Draw Breath

I’m skipping through this paper (h/t Baseline Scenario) this evening (in between finishing more appropriately weekendish books) and am very much enjoying it. Check out the two charts on page 24 if you want to get an insight into what’s gone wrong with global capitalism in the last three decades. Anyway, I love this quote from the intro:

As in the Middle Ages, perceived risks from lending to the state are larger than to some corporations. The price of default insurance is higher for some G7 governments than for McDonalds or the Campbell Soup Company. Yet there is one key difference between the situation today and that in the Middle Ages. Then, the biggest risk to the banks was from the sovereign. Today, perhaps the biggest risk to the sovereign comes from the banks.

I suppose that this article in the Belfast Tele is getting in first where a lot of the week’s papers are going to follow. A good day for the FTSE and good results for the banks might mean the end of the banking crisis.

Not at all.

In the UK this is the end of the credit crunch wave of the banking crisis. The next wave, I’d guess at year’s end, will come when all those newly unemployed people run out of money and default on enormous credit card (also here), mortgage and sundry other debts. In other words, the financial banking crisis may be coming to a close, but the retail banking crisis is yet to kick in.

I’m not sure I agree with all that he has to say, but Michael Taft’s outline of an alternative to the government’s lunacy is certainly worth a read, if only to highlight that there are alternatives to the government’s lunacy.

I don’t have time to go through it at all today, but I suppose the one criticism I would have is that I’m not sure whether this would provide Ireland with the dig-out it needs. Specifically, while it may help alleviate the repercussions of the countries property orgy, Ireland alone can never attend to the major problem: the death of the wholesale banking market (and death it seems to be) will require either banks entirely reshaping their business models along the much more restricted Captain Mannering model, which will take a massive adjustment in the global economy or it will require states coming together to underpin the wholesale markets themselves.

Of course, the Irish government prefers free-riding to international cooperation so they will most likely not even be involved in any international action. And meanwhile, Irish banks are still likely to go to their predictable hell in an only partly self-made handbasket.

Was it just me who was turned off by the following sentence about developer Donal Caulfield in Frank McDonald and Kathy Sheridan’s obituary for the Irish housing market:

He has tried to spread his risk, with developments in Poland, the Canaries, London, Madrid and Ibiza.

Spreading risk by buying up property in a series of bubble housing markets? You spread risk by diversifying a portfolio, not by tyring to cash in on every property bubble going. Language appropriate to describe investment ought not to be used to dignify speculation.

Anyway, I know I’ve said that a dig out for banks is inevitable – or at least I think it is – because Irish banks, and everyone on this island as a consequence, will be in a whole load of bother as banking losses mount, but lets hope that the dig out doesn’t either shore up developers or speculative property owners. There is more than one group interested in the politics of housing and, as this guy points out also in yesterday’s Irish Times, there’s no reason for privileging the interests of owners over aspiring owners (or indeed over taxpayers).

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Congratulations to Maca, who's just bought himself some digs. Fair dues to him, and I mean that. But never let me pass over an opportunity to poo on someone's parade. So here goes…

Maca says that they bought the house because "we figure we’re better off paying our mortgage than someone else’s mortgage." Is this true in the present climate? Is the property ladder the place to be when it's really a snake?

The way I figure it, putting aside all those intangible joys like trips to Ikea etc, the 'am I better off paying my own mortgage?' calculation ought to proceed according to the maxim that the fall in property prices minus the amount paid off the principal on the mortgage ought not be greater than the outlay in rent (by the way, I had this expressed in an equation a couple of minutes ago but decided that I'd never be invited to dinner parties again if I posted it. Truly I am a sad, sad person).

