A NAMA for the people

RTE 1 on the weekend had a panel with David McWilliams and some other members of the Irish social firmament bandying around yet more blah blah blah (excuse my sudden inability to articulate intelligently) about the Irish economy and our mess.

Yet again the cry for a "Peoples' NAMA", under the now common belief that NAMA was designed as a type of debt forgiveness program. Well, it may appear to be run that way, but the cold hard facts are that a "NAMA for the People" would do this:

• Transfer all the outstanding mortgages of those people deemed to be in "negative equity" to a special purpose vehicle - that just means a new company of some sort.
• Call in the mortgages of all those people.
• Begin to foreclose on those people who can't repay and plan for an orderly disposal of the houses.
• Pursue the outstanding amounts (the amount of the mortgage shortfall following the sale of the house) out of any other asset these people might have to the point of bankruptcy.
  

In theory, that is what a "NAMA for the People" would be. I was surprised that David MacWilliams failed to point that out to the journalist, lawyer, politician and broadcaster present and the many people listening.

I wish people with their hands on the microphones to the nation would stop perpetuating this fallacy that NAMA is a bailout. It is certainly the case that people who had command of tens or hundreds of millions of Euros - albeit borrowed - can legally squirrel a nice wedge away protected from future creditors. But it doesn't mean the process to recover as much money as possible from them and their companies is a "bailout" simply because it is frustrated by legal financial shenanigans and the underlying fact that there simply isn't enough money to repay all the debt.

So let's stop the cute hoor nonsense about "NAMA for the People" and start being honest. How about a "Money Grab for the Stupid People". Sound harsh? Well, not harsh enough for those who would insist I and other prudent savers in Ireland now pay to give them a fresh financial start. This isn't a diatribe against those people who are now in negative equity -mistakes are made. Many of those people will quietly and diligently save their way out of their predicament and as a nation we should hold them up as admirable. But I reserve disdain for those who would demand the government expropriate the savings or income of others so that they get a free ride.

A must read

Add this to your reading list. A most insightful and complete lecture from Deepak Lal.

http://www.econ.ucla.edu/workingpapers/wp814.pdf

Negative equity loans

ADDENDUM 24 June 2010:
Something worth adding from a "macro" perspective. Current policy with regard to the banking sector in Ireland should be to support and facilitate an orderly shrinking of balance sheets. This simply means allow banks to reduce the amount they have out on loan on one side and the amount they owe (now increasingly to taxpayers) on the other.

What is described below allows that to happen, without banks taking any loss. To date balance sheets have been adjusting by writing off, rather than retiring debt (as below) and passing the loss to the taxpayer. How could you not love that?


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An interesting announcement this week in the press in Ireland. Negative equity loans. Simply floating the idea seems to have initiated a rash of negative comment, some from people who I wouldn't rate as knowing their financial or economic onions, and surprisingly others who do.

It led me to think because my first reaction was; this is an interesting development. Because among all the loopy ideas that people have been spouting that invariably require taxpayers' money to be used to redistribute wealth from people who have made good decisions to those who have made bad ones, this one is a purely voluntary option designed and entered into by those parties who are relevant - the lender and the borrower.

I also had a favourable initial impression because it was my idea a long time ago.....

So firstly what are the objections? Obvious really.

• Allowing people to enter into a financial agreement that leaves them knowingly insolvent is just plain stupid - no objection there.
• It replays all the stupid risk management that got us in this mess in the first place by lending to people who couldn't wouldn't afford it -that it does if available to all comers.
• People would increase their negative equity and debt problems (see my first link above for an example) - that is true for the hypotheticals posited.

So it is a stupid and reckless idea after all then.

Well, no. It's a good idea and here is why.

What you have above is a knee jerk response based on fears of what might happen if such an mortgage was arranged inappropriately. That is a risk, no doubt. Did you read my post on "Risk versus Uncertainty"? If you did, you will know that having identified what might happen we have risk and risk can be mitigated against.

And what is the risk mitigation tool we have? Yes we have a freshly minted Head of Financial Regulation with new and improved ADDED BALLS(TM). And the appropriate responses to the early information we have on these mortgages have already appeared. Those BALLS(TM) seem to be more than the normal marketing blurb.

