The economy – how we got here

SANFORD (jbeech) – This isn’t a garden variety business recession so doing what’s worked before, e.g. lowering interest rates, hasn’t worked.

Here’s a primer; as the economy went into recession in 2007, we at Genesis Hobby quickly cut back on non-essential spending. We’ve been at this since 1993 and because it wasn’t our first dance with recession, we knew what to do. E.g. cut expenses because there’s no question someone’s car payment, or groceries, comes waaaay ahead of buying model helicopters from us.

At first, the slow down meant running inventory levels lower than usual (this was 3rd quarter 2007) but before long it also meant reducing R&D because gambling on releasing new products for spring 2008 looked less and less like a good idea. By 1st quarter 2008 there was no question things were bad and heading to worse. Thus, in spring 2008 we began laying off folks and cutting back on advertising.

Laying folks off is bad. But for us, cutting back on advertising means things are really, really bad. In fact, we’d never done this for a recession because this is usually when we cranked up the pressure on our competitors. E.g. advertised more.

Anyway, our advertising commitment changed as we went from 4-color, full page magazine adverts in three monthly magazines (plus banner ads on several websites) to just one full-page 4-color advert in a quarterly magazine, plus 1/3-page 2-color adverts in two magazines. And zero banner adverts. Moreover, our little enterprise went from 5 employees to two . . . just Lynn and I. Basically, we entered full-on hunker-down mode.

Naturally, we cleaned up our personal balance sheet too. Other than our house payment, we cut back on everything we could. This meant selling Lynn’s paid-for Mercedes and putting her into a Mazda 6. It meant paying off credit cads. It even meant eliminating little luxuries like satellite television (and switching to over the air) and converting from AT&T and an iPhone to pre-paid voice-only phones. Yes, we reverted back to the dark ages!

Cutting expenses quickly is our formula for survival. It’s a formula 30+ years of marriage and almost 20 years of being self-employed has taught us works. And if we have to, we dip into savings to meet our obligations. Moreover, this formula works for anybody in America who is reasonably solvent and thus, those who can have largely done the same thing. However, this is bad for America’s GDP, and it’s bad for folks living on the financial edge..

While we’ve cut expenses and hunkered down, the unfortunate folks, e.g. those living on the ragged finacial edge (because they spend everything they make every month) this recession has meant not meeting their obligations when employment issues arrose. By issue I mean things like having their hours cut back, or worse, being laid off. An unfortunate byproduct of recessions are folks living the American Dream – on credit cards – never saved for the proverbial rainy day and pay dearly for their financial foolishnesss when the economy turns down.

These unfortunates soon get to the point they can’t meet their monthly payments. Absent a rainy day fund this is when the repo man shows up. He shows up for their cars, TVs, furniture, and homes. Moreover, while it’s quite sad for them, there’s nothing unusual about it. E.g. so far everything has been normal for a recession . . . except it isn’t. Normal that is.

You see, during normal recessions, a few homes are repossessed and when they are, the banks quickly sell them off (since they’re not in the home owning business). Simply put they don’t want to hold the assets. However, this time around there’s been a problem.

The problem came about because of a recent financial tool called a CDO (Collateralized Debt Obligation). Basically, banks had taken their mortgages, a bunch at a time, and packaged them up for resale. These were sold these to investors. Unfortunately, this also made it harder to figure out who owns which mortgages. Moreover, two other problems surfaced.

First, before you buy an apple, you look it over to ensure it’s not rotten. Similarly, before you buy a CDO you pay someone to look it over for you. Companies like Standard & Poor’s, or ratings agencies, do this. It’s their job, so to speak.

Then the rating agencies assign a rating, e.g. good apples versus so-so apples versus bad apples. Unfortunately, they (the rating agencies) did a crummy job. Thus, some folks paid for good apples but received bad apples – or departing the analogy – bad quality CDOs.

