The origins of the current recession are well known. It began in the housing market where some people entered into contracts that eventually became toxic. Mortgage brokers sold subprime loans to people who either didn’t understand that the interest rates would step up dramatically in the future or who gambled that they’d be able to refinance these mortgages with something more conventional in a few years after time had given them some equity in their homes. These mortgages got sold to syndicators, who, in turn, packaged the loans together and sold bonds supported by the monthly mortgage payments the borrowers would be making to investors in the financial markets. Investors bought these bonds understanding that some of the mortgages would eventually go into default, but, because the mortgages had been pooled, the cash flow of the non-defaulting mortgages and the sums that would be raised upon foreclosure of the defaulted mortgages would more than support the prices the investors had paid for their bonds. The rating agencies assured everyone that these were relatively safe investments with good returns.
Of course, this whole house of cards stood on two unstated assumptions. The first was that at any given time, the number of current loans would vastly outnumber the number of loans that went into default. The second was that the value of the underlying real estate would never decline. After all, real estate only appreciates in value, doesn’t it?
Both of these assumptions turned out to be wildly wrong. The loans, after all, were made to subprime borrowers and so, when the loans began to reset at rates dramatically higher than the initial introductory rates (and in fact, higher than prevailing interest rates), it shouldn’t have been surprising that these loans would go into default. And it also shouldn’t have been surprising that, consistent with the laws of supply and demand, when a large number of properties showed up on the market in distressed conditions, prices would fall.
All of this set off a chain reaction that triggered a recession. When people stopped paying their mortgages, the lenders holding the bonds all of a sudden had worthless assets. The big insurance companies had to pay off on credit default swaps based on the loans. Worthless assets reduced bank capital and made it difficult for lenders to lend. The credit market seized up. Businesses that depended on financing from these lenders couldn’t get funded to buy equipment, increase inventories, or even pay workers. With fear of the future, people significantly reduced spending, further hurting businesses and sparking layoffs. With lower income, people started paying less tax to state and local governments making it harder for them to maintain services.
If there ever were a time for the Good Lord to send us Barack Obama and a flock of liberal Democrats to Congress who instinctively distrust big business, this would be it.
With a little more effort than I’m willing to put in right now, I could make an argument that the way the fi
nancial system worked was rational at an individual level but irrational at the aggregate level, and is thus another example of the tragedy of the commons. But what really interests me (and what I really wanted to write about) is the tragedy that is playing itself out in the real estate market.
Imagine that you’re a lender and you’ve got a borrower who has gone into default on his mortgage. In the good old days, you might call the borrower into the office for a nice little chat about fiscal responsibility and the consequences of failing to pay his loan on time. In an unusual case, you might cut the borrower some slack—renegotiate the loan, defer some payments—in return for additional consideration later. The thing you’d try to avoid at all costs is to take the property back. Lenders, after all, are in the business of lending money and collecting payments. They are not in the business of owning and managing real estate—that, of course, is a “hands on,” expensive and risky business.
Suppose though, that you can’t cut a deal and that you have to go through the foreclosure process. That would mean that you’d have to hire a lawyer, go through a lengthy legal process—spending money on legal fees, taxes, insurance and other related costs—and not get any money from the borrower. In the good old days, you’d count on being able to sell the property after foreclosing on it for at least your loan amount and the expenses. Perhaps, after all was said and done, you’d more than break even. That’s what should happen in a functioning market. None of this is a tragedy, except perhaps for the borrower. The distressed property goes into the market and gets sold just like any other property.
But now,
let’s suppose that instead of one property, you have a couple of hundred that are in distress, and so do your 10 competitors. Let’s also suppose that instead of being a banker like Mr. Drysdale or George Bailey, you’re just a loan servicer who has little discretion and represents a huge number of individual bond holders who hold different “tranches” of securities and may have conflicting interests. You’re set up to collect payments, deal with a few property related issues, but you don’t have a big staff of people and you’re certainly not being paid enough to negotiate with hundreds of borrowers. Besides, there may be liability if you try to do anything like restructure any of the loans, even though that may benefit the bond holders.. Now, what do you do?
You take the easy and obvious route. Taking note of the fact that there are potentially thousands of distressed properties about to hit the market, you scurry down to the courthouse and file foreclosure actions as fast as you can. You hope you can get into the market and out of it before the iron laws of supply and demand begin to work their evil magic. Unfortunately, that's exactly what you're competitors do also.
Does anyone hear the cows chewing up the grass? This situation is exactly what happened to the self-interested cattlemen I wrote about in my last post. Individually, there is no harm in putting a few properties into the market since they will not have any material impact on the general health of the market. But, when everyone does it at the same time, just like the overgrazed meadow, the market can’t absorb the load and it tanks. Everyone, including all of the lenders who thought they were protecting their interests by putting properties into foreclosure, loses. To wit:
· The fair market value of most properties sinks;
· As people begin to lose their accumulated equity in their homes they see less value in staying current or in performing maintenance;
· Some people abandon their homes, reasoning that without any equity in the property, they’re simply renters, and if they’re renters, it makes no sense to pay principal and interest when they can move to lower cost apartments;
· As people abandon their properties, more vacant homes make surrounding properties less valuable;
· More properties added to the market reduce property values further;
· People who would otherwise become buyers see that the market dynamics are creating a downward price spiral, so they sit on the sidelines and wait until the market hits bottom;
· Lenders who are holding properties that are worth less than their loan balances may have to sell those properties cheap just avoid even greater losses;
· Cheap sales establish the “going price” for surrounding property and further depress property values.
All in all, this is an irrational way to proceed. But this is what happens when we let Adam Smith’s invisible hand guide the market.
The lessons for our current predicament ought to be clear. First of all, we’re caught in a vicious spiral with the real estate market at its vortex. If we’re ever going to get out of this recession we simply have to do something about the housing market. We may never be able to drive real estate prices to where they were several years ago, but we need to find a way to stop flushing toxic waste into the real estate commons. The market needs a floor, even if the floor is somewhat artificial.
And second, we can’t trust the market to right itself any time soon any more than we could expect Hardin’s meadow to spring back to life on its own. We need a coordinated and reasoned way to prevent people from doing what seems to be in their best interest, but, in fact, is in their worst interest. The solution has to apply to everyone, because if it doesn’t, the people who don’t cooperate will profit at everyone else’s expense.
Is there a way to do this? You bet. I have my own ideas, which I’ll get to in my next post, but I’d love to hear what you have to say. As always, your comments are welcome.
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