The Creation Of A Bubble
I know that this is going to seem like an old and irrelevant topic to bring up now, but I want to address it because I see it as a pertinent issue based on what we see going on in the health care industry in America right now. Trust me, I will tie it in at the end. I didn't discuss this topic at the time that it came up because there was so much of it that I didn't fully understand and needed to research. By the time I got the chance to do so, I didn't feel the need to weigh in on the subject anymore. Now I do, so I will explain how the bubble is created and how it popped the best that I can. I know some pretty intelligent people read my blog, and they can correct me in the comments if I have this wrong, but here goes.
For the sake of this discussion, let's assume Mr. Black lives in a town of 5,000 people. They are 30 miles from the nearest city where one could purchase a car. So, Mr. Black decides to save up some money, then go buy 10 cars at auction for $500 each and bring them back to his town and open up a small used car lot. He will then sell the cars for $1,000 each making a profit of (just for you, Peggy Joseph) $500 on each car. He will then reinvest all of the money at which time he will have 20 cars.
Now, in his town there are 30 people who are both looking for a used car and have $1,000 cash in hand to spend on one. Hence, since supply and demand are now equal, the price he gets is the real market value of the car. Upon selling the second set of cars, he buys only ten more. This allows him to have a small supply as will be useful, but he doesn't want to flood the market which will drive down the price. But this time, he pays $1,000 each and sells them for $2,000 each.
One day, Mr. White comes buy to purchase one of his cars, which he needs to get to work. Trouble is, he doesn't have money until he begins getting paid. Mr. Black knows Mr. White, so he confirms that he indeed has the job lined up, then relies on Mr. White's good character and reaches a payment deal which will allow him to drive the car today and pay in installments. Hence, the auto loan is born. Mr. White tells his friends, and a few of them come by and make similar deals with Mr. Black. Soon, he has sold all of the cars.
Being as it is time to replace the cars, Mr. Black gets ready to go to auction. The trouble is, he doesn't have all of his money yet. He has only the payments that he has received, but that isn't enough to buy the cars that he needs to run his lot. Mr. Black decides to go to the bank and, upon laying out his good business model and showing his legally sound contracts with his customers, the bank agrees to loan him the money to buy cars. Being as his new structure will allow for more sales, he purchases 20 cars at $1,000 each. He has, however, learned from his experience. He has increased demand because people who previously couldn't get a car because they didn't have cash on hand can now buy them making payments. This, however, leaves him short on capital to purchase new cars, so he decides to sell the vehicles for $3,000 each. They are a little overpriced, but the increased demand allows for that and all parties are satisfied. Well, almost all of them.
One day, Mr. Brown comes in to buy a car. He has heard of the payment plan, and would like to take advantage. The problem is clear. Mr. Brown doesn't hold down steady employment, and often is late paying his bills. He also is bad at managing his money, and is not likely to pay the car off completely. He is, however, a likable guy, so Mr. Black thanks him for his interest but declines to provide him with a vehicle unless he can come up with the cash elsewhere. Now, the credit risk is born.
Mr. Brown is not happy with the situation. He also is friends with the Mayor, Mr. Pink. Upon explaining the situation to the Mayor, Mayor Pink sees a political opportunity. He realizes that there are a lot of people in his town who, like Mr. Brown, are nice people who are just not very good with money. He realizes that he can secure their political favor if he simply were to make an ordinance that requires Mr. Black to extend credit to everyone if he extends credit to anyone. Break out the cigars, because you are witnessing the birth of Big Government.
Mr. Black, however, is not taking this one laying down. He hires a lawyer and challenges the ordinance. The judge, who is very empathetic, can see both sides. He determines that Mr. Black shouldn't have to sell to everyone as this would surely crash his business. The judge does, however, see Mayor Pink's case of discrimination. He rules that the ordinance must be changed to require Mr. Black to sell on contract to anyone who has a job, so long as the town agrees to create a fund that will help Mr. Black deal with cases where people don't pay.
Mayor Pink is thrilled with the decision, while Mr. Black is not quite so sure. It doesn't take long, however, for him to change his mind. This ordinance has brought him all kinds of new customers who previously didn't qualify for a car. Demand is high, and he must raise his supply, so he heads to the bank to buy a new lot. They once again review his records, and being as his business has grown and he has faithfully paid his last loan, they infuse his business with the capital to buy a new lot and get some more cars. Remembering lessons of the past, Mr. Black purchases the vehicles for $1,000 but now sells them for $5,000 with ten percent down. This will allow him to buy one new car for every 2 cars sold, keeping supply low enough to justify the higher cost, but leaving him with enough liquid capital to support his business.
And business is indeed good. So good, that Mr. Black soon runs out of cash even with the higher sales price of the cars. No problem, he heads back to the bank. They review his records, and deny him a loan. Mr. Black is outraged. He has been a good customer, and made every payment on time. Why can't he get a loan? The bank defends their decision, stating that they are well aware that he will pay if he has the ability, but they don't believe that the people to whom he is selling have the ability to pay him. Hence, their decision is final.
