Lessons to be learned

From today’s Fin.

Several causes of the financial troubles in the United States – including the non-recourse nature of housing loans – were known to be problems before the crisis erupted. Other factors – such as falls in American house prices – were foreseeable. These weaknesses werent properly addressed because of a failure of government. The same failure affects Australia.

Although enmeshed in the fall-out, Australia did not share all of Americas faults. But Australian companies do award obscene remuneration packages to executives, against shareholders interests. Kevin Rudd has promised to deal with the greed, as he characterises excessive salaries. But the government will not regulate the quantum of executive wages: the treasurer, Wayne Swan, has opposed this.

However, the government can remedy some board failures. For example, we have long known that companies which grant share options to executives have a greater propensity to employ share buy-backs. A known consequence is that buy-backs disproportionately increase the value of share options. To address this, the government should legislate against their use in executive packages. Shareholders hold shares, so should executives.

Allowing executives to sell their shares while employed, or shortly after they leave, also fails to align shareholder and executive interests. An example of this is the behaviour of Lehman Brothers last chief executive, Richard Fuld. Fuld maintained much of the shameful wealth he acquired from Lehman by selling his shares and options before the firm failed. Requiring executives to hold shares for some years after they depart would recognise that executives come and go but shareholders remain until the end.

The government should also allow shareholders a decisive say in all executive pay matters. The current situation, where shareholders advise on but cannot prescribe most parts of the packages of senior executives, is patronising. And it allows market failure in pay matters to continue.

Another weakness we share with the United States concerns credit rating agencies, the bodies which rated junk home loans as AAA. The government says it is relying on the work of the Financial Stability Forum, an international body which promotes financial stability, to address the failures of credit rating agencies. But the Forum has not delivered. It is not helpful to infer, as the Forum did in its April report, that retail investors should do their own risk analysis of financial products. It is not useful to suggest that rating agencies need to manage better the conflicts of interest which arise because they are paid by the bodies they assess. Such conflicts of interest can only be avoided by having the wider community pay for ratings.

Problems with executive pay and ratings agencies are worth addressing even though they are not as important in Australia as they were in the United States. But the government must work urgently to improve Australias savings rate. We see the paucity of household savings in the high level of Australian household debt, about 120 per cent of disposable income. We see it in Australias net foreign debt, about 60 per cent of GDP, and in the current account deficit, about 5 per cent of GDP.

Australia uses foreign savings to finance investment opportunities more quickly than would otherwise occur, without reducing consumption. And the so-called Pitchford thesis suggests that we need not worry about these matters because they are private sector deals, the result of agreements between consenting adults. However, we have seen how contracts between consenting home borrowers and lenders in the United States were a primary cause of the financial meltdown. Our reliance on foreign savings helps explain why Australia has been enjoined in that crisis.

Australia can avoid a recession. But the sharp depreciation in the Australian dollar will lift foreign debt and increase servicing costs in Australian dollar terms. Recent falls in the value of securities have also reduced net household wealth, even before expected further falls in house values. This might stir the Rudd government into adopting policies to increase household savings, something the Howard government neglected. Higher domestic savings would better protect the Australian economy from world crises. Of course, policies aimed at lifting savings are inconsistent with plans to increase the age pension. Such security blankets reduce the need for household savings.

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SJ
SJ
13 years ago

Good piece, Tony.

rog
rog
13 years ago

I am unclear as to whether “a failure of government” includes a failure to address non recourse loans.

As far as I know, in the US non recourse loans are mandated by state govt ie forfeiture of loans for your primary residence are limited to the value of the property and other assets are not to be included. Not all states allow this so you have recourse and non recourse states (California is a non recourse state)

Then there are various govt laws on forfeiture and redemption

The US Govt issues many non recourse loans eg for farming – collateral for loans for crops are limited to the value of the crops.

SJ
SJ
13 years ago

rog Says: “I am unclear as to whether a failure of government includes a failure to address non recourse loans.”

Six of one, half a dozen of the other, rog, in terms of Pareto efficiency. That is, you might look at a situation that isn’t Pareto efficient, and conclude that it’s a market failure, or that it’s a government failure because the government should have intervened but didn’t, or that it’s part market failure and part government failure because a government intervention didn’t get all the way to Pareto efficiency.

The complicating factor is that all markets are connected, and an intervention or non-intervention in a particular market (e.g. home mortgages) can throw up problems in another market (i.e. CDOs), and stuff up the results of the intervention in the first market.

There’s no question the Bush and Greenspan stuffed up big-time, though. Denial of reality, when deliberately pursued as policy ain’t ever going to work.

SJ
SJ
13 years ago

Anyway, rog, Tony’s piece was about something else altogether. The bit you’re complaining about was just an introductory sentence.

JC
JC
13 years ago

Several causes of the financial troubles in the United States – including the non-recourse nature of housing loans – were known to be problems before the crisis erupted. Other factors – such as falls in American house prices – were foreseeable.

