Sunday, 10 November 2013

Sadder, but wiser, in economics…

If you want to blame someone for the recent crisis, the easiest, and the most socially acceptable way of find a scapegoat is pointing at bankers. After all the bankers were granting mortgage loans to borrowers who could not afford even to make the first repayment. After all the bankers pooled the subprime loans, repackaged them and sold them to naïve investors, spreading the disease all over the world. After all bankers were living like lords, reaping profits when good times were rolling in and refusing to take responsibility for their wrongdoing when the house of cards fell apart.

I do not aim do detract from the banking sector’s salient and undisputable contribution to the crisis. I (not as a bank employee, but as a citizen and economist) call for looking at bankers’ faults in a broader social, economic and political context.

If you carefully dissect 20 years of run-up to credit crisis in the United States, you should notice:
- millions of people chasing the American Dream, part of fulfilment of which was home ownership – these were millions of people who could not afford to buy a house, but who thanks to easy access to credit were given a chance to fulfil their dreams, a considerable percentage of those people were those who wanted to live beyond their means,
- politicians and central bankers who wanted to make voters happy, and by decreasing cost of credit and passing laws facilitating home purchases fuelled the housing bubble,
- bankers, who noticed the excessive demand for mortgage loans, decided to earn on it and then discovered ways to earn even more without taking more risk by granting the loans and instantly pushing them away from their balance sheets.

The bottom line is that the whole societies, not only bankers and politicians, can be accused of lack of forethought. Beware though, applying collective responsibility is quite unfair in this case, as the there were several people, ordinary and among the elite, who refused to indulge in the bubble spree.

The problem is, however, that common sense advocates who try to warn of the impending moments when bubbles burst, are disliked, not only when a bubble swells, but also with hindsight. I recently read a comment under another article on property prices that in 2007 in which somebody argued six years ago, when property bubble (?) in Poland was reaching its peak, an average salary in Warsaw would buy 1/3 sqm of a flat, banks eagerly were giving out loans, everyone was happier than now, when banks rebuff many would-be borrowers, despite 20% lower (in nominal terms) property prices. These days for an average salary you can buy 1/2 sqm of a flat, so the purchasing power on the property prices has risen by 50%. Paradoxically, despite less steep prices, banks’ reluctance to grant new mortgage loans will hinder your decision to buy a dreamt-up flat. Thus I come to the conclusion people do not behave rationally – consumerist desire to possess goods without considering whether they can afford them distorts economic decisions…

To shed a different light on the issue, some more examples…

The Polish government blames pension funds for fetching inadequate returns and charging exorbitant fees, without emphasising the crucial role policymakers who set stringent investment policies, flawed system of benchmarks and capped fees at sky-high levels. Companies who were allowed to deal with pension fund management acted rationally – abided by the rules, didn’t try to stick their necks out, reaped profits and ripped off future pensioners quietly. The government regulations coercing every taxpayer to participate in private-run part of public pension system generated demand for pension fund services. Pension fund managers just came up with the supply.

Tobacco companies produce stuff that addicts is unhealthy and generally is considered harmful. Each pack of cigarettes needs to contain properly sized information on destructive impact on smoking on health and cigarettes carcinogenic effects. Are the cigarette-makers blamed for deaths of millions of people from lung cancer?

Carmakers for years have been producing vehicle reaching maximum speed at which any accident could be fatal. Does anyone who hears news of an accident with several fatalities caused by speeding think of blaming automotive industry for producing deathful machines?

Alternatively, when you have in mind the problem of prostitution, do you blame escort agency owners or prostitutes themselves for the phenomenon of the oldest profession? Maybe you see a giggling sleazy guy who runs a massage parlour who claims he runs a relaxation facility and what his female employee and his male customer do when they go together to a dim-lit room with red walls stays between them. Virtually anyone who looks into the issue of prostitution highlights misconduct of procurers and prostitutes, while has anyone bothered to delineate a profile of a typical customer of escort agencies?

Coming back to bankers – in Poland the banking sector has become a scapegoat for CHF-denominated mortgage loans and currency option crisis.

In the former case, many think the banks have earned on appreciation on Swiss currency and CHF-borrowers have been duped by the banks. In fact banks have earned on fees, margins and FX rate spreads, which are all loosely tied of FX rates. In other words, banks’ earnings have been independent of FX market movements and thus banks have not had uncovered FX risk exposure. The other story is that banks were encouraging borrowers to take out loans in CHF due to lower interest rates, which translated into lower instalments and higher creditworthiness. All this was because of the demand for cheap lending. When CHF-denominated lending was rampant, few voices of concern were audible. Banks were happy to earn on margins and FX spreads, borrowers were happy to see their dream of own flat coming true. Some even were called idiots, when they were converting their CHF-denominated loans into PLN at the rate of 2.10. With hindsight, their foresight is enviable. In Poland, unlike in other countries, all borrowers had to be extensively informed on FX risk and had to sign documents to confirm they were familiar with the risks, if they had not been properly informed by a salesperson in bank’s outlet, they should have badgered the salespeople to explain the risks… Ignorance of law is not an excuse and taking those loan contracts to the court would be senseless then…

In the latter case, when PLN was evidently overvalued, there was a natural demand from exporters being on the verge of breaking even, to hedge against risk of further appreciation and a supply from financial institutions coming up with solutions suitable for exporters (if properly used). Exporters noticed FX derivatives helped them not only offset unfavourable effects of PLN appreciation, but also earn extra income, if the same position was hedged more than once with more than one bank. Banks noticed they could earn extra income on margins and fees, if volumes of transactions hedged were higher and so foisted upon exporters the double-edged swords of currency options. When FX market capsized there was actually no winner in Poland (if Polish banks’ counterparties had their positions uncovered, they could have taken large profits). Exporters were facing financial distress, while banks had to face credit losses if their corporate counterparties defaulted. When things were going well and companies benefited from sophisticated derivatives, nobody cried out in outrage, when the tide turned against the companies some politicians were calling for nullifying options contracts. Until today I wonder if those companies that made profits on FX hedging would have to return their profits to banks…

