Most of us, except the extremely boring, have at least once in our lives woken up in an unfamiliar place with no idea how we got there and only partial recollection of the previous day’s or night’s events. With a pounding head and through waves of nausea we promise ourselves never to do again whatever it was that caused us to awake in a walk-in closet in a house belonging to some kid named Lou. Inevitably we make the same bad decisions and take the same risky actions and wind up in someone else’s walk in closet or worse. Some of us break out of this cycle through dumb luck or through outside influence. Some get caught in the cycle and end up creating a downward spiral, a personal hell that leads to death or worse (much of which is captured on the reality show in the time slot after the midget family on the Discovery Channel).
There is a methodology designed to identify when you are caught in a downward or upward spiral. It’s called Systems Theory and it was designed in the mid-twentieth century to help identify and solve non-linear problems. A linear problem, for example, is when the neighbor’s cat comes into your yard at 4:00 AM and yowls. The problem is solved through a combination of cat treats, a hefty bag, and a trip to the dump. Problem presented, action taken, problem solved. A systemic problem is more difficult to identify and very difficult to fix. Often what seems like a solution ends up making things worse. So another fix is tried and that may help for a while but the problem returns or a new problem pops up in its place. This is known as the ‘Whack-a-mole’ syndrome. To understand or identify the root cause of the problem you have to understand the system.
I believe Systems Theory can help explain how and why the current financial meltdown occurred and why it’s going to be difficult and painful to fix. But before I dazzle you with beautiful and intuitive graphics and lay down a logical argument tighter than Valerie Bertinelli’s new bikini, allow me a caveat: Systems Thinking can become amazingly boring, stunningly fast. So in an attempt to lighten the load for the reader while offering me the opportunity to further plagiarize The Wall Street Journal and The Economist over the next couple of weeks, I have broken this analysis into three parts:
The Housing Bubble System (covered in today’s entry)
The Inflation System
The Homeowner Wealth System
In the final installment of the series I will try to bring it all together and if that fails I’ll just post a bunch of porn to try to make things up to you.
First, a Systems Theory primer:
Inputs: Things that contribute to the system. These can be part of the system or external influences on the system.
Opposing: System inputs that have the opposite effect on other inputs. When A goes up, B goes down. A opposes B. These are represented by an “O”.
Same: System inputs that have the same effect on other inputs. When A goes up, B goes up. A is the same as B. These are represented by an “S”.
The Housing Bubble System
Once upon a time you got a job, saved some money, and when you thought you were ready you started looking for a house. You found a nice two or three bedroom home in an acceptable neighborhood and proceeded to the local Savings & Loan to apply for a mortgage. Then, after the financial equivalent of a proctology exam, you bought your house and the bank kept your mortgage. During the 1980’s that all began to change. Technology enabled what economists call secondary intermediaries to enter the mortgage market. These guys could buy bundles of mortgages from banks and sell them to investors or write mortgages on their own. In the 1990’s several deregulatory steps were taken that enabled more complex investments called derivatives to explode in variety, complexity, and growth what had now come to be known as mortgage backed securities. This, in turn, led many finance and investment professionals to believe they could create unlimited upside (profits) by eliminating the traditional risks that accompanied mortgages.
At the same time the Federal Reserve (Fed), under pressure from the Clinton and then Bush administrations, kept interest rates as low as possible to foster economic growth and the American dream of home ownership (the lower the interest rates, the easier it is to buy a home). The combination of low rates and easy to find financing brought on by highly marketable derivatives caused demand and prices for homes to skyrocket. This process fed on itself, even through the 2001-2002 stock market collapse. According to classical economic thinking the rising prices for homes should have lessened demand and the market should have fixed itself. But that didn’t happen.
As shown in the system below three influences acted on the traditionally balanced housing price system to form and incredibly destructive bubble.
1) The Fed kept interest rates artificially low as it thought it could satisfy the dual goal of maximum employment (economic growth) and price stability (low inflation). As we’ll see in Part II, the Fed may have seriously miss-measured inflation, specifically in the housing market.
2) Regulatory oversight of the mortgage lending market all but disappeared as several administrations and Congress switched the goal of oversight from protecting borrowers and lenders to maximizing home ownership.
3) As the ‘Tech Bubble’ burst, home building and supporting services became the main driver of economic growth in the US. No one wanted to kill the goose laying the golden (be they toxic) eggs.
