How I Benefited from the Housing Bubble

In 2000, I was paying over 8% on a 30yr adjustable rate mortgage. By 2006, I had refinanced six times into a 15yr fixed rate mortgage at 5.25% with lower payments than I had six years earlier. So while I don't like the idea of bailing out irresponsible borrowers and lenders, I can acknowledge that I derived significant benefits from the same forces that created the credit crisis that we have today.

A Simplified Explanation of the AIG Bailout

I was asked by Mr. Dawn Treader why the failure of AIG would have lead to a market meltdown. He seemed to find the following explanation helpful.

Suppose you start a bank by selling $10 worth of stock and taking $100 of deposits. It invests $100 in a bond issued by XYZ corporation. Your bank's balance sheet would look like this:

ASSETS		LIABILITIES
Cash	$ 10	Liability to depositors	$ 100
XYZ Corp. bond	$ 100	EQUITY
		Shareholder Equity	$ 10

The capital ratio for the bank is 9.1% (Shareholder’s equity divided by total assets). All banks are required to maintain a certain capital ratio.



Now suppose that the bond declines in value to $95 due to financial difficulties at XYZ Corp. Now the balance sheet looks like this.

ASSETS		LIABILITIES
Cash	$ 10	Liability to depositors	$ 100
XYZ Corp. bond	$ 95	EQUITY
		Shareholder Equity	$ 5

Now the capital ratio is 4.8%. If the relevant capital requirement for your bank is 5%, you must either sell some assets or raise more equity by selling more stock.

Financial institutions all over the world hold bonds that are insured by AIG. If AIG fails, the bonds are no longer be insured and the banks must mark down the value of the bonds on their balance sheets. When this happens, the banks no longer have satisfactory capital ratios and they must either sell assets or raise more capital by selling stock. Eighteen months ago, this would not have been a problem, but the market for bonds and for new stock has dried up completely.

I suspect that everyone remembers the run on the bank in It’s a Wonderful Life. Uncle Billy told George that he had turned over all their cash to the bank because the bank had called their loan. Companies all over the world depend on short term financing from banks to meet fluctuating cash needs. Even more importantly, banks depend on such financing from other banks.

If AIG had failed, there would have been a mad scramble for cash by banks all over the world. Being unable to sell the bonds they own, they would reduce the amount of loans they have outstanding. Businesses would see credit lines pulled and individuals would see the rates on their credit cards jump.

Corporations and the Free Market

It is undoubtedly true that the explosion in sub-prime mortgages occurred after the 1999 deregulation of the banking system spearheaded by Phil Gramm. Nevertheless, many libertarians still seek ways to blame government interference with the free market for the economy’s present woes. It seems to me that the economic system that the libertarians think of as the free market is in fact a product of government interference.

In a market free of government interference, I would think that a man would only be free to make promises that bind himself and others who expressly authorize the man to make promises on their behalf.¹ This would limit the acceptable forms of conducting business to the sole proprietorship and the partnership. However, in our society a man is permitted to make promises that bind an entity known as a corporation. The corporation is a fictional person authorized by government regulation so that investors can share in the profits of business ventures without risking the liability of being a partner. Absent the corporation, the only option available to people who wanted a return from a business without the obligation of overseeing its activities would be to loan the business money.

The corporation is a useful tool because it can lead to the more efficient use of capital. Suppose for example, that a man had an idea for a new restaurant. Restaurants are notoriously risky ventures with a high failure rate. On the other hand, a successful concept can be extremely profitable. The man might find it very hard to borrow the money to open the restaurant because the lender would consider his chances of getting paid back pretty poor and might charge a prohibitive rate of interest. On the other hand, an investor might be willing to buy stock in the restaurant because the profits upon success will be great enough to justify the risk of failure. The existence of the corporation can allow beneficial economic activity.

