September 19, 2008 the Day the US became Socialists

After a week of a near meltdown on Wall St., this week ended with resignation on the need to address the rootcause of the financial crisis - the billions in outstanding mortgages that were at risk.

Never have we seen anything like this - this past week is just the beginning. We thought the subprime mortgage fiasco and the housing bubble collapsing was bad, but that was just the tip of the iceberg.

Even the experience with the Savings & Loan Crisis experienced in the 1980's doesn't compare in scale to what we have experienced this past year.

Many economists are seeing the possibility of a problem of such massive proportions as bad as the Great Depression.


http://www.nytimes.com/2008/09/20/business/20fed.html?ref=business

The Bush administration, moving to prevent an economic cataclysm, urged Congress on Friday to grant it far-reaching emergency powers to buy hundreds of billions of dollars in distressed mortgages despite many unknowns about how the plan would work.

Henry M. Paulson Jr., the Treasury secretary, made it clear that the upfront cost of the rescue proposal could easily be $500 billion, and outside experts predicted that it could reach $1 trillion.

The Treasury in preparation to support the Fed, they've apparently sold $200 Billion in Treasury Securities.

Today has marked the frustration and disgust of many Americans over the bailout of Financial Institutions at the Taxpayers' expense.

The frightening question is how far does this go? Will this be enough to ease the credit crunch?

Today clearly marked the choice for new leadership, but the reality is that the incoming President will be facing massive challenges with two wars, trillions in debt, an economy in recession, and energy crisis.

People often question how Bush 43 will be perceived over time. If anything, George W. Bush will always be infamous.

Are Markets Rational?

Traditional definition of economics is all about the efficiency of markets, "the Price is Right!" (1) , and the optimization of Supply and Demand. Furthermore, it advocates that individuals make rational decisions based on all available information.

That's the theory, but is that necessarily true in real life?

In a simplistic example; when deciding whether to have fruit or a chocolate chip cookie, the rational decision would be to choose the fruit, as it's much healthier. However, when given a choice, many of us would choose the cookie - I know I would!

For a more relevant example, we can easily turn to the current housing crisis. When given the choice between putting no money down for a house, and in addition taking an ARM (adjustable rate mortgage) as opposed to a traditional 20% down payment and fixed interest mortgage rate, we have seen many individuals choosing to go with the first option.

What makes ARMs attractive, initially, is the fact that they usually offer a lower rate than the standard interest rate. However, this is only temporary, and after a set period, the interest rate then fluctuates based on some hybrid or common index of interest rates. The risk is if the interest rates go up, it will significantly increase one's monthly mortgage payments. In addition, many ARMs can be structured by lenders which make it unfavorable to pay off the principle early, in the form of fees.

Unfortunately for many, the rates have gone up, due to the Fed's concern regarding inflation. As a result, many saw their monthly mortgage payments double or triple. Very often, an individual's monthly income does not provide enough flexibility to handle sudden increases in required mortgage payments. When an individual is unable to pay the new mortgage amount in full, what happens is that whatever amount they do submit, first goes towards the interest -- not the principle! This results in negative amortization, whereby the principle (original amount to be paid) increases! This can be exasperated in situations where already the individual did not put any down payment towards the principle. The negative amortization leads to a downward spiral where the interest applied to the principle increases, thereby increasing the monthly mortgage, very often leading to foreclosure.

If interest rates are high and there is some future expectation that rates continue to decline, ARMs may make sense if the individual intends to pay off the mortgage relatively quickly or if they flip the house. However, at some point the rates will go back up, so if the expectation is that you will hold onto your home for 15 or 30 years, this could lead to financial difficulties. So ARMs require very careful assessment, as well as some level of financial savviness - which a majority of Americans do not have according to a recent NY Times blog on Freakonomics.


http://freakonomics.blogs.nytimes.com/2008/07/21/are-we-a-nation-of-financial-illiterates/?scp=1&sq=financial%20Illiteracy&st=cse


So does this imply that we are always doomed to making the wrong choices? Fortunately, the answer is NO! In a recent book, "Nudge: Improving Decisions about Health, Wealth, and Happiness", written by Richard Thaler and Cass R. Sunstein, the authors demonstrate that while individuals have difficulty to make rational decisions, conscious interventions can be applied to ensure that the right decisions are being made. Thaler and Sunstein are Behavioral economists who speak to a different philosophy, which advocates that social, psychological or emotional biases need to be taken into account when explaining or making market decisions.

So we know an individual may not always make rational decisions 100% of the time, but what about organizations - for example Corporations or Wall Street?

(1) http://money.cnn.com/magazines/fortune/fortune_archive/2002/12/09/333473/index.htm