Saturday, November 01, 2014

"House of Debt" by Atif Mian and Amir Sufi - a Review

This was an easy to read book that presented the deep economic realities and principles behind the great recession of 2008 in an easy to read format and language.  The general thesis is that the run-up in the household debt before the recession was the real disease that fueled the loss of spending that turned an ordinary recession into a great recession.  They also looked into the issue in historical context where they analyzed the run-up in hose-hold debt before other recessions in the past.  They see a strong correlation between the two.

The book in general presents the material with sound foundation that makes it difficult to refute the deductions that they made.  There are some points where I do not understand their point completely, for example:

Presentation of a Saver/Creditor seems biased
The book presents two groups of people: creditors/savers vs debtors.  That is not a problem and is generally how loans would work in an economy - but their picture of savers as some rich folks living in their mansions and receiving millions in interest payments and totally immune from the rest of the economy seems exagerated. 

In terms of number of people, a very large group of these savers is made of retiries who are now living off their investments in 401K and pensions.  So rather than picturing Mitt Romney, they should instead picture a retired couple in their seventies who own a $100,000 home debt-free but have a meager income of $3,000/month where $1,000 may be coming from social security, $1,000 from a pension and $1,000 from their retirement accounts.  Out of the monthly income of $3,000; $2,000 would have been exposed to the super-safe investments.  If this couple lost 30% of their $2,000 - that will be quite significant for them and could be comparable to the loss that debtors faced.  But the down side is that moral argument would suggest that putting this couple in this termoil was totally unfair and on top of that they do not even have the ability to utilize other resources to create extra wealth.  For example if they were to dive into their home equity, most likely they will never be able to get it back.

Is it realistic to end the demand of "super-safe" investments?
The demand of the super-safe investments have more to do with the pension funds than the Mitt Romneys.  With aging populagtion, is it realistic to suggest that this demand is goverment's responsibility that should be funded only through government securities?  I see following flaws with this line of reasoning:
  1. The impact of Euro Zone on this reasoning.  Poorer countries will find this quite problemetic.
  2. Even without this, telling someone in Spain that the security of their retirement depends on the Spanish government will not go very well.
  3. Even in an economy like US, is this avenue enough to supply safe investments to the aging population?
Can SRMs (Shared Risk Mortgages) compete with traditional mortgages?
A great insight that the authors provided was the difference between the performance of mortgages that were kept at the bank vs those that were securitized.  I think same will extend to this. 

If shared risk mortgages become mainstream, it will be legitimate for them to be more intrusive.  For example in a traditional mortgage, bank requires homeowners to have insurance.  In case of SRM - they may become more intrusive and require, for example, maintainence schedules, specific services, etc.  So in general the debtor may be bothered more.  Secondly the demand for super-safe investments would still exist so a person with good credit will find traditional mortgages to be cheaper and less intrusive.  This will imply that people with good credit will end up choosing traditional mortgages and rest will end up choosing SRMs and we will end up in the same type of mess again.

If generalize this to all types of loans, a person with good credit and good business plan will choose a bond vs seomeone gaining equity in their holding (house or business).  So I don't think that when there is a demand for super-safe investments - that these models can ever compete to get people that are more credit-worthy.

Negative Interest rate is a must
The authors discussed the negative interest rate concept and that is very intriguing.  That needs to be central in the overall scheme.  Something where, for example, savings above a certain limit should be taxed if they have not been touched in a year.  Something like 2.5% tax will go a long way.

Complete Picture
I dont think interest based economy will ever lose out to equity based for providing super-safe solutions.  Such a solution becomes practical only when interest based products are completely taken out of the picture.  Interest based products provide a very easy option to the savers and they will be willing to forego some profits if they are forced to compete with the equity type solutions.

A better overall solution when interest does not play a part for housing market will be as follows:

  • Demand for super-safe investments will force the market to create genuine products that are more conservative.  For example mortgage houses that would assist buyers in buying houses.
  • So for example if I like a house worth $100,000 - I will have a local mortgage house partner with me.  They will see a reasonable rental value for that property. 
  • So lets say that house's reasonable rental value is $1,000 per month.  If I put 20% down, that means the rent for me is $800. 
  • Such a setting provides a relatively conservative medium that is relatively safe for the savers that are funding the mortgage house.
  • I have the option to start buying more equity.
  • So lets say a few years later I sell the house for $80,000 and by then I had 30% equity.  This means that I will get 30% back on the sale.  Conversely if the house sold for $120,000 - I will still only get 30%.
  • Ideally a market of say 10,000 homes will have more than a few of these mortgage houses that would be competing but it will be in all of their interest to not let the value of houses drop too much.  That incentive will help in not letting the prices fall too much.
  • If prices did fall - that will be happening because there is an excess supply of houses which will naturally imply that rental value would go down and so in that case my rent will go down as well.
Similarly if I am a business owner with a sound plan and I want to expand, I will be forced to go into the equity market and get some investments.  So in the overall scheme we will end up with a solution where interest plays no part and when a shock comes it will spread evenly.

Central to this concept is negative interest on savings.  If someone has more than one year's income in liquid assets that is a burden on the overall economy.  I think anything above six month's salary should be taxed at a rate of for example 2.5%. 

So if Mr. Romney has $2M in excess of the threashhold of six month income in liquid assets; and he sees this 2.5% tax ($50,000), he is not going to like giving this tip to Mr. Obama and would aggressively look at ways of reducing it - and only avenue he would find are equity based solutions.  That will be good for everyone because no one really thinks that the government doing transfer payments is a good solution.

But realistically there will be some tax collected in this bucket.  It is important that this tax is earmarked for specific accounts and not for general fund.  Some uses may be:
  • Running of this system so that it does not create an additional burden on the government
  • Some welfare services that are focused on lower income households
  • Helping conservative funds like mortgage houses

This book presents the subject eloquently and concisely.  And more importantly backed by data.  It does not look like we have learnt much from the last debacle and we are back to our old ways at the macro economic level.  So in a few years we will most likely see another great recesstion and maybe at that time this work could predict that a few years before it happens.  Maybe that will make us all understand that the real problem is the idea of super-safe investments that rely on interest.  When interest is removed from the economy that will lead to a better economy for everyone.

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