Double Journey

In another stupid move, the US government outlined a plan to help borrowers get better terms on their mortgages.  The basic gist of the solution is that through Fannie and Freddie, the US government will encourage loan modifications.  They won’t allow for an outright reduction in the amount owed, but they are willing to allow the mortgage to be extended say from 30 years to 40 years, and they will allow the interest rate to be lowered, which will temporarily make payments more affordable.  Before I go criticize this plan, because I will, there are some things that are not all that horrible.

First off, I have no real problem with private institutions making loan modifications that actually reduce the amount owed on the mortgage.  While I tend to think all homeowners who took out a loan for an overpriced home are responsible for the full amount, I have absolutely no issue if two private parties want to sit down and negotiate new terms.  If it is in the best interest of both parties to keep the person in the house, and one side is willing to take a loss in the deal, then so be it.  A lot of private banks are deciding to do this, and I’m all for it as long as they do not do it with my tax dollars.

So that being said, I also have no problem with what the government is doing here.  They are extending the length of the deal and the interest rate temporarily, but the overall deal remains the same.  Now, I’m sure they are taking a small hit in profitability here since the term is longer and the terms of the deal probably favor the homeowner, but overall, the deal is still a net positive (assuming the borrower doesn’t eventually default which is probably a bad assumption).  Further,  the government is not putting any tax payer money directly in the hands of borrowers.  Something I am sure that will eventually happen but at least not with this plan.

But of course this plan has its problems as well.  And, like the GM situation it comes down to one fundamental problem.   You can not, over the long haul, create demand for a product at an artifically high price.  This is exactly why we have a housing bubble.  Houses are STILL overpriced.  Just look at some of the statistics in the Los Angeles market.  The median sale price is around $375,000 (look at the average listing price for a good chuckle).  While that may sound like a bargain compared to prices before, this is still way overinflated.  The median sales price in 2000 was just around $160,000.  Are you trying to tell me that given all the turmoil we have seen recently, that prices deserve to be double what they were just 8 years ago considering that salaries are relatively flat?  A family making $50,000 a year, which is the California average (the Los Angeles average is even lower) can nowhere near afford a mortgage to buy a $375,000 house.

There is nothing the government can do to fix this fundamental affordability problem.  In fact, the government is actually making things worse with every action they take.  If the market doesn’t just correct, and wipe out this fake equity, the market will languish for years. No doubt, a lot of people will be hurt, but how many more will be hurt if we just stay like we are over the next decade?  We will have an entire generation which won’t be able to buy affordable housing while we prop up an overinflated market.  The vast majority of people who own their homes did not buy them in the last 5 years and have mortgages they can afford. Should all of us suffer because of the small minority that did and can’t?
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One of the things that bothers me a lot when I hear people speak of the need to do something immediately is the fear of recession.  Recessions are not bad things.  In fact they are pretty necessary in a well running capitalistic economy.  Granted, you don’t want to have a Great Depression sized recession, but it is absolutely needed if we wish to have the benefits of a boom cycle.

Think of it this way.  The economy has some average growth path.  But like any average, it is a combination of highs and lows.  The economy does just that, it has highs and lows.  There are going to be times when the economy is going strong.  This is a cycle that feeds on itself, growth begets growth.  But growth can also beget excess.  Economic growth, like a rising tide, raises all boats.  Some of these “boats” really don’t deserve to be raised.  They ride the tide of economic growth but really need to sink to the bottom.  These are the people who get rich by adding very little of real economic value.  These are the idiots who made a fortune buying houses with no money down, sitting on them for a month, and then flipping it for instant profits.  There is no real economic value in that and these are the type of people who shouldn’t be successful.

That is where recessions come in.  They are the great equalizer.  Recessions seperate winners from the losers.  Those who really do add value, continue to survive.  People who were prudent and realize that there is always a bust following any boom, are the ones who make it on to the next boom.  These are the people who realize that a long term outlook is the only outlook.  These are people like Warren Buffet who don’t ride the volatile cycle of boom and bust, but keep a level and even head amidst all the calamity.

In any well functioning society, there need to be winners and losers.  Sometimes in the short term, the winners and losers end up in the wrong bucket, and that is unfortunate.  This is when an average Joe loses his job despite doing nothing wrong.  But in the long run, it always works out.   If he is truly a winner, he will come out ahead before the race is over.

