The Oser View

Of Spirits, both Animal and Human

  Many long-time readers have met my wife Patsy.  She is woman of strong character, great generosity, and an impeccable moral sense, but Economics is not her forte. Patsy recently accompanied me to a conference hosted by the Federal Reserve Bank of Atlanta and held on one of the Georgia Sea Islands.  One morning over breakfast, I outlined the classical theory that economic decision-making is entirely rational.  Patsy burst out laughing.

Patsy’s spontaneous reaction was spot on.  There is very little that’s rational about economic decision-making, or any other kind of decision-making for that matter.  In his new book, Human: The Science Behind What Makes Us Unique, cognitive neuroscientist Michael S. Gazzaniga describes patients with injuries to a part of the brain that rendered them unemotional.  One patient, for instance, “tested normally in intellectual ability, social sensitivity, and moral sense, and could devise appropriate solutions and foresee consequences to hypothetical problems, but he could never make a decision.”  Gazzaniga’s conclusion from this study and much additional research is that “pure reason was not enough to make a decision.  Reason made the list of options, but emotion made the choice….Even though we humans like to think of ourselves as being able to make non-emotional decisions, emotions play a part in all decisions.” (pp. 72-73)

Like Patsy and Dr Gazzaniga, we all know this.  We know that even our most basic economic decisions about food, shelter and clothing—the things we need to stay alive—are heavily influenced by non-rational forces. Otherwise, who would ever wear high heels?  Decisions about finance and business are no different.  “Jack Welch’s phrase ‘straight from the gut’ sums it up: decisions that matter for investment are intuitive rather than analytical.” (p.144)

The authors of this assertion are George A. Akerlof and Robert J. Shiller.  Akerlof is a Professor of Economics at the University of California, Berkeley.  He won the Nobel Prize for Economics in 2001 and is married to Janet Yellen, the former President of the Federal Reserve Bank of San Francisco. Shiller is Professor of Economics at Yale and co-creator of the influential Case-Shiller Home Price Index.  Earlier this year they published Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.  The book’s premise is that the current economic crisis “was caused precisely by our changing confidence, temptations, envy, resentment, and illusions—and especially by changing stories about the economy.” (p. 4)  The authors call these emotional forces “animal spirits” following John Maynard Keynes, the famous British economist who coined the term in the 1930s.  Keynes believed that animal spirits, or “the spontaneous urge to action,” are the essential motivation behind business decisions.  But while Keynes’s economic prescriptions form the heart of the global financial rescue plan, and his description of how capitalist economies function is more or less gospel, his conclusions about how decisions are made have been largely discarded.

Although purportedly written for a general audience, Shiller and Akerlof are not really focused on lay readers.  Their true target is academic economists.  The book is filled with what can only be called blatant rebukes to the profession.  Here is just a sampling:

“Natural rate theory (the idea that there is a sustainable level of unemployment that keeps inflation in check) is now economists’ conventional wisdom.  It is accepted by the vast majority of economists—but we do not believe it to be true.  And it has also been the justification for economic policy of great foolishness.”  (p 107)

“Over the years economists have tried to give a convincing explanation for aggregate stock price movements in terms of economic fundamentals.  But no one has ever succeeded.” (p.131)

“The theories economists typically put forth about how the economy works are too simplistic.”  (p.146)

“The real problem, as we have repeatedly seen in these pages, is the conventional wisdom that underlies so much of current economic theory.” (p.167)

I could go on, but you get the point. 

So why do academic economists refuse to take animal sprits into account?  Why do “they fail to consider the most important dynamics underlying economic crises”? (p. 167) Shiller and Akerlof get part of the answer to these questions, but they too are part of the academy and they cannot or will not follow their conclusions to the source. 

The part they get is that economists have insisted on a theory based on rational behavior because it can be quantified and modeled.  “In their (that is, economists’) attempts to clean up macroeconomics and make it more scientific, the standard macroeconomists have imposed research structures and discipline by focusing on how the economy would behave if people had only economic motives and if they were also fully rational.” (p. 168)   Dear reader, I will make you a deal.  I know there are a lot of quotations in this commentary, but I promise not to include any more if you re-read this one slowly and carefully.

Good. Now, what Shiller and Akerlof don’t get is why economists wanted to “clean up macroeconomics and make it “more scientific.”  For the answer we have to go back to 1957.  In that year, the Soviet Union successfully launched Sputnik, the first artificial satellite.  It was the height of the Cold War, and America was stunned.  The Federal Government responded in the best American tradition: It threw massive amounts of money at universities for mathematical and scientific research so that we would not lose the Space Race.  Suddenly, brand new physics and chemistry buildings sprang up on campuses across the country.  Professors got grants for all the equipment and graduate students they wanted. The liberal arts had to make do with the dowdy old buildings the scientists abandoned.   The message was obvious.  Science equals money, power, and prestige.  Economists realized that if their field became a science, a Social Science, they could cash in too. 

There were two problems with this change of direction.  Since the discovery of relativity and quantum mechanics in the first quarter of the 20th century, the advances in the hard sciences have required increasingly more difficult and abstruse mathematics.  The math has made it all but impossible for non-scientists to follow new developments, which is why so many books and articles on physics and biology for laymen are published every year.  Scientists want their discoveries understood by the widest possible audience.  Altruism and a desire for recognition undoubtedly play a role in this spate of publications, but scientists know that without public support, their funding could be threatened.  An informed public is clearly in their interest.  Economists faced exactly the opposite situation.  The father of economics, Adam Smith, did not include any calculations or statistics in his 1776 masterpiece, The Wealth of Nations.  Things didn’t change much in the next two hundred years.  Economics was a qualitative discipline that required no special mathematical knowledge.  It was more or less accessible to any reasonably well educated person.  To become a “real” science, Economics (with a capital E) had to become less accessible and more quantitative.

That led to the second problem.  At some level, economists knew just as well as everyone else that economic decisions aren’t rational.  But you can’t be a scientist unless you can make mathematical models, and irrationality is extremely hard to model.  So economists made models using assumptions of rational behavior in hopes that they would be close enough to reality to be useful. 

But they aren’t.  Economists have been no better at predicting the economic future than anyone else.  Oh sure, a few predicted the 1987 stock market crash, and a few predicted the long boom of the 1990s, and a few predicted the dot-com bubble, and a few predicted the spectacular rise in home values, and a few predicted the housing debacle that followed.  But nobody predicted all or even most of it.  And economists aren’t even very good about predicting the past; the causes of the Great Depression remain a subject of debate. 

It may seem that I am specifically attacking the economics profession for short-sightedness, greed, or vanity.  Not really.  I have singled out economists only as an example.  The heart of the matter is categorization.  The 20th Century was all about putting things into categories, creating specialties, and making experts.  Economics, considered as specific academic discipline is as artificial as Sputnik, and so are chemistry, Russian literature, and playing the clarinet.  Perhaps no one person can be proficient enough to earn PhDs in all these fields, but that simply speaks to our limitations as human beings.  The fields themselves are all parts of the human and universal condition.  They are not inherently discrete, and many people have a good understanding of and keen interest in them all and more besides.  Twenty-first Century communications, globalization, and the interactive Internet community are rapidly breaking down the barriers between disciplines that were so painstakingly erected in the previous century.  In this century “doing the math” will only be a part, and small part of understanding economics.  A full understanding will require “doing” and blending the cognitive science, the psychology, the sociology, the history, the linguistics and maybe even clarinet playing.  Welcome to the Fun House.   

The Origins of the Crash

The US economy is now a year and a half into its most distressing crisis since, depending on point of view, the Great Inflation of the 1970s or the Great Depression of the 1930s.  We have enough history to make a reasonable assessment of how we got into trouble and where we stand now.  First of all, it’s essential to understand and accept the basic fact that the crisis is Nobody’s Fault.  No person, group, business, or government desired or worked to achieve it.  But all sectors of society are complicit.  This crisis was not caused by some alien shock, some meteor crashing into the Yucatan.  Somehow our own wishes, philosophies, drives, and achievements unintentionally conspired to bring us down.  With that background, it should be clear that a thorough analysis of the problem cannot be encompassed in one commentary.  My hope is that interested readers will remember that the electronic channel is two-way and tell me what I have left out or where I have gone wrong.    

The crisis is international, but it began in the United States.  Three powerful currents in American life, previously separate, were brought together by one catalytic event, which, within a very few years, led to catastrophe.  The first current is social.  It is the belief that nearly every American household should own a home; in short, the American Dream.  Initially, ownership meant free and clear possession.  The Dream was realized only when the mortgage was paid off.  Following World War II, the Dream subtly changed.  It could be realized merely by living in a home with a mortgage instead of renting a home from a landlord.  Later still, the Dream added a further dimension, that home ownership would generate wealth through ever-increasing appreciation of the home’s price.  By the early part of this decade, the belief that home ownership was an unadulterated Good Thing had become firmly embedded in the American ethos.  More than two-thirds of American households, an unprecedented percentage, were homeowners.  But mortgage debt had risen to an all-time high while home equity had fallen to an all-time low.  

The second current is the evolution of the mortgage business.  The demise of the Savings & Loan industry in the early 1980s left a void in the business of mortgage origination that came to be filled by mortgage brokers, who had no direct stake in the mortgages.  The mortgage brokerage model, in which all mortgages are sold as soon as they are made, is purely transactional.  It is low-cost and derives all its income from up-front fees instead of interest paid over many years.  The creditworthiness of the borrower and the value of the property are not intrinsic concerns.  They matter only to the extent they interfere with the sale of the mortgage.  Moreover, because mortgage brokers are not depositaries, they are very lightly regulated.  In the run up to the crisis, no one was looking over their shoulders.  

