What is Obama trying to do? Is this just a small part of the
problem?
Understanding the housing crisis in USA (and Colombo?)
We in Sri Lanka are so much obsessed by the politics of the local
scene. But Minali and her husband who live in New England are not
concerned about US politics.
 Their worry is how they can sell the two houses they bought, apart
from the third house they live in. They had bought them just over two
years ago hoping to sell them at a higher price and a good profit.
They had seen house prices climbing in the last two years and were
waiting to sell when the prices reached the peak. But where is the peak?
Before they could say “Hey Diddle Diddle The Cat And The Fiddle,The Cow
Jumped Over the Moon” the house prices began to fall. Is the situation
in Colombo similar? Or will it become like that soon in the housing and
real estate business?
It is well known that the real estate prices in Colombo are at the
same level as USA prices in premium markets on the west coast and east
coast. That is at the current rate of exchange, which is pegged to a
percentage over hundred rupees per dollar.
How are the Colombo prices so high? Is it because there is no
alternative avenue available for investors where they can be safe, after
the outbreak of the Sri Lankan war? Or is it just the shortage of land
in Colombo compared to increasing demand for housing? Maybe.
Cause and effect
Perhaps the Colombo housing market bears no resemblance to the US
market where there are so many factors at play that one can become quite
busy trying to figure out the chain of cause and effect.
That is why Brooks, a “talking head” in a panel of the National
Public Broadcasting TV news hour said on 17th August, 2008 “Congressmen
will never understand the workings of the financial markets to legislate
to regulate them.” If that is true I am in good company. When I studied
economics at the University of Ceylon I couldn’t make much out of what
they called “money and banking.”
Intricacies
Later on when I studied economics at Oxford I didn’t try to
understand the intricacies of what is called the “City” or the
“financial district” of London, which was the real world that money and
banking tried to explain with such phrases as “money at call and short
notice.” But just now I hear so much talk of the “credit crunch” that
has caused an “incipient panic” in “global markets” that I feel left out
if I don’t try to figure out what the talk is about.
Like the Central Bank in Colombo the Federal Reserve Bank of USA is
at the apex of the financial system. On the 17th August 2008 it
decreased the “discount rate” by half percent. Why? What bearing does it
have on house prices etc?
Here is one explanation. It may not be adequate. But as they say in
hermeneutics, which is a branch of the theory of interpretation in
literature, you understand only a part of a text at any one time and
that will change when you tackle the text the next time. So every time
you explain you get a different view. Is this true? The Economist of
18th August 2008 has an article on it. The Wall Street Journal, (which I
am told now owns the Economist too (!) and both I am told are owned by
Dow Jones, which itself is owned by one family), carries front page
articles on it every day.
Concession
The live debate among the Democratic candidates featured this topic.
“What do you think of giving a concession in the rate of interest by the
Federal Reserve thru a discount window open only for banks?” Brings
ripples of discontent about the role of banks in USA as well as in Sri
Lanka. Apparently the restrictions that banks were subject to in the
interest of good governance in USA have been removed and banks can be
both lender and lendee.
What avenues for corruption that opens up! The strongest and most
general comment of the candidates was on the need to restore the
separation of powers in government or a system of checks and balances in
USA to restore and recover the country from two terms of Republican
misrule.
How appropriate for Sri Lanka too which has slavishly imitated USA.
The Democrats said that while the lenders were being protected by the
Fed it was the borrowers, the house owners who needed to be protected.
Can one transfer this issue too to the Colombo situation? And so the
show goes on.
Intermediaries
An interesting and crucial aspect of this present mystery in the
money and banking business is how a chain has developed linking various
intermediaries between the buyer and the seller i.e. the buyer of the
house and the seller of the house. First of all there is the realtor and
the lawyer who would be the only intermediaries if no loan was involved.
In Colombo even the realtor is not required though now the realtor is
emerging as a powerful and visible figure. In Colombo you get a loan
from a bank or some mortgage institution and deal with the seller or the
seller may also make the loan available as part of the deal. A lawyer /
realtor comes into the picture to see that both sides are well served
and they gat a fee or commission.
In USA (and probably other developed countries) the mortgage
institutions (like the State Mortgage Bank in Colombo) are virtual
banks.
Collateral
They give loans. The loan is secured against the house, as
collateral. If the borrower does not pay the instalment on the loan, the
ownership of the house accrues to the bank, which “forecloses” it and
tries to recover its loan by selling it. This is the way the village
mudalalis in Ceylon accumulated capital by giving loans to fellow
villagers on terms which they did not understand.. And perhaps also the
way that real estate companies deal with people who but their land on
terms, which they cannot understand either.
That’s fairly easy to get. However in USA the mortgage institutions
“sell” these loans to banks i.e. offer them at a lower rate or
“discount” and those banks in turn sell them to other parties, including
the “public,” which term denotes huge finance houses like Merryl Lynch
and hedge funds and huge pension funds (these are called “investors” and
are basically orgs playing around with money not as a means of exchange
but as a commodity) in the form of bonds.
Mortgage
Bonds are promises to repay money borrowed from “investors” on
certain terms at a certain time. So banks converted a promise to pay,
(which is what a mortgage also is), to their own promise to pay to other
parties (the “public”} and got money from the “public” as loans.
Now these bonds were not only bought by Americans but also by
foreigners such as the Japanese and the Germans as investments, in
dollars from which they would get more income (rate of interest or
“yield”) than if they lent their spare money locally. So all these
parties were participants in a transaction, which consisted of buying
and selling a house. The pyramid rested finally on the buyer being able
to pay his instalment. If he could not, the promise of the big banks to
redeem their bonds would be undermined. If he could not pay his house
had to be sold to recover the value of the house.
It was the value of the house, on which rested the value, the traders
in money were developing with their various instruments and tactics such
as hedge funds and bond issues. What happened to make it difficult for
house buyers to pay their mortgage instalments? A couple of years ago
when George Bush started the Iraq adventure a recession was looming and
the Federal Reserve led by the famous Greenspan reduced the rate of
interest to one per cent! This opened a flood of funds from the monetary
system. The idea was to create economic activity by creating money. But
why should intermediaries like banks provide money at such a low rate of
interest when they could charge more? So they lent at higher rates and a
pyramid was created like the one I have described above, with each layer
getting a small part of the unearned income (interest) till finally the
borrower of the money to buy a house paid say 5%. All kinds of mortgages
were created.
You could pay 1% for the first two years and then the loan carried a
variable rate at the discretion of the lender, the mortgage company. So
you could be asked to pay 5% in year 3 and 8% in year 4. Then you will
have to go shopping for someone who will lend at a lower rate and
transfer the mortgage to the new lender. So the principle of competition
would create fair play. That was the theory.
Inflation
However the Federal Reserve began to increase the rate of interest
gradually to control the inflation, which it had created and the rate of
lending, which itself varied from year to year for the buyer became more
and more. The original perspective within which the buyer bought has
disappeared and he is now faced with an impossible situation where he
does not have the money to pay his instalment.
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