Protecting The Economy

The news has been scary lately. I worried about it for a while, but the grey cells kicked in after a bit and reminded me that the source of most of the noise was from people in the business of trying to scare folks. A lot of folks forget that whether it’s broadcast news, cable, or even an internet outlet, they are looking for ratings and the most popular way to do that is do a variation of Chicken Little. The media is – basically – dishonest in its priorities and focus, and always has been. This does not mean that you should not pay attention to the media, but you should keep in mind that they always have an ulterior motive, one which often skews how the present information.

So how big a deal is the present financial mess? Big enough that Democrats and Republicans are seriously talking about spending $700,000,000,000 of your money and mine to face it, with a minimum of narcissistic posturing. Big enough, that all the other markets in the world are affected by what happens here. Big enough that Barack Obama and John McCain actually say pretty much the same thing about what needs to be done. Big enough, that John McCain has suspended his campaign for a while to put his full attention on resolving the crisis. Big enough that even people with decades of experience in Economics are warning that we’d better be serious in how we fix this one.

Unfortunately, a lot of folks, some with advanced degrees, even including some who are in charge of fixing the mess, do not understand how we got here, and therefore they are pretty much clueless about what we do to straighten things out. Of course, I am no Nobel Prize-winner (in either the authentic or Goric sense), so my opinion is subject to a healthy skepticism as well, but I’d like to try to put this in some proper context. What has happened is essentially the combination of three significant causes, each of which would be serious on its own, but which together have caused a crisis of confidence in the United States economy.

The first point is the housing market correction. What basically happened there, was a series of goofs. First goof, the idea that everyone should be able to buy a house, regardless of whether they can pay for it or not. The plain fact is that some folks are lousy with budgeting their money, and some just do not have the fortunate situation that they can afford a big, new, expensive house. In years gone by, such people either saved up until they had enough, worked out how to pay for the house they wanted, or just made do on what they could afford, but about fifteen years ago, suddenly it’s “unfair” to pay attention to how much someone really makes, or even to pay too close attention to how they have handled their money and debts in the past. So, the rules got changed to make it easier for folks to buy a house, who have no business doing so, and to make it easier for folks to get a loan they cannot possibly pay off under ordinary conditions. The question of what would happen to the risk caused by such changes was frankly ignored; everyone just assumed someone else would take care of it. Look, I’m an accountant which means I know numbers but I’m not very tactful or diplomatic sometimes. The new laws were passed by politicians, who are very good at saying things in a way that most people like, but all too often they do not have a clue about the real financial effects of what they are doing. But of course we’re not done yet.
Making it possible for a lot more people to buy houses, meant of course that a lot more people did buy houses, and that old Supply and Demand law kicked in; more people to buy homes meant the price shot up, way way up in some places. That, of course, made it difficult for people with lower incomes to buy houses, including that group which should not have been buying them in the first place, since they could not afford the lower, original price. This time the mortgage people jumped in, offering all sorts of ways to deal with the payments, most notably the Adjustable Rate Mortgage (or ARM), the balloon-payment loan (where you pay a large amount later on the term), and the interest-only loan (where you can pay the principal amount at any time, even waiting until you sell your home). The problem with most of these devices, however, is that they were pretty much all built on the assumption that house prices would always keep rising, and rising faster than the inflation rate, something so absurd that one wonders how so many people bought into it. But of course, we are talking about salesmen and marketing people, whose role in life is so often to take care of their commissions, and let someone else clean up the messes they leave behind. As I said, I am an accountant, and I have a long and unpleasant history of conflicts with marketing people, who not only assume the best-case scenario is the one which will play out, they get angry and abusive if you even mention that there is a worst-case scenario which is bound to happen sooner or later. For years now, accountants have been warning folks that everything has to be paid for, that tricks with money do not change the way things work, that sooner or later the bill comes due, and we’d better be ready for that day.

That day is here.

One of the companies being bailed out is AIG, the giant insurance company. I noticed that earlier this year, AIG got into trouble for what are euphemistically called “irregularities” in accounting. Let’s be clear, irregularity in accounting is not like constipation irregularity, it’s like an irregular heartbeat, serious stuff. Basically, AIG started losing money and tried to hide it. Hide it, I note, without doing anything to find and address the cause. Freaking brilliant. And now the FBI and SEC are looking at more than two dozen companies for possible accounting fraud in connection with sub-prime mortgage lending.

So here’s the second point – John McCain was right when he said the economy’s fundamentals are sound. What happened was a mix of ignoring the accountants, trying to force feel-good policies onto banks without accepting that risk never goes away, and a roller-coaster media which feeds off fear and panic like the monster in Stephen King’s story, “It”. The accountants have been screaming warnings since before Sarbanes-Oxley was enacted (and I have a feeling that Sections 302 and 404 have not been properly enacted at many of these banks, which will trigger certain provisions of Section 1104), and the politicians have only lately begun to recognize that their ‘make everyone happy’ mortgage plan is somewhat less than ideal, but on the whole most businesses will survive the mess with little long-term damage.

So why do we need a bailout? Well, to start with the remedy is not really a “bailout” for most companies. The remedy is actually pretty simple, but it won’t be easy or pleasant:

[] The Housing market will continue to correct – the blunt truth is that houses are overvalued in some parts of the country, and some folks who cannot pay their mortgages will lose their homes to foreclosure. This is always painful, but in the overwhelming majority of foreclosures, the buyer was told about the risks and went ahead anyway. Where possible, loans will be reviewed and adjustments made, ideally to ordinary fixed-rate mortgages, but to do this there needs to be bank participation with willingness to accept reasonable risk. Congress, through Mr. Paulson’s office and requested authority, must decide which high-risk securities to take on itself.

[] The credit policies of banks and lenders must be internally examined for strength of infrastructure. At a minimum, this will cause a number of those companies to significantly delay or restate earnings, in order to clear bad debt. There must be protection against financial failure of the credit system, which includes not only the risks of bankruptcy and default of notes, but also protection of nominal credit access and liquidity instruments. The present fear has reached the point where even money market accounts have been impacted.

[] Despite the desire to look like Robin Hood, any money provisioned for this crisis must be applied to purchase of high-risk commodities and instruments (in a manner similar to the RTC actions of the 1980s), and to provide lines of credit for banks to use in making normal loans and conventional mortgages. The objective is to make money available in the short term which will be repaid as much as possible, not given away and never seen again.

[] Perhaps because it has come up so quickly and appears to be so serious, there has been remarkably and mercifully few attempts to play politics with the crisis. With that said, someone needs to sit the media down and teach them the fundamentals of economics, finance, and accounting. Education about the situation and the reasons for the actions taken would be helpful in preventing panic and advancing an effective resolution of the crisis. Katie Couric in particular should be prohibited from discussing the issue at all.

[] President Bush was correct last night, when he observed that if this deal is not approved there is a risk of panic about the economy as a whole. Public confidence is the most significant factor in addressing the mortgage lender situation. This is the time to restore calm, to work together to handle the issues, and to make clear that the resolution is being built. The answer is present, simple, and time-critical, and we must not waste time, energy, or focus.

UPDATE - I don't know if I believe everything it says, but THIS is a must-read.