How To Cripple a Global Economy In Five Easy Steps

by Jack Strange

A quote widely attributed to the famous physicist Richard Feynman said, “No matter how complicated a subject, if you can't explain something to an average high school kid, you really don't understand it.” The recent cascade of events that has caused credit markets to freeze, the housing market to collapse, the stock markets to crash, and an instability in the global banking system have been in the making for decades and are well understood. What is less understood, even by some of the brightest economic and financial minds in the world, is what to do about it. It challenged me as a teacher of economics and mathematics to find a way to explain it to my students.

Let’s examine what happened in five plus steps that led us to the crisis we’re in today.

Step one. Historically, conventional home loans have required a reasonably significant down payment. 20%-25% was not unusual, with repayment schedules that run from 20-30 years. I remember scrimping and saving for years in order to accumulate enough cash for the down payment on my first house. In such an arrangement both the lender AND the borrower have significant equity (an ownership interest) in the property. This means that both the borrower and the lender have strong incentives to assure repayment of the loan in keeping with the terms of the agreement. That delivers stability and reduces default and foreclosure rates. Potential borrowers were evaluated by trained and experienced loan officers who frequently relied as much on intuition as on a checklist to evaluate the creditworthiness of borrowers. In other words, conforming loans protect EVERYONE when housing markets are rising as well as falling. Both the borrowers and the lenders have equity. But over the last two decades there was a change in how home loans were both offered and evaluated.

So now Congress gets into the act. There was a concerted push in the U.S. Congress to make home loans more “accessible” to a greater number of people; a populist political objective. “Everyone should own a home,” the politicians crowed, “a piece of the American Dream,” whether qualified or not. The prevailing attitude was that accessible mortgages were a positive externality and a public good. (As it turns out it’s not. It may be the world's biggest negative externality and still the government is subsidizing it.) Legislation was enacted that made it a stated regulatory objective of the two big GSE’s, the government sponsored enterprises Fannie Mae and Freddie Mac, to assure that as much as 40% of all the money (liquidity) that the GSE's made available to banks to lend to individual buyers went to buyers in the “affordable housing” markets. Many of these so-called sub-prime borrowers are those customers who could not possibly qualify for conventional conforming loans due to a lack of an adequate down payment, little credit experience, a history of delinquency or bankruptcy, insufficient income, or dubious legal residency. In other words, they were promoting and making risky loans to those who are far less likely to repay them.

Regardless, the banks and mortgage brokers pitched low down payment and no income/no asset (NINA) loans to less-than-qualified borrowers like there was no tomorrow. Sure, the risk of loan defaults was substantially higher with the sub-primes but so was the potential reward since the sub-primes yielded higher interest rates and profits. Institutional investors were hooked. Throughout the 90’s Fed Chairman Alan Greenspan kept the Federal Funds Rate so low that these alternative instruments looked more and more attractive. “If a few borrowers defaulted, so what? We repossess the house and it still keeps gaining in value,” they thought. Sweet!

Many of these loans would then be “repackaged” through process called securitization and re-sold as derivatives such as mortgage-backed securities and collateralized debt obligations to institutional investors who saw their value as high-return investments but who had little connection to the actual borrowers on which these securities were based or to the inherent risk that these mortgage pools carried. Derivatives are financial instruments whose values depend on the value of other underlying financial instruments. They are the house whose inherent stability depends on the quality of the foundation that it’s built upon. Now the trap was set and properly baited.

So there's the smell of money in the water and the feeding frenzy begins fueled by good old-fashioned greed. The banks and mortgage investors throw caution to the wind and try to make sure that they’re able to chomp and gobble as much green meat as they can. And why worry? The government and its GSE surrogates Fannie and Freddie were there to provide the safety cushion. Yes? Absolutely! And if not them... the American people.

