Category: Real Estate and Mortgages

The Rules, Part I

The Rules, Part I

Posted on by David Merkel

Dear readers, I am now on Twitter — AlephBlog is my moniker if you want to follow me.

I have been somewhat reluctant to do this, but tonight’s post stems from a file on nonlinear dynamics on my computer that I developed between 1999 and 2003 for the most part.? Not so humbly, I called it “The Rules.”?? This is the first in a series of what will likely be long set of irregular posts about what I call “The Rules.”? Please understand that I don’t want to make grandiose claims here.? After all, as I once said to Cramer (yes, that one): “The rules work 70% of the time, the rules don’t work 25% of the time, and the opposite of the rules works 5% of the time.”

My best recent example of the rules not working was when the formulas of the quants were blowing up in August 2007.? There were too many quants following the same strategy, and they had overbid the stocks that their models loved, and oversold the ones that they hated.? For a while, the quant models were poison.? Every investment strategy has a limited carrying capacity, and those that exceed the strategy’s capacity are prone for a comeuppance.

Here is today’s rule: There is no net hedging in the market.? At the end of the day, the world is 100% net long with itself.? Every asset is owned by someone, regardless of the synthetic exposures that are overlaid on the system.

There are many people, particularly dumb politicians, who think that derivatives are magic.? To them, derivatives create something out of nothing, and that something is strong enough to smash innocent companies/governments that have been behaving themselves, but have somehow found themselves caught in the crossfire.

First, if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.? You have the upper hand.? But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.? Even without derivatives, that is a tough place to be.

With derivatives, for every winner, there is a loser.? It is a zero-sum game.? Yes, as crises arise there are always those that look for a way to make money off of the crisis.? And there are some parties willing to risk that the crisis will not be so bad, at a price.? Derivatives don’t exist in a vacuum.? Same thing for shorting — there is a party that wins, and a party that loses.? So long as a hard locate is enforced, it is only a side bet that does not affect the company whose securities are being played with.

When there are troubles, it is because a company or government has overstretched its limits.? You can’t cheat an honest man (or country).? You can take advantage of countries and companies that have overreached on their balance sheets and cash flow statements.

Cash on the Sidelines, Market is Oversold/Overbought, Money is Moving into or out of…

Every bit of cash on the sidelines is matched by a short term debt obligation somewhere.? Now, that’s not totally neutral, as we learned in the money markets crises in the summers of 2007 and 2008.? If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short.? It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that.? CIT did die.? Mexico in 1994.? When you can’t roll over your short term debts, it gets really ugly, and fast.? Think of the way we messed up housing finance in the mid-2000s; one of the chief signs that we were in a bubble was that so much of it was being financed on floating rates, or contingent floating rates with short refinance dates.? Initially, that gave people a lot more buying power, at a price of higher unaffordable rates later.? “The phrase, “You can always refinance,” is a lie.? There is never a guarantee that financing will be available on terms that you will like.

This is also a good reason to go for debt that fully amortizes (i.e., when you get to the end of the loan, the payments haven’t risen, and the loan pays off in full).? I’ve never been crazy about the way commercial mortgage loans don’t fully amortize.? I know why it happened this way.? A) in the late ’80s and early ’90s, insurance companies were issuing GICs by the truckload, and needed higher yielding debt with a 5-year maturity.? Voila, 5-year mortgage loans with a balloon payment.? For the real estate developers, the loans were cheaper, but they had to trust that they could refinance — an assumption sorely tested in the early ’90s.? After the death of many S&Ls, a few insurers and developers, and the embarrassment of a more, borrowers and lenders became a little more circumspect.

But the loss of the S&Ls left a void in the market.? The Resolution Trust Company created some of the first Commercial Mortgage Backed Securities [CMBS], that Wall Street then imitated, filling in the void left by the S&Ls.? But to make the securitizations more bond-like, for easy sale the loans were 10-year maturities with a balloon payment at the end.? That way the deals would closer at the end of ten years.? Maybe some of the junk-grade certificates would be stuck at the end with a some ugly loans to work out, but surely the investment grade certificates would all pay off on time.

And that is a big assumption that we are going to be testing for the next five years.? Will developers be able to refinance or not?

This has gotten long, and have more to say, but I’m going to a wedding of a friend, and must cut this off.? Let me close by saying there is a corollary to the rule above, and it is this:

Long-dated assets should be financed by non-putable long-dated liabilities or equity.? Don’t cheat and finance shorter than the life of the assets involved.? There is never an assurance that you will be able to get financing on terms that you will like later.

Notes and Comments

Notes and Comments

Posted on by David Merkel

1) After reading a piece on Falkenblog yesterday, I decided to add up all of the profits from Fannie and Freddie over the last 20 years.? Ready for how much they made?? Ta-da!? They lost $114 billion.

When writing at RealMoney, I was always skeptical of the GSEs, and felt that they were too lightly reserved, because eventually they would run into a situation where real estate prices would fall.

2) Bruce Krasting comments on the solvency of the FHA.? I comment:

“I’ve argued that FHA would go negative for some time. Even the FDIC is engaged in a bit of chicanery by fronting future premiums forward to avoid borrowing from the Treasury.

We may avoid a banking crisis — at the cost of a sovereign crisis.”

3) I probably have a longer post coming on the paradox of thrift, that bogus concept that Keynes put forth.? But Paul Kedrosky crystallized it for me when he posted this.? And so I wrote:

The problem with the “paradox of thrift” is that it assumes there is only one way to save. Same for the “paradox of toil.” It assumes that all work is interchangeable and uniform.

The aggregation of all saving and all labor is necessary to make these models work mathematically, but isn’t valid in real life.

