HodgBlog

Because I used to work on Wall Street, some people I know are under the (incorrect) impression that I’m an expert in all things financial, and they have been asking me if I can explain how we got into our current state of financial collapse. So, I thought I would write a short summary of my understanding of how rampant greed around the practice of sub-prime lending led to a full-scale financial crisis.

First, let’s set the scene: the sub-prime lending market. Here’s a brief summary of how it worked:

• For at least the past ten years, many banks and mortgage companies in the U.S. have been aggressively seeking out people who were not financially ready to buy homes (bad credit history, no savings for down payments, insufficient income to afford a house, etc.), and giving them mortgages. These borrowers had to pay high interest rates for their “sub-prime” mortgages, to offset the increased risk that they would default on them.
• Many of the borrowers were not very knowledgeable about money, and they often did not understand the implications of their mortgages. Some borrowers had low payments for the first couple of years, which they didn’t realize would go up dramatically after that. Other borrowers weren’t able to calculate the full cost of owning a home (including fire insurance, real estate taxes, association dues, and water and sewer bills that a renter typically would not pay), and they couldn’t even afford the initial payments.
• Many mortgage agents and brokers did not educate the borrowers or fairly assess their ability to afford the mortgages — they either were under no legal obligation to do so, or the laws were not enforced.
• Most mortgage agents and brokers are paid commissions (at least to some extent), so they had a financial incentive to make as many deals as possible, and no penalty if the borrower eventually defaulted.
• The lending companies sold the mortgages rather than holding them. Once they had traded a mortgage contract for cash, they had no more risk, and could go out and lend the same money again to another borrower. Because they were able to transfer the risk away and lock in their profits, they also had a financial incentive to make as many deals as possible, and no penalty if the borrower eventually defaulted.
• The companies that purchased the mortgages re-packaged them into very complex “mortgage-backed securities“, and sold them to investors (mostly banks); the companies that originally bought the mortgages therefore also transferred away all risk of default and locked in profits, and again had an incentive to do as much of this as possible.
• Since the Reagan era, we have had less and less regulation of our financial market (under the philosophy that a capitalist market can regulate itself more efficiently). One of the ways in which the financial market is supposed to regulate itself is that we have two big investment rating agencies (Moody’s and Standard & Poor’s), which rate the risk of financial assets. In this case, they failed: the investment rating agencies gave the mortgage-backed securities “investment-grade” ratings. This allowed companies that bought them to count them fully as assets on their books, rather than having to discount them according to the actual level of risk they carried.
• The traders and strategists within the purchasing banks (often people like me: ex-physicists who went to work on Wall Street), who were in the best position to understand the long-term risks of mortgage-backed securities, also had a large personal incentive to do these deals. They were basically gambling using someone else’s money: they made huge bonuses in the short term because the deals they did looked great on paper, and the most drastic down-side risk they faced is the possibility that they could lose their job some years in the future if the value of the mortgage-backed securities they had bought went too far down.
• Because of all of the sub-prime borrowers entering the housing market, there was a strong demand for houses, which contributed to housing prices rising at a rate that far exceeded inflation. This led to additional demand from housing speculators, who could buy a house, hold it for a short time, and sell it again (”flipping”), which drove housing prices even higher.
• So, everything worked smoothly for many years, with many people making a lot of money off the sub-prime mortgage market: even if someone defaulted on a mortgage (and the market expected a certain fraction of these borrowers to default), the principal could be recovered by investors because the house had increased in value. At the same time, many analysts warned that when the time came that the economy wasn’t so strong, the sub-prime mortgage could easily collapse.
• But because they were making money in the short term, banks ignored the underlying problems, and mortgage-backed securities became large fractions of many large banks’ assets.

In order to understand our current crisis, you also need some background on the workings of other (non-financial) businesses in our current economy:

• Much of the world economy currently depends heavily on credit. Medium to large companies do not generally operate by using the proceeds of their current and prior operations to fund their current expenditures. Instead, they fund their current expenditures by borrowing against their future profits. The businesses borrow by issuing bonds for longer-term capital needs, and by obtaining bank loans for their short-term needs. The banks get money to loan by borrowing from larger banks.
• This whole system depends on trust. The banks lend money to companies based on their belief that the companies will be able to generate income in the short term and pay the money back. Banks lend money to other banks based on their trust in the borrowing bank’s assets and loan portfolios.
• The current economy is also focused on the short term. Nearly every publicly-traded company focuses on quarterly profits rather than long-term prospects — the reasons being that their stockholders (who hold stock on average for days rather than years) demand it, and their upper management’s compensation is based on it.
• The current economy is also based on an underlying assumption that the economy as a whole will always grow, that the world will always increase its consumption. But consumption cannot grow forever — it’s not environmentally sustainable.