The problem with the corporation is a product of the very quality that is its reason for existence. The shareholder who stands to benefit from the success of the business is not on the hook for more than his investment if things go wrong. That provides an incentive for the corporation to ignore catastrophic risks if their probability is very small. Suppose that a business executive is presented with an opportunity that has a nineteen out of twenty chance (.95) of producing a 25% profit and a one in twenty chance (.05) of producing a loss of 2000%. If the executive is running a partnership, the expected return for his investors is the sum of the return on success times its probability plus the return on failure times its probability ([25% x .95] + [-2000% x .05]), or negative 76%. On the other hand, if the man is running a corporation, a shareholder’s loss is limited to the amount he invested so the expected return for a shareholder on the same venture ([25% x .95] + [-100% x .05]), or positive 19%. When an investor’s loss is limited, an otherwise foolhardy investment can suddenly look quite reasonable. The excess losses will fall upon third parties such as customers who do not get the orders they paid for, employees who do not get their salary, suppliers who go unpaid, or people who get injured by the corporation. If the third parties are unable to bear the loss, it may wind up being borne by society as a whole.

This is more or less what happened with AIG this week. The insurance giant entered into contracts to insure the debt of other businesses. The odds may have been good that these contracts would produce a generous return for AIG’s shareholders, however, there was a small chance that AIG would not be able to make good on its contracts in which case the losses would be astronomical. Unfortunately the worst case occurred and the federal government was forced to bail out the company this week.

Fifty years ago, most of the major investment banks on Wall Street like Morgan Stanley, Lehman Brothers, Bear Stearns and Goldman Sachs were organized as partnerships. In those days, their income came primarily from fees and commissions earned through transactions. They would help issuers bring securities to market by placing the securities with investors. However, they were limited in the extent to which they could buy the securities for themselves because they depended on the personal wealth of their partners and the willingness of those partners to take risks. It is said that they were in the transportation business rather than the storage business.

Over time, however, the investment banks started incorporating and going public. By floating stock, they got access to investors whose risk tolerance was different than the partners whose personal assets were on the line. As this happened, they started taking more risk. Trading for themselves became a bigger portion of their business. Like AIG, they wound up with positions that had a good chance of producing generous returns and a small chance of producing catastrophic losses. (Interestingly, the healthiest surviving investment bank is Goldman Sachs, which I believe was the last one to go public. Perhaps it best remembers how to manage risk like a partnership.)

Corporations have been around so long that it is easy to think of them as the essence of free market capitalism, but, in fact, they are legal constructs created by the government in order to separate the enjoyment of profits from the risk of losses. Corporations are incredibly useful tools for allocating capital efficiently and promoting general prosperity. Unfortunately, when the government abdicates responsibility for regulating the entities that it created in the first place, the risks end up being dumped on society as a whole and fewer and fewer people enjoy the rewards.

¹ The Barefoot Bum informs me that promises as we know them would not exist in a market that was truly free of government interference because a promise can only be binding by virtue of government enforcement. "In a truly free market, promises cannot actually bind: you are rationally justified in trusting a "promise" only insofar as keeping the promise is in the long-term self-interest of the person making it." I confess that I am not equipped to argue the issue at that level of libertarian purity.

Playing the "Class Warfare" Card

In order to avoid discussing legitimate challenges to their positions, Blacks will sometimes charge their opponents with “racism.”

In order to avoid discussing legitimate challenges to their positions, Jews will sometimes charge their opponents with “anti-Semitism.”

In order to avoid discussing legitimate challenges to their positions, women will sometimes charge their opponents with “sexism.”

In order to avoid discussing legitimate challenges to their positions, many different groups will charge their opponents with “intolerance.”

In order to avoid discussing legitimate challenges to their positions, wealthy Americans like to charge their opponents with engaging in “class warfare.”

What makes dealing with these charges tricky is that many of these phenomena are real: Blacks have suffered as a result of being Blacks; Jews have suffered as a result of being Jews; women have suffered as a result of being women; and many people have been victimized simply for being different from their neighbors. As a result, I think we should be reluctant to reject charges of racism, anti-Semitism, sexism, and intolerance without due consideration.

