-By John Armor
I’ve watched the stock market go up and down lately like a giant yo-yo. I’ve followed the details of how and why the so-called bailout failed in the House early this week, and will probably pass the Senate on Wednesday, and possibly the House a day later. In revised form, of course.
But there’s an aspect of this situation which applies to the bad mortgages, whose failures led to the collapse of Fannie Mae and Freddie Mac. And applies to the failures of Lehman Brothers, Washington Mutual, AIG, Wachovia, the House of Representatives, the Senate, the White House, and both presidential campaigns.
What is the common denominator of all these failures? It is rapid decline in prices of mortgages, bundled mortgages, and businesses which trade on bundled mortgages, and finally, politicians who are rented by such businesses. The part of these related disasters which no one in the press has bothered to discuss, is basic.
What are prices?
Basic fact one: A price for any product or service is the dollar value at which a willing seller will transfer it to a willing buyer.
Basic fact two: Whenever government interferes in the free market by forcing any product or service to become either cheaper or more expensive than it normally would be, the price of the forced change will be paid by other people, somewhere else in the economy.
Basic fact three: Some prices depend heavily on future expectations about the value of the product. No one buys a pencil hoping its value to go up in the future. However, everyone who buys a share of stock expects its price to go up (or dividend increase) or otherwise he/she wouldn’t buy it in the first place.
Mind you, I am not advocating laissez faire economics at the Darwinian level. Telling a manufacturing firm that it cannot dump the toxic byproducts of its factories into the nearest stream obviously raises the price of the widgets that are produced in that plant. And, the cost of controlling, rather than dumping those byproducts will be passed onto the rest of society when people buy and use widgets. The point is that such “social costs” should be honestly recognized, and openly imposed.
Let’s apply these ideas that are taught in the first week of Economics 101, in all colleges where such courses are taught by professors who impart knowledge, not politics, to their students.
As Ben Franklin observed, centuries ago, and Abe Lincoln reaffirmed a century ago, time is money. When Congress passed a law in the Carter Administration to force lending institutions to make home loans to people who wouldn’t otherwise get them, it forced the prices down for certain people. A 5% down payment, or even less, is easier to accumulate and takes less time, than the standard 10% to 20%. Likewise, a shoddy credit record is easier to acquire than a clean one.
Then, in the Clinton Administration, Fannie Mae and Freddie Mac were ordered to increase their purchase of such loans. And, they bundled them and sold them in the open market to assorted private investment banks and brokerages. At the time, the price of these bundled securities were high. After all, they had higher yields than normal loan packages, and they seemed to be guaranteed by the federal government.
Put it in your own terms. If there are two banks on the same street, both with federal deposit insurance, and one pays a 4% interest rate and the other an 8% rate, where would you deposit your money? You should put your money where you receive the highest price.
Ah, but what happens if the higher rate bank turns out to be uninsured? So, your whole deposit could be lost? Then, you should grab your money and run. That is exactly what both individuals and institutions have been doing for the last two weeks.
But, remember that the whole disaster began with the government – both Congress and Presidents – artificially lowering the price of houses for certain people (including as it turns out, people who are not even American citizens). Efforts to place controls on the excesses of Fannie Mae and Freddie Mac sponsored by President Bush and Senator McCain, among others, were defeated on a party-line vote in the US Senate, by Democrats who had received substantial contributions from Fannie and Freddie.
There are no goods and services, and only a fraction of individuals, who do not have a price. And when that price is met, the exchange takes place.
I hope this discussion of prices is helpful to you in considering what is happening, and not happening, both in the economy and in the halls of Congress.
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John Armor is a graduate of Yale, and Maryland Law School, and has 33 years practice at law in the US Supreme Court. Mr. Armor has authored seven books and over 750 articles. Armor happily lives on a mountaintop in the Blue Ridge. He can be reached at: John_Armor@aya.yale.edu