Now that we have set the scene, we are ready to understand the crisis:

• A few months back, the delicate balance in the average sub-prime borrower’s finances tipped (due to rising interest rates, rising oil and food prices, layoffs, etc.), and more sub-prime borrowers started defaulting on their mortgages than had previously been the case.
• Once this started, the houses these borrowers had owned started flooding the market, and housing prices started dropping quickly. This meant that the holders of the mortgage-backed securities not only held more defaulted mortgages, but the houses that formed the loans’ collateral were worth significantly less than the principal of the mortgages.
• The defaults and housing price drops meant that suddenly no one trusted the value of sub-prime mortgage-backed securities, which had become a very large portion of the total holdings of many banks. This led to a problem where the banks wouldn’t loan each other money, even in the short term, since they didn’t trust the financial stability of the other banks.
• When the banks couldn’t borrow from other banks, they couldn’t make loans to businesses, and the businesses didn’t have the money to fund their current operations (payroll, raw materials, etc.), and went into a state of crisis.

So that’s the story: short-term profits and risk transfers fueled sub-prime lending, and it got so big that when it collapsed, it took the confidence in the banking industry with it; without trust, no loans were made and our credit-based economy entered a state of crisis. This is why the U.S. government bailout is aimed at getting capital back to banks, and buying their untrusted mortgage-backed securities: so that the banks can once again loan money to businesses, and the businesses can get back to normal operations.

But I am not convinced this will solve the problem, since the underlying issues will not be changing:

• Economy focused on the short term
• Economy based on the availability of short-term credit, provided by banks
• Little oversight on the operations of banks and the investment rating agencies
• Economic assumptions of continual growth, which is environmentally unsustainable
• Coming crises in food and energy (see my previous blog articles) that no one is planning for

It will be very interesting to see if our next President and Congress will do anything to address these issues. So far, I haven’t seen much evidence that they plan to…

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World leaders are finally realizing that we’re facing a food crisis: they’re currently having a meeting in Rome to discuss it, and UN chief Ban Ki-moon recently stated that we need to grow 50% more food by 2030 to satisfy needs (I believe this is a conservative estimate). This is not much of a surprise to me — I mentioned the upcoming food crisis in my earlier article on biofuels, and it’s also related to the energy situation I discussed before that . Both the energy and food crises-to-be are largely due to a combination of a world population that is growing quite fast (expected to double by 2050), and a rise in the standard of living in some parts of the world (people with higher standards of living tend to use more energy and consume more food). This growth is not sustainable, as far as I can tell.

It has been suggested that to make our way of life more sustainable, we ought to shop locally (see my previous blog entry for discussion). But yesterday I read an article in Science news, based on a study published in Environmental Science and Technology, that I thought made an interesting point: the type of food we eat has a much greater environmental impact than how far it has traveled to reach us, at least in terms of greenhouse gas emissions. The study authors looked carefully at all parts of the process by which we obtain food, and found that the bulk of the greenhouse gases (83%) came from food production, with only 7% from farm-to-store transportation. Therefore, switching to buying only locally-produced food doesn’t really address the bulk of the problem. Instead, we need to think about the production phase: we can get about the same reduction in greenhouse gases by replacing red meat and dairy products with chicken, fish, eggs, grains, or vegetables just one day per week, as we can by buying all of our food locally. This has other benefits as well, in terms of the food crisis: a lot of the grain we grow is fed to animals to produce a much smaller amount of meat and dairy products, so shifting to eating the grains directly can also help alleviate the food crisis. Maybe we’ll all need to become vegetarians soon?

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I have been thinking a lot lately about economic growth. It seems like the news media, and practically everyone else, assumes that if the economy is growing, it’s a good thing, and if it isn’t, something terrible is occurring. This assumption has been bothering me for a while, and I recently read a book that put my vague uneasiness into words: Deep Economy: The Wealth of Communities and the Durable Future by Bill McKibben. In this book, McKibben makes the following points:

• When you measure the economy, only things that cost money count. So, for instance, increases in things like hospital stays, divorces, and burning coal in out-dated power plants count towards economic growth, whereas things like volunteer work, walking rather than driving, and spending time reading a library book with your child don’t.
• Economic growth in recent decades has not actually increased most Americans’ real earnings or standard of living.
• We are already facing food and energy crises, which will get worse if we keep “growing” the way we have been, and we can’t afford the global warming that would result. (See my previous articles on The Energy Future and Biofuels for more information.)
• Economic growth that raises individuals’ income up to the point where their basic needs are reliably met (roughly $10,000 per person per year) certainly makes them happier, but after most people have reached that point, economic growth does not increase people’s happiness.

So the problem is clear: economic growth is not improving the world or our happiness, and it isn’t sustainable. Unfortunately, the solutions are not easy. Here are McKibben’s key ideas:

• In the area of measuring the economy: When we measure the the value of economic activities, put a value on the natural resources they use up, as well as the pollution they produce, and count that against their economic benefit. Also, rather than only measuring things that cost money, attach an economic value to happiness and to beneficial activities like teaching, volunteer work, and child raising.
• In the area of sustainability: Work on making our economy more localized instead of more globalized, letting each local community come together to figure out how to make itself better. McKibben is convinced that if we all try to make more of our economic activities local, we will both solve our larger economic problems and make ourselves happier, as we get more of a sense of being involved in a community. His ideas include using building materials that come from nearby; eating food that is grown on nearby, small organic farms; adding small wind turbines and solar panels to our cities; and building sidewalks, bike lanes, and bus rapid transit. It’s hard to argue that any of those would be a bad idea.

