Steve Keen's proposed reforms

windy · 21st Oct, 2008

I think Steve’s prediction does not necessarily need to be the precise one, but it does give another possibility, which could play out. You all attack him for his ideas but is he not entitled to his point of view? Being a student of Steve's, I congratulate Steve on looking beyond simply orthodox supply and demand and instead model things in a dynamic model, which does take into account debt. We still to this day have macroeconomic books, assuming exogenous money supply in a Mundell Fleming world, look at the empirical evidence we couldn’t be further from the truth.

If feel Steve is well aware that egg may come on his face if his predictions are way of the mark. But look at economist Mr Fisher who made a statement along the lines, "Stock prices have reached what looks like a permanently high plateau" just a few days before the great crash of the 1930's, he lost all of his fortune in just a few days. A few years later he radically refined his thinking and wrote a paper on debt deflation, which is widely sighted these days. You may draw similar parallels to the current situation.

Any Doom and Gloom critics hitting out at Goldman sachs prediction of $200 a barrel for oil in the not to distant future? Im all for a good informed debate! Go check out his website, you may disagree or agree, but it may just add another dimension to your thinking.

ermen · 21st Oct, 2008

Thanks Windy for your comments... i just browsed over to his website since I had nothing to do at work and was reading his "proposals" on reforms.. which I think is rather loony, or at best shows a shallow understanding...

From Steve Keen's blog...
http://www.debtdeflation.com/blogs/2008/10/11/the-panic-of-2008/

I propose three such reforms, in full knowledge that they have Buckley’s of being implemented now–but hopefully they will be considered more seriously when this crisis reaches its second or third birthday.

1. To redefine shares so that, as do corporate bonds, they have a defined expiry date at which time the issuing company repurchases them at their issue price;
2. To impose “caveat emptor” on mortgage agreements, so that the lender’s security is limited if poor credit evaluations were done of the borrower’s capacity to meet the payment commitments in the contract (this will be further explained below); and
3. To base house price valuations on a multiple of the imputed yearly rental of a property, rather than its potential resale price.

The intention of the first redefinition of capital assets (this is much more than a mere reform) is to put some effective ceiling on how high a share price can be expected to go, and to therefore force valuations to be based more on soberly estimated future earnings (of the sort Warren Buffett now does) than on the prospects of selling a share to a Greater Fool–which is the real basis of modern-day valuations.

The intention of the second, which may look paradoxical, is to impose the risk of reckless lending on the lender. Note that a sale of a house by the lender is called a MortgagEE sale–where the suffix indicates that the BUYER is selling the house. The borrower, on the other hand, is known as the MortgagOR–where the suffix indicates that the borrower is the SELLER.

What’s going on? Simple: in a mortgage contract, the lender BUYS a promise by the borrower to provide a stream of payments in the future in return for a sum of money now. The lender is the buyer.

What if the lender didn’t properly check the capacity of the borrower to meet this commitment? If we imposed the old Common Law principle of caveat emptor–”Buyer Beware”–the consequences would fall on the buyer. At the moment, lenders avoid the consequences of poor research into a borrower’s capacity to meet the payments by getting absolute security over the asset the borrower subsequently purchased with the lender’s payment.

Were caveat emptor imposed by the courts, I think that lenders would be rather less willing to indulge in the frenzy of irresponsible lending that has marked the end of this long speculative bubble.

The intention of the third reform is to base lending for house purchases on the income-generating capacity of the asset being bought, rather than as now on the resale price potential. If a multiple of, for example, ten times annual imputed rental income were the basis of valuation, then it would be more than possible for a landlord to borrow money to buy a property, and rent that property out at a profit.

This would establish a firm link between the valuation of a house, its rental income, and the maximum loan one could secure to buy it. It would forge a link between an assets valuation and its income earning potential–a link that is so fragile in today’s speculation driven market. It would also establish a class of wealthy agents–landlords–who have vested interest in keeping house prices and loan levels low.

With such reforms, there is at least some prospect that I will not have a successor writing of the follies of the Stock Market and Housing Market Bubbles of 2060. Without them or similarly effective structural alterations, with merely regulations as were imposed after the Great Depression, we will be here again some time in the future.

My comments.

1. If you do that - you are effectively pricing equity like a bond with a stream of (discretionary/non-discretionary) coupon payments and a set redemption amounst $x in the future. Another word for a bond... is DEBT. So given his crticisms against Miller-Modigliani's proposition (which SK attests that a firm should fund itself with 100% debt - which is very simplistic), I find it rather paradoxical that he is now proposing that a firm funds itself with 100% debt. The equity tranche was created such that it is subordinated to all other payment and firms were able to raise funding without having the constraints of debt service covenants - benefit of course that the residual earnings going to the shareholder. Well eliminate equity then you are left only with DEBT... hmm... (in reality this tranche of "fix redemption shares" will trade like junk bonds).

