The Failure of Economics

[Polk]

what are you, some kind of racist?

w t f?

 

[Oddball]

Figured that would go right over your head.

 

[eagleseven]

If people were rational, people would not have chased up home prices far beyond their economic value. But people are often irrational, creating a feedback loop whereby higher prices beget higher prices, and as we saw in the financial collapse, lower prices beget lower prices. When people are lining up all night to buy a condo that does not exist and is merely being planned so they can flip it to someone else who is also trying to flip it to someone else - as happened throughout the country - irrationality is gripping the market.

For any individual investor, playing the real estate game WAS rational...but how so?

For individuals, they were rationally responding to government incentives to make personal profit. The government, thanks freddie and fannie, made entry into the real-estate game particularly easy...and there were massive short-term profits to be made.

Imagine it, if you will, as a game of hot potato, with a given property being the potato. Everyone who tosses the potato makes several hundred thousand dollars, but the person who is stuck with the potato at the end of the game is ruined. If you have the chutzpah to risk losing it all, you can play the game and come out rich.

The rational choices of thousands of individuals to play this game resulted in a particularly volatile bubble. Only, the game wouldn't be possible without the financial support of Fannie and Freddie...

 

[Polk]

Figured that would go right over your head.

How was my comment racist? O wait, it wasn't.

 

[eagleseven]

Figured that would go right over your head.

How was my comment racist? O wait, it wasn't.

Feeling slow this morning?

 

[Toro]

For any individual investor, playing the real estate game WAS rational...but how so?

For individuals, they were rationally responding to government incentives to make personal profit. The government, thanks freddie and fannie, made entry into the real-estate game particularly easy...and there were massive short-term profits to be made.

Imagine it, if you will, as a game of hot potato, with a given property being the potato. Everyone who tosses the potato makes several hundred thousand dollars, but the person who is stuck with the potato at the end of the game is ruined. If you have the chutzpah to risk losing it all, you can play the game and come out rich.

The rational choices of thousands of individuals to play this game resulted in a particularly volatile bubble. Only, the game wouldn't be possible without the financial support of Fannie and Freddie...

There are a few problems with this argument.

First, the GSEs have been around for generations. What happened over the past decade to cause the GSEs to gun the market that they did not have in the past? We know it is not subprime. Subprime and Alt-A accounted for less than 1% of the Freddie’s and Fannies’ books. Both accounted for a small proportion of the total market. Both became involved well after the subprime took off. Both bought subprime mortgage pools that were qualifying. If you look at the composition of the housing bubble, you find that the homes that went up the most were the homes that were mortgaged with nonqualifying mortgages. The hottest markets were being funded by loans the GSEs could not touch – subprime, Alt-A and jumbo. For people who believe in the supremacy of the market, this is a hard circle to square because if the GSEs were gunning the market as you claim, then the houses funded by the GSEs should have gone up the most and have fallen the most. That’s how supply and demand works. In fact, it was the complete opposite. The GSEs did contribute to the bubble but they were not the primary cause of the bubble.

Second, the real estate bubble occurred around much of the world. Yet most countries do not have extensive subsidization of the housing market by the government. In fact, as hard as it might be to believe, the US actually lagged much of the world in terms of housing price appreciation. How can it be that Freddie and Fannie caused the housing bubble in Spain or South Africa or Australia, markets which rose more than the US?

Finally, I have a hard time believing that anyone who has ever been involved in investing, particularly investing in a bubble, believes what occurs can ever be rational. The psychology of the bubble is always the same – people frantically chase returns because they think they are going to get rich and their market will not go down. You can see it in people when you talk to them. They aren’t thinking “The value of this home is $X because if you discount the implied rent one can receive over the life of the loan, it is inexpensive.” No, that’s not how they think. They think “Home prices have gone up 50% and my buddy is getting rich and I am not. I need to grab a piece of the action.” I have seen it in the housing market of the early 1990s, the Asian Contagion, the tech bubble, large growth stocks, housing this decade, oil, base metals, grains, and so on. People do not act rationally in a bubble. It is an enormous error of thinking to believe that they do.

 

[Paulie]

Low interest rates have little to do with bubbles. Bubbles drive themselves through a wish and a desire to earn great sums of money through little effort. It is sort of ironic that high interest rates were Nixon/Ford/Carter's downfall and now the opposite is true. Shows how much anyone knows.

This is complete and utter NONSENSE.

Low interest rates are what fuel a bubble to grow to such great proportions. The artificially low interest rates are achieved by increasing the reserve amounts in Federal Reserve member banks, and thereby the monetary base. That money then gets lent out (enters ciculation to chase goods and services) or invested...and in the case of the housing bubble, BOTH of those things happened in monumental proportions.

The banks lent out an extremely high amount of money from what was created by the Fed when they lowered the interest rate down to 1%, and the banks also invested a large amount of money in MBS's.

When the Fed lowers the fed funds rate, it creates money on its balance sheet electronically and then purchases treasuries and other securities from various different banks on the open market. That money is deposited in said member banks' reserves as per the reserve requirement, upon purchase of securities. That money will then either be hoarded, lent, or invested by those banks. That's how money moves in this country, Midcan.