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On February 11th, 2008, over 1000 people from over 70 countries, all of whom now live in the state of Washington, visited Olympia (our state capitol) for the second annual Refugee and Immigrant Legislative Day. I decided to take a day off work and attend. Here are some observations from the day:

• The schedule for the day: a bus trip to Olympia, a rally, some time to visit legislators, and a bus trip back.
• The legislative agenda for the trip: improve programs that help immigrants become citizens, housing assistance, English as a Second Language classes with child care and transportation included, and better programs for immigrant children in the public schools.
• The parts of this legislative agenda that I feel strongest about are the educational components. For instance, in my volunteer work (teaching English to adults, interpreting between Spanish-speaking immigrants and social service agencies, and helping out with various school and after-school programs for children), I have met many adults who have difficulties attending ESL classes, due to scheduling, transportation, and child care issues. Yet learning the language is a key determinant of well-being among adult immigrants, so I feel it is important to improve access to ESL classes for immigrants. The issue of education for their children is also crucial, and our schools are generally failing to educate children who arrive as English-language learners — the schools do not currently have the resources to overcome the barriers that these children face (lack of grade-level educational background prior to arrival, reading/speaking English at far below grade level, difficulties for teachers in communicating with parents, and less parental academic support because the parents also may lack English skills and/or educational background).
• At the rally, there were many inspirational words, mostly about how much immigrants matter to our state. One speaker, an immigrant from Korea who is now a state representative in the legislature, addressed the crowd and said, “Some day, maybe one of your children might become the President of the United States” (this made me think of Barack Obama, who is the son of an immigrant). Another speaker used the analogy of our country being a “tapestry” of people — each person a single thread, easily broken, different colors and sizes; together a strong and beautiful fabric.
• After the rally, we were encouraged to visit our state representatives. I went to see Maralyn Chase, one of my two representatives in the state House, and had a long conversation with her about the issues. She seemed very receptive, and very interested in my experiences and observations, as well as the legislative agenda papers I gave her. I felt like that conversation made the trip worthwhile.
• Sometime during my conversation with Representative Chase, I said that I wasn’t sure how things really got done in the legislature, and she said “This is how things get done” (referring to our conversation). I realized at that moment that I was lobbying my representative: trying to convince her to support a certain legislative agenda. So I am now a lobbyist!
• When our bus returned to the Literacy Source (the agency where I have been teaching ESL), the program coordinator congratulated me on moving from just being a volunteer service provider to being an activist, which has fewer negative connotations than the word lobbyist… but I still say that I am a lobbyist.
• Although the trip was short (we left after the morning rush hour, and returned before the evening rush hour, so there wasn’t a lot of time actually spent in Olympia), I thought it was very worthwhile. I hope that most of the people who went had the opportunity to talk, one-on-one or in small groups, with their elected representatives — although the rally was good for inspiration, I don’t think it was likely to accomplish much, on its own. In my opinion, the lobbying time was the most worthwhile part of the trip.
• I heard recently on the news that our governor had signed a new bill establishing a state-wide panel to study the situation of immigrants, in regards to what services they have and what services they need. This seems like a good idea. It apparently came about through lobbying by the organizers of the trip I participated in, probably partly as a result of last year’s lobbying efforts, but it was a nice coincidence coming so soon after this year’s trip.
• Maybe next year, rather than spending all that time on the bus, and standing in the rain at a rally, we could all visit our representatives during the part of the year when the legislature is not in session. The representatives would have more time (for instance, my state senator was not available the day we were there, and the two state house members were pretty busy with meetings), and we wouldn’t have to spend time driving to Olympia, because the legislators would be at their offices in our districts (no more than a few miles from home). Though probably, without the buses and the rally, not too many of us would actually make the effort to do it (for instance, I have rarely even written or called my representatives before now)…. So, the Olympia trip was probably the right way to do this, after all.

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The city that I live in (Shoreline, a suburb just north of Seattle) closed two elementary schools this year, and the city of Seattle has also been talking about closing schools, in both cases because the number of children enrolled in school has declined. Yet the population of both Seattle and Shoreline must be increasing, as houses are replaced by condo buildings and apartments, so I had been somewhat confused about this… Until someone yesterday pointed out the (in retrospect) fairly obvious reason: housing in the nearby suburbs and the city of Seattle is getting more and more expensive. So people in my situation (two good jobs, no kids) can still afford to buy houses, but families with school children are having to move farther north or south, to find housing they can afford. So we are closing elementary schools in my part of town, and Kent (a farther-out suburb) has been building new ones. Food for thought…

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