Banking, Western versis Mideastern

(I'll try that again, and hope the admin takes mercy)

As our debt crisis is all about banks charging (unrealizable) interest on loans, must that be inevitable? Islamic banks are forbidden to charge interest. Therefore they had to find other ways to share the risk with the borrower. Could we learn from them? Here is a comparison worth considering if we're going to stay competitive and "keep up with the Azizzes."

http://www.topmba.com/articles/jobs/...can-west-learn

Also, I think it's noteworthy that the people over there keep a lot of gold underneath the floorboards of the head-of-the-family's home. But that's another method predating our current system, although it would rollback the high inflation rate at the backside of our credit-based fiat currency based banking system. Again interest rears its ugly head, especially for us!

Yes, by all means. Let's learn how to do banking from a culture whose most significant contribution to the world in the last 500 years or so, outside of a few magnificent buildings like the Taj Mahal, has been the concept that suicide bombers engaging in acts of terrorism are "heroes".

I’ll also observe that keeping “a lot of gold under the floorboards” (or other things of tangible value immediately on hand) is not unique to the Islamic world. Rather, it’s a typical historical reaction to political and/or economic instability. Cultures and nations who trust their political and economic institutions tend to invest their capital vice keeping it under the floor – and thus out of the market and unproductive.

Now, regarding banks charging "excessive interest" rates. Interest rates charged by banks are a combination of supply and demand, current/expected rate of inflation, and risk. In a free market, it's a very efficient mechanism of balancing these three competing interests. Set too high, you get no business; set too low, you lose your shirt. The market ensures that things come to equilibrium - at least, as close to equilibrium as any dynamic system can - rather quickly.

Further: for investments involving relatively low risk - e.g. a conventional mortgage loan to a US customer rated as being a good risk - you'd be hard pressed to find a period of time over the last 45 years that had lower interest rates than today. (Mortgage rates today are lower than the rates my parents got 45 years ago when they built a house - and they were good customers.) It's only those investments having a ridiculous level of risk of not being repaid (e.g., Greek and/or Italian bonds) that have very high interest levels.

And loans involving extreme risk should have very high interest rates. In those cases, lenders are accepting serious risk of loss. They should thus recoup more on their loans - which, from the lender's perspective, are their investments in the future. High-risk investments generally involve higher potential payout.

Well, those are some good points, Hondo. But the interest charged versus the risk of the investment has only seemed to be proper. Take the value of houses for the main culprit. Government edicts for the American Dream forced banks to support untrustworthy borrowers (hence the housing bubble). Interest rates charged them were relatively low, but not if the supposed value of the homes was inflated beyond the means of the payers. If banks had looked at the problem more objectively, without reselling the mortgages and all to speculative funds, the buyer would have gotten an even lower rate, if they'd been accepted at all.

It's a house of cards, you see. The whole system is corrupted. We too are living in the kind of times you say they have enjoyed in the middle east since the year 700. Only they have known it longer, and have found other ways to deal with it. Alternative ways to consider. Ways that might not pump up the total and national debt to unrealizable levels.

Here's a link... http://mises.org/Community/blogs/fdo...s/default.aspx

The current real estate situation is part of the normal boom/bust market cycle. It's happened before; one of my great-grandparents made quite a bit of money in the 1930s buying overvalued and/or forclosed property for pennies on the dollar. (Sadly, none of that $$$ made it down to me.) And if I recall correctly, we saw the same happen in Japan in the 1980s/1990s with Japanese commercial real estate.

IMO, you're correct regarding cause, but not regarding mechanics. The root cause of today's real estate crash is indeed ClinToon-era (deliberate spelling) regulatory changes, coupled with political pressure by the ClinToon administration on banks to "loosen" mortgage qualification procedures. The intent was to make it easier for Americans to own their first homes, particularly in minority and low-income areas. And the ClinToon administration put huge pressure on the financial industry to "make it so".