As a personal note, my family was destroyed during the recession in the 1990’s.  My father’s business went under and he subsequently deserted my family.  It wasn’t an easy thing to get over.  At the time it seemed like the end of the world.  But in retrospect, it was absolutely necessary and the best thing for everyone.  My father, although a good cook, probably wasn’t the best business man.  It wouldn’t be in anybody’s best interest, even my own family, to have propped him up and let his business continue.  My family survived it all and came out stronger for it.  I like to think that is because I really do belong on the “winners” side.
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The government is trying to do their best to create a plan to get us out of the mess that they put us in.  Still, nothing is passed yet so there may yet still be hope that they do the right thing which would be to do nothing.  I just find it very ironic that just six months ago, both Bush and Paulson told the American People we had no problems, and now we are suddenly on the precipice look straight at Doomsday.  It was a lie six months ago and its a lie today.  At least they are consistent.

The saddest part of the whole thing is that they obviously didn’t see it coming.  I mean seriously, how could you not.  They created this mess through their own actions.  Let us look back and see exactly how this happened.

In 1999, the government decides that  it would be a great idea if everyone could afford to buy a home.  This is an idiotic notion but it sounds good politically so the American people eat it up.  To enable this “plan” the government allows Freddie and Fannie to lend money to people with less than worthy credit.  Isn’t that nice?  Isn’t it great that we can enable the “American Dream” by allowing people to own things they can’t really afford?  This of course masks an even bigger problem.  These are Govermented Sponsored Enterprises.  This gives them an implicit backing of the government making people believe the government won’t let them fail.  Even worse, people get jobs there by political appointment, further insulating them from scrutiny.  But this is only one of many idiotic things that the government does.

In 2001, we have 9/11.  Fearing a massive recession, the government takes it upon itself to shore up confidence and lower interest rates to an insanely low level.  Rates basically go to 0 percent making the cost of captial very very cheap.  People can now get very low percentage mortgages.   Add this to the above, and you get people who shouldn’t be getting loans able to take how huge loans for very cheap.

Innovation now takes hold.  Financial engineering allowed financial institutions to take all these mortgages, package them up, and sell them off as securities.  They supposedly are able to create very “safe” assets by slicing and dicing them in a myriad of ways.  Of course, this also makes the security very hard to understand and greatly obscures who really owns what.  But becasue banks can do this, they no longer really care about making good loans.  There motives now move from making good loans, because they will eventually have to collect on these loans, to making as many loans as possible so that they can make these new fangled securities.  They don’t care if the payer never pays the money back becasue they already sold off the mortgage.  Of course this isn’t the governments fault, so I’ll give them a pass on this one.

Now the SEC gets involved.  There have historically been regulations that only allow banks to take on so much debt when compared to assets.  This limits their ability to use too much leverage.  Of course you remember how leverage works.   It allows you to greatly multiply your gains AND losses.  Of course, when it seems like housing prices can only go straight up, and people are making money hand over fist, the banks lobby to be allowed to use more leverage so they can make insane amounts of money.  Of course when things go south, they go south in a hurry too, which is exactly what we are seeing.  These banks were able to take huge positions on assets they don’t have, and thus make a situation that threatens the entire financial market.

So there you have it.  Giving way too much easy and cheap money to people who shouldn’t have it and have no accountability for when things go wrong.  Doesn’t that sound exactly what Paulson is asking for when he asks for $700 billion with no restrictions, no oversight and no accountability? How on earth does anyone think that will end up OK?  It of course won’t.  What will happen is that they will pass some form of bailout.  It won’t at all do what they want it to do.  In fact, its pretty easy to see some of the awful effects it will have.

At the very least, the dollar is going to go into the tank.  Inflation is inevitable.  We already owe way too much money to the rest of the world.  Now the government is going to essentially print money to pay for this plan.   This will have very negative effect.  Inflation is one of the worse things that can happen from an economic perspective.  This will also drag out the housing problems we are having now as markets will take longer to correct.  This is just prolonging the pain.  This will increase moral hazard thus creating a crisis even bigger the next time.

How do you play this?  Despite my earlier advice that the dollar was going up in the short term (thanks to a years of getting hammered and the rest of the world also slowing down) the dollar will fall.  Commodities now have a ways to go up, despite their highs.   So sell the dollar, buy commodities, and short the market.
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We are getting closer and closer to finalizing this huge bailout.  I’ll be happy to talk about it as it gets closer to becoming reality which it unfortunately will by very soon.  However, every form of the plan misses a very fundamental problem.