The wealthy, on the other hand, hardly ever suffer as a result of being wealthy. As a result, when the wealthy start complaining about class warfare, I tend to think that it is just a smokescreen to avoid discussing the merits of which economic policies produce the most benefits for the greatest number of Americans,

Palin's Bridge to Nowhere Admission

PALIN: And now obviously, Charlie, with the federal government saying, no, the rest of the nation does not want to fund that project. You have a choice. You either read the writing on the wall and understand okay, yes, that, that project’s going nowhere. And the state isn’t willing to fund that project. So what good does it do to continue to support something that circumstances have so drastically changed? You call an audible, and you deal in reality, and you move on. And, Charlie, we killed the bridge to nowhere and that’s the bottom line.

Let's consider what Sarah Palin is saying here:

• The federal government said no.
• The rest of the nation did not want to fund the project.
• The state wasn't willing to fund the project.
• Palin understood that the project was going nowhere.
• Palin realized that continuing to support the project would not do any good.
• Palin takes credit for killing the project.

The bottom line is that Palin has been lying about telling Congress "thanks but no thanks" on the bridge to nowhere and she knows perfectly well that she has been lying. She did not kill the project. She supported it until it became obvious that it wasn't going to fly. After it was dead, she started kicking it.

Palin on Being Ready

Charles Gibson: "And you didn’t say to yourself, am I experienced enough? Am I ready?"

Sarah Palin: "I didn’t hesitate, no. "

Charles Gibson: "Doesn’t that take some hubris?"

Sarah Palin: "I answered him yes because I have the confidence in that readiness. And knowing that you can’t blink. You have to be wired in a way of being so committed to the mission, the mission that we’re on, reform of this country, and victory in the war. You can’t blink. So, I didn’t blink then even, when asked to run as his running mate."

While I am not really sure what “wired in a way of being so committed to the mission” actually means, I am sure that Sarah Palin should have expected a question like this. I find it sad that this is the best answer she could come up with.

Animal Analogies

In order to avoid further offense, perhaps the McCain campaign could run the following analogies past Sarah Palin to see if any of them hurt her feelings:

• You can lead a horse to water but you can’t make it drink.
• Never look a gift horse in the mouth.
• You can’t teach old dogs new tricks. (This one might make McCain sad.)
• A leopard can’t change its spots.
• Curiosity killed the cat.
• Every dog has its day.
• A bird in the hand is worth two in the bush.
• Don’t count your chickens before they're hatched.
• You can’t make a silk purse out of a sow’s ear.
• A wolf in sheep’s clothing.
• A bull in a china shop.
• That dog won’t hunt.
• Proud as a peacock.
• Stubborn as a mule.
• Busy as a bee.
• Like shit through a goose.
• If it walks like a duck and quacks like a duck, it is a duck.
• Sly as a fox.
• Tiger by the tail.
• Useless as tits on a bull.

Palin on the Chautauqua Circuit

William Jennings Bryan's "Cross of Gold" speech at the 1896 Democratic convention is one of the most famous political speeches ever given in the United States. Economists have never thought too highly of Bryan's call for tying the value of the dollar to gold and silver (bimetallism) rather than gold alone, but people still loved the speech. They loved the speech so much that Bryan kept repeating it for the next twenty-five years on the Chautauqua circuit, long after its relevance to any real political issue had faded.

Every time I hear Sarah Palin repeat her line about saying "thanks but no thanks" to the "bridge to nowhere," I think of all the mileage that Bryan got out of his famous convention speech. Her early support for the bridge and her belated opposition to it were public knowledge by the day after her convention speech, but every time she speaks, she still delivers the line exactly as she did in the Twin Cities. Apparently people just like the way she says it.

WWJD

From the Chicago Tribune's Voice of the People:

Let us not forget: Jesus was a community organizer, and Pontius Pilate was a governor. Tom Mitchell, Wheaton

Letter from a Wasilla Democrat

After John McCain announced that Sarah Palin would be his running mate, Wasilla resident Anne Kilkenny sent an e-mail to some friends and relatives who wanted to know her opinion of Palin. Not surprisingly, the e-mail gained much wider distribution than Kilkenny had intended and it was republished with her permission in the in the Anchorage Daily News. After reading it, I can see why the McCain campaign doesn't want Palin to face questions from reporters.

