Many ideas are more complex that we appreciate.

One of the great bonuses in being part of the author group of Learning from Dogs is that we are all having to dig in deeper on issues than we might otherwise do.  Part of the weakness of our modern busy lives is that we run the risk of forming or reinforcing opinions ‘on the fly’.  The modern media tends towards this approach.  But on a Blog that strives to write about integrity it behoves us all to be more careful about what is correct if, indeed, there is a correct answer.

John Lewis first posed the idea of whether financial products should be regulated in terms of consumer safety, like your toaster!  Sherry Jarrell then replied to that as a comment which was worth being made a separate Post.  That Post then attracted comments and, again, in amongst them was another detailed reply from Sherry that has been made the subject of this Post.  As implied, many of today’s issues are far too important to be left to the headline writers.  Here’s Sherry:

My understanding of the original question was “should there be a minimum level of safety, guaranteed by the government, for financial products.” My answer was, basically, “no.” The comments that have followed seem to me to be responding to a different, unspoken, perhaps deeper issue, and that is what is the proper role of government in protecting its citizens. Even with the question recast in a broader context, however, my response is still no, but I should explain it a bit better.

First of all, I am absolutely opposed to a government bailout of any organization, whether it is financial or manufacturing, large or small. At the same time, I am equally opposed to the government trying to displace or distort what should be the voluntary consumption and investment decisions of its citizens and private industry.

Private businesses strive to create wealth. They do so by employing physical capital and labor to produce a good or service that creates profits, i.e., that sells for more than it costs. Typically, though, a company has to spend money to make money; its costs occur earlier in time than its revenues, so it must raise financial capital, either from internal sources (retained earnings or private equity), or from external sources, namely the debt or equity markets. Investors buy this company’s securities in exchange for a positive return on their money. If the investor buys debt from this company, there is a legal contract backed by the court governing the timing and circumstances for paying back the money. If the investor buys stock, then they, as residual claimants of excess cash flows, accept the uncertainty that they may or may not get their investment back. But the investor would not have bought the stock in the first place unless there was good reason to believe that the company would continue to pursue profits and create economic value. And, in deference to Chris, I do not equate the pursuit of profits with “greed.” It is the pursuit of profits that employs labor, enables financial capital, and enables investment in the future, whatever specific form of investment that may take for the individual. And individuals choose to invest, or “save,” disposable income not consumed; they choose to invest in order to earn a return which enables higher consumption later, for themselves or their children or their charity. Investors are not forced to invest, forced to buy a home, forced to take risks. They choose to do so; and they should be able to do so with full information on the true risks of generating a return.

No one can guarantee a stock’s value; no one can guarantee a stock’s return. But the capital market can set a fair price for a stock; this is the price that, in relation to the expected future dividends and capital gains driven by the earnings generated by management, provides an expected rate of return that compensates the investor for the level of uncertainty about the future profits. An example might help: if you are guaranteed $105 next period in exchange for $100 today, you have earned a 5% riskless rate of return. This return compensates you for delaying consumption and for any reduction in purchasing power caused by expected inflation. But if there is a 50% chance you will get $100 next period and a 50% chance you will get $110 then, even though you expect $105 on average (.5 x $100 + .5 x $110), you will not pay $100 for that deal, because you require a higher expected return to compensate you for the added risk that you may end up with the $100 payoff. You would pay a lower price, say $97, which would generate an 8.25% return (($105-$97)/$97). The extra expected return is generated by a wider spread between the price today and the expected level of payoffs tomorrow; the required return increases as the uncertainty about the payoffs increases. And, yes, Paul, these risks can be “renegotiated” at any time: if you don’t like the returns you are earning on your stock, sell it! An active capital market provides ease of entry and exit, and the liquidity that accompanies it.