So all that is good. But why on earth do I think this stupid idea has some merit? I can think of at least two.

It can address the real problem in some instances. The real problem is of course the gross indebtedness of a household not the red herring of "negative equity" that is being bandied around. While providing such a mortgage to someone who wants to buy a more expensive house (or a new house) would be a bad idea, providing such a mortgage to someone who wants to buy a cheaper house could be an extremely good idea because they could reduce their debt. If you have a mortgage of €600,000 and a house now worth €500,000 and are struggling under the weight of the debt, would it really be a bad thing to sell up and buy a house for €300,000 with a mortgage of €400,000? And what about the bank? Would it be reckless to provide such a mortgage to a customer who is trying to reduce their debt? The risk position of the bank has surely improved, with exactly the same exposure to negative equity, but a mortgage that is now more likely to be repaid in full (including the negative equity!!).

And what about from the debt servicing side. What if the borrower loses their job, or finds a better paying or more secure job and needs to move to avail of the opportunity. Would providing a mortgage that facilitates that move, but does not increase the gross debt burden of the borrower any further be prudent or imprudent for both parties concerned.

In both those circumstances I would argue it is imprudent and extremely poor risk management to rule out such a "negative equity mortgage", because to do so would keep the debt burden higher, or make the debt servicing more difficult and hence increase the likelihood of default.

So this is what I suggest:

• There should be no blanket ban on such mortgages.
• The Financial Regulator should demand of any bank wishing provide such a mortgage that specific pre-agreed criteria need to be met by the borrower
• Such a mortgage can not be granted to a new customer (i.e. current mortgage holders only)
• Such a mortgage must not be greater than the present mortgage outstanding,
• Such a mortgage can be of no greater term than the current outstanding mortgage (this might be open for negotiation).
• The Financial Regulator should review the operation and experience after an initial period and reassess the rules and policy.
• Such mortgages should be allowed for a specified period only (next 5 years say), which may be extended by the Financial Regulator if deemed beneficial and prudent.

In effect, these are extraordinary measures for extraordinary times. And this is one of the very few sensible ideas to float in the country that addresses our problems:

WE HAVE TOO MUCH DEBT!!!!!!!!

It may be appropriate at the margin only, but that would make it 100 times more effective than any other "initiative" I have seen advanced in Ireland to date.

Some better signs for global adjustment

News breaking over the weekend that China has broken the Reminbi/Dollar exchange rate peg. It has been announced that the regime is to shift to a "crawling peg", where the central bank sets an adjustable target rate with some narrow bands for fluctuation. This is clearly a regime to allow the authorities to attempt an "orderly exchange rate adjustment" - note the inverted commas.

There is some background to this, hardly shocking, news, here and here.

What happens now? Well, the market reaction tells the tale. It is general perception, well founded in my view, that the Reminbi is quite undervalued in real terms (read the above links; in effect Chinese prices are currently set at an artificially low level relative to the rest of the world via the fix on the exchange rate). The Chinese authorities have indicated that rather than allow domestic prices to inflate as the process of adjustment, they are willing to let the exchange rate appreciate.

If this occurs, this should provide much more comfort all around. Less inflationary pressure in China, less deflationary pressure in the rest of the world. Common sense - shock horror.

The path from here is most likely to be one of bumps and detours, particularly as markets test the announced target fluctuation bands of +/-0.5%, but at least this is a positive move that the powers in China recognise the futility and potential destructive consequences of trying to centrally plan their economy - even if they don't like the fact.

Let's check on our "Green" investments

Time for another quick check on how our HSBC (and Kate MacKenzie at the FT) recommended investment strategy is getting on.

For those who don't remember, the hypothesis was that windmills and solar panels and other industries that will help fight climate change and herald a new era of free energy and love and peace and milk and honey for all (or some such drivel) were a fantastic investment opportunity that had been hamstrung recently by lies and intimidation from dastardly "Climate Change Deniers" [cue evil music]. But now that the the institution of climate change hysteria was getting a clean bill of health from many "independent inquiries", such speed bumps were passed and we were all set to get massively rich.