People cannot afford the houses they lived in.  They never could.  That’s the key point.  I keep reading things where people are expecting the bottom in the housing market bottom soon and then start its rise up again.  That thinking is crazy.  We aren’t anywhere close to the bottom.  Prices have dropped “significantly” but it still is not enough.  There was a meteoric rise in prices.  Prices more than doubled in most areas in a 5 year period.  Even if you are down 25% from the top, you still have quite a bit more downside before housing becomes anywhere near affordable.

A house should cost you no more than 3 times your annual income.  Even that is on the high side.   If a family earns $100k, which would put them in one of the higher brackets, that is still only a $300k house.  In California, that buys you nothing.  You still have to go out about 40 or 50 miles to find a house anywhere near that price range.  Given the price of gas now, that is unrealistic for most people.

So until the prices come down, there will be pain in the market and the economy.  People have an asset that is overvalued and they must continue to make payments on.  Those out of the market, will be unable to buy until the prices come down.  Alternatively, they could continue this terrible cycle and buy an overpriced asset that will eventually worsen the current situation. This is the fundamental problem and something that wont’ be solved by throwing even more money at it.
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I’m sure you know what I’m going to answer about this before I answer it because you know how I feel about governments stepping in to “save” private businesses.  And of course, you would be right.  I really wish the government had not done anything here, since I really worry about moral hazard.  It also really bothers me that I’m sure the executives of these companies got rich and handsome bonuses based on taking on tremendous risk in the market.  They bought these high yield, high risk assets and made a killing for years.  I’m sure they had bonus structures tied to this performance.  Now that the bill comes due, they are off the hook because the government decided to bail them out.

But I digress for now.  What I really don’t understand is what the government is trying to accomplish.  Do they think that by taking over these two failed institutions, they can somehow turn the tide of the housing market?  If they do, the government is even dumber than I thought because this will do nothing to help the average American who is struggling to pay their mortgage.

Let’s think for a moment what caused the housing crisis in the first place. Put simply, it was a typical asset bubble.  Nothing more, nothing less.  People got caught up in the real estate myth that housing is the best investment you could ever have and that home prices never go down.  So people bought houses and kept buying houses despite souring cost because they feared being “priced out forever“.  All this despite the fact that incomes were not keeping up with the skyrocketing mortgages.  When the music stopped playing, and the chairs were all taken away, we were left with a glut of houses.  Simple economics took over.  When supply starts to outstrip demand, prices fall.  This has caused the underlying value of all the mortgages to fall as well as the asset backing them is plummeting in value.

As these mortgages and derivatives start to lose value, it causes a ripple effect.  Nobody wants to buy an asset falling in price, causing there to be illiquidity in the market.  As nobody will buy these products, new ones can’t be created either, meaning the financial markets freeze up.  This cascades even further and makes a system that feeds back on itself and creates even further price declines.

So given this, how will the bail out help?  The bail out has a net effect of ensuring that there is  more money made available to make mortgages.  This might have the effect of lowering interest rates which in turn could make mortgages more affordable.  But look back at what caused the problem in the first place.  Too many houses are out there for too few buyers.  The average income is not able to pay for the average mortgage.  Having more money available doesn’t solve this problem.  Housing prices will fall until affordability comes back into line with incomes.

So who does it help?  Definitely not average joe American.  It does help a few institutional investors who have Fannie or Freddie debt.   It helps out the stock market in the short term, but it won’t reverse the mid-term trend of the decline.  So we just spent upwards of $25 billion for what?  The short term benefit of a couple of wealthy investors?
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Lots of housing data has come out lately, some of it is actually kind of positive.  Home sales were actually up this past month and the rate of price drops is slowing.  Hooray!

Not so fast.  I have no idea why anyone would honestly think that we are anywhere near a housing bottom.  We are at least a year if not more away from reaching a point where housing price declines reverse direction.  How do I know this?

• Just down the street from me there are some newly constructed 2 bedroom 2.5 bath townhomes. They were put on sale for around $500K.  They are not worth anywhere near that much money.  My girlfriend and I have joked ever since we saw it being constructed that they would never find anybody to buy at those prices.  Just today, I saw that they put up “For Rent” signs on these properties.  Clearly, no interest in these units.
• Prices just are not reasonable yet.  I picked up a real estate magazine to just see what prices are like around the area.  I also go to Redfin pretty often.  There are no decent homes available in the area for anything less than $600,000.  Still don’t know how the average family is going to be able to afford that much especially given the current credit market.
• Economy is going to get worse, not better, in the short term.  Gas prices and inflation still haven’t totally been translated to business problems.  They will soon.  This next quarter earnings announcement will just be the beginning of bad news.  Consumers are just now adjusting to higher gas prices and not being able to use their home equity as a piggy bank.