However, the mechanics producing the real estate crisis were simply the routine, clearly foreseeable workings of the free market. More demand = rising prices. And demand for bigger (and more expensive) houses because you can now qualify to borrow more also means rising prices. Adam Smith knew what he was talking about re: supply and demand and prices.

Unfortunately, what should have been obvious and easily foreseeable second- and third-order effects of these policies were missed (or ignored) by ClinToon and his financially-naive cronies. And these second- and third-order effects were the mechanics that led to today's real-estate difficulties.

Second order effect? The mortgage qualifications in effect previously were largely risk-based. Liberalization of qualifications forced banks to accept more risk - but since inflation was also relatively low, they couldn't justify higher rates across the board (and if I recall correctly, were precluded from doing too much to adjust interest rates for risky customers based on risk - the ClinToon administration would have considered that "discriminatory", since many first-time buyers in low-income areas were minorities). They also introduced new types of loans (or marketed inherently high-risk types of loans more aggressively), as these inherently riskier types of loans (interest-only, ARMs) were often the only mortgages that first-time buyers could afford on their current income. Thus banks were effectively forced to make a huge number of risky loans at interest rates far lower than normal market principles would have demanded for that type of loan.

The third-order effects: since it was now easier to get loans, and there were now more options (the "interest only" loan first appeared late in the ClinToon administration, if I recall correctly), many middle-class homeowners "traded up" - and unfortunately got in way over their heads. During this period, the size (and cost) of homes began to increase dramatically - to the point where "McMansions" (3500+ sq ft, 4-5 bedrooms, 3+ bathrooms, 2-car garage, etc . . . ) began to be the norm in many new subdivisions vice the exception. Plus, rising prices meant they could sell an existing home at a profit - or use it's equity to borrow money for vacations, new cars, etc . . . . People wrongly assumed that real estate prices would continue to rise ad infinitum. In many cases they also bet the house (literally) on a future promotion or raise that would allow them to cover mortgage payment increases due to adding principle repayment or ARM interest-rate rises when they occurred. And many simply guessed wrong.

When an economic downturn inevitably came, the real-estate bubble (predictably) popped - and here we are. Fully predictable, and almost completely caused by purportedly well-intentioned but shortsighted and naive ClinToon-era regulatory and policy changes. In fact, I contend that this ClinToon lunacy was one of the root causes (if not the root cause) of our current financial mess vice a symptom.

Thanks, Billy-boy. I always heard "Willie wants your wallet." It took a few years, but your misguided policies finally got it.

Regarding your contention that we need to "rediscover" financial principles that the Islamic world uses - I think you need to recheck your facts. We knew them 1000+ years ago. For then, they were adequate. Now, they're not.

The Western world used those same principles virtually exclusively prior to the rise of modern financial institutions. One can make a good argument that the creation of modern financial organizations during/after the Renaissance, and the resulting capital influx caused thereby, is a major reason why Western society advanced so much more than the rest of the world during the Renaissance and afterwards. The rest of the world, which generally retained those older forms of finance, advanced at a much slower pace.

Or, in the case of the Islamic world, stagnated - due largely IMO to it's intolerant, insular and theocratic culture.

Clinton was involved along with Freddie Mac promises of underwriting, so it wasn't a normal boom and bust cycle, as Shumpeter would have had it. Also the banks passing on the risk to hedge funds and pension CDs fooled everyone, even their own auditors... Doubt it's ever happened on this scale before.

Government and banks together fueled speculative over-buying both with malfeasance and liberal distortion of the system... Oh, and you don't need to go back a thousand years ago to find a time when gold was the standard, although the vikings did have a form of exchange called hack gold, weighed pieces cut off of treasure made off with from Byzantium, where they staffed the emperor's Varangian Guard. Even so, soon the conquering Ottoman Islamic waves fell down hard and mean on the Eastern Empire (after the emperor banned foreigners from leading the Guard, owing to the young Norwegian King Hardrade, leader of the Varangian Guard, putting out the emperor's eyes. This after strangling a lion in the collosium where he was put at risk as punishment for loving the emperors neice (according Hardrade's Saga).

