Are We Socialist Yet?

To answer this, we have to define what socialism is. There’s often confusion surrounding this, of course. An article in my local paper this week upbraided a previous week’s writer who had decried our country’s “headlong rush into socialism.” The article said this was ridiculous, because Obama isn’t trying to turn the U.S. into the old Soviet Union. While this may be debatable (I say, only half joking), who said anything about the Soviet Union? The Soviet system was what we refer to as communist. Importantly, communism is little more than a logical extension of socialism, with even more power in the hands of the state. But what the letter writer was really objecting to is what he sees as our country’s adoption of European style socialism, with its protected working class, socialized medicine, high tax rates, etc.

Have we become Finland, or France? Again, it seems we need a definition here. Philosophically, socialism is about a large and powerful state, which necessarily comes at the expense of personal liberties. A government can’t spend money without taking it from someone first.

But still, this is a vague definition, and I like to quantify things. I started my thought process with tax rates, but quickly realized this would be difficult to calculate. After all, how many forms of taxation are there in our country? Hundreds? Thousands? One easily forgets all the small taxes built into things like the monthly cable bill. My colleague Daniel Grasman, a European who knows his socialism, suggested I look at total government expenditures as a percentage of the overall economy. Bingo! All taxes find their way into spending, so this method captures everything.

On the next page is the data for OECD countries going back to 1991.

General government total outlays as a % of GDP

A little hard to see, I know, but that archetypal socialist country, Sweden, tops our list, along with France and the other Scandinavian nations. No surprises here. Note, though, that the Scandinavian countries have been inching away from socialism while we have been inching towards it. The gap between Sweden and the U.S. in 1991 was 23.6%. By 2010, it is projected to be 15.1%. And the U.S. numbers don’t even include an assumption for nationalized health care.

By my way of thinking, every country on this list is socialist, including the U.S. Some are just worse than others. To appreciate this, let’s look at a longer term view of the U.S, because this has been creeping up on us for a long time:



The trend is as clear as it is unsustainable. As Margaret Thatcher once famously said, “The problem with socialism is that you eventually run out of other people’s money.” Well, yes, but the problems run deeper than that, including the creation of a culture of dependency, something that runs counter to America’s long standing tradition of self-reliance.

But these numbers don’t capture the whole picture. Socialism is about power focused in the state, and power is not always manifested through money. The state can pass laws compelling citizens to do things. For instance, in Southampton, Long Island, the town board has passed a law saying that henceforth all pools must be heated with solar panels. An 800 square foot pool will require 500 square feet in solar panels. Where to put them? The town board won’t solve that problem for you, but they feel good about themselves because they are saving the planet. A small liberty – the right to heat your pool – is lost. These things add up.

An even more threatening example? The “cap and trade” bill passed recently by the House mandates that your house must undergo an “environmental audit” if you wish to sell it. In other words, a federal bureaucrat will be able to hold up your house sale indefinitely if you don’t have the right kind of light bulbs. To make the policing of this possible, the bill plans to increase the staff of the EPA from 10,000 to 45,000 people. Yikes!

There has been an interesting backlash of late in town halls and letters to editors, and I have a theory about this. The graph on the previous page tells an interesting story. It says that statism has been very effective at advancing its interests over the decades, but it has done so incrementally. This was clever because, like the frog that doesn’t know it’s in boiling water until it’s too late, the logical foes of statism have largely ignored statism’s steady advance. Why? Because, I think, these logical foes are busy with their lives. They have jobs and families, and would frankly not like to take time out from these pursuits to do things like read twelve hundred page bills.

This is quite contrary to the “activist,” whose very life is often organized around advancing an agenda. I noticed this dynamic first in college. The activists seemed to have few other pursuits. Many of us certainly opposed them philosophically, but this opposition was about our fifth priority behind things like sports, socializing, sleep, and yes, even studies. Where activism was concerned, we may have had them outnumbered, but we were at a complete disadvantage.

This dynamic persists in the real world. The activists go into politics, or work for advocacy groups, while the rest of us just…work. Take ACORN, which seems to be able to muster a crowd of people on virtually any weekday. Who are these people and how did they manage to get the day off? They didn’t, because this is what they do.

An ACORN Protest – How Do They Have the Time?