Step two. What ever happened to the steely-eyed loan officer with the trusty and well-worn rubber “NO LOAN” stamp whose job it is to protect the lender’s assets by carefully screening and qualifying loan applicants? Well, he was replaced by a statistical method of screening called credit scoring. Credit scoring had already proved itself an efficient and effective method of evaluating the creditworthiness of potential borrowers of other forms of debt like unsecured credit cards. So it should have worked with mortgages too. Or at least that's what everyone thought. Credit scoring had the other “advantage” of being less likely to be biased by factors that “human intuition” relies on such as, “What kind of neighborhood is the house in? Does the applicant have a steady job? Is his income verifiable and reasonable? Does he really have prospects of paying off the loan over the next twenty years? Does he seem like a solid citizen?” But credit scoring (instead of human intuition) as a predictor of credit risk failed to include a number of relevant variables. The statistical model relied on by lenders was broken so when housing prices declined credit scoring failed. Add that to the fact that, as we saw before, mortgage loans with low down payments are inherently destabilizing. Still 52% of Fannie Mae and Freddie Mac’s lending was to sub-prime borrowers. It was the enabler of the housing bubble… a bubble ready to pop!

OK, so where are we? Home loans are being offered to many new unqualified buyers. Risky? Sure. But as long as real estate values kept climbing you can afford to gamble. Everyone’s a winner! There’s no downside, right? Right?

Step three. With all this easy credit floating around to qualified and unqualified buyers alike it didn’t take long for the housing industry to get into the act. Houses and apartment dwellings were springing up everywhere like mushrooms after a spring rain. So much so that they got ahead of the market and that led to a classic problem of over-supply. According to some estimates, at the beginning of this year there were 18 million unoccupied housing units out of about 150 million households in the US. That leads to the free fall of prices as they seek market equilibrium. Pop! The housing bubble bursts! Add to this supply of housing the thousands upon thousands of new foreclosures coming on the market and things start to get really ugly!

Step four. You are a homeowner. Maybe you’re one of those sub-prime borrowers. You’ve got yourself a $400,000 adjustable rate mortgage (ARM) on a house with no money down. Sweet! But there's very little equity. Hey, when the mortgage broker pitched the financing package it seemed to be almost too-good-to-be-true! No money down, you didn’t need to prove your income, so you got fired twice last year but nobody checked, and the interest rate was really low so even the payments where do-able. Sure it’s an ARM but the rates don’t seem to adjust much and besides that’s two-years into the future. Go for it dude! And many did.

So here we are. The interest rates adjust. Actually, they skyrocket! You can't make the payments. You consider selling the house. But wait a minute! You discover that the house is now worth less than when you bought it. Whoa! That’s not supposed to happen. Real estate values always go up. Right? Worse still, you find out that you owe more than the house is worth. You’re upside down on your loan! So what do you do? You walk away. The bank will foreclose and take a bath. But not you. No sir. You'll only get dinged on your credit rating. A credit rating that wasn’t all that great in the first place. What about the ethics? I mean a contract is a contract. But hey, times are tough for everybody and sometimes you gotta do what you gotta do.

So the bank does indeed take a bath. Not just on this house but on thousands of similar houses. Now it’s in real trouble. And not just this bank but lots of banks.

Step five. The government gets into the act again. The goal of writing loans to unqualified sub-prime borrowers as a regulatory objective in part led to the unsustainable house of cards. In other words instead of allowing market forces to be the self-organizing system that drives the mortgage market, the calculated tampering by Senator Chris Dodd (D-Chairman, Senate Banking Committee) and Rep. Barney Frank (D-Chairman, House Financial Services Committee) to achieve their political objective (the regulatory mandate) of making housing “affordable” to bad-risk buyers has in-part led to a meltdown in global financial markets. Government’s role should have been to put a check on the derivatives and a check on credit scoring. It consciously did just the opposite.

Summing up... it's a tale of reckless behavior, of violation of fiduciary trust, of cynical political gamesmanship, of unbridled greed, of economic illiteracy, of no oversight, of no consequences. Lessons learned? None.

The fix? To close with another quote from Richard Feynman… "The real question of government versus private enterprise is argued on too philosophical and abstract a basis. Theoretically, planning may be good. But nobody has ever figured out the cause of government stupidity and until they do (and find the cure) all ideal plans will fall into quicksand.

Fair share? We need to be reminded...