The third current is financial innovation.  The growing volume of mortgages made to borrowers with less than sterling credit or on homes whose value was exaggerated was enabled by securitization.  Large banks and investment firms bought the mortgages, packaged them, sliced them into classes with varying degrees of support against default, and sold them to investors.  Later, these pools of securitized mortgages were recombined, re-tranched, and re-sold until even the most sophisticated investors were hard put to understand what they owned.  (This begs the question of why “sophisticated” investors would buy securities they did not understand.  There are two fundamental answers, each of which is a commentary in itself.  First, they were over-reliant on the major credit rating agencies—Moody’s, Standard & Poor’s, and Fitch.  Second, the investors were simply unable to imagine and hence did not model, a deep, prolonged, nationwide plunge in home values.)   

The catalyst that brought the three currents together was the deflation scare of the early 2000’s.  The inflation rate fell sharply following the 2001 recession.  The Federal Reserve Board, and especially its Chairman, Alan Greenspan, had been deeply disturbed by Japan’s “Lost Decade” of the 1990s, when that country was wracked by a series of recessions and a seemingly unstoppable deflation.  Now, deflation is not supposed to happen in modern economies whose governments can print money to virtually any extent.  Nevertheless, the Consumer Price Index early in 2003 pointed to a real and dangerous possibility of deflation in the United States.  (These statistics were later revised to show that the danger was not nearly as great as perceived at the time.)  In response the Fed kept the overnight fed funds rate at 1.00% from June 2003 to June 2004.  Even when the Fed began to raise rates, it did so slowly, in 25 basis point increments every six weeks. 

This period of low short-term interest rates opened the door for adjustable rate mortgages with extremely low introductory or “teaser” rates, as well as other exotic mortgage products.  Would-be homebuyers who could not have afforded mortgages at more normal rates could now move into homes with small monthly payments and minimal or no down payments.  Public policy, while not directly encouraging the spread of subprime mortgages, certainly did not discourage it, and regulation was absent.  Cheap money and easy terms also led existing homeowners to refinance multiple times, in effect turning their homes into lines of credit.  The appetite of investment banks and their customers for more and more product to securitize made it all possible by providing the cash.

Still, and this is a key point, the volume of subprime mortgages was not nearly enough to cause a major crisis.  Only about $1.2 trillion of true subprime mortgages were originated.  They have not all defaulted and the underlying properties of those that have are not all worthless.  Delinquency rates of 40% or 50% of subprime mortgages initiated in 2004-07 would, by itself, be a serious social problem, but, to repeat, it could not possibly have touched off a global financial meltdown.

It’s a mistake to speak of a single crisis.  We have experienced a series of interlocking and self-reinforcing crises.  The first crisis began in the summer of 2007.  As subprime mortgage delinquencies rose, investors began to question the value of the securitized instruments that held the mortgages.  But because the instruments had become so complex and because it had become so hard to identify exactly who owned what, all non-government guaranteed securitized assets fell under suspicion.  As a result, the securities’ market value dropped precipitously.  Even this would not have been so terrible if the securitized assets were simply held in investors’ portfolios. 

But—or rather, BUT—they weren’t just sitting in investors’ portfolios.  They had been used as collateral for borrowing, usually in the form of repurchase agreements or “repo.”  And not just once, but over and over again; that is, an entity that held securitized assets as collateral for a loan it made used that same collateral to borrow from some other entity  and so on.  In all, about $10 trillion of repo was outstanding in the summer of 2007.  In repo transactions, borrowers have to post collateral in excess of the amount they wish to borrow.  The difference is called a “haircut.”  The more unsecure the lender feels about the borrower or the collateral, the bigger the haircut.  The loss of confidence in securitized non-government-guaranteed loans meant that haircuts suddenly jumped from 2-3% to 30%, 40%, or even more.  Many who borrowed on short-term repo did not own and did not have the resources to buy this much extra collateral.  The resulting shakeout led to the demise of Bear Stearns, several high-profile hedge funds, and numerous Special Investment Vehicles (SIVs) that large banks held off their balance sheets.  This was the first crisis.

Note that this was a crisis of confidence within the financial system itself.  There were losers outside the system, such as, famously, the town of Narvik in northern Norway that put a major portion of its funds in subprime pools.  At this stage, most people felt unaffected by the crisis, and the mantra among community banks was, “We don’t have to worry; we didn’t make those kinds of loans.”  But, once lost, confidence is not easily regained.  All sorts of loans that had previously been sold and securitized—jumbo mortgages, car loans, credit card receivables, student loans—no longer had a market.  And if they couldn’t be sold, they couldn’t be made because banks, in contrast to global investors, did not have the liquidity to hold them on their balance sheets.  Put very simply, banks were unable to take up the slack left by the sudden and nearly absolute shutdown of the securitization machine.

By mid-2008, a vicious cycle was emerging.  New private securitization had stopped and the market for older, outstanding securitized loan pools was moribund.  Banks and other investors with large inventories of these securities were forced to write them down to their extremely depressed market values.  The result was a drain on capital, in some cases—Fannie Mae, Freddie Mac, Lehman Brothers, Washington Mutual, and Wachovia—to unsustainably low levels.  These American institutions and others in similar circumstances in Western Europe were effectively insolvent.  Because they were deemed too big, too complicated, or too important to fail, various government re-capitalization and merger programs were implemented.  This was the second crisis, and it only served to intensify the first. 

Not the least of the consequences was that the public’s confidence in the financial sector was severally shaken.  The lack of confidence extended to stock markets, which by the end of 2008 had lost more than $30 trillion worldwide from their peak in October 2007, a massive destruction of wealth.  If that weren’t bad enough, more than $3 trillion was sliced from the equity of Americans’ homes.  The loss of equity meant that fewer people could afford to sell their homes and fewer could borrow against them.  With fewer sales, fewer new homes were built and fewer homes were remodeled.  As a result, the many industries dependent on housing, including construction, timber, appliances, and furniture to name just a few, began to falter taking their jobs with them.  Another vicious cycle developed in which falling home sales led to falling home prices and job losses, which in turn led to higher delinquencies and foreclosures and even more homes being dumped on the market at fire sale prices.  And, it wasn’t just housing.  Car loans could no longer be securitized, so fewer cars could be sold.  Student loans could not be securitized, so fewer students could afford to go to college.  Job losses are now feeding on themselves, destroying purchasing power, reducing sales, and creating more unemployment.  This is the third crisis. 

The question now is, will there be a fourth crisis.  The most likely candidate is a steep decline in the value of commercial real estate with corresponding losses in this sector.  So far CRE has held up surprisingly well, but the recent bankruptcy of General Growth Properties, a real estate investment trust that owns more than 150 major shopping centers throughout the country, is not a good omen.  Of even greater concern is, or should be, the effect of the crisis on the developing world.  Just as community banks were in denial in 2007, some developing countries refused to acknowledge the risk to themselves in 2008.  But recent drastic declines in their main source of revenue, exports to more developed countries, have alerted the developing world to its danger.   At risk are not only their emerging middle classes, but even those whose connection to international finance is the most tenuous, the poorest of the poor. 

On the other hand, the regulatory stress tests of the 19 largest US banks and similar tests in Europe may finally restore confidence in the banking sector.  A total capital gap of $75 billion, affecting about half the 19 banks, has been identified.  These banks have all expressed assurances that they will be able to meet the challenge, and the government has pledged to make up any shortfall.  The Obama administration was elected in the belief that it would actively intervene to restore economic health.  Government activism is not everyone’s political cup of tea, but so far the majority of the public supports it.  There is absolutely no reason to imagine that this administration and Congress, with its strong Democratic majority, will back off, particularly if evidence of success mounts. 

At best, we are far enough into the financial turmoil to suggest a coherent explanation of how it started and how it has developed to date.  It is unfortunate and not a little scary that we cannot be similarly confident about how and when it will end.  

Glimmers of a New Day

 

The last, cold, short winter days of 2008 have brought precious little comfort and cheer.  Almost two million people have fallen from the employment rolls this year, while the number of those too discouraged to actively seek work has grown by more than 800,000.  The average workweek for hourly workers dropped to 33.5 hours, the lowest since the Bureau of Labor Statistics began keeping records in 1964.  Hours worked and overtime hours dropped in nearly every industry during November, from mining to motor vehicles.  The worst part is that we are nowhere near an end.  The Society for Human Resource Management (SHRM) reported that significantly more servicing and manufacturing companies plan to reduce their workforces than to increase them.  Recruiting difficulty has dropped significantly, with only about 10% of companies having trouble finding workers.  So far, average wages have continued to increase, but less than 5% of the companies in the SHRM survey indicated that they are increasing compensation and benefits packages for new hires.  An outright decline in wages seems likely early next year.  Unemployment rarely peaks until economic expansion is well underway, so job losses will continue for many months to come and robust job growth could be years away.  In a sign of the times, the National Football League announced plans to lay off 10% of its staff.

The Mortgage Bankers Association (MBA) released their third quarter mortgage performance data on the same day as the November employment report, and their news was just as depressing.  The total mortgage delinquency rate of 6.99% was the highest on records that go back through several recessions to 1979.  The percentage of loans past due more than 90 days or in foreclosure hit 5.2%, up from 4.5% in the second quarter.  The subprime delinquency rate has now been above 20% for a full year.  Loan modification programs have not made much difference.  Comptroller of the Currency John Dugan announced this week that 53% of loans modified in the first quarter are now 30 days or more past due. 

