More likely to go down than up?

After reading this article about the housing market I can summarise the following:

Demand side factors • Highest population growth rate in four decades • Low interest rates • Increased government first-home buyers grants versus • Record levels of private debt • increasing unemployment

Supply side factors • Rising building costs • Weak building levels • Finance difficulties • Developer uncertainty versus • Fast tracking of development

The Great Depression in a nutshell

In the panel discussion "The Crisis and How to Deal with It" Nouriel Roubini gave a good summary of how the stock market crash of 1929 turned into the Great Depression of 1933. Over the following four years government policy exacerbated the problems.

The four causes were:

1. " ..we didn't believe in a counter-cyclical monetary policy. The money supply contracted rather than being eased. Interest rates were not falling, and that made the credit crunch worse."
2. "nobody believed in counter-cyclical fiscal policy. The general theory of Keynes was written only in 1936; in the early 1930s, the government was raising taxes and cutting spending in order to maintain a balanced budget. That made the recession even more severe."
3. "there was a belief that banks should be allowed to collapse. Thousands of them collapsed, the credit crunch became even worse."
4. "by 1933, 75 percent of households had defaulted on their mortgages; they couldn't pay them. So a stock market crash became a Great Depression."

Roubini concludes with other elements "add currency wars internationally, trade wars, protectionism, and capital controls; then you had default by countries and the rise of totalitarian regimens in Germany and in Italy, in Japan, and Spain" and the consequences of using the wrong policy prescription - "World War II"

The buck stopped

The economist Mark Thoma has a good description of how bad incentives at ever step of the lending process in the US made the housing bubble worse. Australia doesn't have non-recourse loans, but the tax laws and FHB grants certainly added to the inflation of the housing bubble in Australia.

Taking bets you can't pay out on

Just as with collateralized debt obligations (CDO), credit default swaps (CDS) are difficult to really understand, even after reading several explanations. Both are however critical to understanding much of the current problems in the finance sector. I understood that they were a type of insurance financial institutions could buy to cover their investments, but I didn't get how they could bring down large institutions.

A post by Satyajit Das on his blog went straight over my head so I went looking for something like this to explain the concept better. This one helped a bit by showing the interconnectedness of the large institutions effectively insuring each other for related risks, but still didn't quite fully explain it for me.

This facinating article from Rolling Stone linked to from Peter Martin's blog has given me the best explanation so far. CDSs were insurance policies sold to cover investment risks by people who had used the wrong risk models. Unlike insuring cars against theft, where large numbers of cars are extremely unlikely to be stolen simultaneously, but the event of a market crash (mistakenly calculated to be exceptionally rare like mass theft) can bring down the value of all investments in concert. Some made lots of money selling them before the music stopped. CDSs also formed a kind of short as players were able to buy insurance on assets they didn't own, akin to taking out an insurance policy on your neighbour's house.

Scrappage shmackage

A scrappage scheme is being raised as a way of getting old clangers off the road to be replaced with new cars. The government would give you $2000 to scrap your old falcon on the condition you bought a new car. Superficially this might have some appeal but if analysed it seems like a terrible idea. A cash grab by an industry that has failed to see the writing on the wall. This is a good example of why a broad based market mechanism, like carbon trading or a carbon tax is needed to find where the most cost effective savings can be made. A scrappage scheme could cost us a lot of money and achieve no reduction at all, because it doesn't necessarily reduce total emissions it just updates the fleet. It's dependent on the cars producing less total emissions, so the cars would have to be smaller on average than the ones they replace and the total distance travelled would also have to be held at a constant. Are people tempted to drive their new cars more?

100 year mortgages

I'd heard about 50 year mortgages in Japan but inter-generational 100 year loans..... Thankfully we haven't had this discussed in Australia yet. Give it time.

I particularly like this quote from the article:

"This is about giving people options - not telling them how to live their lives, not telling them that they can only have a 25-year mortgage which has to be paid off at the end of the term," says Mike Lazenby, the chief executive of Kent Reliance.

People can be trusted to make decisions in their own best interests, right?

"It's worked in Switzerland and Japan, but in this country we do tend to think in straight lines - I think a bit of innovation should be encouraged."

You can't argue with that!

Negative interest rates

To understand how interest rates can go negative, you need to view interest rates as a control lever. Interest rates are put up to slow the economy when demand outpaces supply, causing an increase in inflation and lowered to counteract a slow-down. What happens when you start to approach a zero rate of interest and the economy is still slowing?

Japan experienced a "lost decade" of relatively stagnant growth in the 90's, triggered by the collapse of a real estate bubble. It took Japan about 15 years to barely turn things around. Lately a lot of references are being made to Japan's multiple attempts to restart growth. Paul Krugman and others have written extensively on the topic.

In the Japanese collapse commercial real estate prices fell by over 80% and the Japanese Central Bank lowered interest rates from over 8% to 0% without significantly improving growth because people were concentrating on paying down debt.

Commercial interest rates don't have to reach zero to be considered negative, they just need to fall below inflation, but in Japan in 2003 the actual rate the banks were lending money to each other really did fall below zero. The interest on retail deposits in the bank was effectively zero or 0.001% - so you would be losing money with fees.

Like Australia and other western countries, the Japanese government tried multiple stimulus packages, but struggled to have an impact. It's difficult to draw comparisons with the Japanese experience because of the entrenched culture of savings that means the bonuses are mostly pocketed. They have at times apparently resorted to vouchers for electronic goods to get people spending.