Yes, if everyone tries to do the same thing, stupid things happen, like bubbles from overinvesting. If there only a fixed possible number of tasks, and people work longer hours, it takes fewer people to do them.

But there are many opportunities, including ones that we don’t presently know about. Businesses that no one could imagine before the crisis can spring out of hard times.

This paper oversimplifies the economy. If the economy were that simple, he would be right. But the economy is not that simple.

4) I don’t know if the Volcker Rule will be eliminated or not, but I do know that the same ends could be achieved through changes in the risk-based capital formulas.? What I wrote:

The same ends of the Volcker Rule can be accomplished through adjusting the risk-based capital formulas ? Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

For another off-the-wall idea: ban interstate banking, and let the states rule all depositary institutions. Results: No more too big to fail, and you get back ?scaredy cat? regulators who don?t let banks deal in anything they don?t understand, which isn?t much.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing ? that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

But Life and P&C insurers survive the process because of RBC, and ?scaredy cat? state regulators. What a great system, which prior to the crisis, was criticized as behind the times.

PS ? if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.

5) Is the stock market overvalued?? Probably, but consider this article here.? I wrote:

truth, P/Es are best related to corporate yields, not deposit rates or government bonds. And, you have to flip them to be E/Ps. Current E/P on the S&P 500 is 5.4%. A dividend yield of 2.05% is 38% which is close to the long run average.

The longest corporate series that I have is the Moody?s Baa series ? because of the growth inherent in stocks, for bonds to be the better deal versus stocks, Baa bonds need a 3.9% premium over the earnings yield, or a yield of 9.3% in the present environment.

So, I?ll take it back, because the present Baa yield 6.45% augurs in favor of stocks versus bonds. Not crazy about bonds in this environment ? few categories offer good risk-adjusted yields. Now, maybe both are overvalued vs. commodities, but that one I don?t know.

6) Perhaps the phrase “Greek Banking System” will be a cuss word someday.? Fitch recently gave them a downgrade, and I wrote:

Rating agencies exist to be scapegoats. When they are proactive (yes there have been eras where they have been proactive) the bond buyers scream ? ?Ratings are supposed to be good over a full market cycle!? When they are reactive, which is most of the time, they get accused of being coincident indicators.

They can?t win, which is why institutional investors ignore the ratings, aside from the capital charges that they force, and instead, read what the rating agency analysts write. The true opinion is in the writing, not the rating.

7)? Barry comments on how Goldman Sachs bags clients.? Truth, almost all investment banks bag clients, selling complex products that they understand better than their clients do.? My comment:

I always advise retail investors not to buy structured notes ? Wall Street offers an above-average yield, and has the buyer sell short some expensive option. You lose more in capital losses than you gain in interest on average.

This isn?t any different. It just that bigger players that should have known better are getting hosed.

There is no better defense than ?buyer beware,? and ?Don?t buy what someone else wants to sell you. Buy what you want to buy.?

Unless we want radical revisions to contract law, you are your own best defender.

8 ) One story with more sizzle than substance is put-backs, at least as far as it affects homeowners.? It was featured by Barron’s and picked up in a piece by Barry.? Investors that purchase a mortgage or any o=ther sort of loan have a limited window of time to give the mortgage back to those that they bought it from for full value.? My comment:

This seems to be useful for investors, but not for homeowners. Reps and Warranties claims can be enforced by investors that bought loans through securitizations. It does not help homeowners.

9) Jeff Matthews wrote a piece that was a little critical of splitting the “B” shares and Buffett’s logic on the Burlington Northern acquisition.? My comment:

I don’t always agree with Warren Buffett, but I do agree here. Index investors are passive investors. Individually, they are dumb. As a group they are smart, because they lower their investment costs.

Warren is also correct on Burlington Northern — it should be like his utilities, and throw off a growing inflation-protected return over time, allowing him to earn a spread over his cost of funds (negative) that his insurance enterprises generate.

He is still a bright man after all these years.

PS — I am a Calvinist Christian; the question asked regarding Jesus is not relevant to the short-term running of Berky, but is relevant to an Christian investor who cares about the ethics of the organization. Also, it is relevant to the long-term well-being of Mr. Buffett. The rest of us will have to face the results of that question one day as well.

10) The Developments blog at the WSJ hides in the shadow of better known blogs, but often puts up some really good pieces.? They recently did a piece on whether it is better to buy a home now or wait a while.? My comment:

Anytime you have an artificial deadline for losing a benefit, as the deadline draws near, behavior can become more uneconomic ? ?gotta buy before the credit expires.? Since one can?t see what the price of the house would be in absence of the credit, the higher price doesn?t get factored in. People think, ?If I want it, can I afford the monthly payment and make the down payment??

I suspect that if/when the credit expires, prices will sag on the low end by more than the amount of the credit. We?ll have to look at Zillow to get some hint on that if/when it happens.

11) An interesting piece from the WSJ regarding the fight between wind power providers and natural gas power providers in Texas.? Wind is inherently variable, and so can’t offer guarantees, which other power providers have to. My comment:

The logical way to end this is to align interests — have the wind power producers own some natural gas peakers to offset their variability, and then compete by offering a base load type of power more cheaply.

Or, let them enter joint ventures together, and split the profits. If natural gas and wind can work together they can offer cheap clean power.

12) Another post in the WSJ, asking whether Economics deserves the title “Science” or not?? My answer today is different than if you had asked me 25-30 years ago, when I was a student.? My answer today would be “no.”? Mathematics has added a gloss of seeming science to economics, but the models do not work.? Macroeconomic models don’t forecast well.? Microeconomic models do not explain human behavior well, let alone forecast.? And, models of development economics common when I was a student actually retarded development of countries.? And don’t get me going on Modern Portfolio Theory.? Anyway, my comment:

More to the point, until the economics profession abandons their macroeconomic models, and moves to something closer to ecological models, they won’t have a shot at understanding how things work. Economics has physics envy when it should have ecology envy.

