System of a Downer (Part 2)

Last week I wrote about using Systems Theory to describe the housing bubble. A key input to the system that created the bubble was the Federal Reserve’s (Fed) use on monetary policy to keep interest rates low. So this week I’ll use the same approach to describe how the Fed most likely botched it’s measurement of inflation in the housing market and used the resulting faulty inflation data and the “Everybody and his crack dealer should own their own home” politically driven mentality to keep interest rates artificially low.

I call this week’s PowerPoint catastrophe the “Monetary Policy/Inflation System”. You could call it the “Interest Rate System” or the “Bubble within a Bubble” or…. Oh, sorry, got a little carried away. Here’s the graphic:

Inflation, as covered brilliantly in a past post, is simply defined as too much money chasing too few goods. But inflation is tough to measure and that’s why handy indexes like the Consumer Price Index (CPI) are provided to us so that we can either jump for joy or shit our pants when we see said index fall to 1.2% or rise 56.5% (annualized of course). According to the Bureau of Labor Statistics (BLS) there are 9,108 basic components that make up the CPI. Everything from ‘Whiskey at home’ to ‘Intercity bus fare’ is included, but not home prices.

‘Home Prices’ as a category, per se, does not exist in the CPI. Instead, BLS uses ‘Owners’ equivalent rent of primary residence’ to measure the cost of homeowner occupied units. As proposed by Steven Gjerstad and Vernon Smith in a brilliant article in the Wall Street Journal (see ‘From Bubble to Depression?’)when the CPI’s measurement for home prices was changed to rental equivalence from direct home ownership costs back in 1983 the true cost of housing, as measured by the CPI, was thrown out of whack.

“So what?” you say, followed by a yawn. Well, that little adjustment to the way the cost of homeownership is measured, posit Gjerstad and Smith, caused overall inflation to be understated by 2.9% in 2004 alone (that would have put overall inflation for that year at 6.2% vs. 3.3% as recorded by CPI). Underwear still clean? From 1999 to 2006 the actual rate of inflation of homeownership costs was 151% vs. 23% as measured in the CPI component ‘Owners’ equivalent rent of primary residence’. Squirt!

This difference in the measurement of inflation had a huge systemic impact. When combined with a monetary policy driven by political goals of maximum employment, price stability, and maximized homeownership it effectively drove interest rates well below levels needed to contain an asset bubble. With interest rates artificially low the economy (GDP) grew at an unsustainable rate. GDP growth helped to employ more people who bought more homes through less reliable financing. This caused home prices to rise much faster than the generally acknowledged rate of inflation (CPI). Each cycle through this system created a larger gap between the real value of houses (market prices less inflation of 151%) and the value as measured by most indexes (market prices less inflation of 23%), which in turn, inflated the bubble a bit more.

This was a titanic game of musical chairs. When interest rates couldn’t be lowered any more the economic engine, fueling and being fueled by home prices, began to sputter. The cooling economy cooled home prices and lower home prices meant lower homeowner wealth. The wealth generated by soaring home prices had, for many, filled the gap in slower rising wages. This wealth effect helped grow the economy. Once this system began its downward spiral the impact to economy and homeowners dependent on the housing bubble wealth effect was nasty.
We’ll look at the nastiness next week.

Betcha can’t wait!

Later

System of a Downer (Part I)

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.

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

Introducing the Shade Tree Razor

While watching This Week with George Stephanopoulos a few weeks back (IFC wasn’t showing their usual Sunday block of old Japanese Samurai flicks) I heard South Carolina Senator Jim DeMint say the following (or something very close) to Massachusetts Representative Barney Frank during a round table on the proposed stimulus package “You have to ask yourself if absent the crisis would you still want to do all the things we’re suggesting be done?”

DeMint was responding to a list of items read by Stephanopoulos that seemed to have no relation to economic stimulus yet were part of the proposed package. To me, DeMint’s response was posed as a type of ‘razor’. Obviously I’m not talking about the kind of razor you shave with but I do reserve the right to discuss, at some future point, the subject of George Stephanopoulos, Barney Frank, and razors (although I believe the OutQ channel on Sirius may have already covered this). The kind of razor DeMint employed is more of a philosophical tool used to strip away the irrelevant notions posed in an argument. Some call it logic. However, most discussions these days, especially those conducted on television programs like This Week with George Stephanopoulos are so devoid of logic we never get to see it used.

Well, I’m one for bringing logic back. And what better way to start than by claiming this particular razor and naming it after this blog? If you answered “No better way!”, then good for you.

Allow me to provide a bit of context before fully perpetrating the theft. Perhaps the best known razor is Occam’s razor; “the idea that the simplest or most obvious explanation of several competing ones is the one that should be preferred until it is proven wrong.” I won’t go into details here as I’m not familiar with them and didn’t have any time for research. But trust me, Occam’s razor is a handy a way of getting around having to take forever to make or explain a decision. Had I known about Occam’s razor in my teenage years I could have cruised through many a dicey situation.

Police: “Son, why are there eleven cases of beer in the back of your station wagon?”

17 year old Shade Tree Economist: “Sir, there is a universe of explanations as to how so much beer could have ended up in the back of my Malibu. But officer let’s not waste your time or mine. Allow me to invoke Occam’s razor and propose that the beer you see in the back of my car was put there by people unknown to me without my knowledge and therefore completely exonerates me from any responsibility or transgression of the law.”

Wow, who could fight that? Continuing on with our newly minted (punny!) ‘Shade Tree Razor’, allow me to work DeMint’s question into a razor-like one:

“Absent a crisis would you still want to do all those things you’re recommending to resolve the crisis?”

If the answer is yes, then the bullshit detector should go off as someone is most likely using a crisis to push through an agenda that would, under normal circumstances, not have a chance and should not be considered. If the answer is no, then we may assume the recommendations are directly linked to a crisis and should be considered.

The logic behind the yes and no results is quite simple. If there are recommendations being made that stand on their own as solutions to existing problems not pertaining to the crisis at hand, why put solving the crisis at risk by adding complexity, cost, time, etc? If there are recommendations that make sense in terms of solving the crisis and would not stand on their own as solutions to other existing problems, the only value they bring is in solving the crisis and should only be considered within the context of doing so.

Try applying the Shade Tree Razor to your favorite crisis to see if any of the popular recommendations for ending said crisis are truly aimed at fixing the problem or are more like pile-on pet ideas unscrupulously inserted to satisfy the wants of a certain group.

As a final warning (and charming metaphor), this razor may not produce the best solution to a crisis or the best answer to a problem but it will shave off the back hair that can clog the shower drain that prevents the crisis or problem from being flushed away.

- Later