Thursday, January 29, 2009

why there is a credit crunch

Money is too cheap.

Let's talk supply and demand. When i sell eggs, let's say they're normally priced at $2. Let's say i go to the market and mark them at $2.50. nobody is going to buy them because they're too expensive. I mean with a dozen eggs, people are price sensitive. If i go to the store, and the grocer says that i have to sell them at $1.50, then i'm not going to sell them because i can't turn a profit on them.

So now what? And what's this got to do with the credit crunch?

Well, the Federal Discount is what, .50%. Which is zero for real. A year ago it was 4%. This is the rate that the fed charges when it lends money to banks. The banks then lend money to everyone else, at prime rate, which was 6.5% a year ago and 4% now.

Now what bank in their right mind would want to lend money at 4%? There's no supply because the banks won't make ANY money at that rate. At 6.5%, those were profit margins they could work with, but 4%? That doesn't qualify anyone for a loan except those who have impeccable credit. Banks charge higher interest rates to people with bad credit, so if they have to write-down money on a loan, they write most of it off. But they make less money on lower interest rates, and can only write down less money.

So the Fed has made money so cheap, that it is unprofitable for banks to lend to people.

The other consequence of this is that the only credit available are the high-interest rates of credit cards. So now you borrow money at 15% instead of 6%. This further taxes the underpaid American worker and consumer. Apparently, the people with all the money consistently want to fleece us broke folk.

I was talking with an old friend on how I think there should be a limit on the percentage of debt a person can take on. Just like new mortgages, you have to have verified income, and when you borrow, you can only borrow enough to spend some proportion of your income (28% i think). I think this should be extended to consumer credit also. That means that no matter how much you earn, you can only borrow unsecured credit to the amount that you repay is no more than 20% (or some number) of your income. This creates a ceiling of debt. I think this will be good for the consumer. This is a pro-consumer measure, not a pro-business measure. A loophole for this is that someone can get a waiver if they borrow against some asset aside from their primary home.

The credit crunch will continue until the fed raises its discount rate to about 3%, then lending could be profitable for banks. When that happens, more businesses will get credit to go into business, selling us crap that we buy with credit cards. I think to prevent our country from disaster again, we need to put a ceiling on the amount of credit a person can hold, indexed to their income. We can also factor in the value of their assets if they need more credit. In effect, they could get a line of credit based on the value of some asset besides their primary home. Oh yeah, did i say that we should abolish home equity lines of credit? Yeah, we should.
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Tuesday, January 27, 2009

houses houses everywhere, but no one to live in them

I read two articles today so i could prove a friend wrong. we had a discussion, on the way to the inauguration, about housing prices. My position was that housing prices have been way above historical averages for the last 20 years and need to be reset to those levels. Her position was that housing bubble doesn't need to be deflated back 20 years, but to the start of this bubble. I felt a little vindicated when i searched on google for the info i was looking for: historical prices of houses. The graph below has them both adjusted for inflation and not.
You'll see that 20 years ago was the little blip right before the stock market crash of '89 and the ensuing recession for the next five years. One of my arguments was that the low interest rates of the last few years fueled a lot of people trying to buy houses that they just couldn't afford, or to use the presence of cheap money to flip houses, further pushing up the price of housing for everyone.

She said that the market needs to correct so that people can buy houses at their current prices. And for this to happen they need low interest rates for them to do this. This was the point in the conversation where i said "if they can't afford it at eight percent, they can't afford it at four". It's my opinion after reading a little from Ludwig Von Mises of the Austrian School of economics that the variation in interest rates is what creates boom and bust cycles. The pedal and brake that Greenspan expertly applied to speed up or slow down the economy caused it to spin out of control.

So it's my opinion that what should be happening is that we actually let the housing market tumble. You may think the alternative is to let the 'economy slide' and unemployment go rampant. Somewhere embedded in trying to stop the fall of housing prices is to stick people with mortgages they can't afford! This can then turn into another bubble being burst. I'd rather stick with one long one than two a couple years apart. The question isn't when we reach the bottom, but do we make a pit stop on the way down?

The other article that i read was about the decline in housing starts. The gist of the article is that we've build way more houses than we have people. We have about 1.3 million vacant homes. that is with no bodies to fill them. Even if everyone bought the home they are in, we'd have the vacant homes. So what we have to do is to stop building so many new houses and let the people we have (through going out on their own and immigration) fill the houses through sheer population growth. This means that with the slide in about 700,000 houses per year, we would expect the contsruction market to catch up at about early 2011.

One thing on this i mentioned to my brother is that our new president should instruct his agencies to give preferential lending and treatment to building for density and not sprawl. With the considerations of energy running rampant, we find it much easier to support urbanization than sprawl (which promotes gas guzzling long trips to stores and work). This may in the short term have as much an impact on hybrids and electric cars.

So what i would like to see in the mean time is a slow pre-emptive creeping back up of the Fed's prime rate. If banks aren't lending because money is cheap, they won't lend if money is expensive. We might as well set a stable number for interest rates for the next five years so people can plan around it.
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