In this season of bloviating political bluster, of global economic meltdowns, of financial bailouts and recriminations, of income redistribution schemes, of shameless and unrestrained pork barrel spending, of cynical accusations of greed and selfishness, it is important that we remind ourselves who it is who actually pays the bills. A minority of working Americans are now subsidizing a voting majority who pay little or nothing at all... the same majority who are pandered to with handouts by the economically-illiterate Barack Obama and John McCain. This road leads to tyranny. It is tyranny when a consuming majority possessing of an insatiable appetite can vote itself largess at the expense of a productive minority. It has been said that there is nothing more fun in this world than spending other people's money. When you don't have to earn it and when you can command it by legislative fiat there are no limits to the amount of fun you can have... aside from sapping the will of the productive to succeed. As Alexander Tytler observed, this may be the ultimate fate of democracies.

It makes you different.

Ten days after being hit by a car… well, it makes you different.

I’ve been watching and enjoying professional bike racing as a spectator for years. Crashes aren’t unusual. The risk is always there. After all, you’re racing around the countryside for hundreds, if not thousands of miles. Many of those miles are on under-improved roads, in all kinds of weather on tires that don’t quite span an inch across. When nearly two-hundred riders in a peloton ride at a blistering race pace merely inches away from someone else’s wheel you expect broken collarbones, road rash, sometimes worse. Yeah, accidents happen. It's part of the game.

Commuters and recreational riders face risks too. But slips and falls are just one hazard. Now add the greater fear that comes from the few, but vocal, angry and hostile drivers who may only wish you harm even if they don’t all act on their impulses. Or from the inattentive driver who may not set out to hurt anyone but who will kill you dead just the same. Then there’s the cop who many cyclists know; the cop who sees someone on a bike as an obnoxious nuisance undeserving of the equal rights he's sworn to protect; the cop who through inexperience, laziness or intent shatters the very institutions that many of us grew up with and clinged to by trampling on notions of justice and fair play. We’ll see where this road leads.

If you’re lucky the story continues...

You can’t prevent or even plan for this sort of thing. One minute it’s a beautiful fall afternoon in the Wine Country of Northern California. Temperatures are moderate, the sky is blue and you’re out for a ride to shake off the “dust of the day.” The next minute you’re sprawled on the pavement bleeding next to a twisted bike. If you’re lucky the story continues, if you’re not... it ends there.

Last Monday afternoon I was out for a ride on my shiny new Trek Portland commuter bike. The route included a short portion of Santa Rosa’s Highway 12, a divided thoroughfare that further south is well-known to cyclists for its narrow shoulders, its higher proportion of senior-citizen drivers, and a couple of high-profile motor vehicle-on-bike collisions that ended tragically (for the cyclists). But on this stretch of roadway it was different. The sun was setting behind me, traffic was moderate and the shoulders beautifully wide. As I approached my intended left turn I glanced behind, first in my mirror and then by turning my head, to make sure that traffic would allow me to safely move from the shoulder into the marked left turn lane at an intersection controlled by a light. “Aha, a nice long gap,” I thought. So I cautiously extended my left arm to signal my intentions and trustingly changed lanes while maintaining my pedaling cadence. As I eased across the highway I breathed a sigh of relief. I made it into the relative “safety” of the left turn lane next to the planted median. “Home free,” I thought. Now my thoughts turned to meeting my fiancé at the pool where she is a competitive swimmer.

In the next instant, I got a fleeting glance of the Volvo that plowed into me from behind. No screeching tires… no evasive maneuvers… no shouts of “Look out!” ...just pow! And that’s about all I clearly remember until I found myself in an ambulance on the way to the hospital.

I was one of the very lucky ones. I’m able to write about it afterward. Many are not. What was the driver doing? Chatting on her cell phone? Checking her email? Stuffing a burrito into her mouth and dripping salsa on her blouse? Maybe she was distracted by a Chihuahua on her lap? Who knows? What drivers need to realize, take seriously and take responsibility for is that they are piloting 3000-4000 lb. steel projectiles on the same streets where defenseless cyclists ride, joggers run and children play. A moment of driver inattention is negligence that can result in serious injuries or worse. Still, they’ll be out there… babbling on their cell phones, curling their eyebrows, and stroking their lap dogs.

Ride defensively? Sometimes there’s simply nothing you can do. Your life is entirely in their hands.

SMART Train. How smart?