So, for decades now, these folks have successfully, incrementally, advanced the power of the state. Over the last seven months, though, they have decided to reach for the brass ring. They want everything on their wish list, and they want it now, and this has turned out to be a large strategic error. It was so much, so fast – one trillion dollar bill after another – that the “silent majority,” as they are often called, said to themselves, “hey, maybe we should actually pay attention to this.” A tipping point had been reached, and an angry backlash began. The honeymoon for Mr. Obama is definitely over:

I believe the huge dip in the stock market last winter was largely attributable to the prospect that Mr. Obama would be able to get his entire agenda through, and people were suddenly getting clarity as to what that agenda really was. The huge rally since began almost to the day that it became apparent that cap and trade would likely never get through the Senate, and the rally gained steam as health care floundered. Stay tuned, though, this isn’t over.

Some Musings on Taxation

Question: What is Hauser's Law? Answer: The Most Simple, Important Economic Concept You've Never Heard Of

In 1993, an economist named Kurt Hauser discovered an amazing fact: the federal government, no matter how much it raised or lowered the top income tax rate, always collects about 19.5% of GDP in tax receipts:


This is almost unbelievable. Look at the 1950s, when marginal rates were 90%. The government collected about 19.5% of GDP. Look at the 1980s, when the highest rate got down to 28%. The government collected about 19.5% of GDP.

Some critics say this is misleading because it measures total tax revenue (including corporate revenue, etc.), and not simply revenue from individuals. Fair enough. Take out everything else and here’s what it looks like:

Case closed, I’d say. Note the amazing constancy even during the huge cuts in the 80s. (I remember a former economics advisor of mine, James Tobin, testifying before Congress that the tax cuts would lead to huge drops in revenue and result in recession. This, from a Nobel Prize winner.)

My colleague, Simina Farcasiu, points out that the data above probably understate the case since GDP is likely understated during high tax regimes, i.e. when tax rates are high, the underground economy is larger, so tax receipts during high tax periods are even lower as a percentage of "total" GDP (legit + underground).

The conclusion is clear enough: marginal rates should be lower since this will stimulate economic activity and the government will collect more actual dollars as GDP expands. Not that it’s always desirable to give politicians more to spend, but the point is the economy will be healthier, and therefore society at large.

What's interesting to me is that when people are asked what they consider to be a fair rate of taxation, the most common reply is 20%. It seems that this is also what society, collectively, has decided to pay, regardless of the tax rate.

But wait, you say, willingness has nothing to do with it. The law is the law! True, and not true. First, high income earners are quite dexterous at finding legal ways to avoid taxes. One way is to live more of your life on pre-tax income. Say you run a small or medium size business. Right now you're thinking quite creatively about what sort of expenses can be run through your company. Don't have a dental plan? You will soon. Not expensing at least part of your car lease? You will soon. These are things most business owners won't obsess about in a low tax environment, but they are obsessing about it now, and the taxes haven't even hit yet. Oh, and these same folks are pondering just not working as hard, which is another legal way to avoid taxes. And, of course, there will be those who have no compunction about crossing legal lines.

All this, of course, should remind you of the Laffer Curve:

Hauser's Law can be taken as empirical proof of the Laffer Curve's efficacy. And really, no one can argue with Laffer's basic logic. At a 0% tax rate, the government collects nothing. At a 100% marginal rate, presumably no one will work, or more likely all labor will be off the books, so again, the government collects nothing.

What is difficult to tell is how the curve is shaped, and where the peak of the curve is. I used to live in Hong Kong where there was a 15% flat tax, and tax collection was quite robust. Indeed, the Hong Kong government would run a huge surplus every year.

Some interesting experiments were conducted by three Canadian economists to understand whether there was any psychological underpinnings to the Laffer Curve. It turns out there are very strong ones:

"The fact that tax responsiveness of work is substantially greater when the tax rates are set by another subject in flesh and blood than by nature is taken as evidence that workers respond strongly and emotionally to unfair taxation, which is consistent with the history of tax revolts. To be more specific, taxpayers want to punish the tax setters who intentionally violated the social norm of fair taxation."*

In other words, when tax payers feel like they are getting shafted, they take it personally, and they react. "I'll show them," is the attitude, which is a sentiment I am hearing over and over, and, for the most part, which is amazing because most of the coming tax hikes haven’t even taken effect. This sentiment is most prevalent among the well off, which makes some sense, since the top 5% of taxpayers already pay 60% of federal taxes (source: IRS). Now our president says almost daily that everything he wants to do can be financed by these very same people. He even seems pleased at the prospect.