About four hundred years later the Eastern Empire was destroyed by the Ottoman Empire in 1453. http://en.wikipedia.org/wiki/Fall_of_Constantinople The Muslims "stagnated a thousand years ago?" Hardly. We only live five hundred years after their hey day.

Certainly the gold standard was employed by both empires. But after Byzantium fell, Europe switched to silver, then finally back to gold much later, and even the US had that hedge against hyper-inflation until 1934, I think it is said...

http://en.wikipedia.org/wiki/Gold_standard

As for the other idea they use in Sharia banks, they are said to find ways to share risk without charging interest, which is forbidden. And why should charging interest be so sacrosanct to us? Why shouldn't risk be shared by the banks the same as with any other investor? A share of the profit. Or loss. (Oh, that's right. Obama's treasury is staffed by weasels beholden to the system such that the banks must be insulated by taxpayers.)

Please, just forget Islamic banking was ever mentioned here. I regret clouding the issues with a hot button like that. Just look at the facts.

While it's unclear from the context whether you're referring to something I posted or Wikipedia regarding Islamic culture "stagnating" 1000 years ago, the Wikipedia article you cited doesn't make that statement. I therefore assume you're talking about something I wrote.

Please re-read my replies here carefully. If you do, you'll find I made no such statement. As a general rule, I find that being correct when making accusations lends credence to one's arguments.

Also, you obviously missed a few things along the way relating to financial history. Concerning truly huge real-estate-bubble-fueled financial crises, we've seen this movie before - less than 30 years ago, to be precise. Or perhaps you simply aren't old enough to remember the 1980s S&L crisis?

The 1980s S&L crisis was caused by (1) ill-advised inflationary economic policies in the Carter Administration which set the stage, starting a "bull market" in real estate; (2) foreseeable but unanticipated consequences of financial-industry deregulation (specifically, the 1980/1982 S&L deregulation laws passed under Carter and Reagan, respectively); (3) generally poor financial health of many large S&Ls at the beginning of the 1980s due to inflation and/or accumulated bad debts; (4) the end of high inflation (and consequent slowdown in the rate of real estate value increase) under Reagan; (5) 1986 tax law changes eliminating many loopholes that formerly supported speculative real estate investment. It ended with a significant market downturn.

Sound familiar? It should. The current financial crisis parallels the 1980s S&L crash nearly perfectly, just about 20 or so years later.

Sheesh. You'd think we'd have learned.

Oh, and yes: I'm well aware that the US went off the gold standard in 1934. But the merits of the gold standard are an entirely different discussion than the one you started here. Your argument was that we could learn from Islamic banking practices. My position is that we learned all we needed to know about their current practices by 1500.

You didn't say a thousand years. You only said, "Or, in the case of the Islamic world, stagnated - due largely IMO to it's intolerant, insular and theocratic culture." I got that thousand year figure from somewhere else. Sorry.

But again, let's just say they found different ways to manage risk. Since they have a different system and ours is in trouble, I'm just saying we should make sure their alternative to interest charging banks is worth looking at. Also, I do mention the gold standard difference pretty early on. Even in the tags of the blog itself.

Let's not be too insular ourselves, I say.

That Savings and Loan failure only cost $87 billion... http://en.wikipedia.org/wiki/Savings_and_loan_crisis, while the current debacle looks more like $237 trillion? http://www.ritholtz.com/blog/2009/07...llion-dollars/

The mind boggles, even if we think we already know everything.

You're a bit off here. In 1996, GAO estimated the overall cost of the S&L fiasco at roughly $500 billion - in 1980s dollars. That would be equivalent to somewhere between $1 and $1.5 trillion in today's dollars.

http://www.nytimes.com/1996/07/13/bu...n-dollars.html

I'd also take the overall cost you cited for today's financial crisis with a rather large salt crystal - say, a chunk of rock salt weighing about a pound. My guess is that today's financial contratemps will cost more than the S&L fiasco. But based on the inflation-adjusted amount of public money involved, I'd guess by a factor of around 3 or so. In today's dollars, the S&L bailout cost somewhere betwen $260 and $390 billion in public funds. That's between 1/3 and 1/2 the cost of the 2008-2009 Wall Street bailout. I'd guess that private lossess will be proportionally similar to those experienced during the S&L crash.

