Great Primer on the Mortgage Situation

Steven Pearlstein is not optimistic:

It was Charles Mackay, the 19th-century Scottish journalist, who observed that men go mad in herds but only come to their senses one by one.

We are only at the beginning of the financial world coming to its senses after the bursting of the biggest credit bubble the world has seen. Everyone seems to acknowledge now that there will be lots of mortgage foreclosures and that house prices will fall nationally for the first time since the Great Depression. Some lenders and hedge funds have failed, while some banks have taken painful write-offs and fired executives. There's even a growing recognition that a recession is over the horizon.

But let me assure you, you ain't seen nothing, yet.

What's important to understand is that, contrary to what you heard from President Bush yesterday, this isn't just a mortgage or housing crisis. The financial giants that originated, packaged, rated and insured all those subprime mortgages were the same ones, run by the same executives, with the same fee incentives, using the same financial technologies and risk-management systems, who originated, packaged, rated and insured home-equity loans, commercial real estate loans, credit card loans and loans to finance corporate buyouts.

It is highly unlikely that these organizations did a significantly better job with those other lines of business than they did with mortgages. But the extent of those misjudgments will be revealed only once the economy has slowed, as it surely will.

At the center of this still-unfolding disaster is the Collateralized Debt Obligation, or CDO. CDOs are not new -- they were at the center of a boom and bust in manufacturing housing loans in the early 2000s. But in the past several years, the CDO market has exploded, fueling not only a mortgage boom but expansion of all manner of credit. By one estimate, the face value of outstanding CDOs is nearly $2 trillion.

But let's begin with the mortgage-backed CDO.

By now, almost everyone knows that most mortgages are no longer held by banks until they are paid off: They are packaged with other mortgages and sold to investors much like a bond.

In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its entire investment was wiped out, followed by the next riskiest and the next.

With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches -- those with the lowest credit ratings -- were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities -- some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.

It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used -- in buying the original mortgages, buying the tranches for the CDOs and then in buying the tranches of the CDOs -- the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. No wonder they were snatched up by British hedge funds, German savings banks, oil-rich Norwegian villages and Florida pension funds.

What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value.

One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those will suffer losses of 6 to 31 percent.

And looking across the sector, J.P. Morgan's CDO analysts estimate that there will be at least $300 billion in eventual credit losses, the bulk of which is still hidden from public view. That includes at least $30 billion in additional write-downs at major banks and investment houses, and much more at hedge funds that, for the most part, remain in a state of denial.

As part of the unwinding process, the rating agencies are in the midst of a massive and embarrassing downgrading process that will force many banks, pension funds and money market funds to sell their CDO holdings into a market so bereft of buyers that, in one recent transaction, a desperate E-Trade was able to get only 27 cents on the dollar for its highly rated portfolio.

Meanwhile, banks that are forced to hold on to their CDO assets will be required to set aside much more of their own capital as a financial cushion. That will sharply reduce the money they have available for making new loans.

And it doesn't stop there. CDO losses now threaten the AAA ratings of a number of insurance companies that bought CDO paper or insured against CDO losses. And because some of those insurers also have provided insurance to investors in tax-exempt bonds, states and municipalities have decided to pull back on new bond offerings because investors have become skittish.

If all this sounds like a financial house of cards, that's because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.

That's not just my opinion. It's why banks are husbanding their cash and why the outstanding stock of bank loans and commercial paper is shrinking dramatically.

It is why Treasury officials are working overtime on schemes to stem the tide of mortgage foreclosures and provide a new vehicle to buy up CDO assets.

It's why state and federal budget officials are anticipating sharp decreases in tax revenue next year.

And it is why the Federal Reserve is now willing to toss aside concerns about inflation, the dollar and bailing out Wall Street, and move aggressively to cut interest rates and pump additional funds directly into the banking system.

This may not be 1929. But it's a good bet that it's way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.

Might be a good time to go back to school, since the labor market is gonna suck next year.

U.S. Mobility

Many economists maintain that levels of income inequality aren't of great concern so long as there is a substantial amount of income mobility. In other words, so long as the all the gains from a growing economy are not going to only a few people, all the time, then the social economic situation isn't unjust. Arnold Kling rounds up several studies which have recently come out, examining the state of American income mobility, and the results are very positive:

A Wall Street Journal editorial reports,

The Treasury study examined a huge sample of 96,700 income tax returns from 1996 and 2005 for Americans over the age of 25. The study tracks what happened to these tax filers over this 10-year period. One of the notable, and reassuring, findings is that nearly 58% of filers who were in the poorest income group in 1996 had moved into a higher income category by 2005. Nearly 25% jumped into the middle or upper-middle income groups, and 5.3% made it all the way to the highest quintile.

Of those in the second lowest income quintile, nearly 50% moved into the middle quintile or higher, and only 17% moved down. This is a stunning show of upward mobility, meaning that more than half of all lower-income Americans in 1996 had moved up the income scale in only 10 years.