{*A Micro-foundation for the Laffer Curve In a Real Effort Experiment (Levy-Garboua, Masclet, and Montmarquette, 2006)}

It will never happen. He may try, but the revenue won't materialize, because those 5% are already enraged, and they also happen to be the best equipped to avoid taxes if they want to. As I suggested, many are small business owners who can live more of their lives pre-tax, and many have the resources to say, "Screw you, I'm retiring." They'll move to Florida (no state income tax) and buy munis.

And then there will be the resurgence of the grey market economy. I heard about a contractor on Long Island the other day who now will quote two prices for jobs: one cash under the table, the other above board. He had never done this before. What set him off after all these years? Was it...

35% Personal Federal Tax
8.8% Personal State Tax (NY)
6.2% Social Security Payroll Tax
2.4% Medicare Payroll Tax

No, it was none of these things. It was a new 3% payroll tax to pay for the hugely inefficient Metropolitan Transit Authority in New York City. Even though his business is 100 miles from the city, he has to pay the tax because the Long Island Railroad (part of the MTA) has a single branch that services his town, something that he never uses. For this guy, it was the tipping point, which jibes with the Canadian study. (Interestingly, this guy's employees are also highly incentivized to go along with the scheme since they, too, will avoid taxes by being paid off the books.) If taxpayers feel they are getting jerked around, they will sometimes radically alter their behavior, and may have little compunction about crossing legal lines.

Any and every tax proposal that has ever come out of Washington uses something called “static scoring,” which assumes that people never vary their behavior. This is wildly unrealistic. I can tell you that conversations about tax-minimization are being had everywhere right now, from little shops to big corporations. Look for corporate perks like a car and driver to make a big comeback.

Next month we will ponder the question: are we a socialist country?

People Are Irrational - More Evidence

Can you find the rational agents?

There are many problems with the theory, of course, but the one that has always stuck out for me is the whole idea of a rational agent because, frankly, people are nuts. We are not programmed to be purely rational. Although this seems obvious to most, an associate professor expressing this view anytime between 1970 and 2000 would have been smacked upside the head by his tenure review committee. Enjoy the rest of your career at East Nowhere Community College. It's still a dangerous viewpoint, but so much contrary evidence has rolled in that there are cracks in the monolith.

Which brings me to an interesting study of professional golfers by two professors at U. Penn. They analyzed golfers to see if they sank putts of equal length with differing rates of success depending on whether the putts were for birdies or pars. In theory, it shouldn't matter. A stroke is a stroke. "Par" and "birdie" are arbitrary assignations - they merely describe how you do on a hole.

1.6 million Tour putts were analyzed, and it turns out that pro golfers are 3% better at making par putts for par than for birdie. This adds up to about three strokes per tournament and some serious money. Interestingly, when confronted, few pro golfers doubted the findings. More interestingly, some said there was nothing they could do about it. The bias seems hardwired.
"You can't fool yourself," said Stuart Cink.

“Bogie aversion" has direct analogs in the investment world. For instance, it's a proven fact that people hate losing a dollar more than they like making a dollar. I myself feel this way, even though it makes no sense. Here's another one: lying on the street you find a pair of third row Springsteen tickets that are going on Ebay for $5000 apiece. Assuming you are a Springsteen fan, do you go to the concert or sell the tickets? Most would go to the concert. Would those same people pay $10,000 for the tickets? Not likely. This is also irrational behavior.

Then there’s the fact that two different people, given the exact same set of facts, will often do two totally different things. That means at least one isn’t a rational agent.

There are many, many such examples. As a result, markets will never be efficient. My own view is that they are mostly efficient most of the time, and terribly inefficient some of the time (e.g. lately).

Why does EMT persist? For one thing, it’s beautiful. When you follow it through its development from Markowitz to Sharpe to Tobin, with each economist adding new levels of elegance, you can’t help but admire the intellectual force behind the theory, and how neatly it seems to wrap the messy world of investing up into simple concepts. If this had been the fruits of my own intellectual efforts, I too would be reluctant to give up the ghost. The Nobel sitting in my study wouldn’t make it any easier, either. But the fact is, EMT is dead, as is a host of other market theories loosely banded together as Modern Portfolio Theory.

