The Magazine

High Anxiety

We went from playing inflation-era Monopoly to playing depression-era Monopoly in mid-game.

Sep 29, 2008, Vol. 14, No. 03 • By LAWRENCE B. LINDSEY
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For at least the past 15 years, house prices have risen in most parts of the country. Money was ample. Fortunes were made by acquiring as much land as possible and developing it. Risks were minimal. If you ran into an unforeseen event and had to sell, you could get at least as much as you paid for the house, repay the bank, and move on with a small profit. It was such a sure thing that a record number of American families bought second homes. Owning rental housing became fashionable again for the first time since the 1980s when tax law changes converted it from the one-of-each-bill version of Free Parking into the economically neutral "free space" version.

Our financial institutions evolved to meet the new rules. Lending that required the traditional 20 percent down payment became passé. In 2006, the median down payment for first-time homebuyers was just 3 percent. Proof of income (i.e., that when you passed GO you would collect $200) became optional as did basic tests of past ability to repay debts.

Most important, the accounting and regulatory rules for holding reserves against these loans evolved from hard and fast provisioning to ones based on "historical experience," meaning the low default rates of the past few years with prices only going up. These provisions were not adequate when prices went down. The reason our financial institutions are in trouble is that they are now taking back homes on which they lent 90 cents on the dollar, but which their owners can only sell for 75 or 80 cents. So, even if the bank repossesses the house, it loses money and does not have adequate provision for the loss.

The problem got more complex as financial institutions borrowed and lent to each other, creating a so-called counterparty risk. When one institution got into trouble, it suddenly couldn't pay its counterparties. That meant the other institutions began to run short of cash as well. Cash-short financial institutions had to start dumping financial assets, typically securities backed by real estate, into the market thus depressing prices further. This produced another round of problems for financial institutions and a downward spiral.

Authorities responded by trying to arrange deals where relatively healthy institutions bought the ones on the verge of bankruptcy. In the case of Bear Stearns, they succeeded in getting J.P. Morgan to deal only by agreeing to absorb potential losses up to $29 billion. But the list of potential purchasers is now getting very slim.

Whenever a financial institution expands by buying another, less solvent, institution, its own capital position is weakened. So, this phase of industry consolidation through government-encouraged acquisitions will prove quite limited. Collectively, the amount of capital that exists in the entire financial services industry is already stretched, so unless more capital is injected from outside the system, some institutions will inevitably not find buyers and will fail. (This is what happened to Lehman Brothers.) And when an institution fails, losses due to counterparty risk ripple through the system. The collective amount of capital in the financial services industry drops still further, forcing still more failures.

This is why so many people are now wondering if we are headed for an economic depression. This dynamic of spiraling failure is eerily reminiscent of what happened in the early 1930s--just as there are many good analogies between the 1920s and what has happened in our economy since the early 1990s. There are important differences, of course, but since most of us are really mini-financial institutions, the issues are not merely of academic interest. A digression into economic self-preservation in a game of real-life Depression Monopoly might be useful.

First, readers would be well advised to actually sit down and write up a budget if they have any doubts about whether their current income is covering their bills. Just to be clear, expenses include not only the minimum payment on an item like a credit card, but all the charges incurred in the month plus the minimum payment. And income does not include any draws on saving or home equity lines of credit. I once went through a budget exercise with a struggling 20-something and asked why he didn't have anything budgeted for gasoline for his car. His response was that he simply put it on his credit card so it didn't count as long as he was making the minimum payment.

Second, people should make sure that they have at least three, and ideally six, months' income saved in a place where they can get at it readily like a bank account or money-market fund. This is on top of items like retirement saving and college accounts.