Tranche: Transaction documentation usually defines tranches as different "classes" of notes, each identified by letter (e.g. Class A, Class B, Class C securities) with different bond credit ratings. The equity ("first-loss") tranche absorbs initial losses, followed by the mezzanine tranches which absorb some additional losses, again followed by more senior tranches. Equity is riskier than mezzanine, and so forth.
A simple statement like that above (cribbed from a Wikipedia article), early in the book, would have saved me a lot of puzzlement when I was reading Unintended Consequences: Why Everything You've Been Told About the Economy is Wrong by Edward Conard. A glossary would have been even better, because those few terms bolded above are just the tip of the iceberg of specialized jargon Conard uses. It is really too bad. The back cover has six blurbs of high praise; all are from economists, who of course would understand the book without further education. For the rest of us, the book is quite inaccessible.
Of course, I have spent two weeks with this book, gradually unscrambling the inscrutable, so I can evaluate it better. In the main, I like the author's analysis, which was a relief to me: he is a former partner in Bain Capital and colleague of Mitt Romney, and I am also a financial and political conservative. Here is a synopsis of what I did understand. Bottom Line: The cause of the 2008 Financial Crisis was a classic bubble, in real estate rather than in banking as the media have stated (repeatedly!). The collapse of the bubble led to the collapse of major banks, and we'll get into that.
In the first of three sections, "What Went Right", he outlines the parts played in a national economy—on a global stage—by Investment, the Trade Deficit, and Incentives.
- Investment: There are three things you can do with money that comes your way, consumption, savings, or investment. Here, "consumption" includes charity and any other use of money besides saving and investing, and "saving" means putting money into a bank account, money market account or CD. "Investment" means different things depending on your rôle. For most of us, it is trying to beat the bank rates by putting some money into mutual funds or stocks or bonds. It can also mean investing in more education. For a business owner, it means money spent towards innovation, to increase the competitiveness of the business, or even better to create new and lucrative products.
- The Trade Deficit is seen as a positive, a way to export labor costs. This both drives consumption and reduces its costs. It's a nice idea to "Buy American", but it doesn't make economic sense for a poor or lower-middle-class family to purchase only products manufactured by workers who earn an average $17/hr, when available products of equivalent utility were manufactured for 75¢/hr: that's a labor cost of just 4.4%, effectively zero, so you can afford a lot of transportation cost and still pay much less. This is a major reason most American jobs are in the service sector. You can't export plumbing or auto repair to China. (By the way, make sure your college student also learns a trade; more likely to pay off.)
- Incentives have two sides. A businessperson who invests is likely to compete better, and may get lucky with a blockbuster product. This will bring a great increase in income, and increased status. A businessperson who does not invest, or does so meagerly, will not do as well, and will also suffer a loss of status for failing to grow the business.
Incentives in particular are misunderstood by most Americans, especially in the face of a steady drumbeat of Liberal propaganda that "the rich" are "oppressing" the poor and "taking advantage of the 99%". Let's be frank. Suppose the combined governments in the U.S. were to have a super-flat tax, meaning you can earn up to, say, $30,000 per year tax-free, and then the tax rate is 100% for every dollar above that point (divided somehow among Federal, state and local governments). Do you think Andy Grove or Bill Gates or Warren Buffet would have built their businesses, or even remained in the country? At a much, much lower level, I observed this: When one of my co-workers had been at a particular salary grade a few years, he or she would begin taking on more and harder projects, hoping to impress management and receive a promotion (with its extra 5-10% pay boost). If a promotion was not forthcoming within a year or two, the same person would get discouraged and begin slacking off, and perhaps even drop in productivity to a level lower than a few years before. It is a well known business proverb: you get what you incentivize.
Now, I get pretty bothered when a company executive attains a salary that works out to a few thousand dollars per hour. I don't think anybody is worth that kind of salary. However, when a business owner takes financial risks to grow the company, and happens to hit it big (like Bill Gates, everybody's first example), it may rankle folks that he becomes "worth" millions or billions of dollars, but he hasn't attained that by putting an inflated salary into the bank. What he is "worth" is the market value of that portion of the business that he owns.
I can use a friend of mine as an example. His family-owned business was worth a few million dollars when he took over its management in his 30s. He built the business, investing deeply but wisely, so that it grew a thousandfold. A few years ago he was said to be "worth" about $20 billion. The Financial Crisis has been worldwide. Although most of his company's assets are overseas, they were affected by the recession, and his current "worth" is about $2 billion. In all this time, though, he has been paid the same executive salary of a few hundred thousand, in terms of $US. And let's consider what would happen if Bill Gates or my friend were to attempt to cash out his holdings. There is hardly anybody who can afford to buy all of Bill Gates's stock in Microsoft, and probably no institution that is willing to do so. He'd have to sell the stock over time, and it would depress the market for that stock and possibly bankrupt the company, because the precipitous drop in its value would make capital purchases more difficult or impossible.
So as much as we may envy the rich, for the most part they are enjoying the rewards of their risk-taking luck. Incentives are a necessary part of a robust economy.