You're right about how the bubble continues to drive itself, but you seem to have absolutely no idea how they begin. There has to first be an availability of that much money before a bubble can begin and grow. The rich already have it, but the middle class that bought so many houses they couldn't afford DID NOT have it, until they BORROWED it. They borrowed so much money because rates were historically low, and there was an over-abundance of liquidity sitting in banks' reserves to be lent out from the open market actions of the Federal Reserve when they established such a low interest rate.

You don't seem to know much about monetary policy, so please don't pollute this thread with your uninformed bullshit.

 

[Paulie]

Toro I agree with you that artificially low interest rates ALONE do not automatically lead to a bubble, with all else being the same. But in the absence of such, it's hard for me to imagine one ever getting big enough to cause this much trouble.

There simply has to be the availability of all of that money first, and then for the irrationality of the public to ensue, and misallocate that money.

 

[Vast LWC]

A great read by Paul Krugman. A few exerts below.

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems...

I just want to post this video on Peter Schiff, who was laughed at by all the talking heads and was right on the money.

YouTube - Peter Schiff Was Right 2006 - 2007 (2nd Edition)

Watch it, it's hilarious to see all the talking heads laughing at what he's saying, knowing that they are all completely wrong and he is right.

 

[Oddball]

First, the GSEs have been around for generations. What happened over the past decade to cause the GSEs to gun the market that they did not have in the past? We know it is not subprime. Subprime and Alt-A accounted for less than 1% of the Freddie’s and Fannies’ books. Both accounted for a small proportion of the total market. Both became involved well after the subprime took off. Both bought subprime mortgage pools that were qualifying. If you look at the composition of the housing bubble, you find that the homes that went up the most were the homes that were mortgaged with nonqualifying mortgages. The hottest markets were being funded by loans the GSEs could not touch – subprime, Alt-A and jumbo. For people who believe in the supremacy of the market, this is a hard circle to square because if the GSEs were gunning the market as you claim, then the houses funded by the GSEs should have gone up the most and have fallen the most. That’s how supply and demand works. In fact, it was the complete opposite. The GSEs did contribute to the bubble but they were not the primary cause of the bubble.

True as that is, the GSEs set the pace and got caught holding the paper that ended up going south from good credit risks, who got themselves caught in a debt ratio pickle after the values dropped.

Smart bankers (i.e Wells Fargo, US Bancorp, BoA) dumped those mortgages on the GSAs. and remained liquid.

Second, the real estate bubble occurred around much of the world. Yet most countries do not have extensive subsidization of the housing market by the government. In fact, as hard as it might be to believe, the US actually lagged much of the world in terms of housing price appreciation. How can it be that Freddie and Fannie caused the housing bubble in Spain or South Africa or Australia, markets which rose more than the US?

Hmmm....A GSE subsidizing risk in the nation of the world's reserve currency, subsequently helping to fuel a speculation bubble, and people in other nations who have significantly fewer options to raise their lot in life take big risks to do so??

Go figure.

Finally, I have a hard time believing that anyone who has ever been involved in investing, particularly investing in a bubble, believes what occurs can ever be rational. The psychology of the bubble is always the same – people frantically chase returns because they think they are going to get rich and their market will not go down. You can see it in people when you talk to them. They aren’t thinking “The value of this home is $X because if you discount the implied rent one can receive over the life of the loan, it is inexpensive.” No, that’s not how they think. They think “Home prices have gone up 50% and my buddy is getting rich and I am not. I need to grab a piece of the action.” I have seen it in the housing market of the early 1990s, the Asian Contagion, the tech bubble, large growth stocks, housing this decade, oil, base metals, grains, and so on. People do not act rationally in a bubble. It is an enormous error of thinking to believe that they do.

That's a pretty broad generalization.

In fact, I know a few rational and deliberate investors who left themselves lots of leeway for a price pullback who ended up getting burned anyways.

 

[Toro]

The biggest problem with the GSEs was the same as that of the big banks - they took on too much debt relative to their equity base. This meant they extended too much credit and did not have enough in reserve if the market crashed. It crashed and the companies failed.

The Dems were also the biggest protectors of the GSEs. When legislators - primarily Republicans - tried to reign in the GSEs because of the systemic risk the companies presented, the Democrats shielded efforts to force the GSEs to carry more capital on their balance sheets. Of course, investors didn't want more capital on their balance sheets either, since that would reduce returns on equity and thus the stock price, but the Dems were the ones who stood behind Freddie and Fannie.

In this, because the Democrats were the primary enablers of the GSEs, the Democrats are culpable for contributing to the expansion of credit and fueling the bubble.

 

[Oddball]

The problem with the GSEs is that they're political playthings for rewarding friends, which are underwritten by the taxpayers.

Your very lucid and informative posts on this topic lend a boatload of evidence to that premise.

A shame for Kenny Lay that he wasn't a DNC apparatchik.