You cite the New York Times to show that the GAO put the cost of the Savings & Loan Crisis at $130 billion? Hmm. Yet the GAO report itself looks different... My citation was to The Resolution Trust Corporation (RTC), a United States Government-owned asset management company. Maybe they are less stringent than your Government Accountability Office (GAO). But then, that New York Times figure looks off on that august authority also...

I see on the GAO report, actual page 13, a table that sure enough does mention the RTC 87.9 billion figure, and then they add “direct and indirect” costs to get a grand total of 160 billion. Even worse than the cost you mentioned from the gray lady NYT... http://www.gao.gov/archive/1996/ai96123.pdf (Whew!) It's always better to go to the actual source, isn't it? Or in this case, even worse But in today's dollars, that higher figure would still only be 184 billion in today's dollars, according to this site... http://www.1soft.com/todaysdollars.htm

But the Savings & Loan Crisis figure is humongous nonetheless. As for the current Banking Crisis, let's just say it's a heck of a lot more. But I'm not sure it matters how much, much more so far as this being the bigger disaster goes. It is what it is.

I suppose you have your own solution? I am most eager to hear what that might be. Do you favor some other kind of banking reform not mentioned here so far? Just please don't give us for a solution any more "rock salt" to rub into our bleeding taxpayer wounds, okay? (I'm kidding, but I'm serious too). So what is your plan, Honda?

Yes, it’s generally better to consult primary sources.

That is, it’s better if those primary sources actually support your argument; otherwise you end up looking kinda foolish. So you should always read a primary source completely to be sure it actually supports the argument you're making.

Here, it’s obvious that the NYT read the report in detail – and if you did so, you either missed or ignored quite a bit.

In your posts above, you only discuss direct costs of the S&L bailout ($160 billion), and for some reason appear fixated on the RTC costs - which at one point you pronounced to be the "cost of the S&L failure". As title of the last paragraph on p. 12 of the GAO report you cited clearly states, "RTC’s Costs Represent Only a Portion of the Total Cost of the Savings and Loan Crisis". (emphasis added) In fact, the RTC costs are less than 20% of the total - and the direct costs of the S&L bailout are only about 1/3 of the total bill.

The NYT clearly indicated that it was talking about direct public (e.g., taxpayer-paid) costs when it mentioned the $130 billion figure - and Table 3 on p. 13 of the report you cited clearly shows the public (taxpayer) direct cost of the S&L bailout to be a bit over $132 billion. (Adding the $28 billion in direct private costs found in that table brings the total direct cost of the S&L bailout to $160 billion.) I thought I rather clearly indicated I was talking about public (taxpayer) direct costs when referring to the $130 billion figure; I likewise found the NYT article explicit on that point as well. I guess you must have somehow missed the fact that the NYT (and I) were referencing only the taxpayer direct cost when discussing $130 billion in costs.

For comparison, if I recall correctly the direct taxpayer costs of the 2008's TARP were originally projected to be around $700 billion - larger than the S&L crisis, but only by a factor of between 2 and 3 after accurately correcting for inflation (more about that below). Further, TARP costs to date have been significantly less than projected - see http://www.cbo.gov/ftpdocs/121xx/doc...03-29-TARP.pdf Per this March 2011 document, both the CBO and OMB now estimate that TARP will cost far less than originally thought - e.g., total outlays of about $450 billion vice the $700 billion originally authorized. In fact, recent statutory changes have reduced the TARP authorization to $475 billion. And as of March, $244 billion of those outlays have already been been repaid. I don't remember hearing about the S&L fiasco having much in the way of post-bailout repayments.