There was, of course, a fly in the ointment, long before 2007. As outlined in the second part, "What Went Wrong", regulators loosened regulations on the way banks write home mortgages, administration officials and lawmakers began to put pressure on banks to make mortgages more affordable to lower-income people, the credit rating agencies rated "tranches" of bundled mortgages (as defined above) more liberally than they should have, and banks and short-term investors soon got caught up in the speculative frenzy, driving up home prices.
Continually falling interest rates, led by the Federal Reserve, played a big rôle. If the homes in Suburb A all sell for $100,000, and mortgage interest drops from 8% to 4%, you can get a loan for just over half the payment. But the price won't stay put. Someone paying $587 monthly on a $80,000 mortgage finds he can get almost twice the money for the same payment. He figures, so can someone else with a cheaper house who wants to upgrade, so he puts his home on the market for $125,000, amplifying his $20,000 of equity into nearly $38,000 after paying his realtor. Now, since he can borrow more than $120,000, he buys a house for $160,000 (ignoring the fact that it was valued at $125,000 a few years earlier). Prices spiral upward.
There is a second effect. Banks got more confident in making "subprime" loans, which are loans with smaller or zero down payment, made to buyers who are near the bottom of the "qualified" credit-score window. In a price spiral, they knew that a $100,000 home, financed at full price, would gain in price (not necessarily value!), and be "worth" $150,000 in a few years. Once the homeowner has equity in the home (the $50,000 rise in price), the bank judges he is not likely to default, making the loan no longer subprime. But something happens the bank didn't expect. The homeowner got an equity loan for $50,000 and bought a boat, took a vacation, and paid some college tuition. Now the combined loans are subprime, equity is near zero, and the smallest dip in the market (they happen every few years), makes the homeowner "under water", owing more than the house is worth. This is a fragile situation. Anything even a little unfortunate—a medical bill, a falling tree that damages the roof—puts the homeowner in the position of skipping a mortgage payment so he can buy food or gas for the car. Skip a few payments and the bank forecloses. They don't really want to, because they are going to lose money auctioning off the home, but it is better than waiting to see if this particular homeowner gets back in the black. So they foreclose, the homeowner has to move, and if house prices are still down, is able to rent a home similar to the one he just left for less than he was paying earlier.
The housing market got overheated, and then cooled off, as they always do. Too many subprime loans collided with too many underwater loans, and foreclosures climbed. Some of the loans had balloon payments, leading to more foreclosures. On average, the housing market dropped 30% in value. Even a bank with a conservative loan portfolio (there were very few), meaning there was a 20% buffer of equity, found their entire portfolio at least 10% underwater, as evaluated by the short-term lenders they'd been relying on for capital. That includes people with their money in savings accounts. The short-term lenders bailed. There was a run on the banks. Banks became insolvent, and some went under.
Here is where it gets hard to follow. When I was watching this happen in 2008, Treasury Secretary Henry Paulson announced that we had to bail out the biggest banks to the tune of some $700 billion, because they were "too big to fail". The bailout couldn't save them all, and a few went under. The next year, with companies laying off workers due to a lack of capital—they couldn't borrow money enough to run at full capacity and cover cash flow variations—, a new administration proposed spending more than $800 billion on "shovel-ready" jobs in infrastructure repair, to stimulate the economy. They did it so badly the economy simply got worse, and it turned out nothing was shovel-ready anyway. But now such "stimulus" funds are a permanent part of federal expenditures (and just try to find out where the money is going!), making up more than half the Federal deficit every year since. It is a big reason the national debt went up by $6 trillion since 2008.
In the third section of the book, "What Comes Next", Conard outlines a great number of suggestions for improving the economy. This was hardest to follow, but the general tenor is, he is trying to get lawmakers to take a long-term view, something that is flatly impossible to do. Every one of his suggestions goes against human nature, particularly for a politician who must get elected. Now that roughly half the country's citizens obtain significant Federal support, there is a built-in majority who will never vote for a candidate who promises to make even the smallest dent in their own paycheck!
As much as I hate to say it, here is what we really need (and this is me talking, not the author): We need a Presidential Candidate who lies persistently, baldly, and totally, about "taking care" of "the people". One with sufficient charisma and inspirational power to bring a large number of lawmakers along on his coat-tails into office. He, or perhaps she, will have exactly one term, and perhaps only two years, to enact a flurry of actually intelligent legislation. The bills could be quite simple, of the order of
HB1234 and SB321, also known as The Stupid Ugly Fleece-the-Public Act, is revoked in its entirety. All expenditures authorized under the Act are to end immediately.The trouble is, I suspect it would require jailing the entire cadre of lobbyists for lawmakers to do so. And here is another problem. Last year's $3.6 trillion federal payout supported about 15 million people plus 2 million military personnel. To cut it back to $2.2 trillion, and thus eliminate the deficit, would put about 6.6 million federal workers (probably including some military folk) out of work. So perhaps Conard's way will work better. He suggests returning to the laws and regulations of the late 1990s, in effect, with more conservative bank loan standards. He suggests limiting the "soak the rich" tenor of the country so business owners will find it worth taking investment risks to foster innovation.
Ronald Reagan was not the first to say, "A rising tide lifts all boats". This diagram illustrates that the smallest boats rise most, contrary to what you hear in the media. So to simplify Conard's point even more: The country that innovates the most will have the strongest economy. Investing for innovation is the best use of our money, even if it risks the occasional bubble.
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