• Q&A with Dave Vang: The Age of Uncertainty

    DaveVang

    The economic recession has, unfortunately, become old news now. How did we get here, and how did it get so bad so fast?

    There is a natural tendency in our democracy to enact legislation that is a compromise. Unfortunately, the usual compromise when it comes to financial service firms is toderegulate the asset side of their balance sheets while simultaneously subsidizing the liability side. Today’s crisis comes from decades of these compromises.

    Is the state of our current economy historically unique?

    What is happening now is very similar to what happened to savings and loans as the result of the 1980 Monetary Control Act but on a larger scale. Savings and loan institutions were legally allowed to invest in a wider range of loans for the well-intended purpose of reducing interest-rate risk. However, the act included terms that allowed depositors to receive $100,000 in insurance rather than the $20,000 they had historically received. As a result, savings and loans grew by adding riskier gambles on the asset side, which were financed by deposits that were essentially 100 percent insured by the government.

    The seeds of the financial problems of today also lie in well-intentioned efforts to encourage homeownership. Originally, the government tried to increase homeownership through the 1977 Community Reinvestment Act, which tried to hold banks accountable for a perceived lack of loans to low-income people; however, the banks defended themselves on the grounds that such loans were not “conforming loans.” Holding such high-risk loans could potentially put the banks’ risk measurestoo high to get FDIC insurance, so some financial institutions were successful in using this rationale to limit this effect.

    To more effectively encourage homeownership, then, the government instituted regulatory changes redefining a conforming loan. It no longer meant just the typical 30-year, fixed rate, not-too-small, not-too-big, large down payment mortgage. Eventually, even variable-rate, 100 percent loans with no down payment came to be declared as “conforming.”

    But surely, increased homeownership benefits a market-driven economy?

    It usually does. As a result of the new definition of conforming loans, however, access to mortgages was granted not only to previously-discriminated against people but alsoto home speculators, charlatans and the financially unsophisticated.

    Removing the large down payment requirement is what really sealed our fate in this fiasco. Prior to the downturn, if the real estate market fell by a modest amount, homeowners had a vested interest in making payments to avoid losing their initial investments. After this change, the “moral hazard problem” was compounded by a chain reaction, even before real estate values started to fall.

    First, mortgage brokers didn’t get a fee unless the mortgage was approved, so there was a natural temptation not to get too fussy with details and appraisals. Second, some professional appraisers didn’t get return business from mortgage brokers if they made conservative estimates of value. Third, banks who supplied the funds for the mortgages operated at less risk because they got fees for creating each new loan, and the insurance programs allowed them to unload just about any mortgage, with its corresponding risk, onto the secondary market so that their capital could be used to initiate the next loan. Fourth, institutional investors who bought the mortgage-backedsecurities on the secondary market crossed their fingers and hoped that the people in steps one, two and three had done proper due diligence.

    The fifth and final component of the chain reaction was the directive for Fannie Mae and Freddie Mac to be last-resort buyers of many of these mortgages. Those two firmsused to be government agencies. In 1968 they were spun off into private firms but were allowed to retain the government’s guarantee on their debts. So not only could they borrow for almost the same rate as T-bills, but after the government relaxed the standards on conforming loans, they were commanded to add more of these risky loans onto the asset side of their balance sheets.

    As we now know, once real estate prices started to fall, many of these mortgages started to default, and so, in turn, the various “bundles” of these loans that had been sold on the secondary market lost value.

    Accounting practices recently underwent substantial changes (with Sarbanes Oxley). What contribution, if any, did these changes make to this “perfect storm”?

    They made it worse. The new standards required firms that held bundled loans to “mark-to-market,” which means they required financial firms to periodically change the balance sheet value of these assets to reflect what their theoretical market value would be – even if the firm had no real intention of selling that bundle. This set off another viscous cycle.

    If the value of the bundle of mortgages fell, the financial firms were required to record a loss even if they did not sell the asset. That loss reduced the firm’s equity and hurt its corresponding risk positions. This, in turn, required them to actually sell the asset to acquire the cash needed to improve their risk measurements; however, because they sold these mortgage-bundled assets in an already down market, values fell even further, which, in turn, caused other firms to record additional paper losses when their assets had to be marked-to-market, and the cycle continued.

    In general terms, what has been the government’s response to the situation?

    The TARP plan was designed to allow the government to buy the excess, risky securities or mortgages to keep them from plugging up the system so that banks and other firms would be free to start offering new loans. It was similar to how the government dealt with farm programs. If agriculture policies caused farmers to overproduce a certain crop and thereby depress prices, the government would buy the excess and sell the crops at a later date when prices where higher.

    The TARP program intended to accomplish the same thing with mortgage securities.Unfortunately, diligently valuing these securities could not be accomplished in a rapid enough time frame to satisfy policymakers or the markets. So the government switched to a policy of directly injecting equity stakes in banks and other firms because this could be achieved with little delay.

    The government also has passed the stimulus bill and various other bailouts to industry. The belief is that this should cause some additional economic activity in the short run at the expense of some longer-term potential growth as we try to pay off the corresponding government debt load. Substantial government spending can, under certain circumstances, help stimulate the economy so long as it does not displace investments that would have naturally occurred in more productive uses of resources, and if the spending results in getting money into the hands of individuals as rapidly as possible. The jury is still out on the stimulus bill because some estimates are that only 7 to 25 percent of the total spending in that bill will take place within a year.

    Does the government’s role as an investor affect a firm’s recovery efforts or abilities?

    It creates two serious complications. First, having the government as even a minorityinvestor in your firm can make hard-nosed action difficult. Try to imagine having a business partner who has the power to do anything from printing money to directing the military. Does it really matter to you how much or little that partner’s ownership stake is? Second, equity is a financing source with an infinite maturity, unlike debt, which has a contractually fixed repayment date; therefore, we now have no official end time for when or how we can disentangle our government from ownership in our financial sector.

    In an article you wrote for the fall 2008 issue of B. magazine, you discussed how economic forecasts are dependent on the assumptions being used. As we talk about this in March 2009, what assumptions would you base your forecast on now – and what is your forecast?

    In that issue, I correctly anticipated a drop in oil prices as well as a general shift of government policy away from cutting interest rates to one of proactively doing bailouts. I forecasted a slow down lasting about a year.

    In retrospect, I significantly underestimated the amount of uncertainty that would beinjected into the system by government policy. For instance, I had originally assumed that a new president would be inherently limited by political reality to not add  substantial new debt. I obviously did not foresee the massive and complex amount of government spending and debt that has occurred since July 2008 when I wrote that article. In addition, I had assumed that the focus of whoever won the election would be almost exclusively on restoring confidence in the financial sector and encouraging immediate economic growth. I had not counted on a bold agenda of new initiatives for almost every sector of the economy.

    As a result of the additional policy uncertainty it is going to take our government muchlonger to process all these initiatives. At this point in time, and assuming no new fundamental changes on the world stage or major changes in domestic political direction, economic growth will begin to occur no sooner than the end of 2009, but much more likely afterward; however, I would not be surprised if unemployment temporarily touches the 9-10 percent range before it starts to fall.

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