Sunday, October 05, 2008

Maybe this is why the Dow dropped anyway...

Not all economists believe the bailout will bail anything. The underlying problem which we keep drifting away from is the downward spiral in home prices.  This deflationary current is carrying lending instruments of all kinds along with disastrous results.

But maybe it won't necessarily lead to a depression (a word we've been seeing frighteningly often).
Harvard finance professor Robert Merton, a Nobel laureate, notes that one of the problems at large financial institutions is the gap between the executives and the financial engineers, or what I call the “suits” and the “geeks.” The geeks possess knowledge that is highly specialized and extremely technical. Many suits have never even taken a course in the fundamentals of valuing complex financial instruments, even though the health of their firms depends crucially on that very issue.

Today, the suits are saying that mortgage-backed securities are undervalued, and that if the government just holds them to maturity it will make a profit. But the geeks will tell you that we cannot be certain these securities are undervalued.

The valuation of mortgage-backed securities is marked by an enormous asymmetry. If house prices rise, the security holder gains little. He or she is happy to be relieved of the risk of default, but he or she cannot share in the homebuyer’s profit. On the other hand, each drop in house prices lowers the value of the security further.

Saying you will be just fine if you hold a mortgage-backed security to maturity is like saying you will be just fine if you don’t evacuate when Hurricane Ike is approaching. Depending on where it makes landfall, that strategy may cost you nothing—or you could be Galveston.

In terms of the bailout, a Galveston-like scenario would be a decline in the housing market that turns out to be steeper or more protracted than what financial markets currently expect. If such a hurricane makes landfall, almost the entire $700 billion could go down the drain. Under better scenarios, a small profit could materialize.

Main Street might prefer to have a choice about whether to take that risk. Instead, the choice is being made by politicians, who are gambling with other people’s money to advance their own agendas.

This bailout isn’t as bad as Main Street thinks. It’s worse. [More]

The author, Arnold Kling, is well-respected, but clearly in the minority in stating consolidation would not be unbearable for our economy.  He is, I believe, correct in predicting the massive loss of free enterprise and growth of state intervention in our economy will be a long time unwinding - if we ever do.


Ol James said...

If the housing market keeps dropping....Farmers can buy sub-divisions and convert them to farmland, couldn't they??

Farmer 4ez said...

Doesn't the home mortgage crisis have less to do with the home values than it does the inability to service the debt? The underlying value of non income producing property should have no impact on the borrowers ability to repay the debt. The problem lies in the fact that people borrowed money that their cash flow could not support!

Lending institutions made these loans regardless of the borrowers ability to repay because it resulted in an interesting game of balance sheet gymnastics. As long as the value of the asset backing the loan continued to increase so did the asset side of the lenders balance sheet. Once the underlying value of that property began to decrease so did the asset side of their balance sheet. As the lenders net worth dropped so did their ability to make new loans. When loans dried up the housing market continued to slide because it is almost entirely dependent on the ability of the buyer to borrow enough money to make the purchase.

Lending institutions bet the "house" that the market would continue to go up. I've been farming long enough to know that that is a fantasy!