My metaphor for income distribution is an escalator, with new families and immigrants starting at the bottom and most people moving up. This new study appears to be consistent with the metaphor.

A commenter found the actual study. I did not read it carefully, but I don't see how looking at tax returns can be complete, because some people don't file (of course, many who file pay no taxes, but that is ok as long as their returns are included).

Meanwhile, another study was conducted by Julia Isaacs of the Brookings Institution, using the Panel Study for Income Dynamics, following families from the late 1960's through today.

Isaacs' study is called the Economic Mobility Project. It is covered in The Wall Street Journal. The Executive Summary says,

Median family income for adults who were children in the late 1960s and are now in their 30s or 40s increased 29 percent, from $55,600 for parents to $71,900 for their children, adjusting for inflation. Moreover, family sizes have shrunk over this same period (from 3.1 to 2.3 individuals between 1969 and 1998), so higher incomes are spread over fewer people.

...four out of five children whose parents were in the bottom fifth of the income distribution end up with higher incomes than their parents.

...Forty-two percent of children born to parents in the bottom fifth of the income distribution remain in the bottom, while 39 percent born to parents in the top fifth remain at the top.

An executive summary of Differences by Race says,

Between 1974 and 2004, white and black men in their 30s experienced a decline in income, with the largest decline among black men. However, median family incomes for both racial groups increased, because of large increases in women’s incomes. Income growth was particularly high for white women.

The lack of income growth for black men combined with low marriage rates in the black population has had a negative impact on trends in family income for black families.

...Overall, approximately two out of three blacks (63 percent) exceed their parents’ income after the data are adjusted for inflation, similar to the percentage for whites.

However, a majority of blacks born to middle-income parents grow up to have less income than their parents. Only 31 percent of black children born to parents in the middle of the income distribution have family income greater than their parents, compared to 68 percent of white children from the same income bracket.

The demographic effects are important: middle-class men have lost income as women have increasingly become substitutes for their labor. In other words, the supply curve shifted pretty far right during the latter-half of the 20th century, forcing down wages for some men who faced more wage competition. Overall, however, the trends was largely up, especially for households. It's also important to recognize, as the study does, that household size has decreased while household income has increased. If household size is controlled for, the income gains would be even higher. Similarly, the decreases in the size of black household income is probably largely explained by the decrease in the number of black households rather than institutional discrimination (I'm guessing that increased education premiums and skill-biased technological change have something to do with it also). Overall, the news is pretty remarkably positive.

Now, I might hear you say, the increases in household income have come because women are working, and therefore there are more total household hours engaged in market work. Therefore, the gains are artificial: it isn't that the economy is any better, but that more people are working more hours. But that would be to miss the point. To a large extent, home work and market work are substitutable, especially if part of the earnings from market work go to purchase labor-savings devices (e.g. new technologies which save labor time) and/or substitute laborers from household tasks (e.g. hiring a landscaper or a housecleaner). So, the extra income gains are real, and not artificial.

All in all, these studies could go a long way in rebutting the charge that America is a less egalitarian country than it used to be.

Vacation blogging

I completely disagree with Good Klein when he says this:

Luckily, there are alternate ways to test my hypothesis that people actually wouldappreciate more vacation. A major presidential candidate, possibly a Democratic nominee, could make a proposal for enforce three weeks paid vacation a major issue in the campaign. If this turned out to be popular, well, then we'd know it was popular, and accorded with the nation's preferences.

First of all, this wouldn't be a true test at all. If phrased in that way, very few people could follow the line of logic to its natural conclusion. Therefore, very few people would say that they opposed this mandate. After all, who doesn't want more vacation?

But that's not the appropriate question. The appropriate question is whether people want more vacation time more than they want more income. There is a pretty clear trade-off here. It's not just the productivity or dis-employment effects which Klein (sort of) discusses later in the post. It's just that mandating an extra week of paid vacation for all the country's full-time workers will have effects elsewhere; most likely, it will come at the expense of salary growth. Or, other benefits (e.g. health insurance, pension plans) will be less generous. Unemployment isn't the only concern here. In fact, it is well down the list.

Of course, this says nothing at all about the philosophical question; to whit: Who is Klein to arbitrarily say that an employer must grant three weeks of paid vacation to everyone, even if the majority of public opinion is on his side? I mean, yeah... it would be nice to have more vacation. But it would also be nice to have more money. To the extent that there is a trade-off between the two, and it seems impossible that there isn't, Klein's decision to mandate one at the expense of the other for purely normative reasons (i.e. he personally wants more vacation, and is willing to sacrifice some salary to that end) is patently absurd. It is not the job of government to legislate preferences. Or, at least, it shouldn't be.

If this truly was something that was important to people, then labor unions would be pushing hard for the expansion of vacation time. Instead, they lobby for higher wages, more lucrative retirement plans, and more expansive health insurance. Those are the priorities, and forcing more vacation time on to people works against those ends. The fact that this isn't already a political issue, at all, should be enough of an experiment for Klein.