And then, they will realize that you can’t come up with good mathematical models there either, at least not those that allow for prediction and control. Then we can bring economics back to what it should be, a non-mathematical discipline that attempts to explain how men act to gain/create resources to pursue goals.

13) Felix had a good piece on Buffett’s recent shareholder letter.? My comments, edited, because they did not post right:

Felix, for what it is worth, if Berky wanted to issue debt today, they would have to issue at around 0.75% +/- 0.15% over agency yields. More around 5 years, less around 30.

While I?m here, here are 2 curiosities ? Bloomberg?s DLIS function doesn?t work with Berky, which gives a list of maturities, probably because of all the nonguaranteed debt, and EETCs [enhanced equipment trust certificates] from BNSF.

But, using a download feature on Bloomberg off of [BRK Corp] a list is easily available. Sorting it by size of issue outstanding, what is fascinating is that most of the holding company debt has a short tenor. My estimate is an average maturity of 4.4 years and an effective duration of 2.8 years. 90% of it comes due by 2015.

Now, Berky doesn?t have that much debt at the holding company level, but it is remarkable that they are financing so much short. It is a negative arb, because he has a little more cash on hand than holding company debt.

It is a fascinating side of Berky.? Buffett could pay off all of his holding company debt with cash on hand but does not.? He pays a small price to stay flexible, in case he wants to make a big investment.
14) Finally, I’m going to be on the Ron Smith show today, talking about my recent piece on the finances of our Federal Government.? If you are not in the Baltimore area, you can listen here.? I will be on at 5PM Eastern.
More on Sovereign Risk and Semi-Sovereign Risk

More on Sovereign Risk and Semi-Sovereign Risk

Posted on by David Merkel

When does a sovereign or semi-sovereign government default?? I have seen three answers:

1) When debt is greater than future seniorage revenue (central bank profits) plus future debt repayments.? (Kind of a tautology, but what is implied is that if future debt repayments are onerous, a government would default.)

2) When the interest rate a government pays is greater than the likely growth rate of revenues. (I.e., if you are paying more than your revenue growth rate, the indebtedness will continue to grow without bounds?)

3) When the structural deficit is high, and total interest paid exceeds the size of the structural deficit.? (In that case, default would bring the budget into balance, at the cost of being shut out of the bond market.? But, given the situation, in the short run, being shut out of the bond market isn?t a problem.? There would be problems if the day comes when they need to borrow again; negotiations would begin over paying old debts.)

I will propose a fourth idea: governments can lay claim to a percentage of the GDP of their country/state/municipality.? How large that can be will vary by culture.? Beyond a certain point, attempts to take more than the natural limit for that culture will not result in higher revenues, because people will hide income, and/or leave the country/area.? When debts and unfunded obligations exceed the present value of maximum GDP extraction by the government, default is likely, the only question is when it will happen ? when does cash flow prove insufficient?? Perhaps the earlier three rules can help with that.

Tough Time to be a Municipality

Revenue is declining for almost all states and municipalities.? Given the need to run balanced budgets (on a cash basis), and not having a central bank to fall back on, the problems are much deeper for States and Municipalities than for the Federal Government.? This report from the Rockefeller Institute shows how widespread the loss of revenues is.

But what should larger governments do for smaller governments in this crisis?? Oddly, the best answer is nothing, and even some of the Europeans recognize this.? Smaller governments need to grasp that they have to solve their own problems, and not rely on the Federal government to help ? it has enough problems of its own.

So, if I had any great advice for strapped municipalities in California, or any other place in the US, one of the first things I would recommend is that you assume you aren?t going to get any help.? Those that could help you are in worse shape.? Such does the Pew Institute indicate.? Few states have their pension and retiree healthcare benefits funded.? They won?t have excess funds to aid municipalities, and my even compound the problem by reducing revenues shared with municipalities in order to stem their own budget shortfalls.

The Federal Government Won?t Be Much Help Either

The politics of the US are dysfunctional enough with opaque congressional earmarking benefiting local and special interests.? It will be yet more dysfunctional if states and municipalities ask the US Government for aid.? Besides, the US Government has issues of its own.? Tonight, it will release the 2009 Financial Report of the United States Government, somewhat behind schedule.? With all of the chaos, who could blame them for being late?? My suspicion is that when one adds up the explicit debts of the US Government and its unfunded obligations, it will add up to a figure near four times GDP.? If the US dollar were not the global reserve currency, we would have long ago slipped into chaos.

What would it take to make the US?s debt to GDP ratio stop rising permanently?? We would need to run surpluses of around 8% of GDP, if I understand the charts on page 5 right.? Absent some major shift in governing philosophy, that?s not even close to being on the table.

As I wrote in my seven part article, My Visit to the US Treasury, Part 5: After the meeting, I said to one Treasury staffer, ?One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.?

?What do you mean??

?Just this, prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018.? Now the estimates are 2016, and my guess is more like 2014.? The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow.? This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.?

He looked at me and commented that it would be the job of a later administration.? No way to handle that now.? To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids.? There is nothing we can do to change matters.? The only thing to adjust is attitude.? So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

Now, with interest rates so low on the short end, there is one further risk: that the Fed would keep rates low simply to keep? the US Government?s financing costs down.? As the Kansas City Fed?s President Hoenig said recently,

?Depending on your assumptions about the economy, that federal debt will grow at an unsustainable level starting immediately, or in a very few years,? Hoenig said. ?We do have significant private debt, so that?s in place, so what worries me about that [is] that puts pressure on the Fed to keep interest rates artificially low as you try to deal with that debt.?