Nobels await those with better ideas, but they won’t be as beautiful, because they will need to explain the messiness of the human psyche.

Inflation - The Other Side of the Story

We often hear the phrase, "moral equivalent to war." I would like to introduce a new thought, which is the "economic" equivalent of war. I will circle back to this thought momentarily.

Milton Friedman famously said that inflation is first and last a monetary phenomenon. Print more dollars and, all else equal, each dollar is worth less since there are more of them relative to whatever goods are out there. On this score, inflation could get ugly because the money supply is going berserk. While the Bush administration was no model of fiscal discipline, the Obama administration has spending plans the likes of which the world has never seen, and apparently the fact that the government doesn't have the money isn't a deterrent because, heck, they can always borrow it or print it. Borrowers need to be paid back, of course, so ultimately the only option will be to run the printing presses morning, noon, and night. Friedman is surely rolling over in his grave.*

(If you’ve never seen it, one of my favorite YouTube videos can be seen here:

http://www.youtube.com/watch?v=RWsx1X8PV_A

(It features Friedman debating an unctuous, intellectually impaired Phil Donahue, in 1979.))

The “monetarists,” as they are known, are in Inflation Camp #1. I am a big fan of the monetarists, and history favors their view, but I think they miss half the story.

Then there are the Keynesians, who fret about people being too successful. This is Inflation Camp #2. High growth rates produce too many rich people who then presumably buy lots of things, chasing prices upwards. The only problem with this theory is that the historical evidence would suggest that, as theories go, this one is a steaming pile of poop. In the 50s, 60s, 80s, and 90s, we had high growth and low inflation. In the 70s we had the opposite: low growth and high inflation. So what gives?

So the monetarists, in my book, get it half right while the Keynesians get it half wrong. There’s another side of the story, one that I never hear anyone talk about, and one that doesn't make our current picture any prettier. Regardless of how it gets there (the economy or printing presses), monetarists and Keynesians both focus on how much money is in people's pockets, which in turn affects the demand for goods. But what about the supply of goods? Why doesn't anyone ever mention that? Prices are based on both demand and supply, after all. My thesis is that the pronounced statist direction our country is being taken will have a major negative impact on the supply of goods.

It's useful to look at a bit of history to understand this statement. In the 80s and 90s, money supply was kept under control and inflation was low, so two points for Friedman. But our wealth grew at an unprecedented rate, so how come all those rich people didn’t bid up the price of everything like the Keynesians said it would? The answer could be found in productivity gains. Simply, as demand for widgets grew (don’t groan, all ye econ majors), more widgets were delivered to the market, which kept prices in equilibrium. Supply kept pace with demand, in other words. But how? The answer lied in the ability of people and companies to marshal capital, invest it in production, and deliver goods to the marketplace in a timely fashion (something that began to be played out on a global scale). Minus 10 points for the Keynesians.

Sounds simple, but there are certain really important pre-conditions necessary to make all this possible. First, the widget makers have to be inclined towards risk taking, both in terms of time and money. Second, capital must be available for the widget maker to increase production.

Capital obviously comes from investors, and their calculus is simple. How much might one be rewarded for taking the risk? Of course, this is an after-tax calculation. Raise taxes, and investors will risk less.

Less obvious, and less recognized, is the decision matrix for the manufacturer. That taxes play a key role here as well is clear enough. But what about regulation, or legal risk? These things impose costs as well. Socialist societies aren’t just about taxes, after all, they are about control. What if our widget maker is told that he must, say:

· Provide health care benefits for all his workers, even the part time ones

· Buy Carbon credits since his plant will be emitting CO₂

· Pay for a complex environmental impact study for his new plant

· Buy more insurance to cover ever-increasing class action suits

· Source a certain percentage of his energy needs from expensive alternatives like solar or bio-fuels

And then there’s the additional ongoing cost of compliance with all these initiatives. Maybe the worst thing about socialism is all the damn paperwork.

