Wavepacket Blog

Mon May 17 21:31:39 2010
A Modest Proposal
One way to fix, or at least alleviate, the mortgage crisis.

Don't give it all back to the banks.
Image courtesy of Gregoryj77 (wiki)

Today there was news that people are dropping out of mortgage assistance programs. Some of that article was a bit troubling, such as this quote from one person who did finally get assistance. This is how she saw the banks behaving:

"They kept calling me and asking me to send the same things," she said. "I felt like they just wanted to run me around until I got so frustrated that I gave up."

I wouldn't be surprised if many banks dragged their feet. Why would they give up the chance of an income stream? Even with government assistance, banks don't have much financial motivation to make the program successful. Anytime you have a program that is counter to important participants' self-interest, it is usually doomed to fail, no matter how well-intentioned.

Some underwater homeowners are getting a permanent modification to their mortgage. But many others are being forced to foreclose or make a short sale.

So how about if we had a mortgage assistance program that was actually in everyone's best interest?

The best idea I've been able to come up with would be to have banks receive an equity share in the home.

For instance, if your mortgage was 20% more than the house was worth, instead of having you just walk away, the bank would take a 20% equity stake. You could keep paying back the mortgage for what you owed. Later, when you sold, the bank would take a 20% cut of the sale.

Another problem is people who took out mortgages that are too big. Those homeowners are now facing mortgage payments that they can't pay. One option may be to have the bank adjust the principal down in return for an equity stake.

This could be a good option for many homeowners since they would still have a lot of equity in what should remain an appreciating asset. And for banks, they have a chance to recoup some of their losses later as homeowners sell.

I think this plan should require that the banks allow people to buy them out, so people would have the option to buy back their equity at any time.

Obviously, with a sizeable long-term equity stake, a bank will be sensitive to what a homeowner does with the home. For instance, what sorts of renovations are made, and how the house is kept up. But banks already care about that! If you have mortgage, then there are already restrictions on what you can do with the home.

I don't think this would fix everything, but I think that in some situations both banks and homeowners may be interested.

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Tue May 11 20:59:49 2010
Greece's Surrender
The European Union brings the hammer down.

To quote The Economist: "Acropolis Now"
Image courtesy of Glen Larson

Just Sunday I blogged about Sovereign Bankruptcies. I was mostly worried about the United States, but lately Greece has been stealing the headlines due to its imminent bankruptcy instead.

On Monday the European Union announced it was going to bail out Greece with a $1 trillion stabilization package, which is, to quote the article, "shock and awe." Markets rebounded on the news after last week's slides, but were a little less enthusiastic today.

People are worried, rightly, that bailing out Greece with more loans could ultimately make the problem worse.

But today Slate had a great article about the EU bailout. One of my favorite quotes, referring to Greece's end of the deal:

This is the kind of thing a surrendering field marshal signs in a railway car in the forest at the end of a bloody war.

Basically, Greece had to agree to a long list of deep structural changes which their parliament must enact over the next several years, with some deadlines in June 2010!

Overall, I think this is a good thing. The European Union made it clear it will protect its own, but also imposed serious changes on how Greece does business (including making it easier for Greeks to do business!).

One scary sidenote: central banks are realizing that an important component of bailouts is the size. They feel like they need to put a lot of money on the table to calm markets. Obviously, that can't keep escalating like it has. Which means the next bailout may already be doomed--no one will have the money to trump the EU's $1 trillion package.

So again, it all comes down to not spending more than you have.

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Sun May 9 20:52:16 2010
Sovereign Bankruptcies
What really happens when countries go bankrupt?

Spain celebrating peace, just before running out of money.
Image courtesy of Razr (wiki)

I've been wondering about this for a while. How do sovereign countries go bankrupt, and what happens when they do? So I decided to find out.

I am mostly (and selfishly) worried about the United States. We seem to be unable to constrain our spending, meaning that we have to borrow a lot of money. Whenever you keep borrowing money, whether you are a person, a company, or a country, eventually people get tired of lending money to you. Over time, people stop lending, or lend at ever-higher rates. At some point you either pay off your debts and live within your income, or you go bankrupt.

But lately this has come up several times for countries besides the US. Iceland nearly went bankrupt 2 years ago, and now Greece could go bankrupt, and some say Portugal and Spain may not be far behind.

What with talk of bond markets and "contagion risks" and riots, it can all look very complicated.

But really, bankruptcy is very simple. If you can't pay your debts, then you are bankrupt. You have to pay what debts you can, and the rest are left forever unpaid. Most investors (the people doing the lending) simply lose their money--that's why bonds aren't completely risk-free. Countries have leveraged debt since the concept was invented, so it's no surprise that countries themselves also go bankrupt.

