From: dlw@odi.com (Dan Weinreb)
Subject: Re: Efficiency
Reply-To: dlw@odi.com
Organization: Object Design, Inc.
	<1992Sep4.034400.12110@odi.com> <1992Sep4.141345.10356@spdcc.com>
	<1992Sep6.035842.14635@odi.com> <BZS.92Sep6003943@ussr.std.com>
Date: Mon, 7 Sep 92 11:15:52 GMT

In article <BZS.92Sep6003943@ussr.std.com> bzs@ussr.std.com (Barry Shein) writes:

[In reference to the scenario in the previous posting:]

   Now the bank has a $2M building and a $5M (approx) bad mortgage. Where
   did the other $3M go?

   Well, it went to whoever it was you bought the building for $5M from,
   but of course they're long gone and got their money fair and square
   (in most cases.)

It all depends how you look at it.  The person you bought the building
from sold a $5M building and got $5M from it.  So he came out even,
rather than $5M ahead.  The point at which the real estate market
collapsed is the point at which $3M of wealth vanished into thin air.
The real estate market collapsed because people suddenly realized that
they were not really going to get an income from that building that
would justify a $5M price, after all.  In a real all-out speculative
bubble, the speculator probably bought the building for $5M because
real estate prices "were going up" and he assumed that meant that
they'd *keep* going up; this is optimism at its blindest, but it
happens every day, and the feeling can be infectious.

By this reasoning, value appeared suddenly as the building rose in
price.  If you look the the whole era, with the building starting at
$2M, going up to $5M, and crashing back down to $2M, then you can say
that everyone who owned the building along the line got money from the
poor schnook who was left holding the bag when the party ended.  And
since he was leveraged, his bank incurs a large part of the hit, which
can be seen as the bank's just desserts for having ever considered the
building to be reasonable collateral for a $5M loan when its "true
underlying value" was never that high.  Quite a lot of this happened
in the Eighties.

   What is not conserved is collateral value.

Right.  It's just that if you can find a bank that will accept
something as collateral, collateral value gets converted into money,
which is created by the bank.  So I agree with everything you're
saying; I was just looking at it somewhat differently.

   This is why the banks took it in the ear. That alone is a problem, the
   question is whether or not illegal/immoral/unethical acts occurred
   that either caused or exploited the situation.

Yes indeed, and that's complicated because in a typical speculative
bubble, there are always some real crooks in there taking advantage of
the situation, and yet typically most of the harm that is done is not
as a direct result of embezzlers etc., but of the unwisdom of the
speculative fever.  Of course, you can always argue whether the latter
constitutes the crime of "breach of fiduciary duty" or something.

   For example, trying to ride out the storm by offering the public
   unrealistically high interest rates (e.g. CD's) to attract cash into a
   sort of Ponzi scheme, hoping you can use the new cash to ride it out
   and that the new depositors won't ask for their money back before you
   straighten things out. And then you don't straighten things out, or
   maybe you never really intended to...

That's true, although you have to distinguish Ponzi schemes from what
banks are really supposed to do.  Banks do take your money and lend
out most of it, and hope that you won't come back for it too soon (in
other words, they hope there will not be a run on their bank).  In a
classic Ponzi scheme, the returns to the early "investors" are coming
entirely from the deposits of the later "investors", whereas in real
banking, if nobody else makes a deposit, every investor should be able
to get his money back (plus interest), at least it all the loans turn
out to be good.

   Where Dan may be right is when a bank has a mortgage on a $5M
   building, it collapses to $2M, but they keep it on the books as $5M
   trying to use it as collateral or apparent assets in order to foster
   other manipulations. From some point that excess $3M is pure vapor and
   doomed to be lost. That's where some of the illegality/unethicality
   may lie.

Yes, it's an interesting matter of policy to do accounting of
"trouble" or "non-performing" loans.  Typically the borrower stops
payments on the loan, and the bank wants its $5M back.  The borrower
may then decide to file for Chapter 11 protection.  (One of my
brothers, a lawyer, tells me that bankruptcy law is suddenly one of
the real hot areas of legal practice!)  It can take a while to go
through all the negotiations with other creditors, set up a plan, etc.
During all that time, the bank has a non-performing loan, and in order
to fairly value it you have to predict the outcome of the "workout",
which you don't know.  Accountants have various rules to handle this
sort of thing; beyond that I am out of my depth, but you can see how
such rules can't help but be somewhat arbitrary.  Naturally it gets
a lot more complicated when you're Citibank and Brazil has stopped its
interest payments...

   The stock market handles these situations better, they have something
   known as a "margin call"...
        And generally mortgages can't be called like this, there's
   just no legal (or, more likely, practical) footing to it.

Yeah, I think it's not practical because real estate is so much less
liquid than stock.

Anyway, it hardly seems surprising that banks were speculating out of
control.  Who was going to stop them?  The depositors were not
exerting any pressure; since they were all FDIC insured, it didn't
really matter to them.  The regulators were doing very little, in
accordance with the Republican/conservative hatred of regulation.
Removing government regulation without substituting market pressures
seems like an obvious formula for disaster.