(Dt. Tuesday, April 8, 2008)

Update 1: Housing Example in Role of Markets

I would like to thank all the Economics Professors who were kind enough to spend their time carefully reading my research proposal. I heard back from twenty one Professors. Although all twenty one Professors said that they didn't have funds to employ me, five of them have kindly sent me incisive comments on my research proposal. I would like to thank these five Professors specially. They are, in alphabetical order of last names, Professors Kenneth Arrow, Richard Cooper, Jeffrey Frieden, John Roemer and Alvin Roth. Also, I would like to say to all the Professors that if you do not have funds to employ me, it is fine with me. I would rather much prefer to hear your intellectual opinions on my research proposal. Once again, I thank you all for your time and your patience.

In this e-mail message, I would like to provide an update on my research proposal (titled 'A New Perspective on the Role of Markets in an Economy') which I had sent out two to three weeks ago. I have now focused completely on Example 1 in my research proposal which was on the ongoing Housing Mortgage crisis. Upon following the media's coverage of the mortgage crisis in the last few weeks and reading several pre-prints of research articles related to this crisis, I felt that professional economists have done an excellent job of analyzing most aspects of the mortgage crisis. Hence, I have restricted myself to four issues on which there has not been adequate coverage or no coverage at all.

These four issues are mentioned briefly here. I have discussed them in detail later in individual sections. The four issues are (I) Securitization, on which the media coverage has been mainly that this process separates the property rights on mortgaged homes from the investments on mortgage-backed securities. For sure, this separation leads to increased uncertainty about the recovery of the mortgage loans. But, there is no coverage on the duration of interaction in a mortgage transaction (the main theme of my research proposal). (II) Theory of marginal utility, on which the media coverage has only been that the mark-to-market accounting rule has led to the perception of widespread losses, which could have supposedly been avoided otherwise. There is no coverage on the question whether the theory of marginal utility is the appropriate methodology for valuing family-occupied modern houses, or the question whether house-owners can be expected to adapt to the market mechanism in such a short time when it has taken companies many decades. (III) Comparative advantages of the US housing sector versus the technology sector as investment destinations and the resulting long-term implications for globalization in the 21st century. There has been practically no media coverage on this issue. (IV) Asymmetric information, on which the media coverage has been that the Wall Street investors of mortgage-backed securities did not get accurate information about the mortgage loans because there were plenty of information asymmetries down the mortgage pipeline all the way to the house-owner at the other end. But, there is almost no coverage from the other end of the pipeline, i.e., nothing from the house-owners' perspective on the asymmetry of information.

For the sake of completeness, let me also just list here the issues on which there has been excellent coverage, before going on to discuss the above four issues in detail: 1. Low interest rates and continued pile-up of huge trade deficits, financed by foreign countries, made credit easily available, which led to rapid increase of mortgages, 2. Bush tax cuts led to trillion-dollar investments in mortgage-backed securities which amplified the housing boom, for better or for worse, 3. Sub-prime mortgages and Predatory lending practices, 4. High leverage, 5. Shadow banking system (and hedge funds), 6. Government regulations, 7. Failure of Insurance agencies and rating agencies, 8. Liquidity crisis -- credit freeze in the financial system, etc, 9. Crisis of confidence -- sale of Bear Stearns, etc, 10. Social consequences -- foreclosures, homelessness, debt, etc, 11. Spill-over to other parts of the financial system -- prime mortgages, corporate bankruptcies, credit cards, auto loans, commercial mortgages, etc, 12. Effect of the mortgage crisis on the overall economy -- recession, unemployment, etc.

I. Securitization

Could the market framework really handle a situation wherein on one side, securities worth billions of dollars were traded through computers at an instant, and on the other side, millions of home-owners thought that they were getting into long-term financial obligations? Also, almost no consideration has been given for the fact that both parties in a mortgage loan are liable for the initial appraisal of the value of the house. Recall that in the process of securitization, a large number of mortgages, possibly several thousands, are pooled together in a single package, and using these mortgage-packages as collateral, securities (shares or bonds) are sold and re-sold in the market. So, hypothetically, we could think of this situation as a market transaction in which one side is the house-owners of the mortgaged homes pooled into a single package, and the other side is the current owners of the securities issued on this package (in practice, of course, the interaction is not so direct because the security-owners do not have property rights). Now, the 'average' house-owner expects to stay in his/her house for a period ranging from the medium term (2 to 5 years) to the long term (more than the full course of the mortgage). Typically, he/she refinances the mortgage once or twice in its lifetime, mainly to take equity out, or to take advantage of low interest rates. Whereas the 'average' security-owner trades off the security in a much shorter time, ranging from a few days to a few seconds. Each time a security-owner trades, he/she has updated information on the housing price index and the interest rate on loans (although he/she has no property rights). In contrast, the house-owner is locked in with the value of the house that prevailed at the time of signing the mortgage. Please note that this situation is not a case of asymmetric information, but that of only one party in the transaction getting the benefit of posteriori information (the information itself becomes available only much after the mortgage contract is signed and done). Would it throw enough light to just view this situation as a market with imperfect information, or are new theoretical tools necessary to analyze the mortgage securitization situation?