Many things in Kilkenny's letter disturbed me, but none more than this:

Sarah complained about the "old boy's club" when she first ran for Mayor, so
what did she bring Wasilla? A new set of "old boys". Palin fired most of the
experienced staff she inherited. At the City and as Governor she hired or
elevated new, inexperienced, obscure people, creating a staff totally dependent
on her for their jobs and eternally grateful and fiercely loyal--loyal to the
point of abusing their power to further her personal agenda, as she has
acknowledged happened in the case of pressuring the State's top cop.

Do the names Goodling and Brownie ring a bell?

Palin's Hockey Rink

Today's Wall Street Journal tells the story of the $14.7 million sports complex that Sarah Palin built while mayor of Wasilla, Alaska that ended up costing an extra $1.3 million due to the failure to secure a signed contract prior to building the complex. The city had won a trial against another buyer who claimed that the property had been sold to him and started to build despite the fact that the competing buyer had filed an appeal. When the trial judge reversed the decision, Wasilla was forced to obtain a smaller slice of the property by eminent domain for $710,000 more than the original price and pay the other buyer $336,000 in interest. The city's legal bill has been approximately $250,000.

Not surprisingly, Palin is not taking any questions.

The McCain-Palin campaign referred questions about the sports complex to Mr.
Leonard, the former city finance chief. He blamed the Nature Conservancy [the
seller] for dealing with two different potential buyers at one time. "That's
what caused the confusion," he said.

"At the time, with the information she had, [Ms. Palin] made the right
decision," Mr. Leonard said. "But you know what? Litigation happens."

If Palin ever does answer any questions about her record in Alaska, here are two I would like to ask about this situation:

• Have you ever heard of title insurance?
• Are you really confused by the idea of a seller dealing with more than one potential buyer?

Republican Hypocrisy Regarding Sarah Palin

Jon Stewart doing what he does so well, skewering politicians who talk out of both sides of their mouths.



Among the highlights:

Karl Rove explaining how Virginia governor Tim Kaine would be a bad VP choice for Obama because he had only been governor for three years and he had only been mayor of a city of 200,000 people.

Bill O'Reilly pontificating on how teen pregnancy was a private matter when it comes to the Palin family and blaming the parents of "pinhead" Jamie Lynn Spears for her pregnancy.

Dick Morris and McCain policy advisor Nancy Pfotenhauer slamming Hillary Clinton for playing the gender card and crying over the sexist treatment of Palin. However Stewart correctly noted, "In Dick Morris' defense, he is a lying sack of shit."

Palin herself criticizing Hillary for complaining about the way women are treated.

Tell Me Another Story Daddy

If Sarah Palin is such a fearsome fighter of corruption even in her own party, why don't any Republican bigwigs seem nervous?

Palin's Pregnant Daughter

On the one hand, I agree that candidates’ children should be off limits. On the other hand, I am a parent who supports a high school English curriculum that includes some books that deal frankly with issues of human sexuality. In my community, that has earned the ire of certain evangelical Christians who have tried to get those books removed. Local Christian talk show host Sandy Rios has stated on her radio show that parents like me must not care about the welfare of our children because we would allow our children to be exposed to works like Slaughterhouse Five, Freakanomics, Beloved, The Things They Carried, and The Laramie Project.

So while I do not wish to cause any pain to Bristol Palin, I am curious to know her mother’s thoughts about how public schools should deal with issues of sexuality because in my community, the evangelical Christians of Sarah Palin’s ilk like to blame permissive parents for inciting young peoples’ sexual desires with racy books. I am not bothered by the fact that Sarah Palin’s daughter is pregnant any more than I was bothered by the fact that Dick Cheney’s daughter was a lesbian. I am bothered by the extent to which the conservative Christian wing of the Republican party thinks that other people’s sexuality is their business.