My favorite economist, Chris Low of FTN Financial, has concisely summed up the current situation.  “Consumers have less money, are earning less money, can borrow less money and are worried about the future, which is always a good reason to cut back spending.”  He concludes, “This is a consumer recession, and history tells us consumer recessions are much, much worse than corporate recessions” like those in 1990 and 2001.  

Brighter days will eventually come.  I, for one, am not ready to completely abandon belief in the time-honored adage, “Never bet against the American consumer.”  A bit of good news—admittedly the only bit of good economic news lately—has been the rush of homeowners to apply to refinance their homes whenever mortgage rates head south.  Generally, when mortgage rates rise, refinance applications fall; when mortgage rates fall, refinance applications increase.  That’s common sense, but recently applications haven’t just increased, they have zoomed up instantly whenever rates drop. Two weeks ago, refinance applications more than doubled when mortgage rates fell from 6.50% to 5.50%.  What would happen if mortgage rates were 4.50% instead of 5.50%?

A more intriguing speculation is what our economy will look like when those brighter days come.  One thing is certain.  Just as capitalism was never the same after the New Deal, finance will never be the same after all of this year’s federal programs, which, by the way, need a good collective name of their own.  How about the No Deal, because the Federal Government will call the financial tune, leaving lenders considerably less room for maneuver. 

Take automobile financing for example.  And, take an old term that the business press has given a new connotation.  To “have balance sheet” means to have the ability to carry an asset.  An individual who withdraws $20,000 from a savings account to buy a car has balance sheet.  An individual who must borrow $20,000 to buy a car, doesn’t have balance sheet.  Of course, whenever a car is purchased or leased someone has to have balance sheet because the money has to come from somewhere.  A hundred years ago, when Henry Ford sold Model Ts in any color you wanted as long as it was black, almost all car buyers were individuals who had balance sheet.  Ford’s whole idea was to build a car that the average working family could afford.  As car prices rose after the World War II, banks, finance companies, and the automobile companies’ captive financing arms provided the balance sheet.  In truth, though, only the banks had real balance sheet; the others had to borrow money to finance the individual car buyers.  The car companies often issued a type of bond called asset-backed securities or ABS, which are securitized pools of car loans.  ABS are divided into classes, with the lower-rated classes absorbing losses and the protected higher-rated classes receiving lower yields.  This year, the automobile financing subsidiaries lost balance sheet as the market for their ABS evaporated.  A short-term government bailout isn’t going to solve that problem. 

What might induce the markets to start buying automobile ABS again is some type of government guarantee, not on the whole ABS structure, but perhaps on the bottom 10% or so.  Why would the government do this?  Because it will have a vital interest in the companies.  No matter the final terms of the bailout, the government will have taxpayer money at risk and management control through the “car czar”.  The car companies will be told, “You can make any sort of vehicles you like as long as they meet strict mandated fuel efficiency and emissions standards.”  The central premise that the car companies, and by extension manufacturers in general, can simply respond to customer demand will be permanently altered.  The government will make its mandate stick not only by legislation, but by the greater and more direct power of controlling the companies’ ability to finance themselves.

Mortgage finance will be changed too, but it starts from the opposite end of the spectrum.  Since late summer 2007, private mortgage securitization has been dead, and the longer something is dead, the more it tends to stay dead.  Today the only effective mortgage securitizers are the government-owned Ginnie Mae and the government-controlled Fannie Mae and Freddie Mac.  This is a makeshift situation that can’t last permanently; that is, the federal government can’t permanently guarantee all the mortgage debt outstanding in the entire country.  The quasi-public, quasi-private hybrid model of the old Fannie Mae and Freddie Mac can’t be resurrected, so something new will have to be invented.  My guess is that the new model for Fannie and Freddie will look something like the Federal Home Loan Bank System.  Members of the Fannie/Freddie “system” will be the financial institutions that make and sell mortgages.  These members will own the system, buying stock proportionately to their usage of services.  But even a revamped Fannie and Freddie will require some backstop government debt guarantee, which would allow the government significant control. 

The government is already showing its hand, as the following news article attests:  “Dec. 10 (Bloomberg) -- Fannie Mae and Freddie Mac, the mortgage-finance companies seized by the U.S. government, are considering waiving a requirement for new appraisals on refinanced loans, their regulator said.  ‘If they refinance someone, rather than doing a loan mod, do they need a new appraisal if they already have the credit?’  Federal Housing Finance Agency Director James Lockhart told reporters after a speech in Washington today.  ‘That’s an issue that’s being discussed.  They’re looking at it.’”

As any lender knows, you have to get a new appraisal on property you intend to refinance to determine if the property still has sufficient value.  Clearly, the abandonment of this fundamental underwriting practice is not something that the professional managers at Fannie and Freddie just happened to think up.  Their government masters are pushing it as a way to lower mortgage costs for existing mortgage holders.  This may or my not be good public policy, but it is certainly not prudent lending.  It shows how government may exercise its new power over lenders.

Similarly, the Treasury announced that, in conjunction with banking regulators, it will monitor how each bank is spending Troubled Assets Relief Program (TARP) funds received from the government.  The Senate unanimously passed a bill giving the TARP inspector general the authority to investigate any use of TARP funds he deems questionable.  These actions came in response to a call by the Government Accountability Office for formal internal controls to ensure that TARP funds are used in accordance with the government’s intent.

The government’s new power over the financial world can also be exercised indirectly.  Chicago’s Republic Windows & Doors factory was forced to shut down when Bank of America refused to extend additional credit.  Outraged workers refused to leave their factory and hoisted picket signs reading: “Bank of America: You Got Bailed Out.  We Got Sold Out.”  After a few days, Bank of America caved in, a provided $1.35 million to Republic in what is essentially a gift of the workers their severance and vacation pay. 

None of this is bad, it’s just different.  All large scale changes produce unintended consequences.  This is an iron law.  The changes currently being imposed on the financial system are enormous and necessary.  Without massive government intervention, it’s terrifying but true that the system would have collapsed.  A new system is evolving, whose first faint glimmers we are just beginning to discern.  

Fighting Fire with Fire

Former Federal Reserve Chairman Alan Greenspan recently told the House Committee on Oversight and Reform that “subprime mortgage originations were undeniably the original source of the crisis.”  In the Q&A that followed his testimony, Mr Greenspan was forced to admit to serious errors in monetary policy on his watch.  His conclusion about the cause of the present crisis is also wrong. The high default and foreclosure rates of subprime mortgages are not the cause but rather the first major symptoms of a crisis whose roots run deep into the bedrock of modern American culture.  Put in the simplest possible terms, we are suffering from too much debt.  There is too much debt at the individual level, at the corporate level, and at the governmental level.  And the scariest part is that the only solution anyone has come up with so far is…more debt.

Before the advent of nearly universal consumer credit, living within one’s means meant paying cash for everything.  Now it means being able to afford all your minimum monthly installment payments: your mortgage, your credit cards, your car note, and on and on.  The change in meaning happened gradually over many years.  Following World War II, consumer debt was a mere 6% of consumer assets; today it is 20%.  Similarly, total mortgage indebtedness as a percentage of home value has risen to more than 50% from less than 20%.  While there are still a few human dinosaurs who live debt-free, for the most part, the fear of debt passed away with the generation that lived through the Great Depression. 

Regardless of borrowers’ psychology, though, debt could not have proliferated as it has without its being securitized through financial engineering.  Debt securitization began in 1970 when the first Ginnie Mae mortgage pools were created and sold.  From the start, debt securitization served two beneficial social purposes.  It provided liquidity to lenders, allowing those who had the ability to make loans but not the capacity to hold them on their balance sheets to continue lending.  Second, it packaged debt in forms that met the needs of a wide range of investors.  The result was credit that was cheaper, more readily available, and more flexible for all concerned. 

The original securitized mortgage pools were simple affairs.  A large number of mortgages with similar terms and interest rates were gathered together, legally placed into a negotiable debt instrument, and sold in public markets.  An investor who owned 2% of a pool received 2% of the monthly principal and interest payments it generated.  Everything went smoothly until mortgage rates spiked to double digits in the 1980s, and prepayments of older 5% mortgages stopped dead.  The cash flows coming from securitized mortgage pools slowed to a trickle, which was not what most investors wanted or expected. 

American finance was up to the challenge.  Business schools were breeding a corps of sophisticated financial engineers, and Wall Street put them on the case.  Their solution was the Collateralized Mortgage Obligation (CMO).  CMOs are bonds that divide pooled mortgages into segments, called classes or tranches.  Each class has its own cash flow and risk/reward characteristics.  Money market funds can own short term CMO classes, banks can own medium-term classes, and life insurance companies can own long-term classes, all constructed from the same underlying mortgages.  But hidden within the math of CMOs were seeds that would eventually bear the toxic fruit of SIVS and squared and cubed CDOs that have so sorely wounded the global financial system.

To continue our story, Wall Street, by the middle of this decade, had moved beyond mere engineering.  It was now operating at the level of genetics.  Mortgages and other debt were combined and re-combined, tranched and re-tranched into ever more recondite structures.  The financial geneticists relied on the mathematical models they built from too recent and too benign consumer data.  The models “proved” that risk could be isolated in tranches for those aggressive investors willing and able to accept it.  For the rest, the credit rating agencies were well paid to certify most tranches AAA, the highest grade of credit quality. 