Every bust has a dead-cat bounce.  People who have been sitting on the sidelines suddenly see these new “deals” and come in.  However, this is only false demand.  Eventually fundamentals HAVE to catch up.  And there is no way that an average family in my area can afford a $600,000 house.
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While driving, I heard on the radio a news story where a politician was proposing putting a halt to all foreclosures for two years.   The purpose of such a moratorium was to “save the American Dream” for all those families who will be kicked out of their homes in the coming years.

Let’s forget the fact that most of these are homes that these people could never have afforded in the first place.  Let’s also forget about the rights of companies, and by extension their shareholders, to collect the money that was agreed to in writing by the people who signed these mortgages.  But really, to protect the American Dream.

That is clearly a phrase that politicians just love to throw around whenenver it is convenient for them or when it makes for a good sound bite.  But are we really protecting the American Dream by allowing these people to stay in these homes that they can’t afford, even with a lower mortgage payement?  No.

What about the American Dream for all those people who didn’t get caught up in the craze?  Those who were careful and responsible with their money and didn’t get caught up in the frenzy of a housing bubble?  Are you telling me that our government should favor those who already own a home vs those who don’t?  Doesn’t that sound a little bit like the rich getting richer, pretty much exactly the opposite of the American Dream?

How can I make such a claim?  Wouldn’t helping all these familes stay in their home be the right thing to do?  Sure, if you want to prevent anyone else from ever being able to reasonably afford a home.  How can this be?  Look, the current foreclosure wave is a GOOD thing.  It will bring prices back in line with where they should be, much much lower.  If you allow people to continue to live in homes they can’t afford, you will not put downward price pressure on home prices.  This desperately needs to happen if we ever hope to get back to a level of afforability.  People will have no reason to sell their homes for less, because the supply of homes will be much lower.  Banks won’t have any incentive to sell foreclosed homes at a lower price either since the inventory on their books will be much lower than would be otherwise.

So let us not kill the American dream for the rest of those unfortunate enough not to already own a home.
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I was chatting with a friend today that I hadn’t talked to in a while.  We were just discussing how things were with each other and the conversation eventually turned into how she was doing at her job.  She has been in the job for a while, and I know she has been thinking about leaving for a long time.  But as we talked it came up that she was thinking of looking for a job out of state.  I couldn’t believe what I was hearing until she explained that California has just gotten to expensive to live in.

And to a large degree she is right.  She is, like me, part of Generation Screwed.   She does OK by most standards, but she is, like me, a renter.  She wants to get married, raise a family, and eventually own a home.  Of course those in the generation face the daunting problem of saving a small fortune to buy a house.  Coupled with the high taxes and high gas prices in California, no wonder she is thinking of leaving.

It really makes me wonder how bad it is for those in California less fortunate than me.  I have started thinking about how I can save money when faced with these economic uncertainties.  Now for me, most of this is psychological in nature (more on that later), but for many many people it is a stark reality.    California is a very expensive place to live.  For many people, all the benefits of living in California don’t outweigh the lower standard of living. How does the average person achieve the American Dream in California?  How is it possible to start out, pay off loans, stay out of debt, save enough to buy a house, save enough to send your kids to college, and then save enough for retirement?  I find it difficult enough as is with a high salary, no kids, and no debt, I just can’t imagine how it must be for those faced with multiple challenges.

So what happens when more and more people start feeling this way?  Is it possible that we see a migration out of California?
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I often think that my generation is getting the very short end of the stick.  I’m sure lots of people feel that way about their respective lives, but it is an odd thing for me.  You see, I’ve always done very well, but I think I’ve done very well despite some pretty big obstacles put in front of people my age, 30.  Here is the quick list of what 30 year olds today have a right to gripe about

