Fallacy of Composition

Let’s say there’s a hole in the dike. Sea water pours through the hole and onto the land and, since water seeks its own level, flows everywhere. There are several possible approaches to dealing with this problem:

  1. You can patch the entire dike.
  2. As the water rises you can build everything in the land protected by the dike higher.
  3. You can learn to breathe underwater.

Or, you patch the bloody hole.

Once the dike has been completely breached, it’s too late. Then you’ve got to retreat to higher ground and, eventually, rebuild.

The financial crisis that’s been precipitated by the default of mortgages, particularly subprime mortgages, is a lot like having a hole in the dike and I’ve seen every one of the approaches above suggested in one form or other except patching the hole. More about that later.

The problem of mortgages defaulting is actually getting worse:

interviews and a Washington Post analysis of available data show that the foreclosure crisis knows no class or income boundaries. Many borrowers ensnared in the evolving mortgage mess do not fit neatly into the stereotypes that surfaced by early 2007 when delinquency rates shot up. They don’t have subprime loans, the lending industry’s jargon for the higher-rate mortgages made to borrowers with shaky credit or without enough cash for a down payment.

The wave of subprime delinquencies appears to have crested. But in October, for the first time, the number of prime mortgages in delinquency exceeded the subprime loans in danger of default, according to The Post’s analysis.

This trend shows up most acutely in California and other high-growth regions, such as Arizona, Nevada, Florida and pockets of the Washington region, most notably in Prince William and Prince George’s counties.

The coverage that this problem has received in the media and the way that the leaders in Washington are responding to the problem has one serious defect: although the consequences in the form of the credit crunch and the economic slowdown (when prosperity is fueled by credit that things slow as credit tightens stands to reason) are felt nationwide the problem of mortgage foreclosure is not spread evenly throughout the country in every state and every county. All of the twenty zip codes with the highest proportion of “underwater” mortgages (which are at the highest risk of defaulting) are in just four states, eleven in southern California alone. All of the top ten are in just three states, California, Nevada, and Florida, and only one of those is in Florida. Nearly all of the problems with foreclosures are in just seven states: Florida, California, Michigan, Nevada, Arizona, Georgia and Ohio.

Treating the problem as though it had nationwide causes is, frankly, a waste of time and money. We’ve got to concentrate our attention where the problems actually are, namely California. Get California’s house in order and you’ll ameliorate the problems of the banks, ameliorate the problems of the banks and credit will loosen, loosen credit and you’ll reduce the problems of corporations and individuals, reduce the problems of corporations and individuals and the the economy will perk up.

The dike hasn’t been breached yet. Fix the bloody hole.

My previous post today on California’s problems might have been interpreted as an exhortation for the rest of the nation to forget California. Not so. But we can’t help California solve its problems without cooperation from California and part of that cooperation should be putting the state government back on the road to solvency.

And let’s not be under the misapprehension that things will return to the way they were before 2006 with California’s housing prices skyrocketing. A “return to normalcy” needs to recognize what normal is and what the aberration was.

14 comments… add one
  • Drew

    As an ex-lender, I think I have to take exception to comparing the two types of default.

    The sub-prime defaults have primarily resulted from the borrower’s inability to generate sufficient cash flow to service the loan. Classic bad credit extension, but a cash flow oriented problem.

    I believe the defaults in states where real estate prices escalated beyond all reasonableness are different. The day 1 “loan to value” percentages were too high, given the reality of the asset value. Incurrance tests (is the asset still worth this much??) have resulted in “loan to value” ratios getting way to high, perhaps exceeding 1. That is a collateral lending concept. Still bad underwriting, but two different source causes, and perhaps two situations requiring different “workout” approaches.

    In the former example, the lender is usually really hosed. Borrower cash flow has been serioulsy comprised. The bank’s funding costs exceed the ability to get a compromised level of payment. You forclose and move on.

    In the latter, the borrower’s cash flow may be fine (or somewhat compromised), but its just a loan to value covenant that has been violated. A wise lender will waive the default, work with the borrower, and take those cash payments (even if reduced), and hope to get his loan to value back in order over time. Now, unscrupulous speculator/borrowers may just do the proverbial “throw the bank the keys” and walk from the loan and the asset. But there is no way to fix this situation anyway.

    So to your point, how do we “fix the bloody hole?” I think the subprimes are pretty much lost causes. However, the high RE price problem loans are workable. So I’d focus any assitance on those.

    Of course, this won’t fit with the public sympathies toward the subprime borrowers. Hence, in my view, steely eye’d analysis loses to sob stories.
    Seems to be where our sloppy thinking culture is right now.

  • Drew

    Ooops. The bank’s funding costs exceed the economic benefit from accepting the reduced mortgage payments. You forclose……

  • Of course, this is all based on the assumption that the universally public-spirited servants who are our elected officials and bureaucrats would not have any designs on increasing their own power and wealth at the expense of the rest of us. If they did, they would be taking advantage of the crisis to move money from the private sector to the public sector, while dramatically increasing regulations and penalties for remarkably nit-picky infractions of laws that make no real-world sense. So I guess it’s a good thing we dodged that bullet.

  • I wouldn’t say I’m assuming that, Jeff. Indeed, I think that’s one of the core problems. Check my earlier post on California.

  • Somewhat off-topic, I just moved to one of the epicenters of the crisis: Orange County, CA. I don’t know what it was like a year ago, I don’t really have a baseline comparison, but while businesses — malls, restaurants etc — do seem a underpopulated, there are an awful lot of Mercedes and BMW’s, a lot of well-dressed folks, happy smiles all around. Not seeing homeless, or people living in their cars, or furniture piled on the lawn from evictions. No hobos yet.

    If you didn’t know we were in deep trouble you wouldn’t know we were in deep trouble. I’m not denying the facts, but it’s a weird depression if the Apple store is still full.

  • I wasn’t saying you were, actually. I was just being snarky, because so many people are making the assumption that I sarcastically presented, and in the face of all the evidence to the contrary. I am watching my kids’ tax burdens rise beyond any reasonable ability to pay, before they even enter the work force, and I’m a bit bitter and dispirited about that. Better sarcasm than revolution, at least for now.

  • The problem is greater than mortgages. We have also discovered that the great financial institutions have been running giant scams, such as turning subprime mortgages into AAA rated bonds. The crisis of trust that has created can’t be fixed simply by repairing problems in the mortgage industry. Our system (and as Dave has pointed out, ANY system) of enterprise requires a certain amount of trust. Now we know we can’t trust the large financial firms, nor can we trust the (government mandated) bond rating agencies, nor can we trust the public “servants” who are supposed to oversee everything. In that sense, the dike has been completely breached.

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