Now, there are two familiar situations that have been existing for a long time, in which similar phenomena happen, but the current mortgage crisis is, in fact, quite unprecedented. (i) Historically, commercial banks have taken deposits from people for the short-term and lent out money to businesses for a longer term. Thus in this case too the two sides of the transaction are locked into the transaction for uneven durations. However, the major difference is that in this case both the depositors and the borrowers are committed for non-instantaneous durations; whereas in the securitization process the security-owner transfers his/her claim almost instantaneously. Moreover, government regulations on commercial banks regarding reserves on capital, FDIC insurance and reserves from the Fed help to prevent any liquidity crisis for the bank. Also, please note that the typical road-side branch of a commercial bank is much, much smaller than the Fed, which makes it possible for the Fed to act as the guaranteeing agency. Thus the bank-run risk for a commercial bank is small and localized. In contrast, each of the investment banks which trade in mortgage-backed securities constitute a significant portion of the entire financial system (when their leverages are also taken into account). (ii) Fannie Mae and Freddie Mac have been issuing mortgage-backed securities for many decades now. However, only in recent years when Wall Street has poured trillions of dollars into mortgage-backed securities and has traded intensely on these securities with split-second information has the market mechanism for trading in mortgage-backed securities been pushed to the limits.

II. Theory of Marginal Utility

The theory of marginal utility enables the market mechanism to play an important role in determining the price of an entity, in addition to the market's primary roles of providing coordination and availability. Moreover, marginal utility theory has vastly expanded the applicability of the market mechanism. For example, if firms were to be bought and sold as a whole, then their intrinsic value could be considered (based on fixed assets, loans, earnings, bills receivables/payables, reserves, inventory, human capital, good will, reputation, market share, etc). Needless to say that if firms could only be traded as a whole, then liquidity as well as demand would be insurmountable problems. Thus trading in shareholding claims on the firm, makes it possible for the firm to raise additional capital without losing management control, and also to enable the participation of small investors.

Now, in reality, at any given time, only a fraction of the outstanding shares of a firm are available for trade in the market, and the price of these shares is determined by their current demand (which may take the firm's performance into account in varying degrees). However, in valuing the majority of shares which were not for sale in the market, it is still this market price that would be considered as their worth. This is the key fact that enables the market mechanism to retain its relevance during times of great social and technological changes. For example, at the height of the 'tech boom' in the late 90s, the vast majority of software 'start-up' companies had no earnings at all. Yet the market provided them with enough capital to compete with traditional, 'Main Street' companies, by making the paper worth of the software entrepreneur in the millions of dollars even though his/her most important asset was something as intangible as an idea or an innovation. Another important example demonstrates the enormous power of marginal utility theory to destroy outmoded wealth. And this was the prolonged languishing of the US stock markets in the 70s and 80s. This led to the drying up of working capital for many companies, since for equities as well as borrowings, the stock prices were used for the valuation of the company (with plant, equipment and buildings having depreciated). Thus followed a string of takeovers on Wall Street. Takeover tycoons would buy up shares at cheap prices to get majority control of a company and then proceed to dismember the company and sell off its assets for a handsome profit.

Enabled, largely by the power of marginal utility theory, to create and destroy wealth at a breathtaking pace, the market mechanism, of necessity, trades objects in an impersonal manner. Over the course of the last two hundred years, firms in a capitalist country have made adjustments to this impersonal nature of the demands of the market. Whether the issue concerns the workplace, or the employees, or the management, or the customers, or the community, or the nation-state, or the environment, all of these concerns have taken second seat to the priority of the modern firm to deliver profits to its shareholders. Moreover, to ensure that the share price of the firm does not decline due to the market's perceptions of weakness, publicly traded companies report their earnings each quarter. The entire operation of a modern public company is put on a schedule that is suitable for keeping the interests of the shareholders paramount. These adjustments have taken many decades to evolve.

Now, the question is could such an impersonal manner of valuation apply to the home in which a family resides, and which is located in a neighborhood shared by a community? This question, of course, does not admit a simple answer. But, we can identify the major issues here. On the one hand, during the course of the 20th century, four major technological developments have steadily added to the impersonalization of the household. Firstly, electrical gadgets like microwave oven, refrigerator, laundry-washer/dryer, blender and the vacuum cleaner have made it unnecessary to spend much time in the house to do household chores. Secondly, frequent travel, whether it be long commutes to work, or it be driving on the interstate highway or air travel on vacations have loosened one's ties to one's home. Thirdly, 24-hour grocery stores, supermarkets and restaurant chains have standardized and simplified food producing activity. Fourthly, television, cell phones and the internet have connected the residents of the house to global developments on a round-the-clock basis. So, the modern house-owner may, in fact, welcome a globally connected lifestyle with reduced ties to a fixed physical space like a residential home.