In any case: the direct costs were not even close to the total cost of the S&L bailout. For the full cost, you need to also look at Table 4, p. 19.

The GAO report you cite identifies other costs over and above those paid by the RTC – starting with the nearly $65 billion spent by the FSLIC during the crisis due to failed S&Ls (another direct cost) and the $7.5 billion in tax breaks granted to institutions participating in S&L consolidation (also a direct cost). However, it also goes on to identify indirect costs (Table 4): the nearly $112 billion in interest on bonds issued in conjunction with the S&L fiasco, and the $209 billion in other interest costs. In your post above, you ignored the indirect costs shown in Table 4 entirely.

Adding the numbers in Tables 3 and 4 gives the total cost of the S&L fiasco. This total cost indeed turns out to be reasonably close to $500 billion (about $481 billion), all but about $28 billion of which appears to be cost to the US taxpayer. Both the NYT article and I also gave the total cost of the S&L bailout as "nearly $500 billion" - and were, according to the GAO report you cite, essentially correct. By focusing only on the $160 billion in direct costs (and the $88 billion for RTC), you missed about 2/3 of the total cost of the S&L bailout.

Your inflation adjustment figures also appear to be incorrect. CPI is the generally-accepted metric used to adjust for changes in the buying power of money due to inflation; the US BLS is considered the authoritative source of CPI data. Per the BLS CPI-based inflation calculator, a dollar in 1980 is worth $2.75 today; a 1989 dollar is worth $1.83. The linear average for the decade 1980-1989 is $2.194. Using this average as a benchmark, my ballpark figure of a factor of between between 2 and 3 for inflation since the 1980s appears reasonably close. This makes the taxpayer direct cost of the S&L bailout - which is the correct figure to compare with TARP - worth approximately $275.8 billion in 2008 dollars ($132 billion x $2.194/$1.05 - a 2008 dollar is worth $1.05 today). And that also makes the total cost of the S&L bailout worth approximately $1.005 trillion in 2008 dollars.

In contrast, the web site you cite for inflation adjustment appears seriously out to lunch. And since the website you used claims to use BLS CPI figures to calculate inflation, I think I'll believe the primary source here (BLS website) vice a questionable third-party implementation.

http://www.bls.gov/data/inflation_calculator.htm

To answer your question of what we should do: hell, if I had that answer I’d probably know enough to be making obscene profits on Wall Street and "living large." No, I don't know with certainty the best way forward. But reverting to literally Medieval methods of financial management (as you suggest) certainly doesn’t seem to be the answer.

Alright...

But to get more specific: I wonder if I should I switch our mortagage to a Sharia compliant deal to save money? As I read it, although I'd eventually have to pay the whole schmeer anyway, here is this: if I ever pay late I pay a fixed low penalty (whatever that means). That is the only advantage I can see so far, as detailed here...

http://ihfp.wharton.upenn.edu/Main%2...%20program.pdf
Still there is a question about the ultimate financing if I fail before I bail, since I'd have to buy the whole property even before I could sell it, although then I'd make exclusive profits

But in that eventuality it looks like I'd have to get supplemental conventional financing anyway, since I have no gold stashed under the floorboards to draw upon. I could be wrong about this alternative, but help me out here... This linked Sunni fatwa-based analysis says, “Paying the financier is not a pre-requisite in order for the transaction to be valid, for it can be a credit-sale (italics mine). Thereafter, the client may go ahead, sell his property and pay off the debt that he owes to the financier”...
http://qa.sunnipath.com/issue_view.a...D=8603&CATE=44

A so-called credit sale, what is that? if not borrowing money from the bank? Not sure this avoids Western-style interest payments even after reading the article that claims to answer it. Obviously the fatwa is not Byzantine, but still I'm confused, although I'm thinking there might be some kind of an advantage here, depending on the timing, the cycles of boom and bust and all, but I'm just not sure, being no Muslim myself. Dare I switch? Does my wife have to wear a headscarf? Just wondering...