There is a methodology designed to identify when you are caught in a downward or upward spiral. It’s called Systems Theory and it was designed in the mid-twentieth century to help identify and solve non-linear problems. A linear problem, for example, is when the neighbor’s cat comes into your yard at 4:00 AM and yowls. The problem is solved through a combination of cat treats, a hefty bag, and a trip to the dump. Problem presented, action taken, problem solved. A systemic problem is more difficult to identify and very difficult to fix. Often what seems like a solution ends up making things worse. So another fix is tried and that may help for a while but the problem returns or a new problem pops up in its place. This is known as the ‘Whack-a-mole’ syndrome. To understand or identify the root cause of the problem you have to understand the system.
I believe Systems Theory can help explain how and why the current financial meltdown occurred and why it’s going to be difficult and painful to fix. But before I dazzle you with beautiful and intuitive graphics and lay down a logical argument tighter than Valerie Bertinelli’s new bikini, allow me a caveat: Systems Thinking can become amazingly boring, stunningly fast. So in an attempt to lighten the load for the reader while offering me the opportunity to further plagiarize The Wall Street Journal and The Economist over the next couple of weeks, I have broken this analysis into three parts:
The Housing Bubble System (covered in today’s entry)
The Inflation System
The Homeowner Wealth System
In the final installment of the series I will try to bring it all together and if that fails I’ll just post a bunch of porn to try to make things up to you.
First, a Systems Theory primer:
Inputs: Things that contribute to the system. These can be part of the system or external influences on the system.
Opposing: System inputs that have the opposite effect on other inputs. When A goes up, B goes down. A opposes B. These are represented by an “O”.
Same: System inputs that have the same effect on other inputs. When A goes up, B goes up. A is the same as B. These are represented by an “S”.
The Housing Bubble System
Once upon a time you got a job, saved some money, and when you thought you were ready you started looking for a house. You found a nice two or three bedroom home in an acceptable neighborhood and proceeded to the local Savings & Loan to apply for a mortgage. Then, after the financial equivalent of a proctology exam, you bought your house and the bank kept your mortgage. During the 1980’s that all began to change. Technology enabled what economists call secondary intermediaries to enter the mortgage market. These guys could buy bundles of mortgages from banks and sell them to investors or write mortgages on their own. In the 1990’s several deregulatory steps were taken that enabled more complex investments called derivatives to explode in variety, complexity, and growth what had now come to be known as mortgage backed securities. This, in turn, led many finance and investment professionals to believe they could create unlimited upside (profits) by eliminating the traditional risks that accompanied mortgages.
At the same time the Federal Reserve (Fed), under pressure from the Clinton and then Bush administrations, kept interest rates as low as possible to foster economic growth and the American dream of home ownership (the lower the interest rates, the easier it is to buy a home). The combination of low rates and easy to find financing brought on by highly marketable derivatives caused demand and prices for homes to skyrocket. This process fed on itself, even through the 2001-2002 stock market collapse. According to classical economic thinking the rising prices for homes should have lessened demand and the market should have fixed itself. But that didn’t happen.
As shown in the system below three influences acted on the traditionally balanced housing price system to form and incredibly destructive bubble.
1) The Fed kept interest rates artificially low as it thought it could satisfy the dual goal of maximum employment (economic growth) and price stability (low inflation). As we’ll see in Part II, the Fed may have seriously miss-measured inflation, specifically in the housing market.
2) Regulatory oversight of the mortgage lending market all but disappeared as several administrations and Congress switched the goal of oversight from protecting borrowers and lenders to maximizing home ownership.
3) As the ‘Tech Bubble’ burst, home building and supporting services became the main driver of economic growth in the US. No one wanted to kill the goose laying the golden (be they toxic) eggs.
So, as interest rates were kept flat or decreased through a heavily politicized monetary policy, home prices rose (opposing). As home prices rose the percent of income required to own a home rose (same). As home ownership took more from income, people engaged in riskier borrowing to get financing (same). As risk increased, the use of derivatives to shield (hide) that risk increased (same). The use of derivatives pushed the housing market and the economy forward (same).
Well what’s wrong with this picture? Other than a third grade level of proficiency with PowerPoint what should grab your attention is the curved arrow leading from Interest Rates to Home Prices. If interest rates were kept artificially low to prop up the housing market, why did the housing market implode?
To find out, tune in next week…..
Later
Don't sell yourself short, Mike. That slide has the best use of the color blue that I have seen in a long time. Nicely done.
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