None of these measures is a direct tax, but they might as well be. Argue about the greater good all you like but unarguable is that regulation lowers the return on capital. Socialism amounts to a huge marginal tax on risk taking. Reduce the potential return from risk taking too much and manufacturers will say “screw it, I don’t need this,” and investors will buy munis and go to the beach. Initiative doesn’t happen if the rewards aren’t there, not even in America.

And so, that new widget plant never gets built. Existing widget plants can’t meet demand and widget prices therefore rise to put supply and demand back into equilibrium.

So, back to the whole “economic equivalent of war” idea. If you look back through very long periods of history, inflation is primarily a wartime phenomenon. Sidney Homer, in his groundbreaking book, A History of Interest Rates, looked at inflation all the way back to the Mesopotamians (an exercise that was on all our “to do” lists, I'm sure). What sticks out is that almost every serious inflation spike across many cultures and economies came due to war. Here are some "recent" examples:

Event	Inflationary Period	Years	Inflation
American Revolution (1775-1783)	1776-1778	3	81%
War of 1812 (1812-1815)	1811-1814	4	34%
American Civil War (1861-1865)	1861-1865	5	96%
World War I (1914-1918)	1914-1920	7	109%
World War II (1941-1945)	1941-1948	8	72%
1970s stagflation (1973-1982)*	1973-1982	10	131%

But why is this so? Inflation doesn't happen just because people are shooting at each other. No, it happens because government forces a reallocation of resources away from where the natural demand is. For instance, if car factories are turned into tank factories, cars become scarce, and their prices go up.

This is why socialism is the economic equivalent of war, because both involve extensive government intrusion into the economy, and both divert resources away from where they would naturally flow. This is exactly what happened in the 1970s, our last great foray into the foul waters of a statism. Remember gas lines? They were caused not by a sudden spike in demand, but by supply bottlenecks caused by the stupid regulations and price controls of the era (in addition to supply tightening from the Middle East). Unfortunately, the regulations being contemplated right now by an unfettered Congress make the 70s pale by comparison, and they will not be easily undone.

(Side note: Congressional Democrats just introduced a twelve hundred page “Cap and trade” bill that they are forcing members to vote on Friday. Is anyone actually going to read it? This bill will be a huge tax on energy usage. As energy is baked into the price of just about everything (particularly food), the inflationary impact should be obvious. Additionally, a whole new federal bureaucracy will have to be created to police this. They will monitor energy usage of business everywhere and will dictate the need to buy carbon credits. We will come to think of these bureaucrats as “greenshirts.” I can hardly understate what a bad idea all this is. Where is the thoughtful debate?)

So, as you can see, we’re in for a double whammy: lots more money chasing fewer goods. Are you protecting yourself? Not to use this as an advertisement, but inflation is one reason Belstar has stepped up its efforts in timber. As more and more money is printed, trees – whose supply is relatively fixed – will become scarce relative to dollars and therefore will appreciate in value. It is perhaps unfortunate for our economy, but it’s going to be far more advantageous to own non-financial assets in the next few years.

Travelogue - Disneyworld

We love traditions in our family, and one is that each one of our kids gets a solo trip to Disney World with Kelley and me on graduation from pre-school. This year is Brady’s turn, our youngest, and I am writing this from our hotel room where we have taken shelter from a violent electrical storm. Naturally, we chose this day to go to one of Disney’s water parks. The storm closed in out of nowhere as we were reaching the top of an interminable line atop Blizzard Mountain. The sky turned black and lightening was striking close by. We ran like hell since, as a golfer, I appreciate the dangers of lightening. On top of this, we were soaking wet and standing near the top of a faux 130 foot mountain in the otherwise flat topography of central Florida. Interestingly, most other people didn’t seem to be in any hurry. Perhaps they thought lightening would not possess the temerity to strike in the Magic Kingdom.

The interesting part of Disney, for me, is the people watching. The sheer girth of the average American is not to be believed. What the heck is everyone eating? I’m the first to admit I should lose 20 pounds, but I’m talking about people who are 100 pounds overweight, and they are everywhere. Which leads to the other interesting phenomenon, which is the sight of hundreds of otherwise ambulatory people riding around in little scooter chairs. Some had medical reasons, to be sure, but many appeared to just prefer spending $60 a day to avoid the nuisance of walking from the Haunted Mansion to Pirates of the Caribbean. Some were as young as their 20s. It was kind of nauseating, really. Kelley got mad at me for pointing it out over and over.