The US Government is in a tough spot financially, and if inflation rises (which is not impossible, consider stagflation in the 70s), its ability to continue to finance itself cheaply will erode.? On the bright side, the US is still viewed as a safe haven, so if there are troubles in Europe or Japan, the US will benefit from additional liquidity in the short run.

Back to the States

For another summary of how tough things are at the states, consider this piece from the Center on Budget and Policy Priorities.? Because many state budgets assume a better economy than they actually got, and some were quite optimistic, the average state has a 6.6% gap to fill as a percentage of its 2010 budget.? The gap projected for 2011 is 17% of the 2010 budget.? Not pretty, and if you want to look at it from a bottom-up perspective, this article offers a lot of links to the various emerging troubles.

One further wrinkle in the matter is Vallejo, California, which is in Chapter 9 now.? In the past, muni bond investors and insurers felt assured that in defaults by cities and counties that they would eventually be paid back in full.? With Vallejo, that may not happen; bondholders may have to take a haircut.? If that happens, and it establishes a precedent for Chapter 9 cases, yields will rise for cities and counties that can file for Chapter 9, in order to reflect the increased risk of loss.? Higher future borrowing costs will further burden city and county budgets.? There is no free lunch in the muni bond market.? (For more good articles by Joe Mysak of Bloomberg, look here.)

Conclusion ? Why do I Write This?

This is a pretty gloomy assessment, but it is consistent with the deleveraging process that is rippling through the US economy.? All sorts of hidden leverage have been revealed including:

  • Reliance on optimistic economic assumptions in budgets.
  • Reliance on a robust housing sector.
  • Reliance on financial guarantee insurers.
  • Reliance on increasing leverage at banks, and sloppy underwriting of loans.
  • Reliance on Fannie and Freddie to absorb poorly underwritten mortgages.
  • Reliance on large pension and retiree healthcare promises to keep wages low, and not funding those promises to keep taxes low.
  • Reliance on high stock returns to pay for pensions.
  • Reliance on increasing debt levels in households.
  • Low bond yields make it difficult to invest for pensions.

And there may be other things we have relied on that may fail.? Banking crises often lead to financial crises, as is pointed out in the excellent book, This Time is Different.

  • The US government can always borrow more.
  • The Treasury and Federal Reserve can stimulate the economy out of any crisis.

My main message is that this is a serious situation almost everywhere in the US.? We have borrowed ourselves into a corner.? I write this so that all parties can understand the dynamics going on, so that when muni defaults happen, and the normal dynamics in the bond market shift, you won?t be surprised at the results.? Also, now you have links to a wide number of reports indicating how serious the problems are with Federal and State debts and unfunded liabilities, so that you can do your own digging on the topic.

Thoughts on my Last Two Posts

Thoughts on my Last Two Posts

Posted on by David Merkel

Some follow-up on my last two posts.? I will be talking to those that suggested parties that would be willing to create a definitive bond blog.? But, others brought up a good point, which I am well aware of, but forgot for a moment.? The bond markets are mainly institutional.? Institutional bond investors have no lack of research sources to guide them.? Retail investors get ripped of, or are relegated to government bonds, ETFs, or mutual funds.? So, maybe creating a definitive bond blog would not be a good use of time?? Maybe, maybe not.

What is clear is that such a blog would have to be retail-focused.? It could not dwell on minutiae that would be valuable to institutional investors, but would have to deal with the hard problems that retail investors face with fixed income.

The alternative would be to try to do a blog for institutional investors and bright amateurs, and invite institutional investors to write pseudonymously — think of it as a Zero Hedge for fixed income, without so much attitude.? But would institutional investors read it?? They are inundated already.

Now, John Jansen himself has encouraged the idea, which I appreciate.? He did great work while he was at it.? Could we do as well or better?

Thoughts?? I am still game for this idea, write to me here.

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How long to the point of no return?? I don’t know.? In all of the time that I wrote at RealMoney, I tried to point at directions, but not give timetables.? Giving timing is a mug’s game.

But let me consider some of the commentary that I have received.? My last two posts generated so much traffic that people were not able to access my site for a time.

Promises, promises.? What is a promise to pay worth?? All I know is that the more promises there are outstanding, the less a promise is worth.? The same applies to the Federal Reserve, who issues small-denomination short-duration 0% CP, otherwise known as currency.

Some say that so long as a primary dealer can “repo previously issued govt bonds at the central bank to gain reserves to purchase the new issue bonds at a Treasury auction, that nation can never default, no matter what the level of debt to GDP ratio is….” The effect of that is to raise interest rates.? Higher rates will harm the economy.? As more long-term promises are issued, the safety/value of a promise diminishes.? The same is true of short-term promises, but the effect is more immediate.

Which reminds me that nations with a lot of debt to roll over are most at risk.? There are others in worse shape than the US.? The US Dollar may be the best among bad major currencies, as I have argued on many occasions.? Also, banking crises tend to lead to sovereign debt crises.? The nation absorbs the losses of the banks, and then some fail as a result.

In a true free market, no one would care about currency levels.? They would take spot and future currency rates and factor them in as a cost of doing business.

The Keynesian solutions assume that growth will occur as a result of government spending.? I disagree.? In Japan, there has been no end of such spending, and from what I have read, that spending has not resulted in additional productivity.? Additional productivity only comes from projects that yield more benefits than their costs, and Japan has had more than its share of white elephants.

Throwing a brick through the window and having the glass repairman do his work may raise GDP, but the net worth of society is diminished.? True growth comes from entrepreneurs competing for advantage, and finding places where there are needs to be met.