It is a little more complicated with derivative securities like options, hedging, and insurance, but the same principle applies: the less certainty about future payoffs, the higher the expected return the market requires before it lends the money and buys the financial instrument in the first place. If the government steps in and somehow limits that risk by trying to guarantee future cash flows to stockholders and other investors, the entire capital market would cease to exist as we know it. Liquidity would dry up; firms would be limited in the size of their operations and their ability to redeploy assets and grow; output and employment would drop. The reason the U.S. economy is as strong and vibrant as it is is because of our labor market, our capital market, and free enterprise. These markets are supported by the legal and regulatory systems that define the rules of the game; they are damaged when the government steps in and tries to play the game or change the outcome of the game.

The financial crisis began when an excessive, untimely number of home mortgage foreclosures began to surface. It is my conclusion that government intervention in the mortgage market caused this spike in foreclosures, which ultimately snowballed into the financial crisis we’ve all observed. Before the government intervention, lenders and potential homeowners negotiated mortgages just fine for decades. Homeowners provided information to the banks and mortgage brokers about their financial status so that the lenders could assess the risk or uncertainty of getting their money back; the less certain the bank was about the homeowner’s ability to make the mortgage payments, the higher the rate of return required. The higher rate of return could take the form of a higher down payment and/or a higher interest rate on the mortgage loan. Notice the analogy to the risk-return relationship of stocks.

The mortgage market was operating smoothly. Yes there were foreclosures but this possibility was priced into the interest rates charged on the loans. Then the government stepped in with its “every citizen has the right to own a home” social engineering initiatives. No longer was it the face-to-face negotiation between the banker and the potential homeowner. Now the banker had to satisfy government mandates on the number of mortgage loans made to high-risk customers; because these customers would have failed to qualify otherwise, banks had to reduce the costs to the homeowner, either by waiving the down payment, accepting a lower credit score, or lowering the interest rate below that which would compensate the bank for the uncertainty of the borrower. All of these measures reduced the expected rate of return the bank could earn on these loans. Left to their own devices, without the mandates of Washington, these mortgages would have never been approved. From the homeowners’ and taxpayers’ perspectives, the initiatives from Washington basically reduced the price of the mortgage to them. And, as prices come down, demand goes up. People who would not have “bought” the mortgage at the higher price are now in the housing market because the government has basically used its power over the banking industry to limit the price banks can charge for their service; to limit the rate of return they can earn to below that required to compensate them for risk.

But Washington had another carrot to offer the banking industry; Fannie Mae would buy those underpriced subprime mortgages from the banks to get them off their books. (I know this from firsthand information; I teach MBA students, a number of them are former mortgage brokers who left the industry because they couldn’t justify making loans to people with low credit scores anymore just to satisfy government mandates.) Now the homeowner would make their mortgage and interest payments directly to Fannie Mae. Fannie Mae then pooled all the mortgage funds together, and resold the principal and interest payments as new distinct derivative securities. Buyers of the repackaged mortgage payments often sold commercial paper to fund their purchase, so now the commercial paper market was dependent on the timely receipt of mortgage loans payments by subprime borrowers. Notice that the risk of mortgage default was not reduced by the government mandate, but the return earned by the lender was. This is the distortion caused by a politically motivated mandate being inserted into what should be an objective business decision made by private industry.

Fannie Mae, as a government-sponsored entity motivated by fulfilling a political mandate and assessed by the number of low income families who now owned a home, certainly had no incentive to determine the true risk of the mortgages they purchased or the new securities they issued. The value of the mortgages and the rate of return on the new Fannie Mae securities were determined by government edict, not by a freely functioning capital market serving private businesses seeking to maximize their efficiency and their profits. The signal normally provided by the rate of return about the value of the investment was distorted.

The only real “greed” I see in this picture is of the political variety; the desire by politicians to hold on to their power and position by diverting tax dollars to segments of society they hope will return the favor by contributing to their campaign or voting for them and keeping them in office. The only people taking “risks with other people’s money” are the politicians. Investors purchase securities in order to benefit from business risk; their money is not “taken” by business or financial experts; it is invested. It is tax dollars that are taken by power-hungry politicians to buy votes and support; it is tax dollars that are spent on exorbitantly risky ventures, like bailouts, like Cash for Clunkers, like purchasing the very toxic assets that their mandates created.

That’s my view.

By Paul Handover

• Business
• Finance