Meanwhile, unregulated mortgage brokers had discovered that Wall Street viewed debt merely as a commodity to be securitized, regardless of its quality.  Once all the right people had been put into the right kinds of loans, and those loans were securitized, the brokers simply went down market.  They put the wrong people into the wrong kinds of mortgages, which were securitized to the tune of $850 billion. They could not have done it, though, without willing borrowers.  The people who signed the wrong mortgages took on debt out of all proportion to their ability to repay it.  Some realized what they were doing and some were misled, but for all of them, debt was not something to fear.  It was the American way of life. Too much debt, by definition, means too little equity.  Without enough equity, it only took one small crack in the Tower of Debt to bring the whole thing tumbling down.  That one crack was subprime mortgages. 

The normal and natural reaction to a debt crisis is retrenchment.  Lenders tighten their standards, and borrowers do their best to be more frugal.  Unfortunately, in an economy fueled by consumer spending, we are too far gone for the normal and natural to work.  In fact, the normal and natural would turn this crisis into a full-scale disaster.  I strongly urge you to read Federal Reserve Chairman Ben Bernanke’s prepared testimony to the House Budget Committee on October 20.  It is available on the Fed’s website, http://www.federalreserve.gov/newsevents/testimony/bernanke20081020a.htm .  Mr Bernanke provides as cogent and insightful a summary of the financial crisis and current economic conditions as I have read anywhere.  But a continuing motif running through the testimony is the need for more lending, not more saving, to “promote the return of solid gains in economic activity and employment.”

Mr Bernanke chronicles the Fed’s efforts to revive lending among banks and borrowing by primary securities dealers.  He describes the many steps the Fed has taken to jump start the commercial paper market, on which major corporations depend for operating funds.  Next he turns to consumers and businesses, explaining what the government is doing to “restore trust in our financial system and allow the resumption of more-normal flows of credit to households and firms.”  He laments that the “increased difficulty in obtaining auto loans appears to have contributed to the decline in auto sales.”  He highlights “reduced credit availability from banks and other lenders” as a primary cause for the fall-off in business investment.  Finally, he concludes that “the time needed for economic recovery will depend greatly on the pace at which financial and credit markets return to more-normal functioning.” 

That’s a lot of mentions of credit and no mention of saving.  No one in or out of Government has said, “The solution is to save more and spend less.”  Indeed, there is little the Fed and the Treasury are more afraid of.  The Japanese call the 1990s, a period of recession punctuated with a few anemic attempts at recovery, “The Lost Decade.”  No amount of fiscal or monetary stimulus could get Japanese citizens to open up their wallets and spend.  Instead the Japanese built up one of the highest savings rates in the world to go along with an economy that hasn’t yet fully regained the position it held in the 1980s.   Thrift is, without a doubt, a personal virtue.  But America as a whole can’t be a creditor.  To uphold our own and the global economy, our job is to buy what the rest of the world makes.  And the rest of the world has to lend us the money to do it. 

They will have to lend us a lot.  Treasury debt issuance will rise to a record $550 billion in the fourth quarter, up from $530 billion in the third quarter, which was also a record.  The previous record, $244 billion, was set in the first quarter.  The economic consensus is that the Treasury’s budget deficit for the current fiscal year, which ends on July 31, will be $988 billion.  Estimates of total Treasury borrowing in calendar 2009 as high as $2 trillion and federal deficits of $1.5 trillion are being made, and taken, seriously.  And beyond the current shortfalls, we have the specter of unfunded Medicare and social security to look forward to. 

Yet, somehow, we’ll make it through and things will get better, especially with a new administration in Washington.  Probably we will save a little more and borrow enough to keep everything in motion.  But, like those who lived through the Great Depression, we will bear the scars of this experience with us for our lifetimes. 

Life Lessons

The weekly economic newsletter, "Comments on Credit," became famous in the late 1970’s when Salomon Brother’s Managing Director, Henry Kaufman, used it to spread the bearish analysis that earned him the nickname, "Dr Doom." Salomon was long ago acquired by CitiGroup, which continues to publish "Comments on Credit" as its flagship opinion-shaper, now under the authorship of Chief US Economist, Robert V. DiClemente. On Friday he wrote, "Given the systemic stresses, recession scenarios do not capture the potential for a more serious breach that could entail lasting changes in financial intermediation which flows through to reduced productivity and a slower rate of economic growth beyond the cyclical horizon."

English translation: "Oh shit!"

Yes, the economy is in bad shape and likely to get worse before it gets better. At this moment of confusion and apprehension, the most valuable contribution I can make is to distil what I have learned in almost thirty years of professional investing into three inter-related principles, my life’s lessons.

1. Nobody can ever consistently and accurately predict the financial markets. Those who know me will know how I persistently avoid making interest rate predictions or giving financial advice. I am profoundly uncomfortable even providing the annual rate forecast without which the Bank’s budget cannot be written. My reluctance is not based on a selfish desire to keep some deep knowledge secret or from an equally selfish fear of being proven wrong by events. The simple truth is that I don’t know what’s going to happen in the future.

And neither does anyone else. Our society has placed economists in the false position of having to predict the future in order to make large salaries and garner lucrative lecture fees. Economics is not prophecy; it is science in the same sense that History and Anthropology are sciences. It can illumine the past and help us understand the present. That’s a lot, but that’s all. It’s part of human nature to look to some expert for "The Answer." When we were children, Mom and Dad always had the answers, and somehow, we just can’t shake the belief that somebody, somewhere, KNOWS, but just isn’t telling. There may be universal truths in the hard sciences of physics and chemistry, but not in economics.

2. The financial markets are enormously more powerful than any human attempts to control them. I grew up in San Francisco, within sight of the Pacific Ocean, so maritime imagery is natural to me. I think of the markets like an ocean and market participants like sailors. We make our ships as seaworthy as possible. We study the ways of the sea and its lore. But we know that we do not control the ocean. We know it can rise up and overwhelm us anytime, with no warning and no regret. In recent years Federal Reserve chairmen and governors have taken to boasting that their wise policies were responsible for the low inflation and financial stability the country enjoyed for so long. This was pure hubris. The monetary policy of the Federal Reserve worked for precisely the same two reasons that the unique public/private amalgams that were Fannie Mae and Freddie Mac worked: It was in enough people’s interest and the fundamentals of the economy were sound.

Don’t believe me? Then ask yourself this: How else could a change of one quarter of one percent in the rate of interest banks charge each other for overnight loans maintain price stability and contain unemployment, the Fed’s statutory mandates? The Federal Reserve possesses a popgun that investors have, for many years, tacitly agreed to treat like a howitzer. To again quote Robert DiClemente: "It is especially frustrating that the most immediate avenues to improvement in the money market have defied policy action. If the Fed were raising the funds rate in this environment, officials could not have expected a more significant response across interest rate markets." In other words, when times are rough, fiddling with the fed funds rate is ineffectual. Indeed, one of the casualties of the present crisis could be the Fed’s ability to use the fed funds target rate as an effective tool of monetary policy.

This is not to say the Federal Reserve is not essential. The prudent use of the Fed’s reserves to increase or decrease the money supply is a vital function in maintaining our financial system’s integrity. But the Fed doesn’t control the system. In fact the Fed’s greatest triumph—breaking the back of the Great Inflation of the 1970s—was achieved not by manipulating the fed funds rate, but by explicitly setting the rate free to be determined by the not-very-tender mercies of the markets. In October 1979, Paul Volker announced that the Fed would target the money supply instead of the fed funds rate. The markets raged like a typhoon and the economy eventually fell into its worst post-World War II recession, but inflation was crushed. This is not a prescription for future action; it’s just some historic clarity on what a nation’s central bank can and cannot do.

3. Investing is a function of personality. The financial markets are startlingly democratic. They don’t care where, how, or even if, you were educated. They don’t care about race, gender, religion, sexual preference, or anything else. They only care about success, and there are many ways to achieve success. We see this most clearly in the stock market where technical analysis thrives on its arcane charts with bear flags and head shoulders formations despite the majority opinion that it’s all mumbo-jumbo. But in all markets, there are successful bulls and successful bears. There are investors who are successful because they are analytical, and investors who are successful because they are intuitive. Most people, of course, are a mixture, but while there is no surefire guarantee of success, there is a surefire guarantee of failure. An investor who is fundamentally analytical will fail if she tries to invest intuitively. An investor who is fundamentally intuitive will fail if he tries to invest analytically.

The notion, that the key to successful investing is embedded within the essential nature of the investor may sound simplistic or perhaps bizarre. In fact, it is nothing more than the application of the ancient Greek dictum, γνῶθι σεαυτόν, know thyself. The practical result should be a discipline that can be followed in good markets or bad. My discipline has been built up over many years. It ensures that when I buy a bond, I must have a good reason for it. The next day, I must have a good reason for holding the bond, and so on for each subsequent day. If not, I should try to sell it. Every trade must benefit the Bank, both on its own merits and in its contribution to the Bank’s entire balance sheet. I am honest in my dealings with brokers. If a trade is their idea, I may or may not do it, but if I do it, I’ll do it with them. I do the best I can every day and come back tomorrow and do it again. Tactics and even strategies change, but not my discipline. Discipline in investing is the antidote to fear. And fear, as FDR so astutely remarked, is exactly what we have to fear in difficult times like these.