That is one reason why I say that the deficit spending of the US is destructive.? It does not reflect the needs of people, but the needs of politicians currying favor with interest groups.? We need to shrink the US Government, so that it cannot meddle with the details of our lives.? Let it focus on defense, justice, internal security, and public health, goals worthy of a government.? Let local governments deal with other issues.

The budget troubles will percolate down to all municipalities.? It cannot be otherwise.? Local governments will toss out less needed actors, such as social workers, and retain those more needed, like policemen.? On the whole, society will be better off, as we reduce unproductive actors.

Growth matters a lot.? We need to focus on eliminating things that constrain the growth of the economy, without sending the government budget into greater deficit.? Let the US government reduce corporate welfare.? Let them eliminate the deduction for employee health care expense — that will shrink the health care sector significantly.? My view is that we need to eliminate all tax preferences in the economy, and tax people/institutions in their increase in value every year.? Get the government out of the social engineering business.? Let’s have true tax reform.? Let government do what it does well, and leave the rest to the people.

I recognize that I have a point of view here.? My contention is (aside from ethical issues) that when there is a high level of debt in an economy, that efforts to stimulate fail.? Better not to stimulate at all, ever.? Rather, focus on constraining credit, so that speculation does not overcome the economy, whether personal or corporate.

As for now, let us encourage short sales, foreclosures and bankruptcies, which eliminate debt.? Prices will reset lower, but predominantly equity-financed businesses will not fail easily.? Once the Debt/GDP ratio gets below 1.5x, the economy will grow on a healthy basis again.

Ignore anyone who tells you that debt levels don’t matter.

Ignore anyone who tells you that debt levels don’t matter.

Posted on by David Merkel

Debt levels in an economy matter.? They matter a lot.? An economy that is financed primarily by debt can be like a chain of dominoes.? If one fixed claim fails, and it is large enough, many other fixed claims that rely on the first claim could fail as well, triggering a chain of failures.? This is a reason why a fiat-money credit-based economy must limit leverage particularly in financial institutions.

Why financial institutions?? They borrow and lend.? They also lend to other financial institutions.? A? big move in the value of some assets can make many banks insolvent, and perhaps banks that lent to other banks.? The banks should have equity bases more than sufficient to absorb losses at a 99% probability level.? That means that leverage should be a lot lower than it is now.

Economies are more stable when they limit fixed claims and encourage financing via equity rather than debt.? Imagine what the economy would be like if interest was not deductible from taxable income, but dividends were deductible.

  • People would save money to buy homes, and would put more money down when they borrowed.
  • Corporations would lower their debt-to-equity ratios, and would pay more dividends.
  • Fewer people and corporations would go broke.

Pretty good, but in the short run, the economy would probably grow slower.? The debt bonanza from 1984-2006 pushed our economy to grow faster than it should have, where people and firms took more chances by borrowing more, and making the overall economy less resilient.? Debt-based economies lose resilience.

What was worse, the Federal Reserve in the Greenspan and Bernanke years facilitated the debt increases because the Fed never took away the stimulus fast enough, and offered stimulus too rapidly.? This led to a culture of unbridled debt and risk-taking.? If only:

  • Greenspan had been silent when the crash hit in October 1987.
  • Greenspan had not given into political pressure in late 1990, where he set up a process of cutting interest rates too much.
  • Greenspan had not cut rates in 1995.
  • Greenspan had not cut rates during the LTCM crisis.
  • Greenspan would have cut far less 2000-2002.
  • Instead of tightening 1/4% at a time 2004-6 , they would have raised the rate far more rapidly, completing the rise in one year.
  • Bernanke would not have let the fed funds rate go to zero, but would have limited fed funds to never go lower than 1% below the ten-year Treasury yield.? We never need more than that to stimulate, but some patience is necessary.

What’s that you say?? The economy would have grown more slowly?? Right, and the economy should have grown more slowly, rather than gunning the engine through the overaccumulation of debt.? As it is, the economy will grow more slowly for some time a la Japan, until we delever the economy enough that it can once again grow without stimulus.

The economy is at a fork in the road.? Do we:

  • Leave rates low and leave quantitative easing in until price inflation unfolds?
  • Let rates rise gradually and drain quantitative easing slowly?
  • Raise rates significantly and drain quantitative easing rapidly?

The third view is off the table.? No one wants to see any failure.? Bad decisions of the past must be grown out of, even if it takes a long time of subpar growth to do that.

When Eastern Europe left the Soviet orbit, the countries that did the best were the ones that freed their economies most rapidly.? Well, not in the short-run.? Letting companies fail is always a drag in the short run, but in the longer-run it leads to faster growth, because bad investments fail, and are replaced by better investments.

The same is true with monetary policy.? The US grew faster during periods where failures were reconciled and liquidated, rather than attempting to smooth the economic cycle — leading to fewer failures in the short run, much but bigger failures when the amount of debt became too large.

Before the crisis, when I was writing at RealMoney.com, I usually encouraged taking the less risky macroeconomic route, suggesting policies that would not increase debt levels.? The trouble was, that all of those ideas were losers in the short-run, and so they were not followed.? In the long run we are all dead, leaving the failures of short-run policies to our kids.

Personally, I would raise the Fed funds rate to 2% immediately, and let it shadow the 10-year rate less 1% thereafter.? But no one likes jolts, except when the Fed is loosening.? After that, I would rather the Fed allow inflation to raise collateral values and end the home and commercial mortgage crises.? But no, what we are likely to get is a Japan-style muddle-in-the-middle where they struggle with a slow raising of rates, and a slow end to quantitative easing, with a premature giving in when the economy has a negative burp before the removal of policy accommodation is complete.? I expect us to move in the direction of Japan.

