Dispelling the Financial Myths Behind the Credit Crunch

No offense to the Financial Times’ commercials on BBC America, but I often think we live in a time of “Financial Myths”, or rather a time of Financial Myths that people desperately want to believe in. For example:

1. Foreclosures are the result of a declining housing market preventing people from refinancing out of trouble; the fact that many people are simply in a house they can’t afford is never given as the reason.
2. The Housing Markets are in decline due to tightening credit standards. If we get the banks to lend again the markets will recover. I read this line of reasoning in the business press and often gasp in disbelief. Okay, to be honest, I usually curse in frustration. The housing markets were over-inflated due to a combination of over-speculation, overspending and bad credit standards. What’s happening now is a much needed correction. Happy medium credit standards won’t return housing prices to their inflated levels, nor should any sane person wish for such a thing to happen. The correction is a positive thing and everyone should just go ahead and accept it.
3. The Financial Markets are only in turmoil due to fear, so if we do something grand to calm everyone down and inspire confidence, things will improve. Yes there is a strong fear element depressing the markets, but the markets are afraid because investors are losing money, i.e. many investors are making rational decisions around managing risk and protecting their assets, as investment losses are the core issue not fear.
4. If we delay foreclosures, guarantee loans or ignore missed payments and offer refinancing, we can keep people from losing their homes. The truth is that people are in homes they can’t afford and the measures offered only work for people who can afford their homes normally, but are facing temporary financial difficulties. The best way to help many struggling homeowners is to help them get into new, affordable housing situations, not to delay the inevitable or pass on the risk to the taxpayer. Remember, mortgage CDOs were supposed to shift the risk to other people and they didn’t work out so well.
5. The economy is just suffering from a combination of financial market fear and tightening credit standards, so lower interest rates and confidence inspiring measures will fix things. The real truth is that the financial sector, investors and households have all made a lot of bad decisions; at this juncture they need to pull back and shore up their balance sheets before pressing forward. Confidence won’t magically shore up shaky finances, nor will it offset real investment losses.
6. We need to avoid a recession at all costs. A recession would probably be a good thing in the long-run. It would enable us to work the bad blood out of the system and emerge stronger and more resilient. Furthermore the costs of avoiding a recession are often worse than the recession itself, as our current economic situation is nothing more than the cost of avoiding a past recession coupled with widespread financial stupidity. Why would anyone want to visit a worse fate on a future economy?

Normally financial myths are the domain of those with a middling knowledge of finance and business, and we normally expect only the layman to make decisions based on them. The problem the current global economy faces is that business leaders, policy makers, politicians, serious investors, et al, are all making decisions based on a set of ill-informed assumptions. One has only to look at the housing/mortgage crisis and think about the nonsensical assumptions around real estate always going up, CDOs making risky lending risk-free, etc, to see evidence of this. In order to build a strong economy for the future executives, consumers, investors, politicians and policy makers, we need to abandon the myths and confront reality.

It’s impossible to develop viable solutions if you haven’t accepted the reality of the problem in the first place.

Comments

[Tony Soprano]

This is a pile of recycled bunk. If I could short bunk I would.

There should be a bunk index!!! That'll help us measure sentiment. lol

Who are you trying to kid? You are using myths as example of something that is not real or realized. This is NOT true. Everything you have mentioned above has been discussed and debated. You talk about the real truth as if you have some special insight when it is nothing but recycled arguments of the past year -- bunking the bunk.

[NI123]

Tony Soprano, you are an idiot.

[Tony Soprano]

For Mr. NI123

Now, now, now, don't get personal. Just give me some logic that makes sense.

[Malkiel]

I agree with the Soprano. Dr. Freud can see that Mr. Lee's own insights are based so largely on the simple myths that are close to his own heart that he lashes out at all competing facts as myth, a classic reversal. It would take more of my bosses' time to contest his facts than I dare take, so let's just point out that the non-subprime borrowers who took out ARM's for equity or HELOC holders who are losing their credit lines because their equity declined don't exactly fit the pristine notion of people who bought a house they couldn't afford. And the pullback in consumer spending starting in the fall looks more like mass behavior based on a type of fear we call caution rather than specific financial calculations...