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What all three principles have in common is humility and modesty in the face of a force far greater than any possessed by an individual or group. That force is the collective weight of all the opinions of all the investors around the world translated into actions in (relatively) free financial markets. This is not fatalism or a Zen-like acceptance of what is simply because it is. Rather, it is the acceptance, indeed the celebration, of the enormous collective power of human intelligence, emotion, and choice. Investing is a profoundly human activity; there is nothing "natural" or "organic" about it. It’s something human beings have chosen to do, and something we will keep on doing no matter what. And like every human activity, the more light and truth we bring to it, the better it will promote the ultimate goal of human happiness.

Confronting the Obvious

As I write on a quiet Sunday afternoon, momentous decisions about the future of mortgage giants, Fannie Mae and Freddie Mac are being considered in Washington. Treasury Secretary Paulson has announced a three-pronged plan to provide liquidity and capital (up to $15 billion according to "The Sunday Times") in concert with a more stringent regulatory framework for the two companies. In recent days, Mr Paulson, President Bush, Fed Chairman Bernanke, both major Presidential candidates, and many other members of Congress have advocated the critical necessity of ensuring Fannie and Freddie’s survival. On Friday, Mr Paulson stated, "Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission." The key words are "in their current form," and Mr Paulson repeated them today. An outright government takeover or some more indirect form of nationalization is, at least for now, off the table.

The impetus for Mr Paulson’s weekend duty is the huge slide in Fannie and Freddie’s share prices in an avalanche of selling. The media has had a field day with the story, tearing into what "The Wall Street Journal" calls "these financial beasts," 1 and gloating over the evaporation of "profits [that] enriched Fannie and Freddie shareholders over the years and bestowed significant wealth on the companies’ executives." 2  Most disturbing of all was an outburst, last Wednesday by former St Louis Federal Reserve Bank President William Poole. "Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer," Poole told Bloomberg News. The final downward spasm in Fannie and Freddie’s share prices was a panic response to Poole’s comments. By Friday, even Poole was singing a different tune. "Clearly they must be supported. They (the U.S. government) cannot allow that amount of assets ... to go into limbo. It would produce a worldwide financial crisis of unspeakable magnitude if they were allowed to default," Poole told Reuters in an interview.

"A worldwide financial crisis of unspeakable magnitude." That, to state the obvious, is serious. It’s also true. Here’s just one of the reasons:

"Fannie and Freddie are crucial to the smooth flow of everyday American life. They are the cement that holds the nation's housing markets together. The companies buy home loans from banks that issue them, repackage those loans as bonds, and either hold them as assets or sell them to the public. Roughly 70% of U.S. home mortgages pass through the hands of Fannie and Freddie. Together, they own or guarantee $5.2 trillion in mortgages. Without Fannie and Freddie, it could soon become all but impossible to buy or sell a home." 3

Here’s another reason, one which has received almost no media attention, but which Mr Paulson alluded to today. As of March 31, the 7,240 commercial banks in the United States held $11.5 trillion in total assets, of which $1.6 trillion were bonds. FDIC data doesn’t break out precisely how much of the total are either direct obligations of Fannie and Freddie or mortgage-backed securities they guarantee, but a safe estimate is about half or $800 billion. Total equity capital held by US banks was $1.16 trillion, so if Fannie and Freddie debt were suddenly worthless, there goes 70% of all the capital in the US banking system.

Total default is extreme, but even a much less drastic change in Fannie and Freddie’s status would be crippling to the banking system. In 1946, when interest rates were still regulated, well over half of all banking assets were held in direct US Treasury obligations—that is, bills, notes and bonds. The percentage today is 0.20%. It’s not that banks don’t want to own Treasuries; it’s that Treasuries are unprofitable. The rate of interest they pay is lower than most banks’ own cost for deposits and other funding. Fannie Mae and Freddie Mac (along with the other primary Government-Sponsored Enterprise (GSE), the Federal Home Loan Bank system) have filled the breach. The GSEs issue a constant stream of bonds and mortgage-backed securities with innovative features that allow banks to own them profitably. What’s more, banking regulations do not restrict the amount of GSE debt a bank can own, and the debt requires less capital. 4  And banks can use GSE debt as collateral to acquire additional funding. A change to any or all of these benefits would force banks to raise more capital (at the worst possible time) and curtail lending even further.

So far, the bond markets have not joined in stock market hysteria. Prices of Fannie and Freddie bonds and mortgage securities have fallen compared to Treasuries, but the damage has been slight. This is also good for banks and other entities that use "mark to market" accounting, which requires that changes in the market values of certain assets and other items be recorded through a company’s capital accounts. Had Fannie and Freddie’s bonds lost market value even approximating the extent of their stocks’ loss, banks’ capital would be reduced just as surely as if the bonds were in default.

Mark to market is a controversial—and not at all obvious—accounting technique that has only recently come into wide use. Every asset, as E-Bay has definitively proven, has a market value. If I advertise my four-year old refrigerator, surely someone will pay me a couple of hundred dollars and take it away. But the value to me of my refrigerator is not what I could sell it for; its value is what it does. In fact, its market value is irrelevant as long as I am not in desperate need of cash. Bonds have readily observable market values and, in the US and other developed countries, trade freely in deep and liquid markets. If, however, a holder of a bond has the capacity and intent to retain it until maturity, the market value at any given time may be as irrelevant as my refrigerator’s monetary value. Derivatives—that is, financial instruments such as interest rate swaps that are used to mitigate market risks—also have market values, although they may not be quite as observable. New and complex accounting rules require that they too be marked to market.

Many of Fannie and Freddie’s recent problems center on accounting for derivatives. Both companies had to restate years of earnings because their interpretations of the derivative accounting rules did not pass muster. In the first quarter this year, Fannie Mae, now following the new rules, announced a loss of $2.5 billion even though income from operations was nearly $1.9 billion. What sunk quarterly earnings was a charge of $4.4 billion for "fair value losses." Three billion dollars of this loss was caused by marking to market the value of derivatives that Fannie used to hedge its interest rate risk. In other words, Fannie Mae booked a huge paper loss that it will ultimately reverse, to prevent a permanent economic loss. Prior to the recent accounting standards taking effect, this was called prudent risk management.

Not that the housing crisis has left Fannie and Freddie unscathed. Far from it. In the first quarter Fannie Mae set aside $2.3 billion for potential credit losses compared to $180 million a year earlier. It charged off 0.126% of its loans compared to 0.034% in the first quarter of 2007. In its published outlook, the company stated, "We expect significant increases in our credit-related expenses and credit loss ratio in 2008 relative to 2007. We also believe that our credit losses will increase in 2009 relative to 2008." Hardly good news, but not catastrophic either and certainly not enough to torpedo the two companies that keep the US mortgage industry—and thus the US economy—afloat.

That’s the heart of the issue. Commercial banks are struggling for capital. They can hold few mortgages on their books. Mortgage bankers and brokers, by definition, sell all the mortgages they originate. The markets for privately securitized mortgages—whether subprime or loans for amounts above the limits imposed by Congress on Fannie and Freddie—have evaporated. All but a tiny fraction of mortgages being sold and securitized today are guaranteed by Fannie Mae or Freddie Mac. 5  In June alone Fannie and Freddie securitized $39.6 billion of 30-year single family mortgages. It’s impossible to say exactly how many of those mortgages would have been made without Fannie and Freddie, but the total amount is closer to the .6 than the 39.

If it isn’t obvious, it should be. Fannie and Freddie are a big part of the solution, not the problem. It is not an exaggeration to say that if all single-family mortgages originated between 2003 and 2007 had been underwritten to Fannie and Freddie’s standards, we would not have a housing crisis today.

Fannie Mae describes itself as supporting "liquidity and stability in the secondary mortgage market." Its mission objectives are "helping to increase the total amount of funds available to finance housing in the United States and to make homeownership more available and affordable for low-, moderate- and middle-income Americans." That’s really what Fannie Mae and Freddie Mac do. At this moment, it doesn’t really matter whether Fannie and Freddie have gotten too big or too arrogant. It doesn’t matter whether their lobbyists are too aggressive or their top executives are over-paid. It doesn’t matter if their regulator is too weak or Congressional oversight is too lax. Fannie and Freddie evolved into their present shape for all sorts of reasons, many of which will be addressed in the months and years ahead. What matters now is that Fannie and Freddie be allowed to continue their indispensable roles in the American financial system. I think that’s obvious.

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1 "Fannie Mae Ugly." Editorial, July 12, 2008

2 "The Fannie and Freddie Fallout" Gretchen Morgenson, "The New York Times, July 13, 2008

3 Fred W. Frailey, , July 11, 2008, Kiplinger.com

4 Banks are required to maintain levels of capital based on their assets. One key measure of capital is "risk-based capital." Put simply, if a bank makes me a $10,000 car loan, it must hold $1,000 of risk-based capital to support the loan. If it buys a $10,000 Fannie Mae bond instead, it need only hold $200 of risk-based capital, and if it buys a $10,000 US Treasury note, it needs no risk-based capital at all.

5 There is an exception to this broad statement. Loans made under FHA and VA programs are sold to and securitized by Ginnie Mae, which is a direct US Government instrumentality.

Swiss Miss

UBS is the largest bank in Switzerland, a country where banking is as much an indigenous art form as watch making and yodeling. UBS’ origins date back to the mid-19

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Century. The modern bank is an amalgam of predecessors including the Union Bank of Switzerland and the Swiss Bank Corporation with brokerages such as PaineWebber and Dillon Read. In addition to its banking franchise, UBS is also the world’s largest money manager for wealthy individuals, but its troubles are legion. UBS has suffered $38 billion in write downs related to its subprime mortgage exposure; only Citigroup has lost more. UBS recently announced plans to exit the US municipal bond market, a business that, according to Bloomberg News, "it sought to dominate for almost a decade." Clients pulled out more than $12 billion in the first quarter and inflows of new money are down 82%. The bank is slashing its workforce and its market value has been cut in two. And if that weren’t enough, the Justice Department is investigating it for helping clients evade US taxes.