So, if the amount you spend on your rent is more than a fall in value of your house minus the amount you pay onto the principal on the mortgage then buy. If not, then rent. Or, to take an example: in the first year of a mortgage, assuming an average priced €300,000 house at 5.4% APR, you will only pay about €4,200 off the principal (and €16,000 odd in interest). In that time in 2008, the house will have fallen in value by €24,000 (about 8% according to Goodbody). So the purchase of a house is worthwhile if you would otherwise fork out €19,600 in rent in the year. That's €1,633 a month. Of course, you could buy a cheaper house. It's also not unlikely, if you are renting a house, that this calculation might work in favour of buying (well, that or renting somewhere smaller). On the other hand, you could be saddled with a higher interest rate on your mortgage than I've allowed for here. Either way, what is undoubtedly true is that part of the value of the house will simply disappear into thin air in 2008/9. And lots of the mortgage will go toward the upkeep of the bank's shareholders, not towards the principal on the loan.

In which case it's not unlikely that renting until prices bottom out would be better overall than paying one's own mortgage. Let someone else suffer the loss in wealth and then jump onto the ladder. Or at least that it's not automatically the case that you are better off paying your own mortgage from 2008 than you would be leaving it until 2010.

There's a good interview with John Fingleton in today's Times. I think Fingleton lectured me when I was an economics undergrad, before he moved on to the Competition Authority. He always seemed like a very nice guy. Anyway, he's now chief executive of the UK's Office of Fair Trading and is doing an excellent job to my mind.

The best line in the interview has him reflecting on his relative anonymity, where most people seem to think that the OFT has something to do with coffee:

'It was the same when I was in Ireland at the Competition Authority,' he says. 'We had schools writing in asking what competitions we were organising.'

There are two interesting articles in today's Times, suggesting at major extensions of domestic law in response to globalisation. The first reports on the US Supreme Court's decision (though in odd circumstances) to allow a lawsuit to go ahead, under the Alien Tort Claims Act (see also here), of companies that collaborated with the Apartheid regime in South Africa. If lawyers establish that these companies knowingly assisted the South African regime in breaching human rights, they may be liable for millions of dollars.

Second, there's an article on the implications of corporations being found responsible for bribery in both developing and developed countries. It's always one of those things denied by the sorts of twats who advocate cutting aid to developing countries because of corruption: corrupters are just as guilty and they tend to be a lot closer to home. Certainly, the BAE probe was depressing, but corruption is very much coming onto the agenda. Again, the Alien Tort Claims Act may be start to be employed in interesting ways here. In which case, private action will emerge as one of the major sources of regulation of globalisation.

I'm sure, like me, you spend most of your waking hours speculating as to why it is that Boeing is doing so much better than Airbus. Of course, to a large extent it has to do with the weakness of the dollar and with the spectacular governance near-meltdown of EADS, Airbus's parent company.

But don't underestimate the power of government intervention. There is of course the thorny issue of who pisses highest (or lowest) on the subsidies wall (see also here and here).

And then there's all that military revenue…

According to a quick back of the envelope calculation ('defence and security' revenue as a percentage of Airbus revenue according to EADS's annual report (pdf)), about 18% of Airbus's revenue comes from military spending. On the other hand, fully 50% of Boeing revenue comes from their military wing (so to speak). Of that 90% comes from the US government.

So 45% of Boeing's revenue comes directly from the American taxpayer through the military. Unlike in Europe, the bombs game in America really is a state spending success story at the moment. So, if you want to know why these sorts of businesses do so well, and why Boeing is whupping Airbus, spare a thought for Iraq.

Good post over on Brad deLong's blog that gives a parallel perspective to the one I gave here.

According to the people deLong quotes, we have to see the subprime crisis in the context of new modes of banking, rather than in the more traditional terms of banking that have held up until now.

The conventional story about hedge funds is that, through their profit-making behaviour, they iron out the inefficiencies of the securities markets. They make money from information inefficiencies but since their investors tend to be the very firms who created the inefficiencies hedge funds act as a feedback mechanism, retrieving some of the money lost by the banks etc in the normal course of their work. In Sebastian Mallaby's words, linked to above, hedge funds "do not so much create risk as absorb it."