What may change the story are sovereign defaults as government debt levels get too high.? In the short run, that may favor the dollar — it won’t fail rapidly.? But perhaps the euro might fail.? Even the yen might.? The era we are in is like the mid-1800s, when nations were constrained by their debt levels.

From the recent book “This Time is Different,” we know that countries with high debt levels grow more slowly, and defaul more frequently.? Ignore anyone who tells you that debt levels don’t matter.

Redacted January 2010 FOMC Statement

Redacted January 2010 FOMC Statement

Posted on by David Merkel
December 2009 January 2010 Comments
Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating. Information received since the Federal Open Market Committee met in December suggests that economic activity has continued to strengthen and that the deterioration in the labor market is abating. No real change; they shade their views up a bit on economic activity.
The housing sector has shown some signs of improvement over recent months. Sentence dropped.? Area moved two sections down.
Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit. Household spending is expanding at a moderate rate but remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit. No real change, though they shade up their certainty level.
Businesses are still cutting back on fixed investment, though at a slower pace, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales. Business spending on equipment and software appears to be picking up, but investment in structures is still contracting and employers remain reluctant to add to payrolls. Firms have brought inventory stocks into better alignment with sales. Unemployment unchanged.?? They think they see more business activity in equipment and software.? Housing and CRE markets are getting worse, as opposed to the optimism expressed two sections above.? They think the inventory adjustment is done.
Financial market conditions have become more supportive of economic growth. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Banks aren?t lending much, but corporate debt spreads have tightened.
Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability. Shifts their overall view of economic activity upward.

Implies that no further actions are needed on a monetary, fiscal, or market basis in order to keep the recovery going.? So, why no greater change?
With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time. With substantial resource slack continuing to restrain cost pressures and with longer-term inflation expectations stable, inflation is likely to be subdued for some time. Shades their certainty up on goods and services inflation remaining low.
The Committee will maintain the target range for the federal funds rate at 0 to ? percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. The Committee will maintain the target range for the federal funds rate at 0 to ? ?percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. No change.? This gives you the trigger for when they will raise the Fed Funds rate.? As I said last month, watch capacity utilization, unemployment, inflation trends, and inflation expectations.
To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. No change.
In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter of 2010. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter. The Committee will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets. No real change.? The end is in sight for purchases, which will be a new beginning.
In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve?s special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve?s announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility. The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1. The Federal Reserve expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral. In light of improved functioning of financial markets, the Federal Reserve will be closing the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility on February 1, as previously announced. In addition, the temporary liquidity swap arrangements between the Federal Reserve and other central banks will expire on February 1. The Federal Reserve is in the process of winding down its Term Auction Facility: $50 billion in 28-day credit will be offered on February 8 and $25 billion in 28-day credit wil be offered at the final auction on March 8. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30 for loans backed by new-issue commercial mortgage-backed securities and March 31 for loans backed by all other types of collateral. No real change.? This was all known in advance, though not in such detail.
The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth. The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth. No change.? A useless sentence.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen. Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted. The regional bank governors change since it is a new year.? Hoenig has the guts to dissent.

Comments

  • Hoenig?s dissent is interesting, but not significant.? The regional bank presidents have lost a lot of effective authority since unconventional lending came into existence.
  • As has the Fed funds rate ? so long as the Fed is buying long dated paper such as agency MBS, the Fed funds rate is not the pinnacle of monetary policy.
  • Watch capacity utilization, unemployment, inflation trends, and inflation expectations.
  • The FOMC shades up its certainty level on almost everything except real estate, where they seem to express more doubt.
  • They think the recovery has begun, and they are definite about it.
The Land of the Setting Sun?

The Land of the Setting Sun?

Posted on by David Merkel

Before I begin, I want to tell all of my friends in Japan that I have a great love for their country.? I have not traveled much, but if I were to travel abroad, Japan would be my first choice.? Plus, I have many friends in Kobe, Japan.

Japan is at the leading edge of the demographic wave where many developed countries have a shrinking population.? But beyond that, Japan has high government budget deficits and a very high government debt.? Consider this graph from Bill Gross’ latest missive:

Japan is in the awkward spot of having high government debt, though much is internally funded, and is still running high government budget deficits.

What a mess.? I happened across a blog I had never seen before today, and it gave a simple formula for when government debts would tend to become unsustainable.? It was analyzing Greece, but I looked at it and said to myself: “What about Japan?”

The main upshot of the equation in the article about Greece is that you don’t want the rate your government finances at to get above the rate of GDP growth.? If so, your debt will increase as a fraction of GDP, even if your deficits drop to zero.

So, what about Japan?? Can we say two lost decades?

Oooch! 0.2%/yr average growth of nominal GDP?!? That stinks.? But here is what is worse.? The Japanese government? finances itself at an average? rate of 0.6%.? The debt is walking backward on them unless GDP growth improves.? No wonder S&P has put Japan on negative outlook.

Japanese interest rates could rise.? Like the US. Japan has an average debt maturity around 5.5 years.? Unlike the US, 23% of its debt reprices every year, which makes them more vulnerable to a run on their creditworthiness.

Here are three more links on the Pimco piece, before I move on:

We can think of central banks as equivalent to a margin desk inside an investment bank in the present situation.? Though I can’t find the data on the web, what I remember from the scandal at Salomon Brothers that led Buffett to take control, there was a brief loss of confidence that led the investment banks margin desk to raise the internal borrowing rate by 3-4% or so. Within a day or so, the trades expected to be less profitable of Salomon were liquidated, and Salomon had more than enough liquidity to meet demands.

