now I realize that everyone not afflicted with a terminal case of BDS has gotten sick of the relentless negativity of the press regarding the economy. I am sick of it as well. I concede without any reservation that if Bush figured out a way to make gold coins drop from the ceilings of American homes every time a toilet was flushed, the NY Times would run a series of articles discussing the Bush administration's diabolical plan to attack American citizens with heavy metal weapons in their own homes, and the editorial pages of the nation's newspapers would be filled with outraged calls for Bush's impeachment.

Nonetheless, logic requires skeptical readers to realize that not every concern published in the NY Times is purely political. Indeed, the degree of the reality of this risk can be measured by the fact that the editorial pages of the newspapers aren't filled with outraged calls for Bush's impeachment. The big boys are too scared to spin this one, because their own wealth is threatened. This risk is real, and if you are in a marginal position, you should try to reduce your risks while you still can.

It's not at all clear that increases in the value of housing represent "wealth creation" from the standpoint of the economy as a whole...rather, they are a delayed-action transfer of wealth from those who bought property before the prices went up to those who must buy it subsequent to the rise. There's an exception to this to the extent that the buyers are non-US individuals or entities, but that's probably a small part of the overall picture.
Afternoon, Mama. Just sitting here waiting for the Fed. Yahoo. It's a minor point, but Isn't the effect of these loans a wealth transfer, not a wealth destruction? It's arguable, but it somehow seems to me to be a zero sum game. Borrower pays fees/interest, lender+broker receive fees/interest.
Good points, both of you. I'll try to expand later.

In a rational market, the transfers are as you describe, although the wealth transfer can also be from seller to buyer (and frequently enough is). In an irrational market (one with obscured but strong underlying realities), the result is that money is made only through transfers, and not through the underlying asset. This destroys the free market, and that is what predatory lending does - it destroys the ability of the borrower to realize gain from the property. At somewhere between 5 - 10% of predatory loans in a community, the imbalance becomes a common imbalance that destroys the ability of those who are not subject to predatory lending to realize gain from their property. Thus, for a few parties to gain a little wealth, many more parties must lose wealth.

This particular outbreak is far more damaging than the normal types of predatory lending.
Hi Mama; This would be an easier discussion over the phone, as I don't type(or spell) very well, But I have a slightly different take. I agree with the concept that some unsophisticated people are taking out loans they don't understand, causing great distress. The real problem is not the cause of the lenders. It's the consumption patterns of the borrowers. People are just spending more money than they can afford. A loan is a loan, interest is interest, Neg Am or whatever you want to call it. People want a bigger house than they can afford. Or they cash out refi and blow it on a vacation. Might as well close the casinos because some people have a gambling problem.
Yes, and I do need to explicate this further.

I am skeptical myself of all these sob stories I read in the press about engineers who suddenly, magically find themselves in a loan they had no idea would ever adjust, much less was negatively amortizing, especially when I know darn well they were getting four different payment choices each month and consistently making the lowest! Some of this is nonsense - but not all.

I think you way underestimate the surprising innumeracy of a number of people with degrees and professional jobs. Many of these people have somehow been acculturated to look only at monthly payments. I have worked with people who asked for help and who really did not understand the effect of continuously refinancing car loans and credit card debt into a home loan. But others - there's nothing anyone can do to help them. They will spend every last penny until no one will give them another.

However, even presuming that 70% of the borrowers were at least very willing participants in the mass delusion that housing values could escalate far beyond wages indefinitely, we are still left with the big public policy problem. When hopeful greed is allowed to get so out of control, the prudent investors end up getting whacked also, and so do the prudent lenders.

A lot of banks fought this tide as long as they could, until their ethics were putting them out of business. And a homebuyer who put down 10% and got a fixed mortgage but bought in 2004 or 2005 in some of these areas now is going to find him- or herself upside down in quite a few areas, with all the attendant risks.

I believe in free markets, and one of the reasons I do is because in the long run, letting the reckless or those with bad judgement transfer their assets to those who can handle them better produces more prosperity overall. But this is a reversal of that reality. It's more likely to be the cunningly reckless who walk away having made money or having not lost much, and more likely to be the prudent who end up in trouble for a decade.

Free markets work better because individuals have many choices. Many choices without full knowledge is not really a free market, though. That's why we have the SEC.

What chance do you think a prudent person has of understanding the working of mortgage securitizations and how all this risk was moved around and hidden? Wouldn't common sense at some point tell a prudent person that somehow when the loan officer said that real estate never went down they must be right, because otherwise everybody wouldn't be offering these loans?

And on the market side, a bubble like this can end up robbing individual banks and lenders of some of their choices. It is hard to make the case to borrower X that lender Y is not really giving them a good deal on a loan payment that's 40% lower than what you're offering them. What I saw was that many banks in secluded areas were able to hold out all the way down the line, until Countrywide started running those "Big Mo" ads. The same type of lenders in more urban areas were forced to go with the tide a lot earlier. Bankers are forced to deal with market reality just like any other business.

This was a collective failure that resulted in a lot of people being pressured out of using their best judgement.

Do you really think that "wealth creation technology" describes the last 3 years?
Hi Mama. I think you've hit the nail on the head. I was talking to a friend tonight and gave him the casino example. He pointed out that just because I understand how a loan works ( I=P*R*T, regardless of any bells or whistles), it's beyond most peoples ability. Combine that with humans unlimited wants and limited resources (Econ 101) you get the mess we're about to see.
I really enjoy reading your blog. Perhaps one day I could get your email address as it would be nice to have a dialogue from time to time without the whole world (or around 200 people per day) looking in.
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