I’m not sure how you can say that. With minor interruptions only, house prices have been going up since the early 60’s

http://investmenttools.com/median_and_average_sales_prices_of_houses_sold_in_the_us.htm

It would be a brave person to have suggested the long term direction was going to be broken so suddenly. How many economists who were saying this actually took a bet and shorted the home builders?

For example, we have long known that companies which grant share options to executives have a greater propensity to employ share buy-backs. A known consequence is that buy-backs disproportionately increase the value of share options

Actually buy backs are tax effective for big mutual and pension funds which is the prime reason boards support them. You’re implying that stocks wouldn’t reflect reality unless there was a buyback. I think one could dispute that, as a giveaway from earnings would reflect in the stock price too.

Requiring executives to hold shares for some years after they depart would recognise that executives come and go but shareholders remain until the end.

Vesting takes place usually over a period of 5 years or so. Termination doesn’t always mean the executive gets the stock as that is at the discretion of the board.

But the government must work urgently to improve Australias savings rate. We see the paucity of household savings in the high level of Australian household debt, about 120 per cent of disposable income. We see it in Australias net foreign debt, about 60 per cent of GDP, and in the current account deficit, about 5 per cent of GDP.

Tony, our C/A as an annual % of GDP has been bigger than it was before Keating instituted compulsory super. Demand for debt is contingent on two things. The individuals estimated prospect to repay the loan and the ability to service the loan. If we don’t want to see a debt binge being created we should ask the RBA to start running an appropriate monetary policy that is in the long term interests of the country.

Our reliance on foreign savings helps explain why Australia has been enjoined in that crisis.

It’s not always so. Self funding could retard higher living standards. Despite the current problems if we look back in 10 years time we could say that running a high C/A actually sped up wealth accumulation over the past 15 years or so even after taking into account our current problems.

But yes, the C/A does seem to present a problem. However I think part of it is due to the RBA simply making too many dollars allowing us to export them.

But the sharp depreciation in the Australian dollar will lift foreign debt and increase servicing costs in Australian dollar terms.

Australian have very little foreign debt unexposed to FX risk. In fact it’s next to nothing. The people who have taken the hit seem to be a large number of Japanese housewives and Asian investors hunting around for high returns and not thinking about the potential dangers of risk.

JC
JC
13 years ago

oops

our C/A as an annual % of GDP IS BIGGER after Keating instituted compulsory super.

SJ
SJ
13 years ago

JC Says: “Im not sure how you can say that. With minor interruptions only, house prices have been going up since the early 60s”

With respect, JC, only a liar or an idiot could come up with that argument.

JC
JC
13 years ago

Is the US census bureau incorrect then or am I looking at the chart in the referred link upside down. :-)

I may have the chart upside down in which case house prices have been falling in the US since the early 60’s. lol

Here’s the link again

http://investmenttools.com/median_and_average_sales_prices_of_houses_sold_in_the_us.htm

SJ
SJ
13 years ago

So you can look at that graph, and deny that house prices are falling. Interesting.

JC
JC
13 years ago

Let me clean up the sentence as it is obviously confusing you.

With minor interruptions only, house prices had been going up since the early 60s until about 2006 when the fall began

Patrick
13 years ago

Other factors – such as falls in American house prices – were foreseeable.

I think that one lesson (maybe the lesson) from this is that any decent risk modelling has to factor in unbelievable asset price falls. Fundamentally it is conceivable that prices will fall, without qualification. The fact that it may not be believable at a given point in time should not be allowed to become an assumption.

NPOV
NPOV
13 years ago

JC, you could just as well look at that graph and note that up to 2001 or so, house prices had risen at a steady rate, and that the rate they rose from 2002-2006 was clearly an unsustainable anomaly. Which is pretty much what Robert Schiller noted back in 2005.

“Using old classified advertisements, he was then able to fashion a chart for the United States that goes back to the 19th century.

It all points to an unavoidable truth, he says. Every housing boom of the last few centuries has been followed by decades in which home values fell relative to inflation. Over the long term, the portion of income that families spend on their shelter stays about the same.”

JC
JC
13 years ago

You could do a lot of things, N. However you couldn’t really come up with a prediction that US house prices were going to tumble and take the banking system with it. It wasn’t in the tea leaves.

pedro
pedro
13 years ago

I’m not sure the problem with ratings agencies is solved by public funding. It might be better to limit the importance given to them.

derrida derider
derrida derider
13 years ago

JC quite a few economists did predict housing prices would fall when the bubble popped. Few, though, predicted that they would take the banking system with them – that’s the nasty surprise.

Australia’s aggregate savings rate is not especially low. We have less household savings than most countries with our demography (there’s a good argument that the ABS definition underestimates it anyway), but we have more government saving and more corporate saving (retained earnings) than most. And it is aggregate saving that tells you how much, as a nation, we’re foregoing current consumption to improve future consumption. Our current account deficit is more because we have lots of good investment opportunities than a savings deficiency.

I don’t think tighter monetary policy would have boosted the household savings rate – the uncompensated elasticity of household saving wrt interest rates is generally believed to be very low, because the effect of lower incomes on propensity to save is so strongly negative.