Now, Mr. Black has to make a decision. Does he close his business? Does he stop giving credit to anyone and sell for cash only? Either option will severely hurt his profits. Then, Mr. Black has an idea. What if he could "sell" his outstanding loans to other people? Since he is paying $1,000 for a car and selling it at 10 percent down on $5,000, that means that he is only out $500 when he makes the sale. If he could get someone to buy the loan from him for $3,000 when it was fully paid off they would have a profit of $1,000. He pitches the idea to some friends, and they are interested. They come down to his car lot to make a deal.
Mr. Black, being the good businessman that he is, keeps the safer loans tucked away in his desk, and presents the riskier loans to his potential investors. The deal is about to go through when one of them discovers that he is about to purchase a loan that was made to his neighbor. He knows that she is a single mom and was struggling to get by before she got the car. Just last week, he loaned her $50 to make the payment. It would be a terrible risk to buy that loan because he is quite sure that she can't pay enough of it off to cover his investment, let alone make a profit. The deal is off, and Mr. Black is back at square one.
What is a man to do? Mr. Black is just about to shut down his business when all of a sudden he has an idea. He calls back his investors for one last ditch try. What if he sold them several loans taken apart and bundled together. This way, no individual was depending on another individual to pay a loan. You were instead depending on the average rate of payback for his customers, and that would indeed profit everyone. They shook hands on it, and the "car loan" backed security was born.
Everything looked good on paper. The problem was, the average rate of payback included the first batch of cars that he sold only to good credit risks, and didn't include the last batch of cars he sold mostly to bad credit risks. It certainly didn't take into consideration that he was going to take this new infusion of capital to the auction and buy a new round of used cars to sell to high risk buyers, but that is precisely what happened. And upon selling those cars he bought more with the down payments and brought them back to his lot.
Mr. Black wasn't too worried when the first customer quit making their payments. After all, he could reposes the car and sell it again, right? Trouble is, the motor was blown. That week he had to take two more cars back. And, being as he sold so many cars, demand was now down. It was when he had to squeeze those two cars onto the lot that he realized that the supply and demand table had begun to turn on him. Suddenly, his price of $5,000 was too high. He lowered the price all the way down to $3,000 before he sold another car. But as the repossessions continued, he was now struggling to make his payments on his loan from the bank. Soon, he had to take a round of cars back to the auction, where he got $250 less per car than what he had paid for them.
And that is when his friends came by to check on their investments. They were all going to lose money big time on this one. Then, Mr. Black remembered the account set up by Mayor Pink to cover just such an occasion. The Mayor was outraged when he heard how many cars Mr. Black had sold to these high credit risks. He called Mr. Black greedy, and informed him that the account didn't have sufficient funds to cover his losses.
At this point, the story can go one of two ways. If Mr. Black is "too big to fail", then a Government bailout is born. If he is not, then a bankruptcy will happen. That part is irrelevant for our purposes here, because what we just witnessed is the burst of the bubble.
The bubble was created when Mr. Black began selling cars to people who could not afford them. It became a bubble because the increase of demand artificially raised the market value of the vehicle far above the fair market value. Thus, the new lot he purchased was bought on false perception. It appeared that he could afford it because of the inflated prices of the vehicles. But once supply began to exceed demand, the market began to correct itself and prices began to head back to the real value of the cars. His increased demand at the auction had driven up the price of their supply, and they wouldn't feel the pinch until after he did, and by then it was too late because he didn't need to buy any more new cars because the ones he had sold to those who couldn't afford them were coming back.
The question is, was Mr. Black greedy? It is fair to say that he became so. He was warned by the bank that he was in over his head, yet he pursued other means to continue to grow his business. But where did the greed start? Remember, Mr. Black didn't want to sell to bad credit risks at the beginning. This was standard practice in the home loan industry prior to the Community Reinvestment Act. But community organizers like Gale Cincotta said that it was unfair for the banks to only lend to good credit risks. So despite the protests of the bankers, the law was passed.
This action flooded the housing market with new potential buyers, creating high supply and low demand. Thus, it seemed good to the sellers. The price of real estate took a steady climb upwards. And that is when some in the banking industry began to get greedy. Standards were lowered to the point that customers were not only loaned the money to purchase a house, they were loaned the down payment money. Whole industries sprang up built on the demand, and we began building "pre-fab" homes in factories. It was great for everyone, especially the politicians who passed the bill and continued to support it. You see, the Democrats just 20 years earlier had filibustered the civil rights act, and that had given them a bit of a political black eye. Since many of the poor neighborhoods that had previously been "undeserved" (denied loans based on their inability to pay) this was a giant step in repairing their standing with the voters they had just oppressed. The greed reared it's ugly head on Pennsylvania Avenue long before it ever made it's way to Wall Street.
But it is also true that the bankers did become greedy. They knew it wouldn't work at the start, and they got several reminders along the way. Yet when the burden of their bad loans became high, and their capital was strapped by low or no down payments, they didn't stop there. They just took the bad loans, strapped some good ones to them so they would sell (or got the backed by Freddie and Fannie), and used the capital to make more bad loans. They already knew what Mr. Black learned, but they just didn't want it to end.