SMART is a proposed 70-mile passenger railroad and parallel bicycle-pedestrian path along the publicly owned Northwestern Pacific Railroad right of way through two counties. The rail line runs from Cloverdale, at the north-end of Sonoma County, to Larkspur, where the Golden Gate Ferry connects Marin County with San Francisco. Contiguous bike trails from Cloverdale to Larkspur... what's not to like? Well, I'm a taxpayer too.

The first problem that I see with the SMART train project is the in-excess-of half billion dollars that it will cost to develop. As an economics teacher I view everything from the perspective of choices and allocations. If a region (like ours) had a not-insignificant half billion dollars to spend should we ask, "Is this the best way to invest it given the many priorities we have?" In other words, we will be making a conscious decision to spend it on a train rather than health care, children, the elderly, etc.

Second, every time I see a public bus it is nearly empty with the exception of the bridge-subsidized Golden Gate buses headed to San Francisco, exactly where SMART won't go. Can you (or anyone else for that matter) honestly say that you will take the train to San Rafael, Novato or Larkspur rather than drive with enough frequency to even remotely approach SMART's ridership estimates? And when you get to San Rafael, Novato or Larkspur you do so on public transit's schedule not yours. "Darn! There goes the ferry! When's the next one?" Then, when you get to San Rafael do you wait for a bus to get you closer to your destination or do you rent a car or hire a taxi, walk maybe?

Lastly, SMART is being positioned by proponents as costing "only" a 1/4% increase in the sales tax. That works out to more than a regressive 3% increase in tax dollars paid. So if you buy $50,000 per year in taxable goods and services you will pay an incremental $125 per year for the next twenty years. Imagine getting a bill for $125 every year from SMART. Then imagine writing a check to pay the bill... and that's whether or not you ever buy a ticket.

Well, I still like the bike trails.

Tolerance

If individuals from an ethnic minority, or the homeless, or women, or the disabled, or gays, or illegal immigrants, or legal immigrants, or children, or a religious sect, or the poor were targeted for random let alone systemic harassment there would be justified outrage in the media, officialdom, and the community as a whole.

Imagine the alternative. A well-dressed executive in his BMW loudly curses random women passers-by simply for their gender. A hard-working tradesman jeers gays because of some perceived affront to his sensibilities. An over-stressed soccer mom spits on an old man in a walker because he can't get across the intersection fast enough. A civilized society would neither tolerate those behaviors nor those who do.

Yet cyclists exercising their legal and constitutional right to the highway experience these harassments with alarming regularity... and there is silence, there is apathy and worse… there is tolerance.

When Beams Collide

Buried beneath hundreds of feet of pastureland, straddling the border of France and Switzerland, lies the world’s largest and most powerful scientific instrument… a “big bang simulator.” Seventeen miles in circumference, CERN’s Large Hadron Collider uses more than 3 million amperes of current to accelerate counter-rotating beams of protons to within a small fraction of the speed of light. These protons acquire mass as they approach relativistic speeds… the faster and faster the proton packets go the more massive they become as energy is converted directly into matter.

In just a few weeks high-energy physicists operating the big machine will coax the proton beams into head-on collision. Conditions at the heart of the accelerator will be similar to the extreme temperatures and energy densities that existed a tiny fraction of a second after the the moment of creation. By studying the debris from these collisions scientists hope to gain a deeper understanding of the nature of “everything.” They may even see traces of the elusive Higgs Boson, the so-called “God Particle” thought to give matter properties of mass.

But, there is the more remote chance that a microscopic black hole may be spawned. Most scientists dismiss claims of any real danger that the Earth itself could be swallowed up and plunged into the abyss of “spaghettification,” since any microscopic black holes would likely evaporate in a billionth of a second or less. But one can never be too sure. Best advice... on the eve of beam collision day, have a margarita or two and kiss your ass goodbye. Bottoms up!

UPDATE (21 Sep 08): The day of our extinction has been postponed at least a couple of months due to an electrical failure followed by a helium leak in the collider.

Lions and tigers and bears!