Hedge funds are the dung beetles of the financial world, in other words. While the great elephants of the plain lazily half-digest everything they eat, beetles, in looking after themselves, spread the fertiliser far and wide thus put all the pooey goodness back into the system.

But the problem is that the greatest profits are to be had at the margins and, in a segment of the financial market that is totally unregulated, nobody knows where those margins ought sensibly to end.

The fallacy of the subprime bet was that risk was regarded as another market inefficiency that could be addressed as a simple matter of price.

What nobody realised was that, with risk seemingly spread so thin, people at every level had an incentive to exploit the system. This was fine and dandy while new money kept getting thrown into the pot. It became a problem when the run towards the lucrative margin turned into a flight from the edge.

So, with the help of deLong's post, here's an alternative story about hedge funds, at least where they seek to bite the giddy fruit on the outer branches of the banking tree: they sought out risks that regulated and self-regulated banks dared not take on on their own and took a punt on them. The bet backfired because everyone thought they were passing the inevitable costs on to someone else before the music stopped.

But the risks were not spread so thin as they seemed. Or rather, the known knowns of subprime got large enough for people to become seriously worried about the unknown unknowns. And that's when the current panic really started to bite. After all there's nothing quite like playing Russian roulette when you think the gun is fully loaded.

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PS. Zoology; musical chairs; Genesis; Siberian parlour games. I'm telling ya: no metaphor is safe…

 

I've spoken before about the evidence on how SUV drivers, having exported the risks to people outside their cars, tend to drive more recklessly. Not that this makes SUV drivers a particularly unique demographic: for instance this graph suggests that, if anything, the introduction of mandatory seatbelt-wearing led to a worse situation than would otherwise have been the case in terms of overall deaths: the reduction in driver deaths was more than matched by a the growth in pedestrian and other deaths. As the study from which the graph was taken says, "to compel a person to use protection from the consequences of hazardous driving, as seatbelt laws do, is to encourage hazardous driving."¹

So. What has this got to do with the ongoing subprime crisis? Well, they're both stories about risk.

As this article in Wednesday's Financial Times (subs req'd) suggests, there is quite a bit of ground-level fraud at the root of the subprime problem.

It seems that people were falsifying applications for mortgages they couldn't afford partly by paying for people to pretend to be high-paying employers for instance. And it seems that they were encouraged by mortgage brokers to do so. As the article says,

"fraud has been detected up and down the financing chain: just as borrowers have lied to get better rates and larger loans, mortgage brokers and loan officers have lied to borrowers about the terms of their loans and may also have lied to the banks about the qualifications of the borrowers. Appraisers, likewise, have lied about the value of the properties involved.

"The recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and outright fraud," Ben Bernanke, Fed chairman, recently told lawmakers."

In other words, this weeks crisis in the securities markets hints at a disease at the roots: a pattern of reckless lending either through actual deception or through the encouraging of deception on the part of the borrower. But why would lending institutions collude in behaviour that could ultimately lead to their downfall? Why would the word be coming down from on high that volumes of borrowing was a higher priority than the quality of the loans?

The reason lies in the exporting of risk, itself the reason for the stock markets' responses to the crisis in subprime. Individual subprime mortgages were packaged together and sold on the securities markets so that all the risk didn't lie with the lending institutions, but with hedge funds. Not only did no single group own the risk, but there was an almost total disconnection between the people on the lending coalface and the people who owned the risk of their decisions.

The division between ownership and control is the classic dilemma of corporate governance – something I have a bit of a professional interest in. What happens when people – CEOs etc – get to make decisions using other people's – shareholders – money? In a sense, the subprime thing highlights another question – what sorts of risks will some people – investment bankers – take when the consequences of the risk either won't fall on them or are diluted through hedging?

The dynamics of subprime, just as with mandatory seatbelt legislation, gives us at least some part of an answer: risks are far easier to take if they're not your own.