•  Tech Bust of 2000 -  Right before I graduated college and was about to enter the working world, the tech bubble was in full swing.  the Dot Coms of the world were producing millionaires for people with my exact skill set.  Of course, right when I graduated, tech mania subsided, the bubble burst, and lots of my peers lost their jobs.  I even technically lost my job.   So right when it was most important to have a job, since few, if any, of my peers had a safety net, we were losing our first jobs.  The jobs that would set a foundation for the things to come.
• 9/11 - One short year after I graduated, we had 9/11.  This changed the face of the United States and brought on an even wider economic slowdown than the tech bubble bursting.  Our lives became a little more frightening and a lot more inconvenient.  It brought changes to our government and our lifestyles which I frankly don’t really care for.  A few years down the road it even helped re-elect one of the biggest idiots we have ever had as President ….
• George Bush - Can you believe that this has been the man who has been President of the United States my entire adult life?  If that doesn’t show you how screwed my generation is, I don’t know what does
• The Housing Bubble - This one might just be the worse one of all.  My combined household income would, according to wikipedia, qualify me to easily be in the top 5% of households in the United States.  If we took into account how much I have in savings …  Well let’s just say I’m not doing half bad.  Yet I don’t own a home.  I don’t because ever since I was able to afford it, it hasn’t made any economic sense to buy.  Prices were just too high.  Most people my age probably could not even really afford it until about 2005, but by then housing prices had skyrocketed to unprecedented levels.  To make matters worse, many of my peers bought anyway!  So now, they are losing their shirts as home prices fall.  Since they just bought, they have no equity.  Many of them will be foreclosed on, ruining their credit for years to come.
• The end of Pensions and the Collapse of Social Security - Pensions as we know it are done.  My generation now faces the very daunting taks of an unsecure retirement.  Many of our parents have guaranteed income the rest of their life thanks to generous pension benefits.  My mom retired in her early 50’s and has a pension that will pay her 1/2 her salary for the rest of her life.  No such luck for me.  I’ll be saving for retirement by myself with no such guarantees.    To make mattes worse, my generation will be the one to have to deal with the Social Security mess.  Fantastic!
• Inflation - I’ve written before and I’ll say it again.  Inflation is very, very bad.  It has been dormant for almost my entire lifetime.  But right when it matters most, when people my age should be starting to accumulate wealth for retirement, it springs back to life.

I could go on and on.  These problems aren’t like the Great Depression or a World War (although we have had to deal with a very long, protracted war even though we reached “Mission Accomplished” years ago) but still.  While these problems haven’t really affected me personally, I’ve seen their effect on my friends.  It makes me think that things are even worse for us than I believe since I myself have never felt the pain first hand.  What do you think?  Am I part of generation screwed or am I making a bigger deal about this than it really is?
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Someone asked me the other day why I don’t own a house. Considering my age and income, its a pretty good question.

There are lots of reasons I haven’t bought a house yet. Some of it just goes to my lifestyle. I want it to be as flexible as possible because I really don’t know where life is going to take me. Three years ago, you could have never made me believe that I would move to Seattle. Just a year ago, I was prepared to stay in Washington a few more years. Each time an opportunity came, I grabbed it because there was nothing like a house holding me back.

But that’s not the real reason, or at least not the whole reason. It’s much more a convenient story I tell to people so they just leave me alone. I’m a traditionalist when it comes to buying a house. I want it to put down 20%, a 30 year fixed mortgage, and I want to only spend about 33% of my gross income a month. When I finally got to the point I could put 20% down on a place, the places I could afford just didn’t seem worth the money. I couldn’t understand how someone like me, who earns well above the average, couldn’t afford a decent place.

So I waited while the prices kept going up. I knew they would eventually come down because I just looked at my own situation. If someone like me, who saves like crazy, earns lots of money, and lives a understated lifestyle couldn’t afford something, how could everyone else. So I waited while all my friends told me I was being stupid. It was hard, believe me. Logic seemed to be flying out the window because prices kept going up and up. But I knew things would eventually come back to a sane level. They had to.

That’s why when I read articles about the problems in California housing prices, I just laugh. Just read the subtitle, “People in L.A. are coping in ways they never imagined with a crisis they never saw coming.”  How did people not see this coming?  I saw it coming five years ago when I refused to buy a house here.  I saw it three years ago as I left the state.  I saw it two years ago as the peak was finally hit and prices topped out.

However “mean” it sounds, I just don’t feel sorry for any of these people.  I really don’t.   People bought something they could never afford.   Now that sanity is returning to the world, people are looking for others to pay for their mistakes.  The sad part is, it will happen.  The government will step in and help.  That’s just how things seem to work around here these days.  Not sure what that does to moral hazard or how people like myself, people who don’t get into these types of problems, will react.  What are your thoughts?  Did you see it coming?
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