But this is the opposite situation: what if the margin desk were to drop the internal lending rate to near zero?? Risk control would be hard to do.? Lines of business and people get used to used to cheap financing fast.? If it were just one firm that had the cheap finance, say, they sold a huge batch of structured notes to some unaware parties, it would be one thing, because after the easy money was used up, the margin rate would revert to normal, and so would business activities.

But let’s expand the paradigm, and think of the Central Bank as a margin desk for the nation as a whole.? Pre-2008, before the Fed moved to less orthodox money market policies, this would have been a more difficult claim to make, but the claim could still be made.

Pre-2008, the Fed controlled only the short end of the yield curve, which, with time, is a pretty powerful tool for making the economy rise and fall.? Short, high-quality interest rates move virtually in tandem with the Fed funds rate, but during good times, with the Fed funds rate falling, economic players seek to clip interest spreads off of longer and lower quality fixed claims, causing their interest rates to fall as well, with an uncertain timing, but it eventually happens.

And when Fed funds are rising, the opposite happens — funding rates for those clipping interest spreads rise, and the expectation of further rises gets built in, leading some to exit their trades into longer and riskier debts, which makes those yields rise as well, with uncertain timing, but eventually it happens.

I like to say that every tightening cycle ends with a crisis.? Let’s see it from an old RealMoney CC post:


 David Merkel
Gradualism
1/31/2006 1:38 PM EST

One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

  • 2000 — Nasdaq
  • 1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis

    • So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

    But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.

    Position: None

    Or, these two posts, which you can look at if you want… one suggested that housing was the next bubble (in 2004), and the other critiqued Bernanke’s reasoning on monetary policy.? (Aaron Task has an interesting rejoinder to the latter of these.)

    Things are a little different now, because the Fed is not limited to the Fed funds rate any more.? They have a wider array of tools, and the Treasury is in the act as well through the TLG program.? The Fed owns over $1.5 Trillion of longer dated debts, mostly residential MBS.? The Fed as the margin desk has itself become involved in clipping interest spreads, using its cheap short-term funding to buy longer dated paper, directly forcing long rates down.? The Fed may innovate in other ways as well, offering/receiving term financing as well as overnight financing via Fed funds.

    But, here’s the rub.? If the Fed brings the margin rate down to near zero and leaves it there, while actively creating expectations that it will stay there “for a considerable period,” and does so in a lesser way for long-dated paper as well, it can manufacture lower interests rates seemingly everywhere for a time.? It’s amazing how fast bond managers can shift from fear to yield lust.? (I leave aside the effects of foreign players for now.)

    But as I pointed out in my visit to the US Treasury, you can change the financing rate, but the underlying cash flows don’t change.? The margin desk drops the financing rate, and prior good trades look better, marginal trades look doable, but there are investments that are still losers at a discount rate of zero.? No way to help those.

    So what happens when the next crisis arises?? It could be commercial real estate, inflation, a war, a sovereign default (e.g., Greece, Japan, UK, Italy), another wave of corporate defaults, or, a very weak economy, with banks that are willing to clip spreads, but not take any significant financing risks.

    Back to Japan.? Two lost decades.? Debt walking backwards on them.? All of the Keynesian remedies they applied.? Government spending and deficits ultrahigh.? Interest rates ultralow.? Start with a government with little debt; end with a government that is the most indebted among developed nations.

    This developed world in Bill Gross’s “ring of fire” is pursuing the same strategies that Japan did over the last two decades.? They should expect the same results, until sovereign defaults begin.? Then the game will change — mercantilists like China will see their strategies blow up, and the nations that default will see their living standards decline.

    This has gotten too long, but one thing that I will try over the next few days is estimate Nominal GDP growth rates for nations in the “ring of fire,” and their Government’s financing rates.? If I find anything interesting, I will let you know.

    Final note: Ben Franklin at the Constitutional convention in 1787 commented that the half-sun on Washington’s chair was a rising sun, not a setting sun.? Though my title plays on a name for Japan, all nations in this predicament may find that their sun is setting as well.? Unwillingness to take short run pain in trading leads to failure in trading — even so, it is the same for nations.

    Too Much Leverage Precedes Many Disasters

    Too Much Leverage Precedes Many Disasters

    Posted on by David Merkel

    There seems to be some confusion over what threatened to cause major banks to fail.? Let me go over my list of the risks:

    • Many relied on AIG to insure their subprime and other structured lending risks.? Note: initially, when an insurer underprices a product dramatically and attracts a lot of business, the sellers of risk chortle, and say, “Sell away to the brain-dead.”? After it has gone on for a long time, a sea change hits, where they think — oh no, we’re the patsies — the industry now relies on the solvency of AIG!? Alas for risk control, and the illusion of the strength of companies merely because they are big.
    • As an aside, though I have defended the rating agencies in the past, please fault the rating agencies for one thing: the idea that large companies are more creditworthy than small ones.? Big companies may have more liquidity options, but they also take advantage of cheap financing to bloat in bull markets.? When the tide goes out — oh well,? GE Capital might not have survived without the TLGP program.? Another reason why I sold all my GE Capital debt when I was a bond manager.? Big companies can make big mistakes.? Instead, I bought the debt of well-run smaller companies with better balance sheets, lower ratings, and more spread.
    • Most of the real risks came from badly underwritten home mortgage debt, whether conventional (bye Fannie and Freddie), Alt-A and Jumbo, or subprime.? Underwriting standards slipped everywhere.
    • Commercial mortgage lending hasn’t yet left its marks — there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.
    • In general, banks ran with leverage ratios that were too high.? Risk-based capital formulas did not properly account for added risks from: securitized assets, home equity loans, construction loans, overconcentration in a single area of lending, the possibility that the GSEs could fail, etc.? Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, etc.
    • The high leverage particularly applies to the investment banks, which asked for a change from the SEC and got it in 2004.? The only bank to not lever up was Goldman; Morgan Stanley did it only a little bit.? Guess who survived?
    • The Fed encouraged risk-taking by the banks by not allowing recessions to damage them.? They tightened too late, and loosened too early, and that pushed us into a liquidity trap.
    • Residential mortgage servicers priced their product in a way that could only work if few borrowers were delinquent.
    • Financial insurers took advantage of loose accounting rules, and insured more than they could afford.
    • State and local governments came to depend on increased taxes off of inflated asset values.

