Financial Wisdom From Wong’s Palace by Josh

Josh

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Josh’s Blog Post

Aug. 19, 2007

Well, now its official – the party is definitely over. Just as J.P. Morgan reportedly knew it was time to sell when his shoeshine boy started giving him stock tips, my $7.95 All-You-Can-Eat Chinese buffet dinner tonight turned into an unexpectedly educational experience.

To set the scene, picture a non-descript, medium-sized restaurant on a commercial drag in South Knoxville – no windows and 5 or 6 beat-up cars in the parking lot. You walk in and the place is about 80% empty with a few tables of morbidly obese families eating in silence. In other words, not the type of place where you’re likely to run into a lot of stockbrokers.

As I started in on my egg drop soup I overheard one of the guys sitting at a table nearby me ask his buddy, “Hey, did you see the stock market today?”

My ears perked up. When the friend replied that he hadn’t, the guy made a high-to-low whistling sound accompanied by a hand gesture describing a plummeting trajectory. I could tell that I was about to learn something.

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One of the things that make understanding the economy so difficult is that even “official” data is often manipulated or engineered to tell a story that the providers of the data want us to believe. For example, I surely don’t need to go into a detailed analysis of why it might not be a great idea to take the National Association of Realtors outlook on the real estate market without at least a few grains of salt.

These days we are told by our government that the American economy is sound. To support this claim we are shown data indicating that both unemployment and inflation are low. Low unemployment combined with low inflation is basically the definition of financial health, so if it is really true that we have both, it would indeed be strong evidence that our economy is in good shape. But the wrinkle is that it is notoriously difficult to actually measure these phenomena.

Consider inflation. Webster’s defines inflation as, “a substantial rise of prices caused by an undue expansion in paper money or bank credit”. Seems simple enough. But when you start to think about how one would actually measure such a thing, you’ll quickly realize that its not simple at all. A truly comprehensive measure of inflation would require collecting data on every single transaction that takes place in the economy. Since this is clearly impossible, those who wish to discuss inflation must do the next best thing – i.e. estimate. For example, if you want to know how much gas prices have risen in the last month, you don’t need to check every gas station in the country. If you use a good statistical sample, you could probably arrive at a fairly precise estimate based on a survey of just 20 gas stations nation-wide. But even so, that’s just gasoline. Now try to imagine all of the different categories of goods and services that make up the economy. Again, the point is that its not easy.

When our government talks about inflation, they normally use an official “price index”, for example the CPI (Consumer Price Index). A price index is a way of identifying and measuring a basket of consumer products that is judged to be statistically representative of the overall market. Now, I would guess that not one person in 100,000 has any idea what the makeup of the CPI basket actually is. Nevertheless, we take at face-value assertions that since the CPI is only up a few percent in a year, inflation is “under control”.

Now, when things start taking a turn for the worse, the government has a few options. They can acknowledge the problem and take steps to try to remedy it. The problem is that inflation has elements of self-fulfilling prophecy – if people expect inflation, they are more likely to borrow and spend, thereby causing more inflation. So, even if inflation is occurring, the government has a strong disincentive to acknowledge it. The alternative to facing the problem head-on and dealing with it is to simply pretend it doesn’t exist by changing the way we calculate the official figures.

The Fed did just this in 2000, when they changed from using the CPI to the PCE (Personal Consumption Expenditures Price Index) to measure inflation. One of the differences between the two is that the CPI includes energy and food products while the PCE does not. So, just at the time when gasoline prices were doubling, this vital factor in the household finances of most Americans was conveniently no longer included in the official measure of inflation.

Real estate is also not included in the PCE. So, despite the fact that the price of gas has doubled and real estate prices are up 50-100% in parts of the country, none of this has caused even a blip in the official inflation figures. (In fact, it might even be true that the sharp price increases in these categories could exert a downward pressure on the PCE, since the fact that people are spending so much more on things like gas and real estate may be causing them to compensate by spending less on categories that are included in the PCE.)

The point of all of this is that pretty much all official economic data, whether it be from the National Association of Realtors or the US government, must be taken for what they are – i.e. propaganda. When Henry Paulson (Secretary of the Treasury) tells us that he expects the housing market to recover shortly, or when we hear Ben Bernanke tell us that inflation is under control, we should call to mind Dick Cheney telling us that the Iraqi insurgency was in its last throes. These are all statements of what the speaker wishes would happen, not what is really happening.

———-

Which brings us back to Wong’s. If we conclude that official sources of information are biased and unreliable, what else can we use to make sense of the overall economic picture?

I would argue that simply paying attention to the world around us is one of the best ways to get a handle on the realities of the economy. For example, if the government tells us that unemployment is low but half the people you know are out of work, this might call into doubt the official story. Likewise, eavesdropping on dinner conversations at Chinese restaurants can sometimes be as informative, if not more so, than listening to the latest pronouncements of the Fed.

So, after touching on the day’s action in the stock market, my fellow diner started in on a long discussion of the hazards of interest-only mortgages. He ran through a pretty complete analysis of why these mortgages don’t make a bit of sense. The subject is now familiar to most people, so I won’t bother to repeat the litany. But the point is that this conversation was taking place in the first place.

I have had my eye on the real estate market and the proliferation of newfangled mortgage practices for several years now. Being a former financial professional, I understood from the start that products like interest-only or sub-prime mortgages were extremely risky propositions which would only be appropriate under rare conditions. The fact that they came to make up a huge percentage of the overall mortgage market in the past few years convinced me that a crash in real estate was inevitable. Now, again, this wasn’t the product of any particularly advanced economic analysis. The logic was as simple as this – if a home buyer who could ordinarily only afford to buy a house worth $200,000 (using a conventional mortgage) was convinced to buy a $400,000 house by means of an interest-only loan, the only way that person is going to be able to keep up with the payments is if his/her personal income increases dramatically. And, if you take a look around you (with the exception of the very rich, who don’t need interest-only mortgages in the first place), not many people these days seem to be making much headway in terms of personal income. Therefore, it took little more than basic common-sense to know that within a few years, a ton of people were going to be forced to sell their homes. Combining this with the fact that prices had risen so far and so fast, it wasn’t hard to see that the market was likely to get hammered at some point.

But, try as I might to engage people on this subject (no wonder I don’t get invited to many parties), few people were interested in talking about it. Even highly-educated professionals simply nodded and quickly changed the subject. After all, when the reality all around you is that people are making money hand over fist by borrowing money and investing in real estate, who wants to hear about doom & gloom? Better to get in on the action and hope you’re smart enough to get out before the crash.

Anyway, the point is that if the folks at Wong’s know the score, something has definitely changed. The only way for the greater-fool theory to work is if there is a ready supply of greater fools out there. And, not that I wish to imply any disrespect to my fellow diners, if the clientèle of Wong’s Palace is hip to the pitfalls of the smoke-and-mirrors mortgage game, you can rest assured that the supply of greater fools has finally dried up.

As the one diner said to the other, when recounting a recent interaction with a mortgage broker, “I told the woman, ‘I don’t want to hear nothin’ about no interest-only mortgage – I don’t want to even hear you mention the words ‘interest-only’ ”.

And, if all those folks who really could only afford $200,000 houses (but were conned into believing that they could afford houses costing twice that much) have finally returned to reality, it means that its going to be very difficult to find enough buyers for all those $400,000 homes that people are going to be forced to sell. Thus, as I stated at the top, the party really is over…

see:

Big Ben & The Shit-Cloud by Josh