My hypothesis was slightly more prosaic. Dangerous Human Caused Climate Change is bunk of the highest order. The "alternative energy" industry in all its guises was a subsidy farming scam - fuelled by stupid and duplicitous politicians taking money from people who earned it and giving it to sleazy entrepreneurs with low morals. And now that the public subsidy well is running dry with massive public deficits, the economics of these industries (pouring taxpayers' money into industries that have no economic rationale on their own) will inevitably collapse. My hypothesis suggests investors are best to remain out of these industries (at least until you think they will have the ability to steal more taxpayers money).

The latest results are now in for May . I know this is a short period and returns are noisy, but it still looks like the FT and/or HSBC would be better off simply reprinting this blog (hell, they can have it for free) rather than continue to pay the salaries of Kate MacKenzie and whoever is pumping out their "Green" research.

Total returns on the HSBC Climate Change Index were 12.5% less than broad Global Equities. over the last 12 months and 7.2% less in the year to date (so under performance accelerated). [the red line is the Climate Change Index returns and the green one is for Global Equities]

Economics for crash test dummies

Time for a change of gear from recent posts. Every now and then it is interesting to see where economics has applications in the real world in areas that one wouldn't normally expect to see any relevance. I suppose you could call this a bit of a "Freakanomics" diversion [that was in fact the book I always intended to write - but I don't think Freakanomics will be bettered in this genre].

So, I was watching a car show on television the other day, not Top Gear (which is brilliant). In it there was a segment looking at car impact safety and how it has advanced over the last 10-15 years. The set up was that they crashed a 1990 something Volvo 940 into a 2007 Renault Modus. Now, Volvo have always had the reputation for being safe cars and the 940 is a significantly large car than a Modus - and crucially has a much longer front bonnet (better for providing an energy absorbing crush zone than the stub-nosed Modus).

http://www.youtube.com/watch?v=qBDyeWofcLY

What happened when they threw the cars at one another head on at 40 mph was a near total destruction of the Volvo, with very serious incursion of the impact into the passenger cell of the car. By comparison, the Modus showed virtually no sign of impact from within the cabin. A driver in the Volvo would almost certianly have suffered extremely serious injuries, while one in the smaller Modus may have escaped with light grazing only.

Interesting, huh? But where is the economics?

The economics is here - and it is in the form of an application of both externalities and game theory. To take you through it you need to go back a few decades in car design, to a time when big, strong and rigid was the order of the day.

In the 1960s a safe car was a big and strong car, able to withstand impact and keep the passengers inside within a protected shell.

By the 1970s engineers were working with new materials and technology and thinking shifted to provide for a rigid passenger cell, with softer, energy absorbing crumple zones at the front and rear. That technology existed into the 1990s - and is evident in the Volvo 940 here.

Now we have moved on further, with new technology entering into the industry, designed specifically to make smaller cars (now more popular) safe in high speed impact. That is the Modus, which has a very small crumple zone in the front, and extremely strong front firewall and just as crucially a small and light low mounted front engine.

What the display showed was how effective all those elements worked together on the Modus, but one thing caught my attention. As good as the Modus saftey features were, a large amount of the energy in the crash was absorbed by the Volvo, which all but disintegrated. In effect, the Modus used the Volvo as an additional crumple zone. Had the same test been run with a big heavy and rigid 1960s design car, I doubt the Modus would have fared nearly as well. Not only would there have been less energy absorbed between the two cars, the opposition would have been significantly heavier and we know that energy is equal to mass squared.

And there is the economics. You can design a really safe small car like the Modus, if you know that everyone else will be driving around with a big soft crumple zone on the front of theirs. You can get away with carrying less energy absorption around yourself. That is the externality - you can be safe by demolishing somebody else. Of course, that works only until other drivers recognise that change their cars to something that provides them with more safety in the event of a crash with a Modus - the alternative strategy is to drive a Hummer with a "roo bar" fitted. A Modus wouldn't survive so well as the Hummer would likely use it as a stopping aid.

And there lies the game theory. The safety of your own car in a crash is a function of what someone else drives. You modify your decision based on what the best payoff will be for you given the likely option chosen by others. The next time you run into that Volvo 940 driver in your Modus, it is more likely they will have switched to the aforementioned Hummer.