Second, a business called AIG was selling CDS (Credit Default Swaps) on the CDOs. Think of CDSs as insurance policies on the CDOs (in case things go wrong). Naturally, prices are based on ratings just like car insurance is cheaper for people with stellar driving records. So AIG was selling CDS based on the faulty ratings assigned by rating agencies like S&P . . . oops!

However, there was another problem. AIG didn’t have the reserves they should have had to engage in this kind of business. The problem was government regulators dropped the ball, which let them engage in this business without adequate reserves . . . double oops!

I could go on and lay blame on the government for forcing the banks to make poor judgment loans but long story shortened, AIG went broke. Or so close to it as doesn’t matter because too many buyers of the CDSs tried to cash in their insurance policies on their CDOs (e.g. those made up of poorly performing mortgages).

This was a big deal. Moreover, because everything was quickly going to hell in a hand basket, the government stepped in. By the way, the term for this is systemic risk because it could lead to everybody going out of business. Anyway, Uncle Sam stepped in and saved the day – sort of.

We learn about supply and demand in Economics 101. This is basic stuff like too much supply leads to lower prices. Similarly, too little demand also leads to lower prices; remember?

During a recession, fewer people can buy, and thus the lower demand means prices fall. Unsurprisingly, banks selling a lot of houses increased the supply, so prices fell. Unlike mathematics where two negative multiply to make a positive, in this case, these two negatives have made things much worse.

You see, as home prices fall, more and more people find themselves owing more than their homes are worth. Folks making a 20-25% down payment have to see prices fall a lot before they’re so upside down they can economically walk away. However, folks with only a 1 or 2% down payment were upside down almost immediately.

Unsurprisingly, with very little skin in the game, many of the latter folks walked away. Jingle mail entered the lexicon (a reference to the sound of the mail because folks were mailing the house keys to the bank). Naturally, the banks then are putting more and more houses on the market. Way more than usual.

This means prices are falling further, and further. It’s a vicious cycle and is pretty much where we are now. If anything, things are getting worse. We need a fix.

The fix won’t be politically palatable. It doesn’t matter. We need a fix or we’re going to be enduring this recession for the next decade. It’s that bad.

Since any idiot can point out a problem, how about coming up with a fix? This has proven to be harder than I imagined. Smart people have tried. While I’m not one of the smart guys, I do have an idea. Here goes; since the GSE’s backstop +90% of mortgages in the USA already, e.g. we the people are on the hook anyway, why not try changing the dynamic?

First, we’re presently loaning to the banks at 1/4% (to help them repair their balance sheets). The idea behind this is they, in turn, will extend more loans. E.g. to folks needing a refi out of too expensive mortgages (to preclude them defaulting). Unfortunately, the banks are not making many loans. This is because they’ve tightened their lending standards. So why don’t we short circuit the situation? Let’s refi folks directly (cut out the GSEs if they don’t want to play ball). Make the loans to the people with exisiting mortgages at 1/4% . . . instead of continuing to loan to the banks. The banks will howl bloody murder. The GSEs will too because they are private businesses and are making money on the loans despite the rate of forclosures. Since we need to do something about the GSEs anyway, this takes them out of the equation by putting them out of business. Of course, plenty of smart people will explain this won’t work.

However, I figure someone struggling with a $1400 mortgage, but current, isn’t spending anything on toys and stuff, which aren’t absolutely essential because they’re in hunker-down mode. Unfortunately, as long as folks are in hunker down mode they won’t spend.

Mortgages at 1/4% will see house payments drop from $1400 to maybe $700. And once folks catch their economic-breath (form having mortgages drop in half) they’ll start seeing money left over in their pockets after paying their bills. It won’t take long before they’re spending again.

After all, ordinary folks spending makes up 70% of GDP and as things stand, they’re not spending. Let’s just cut to the chase so they can spend again. I know this won’t happen but if it did, I bet we’re out of recession before Christmas.