The Swiss Federal Banking Commission required UBS to prepare a detailed analysis on what went wrong. On April 18 the bank issued a document called "Shareholder Report on UBS’s Write-Downs" based on that regulatory requirement. The report tells the story of how a financial institution filled with highly intelligent, highly educated, and highly motivated people, screwed up. And not for the first time. In 1998, UBS lost more than $600 million in the Long Term Capital Management fiasco and had to contribute an additional $300 million to the subsequent bailout. To quote UBS’ own publicity (written before the current losses), "Far worse than its financial impact, the LTCM episode dealt a crushing blow to the firm’s image and confidence. An air of pessimism pervaded most divisions, leading to significant employee dissatisfaction and client losses." So UBS knew the stakes and the consequences, up close and personal.

Why then, did it happen again? The answer is deceptively simple. UBS believed its mathematical models. That’s it, the core mistake at the very heart of our current financial crisis. It’s not the only reason, but it is the single, indivisible particle from which everything else evolved, $323 billion of credit losses and write-downs worldwide, and counting.

We have to back up a bit to understand why this is so. In fact, we need to back up about 75 years. New Deal legislation created a legal framework and a set of national safety nets to encourage and protect home ownership. The Roosevelt program, however, was grounded on a familiar and practical reality. Mortgages were made to creditworthy borrowers by experienced home-town lenders who knew their customers and their communities. That was the ultimate safeguard. Local banking, however, is expensive and, over time, that expense made local lenders less competitive. Mortgages became less of a bank product than a product of financial markets. Risk was evaluated, not in terms of individual borrowers living in specific neighborhoods, but in terms of value at risk, Monte Carlo simulations, and two sigma events. models. They aren’t the real thing. When we see pictures in a magazine of a high fashion model wearing garish makeup, clothing that barely conceals anything, and an expression of unbridled lust, we do not expect to actually run into such a person at the supermarket. Those of us who were boys in the era before video games knew that the plastic models of jet planes we built couldn’t really fly at supersonic speeds. But the people who built the mathematical models for the behavior of subprime mortgages thought they were accurate representations of how those mortgages would perform in the real world.

If you don’t understand those terms, don’t worry. Most of the people who relied on the outputs of these statistical techniques didn’t understand them either. The problem of modern mathematical models is not that they produce flawed results. The people who write the models and who really do understand how they work are very, very smart. No, the problem with mathematical models is that they are

Paul Volcker, the Federal Reserve Chairman who preceded Alan Greenspan, stated the point succinctly in a speech last month. "Mathematical modeling, drawing strong inferences from the past has demonstrably failed to anticipate events of potentially systemic importance…Part of the problem, as I understand it, is that mathematical modeling simply cannot deal with markets, where it is not random or physically determined events, but human instincts that cause self-perpetuating waves of unwarranted optimism or pessimism."

Mathematical models can’t predict real human life because they lack the basic human traits of imagination and irrationality. Nevertheless, UBS relied on them implicitly. A couple of examples will suffice to demonstrate how bad it got. UBS’ risk management system downgraded its credit rating for Japan in 2003. As a result, the part of its investment apparatus that managed short-term funds stopped buying Japanese Government Bonds, the Japanese equivalent of US Treasury securities. Instead they bought triple-A rated classes of US asset-backed securities. These are pools of car loans, credit card receivables, and home equity lines of credit made to US borrowers. How much imagination does it take to understand that the Government of Japan is a better credit risk than the guy down the street? Apparently, it takes more imagination than UBS’ models. As a result of this decision, UBS’s cash equivalent trading area lost between $25-30 billion in the third quarter of 2007. This was about a 7% loss, which is an astonishing loss rate for short-term investments.

The second example is, if anything, more astonishing. Unfortunately, I can’t quote the most relevant paragraph in the UBS shareholder report because it is so full of jargon and acronyms as to be all but unintelligible without a glossary. (UBS thoughtfully provided its shareholders a six-page glossary along with its report, and I’ll have more to say on this later.) The gist is that UBS’s risk systems did not even collect, much less analyze, the relevant and available data on the mortgages making up the subprime and asset-backed pools it bought! Among other things, UBS ignored whether the loans were first or second mortgages, when they were made, and the credit scores of the borrowers. And UBS wasn’t alone. "Based on publicly available information, UBS believes that its approach to the risk measurement and valuation of structured credit products reflects issues which were not unique and that a number of other financial institutions with exposure to the US subprime market used similar approaches." Don’t blame us, everybody did it!

What they all did was build models with a few years of mortgage history, which showed continually rising home values and low delinquency rates. Since the future reflects the past (doesn’t it?) there was no warning of trouble ahead. But let’s suppose that some model builder had used her imagination and included a catastrophic loss scenario. Would anyone have believed it? The answer is, "No." Up until the present emergency, there had not been a prolonged nationwide housing slump since the Great Depression. Certainly there had been brief nationwide slumps and prolonged local slumps, but nothing like the present. It’s obvious in retrospect that home values can decline across the board, but even a year ago and certainly two years ago, it was unimaginable. And what’s unimaginable, even in the unlikely event that it can be modeled, will not be believed.

Besides, there were enormous pressures to believe what the models were saying. They were, after all, written by the smartest people in the room. Who would have the courage to doubt them, especially when everything was wrapped in jargon and in-crowd acronyms? Here’s a sample: "The business did not submit NBI requests for either the CDO structuring business or for the AMPS business and there were no overall notional portfolio limits established for CDOs or AMPS. CDO and AMPS deals were approved on a transaction-by-transaction basis, using the TRPA process."

UBS had a perfect risk management philosophy. Each business unit "owned" its risks, and independent controls were established to check and verify. Timely and full disclosure of risk was required. The main goals of risk management were the protection of earnings and the protection of UBS’ reputation. None of it mattered. UBS couldn’t protect itself against a risk it couldn’t imagine.

Some people, not at UBS, did imagine the risk. Some people, not at UBS, made enormous amounts of money betting that the housing boom would bust. But, even imagination isn’t enough. There were probably a lot more people who thought that housing would crash but who didn’t have the patience, the money, or the nerve to hold out through the long period when home values were soaring. And even imagination, patience, money, and nerve are insufficient without a healthy dose of luck. There is a cynical but sadly true saying that sums it all up, "The markets can stay irrational longer than you can stay solvent."

Rice

One-fifth of the calories consumed by human beings come from rice. Rice is the staple diet for half the world’s population. The price of rice futures on the Chicago Board of Trade has increased 86% since last summer.

The US Department of Agriculture’s latest estimate for global milled rice production in 2008 is a record 425.3 million tons. But, projected year-end stockpiles of 77.2 million tons will be just half what they were in 2001. Rice is unusual in that only about 6.5% of the total global harvest is exported. The rest is consumed in the countries where it’s grown. For example, China, which grows 30% of the world’s rice, consumes 98% of its production. Indonesia, the third largest producer, is a net importer. The United States accounts for a mere 1.5% of global production, yet we are a major rice exporter because we consume less than two-thirds of what we grow.

Thailand is the world’s number one rice exporter by far. Though it grows less than 5% of the world’s rice, it represents a third of the export market. Export prices for Thailand’s top-grade milled white rice have risen 58% just since March and have more than doubled since late January. The year-over-year price increase is 163%. Vietnam is another major exporter, but its authoritarian government recently "asked" rice exporters to stop signing new contracts, at least until June. The government is also considering a special tax on exports. As a result, Vietnam’s exports are expected to decline 11% in 2008, and prices could rise 30% more, from $700 to $900 a ton. China, India, and Indonesia have also imposed export restrictions, and Pakistan will ship 15% less rice because of power shortages at rice mills.

The Phillipines are at the other end of the spectrum. Already the world’s largest rice importer, the country is expected to increase this year’s imports 42% to curb speculation. Phillipines President Gloria Arroyo recently warned against hoarding and threatened jail to anyone "stealing rice from the people." US ambassador Kristie Kenney promised to supply all the rice needed, not so much for humanitarian reasons, but because the Phillipines is "a front-line state in the war on terrorism."

The rapidly rising cost of rice is not an isolated incident. The United Nations Food and Agriculture Organization reported a 57% year-over-year increase in global food prices.

Commodity prices in general have been on the rise for seven years, for a variety of disparate reasons. One, perversely, is that the developing world is becoming more affluent. Ernst Engel, a 19

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Century Prussian statistician, was the first to demonstrate that poorer households spend a greater percentage of their income on food than wealthier households. At the lowest economic strata, 80% or more of a family’s income may go for food, and poorer families subsist on the cheapest source of calories. As income increases, more meat and less starches are consumed.

Animals thus become competitors for grain with people, and since meat and dairy products are more profitable for growers, guess who wins. In the 21

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Century, machines are becoming competitors too. Corn, wheat, soybeans, palm oil and maize are in demand as the raw material for bio-fuels. According to the World Bank, almost the entire increase in world-wide maize production between 2004 and 2007 went for bio-fuels. Rising energy prices also contribute to rising food costs by making transportation more expensive.

Another reason for rising commodity prices is speculation. Citigroup reported that investments by speculators in commodities have increased by $70 billion or 21% so far this year. Climate change is having an impact, too. Australia has been in a nearly continuous drought for seven years and during that time, its rice production has been virtually nil. In the US, heavy rains and flooding in the Mississippi delta will curtail production. More acerage in West and Sub-Saharan Africa is coming under production, but, with desertification increasing, it tends to be of poorer quality, resulting in lower yields.