“Lions and tigers and bears, oh my!” chanted Dorothy and her friends as they hustled through the dark forest on the way to the Emerald City. Cycling is like that. You follow the road… ok, so it’s not yellow and it’s not brick. Instead, there are these little white stick men, each so-correctly sporting a little helmet leading you though the “safety” of white lines painted on the asphalt. A safe lane to follow… sometimes eyed menacingly by creatures of the urban forest who will do you harm.

So who or what worries me on the road? Are they the cranky, snarling apple trees? Nope… I can jam faster than they can. Or, maybe the fez-capped flying monkeys? No way… toss ‘em a Luna Bar. I’m scared of that guy in the SUV who wants to beat the red light and crushes the accelerator.

You patiently take your lane... waiting for your light to turn green. It does. You stand on the pedals and just then a blur of metal goes flying across your path… a chick on a cell phone in a Honda. She’s oblivious to you. She sees her light go from yellow to red but that’s not for her. That’s meant for the guy behind her. She’s gonna scoot across the intersection and as long as she presses that phone to the side of her head, stiffens her neck and keeps her eyes focused straight ahead then she can’t see anybody and nobody will see her! That’s leads to road-kill. Don’t let it be yours. When your light turns green that means look left, look right, look left again… oh my!

The Naked Cyclist

With gas hovering around $4.00 at the pump coupled with a growing concern for the environment many drivers are discovering the cycling alternative to cars. Then somewhere along the way these riders discover the sweeping sense of freedom that one gets from floating on two wheels -- a sense of freedom that comes close to that of flying without ever leaving the ground. Health, fitness, smiles and memories of childhood follow.

But cycling in Sonoma County can also deliver you to a dark and scary place -- a place populated by hostility, menace and official indifference.

There are few cyclists who have not encountered the angry, frustrated motorist who believes that cycling is a politically correct movement that further restricts the motorist’s ability to travel the highways unimpeded -- highways that are really “intended” for cars not bicycles. These spandex-clad bike riders with those funny mirrors stuck in their helmets or worse yet, those cyclists who sport knickers and messenger bags and ride single-speeds, have created one just more obnoxious obstacle for the harried motorist. “Just who do they think they are? Get off the road! Someone needs to teach them a lesson!”

Road rage against cyclists can range from flipping off the offending bike rider punctuated by a choice f-bomb; to “buzzing” the cyclist – veering to within inches of the bike’s handle bars at high speed with an intention to intimidate. Taken a step further, some deliberately touch or collide with the bike rider, often with tragic consequences.

Under state and federal law bicycles are vehicles and their riders have the same constitutional right to use the highway as do cars, trucks and farm tractors. They must obey the same traffic laws that apply to all. Yet there are motorists who through either ignorance, arrogance or a perverse sense of entitlement view cyclists as a nuisance to be restricted to the bike path or sidewalk. But it is when those motorists who pilot two to three tons of steel act out their rage against a 20 lb. bicycle that their impulse becomes murderous intent.

Cyclists are harassed, threatened, cursed and spit upon with uncomfortable regularity by drivers who feel compelled to show me their contempt and disapproval of my legal right to share “their” road. Friends have had cans and bottles thrown at them while riding the scenic roads of our county. A beer bottle striking you at 50 mph squarely between the shoulder blades is a sick form justice for the perceived “offense” of encroaching “their” highway and violating “their” sense of driving etiquette. And for some, frightening or hurting a cyclist is just plain fun.

Road rage with the design of trying to instill an apprehension that physical harm is imminent is committing assault under state law even if the offender doesn’t touch you. It’s an interesting commentary that if someone were to approach a pedestrian and aggressively threaten them it’s likely that the perpetrator would be spending the night in jail. Sadly, that’s not true with cyclists. Reports of police indifference to the harassment of cyclists are not uncommon. Officers take complaints and do absolutely nothing as I can personally attest. That kind of official indifference shows tacit tolerance for road ragers and further emboldens them. These drivers disrespect the law and violate the cyclist’s rights but most important, they are a deadly menace to society.

No bike rider should ever take to the roads of Sonoma County feeling naked in the face of harassment against cyclists or against anyone else for that matter. It is our duty to speak out against road rage and against those who tolerate it. We must hold them accountable for their actions or for their indifference before another human being riding a bicycle is seriously injured or killed.