Thursday, October 2, 2008

Loosen credit?

Look, I can't second guess the folks in Congress. I'm not sitting there at the negotiations. I haven't read the full version of the bill that passed the Senate, and I don't know what may likely pass the House. What I do know is this: half the chatter I hear on the radio and read online indicate the concern over the tightening of credit standards. A bit of the chatter regards these absurdly convoluted structured securities that bundled loans together in a fashion that even those doing the bundling weren't sure what real value if any the securities represented. And finally, most of the remaining chatter speaks of how much of this mess began with defaulted mortgages and other loans (which were due in part to lax lending standards). So... wouldn't shoring up capital to encourage banks to relax their now tightened lending standards be counterproductive?

I think what needs most to be accomplished by any pending action (though from where I sit I can't say I'm yet convinced of the wisdom of what may or may not be done) is to change the present culture of living beyond our means. The problems did not begin with defaulted mortgages. The defaults were symptomatic of the underlying problems. When I moved with my wife to Paradise from Colorado to enter a doctoral program in 2000 we were shocked by the cost of housing. Granted, it was Paradise. But we had been paying about $800/month on our mortgage in Denver for a 1700 sq.ft. bungalow (with a 1500 sq.ft. finished basement). Our rent that first year, for a 1000 sq.ft. condo (in a marginal neighborhood) was $1600/month. Didn't make sense. But the apartments we had looked at for under $1600 were not livable by our standards (and we're not talking high standards here!).

But, we could afford that only because my wife got a 40% bump in salary (doing essentially the same work as she had in Colorado). Why did they pay so much more? In large part to attract and retain employees (since they all expected to afford a house). Problem was, the more firms paid, the more housing prices rose. We bought a condo the next year, because after the mortgage interest deduction, the cost of buying was equivalent to rents (and the location was better and closer to work and campus). We sold the property two years later at nearly a 60% profit! But rentals had barely budged. Meaning that the buyers were paying a hefty premium to buy, which made no sense. Of course, the value of that property grew another 60-75% over the next 2-3 years. According to zillow it's now worth about 20-25% less than at it's peak, about 15% higher than we sold it for in 2003.

The point I made then was that housing prices like that were unsustainable. They were even more unsustainable when we sold it, certainly even more so two years later... but I find it hard to believe that they are sustainable even at today's reduced level. A few years ago we were all led to believe by the "experts" that the "new economy" sloughed off the old standards of productivity and profit. We were told to ignore the price-to-earnings ratio of new firms. The old standard P/E of 15 or less was passé.

The Bush administration has relied on a simplistic view of wealth creation: spend, spend, spend. The objective has been to keep money flowing throughout the economy. Think of the tax cuts. Think of the "stimulus package". Go out and buy things, my friends. That was the mandate. We need to return to some sanity. We need to return our valuations to real values.

That will take a lot more than simply keeping money flowing. In some cases, it may take the opposite. If lending standards are tight, it will force us to rethink our priorities. Would that be such a bad thing? The best role of any government intervention at this point would be to ease our way back out of a credit card culture of easy spending, and overspending, and speculation. The stock market should not be a gambling haven. We should renew expectations of reasonable P/E values. Dividends should once again be standard practice of established companies. Housing values should return to a reasonable multiple of income (say the old standard of 2-3 times annual household salary). Any intervention by the government should aim toward these effects. Anything short of that is failure!

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