[Markham]

Ultimately all that really matters is whether or not a particular problem has been properly diagnosed, so that effective solutions can be developed. If problems aren't viewed properly, are improperly diagnosed, etc, the result is misshapen solutions that can't solve the problem.

Re-inflating housing prices is not sound economic policy.

People living in houses they can afford can continue to make payments regardless of the direction of the housing market, however significant % of the people facing foreclosure simply can't afford their payments without a refinance into a new teaser rate ARM (in many cases).

The list goes on and on

At the end of the day the proof is in the pudding, are the solutions developed by those I think have mythic beliefs deploying solutions that are solving the economic problems discussed above?

Will a temporary stay on foreclosures for people whose housing payments have doubled, prevent them from losing their homes over the long-term?

Is using an over-inflated housing market to refinance your way out of trouble into a new exotic loan, an effective financial management strategy?

At the end of the day we're all entitled to our opinions, but if my opponents solutions aren't working than they're basically validating my ideas.

[unlawflcombatnt]

Markham is right on every point. A decline in home prices does not change the monthly payments current homebuyers are paying. If they could afford the payments, it doesn't matter whether the home has gone down in price or not.

If I'm making $300/month car payments, my ability to afford those payments doesn't decline any if I wreck the car and it becomes worthless. My ability to make the payments doesn't change any.

The same is true with a home. If you're paying $2,000/month, it doesn't affect your ability to make payments when the home goes up or down in value. It only affects your ability to re-finance out of already unaffordable payments. Which means you should never have bought the home in the 1st place.

[your_avid_investor]

Great, great column. Anybody that has been in the market this past month will attest to having at least one or two existential revelations about trading this market. I can agree with associating current market behaviors with something intangible such as "the masses being misinformed". Usually those revelations come at your worst trading moments when the red just keeps going redder. If you haven't experienced those moments, yet, you must know more about this market than I do. Anyhow, I have the myth of the day (3/19/08) for you: "... sell gold, in fact, don't ever get near it again, the Fed has finally managed to stabilize the economy, inflation expectations, and prospects for its own currency ...". Good luck everybody.

[Rhett]

The market works - if we let it. It will not work if government steps in to alter its workings. And that is what the government is doing with respect to housing. Housing prices must fall - a lot - for the market to work.

[Tony Soprano]

Since there is so much angst directed toward the Fed and the US Government, I decided to listed some events, not all of them, that had dramatic ramifications on lives, cost and the psychology of our country. I started in 1906 because it’s just a little over a hundred years. As I compiled the list, I could not help but feel the great sacrifices that many American’s have made and what a resilient country, economy and government we have in American.

The 1906 San Francisco Earthquake and fire, registered 8.25 on the Richter scale; estimates range from 700 to 3,000 dead or missing, approximately 225,000 injuries and $400,000,000 in 1906 dollars.

Recession, May 1907-June 1908, 13 mo

Recession Jan. 1910-Jan. 1912, 24 months

Completion of the Panama Canal, 1914 – 27,500 workers are estimated to have died

Recession Jan. 1913-Dec. 1914 23 months

World War I -- 116,708 killed – 33 billion

Spanish influenza, 1918, killed over 500,000 people in the worst single U.S. epidemic.

Recession Aug. 1918-March 1919 7 months

Recession Jan. 1920-July 1921, 18 months

Recession May 1923-July 1924 14 months

Recession Oct. 1926-Nov. 1927 13 months

The Great Mississippi Flood of 1927, flooded 27,000 square miles, 246 killed

The Great Depression, Black Tuesday, crop prices fell by 40 to 60 percent, after the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. (In all, 9,000 banks failed during the 1930s). By 1933, depositors had lost $140 billion in deposits.

The Dirty Thirties, longest drought of 20th century. Peak periods were 1930, 1934, 1936, 1939, and 1940. The "dust bowl" covered 50 million acres in the south-central plains during the winter of 1935-1936.