The good news is that there doesn’t appear to be any recession here. Disney is a sea of people who also appear to be spending money in the stores. That edge-of-the precipice feeling we all had last fall has clearly been forgotten by most. Last December, looking at data from past recessions, I ventured a guess that we’d be done with this recession by July with unemployment peaking at 10%. I just might hit the nail it on the head, which goes to show you we shouldn’t actually pay anyone to be an economist.

The recovery, though, will be anemic, largely due to the ghastly developments in Washington. I know many of my readers have been wondering why I haven’t leveled both barrels in this direction. Truthfully, it has been too painful to contemplate. The act of writing it down would somehow make it real, and I’m still holding out slight hope that, like JR Ewing, I will wake up in a cold sweat saying, “thank God, it was only a dream. Kelley, I thought they’d taken America and turned it into Belarus. It was so real.”

Perhaps next month. In the meantime, it has been interesting to note that the inflation/deflation debate seems to have been settled in the last few weeks, which is to say few are worried about deflation any more. Which is good news, sort of. More like less terrible news. As a country, it’s like we just went on Let’s Make a Deal and passed on door #1, which had a canon behind it that would have shot us dead, and won what’s behind door #2, which is man with a rifle who shot us in the spleen, a wound which will require a long and painful recovery.

As a firm, we have been harping on this for months, that something wicked this way comes…

(see next post)

Bad Parent?

This month I will focus on inflation, irrationality, and Mickey Mouse. But first, can someone tell me what's up with the weather? Someone has apparently moved New York to Seattle without telling anyone. How else to explain the last two months of cold rain here in the Big Apple? Still, like anyone else, I love this time of year, and as any parent with young kids knows, it comes with multiple school attendance obligations. Not that I mind these milestone events, of course. It’s a proud moment for any parent to see their child move to a new level, and I recently attended a spate of these events.

I grow concerned, however, about my dedication as a parent. I apparently don’t love my kids as much as the other parents, because what else can explain the fact that I haven’t documented every moment of my children’s’ existence? I am clearly negligent. One father, at my daughter Caroline’s graduation from lower school, loves his daughter so much that he stood through the entire ceremony while simultaneously operating a camcorder in one hand and a large digital camera in the other. His wife, who is also a really loving parent, stood by his side holding a third camera. They were immediately in front of Kelley and me, so we could fully appreciate how much more they loved their daughter than we loved ours. Some circle of hell reserved for bad parents awaits us, I fear...

Somebody told me that Caroline looked beautiful as she marched in her spring dress with the other girls, which made me smile.

Crash Test Dummies

I spent the better part of my undergraduate career in a restaurant named Rudy’s. Okay, it wasn’t a restaurant, exactly, although I think they had hamburgers. It was an upscale tavern.

Okay, it wasn’t that either, but we solved many of the world’s problems there, fueled by $4 pitchers. Lately I’ve been thinking about a picture on the Rudy’s wall, one I sat beneath countless times.

Prelapsarian New Haven

This football game in the photo is a famous one. With 70,000 fedora-clad people watching in a sold-out Yale Bowl, Albie Booth, an unknown Yale sophomore, came off the bench to lead Yale to a come-from-behind 21-13 victory over a heavily favored Army squad. Newsreels of the day reported the game with the caption, “Booth 21, Army 13.”

I had the son of a friend of mine who’s currently an undergrad go snap this for me. I called the proprietor and asked him if he could do it, but that never happened, and I frankly would have been disappointed if service at Rudy’s had improved to the point where this was possible. So thanks, Phil, for pinch hitting.

I can still see the remnants of my initials, incidentally, on the wall beneath the corner of the second picture from the right (only the top half of the “J” is visible). It was in the booth below that we penned the song “P is for the P in Pierson College,” a fact meaningful to you if you are one of a few thousand people, and completely without meaning otherwise. I digress.

Here’s what I always noticed about this picture. In the lower right hand corner of the photo is the date of the game: October 26^th, 1929, forty-eight hours before the crash. I would stare at that photo and think, if only I could lean inside that photo and scream sell. If only they knew what we know now.

Hmm, scratch that last thought, because here we are again, in another doozy of a crisis. I wonder, what picture will students of the future stare at from our era? Will it be something like this?

Or this?