On the other hand, the residential home is the place where the family reinforces its emotional and psychological ties. There is a strong case that the utility of the house to the family cannot be measured by the going rate for the most recent house in the neighborhood, that was sold in the market, which is what marginal utility theory would prescribe. Moreover, homeownership promotes marital and financial stability. Residential homes provide enhanced quality of living for raising children. Presumably, community participation is higher among home-owners than apartment-renters. A workplace could be naturally suited for an impersonal characterization, which demands professional behavior at all times from the employee. In contrast, the home is a place for rest, recuperation, love, joy, sorrow, hobbies and entertainment. For these reasons, it may be unfair to expect the home-owner to accept the wide variations of a marginal valuation of his/her house. In any case, considering that the publicly traded firm took many decades to adjust to the valuation method based on marginal utility, perhaps it is not unreasonable to give some consideration to the fact that the house-owners have had no such period of adjustment. As a moderating influence, alternative methods of house valuations like the cost of construction approach and the price-to-rent ratio approach could be considered in a supplementary fashion.

III. Investment Destination

Modern economic and financial theories are enormously powerful and precise. Yet they are not completely adequate to deal with the blinding pace of modern technological developments. Joseph Schumpeter's concept of Creative Destruction was the last truly penetrating insight into the nature of technological change in a capitalist economy. As the most telling example of their inadequacy, we note that modern economic theories could not guide us in figuring out how to safeguard the enormous transitory wealth created during the 'tech boom' of the 90s. The NASDAQ composite index peaked at 5048.62 on March 10, 2000. Fifteen months later, in August 2001, it stood at 1805.43, before touching a 5-year low of 1114.11 on October 9, 2002. The loss in the total market capitalization of NASDAQ stocks during this 17-month period ran in the hundreds of billions of dollars. Of course, this empirical fact does not prove beyond doubt the ineffectiveness of financial markets to handle fast technological developments. However, one may note that a wealthy investor trying to make a decision in 2002 about where to make a long-term investment of his/her money would have definitely found the hedge funds dealing with mortgage-backed securities to be much more promising an option than the then-recently decimated stocks of the technology companies.

More importantly, to face the emerging challenges of globalization in the 21st century, America needs to have a clear sense of the sources of its own wealth. Rising homeownership speaks directly to core American values which include working hard to gain wealth. Away from the crime-prone inner cities, old houses are being replaced, in vast numbers, by modern energy-efficient, green-friendly, spacious homes in hundreds of towns and cities across America. The spaciousness of the American landscape, the safety of American neighborhoods especially in the towns and smaller cities, the surety of property rights, the participation of the home-owner community in local government and jury duties, the effectiveness of law enforcement are some of the strengths of the American home-building tradition. The constant supply of clean drinking water, waste management, garbage disposal, 24-hour electric supply, clean toilets and hot showers in an American home speaks directly to the impression of the American dream among the people of other nations. In comparison with the emerging economies, America definitely has a 'core competency' in home-building which would stand it in good stead when difficult challenges arise in a globalizing world of the 21st century. Thus the choice of the financial investors to pour trillions of dollars into the mortgage industry in the last 8 years, whether by design or by accident, is a sound investment that would have many positive benefits, if only the current mortgage crisis is handled successfully.

IV. Asymmetric Information

Until recently, conventional wisdom considered housing mortgages to be local markets. Many house-owners had no idea that their mortgages are counter-balancing the intense trading of securities issued against them to investors all over the world. The high value and the high frequency of trading these securities using computers, in an instantaneous fashion, could not be totally unrelated to the instability of the housing prices. The irrational exuberance of the housing boom could not have been so forceful without the massive world-wide supply of funds for the purchase of the mortgage-backed securities. Another point I would like to make is that the portrayal of the home-owner in the media as a gullible ignoramus who got 'smooth-talked' into complex financial instruments is not quite accurate. This portrayal has resulted in the continued neglect of the government authorities to directly help the home-owner, under the excuse that the home-owner is liable for irresponsible decisions. However, there is no evidence that, given the asymmetries of information, the home-owners acted in a particularly foolish or irresponsible way.

Finally, the fact that the financial markets froze up during the past few weeks may, in fact, be a positive outcome in the long run. It would have been far more destructive if, instead, an Enron-like accounting scandal had hidden the losses for now, only to have them show up later with much greater loss of confidence. Thus, in some sense, the financial markets have been functioning in a transparent manner, and this shows that the incidences of asymmetries in information, ranging from falsifying home-owner's credit worthiness to the shadow banking system, may be relatively small, after all.