    What I don’t see is problems from private equity or proprietary trading.? These were not big problems in the current crisis, but the Obama Administration is focusing on these as if they are the enemy.

    Look, my view is that banks should be able to invest in equity-like investments up to the level of their surplus, and no more.? By this, I mean real common equity, not hybrid equity-debt financing vehicles.

    I believe that bank risk-based capital structures need to be strengthened.? I don’t care if it means that lending diminishes for a few years.? Far better tht we have a sound lending base than that we head into a Japanese-style liquidity trap, which Dr. Bernanke is sailing us into.? (He criticized the Japanese, and he does not see that he is doing the same thing.)

    President Obama can demagogue all he wants, and make the banks to be villains.? In the long run, what makes economic sense will prevail, not what scores political points.

    Fat Fed Profits Do Not Create a Healthy Economy

    Fat Fed Profits Do Not Create a Healthy Economy

    Posted on by David Merkel

    1) Inflate the size of my balance sheet by 2.5x over last year, all through borrowing at really low rates.

    2) Increase my interest spreads by ~50% over last year.

    means:

    3) I only increased my profits by ~50% over last year??!? :(? I would have thought that profits would have more than tripled.

    Such is life for the Fed.? The crisis was a time that led me to write pieces like The Liquidity Monopoly, where the Fed, FDIC, and Treasury played favorites in the economy, and starved the portions of the economy not dominated by large firms, particularly with banks and autos.

    My main point is that the Fed should have earned a lot more.? Where did it all go?? It will be interesting to see a detailed rendering of the Fed’s finances when this is done.? Did they realize losses on some of the assets that they bought?

    My friend Peter Eavis of the Wall Street Journal agrees.? Or, read Felix, and then read the exchange between my two friends Alea and Kid Dynamite.? Alea knows more, but I like KD’s spirit.

    The Fed has become more like the banks that it regulates.? They are taking on credit risk, duration risk, convexity risk, etc.? And being a government institution, they don’t have good incentives for knowing how to price risk.

    So, when I see the Fed’s seniorage profits up only 50%, I am not impressed.? The Fed doesn’t mark to market, so we really don’t know the true performance.? Also, remember that seniorage profits are a hidden tax on savers, would earn a higher yield if the government provided less financing.

    Part of why we end up in an economic funk is that we finance dud assets at favorable rates, so capital does not get redeployed to better uses.? Aside from that, cheap leverage creates a yield frenzy over healthy assets, so that they can become over-levered as well.? Examples are numerous:

    To me it is no great achievement that the financial markets are doing well while the real economy is in the tank (Unemployment, Production).? That is the nature of what happens when credit is force-fed into an economy, even leaving aside the problems of cronyism.? There should be no optimism over the large profits realized by the Fed; it may defray our taxes, but on net, the policies have not helped create a healthier real economy.

    Don’t Strategically Default on your Mortgage

    Don’t Strategically Default on your Mortgage

    Posted on by David Merkel

    I like Roger Lowenstein; he is a bright guy.? I have reviewed several of his books, and would recommend to readers that they are worth buying.

    But, I disagree with Lowenstein in some ways regarding defaulting on home mortgages.? I want to give some credit to my wife here.? My dear wife of 23 years, who I thought about many times while we were attending a wedding today (I could not sit with her because I was leading the singing), and who does not have an economic bone in her body, helped me think about the issues around defaulting on home mortgages.

    There is a false notion that because firms default when it is in their economic interest to do so, so should homeowners whose mortgages are greater than the underlying house value.

    First, firms can’t so easily enter Chapter 11.? How does Chapter 11 work for firms?? Two things must be true — a firm must not be able to raise cash to make a debt payment, and the assets of the firm are worth less than the liabilities.? If a firm can’t pass both tests, the bankruptcy court should refuse the filing, forcing the firm to sell assets to make a payment.

    To use this analogy for defaulting on a home mortgage, it is one thing to take out a mortgage in buying a home, having reasonable margins for error, and then disaster hits, and the mortgage payment can’t be made.? It is quite another thing to have the capacity to make the mortgage payment, and default.? Corporations usually can’t get away with that (please ignore KMart); if they can make payments on the debt, they can’t go into Chapter 11 bankruptcy.

    Bankruptcy primarily exists as a protection for borrowers who have suffered loss, leading to inability to pay their debts.? It does not exist to allow people with the capacity to pay to slip out of contracts, simply because the creditor won’t go after them because it is not worth their effort, or, they don’t want the negative PR.

    Would you borrow from a relative and default, because you know they would never sue you?? Would that be ethical?? Taking advantage of the extreme kindness of others may be legal, but it is never ethical.

    If you can pay, you should pay.? That the mortgage lender will not enforce their rights does not mean that the one who can pay but defaults is ethical.

    Imagine a society where any can default at their pleasure.? My, but the interest rates should get high to reflect the possibility of loss from borrowers that could pay but won’t.

    If you can keep your word, and make your payments, do so.? You entered into the mortgage agreement with no assurance of where housing prices would go.? That they turned against you is no reason to default; but if your ability to pay has declined, well, that is another thing — default if you must.

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