The Discipline of the Market

If you owe the bank $1000 and can't pay, says the old maxim, you have a problem – but if you owe the bank a million dollars and can't pay, the bank has a problem.

No doubt. But if the bank owes billions of dollars and can't pay, then the taxpayer, the consumer, the small investor and the householder all have a problem. That's the latest message from Wall Street – that the Masters of the Universe can take idiotic risks, and if they lose, the little guys should bail them out.

My degree is in English literature, so naturally I don't understand finance and economics. But I do hold certain financial truths to be self-evident. I agree with J.P. Morgan who, when asked what the stock market would do, replied, “It will fluctuate.” Indeed it will, and sooner or later, all soaring markets will tumble. When gleeful investors tell you, “This time it's different,” head for the exits. Remember when the NASDAQ stood at 5000 points? Since the technology stocks crashed, it's never reached half that height again.

We're seeing a similar crash in US housing.

Fundamentally, houses are not investments; they're places to live. The amount that people can pay for housing is limited by their family incomes. For generations, the rule of thumb was that a down payment should be 25% of the value of the house, and that a family should not spend much more than 25% of its income on housing. Prudent lenders charged higher interest rates to families which strained these criteria.

No more. In recent years, US institutions have been lending 100% of the cost of a house – in some cases, 105% or 110% – to borrowers whose credit histories and incomes were ridiculously insufficient. New buyers rushed into the market, pumping air into the bubble. Initially, they got a very low interest rate, and often paid only the interest on the mortgage. By renewal time – so went the theory – the value of their houses would have risen, and buyers could raise cash by re-financing.

And if house prices fell? They wouldn't. “This time it's different.”

Ah, yes.

Loans like that – loans that the borrowers can carry only by defying gravity – are the financial equivalent of goose guano. But the Masters of the Universe had another wrinkle. Roll a bunch of these “sub-prime” mortgages together, and call them a bond. A few of the assembled mortgages might go sour, but the whole bundle surely wouldn't, so the bond was a perfectly safe investment. The boys in the bond-rating houses would give it a good rating, and all kinds of institutional investors would buy them – universities, pension funds, municipal governments in Finland.

But the bonds were simply gift-wrapped globs of guano, based on a game of musical chairs. When the music stopped, house prices plunged. Homeowners found themselves with $300,000 loans on $250,000 houses. Worse, mortgage payments increased sharply once the incentive periods had passed. People couldn't manage the new payments – and why would they try? Much simpler just to walk away from the house.

Wall Street's fifth-largest investment bank, Bear Stearns, was hugely successful at peddling mortgage-backed bonds, which drove its share price to $170 in 2007. Alas, gift-wrapped guano is still guano, and when the music stopped, you couldn't give those bonds away. To stave off a bankruptcy which might have started a whole cascade of bank collapses, the US government, through the Federal Reserve, advanced funds to JPMorgan Chase & Co to buy Bear Stearns – for $2 a share, later increased to $10.

This is “the discipline of the market” which sends right-wing ideologues into rhapsodies. The omniscient Market God impassively allocates rewards and penalties in accordance with the courage, perception and skill of the players. If some poor slob in Cleveland gets bounced out of his house, that just shows he lacked those sterling qualities. Tough guano.

Today, tens of thousands of US houses stand vacant and abandoned. A search for condominiums under $50,000 in Fort Myers, Florida – a very pleasant place – turns up 91 properties. Two bedrooms, one bath, $34,900, a price that would be competitive in Reserve Mines. Nationwide, whole streets are in foreclosure, placed there by the implacable discipline of the market.

But when a contagion reaches financial institutions, the Market God is rudely shoved aside, and government bails out the bankers. This is the social safety net of the rich. When the discipline of the market threatens Wall Street, hard-nosed free-enterprisers suddenly discover the merits of socialized banking.

People with degrees in necromancy and prestidigitation – who are far more qualified than I to comment on the markets – contend that the Federal Reserve was right to shovel cash into the financial system. Maybe so. But after this episode, could we please be spared any further guano about the discipline of the market?

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Last Sunday was Easter Sunday -- and since the Sunday Herald doesn't publish on Easter Sunday, I did not write a column.