Because of rising energy and food costs, inflation is building throughout the developing world. The International Monetary Fund has estimated that consumer prices in emerging economies will rise 7.4% this year, the most since 2001. In many countries, inflation will be much higher. Some places are surprising. In Latvia the inflation rate was 16.8% in March and food costs rose 21%. Next door in Lithuania, inflation rose 11.3% with food up 18.1%. The numbers for Egypt are 12.1% and 16.8%. Even in China, inflation is at an 11-year high.

Many governments are responding to rising inflation by imposing price controls. In Mexico, for instance, the government capped the price of corn tortillas at 8.5 pesos a kilogram last year. The cap is now expiring and the price of tortillas is predicted to rise to 15 pesos. The Russian government is imposing controls on bread, eggs, and milk. The World Bank reports that 21 countries, from Argentina to Yemen, now have price controls on staple foods. Price controls, however, are not free. In a globalized economy they create distortions that can easily produce more harm than good, plus they often don’t

work. Controls dampen domestic production bcause they lower farmers’ profits. In response, farmers naturally turn to growing non-controlled crops or seek ways to avoid government oversight. At the consumer level, the results are hoarding, shortages, and black markets. To prevent these consequences, the government is forced to provide deep subsidies. As the subsidies strain the government’s resources, the temptation to print money beomes irresistible, stoking the fires of inflation. When controls finally become unsustainable, an outbreak of inflation, in some cases, even hyper-inflation, is inevitable. This is just what happened in the United States in the early 1970s. President Nixon imposed a freeze on prices and wages for nearly three years to reduce the unacceptably high 4% inflation rate. By the time the controls were lifted, inflation was running at 10%.

Nothing breeds anger more than hunger. Food riots have broken out around the world in recent days, from West Africa to the Carribean, from Egypt to Indonesia. In a widely quoted remark, World Bank President Robert Zoellick, said, "The World Bank Group estimates that 33 countries around the world face potential social unrest because of the acute hike in food and energy prices. For these countries, where food comprises from half to three-quarters of consumption, there is no margin for survival."

For the past year, most of my commentaries have focused on housing and financial market issues affecting Americans. Serious as our current problems are, it can be useful to keep them in perspective. When government statisticians measure core inflation in the United States they exclude food. Changes in food prices are deemed too volatile to be useful in determining the true cost of living, and besides, Americans, on average, spend less than 15% of their income on food. What a luxury!

e ≠ mc2

Human beings’ great intellectual talent is pattern recognition.  As Harvard linguist Steven Pinker notes, we think in metaphors.  Things and actions always remind us of other things and actions, allowing us to categorize and make sense of them.  Albert Einstein’s famous equation, e = mc2, is a preeminent example of this gift.  Energy equals mass times the speed of light squared.  Einstein saw that energy and mass are fundamentally equivalent.  He recognized a pattern where everyone before him saw two entirely different phenomena.

Einsteins are few and far between.  He found a pattern where others could not.  Most of us do just the opposite.  We assume there is a pattern where none necessarily exists.  We assume that because certain relationships have held for what seems a long time on our human time scale, they will hold indefinitely.  One such relationship that has held for decades in the bond markets may be expressed, with some license, by the following equation: D = T + x, where “D” stands for the interest rate of all types of debt—personal, corporate, and government—except for direct obligations of the US Treasury.  “T” stands for the interest rate of direct obligations of the US Treasury.  “X” can be any fraction or integer greater than zero.  The interest rate of all debt except Treasuries is equivalent to the interest rate of Treasuries plus some amount, given equivalent duration for both D and T.  The key to the formula is that “x” is always positive; other debt instruments always return a higher rate of interest than Treasuries.  (It is, of course, possible to charge a lower rate than the Treasury rate on a given debt; this is a human, not a natural law.  But, such undercharging is always unusual and is called “below market rate”.)

The observable pattern was that, for any “D” and “T”, “x” would remain in a fairly consistent range over time.  For example, 30-year Fannie Mae mortgage-backed securities (MBS), which are securitized pools of 30-year single-family mortgages made to creditworthy borrowers, have about the same duration as 10-year US Treasury notes.  The difference in the interest rates between the two securities, called the yield spread, has fluctuated between 110 and 150 basis points for many years.  In other words, an investor in Fannie Mae MBS could expect to earn 1.10% to 1.50% more than an investor in Treasuries.  Recently, the yield spread between the two securities has shot up to 230 basis points and even more.

Assuming you are not a bond market professional, your reaction is probably, “So what?”  This seems a trivial change, hardly worth getting excited about.  Nothing could be further from the truth.  Spread risk—an unexpected, unprecedented, and prolonged difference in yields between types of debt instruments—occurs when market participants become conservative regarding credit risk.  Spread risk is not the problem affecting the financial markets today, but it is essential to the problem, and for our purposes, a useful guide for understanding just how dangerous present conditions are.

The current disruptions in the financial markets have been described in various ways, first as the subprime meltdown, later as a liquidity crisis, and more recently as a credit crunch. In fact, the crisis is all of the above and more.  It is nothing less than a loss of confidence in the financial system, and it is by no means limited to Wall Street.  Every governmental unit, from the federal government to the smallest local park district, every corporation, and nearly every citizen in America is dependent on debt.  The issuance of debt is fundamentally based on confidence.  No confidence, no loan.  It’s that basic.

The widening of spreads between US Treasury securities and Fannie Mae MBS is one manifestation of eroding confidence.  It’s important both symbolically and practically.  As I have often remarked in these commentaries, the 30-year fixed rate mortgage, made to a creditworthy borrower, is the bedrock of the American financial system.  In their millions, these mortgages evidence trust between creditors and debtors throughout the country.  They provide millions of jobs, both directly and indirectly.  According to Citigroup research, 776,000 jobs in construction, manufacturing, finance, and real estate have been lost since early 2006.  The Wall Street Journal estimated that New York financial companies could layoff up to 20% of their employees, and that was before the Bear Stearns collapse.  Even more crucially, mortgages allow ordinary people to accumulate wealth in the form of home equity, and they provide the borrowing power that has kept consumer spending on the rise without a break for 16 years.  The Federal Reserve reported that household net worth declined for the first time in five years in the fourth quarter of 2007, and home equity dropped below 50% of mortgage amounts for the first time since the 1940s.

Falling Treasury rates and cuts in the fed funds rate have not produced any reduction in home mortgage rates.  Thirty-year fixed-rate mortgages that conform to Fannie Mae standards carry about the same rates now that they did when the fed funds rate was 5.25%.  This is not happening because (or just because) lenders are greedy.  Mortgage rates, despite what most people think, are set less by lenders than by MBS investors.  This market is beset by rising supply and falling demand, which, as in any financial market, is a recipe for lower prices and higher rates.  Today, fewer lenders, including Fannie Mae and Freddie Mac, are able to hold mortgages on their own balance sheets, because their capital and liquidity are under stress.  According to JPMorgan Chase research, net income for all US banks in the fourth quarter fell from more than $30 billion to less than $10 billion, while loan loss provisions soared.  Loans delinquent 90 days or more rose to 1.39% of total loans.  At 1.71%, non-current real estate loans more than doubled from the fourth quarter of 2006.  Not surprisingly, regulators are demanding higher standards, tighter risk management practices and more due diligence.  At the same time, they are urging banks to raise more capital.  For many banks, the fastest way to increase capital ratios has been to decrease assets by selling them.  The assets they are selling are their most liquid, including Fannie Mae MBS.  Borrowers, meanwhile, are increasingly drawn to 30-year fixed rate mortgages, as monthly payments on 15-year mortgages become more expensive and adjustable-rate mortgages are simply unobtainable.  The combination of these factors means that more 30-year mortgages are being securitized and sold just when fewer buyers are in the market for them.

But that’s only part of the story.  The financial markets make a distinction between “real money” and “fast money.”  Real money is invested by banks and similar institutions that have the intention and capacity to hold assets for a long time.  Fast money is turned over quickly and is highly leveraged.  It is borrowed short-term and collateralized by the assets it is used to purchase.  If the market value of those assets declines, two things will happen.  Creditors will demand more collateral and they will demand a higher percentage of over-collateralization.  For example, a hedge fund might borrow $1 million and use it to purchase a Fannie Mae MBS.  In normal times, the hedge fund might have to collateralize the borrowing with $1,050,000 worth of the MBS.  Wall Street calls this a 5% haircut.  If the market value of the MBS drops from par (100) to 98, the borrower must come up with another $20,000 worth of collateral.  And when the borrowing matures, the creditor may demand a 10% haircut, meaning the debtor must pony up another $50,000.  Now the hedge fund needs $1,120,000 to borrow $1 million, but the fund is highly leveraged and doesn’t have that much capital.  If it can’t get help, it goes under. 

Of course, a real hedge fund doesn’t borrow $1 million.  Real hedge funds borrow billions.  Carlyle Capital Corp, a real hedge fund that invested in MBS, defaulted on $16.6 billion of borrowed money on March 12.  Carlyle’s creditors will sell their collateral, which puts more strain on the MBS markets and motivates lenders to demand even bigger haircuts.  Bloomberg news reported last week that banks have raised the haircuts on AAA-rated residential MBS to 20% and on non-Agency guaranteed MBS to as much as 30%.