Labor Day Hurricane of 1935, 400 killed

Recession May 1937-June 1938 13 months

World War II – 408,306 killed – 360 billion

Wartime Controls: 1941-1945 rationed consumer items ranging from sugar to gasoline

Recession Feb. 1945-Oct. 1945 8 months

The Marshall Plan, July 1947 – 13 billion in economic and technical assistance were given to help the recovery of the European countries

Recession Nov. 1948-Oct. 1949 11 months

Korean War, July 1951 - July 1953 – 33,000 killed in action

Recession July 1953-May 1954 10 months

Recession Aug. 1957-April 1958 8 months

Recession April 1960-Feb. 1961 10 months

The Cold War, some estimates shows $8 trillion was spent, worldwide, on nuclear and other weapons between 1945 and 1996

The Cuban Missile Crisis, Oct. 1962

Good Friday Earthquake (1964) In Alaska, it was the fourth biggest earthquake recorded

Vietnam War, 1963 – 47,378 killed in action

The murder of JFK, 1963 Nov

The Gulf of Tonkin Incident, Aug 1964

The murder of Dr King, April 1968 and Bobby Kennedy, June 1968

The city riots of April, 1968 – 30 cities affected

Hurricane Camille, Aug 1969, 259 killed

Recession Dec. 1969-Nov. 1970 11 months

Stagflation of the 1970s began

Nixon first imposed wage and price controls on August 15, 1971

Oil Embargo, Oct 1973 long gas lines

Recession Nov. 1973-March 1975 16 months

Articles of Impeachment of Nixon started
(Approved by a vote of 27-11 by the House Judiciary Committee on Saturday, July 27, 1974.)

Deregulation: 1974-1992 this era began when Nixon left office

Three Mile Island nuclear power plant crisis, March 1979

Mount St. Helens eruption 1980

Recession Jan. 1980-July 1980 6 months

Prime reached unbelievable 20% in January 1981,

AIDS was first reported June 5, 1981 by the government – It is thought that more than one million people are living with HIV in the USA and that more than half a million have died after developing AIDS.

Recession July 1981-Nov. 1982 16 months

California earthquake 1983

The 87 market crash - Black Monday

California earthquake, 1989

Recession July 1990-March 1991 8 months

Iraq invaded Kuwait on August 2, 1990

The Persian Gulf War, 1991 or Desert Storm Jan 1991

Hurricane Andrew 1992 very destructive United States hurricane

The Great USA Flood of 1993

Intervention in the Former Yugoslavia,

Dot Com Bubble, climaxed on March 10th, 2000 with the NASDAQ peaking at 5132.52

9/11 Attack, 2,974 people died

Recession March 2001-Nov. 2001 8 months, Airline Industry Collapsed

Enron bankruptcy in late 2001, employed 22,000

WorldCom, July 21, 2002, filed for Chapter 11

Iraq War, March 19, 2003 – 4,000 dead

Hurricane Katrina, late August 2005, 1,836 people lost their lives

Start of the Great Housing Recession or Sub-prime Recession 2006 or 07, 08? Date to be determined.

[your_avid_investor]

Interesting list. Never seen those events listed in that order. Glad I came back to check on the article. Makes our current "Great Housing Recession of 2007-200?" crisis sound like a walk in the park considering the other adversities that this country has experienced. If you are a believer, I think the time to invest is now and in the next year or two. The returns might not be great yet, but if you look at the big picture, a little bit down the road, the next boom will be just unbelievable. And as far the housing prices are concerned, by the time home prices have bottomed, the economy will have already taken off like a rocket. So, personally, I would not wait until home prices are bottoming to invest, unless of course, you are investing in real estate which right now is out of the question.

[Kunst]

Excellent article.

[Polyman]

This article summarises the situation COORECTLY, The world needs to retrench and learn to live within our limited to be happy and secure. As much as Democracy is to be lauded, we should understand that they way we operate the economy is more like Socialism without the stigma. Socialism is a stepping stone to Communism which is closer to Dictatorship then we realise. Russia and China are great examples.