Who knows? But it begs the question,

How Did We Get Here?

This is the only time I can remember when the “world to end tomorrow” crowd actually got it right. Normally, you can make a very nice living betting against the guns ‘n gold crowd. Y2K anyone?

Not this time. While we’re not heading all the way back to the 1930s, this is still bad, bad stuff. And yet, there’s a lot of confusion around what happened, exactly. Oh, we all know bits and pieces, but would you be comfortable explaining it to someone? So, I’m going to humbly attempt to distill down my own take on this into a couple of pages. If you feel you have total clarity, feel free to skip ahead.

First, the 20,000 foot view:

We were too leveraged.

Okay, simple enough. Now the 10,000 foot view:

People borrowed money irresponsibly.

Institutions lent money irresponsibly.

The first part is easy enough. Everyone had too much debt on their personal balance sheets. More specifically, they got into mortgages they couldn’t afford when the economy went south. Yes, there was a lot of credit card debt, etc., but the real problem was mortgages. And I say “people,” because while corporations got fairly levered, too, they were not what got our whole economy into trouble.

One problem I have is that the chattering classes don’t assign any of the blame to irresponsible borrowers. Nobody forced anyone to take on huge mortgages and not even read the contracts. The notion of bailing these folks out steams me. And I have always found the phrase “predatory lending” faintly ridiculous.

The second part of the problem, irresponsible lenders, takes a little more ink. It falls into two categories:

1. Government-created problems

2. Privately created problems

That the government bears a huge part of the responsibility for what’s going on is quite clear. Since the 70s, the federal government has pursued policies that pushed homeownership into the hands of those who couldn’t afford it. Fannie, Freddie used implicit government guarantees to make mortgages cheaper, and they financed billions of subprime mortgages. The Community Reinvestment Act and its enforcers like ACORN and the Justice Department were used to browbeat and threaten lenders into making subprime loans. So they did, lest they be picketed, or worse, hauled into court.

But that doesn’t mean that the private sector was blameless. Some very creative mechanisms were invented to feed the ever-growing lending machine. To understand this, let’s go back a bit and recall the Bailey Brothers Building & Loan model from It’s a Wonderful Life. Local citizens deposit money in the bank and the bank loaned this money out in the form of home mortgages to other local citizens.

“You're thinking of this place all wrong, as if I had the money back in a safe. Your money’s not here. Your money is in Joe's house, that's right next to yours, and in the Kennedy house and Mrs. Macklin's house and a hundred others. You're loaning them the money to build and they'll pay it back!”

This model had the great advantage of “knowing the customer.” George Bailey knew everyone in town and could make reasonable credit judgments. Further, if his judgment was wrong, he paid the price. No subprime here.

On the other hand, Bailey Savings & Loan had one big disadvantage: a huge mismatch between assets and liabilities. Liabilities (deposits) were short term, while assets (mortgages) were long term. This left George prone to ruinous bank runs, just like in the movie.

Fast forward to the late 1970s. Lew Ranieri, an overweight, chain smoking man without a college degree, had a clever idea. He thought, why not buy up lots of these mortgages from all the Bailey Savings & Loans and package them together, and then sell the package? This would make for an interesting, bond-like investment for lots of institutions, plus it would solve the mismatch problem for the S&Ls by letting them just sell the mortgages to someone else. Brilliant. Ranieri helped Salomon Brothers, his employer, climb to the pinnacle of Wall Street. I was there at the time. We used to gaze over to the other side of the trading floor and watch Ranieri’s group consume prodigious amounts of food at lunch. Hey, they were making the firm tons of money; a little spilled marinara on their ties could be overlooked.

The market boomed as mortgages became a key part of any institutional portfolio. But the seeds of a new problem were being planted: while the mismatch issue was solved, mortgage originators had less incentive to “know their customers,” since they were just passing the mortgages upstream. As time went on, it wasn’t even S&Ls that were doing the mortgage originating anymore, it was firms like Countrywide Credit, who were simply paid a commission for any loan they could originate.

Wall Street was the next stop for the loans as bankers would gather them up and package them. Shouldn’t Wall Street care about crappy loans? Yes, and they did, but they thought they had a clever way to deal with them. More on that in a moment.

The packages they created were often in the form of CDOs, which prioritized incoming mortgage payments.