But again, that’s only part of the story.  Credit-default swaps are defined by Bloomberg as “financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt.”  The buyer of the swap will receive the face value of the debt should the debtor fail to pay.  Note the word, “speculate.”  One might think of credit-default swaps as insurance against a company failing to make good on its obligations.  It is, but it’s a negotiable insurance policy, and so it can be traded.  On Wall Street, anything that can be traded, will be traded.  Although they have only been around for a few years, credit-default swap contracts with a total notional amount of more than $45 trillion are now outstanding.  (To put this number in perspective, it’s about 3½ times our annual gross domestic product.)  Between January 1, 2005, and June 30, 2007, the premium for credit-default swaps on Fannie Mae 10-year senior debt averaged 19 basis points.  Since then, the average has been 45 basis points, and in the last month, it has soared to 78 basis points.  Whether justified or not, higher premiums on credit-default swaps add to the cost of Fannie Mae debt by increasing the spread between Fannie Mae and Treasury obligations.

Now for the bad news.  Credit-default swaps, like interest-rate swaps, currency swaps and a host of other derivative instruments are sold between counterparties, one or both of whom is typically a large money center bank or investment bank.  Because of its incestuous nature, counter party risk is the biggest financial risk we face today.  Here is The Wall Street Journal again, describing the linkages in the financial world, “With each firm intricately intertwined with others in a maze of loans, credit lines, derivatives and swaps, the Fed and Treasury agreed that letting Bear Stearns collapse quickly was a risk not worth taking, because the consequences were simply unknowable.”  Unknowable.  Not unknown for a while until the calculations can be made, but an unknowable maze that can’t be untangled.  An analyst for Barclays Capital estimated last month that if a counterparty with $2 trillion in notional credit-default swaps were to fail, it could lead to losses of between $36 billion and $47 billion for its trading partners.  But any such failing counterparty would have many other kinds of derivative exposure and so would its partners, so that Barclay’s estimate is surely low. 

The world financial system is facing a vicious self-reinforcing cycle of less and less confidence.  The biggest loser so far is Bear Stearns.  The Fed and the Treasury, by engineering a swift bailout of the investment banking company have demonstrated that they clearly understand the seriousness of the situation.  I am reminded of an anecdote repeated by Walter Isaacson in his biography, Einstein: His Life and Universe.  Following a lecture in the early 1920s, Einstein was approached by a young physicist who claimed that the equation e = mc2 implied that huge explosive forces were latent in tiny particles.  Einstein brushed the young man off.  It wasn’t until nearly 20 years later that he came to the same conclusion and wrote the letter to Franklin Roosevelt that sparked America’s development of the atomic bomb.  Sometimes, simple equations can have very far-reaching and profound consequences.

...tails, you lose.

Oscar Wilde famously defined a cynic as someone who knows the price of everything and the value of nothing.  The wit appeals to us intuitively as we think of an old family photograph, which may have enormous sentimental value to us, but for which there is no market and therefore no price.  But let’s turn for a while to the world of financial assets, where sentimentality doesn’t, or at least shouldn’t, play a part.  When it comes to financial assets, price and value are synonymous.  The cynic in Wilde’s definition is a contradiction in terms.  If you know a financial asset’s value, you know its price, and vice versa.  Financial assets are intangible; they have no intrinsic use.  A financial asset isn’t a gallon of milk you can drink, a car you can drive, or a house you can live in.  Financial assets always and only are worth what the next person will pay for them.  The financial markets are in crisis today because the next person does not know what to pay for many of the financial assets traded in those markets.  The reason for this comes down to the difficulty, perhaps even the impossibility, of accurately assessing tail risk.

The graph above is a bell curve.  When a teacher grades on a curve, the curve in question is a bell curve.  In a class of 30 students, most scores will be in a fairly tight cluster.  Only a few, perhaps none, will score on the very high or the very low end.  Those ends are called the tails of the curve.  Over a wide number of data sets, most scores will be within 95% of the average score, and practically all scores will be within 99% of the average.   .  People who evaluate risks for a living use the same concept. Gathering relevant historical information, they calculate the probability of potential future outcomes.  Plotting the results of a school test is easy; the outcomes are finite and circumscribed. But virtually anything and everything can affect the value of a financial asset.  A risk manager may be concerned that Godzilla will rise up out of the ocean to ravage Tokyo, and, in the ensuing confusion, knock the bottom out of the market for securitized subprime mortgages.  The historical data indicate, however, that the probability of that event is less than 5%, putting it way out on the tail of the curve.  The risk manager—or more likely, the risk manager’s model—discounts it.  But suppose Godzilla does ravage Tokyo.  Now the probability is 100% and financial market participants find themselves in a predicament no one has prepared them for or warned them against.

The most recent manifestation of tail risk in the financial markets has popped up in the $300+ billion realm of auction-rate securities. Like the asset-backed commercial paper market that blew up last fall, the auction-rate securities market matches lenders who want short-term exposure with borrowers of long-term debt.  Many debtors who participate in the auction-rate markets are tax-exempt organizations or governmental units who have needs for long-term funding for capital projects, such as school or hospital buildings.  To avoid high fixed rates of interest, these entities issue bonds that are auctioned weekly at prevailing short-term interest rates. The auctioneers are the large banks or brokerages who underwrite the debt.  The sellers and buyers are money-market investors who want the safest, shortest and most liquid investments.  In the past, a shortage of buyers was rare, and when it did happen, the large bank or brokerage bought the paper, essentially acting like a market maker on the stock exchange to preserve the smooth functioning of the market.  But, the willingness of investors to buy or banks to provide a backstop was never guaranteed.
In recent days, sellers have greatly exceeded buyers in security auctions.  Sponsoring banks have been unwilling to act in the normal buyers’ stead.  When the auctions fail, the sellers must hold onto the bonds and the interest rate resets to a contractual level, which can be startling.  A few days ago, the weekly rate on a $100 million Port Authority of New York bond reset at 20% when an auction run by Goldman Sachs failed.

The Port Authority of New York is not going out of existence anytime soon, unless Godzilla transfers his attention from Tokyo to Manhattan.  Why did both buyers and banks shun the credit?  For the last 20 years or so, many municipal bonds have been insured by specialized companies who transferred their triple-A ratings to the bonds.  Since almost no municipal bonds ever default, this was a no-brainer business, the equivalent of selling life insurance to the immortal gods.  But then the insurers got greedy.  They began insuring more and more exotic types of securitized loan deals including subprime mortgage pools.  In the process, they killed the goose who laid the golden egg.  Most of these insurers are now losing their triple-A ratings, causing the municipal bonds they insured to lose theirs as well.  Many of the investors who participate in the auctions, such as tax-exempt money market mutual funds, require at least a double-A rating on the bonds they buy.  That explains the buyers’ strike.  As for the banks and brokerages, their problem is capital.  They have suffered well over $100 billion of losses tied to subprime mortgages, and they have had to retain other risky assets on their balance sheets that they would prefer to sell.  They have no wish to add significant additional assets onto an already strained capital base, even when those assets are in no actual danger of default.

The trail leads back to the tail.  The rocket scientists who calibrated the risk in subprime mortgage pools should have known that home values could not appreciate forever.  But could even the brightest of them have imagined that falling home values would create a meltdown in subprime mortgages leading to a devaluation of municipal bond insurers’ credit ratings, which in turn would cause the auction-rate securities market to seize up? Frankly, I don’t think they could have.  I think that risk was too far out on the tail to have been considered.

The crisis now playing itself out in the auction-rate securities market is a perfect example of the law of unintended consequences.  A group called the Financial Stability Forum, composed of international central bankers, recently published an interim report of recommendations or lessons learned from recent market events.  The group blames “a wave of financial innovation [that] created instruments and risk exposure so complex that risk management systems at a broad range of financial institutions, including many of the largest global banks, failed to control them effectively.”  They suggest, as a remedy, that both bankers and regulators “sharpen firms’ focus on tail risks.”

This is whistling in the wind.  The introduction of Godzilla into this commentary was not, as some readers may suppose, simply an ill-advised grasp at humor.  The point is that financial markets are at risk of anything, even pre-historic monsters, and no person or computer program can identify or guard against all of them.  The specific excesses and failures of judgment that led to the subprime mess won’t be repeated but others will be.  Different tail risks will emerge in future crises and they will be just as unpredictable as those we are seeing today.

In closing, it seems appropriate to note another tail risk in the making.  Ben Bernanke and the Federal Reserve received harsh but deserved criticism for failing to understand the magnitude of the subprime problem.  The Fed sat on its hands through the summer when it should have eased credit conditions proactively.  Now the Fed has caught up.  The dramatic reduction in the fed funds target in January to 3% leaves no doubt that the Fed gets it.  Chairman Bernanke in testimony to Congress today indicated that the Fed stands ready to reduce rates further.  “More-expensive and less-available credit seems likely to continue to be a source of restraint on economic growth,” Bernanke said. ``The outlook for the economy has worsened in recent months, and the downside risks to growth have increased.''

True, but credit is constrained not because short-term rates are too high, but because lenders are afraid to lend.  They don’t know the value of the assets they are lending against.  This is a problem that only time will solve.  Continued reductions in the federal funds target rate at this stage will have a diminishing impact on easing credit conditions.  In fact, they would be counter-productive if, as is likely, they ignite fears of rising inflation thereby driving long-term rates higher.  That would cause 30-year fixed rate mortgages to become more expensive, since they are priced off long-term bond rates.  Lower short-term rates would, however, make adjustable rate mortgages cheaper and more attractive. And that’s what opened the door to the whole subprime mess in the first place.