In brief, all the paragraphs above narrow down to subject of sharing responsibility for a misery between the supply side and demand side. In each case described above, there is a demand for some service or product, matched by supply. You could of course argue, demand is a response to supply. I would point out in turn, the problem is not akin to egg and chicken dilemma. In overwhelming majority supply matches demand. Imagine there are no males willing to buy sexual services – then all escort agencies would go bankrupt and prostitutes would be jobless. Imagine nobody wants to take out a risky loan – would banks keep on foisting them upon not eligible reluctant clients?

The separate matter is whether the government should step in and impose restrictions which would prevent demand for harmful services or products from being matched by supply?

Should the government protect individuals from their own recklessness, ignorance, short-sightedness, etc. The answer to this questions probably depends on your view of a human and its autonomy. Conservatives and liberals claim a human is wise enough to take rational decisions and take responsibility for them. Socialists argue a human is fragile and pliable and someone else knows better what should be forbidden and what should be warranted. Moreover, the answer might depend on existence of spillover effects of an individual’s detrimental decisions. If a reckless individual is the one who pays the price, then OK, may the government stay away, but if price for one person’s decision is paid by other people (which indirectly limits their personal liberty), these other people are most often all taxpayers who chip in for government-funded bailouts, there is a deep rationale for governments to intervene.


DC said...

I'm sorry but seem to be missing some key information and that causes you to largely assess the US situation incorrectly.

First what you got right: yes, many in the US live beyond their means, and don't really understand the cost of the credit that they agree to. Many believe that free mobile phone really is free, and it goes downhill from there. We are quite spoiled with the ease of credit.

In the middle: "easy credit" brings some other advantages beyond just material consumption. There is data that home ownership increases the stability of neighborhoods, and especially in lower-income areas, this can have overall net positive social effects such as lowering policing costs, and all that goes with public safety - in the extreme, even lower costs for uninsured people showing up in emergency rooms with gun shots. So turning renters into homeowners isn't just to "make voters happy." If well managed, it can be quite smart.

But the main thing you should understand is that this crisis wasn't just a normal cycle of rising prices after a period of stagnancy. It wasn't just a gross mis-estimation of risk. It wasn't even only about greed. It was about people who _knowingly_and_agressively_ broke the law.

It started not so much with the previously well-regarded big-name banks, but rather with upstart finance companies who specialized in providing mortgage loans only. Countrywide financial is one. But larger firms started to salivate when they saw the profits and couldn't stay away.

What did they do? Well, it varies by US state, but there are legally required worksheets in many (most?) to help calculate the suitability of a borrower for a loan, and this must be filled out based on documentation, such as pay slips from employers. Employees at these firms were told by managers to omit or falsify the income information, even if the borrower submitted honest information that showed he could not afford the loan. Unless the borrower double checked the stacks of papers (and there is a lot!) at the closing meeting, it went unnoticed. A lawyer is supposed to sign of on these packages - guess what? Our firm can provide you with a lawyer too! Just sign right here. Few people had the foresight (or the balls - sorry) to slow down a room full of well-dressed people so that they can look through papers they are seeing for the first time.


DC said...

Most employees who spoke up about the problem were simply fired or threatened with job loss. At least one court case was won by terminated employees.

Now _here_ is where the government failed, not in promoting home ownership, in my opinion. The federal government should have noticed this court case and slammed the brakes on. But it was the Bush administration, and his friends were all making money, so this wasn't going to happen.

So I get fuzzy here, since I haven't read enough lately. But these big numbers that the banks are paying to the US government are settlements. Apparently with 4 years of Obama overseeing the Justice Department, they found enough dirt to scare the banks into payment. The banks pay so that it doesn't go to court, and therefore their further violation of the law does not become public record (unless a journalist wants to try under the FOIA law, but most journalists are either too lazy or too underfunded to pursue this. It takes a really long time)

No, I don't think all bankers are evil, and current ideas like that floating around are counter-productive. But it should be clear that there were a large number of criminal acts committed in the case of housing loans in the US. Had the US federal government played it's role properly as regulator early enough, much misery could have been greatly dampened in my estimation.

But at least with these settlements, some money finds its way back into US tax coffers, and costly and difficult prosecution is avoided. No comfort to those outside the US who got hit, however.

I've been running around Kraków all week with a friend visiting from Ottawa, so I'm feeling a bit lazy at the moment. But if you want references for some of this, just let me know.

student SGH said...

DC, thanks for taking the trouble to write an extensive comment. Maybe by dint of not being to the US, my comprehension of the problem is insufficient to assess the situation.

I heard and read about positive effects of home ownership, they were one of key rationales quoted by programme's advocates. As there are two sides of one coin, a cost-benefit analysis would be useful in evaluating whether pursuing home-ownership support initiative would do more harm or good. Foreclosure among low-income borrowers have probably offset those positive effects.

Maybe it was about breaking the law, or maybe it was even worse - the law was constructed to morally wrongful deeds did not constitute law violation. If you pass a law which allows you to steal your neighbour's stuff and go unpunished, a thief remains a thief, but from a legal point of view is not a criminal...

Seems a lot could be found if somebody scratched beneath the surface.