Other relevant, and good questions might be: Has the government implemented any long-term solutions? and.. Why can't we draw from prior experiences and adopt those solutions?
How come the economy looks just as bad, if not worse than a few months ago?
What the government has done so far is just help the financial sector in hopes that they'll continue ordinary business operations. Yet, they're being somewhat short-sighted and not looking at the source or origin of the issue. Bottom line, the economy is getting worse because the real estate sector is getting worse and people are not able to make their monthly payments.
Has the government implemented any long-term solutions?
No, the government hasn't really addressed the root of the problem; it has only responded by bailing out companies where the risk of failure has been greatest (ie AIG, Fannie/Freddie, Citigroup etc). None of these actions are solutions for the long-term. Put another way, they are merely bandages applied to a severe wound.
Why can't we draw from prior experiences and adopt those solutions?
Everybody compares this crisis to the Great Depression. First off, this comparison is somewhat warranted because of some similarities such as the stock market crash, large loss of consumer confidence, financial sector issues and high unemployment rate, but we shouldn't get carried away just yet. The extent of the issues I listed are not as severe as in the Great Depression and we now have policies and reforms specifically implemented during the Great Depression that have largely prevented the scenario from playing out the same way - ie Federal Deposit Insurance Corporation ("FDIC").
So with that in mind, why can't the government use prior experience, or more specifically, the Great Depression itself, to solve the current financial crisis? Well, the answer to this question is two-fold; First, Ben Bernanke is an expert on the Great Depression, and he has used his knowledge and expertise on that subject to his advantage. While this is certainly not a consensus, economists have generally attributed the length and severity of the Great Depression to the failure of the banks and the lack of money or liquidity in the economy. Ben Bernanke and the Treasury have done all they can in these areas; they have saved the banks and they have pumped a lot of money into the economy. So why hasn't it worked? Well, it may stop us from going into a depression so in that sense it will serve its purpose. But, essentially, the facts and circumstances are different this time.
Secondly, economics is an imperfect science, or what some may call a soft-science. What I mean by this is that you can't run experiments of countries and just throw in different factors (policies) to determine the net effect on the economy. The only data economists have is empirical, or from observation of past events. This is a problem, because not only are the facts and circumstances different, but our country has also only gone through 1 or 2 crises that are mildly comparable. The first was the Panic of 1893 which we don't have much data on, but our economy was a lot different so the data might be moot anyway. The second is the Great Depression. However, the issue with the Great Depression is not only that the facts are different, but that we do not really understand or know how we got out of that. There's a myth that people know for sure that Keynesian economics or large government spending brought us out of the that crisis. Others say the war and the large spending and employment during that period helped our economy recover. It may also be that the crisis was solved by time itself, but we will never know.
So we can't draw much out of the Great Depression because even if it is comparable, it is only one instance that we do not really grasp fully. (if you have one data point in statistics you know how unreliable that can be)
What is the solution?
I came upon the writings of professor Stephen Finglewsi, an NYU finance professor and his proposed solution to the financial crisis. His is the first reading I've found that I completely believe in because it makes economic sense and is very intuitive to understand; There's a clear goal and practical approach to solve the crisis.
- From an Approach to a Plan: The Key is Fairness (Full paper if you're willing to read it)
So in his paper he provides a great analogy that I briefly referenced in my earlier post to describe the situation we have. Essentially, the financial sector troubles can be compared to what insurance companies experience with natural disasters.
So, let's say an insurance company offers insurance against hurricanes hitting homes. If hurricanes were to hit all the homes that the company provided insurance to, the company would have huge losses as it would use all its money (cash reserves) to cover the insurance policies . However, if everybody were to claim their insurance at the same time, the insurance company might not have enough cash to pay everybody so it goes into bankruptcy. At the same time, even if it were able to pay off all its claims, it would have problems running its business as it now has no money. It might have to lay off employees and it would need to raise more money to continue to issue new insurance contracts.
The same principle applies to the financial sector. Basically, they invested in the mortgages through securities and now have to bear the losses. For some companies, the losses were too much so they went into bankruptcy (see Lehman Brothers). Either that or they were bought out by another company or bailed out by the government (see AIG, Citigroup, Merrill Lynch, etc.)
The ones that could bear the losses, were crippled financially and do not have enough money to continue ordinary business. Also, they're scared that the companies they lend money to will go into bankruptcy as well so that limits business as well.
Alrite, so let's go onto what he proposes. (Sorry for the technical verbiage. It would be hard to describe in more simplistic terms)
Figlewski's plan:
The plan focuses on disconnecting the real estate sector from the financial sector: "When an electrical device catches fire, the first thing to do is to disconnect the power. The financial system is connected to the real estate sector by mortgage loans, and it is being severely damaged by the uncertainty over how many of those loans will default and how much the lenders will lose when defaults occur."
To accomplish this overarching goal he has several proposals for the Federal government to "step between the homeowner and the mortgage lender to remove the risk from the mortgage payments": (read his paper if you want to know more of the details)
- "Government would eliminate risk of default and prepayment by guaranteeing all mortgage payments to be made in full and as scheduled."