Here are some of the historical national bankruptcies I've found:

Spain's bankruptcies of 1557, 1560, 1576, and 1596. Yes, four national bankruptcies in 40 years. This is while Spain was plundering the New World and raking in huge amounts of gold and silver bullion! In the 1557 bankruptcy King Phillip II simply refused to pay debts, and that ruined several large banking houses in Germany.
France's near-bankruptcy of 1789. France was likely only months away from defaulting on several expensive loans, but then revolution broke out. The poor state of the nation's finances has been called out as a major reason for the French Revolution (see the wiki link). After the revolution, the new leaders of France simply expropriated property as needed and executed unhelpful lenders--which I think counts as default.
Portugal's bankruptcies of 1892 and 1902, which, like today in Greece, caused widespread unrest and riots in Portugal.
Germany's bankruptcies of 1923 and 1945. The 1923 bankruptcy (and preceding hyperinflation) was especially chilling because it helped launch Hitler's career and the rise of the Nazi party. The 1923 bankruptcy came about due to complete currency collapse, leading the counry to default on foreign debt payments (debt payments which themselves were poorly-conceived reparations for World War I). The defaults of 1922 and 1923 led to occupation of its territories. The 1945 bankruptcy was due to the country's production problems after the decimation of its industries in World War II. Clearly, both bankruptcies caused widespread pain--and as I said, the 1923 bankruptcy was a major event that pushed the country psychologically towards World War II.
Russia's defaults of 1998. Russia defaulted on domestic debts, and massively devalued the ruble. Other debts were unilaterally restructured.
Argentina's bankruptcy of 2001. The impact on the economy (riots, bank runs, 25% unemployment) was severe. After years of deficit spending, corruption, and poor monetary policy, Argentina was forced to default on over $120 Billion (US Dollars) and massively devalued its currency.
Iceland's near-bankruptcy of 2008. This wasn't a "true" bankruptcy since Iceland didn't actually default on any loan payments. But that is only because they took a massive loan from the International Monetary Fund, and instituted harsh austerity measures. Their GDP is expected to shrink by around 10% (maybe more), unemployment has nearly tripled, and their currency has collapsed. Furthermore, many households have their debt indexed or denominated in foreign currencies. So the collapse of their currency has made things much worse for them. [this data is from the wikipedia article]

Printing money can be hard to clean up.
Image courtesy of Timur lenk (wiki)

On top of the human misery at the time, after the bankruptcy the countries found themselves unable to borrow at favorable rates. In general, this gives governments less flexibility and is (I think) a security risk--a lack of funds could be exploited by other countries for economic or even territorial gains. Certainly Greece will be hard-pressed to borrow more money until it demonstrates to the world that it can maintain fiscal responsibility for several years.

What I find most scary is that these defaults (with corresponding catastrophic impact to the nation involved) were usually not well foreseen ahead of time. That is, there were many people who recognized that the fiscal and/or monetary health and behavior was poor, but default and bankruptcy were usually a bit of a surprise to everyone.

The "surprise" nature of national bankruptcies is either due to fraud and misinformation at the highest levels (such as France's 1789 financial problems), or more commonly due to the fluctuating nature of national income. A country may think it can pay back its debt in 10 years, but then a war, famine, or recession can suddenly decimate cash flow to the point where a country realizes it is only months or weeks away from default.

Once you get to that point, you're toast. Anyone with money to lend won't go near you, and anyone who already lent you money is now freaked out and wants their money back. That's the nightmare scenario that Greece is facing now.

In the past, many countries have simply printed more money to solve the problem. Printing money is effectively a country-wide tax: as the currency devalues, all the money that you have becomes worth slightly less, and the value that you lost is now transferred to what was just printed. Taken to extremes, this corrodes trust in the currency to the point that it accelerates towards zero worth. But in some cases, careful inflation (printing money) allows the government to tax everyone enough to pay off debts.

However, printing money doesn't always work. If a large amount of your debt is foreign-denominated, devaluing your currency will make it even harder to pay off foreign creditors. That's what happened to King Philip (Spain) and the Weimar Republic (Germany) above.

Europe may just have to print Euros to bail out Greece. Basically, all of Europe will be taxed to save Greece. Personally, I think a solution like that is best: it reinforces what it means to be a European state. It is what we (United States) might do if we had to bail out one of our states, along with other measures.

Will any of this happen to the United States? That depends on if we can reign in spending, and how much patience our creditors will have. Personally, I see risks for both.

First of all, we haven't been able to stop overspending, and the problem with just get worse in the next few years as we won't be able to pay for Medicare or Social Security. Politicians are unable to fix either of those programs because it would be political suicide to even suggest changes. This isn't our politicians' fault: voters in the US recognize that we have fiscal problems here, but nobody is willing to accept cuts in their (future) benefits--even though cuts are mathematically inevitable. This is the same reason we see people rioting against austerity in Greece even though it is clear their government has no money.

Secondly, foreign investors are starting to see credible alternatives to the US Dollar. Both the Euro and, in a few years, the Yuan, will be good options for countries to hold foreign reserves. There are already proposals for just this sort of model. Once there are credible alternatives to the US Dollar, foreign investors won't put up with large deficit spending in the United States, and any risks (such as Medicare/Social Security insolvency) will result in even higher interest rates we'll have to pay to borrow money.

My predictions?

The European Union will save Greece. That seems most prudent from a stability level, and is also a painful but deep reminder of what it means to be a true European State--the Union will help (at a price).
Foreign creditors will continue to look for alternatives to the US Dollar. We'll see increasing interest rates as we borrow more money to pay for our deficits. This might lead to better fiscal discipline on our part, but I am a bit worried that we'll keep overspending anyway.

The result? Greece won't go bankrupt, although it will be painful for them over the next several years. And the US will face a high risk of bankruptcy in 5-10 years when creditors suddenly decide to stop lending. At that point we ourselves will be dangerously vulnerable to recessions or other events that reduce national tax revenues.

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