Securitization Done Right

In the picture above, claims on the loan portfolio are prioritized. Cash, as it comes in, goes first to the holders of the triple-As and last to the people at the bottom. This structure is sometimes known as a “waterfall”. On the other hand, defaults would start at the bottom and work their way up. This is a totally sound structure where defaults have to reach absurd levels to affect the triple-A tranche.

But then, Wall Street, along with the ratings agencies, took a horrible turn. Mind you, few understood that it was a tragic mistake, so it’s not like there was malicious intent. Nonetheless, here’s what happened:

Securitization Done Wrong

Someone got the bright idea to take a low-rated slice out of the first “waterfall” and make a whole other waterfall, often called CDO². This waterfall was then given its own cascading series of ratings, including a big slug of triple-A. How? It was surmised that even if the tranche was filled with deadbeats, someone would pay their mortgage. Statistically, it was thought that in fact most would, and therefore the triple-A investors would be safe. This is where the ratings agencies made their big – colossal – mistake.

The problem was that no one had modeled a meaningful decline in American home prices because the historical data didn’t show that ever happening. It happened in the 30s, of course, but no one had the exact data, so, where the modelers were concerned, it was like it never happened at all. So, as prices actually did start to decline a couple of years ago, defaults started flowing up the left-hand waterfall and sure enough, the B-tranches were taken out almost all at once. Of course, that means the second waterfall was also taken out all at once. Triple-A had become meaningless. It was all junk.

Another problem has its roots in the way Wall Street pays itself, which is generally a smallish annual salary and a large bonus based on each year’s performance. (This is something I have written about before.) As a result, even if someone had realized how dangerous a game they were playing, they wouldn’t have had any incentive to care. The game became so profitable that you only had to play it for a few years to make a pile of money. If it blew up in year four or five, it was fun while it lasted. It’s not like you had skin in the game.

Coming up with a comp structure that corrects these flaws is no easy task, but clearly pay has to be pegged to performance over a longer time frame. I know that various banks are thinking through this right now.

And there you have it - the genesis of almost all the “toxic assets” you hear about. It’s what has made our big banks insolvent, because they own tons of this stuff (as it apparently never got resold). Understand the last couple of paragraphs, and you know most of what there is to know. Sure, there were other issues like credit default swaps, which is what got AIG in trouble, but CDOs are at the epicenter of this crisis.

Back to the irresponsible lending part. You can see, I’m sure, that once you had this clever machine that created triple-A out of thin air, all you wanted to do was feed it. It didn’t matter what you fed it with. The mortgage originators, happy to oblige, eliminated any credit standards for loan applicants and even began lending 100% against home values (side note to all of us: should we ever see this happen again in our lifetimes, sell, Mortimer, sell).

This also became fertile ground for scam artists who would find crooked appraisers to value a home at, say, $1.5 million instead of $1 million. The Countrywides had no real incentive to look closely into this, and by the time it got to Wall Street it was too late.

So, what are the lessons in this? Can we actually get smarter, or are disasters like this in our DNA? Ideally, we’ve learned the following:

1. The government should stay clear of trying to influence markets, other than putting in place broad, commonsense regulations such as credit limits. Sadly, I don’t see this happening. In fact, things seem to be going quite the opposite. (So distressing is the current political climate that I haven’t yet had the mental strength to comment – but that will come.)

2. No one should borrow too much. Okay, that’s a no-brainer. It’s also a no-brainer that people will just as soon as credit becomes easy.

3. We should avoid creating (or buying) overly complex instruments. In the end, not even Wall Street CEOs understood what some of the mad scientists were creating. I doubt we’ll pay attention to this lesson for more than another three years or so.

The inescapable conclusion, for me, is that a meltdown every generation or two is inevitable. It is quite literally in our DNA, because its roots are in our natural instincts for fear and greed (I’d throw in sloth, too). And remember, the next crisis will not look like this one, just like this one doesn’t look exactly like 1929. It will take on a different form, just different enough for people to convince themselves the threat is not real.

For those tempted to think this is some sort of fatal flaw in capitalism, and that some sort of Euro-socialism is the answer, think again. Socialist countries suffer economic downturns just like we do, and in the good times they, well, suck at wealth creation. Socialism is all the downside with little of the upside. Unfortunately, this dynamic openly pleases the statists among us.