All of this leads us around to the point of the matter, and this is largely insensitive, but that is completely in character for me anyway. I am aware that some people are ill or disabled, and thus unable to work. That having been said, the vast majority of people who can't afford to purchase a home under standard lending procedures cannot do so because of their own decisions in life. I say this as a person who does not own a home, and would not qualify to buy one. Yes, I am a member of that group. Hence, I understand that for some people like myself, owning a home just isn't a high priority. For others, they would like to but made bad decisions such as dropping out of school, borrowing money they couldn't pay back, or marrying the wrong person and find that their credit is too poor, or their income is too low. Hey, it happens, but if all of is in this group will be honest with ourselves, most of us know why we are here and what we could have done to be somewhere else. Live and learn, right?
What the CRA did was punish those who had made the right decisions by rewarding those who had made the bad ones. Many people who had saved up and protected their credit were priced out of the market before they could buy. My sister constantly gets credit card offers in the mail, and one day she wondered aloud to me why they send them because her income isn't that high. She gets them because she knows when she is priced out, and doesn't buy things she can't afford. People who have great credit have it because they act in a similar manner. They rented. Those of us in the other group (although this is one mistake I avoided, mostly because I am always traveling so owning a home doesn't appeal to me) bought anyway, and many of us lost.
But what in the heck does this all have to do with health care reform? Simply put, some people don't have health insurance because of a medical condition that is no fault of their own. Others can't get it because of health problems based on bad decisions that they made, be it cancer caused by smoking (again, guilty), liver problems from drinking (am I preaching to you, or me?), or stds from unprotected sex or sharing drug needles (dodged that bullet). Others don't have insurance because they failed to get an education and thus cannot earn enough to purchase it or get a job where it is a benefit. Again, their fault.
Much like bankers were told that the CRA would make them better off because they would have new customers, we began telling the insurance companies that they would be better off because we would be infusing them with new revenue streams if we passed HCR. We even had the CBA look out 20 years, and sure enough, everyone gets better coverage and saves money. Remember though, we began giving the high credit risks home loans in 1977, and 20 years later in 1997 it still looked like a good idea. How did that work out for us in 2008? Not so much. While it is possible, though less likely, that we could be satisfied with HCR in 2030, how will we feel in 2040 if the whole thing goes under and we need a bailout? Lending money to bad credit risks is irresponsible. So is giving health insurance at the same costs to bad health risks.
Wow, that is sure insensitive, isn't it? Some will say yes, I say no. Think it through. The Government is already practicing the 5% in 5 year rule (meaning five percent survival rate five years from now) in determining if people on medicare will get treatment. Of course, people have the option of paying out of pocket, but most don't have that type of money. So what does this ultimately lead to? People who cared for their health and avoided risks like smoking, high fat diets, and unprotected sex will be denied treatment (based on 5 in 5) in order to treat those who took risks that resulted in lung cancer or hiv but have a fifty percent survival rate five years out if treated. That, to me, is insensitive.
But it gets worse. At what point do the health insurance companies start to see their ability to fund treatment drop based on providing more than they are being paid, much like what happened at Mr. Black's car dealership? Do they then sell health backed securities to keep it all afloat? Do the feds start a "Nursey Kay" and "Doctor Smack" to encourage them to go even further? What happens when the need a Troubled Asset Relief Fund? Will they start to fall? If so, does the Government step in and take them over as they did with General Motors and some of the banks? At some point, the money is no longer there folks. Yes, some of you will have it, but when the Government becomes the sole provider of insurance and health care, where do you go when they deny you treatment?
I know, I know. I will be called a fear monger. After all, none of this has happened yet, right? Not here. But maybe the 4,000 women in England who were forced to deliver babies in hospital hallways and bathrooms might say it is already here. Maybe the people with MS or Ovarian cancer who are being denied treatment in England wish they had an insensitive guy like me around to point out these problems before they handed over there health care system to their Government.
Rationing is already being discussed here. Indeed, President Obama's appointment to oversee the implementation of HCR says “It’s not a question of whether we will ration care, It is whether we will ration with our eyes open.” The New York Times described rationing this way.
Is there any limit to how much you would want your insurer to pay for a drug that adds six months to someone’s life? If there is any point at which you say, “No, an extra six months isn’t worth that much,” then you think that health care should be rationed.
I think we could all agree that $6 trillion is too much to extend my life for 6 months. Indeed, after reading this, some of you are thinking that $6 is too much to extend my life for 6 years. So since we all agree that rationing is the way to go, I would like to thank the NYT for being idiotic in a grandiose fashion previously reserved for Media Matters readers who leave comments typed in all caps. I, on the other hand, am being completely serious. Since under this standard we all do agree with rationing, then let's follow this thought to it's logical conclusion. There is another form of rationing available. Those who can pay get, those who cannot receive what treatment charity, friends, and family can afford to give them. After all, Berwick was right. At some point we have to ration. Why don't we the people decide when and where rather than leaving it to the same people who "fixed" our housing problems so well with the Community Reinvestment Act? Feel free to fire away in the comments below.