- The main thing we need to do is to continue the mortgage payments - whether in full or at least a significant portion of it but that's all in the details.
- Why? Because these payments are crucial for the financial sector. The ultimate investors are financial institutions and because they're losing a lot of money from these investments so they cannot perform their functions as financial intermediaries.
- We cannot re-structure or change the investment terms to make the payments less because they are very complex and have a lot of moving parts.
- The main thing we need to do is to continue the mortgage payments - whether in full or at least a significant portion of it but that's all in the details.
- "Government would work with homeowners that are at risk of default to reschedule and reorganize loan size and payments. The objective is to keep as many families in homes as possible and to avoid the costly process of foreclosure, evictions and fire sales of repossessed properties."
- "The standard mortgage has a "level pay" structure, in which the monthly payment of interest and principal is constant over the life of the loan. For example, a 30 year conventional mortgage with an interest rate of 7% calls for a monthly payment of $1330."
- "But this is a little strange. No one renting a house or an apartment would expect to pay the same rent every month for the next 30 years. Simply allowing the monthly mortgage payment to grow in the future would make it possible to lower it substantially right now. We can restructure the payment schedule and still satisfy the principle that "A deal's a deal." As long as the loan is fully paid off over its lifetime and the agreed interest rate is always paid on the outstanding principal balance, the government intermediary would be receiving the same economic value from the borrower over time that it is paying to the lender."
- "For example, rescheduling the monthly payment in the first year to be just equal to the interest on the loan, but to grow at a rate of 1.3% a year thereafter, would reduce the payment on the 7% 30-year loan by $163, to $1167 in the first year. This simple change in the pattern of mortgage payments would represent no real cost to the taxpayers at all. But it could make it easier for many homeowners to meet their mortgage obligations."
- The government could go even further and make mortgage payments even lower with higher growth rates. "For example, with a growth rate of 3% or 5% a year, the first 5 year's payments go down to $974 or $769 per month, respectively. These schedules still represent fair exchanges, in that there is no reduction of principal or interest involved. However, because the government would continue to pay $1330 a month to the lender, the homeowner would be gradually building up a debt in the early years, which would be paid off over time."
- If the homeowner cannot meet the above mentioned restructured mortgage payments, the government could convert a house to a rental unit in the interim, allowing homeowners to stay in their homes until they are financially viable.
- This would lower mortgage payments to rental payments and would give the government temporary ownership of the house.
- So the government would pay the difference between the scheduled mortgage payments and the rental payments to satisfy the ultimate investors who are dependent on those cash flows.
- There is also the issue of "upside-down" or "underwater" homeowners whereby the current market value of the house is less than the outstanding mortgage loan they have. For instance, if you took out a loan for $250,000 in 2006 for your house that was worth $300,000 at the time: but now, the house is only worth $200,000, so you have an incentive to just default because even if you sell the house, you'll only get $200,000 and you'll still owe more money.
- This is more complicated because we do not know how each person will act, but presumably, homeowners bought a house because they liked it in the first place so they would continue to make payments if they could.
- Also, there's the cost of moving out of the house and to find another place to live
- Finally, a person's credit rating goes down the tubes if they default on a home.
Fairness: Is it fair to bailout homeowners that bought houses they could not afford and payments they could not meet? A lot of people feel the bailout of the banks was not fair, so are they willing to go along with this plan? If the government is changing the terms of the contracts, how is that fair for other homeowners?
Well, Figlewski's plan makes the government bear the immediate losses, and does not lower the total overall payment so in that sense it is fair. Plus, it would be beneficial overall to go through with this because everybody would be better off in the end.
As Figlewski's mentioned, the purview of his plan is not all encompassing - so it is not a panacea - but it ultimately stops the source of the problem and prevents our situation from getting significantly worse than it already is.
What will happen if we implement this plan? What other issues exist?
The US economy will continue to have problems after we implement this plan mainly because of US consumers and exports. Businesses need people to buy their products and services to make money. People will spend a lot less because of the economic crisis so that will keep GDP down for a while.
- The unemployment rate is extremely high and will continue to rise. The unemployed will definitely cut back significantly and only stick to necessities. This is apparent.
- Unfortunately, the problem is magnified by the real estate and stock market crash. Economists have studied how price drops in both of these have decreased spending in the past. They measure this by a statistic called the Marginal Propensity to Consume (MPC).
- A MPC of 0.50 means, for every dollar drop in price, consumers will spend 50 cents less overall.
- An assistant NYU finance professor Stijn Van Nieuwebrugh shows the MPC for real estate is between 0.05 and 0.15 while the MPC for stocks is between 0.02 and 0.04.
These numbers may not seem that large, but given the crash that has occured, they will have a sizable effect on the overall economy. (read his article here) - Exports will also decrease because the dollar is strong right now, so for foreigners it costs them more now to buy goods from US companies.
- Sean
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