By: David A. Smith
Money is a claim check on other people’s products and services.
Once a month, Mrs. Guggenheim sends the bank the same amount of money.
Darling, if you have to ask the price, you can’t afford it
Is she saving for herself, or repaying a debt?
Either way, her actions are identical. Either way, the payments are the same, the timing is the same.
Yet the scenarios, saving and lending, differ in two greatly profound ways:
1. When is the payoff? When Mrs. Guggenheim is saving, she receives a lump sum at the end, an accumulated nest egg that is the reward for all her thrift and dedication.
A little nest egg to house all my purchases
When Mrs. Guggenheim was borrowing, she receives the lump sum at the beginning, and she now has cash she did not have before – Buffett’s claim checks redeemable immediately for other people’s products and services.
2. Who has the optionality? When Mrs. Guggenheim is saving, she has complete optionality: she chooses how much to save, how frequently to make deposits, when she will withdraw savings, and what she will do with the savings. Mrs. Guggenheim need consult no banker, no financier about these decisions. It is her money and she does what she will with it.
Financially, ‘optionality’ means the ability to change strategy without suffering harm. Optionality includes:
· Timing of actions. Save now or save later?
· Choice of actions. Buy stocks or bonds?
· Scale of actions. Concentrate or diversity?
Once she borrows, however, Mrs. Guggenheim’s optionality is all gone. The choices of all her tomorrows are condensed into a single big-bang point source today, and whatever whims or inspirations or bonanzas she might have pursued she must now pass by. Worse, her positive optionality has been replaced with negative optionality: now she must make the payments, on penalty of losing her posted collateral.
The art is priceless, but try telling that to a banker
Hence the instant of borrowing is a plunge from high positive optionality into a self-dug trough of anti-optionality – in exchange for a pile of cash.
All of us know that – the moment of signing on the line which is dotted fills us with dread, and that dread is healthy.
(Here is why credit cards can be insidious, because the line which is dotted is a dozen or a hundred lines each of small purchases whose cost our psyche swiftly devalues.)
Without vocalizing it, all of us know the optionality chasm between saving and borrowing, and yet despite this, most of us borrow rather than save, because we devalue optionality and overvalue immediacy – and that, more than any other single cause, may be the real reason behind the Great Recession, if one is to believe a new book reviewed in the Economist (May 17, 2014)
“House of Debt: How They (and You) caused the Great Recession, and How We Can Prevent It from Happening Again”, by A. Mian and A. Sufi.
A new book argues that household debt, not broken banks, fuelled the recent recession
Before Ben Bernanke found himself trying to prevent a second Great Depression as chairman of the Federal Reserve, he had become well known in economic circles for explaining why the first one happened. In a paper published in 1983, Mr Bernanke blamed the collapse of the banking system for constricting the supply of credit, which “helped convert the severe but not unprecedented downturn of 1929-30 into a protracted depression”.
Of course, when one owes money, aside from losing one’s own optionality, we subject ourselves to the optionality of others, and when the financial or economic markets are heading south at speed, naturally enough the creditors run for their own lifeboats.
It’s never good when your lifeboat itself is underwater
Everybody needs continuing liquidity
The notion that financial crises are transmitted to the broader economy by the “bank-lending channel” has dominated subsequent policymaking. It is why Mr Bernanke fought so hard to stop the panic in 2008 and to recapitalise the banking system afterwards.
In this, he was entirely right to do so, although his decision to hold interest rates deliberately at minuscule levels, albeit fueled by Chinese and other global willingness to buy US paper as the best post in the global capital storm, has slowly and steadily drained savings wealth from America’s elderly and the near-elderly Baby Boomers.
Tim Geithner, who was at the Fed with Mr Bernanke and then became Barack Obama’s treasury secretary, spends much of his new memoir reiterating their argument (see article): “When the financial system stops working, credit freezes, savings evaporate and demand for goods and services disappears, which leads to lay-offs and poverty and pain.”