It was entirely foreseeable (and, if I may be modest, foreseen by yours truly) that compulsory super would not boost household savings. In a deregulated credit market you can’t force people to save if they don’t want to. Middle class households and their bankers got comfortable with longer mortgages when they knew they no longer had to clear the mortage before retirement. Poorer households just ran up credit card debt to cover the lower after-super wages, or ceased work altogether.

JC
JC
13 years ago

DD

I agree, there were quite a few people that suggested there was going to be a real estate problem, but certainly not this. In any event the math models being used in figuring VAR and the risk parameters for CDO’s had nothing like this either. Even the Fed with its army of of 1500 economists (the largest economic research unit in the world) didn’t model such wreckage.

Having said that the BIS (which seems to have a touch of Austrian economics) was actually putting out warning lights 4 odd years ago suggesting that the world was it’s most economically unbalanced since the 30’s.

see: http://www.nakedcapitalism.com/2008/06/bis-warns-of-deepening-contraction-not.html

The BIS was warning of economic instability since 2004 if I recall. (as far I’m concerned they are the best macro research body in the world bar none).

——-
I’m don’t think the C/A is much of a problem until it becomes a problem. Having said that there were pretty good signs of a consumption binge going on as our imports didn’t just comprise of capital equipment. There were a number of $20,000 Hermes handbags in there too:-). (not that there’s anything wrong with that).

Australias aggregate savings rate is not especially low.

Sure, but by definition a current account deficit suggests there isn’t enough domestic savings to satisfy aggregate spending, otherwise there wouldn’t a capital account surplus.

I dont think tighter monetary policy would have boosted the household savings rate – the uncompensated elasticity of household saving wrt interest rates is generally believed to be very low, because the effect of lower incomes on propensity to save is so strongly negative.

Right, tighter money wouldn’t have in of itself, however monetary policy does has have more than a passing effect on aggregate spending and demand as it distorts everything and causes asset mis-pricing. And there sure was asset mis-pricing when risky investments were trading at a few points over govies.

What i now find interesting in all this is that we’re all flailing around looking where we should pin the blame when the most basic economics learned in 12 grade easily it explains. A demand curve shifting to the right due to lower prices (interest rates) and a commensurate increase in supply (bank balance sheets) leads to higher demand (loans).

SJ
SJ
13 years ago

Back again. The are a few problems with your house price graph, JC. It’s not a log scale on the vertical axis, so falls in earlier years are masked. And being an average, it masks hotspots.

Take a look at this one.

Real house prices in Las Vegas fell for about 7 years straight between 1990 and 1997. This was the result of the real estate bubble that developed after the 1987 stock market crash. It should have been obvious to anyone that house prices in the U.S. don’t always go up, because they just don’t.

JC
JC
13 years ago

SJ
Let’s just make it really easy for you. US median house prices had been going up since 1963 until about 2006. There is nothing wrong with the chart and there’s nothing wrong with any axis. It’s a simple, easy to understand chart.

Now I can appreciate this may be a little confusing to you and being the ever helpful type I’ll try to offer any assistance I can your steely determination to understand very difficult concepts such as the slope of a line on a chart.

(If its sorta pointing towards the sky/ceiling it means it’s going up. If it’s pointing towards the floor/ground it means it’s heading down)

Did the Vegas market fall in those years you mentioned. Dunno, but I’ll take your word for it. Did Texas house market fall or remain unchanged for 10 odd years with the bust in the 80’s? Yep. Did the rust belt also feel the pinch in the 80’s? Yep. But overall during those times the median price of US housing continued to rise. It’s that simple.

So I’m sure you could find various markets heading down (towards the floor/ground) when the national median is heading up ( sky/ceiling).

SJ
SJ
13 years ago

As I said earlier, “Denial of reality, when deliberately pursued as policy aint ever going to work.” Didn’t work for Bush and Co, ain’t gonna work for you.

Look at your own graph. It shows a 10% fall in average between 1989 and 1992, and an 8% fall in median between 1989 and 1993. End of story.

JC
JC
13 years ago

You’re turning this in George Costanza conversation.

As I said earlier, Denial of reality, when deliberately pursued as policy aint ever going to work. Didnt work for Bush and Co, aint gonna work for you.

Ok, look, if it makes you happier let me just agree with you that US median house prices fell for 45 years. There, happy now? lol.

Look at your own graph.

I did. It’s goes up in a nice steady curve (ceiling/ sky) with a few minor blips along the way.

It shows a 10% fall in average between 1989 and 1992, and an 8% fall in median between 1989 and 1993.

Ah ha, yep.

End of story.

Thank god for small mercies.

SJ
SJ
13 years ago

McCain should put you on his permanent staff, JC. It’d give you something to do until Tuesday.

JC
JC
13 years ago

McCain should put you on his permanent staff, JC. Itd give you something to do until Tuesday.

Didnt work for Bush and Co, aint gonna work for you.

If I were you, I would be blaming President Grover Cleveland for all the problems. Why? Dunno, but its about as relevant as you bringing these two jokers in a discussion about US house prices over the past 45 years.