On the other hand … any given number of payments can be expressed as a big principal with low interest or vice versa. So of course lowering interest rates increases buying power now, but that places you in the wrong spot for later macroeconomic interest rate movements.
A new book, by Atif Mian of Princeton University and Amir Sufiof the University of Chicago, challenges this orthodoxy. The real cause of the post-crisis slump, they argue, was not the damage to the banks, but the run-up in household debt that came before, which became an anchor on consumption when home prices subsequently collapsed.
That is true enough, yet it’s only one aspect of the damage done by overleverage – the greater damage is in loss of householder optionality (to cut expenses, say, or to downsize by moving to another house).
By analysing the relationship between consumption, employment, home equity and other debts and assets by county, Messrs Mian and Sufi find that consumption fell most sharply in counties that experienced the biggest drop in residents’ net worth.
By itself, that insight falls into the category of “It is indubitably so, Socrates” findings: true but admitting of many possible explanations.
No man of sense could dispute that
This, they argue, would not be the case if the primary restraint on consumption was damage to the banks brought on by the collapse of Lehman Brothers.
For most people, housing is their large-purchase piggy back, one that they can tap only with some effort and trouble, so in the short and intermediate run, people do not refinance their homes just because they need cash; instead they run up current or credit-card debt, figuring (rightly, at least most of the time) that if the debt becomes large enough to be burdensome, they will refinance the house into a lower interest rate.
But that model of spending close to one’s monthly budget depends on two beliefs: (a) that my house has meaningful equity buildup, and (b) that I can liquefy that equity buildup through access to a home mortgage financing. If either belief is shaken, consumer spending drops.
They found similar evidence in county-level employment. In counties where net worth fell most, jobs were slashed not by small companies, which depend most on banks, but big ones—because sales were slumping.
Throughout the Economist’s review, I find myself agreeing with their analyses and seriously questioning the prescription (though not having read the book, I could easily be missing relevant analysis).
A Mian great at describing, not so great at prescribing?
Shifting focus from banks to households, leads [the authors] to very different remedies, the most radical of which is to replace many loans with equity-like contracts in which lenders share losses with borrowers.
There are many practical obstacles to these ideas.
While that’s natural enough to propose in the abstract, the Economist is usefully skeptical and analytical:
There are many practical obstacles to these ideas.
The problems aren’t just practical ones, as it seems Messrs. Sufi and Mian misunderstand or fail to appreciate properly the differences between debt and equity.
They’ll notice me now
While debt may be dangerous for the borrower, it is the opposite for the lender.
Moving from debt to equity shifts risk from the borrower to the lender, and in so doing, it shifts risk from the person who has person to the person who lacks control. Almost by definition, such a shift increases aggregate risk (risk taken by the two parties combined), so if the borrower’s risk is reduced by some quantum, the lender’s risk is increased by a greater quantum. Risk-shifting away from control is entropic – which has consequences for savers as well, since they are the real counterparty to borrowers (banks being just an intermediary money store).
Savers prefer the safety and predictability of a debt contract, which is why they accept lower returns on bonds over time than on equities. Many debt contracts exist primarily to satisfy this desire for safe assets—most notably bank deposits
In debt, the borrower – who has control of the asset – takes all of the gains, and all of the losses up to the point of default, whereupon the lender takes all the remaining losses. When the capital provided is via pure debt, and assuming the borrower has hard equity in the property, then the lender can be comfortable giving the borrower full unmonitored control over the property. If the borrower makes improvements to the asset (adding a porch, repainting), those improvements are being paid by the borrower’s cash, and as long as they do not diminish the asset’s value, they will improve the lender’s security even as they improve the borrower’s embedded equity.
Borrowers may prefer debt, because it allows them to capture the upside of their investment.
In general, borrowers always prefer debt because they want to see the lowest required payment/ stated interest rate, and they go into a borrowing under-estimating their own risks.
Most of the time that optimism is justified.
Those dynamics change dramatically if the capital provider has both downside and upside –
Which of us is at risk here?
[Continued next week in Part 2.]