2. Nice concept except the fact that lenders are not stupid. If they are not assured security over an asset, they will just raise rates to reflect the fact that the loan is now unsecured with a correspondingly lower lend (with the latter not nececssarily being a bad thing). Now let us assume the following for the moment though - life is normal (i.e. still normal lending and normal rates) except that there was this caveat emptor principle in place - this will create moral hazard in the first place. If i somehow am able to get a loan when I can't service it and I default, I get to keep my house, and my lender gets nothing. Great moral hazard and a punt on the upside without the correponding downside. Or on the converse, he can sue me as an unsecured creditor and I am forced to sell my house and go into bankrupcy - same result - just a longer process for the bank and higher risk - which will increase the interest rate charged. Unless of course SK is proposing limited recourse on the lender, which brings us back to the same case on moral hazard - which was exactly what caused the sub-prime crisis - where the loans were allegedly limited recourse to the borrower...

3. I don't have time to talk about this as I have to go...

Bill.L · 21st Oct, 2008

Hi all,

erman, you quoted this from who's blog???

1. To redefine shares so that, as do corporate bonds, they have a defined expiry date at which time the issuing company repurchases them at their issue price;

That has such a lack of understanding about what companies do with the money they get from floats/share offers that it is not funny.

If there was an expiry date on all shares, then any company that tried to invest in new plant/machinery/processes etc would have to be wound up at expiry with shareholders getting a return of cents in the dollar most of the time due to the fire sale.
It may sound great from an investors point of view, but as I have been a company director (private company with 18 shareholders), the directors hands would be tied. All you could do with said money is put it in cash deposits and not actually spend it on anything. It kind of defeats the purpose of a company raising cash by selling shares.

bye

ermen · 22nd Oct, 2008

Bill.L - sorry for not sourcing the thing properly - that cam from none other than Steve Keen...

I was stating that point 1 absurd because if you had a redemption date of shares, it simply meant that the company was effectively 100% debt financing his operations... A consequence would be that the company would have to re-finance every couple of years just like debt if they weren't going to do what you said and close shop % liquidate....

I don't think he has a very sophisticated view of the markets unfortunately...

http://www.debtdeflation.com/blogs/2008/10/11/the-panic-of-2008/

HiEquity · 22nd Oct, 2008

ermen said:
Thanks Windy for your comments... i just browsed over to his website since I had nothing to do at work and was reading his "proposals" on reforms.. which I think is rather loony, or at best shows a shallow understanding...

From Steve Keen's blog...
http://www.debtdeflation.com/blogs/2008/10/11/the-panic-of-2008/

This guy has now lost all my respect. To respond to his points:
1) Wha...? He doesn't like equity? He doesn't like the idea of taking a big risk to reap a commensurate reward? He doesn't like free enterprise at all! I seriously don't get how anyone can propose this with a straight face. My take is he just doesn't understand option valuation. Equity gives you the exposure to future rising earnings from a company, at minimal cost as the debt of the company funds the bulk of its resources. There is an asymmetry here - if the business booms the upside is enjoyed by the equity holder and if it tanks you only lose what you put in, which is less than the assets of the company (which is financed also by debt), especially with limited liability. That asymmetry drives investment and risk taking. If all equity was the same as debt what would be the friggin' point?

2) It's all very well and good to talk about "limited liability" or "limited recourse" for lenders but what is the exact limit? Is he saying the debt should be "non-recourse"? I hope not for all the obvious reasons! If it is something else then he should propose it. For me the current situation in Australia is perfectly sufficient. The home buyer should be giving a personal guarantee if they want the money at reduced IRs. I can see an argument however for people being able to get a non recourse option at a (much) higher IR though.

3) How would that work for valuing vacant land exactly? Commercial valuations already do this as one of their three methods anyway. I have no problem with it being one method of valuing real estate but to make it the only one is nonsensical. Again, it shows a lack of understanding of option value and the asymmetry of upside vs downside. In any valuation there has to be a recognition that future earnings (ie rents) may be much higher than current rents, and that upside is a much greater financial outcome for the equity owner than the downside case of the same probability. Therefore current value should be higher than that indicated by current rents. Valuing property without recognition of this asymmetry is one of the classic mistakes of investing.

By the way ermen, I also agree with your points.

Trogdor · 23rd Oct, 2008

HiEquity said:
This guy has now lost all my respect. To respond to his points:
1) Wha...? He doesn't like equity? He doesn't like the idea of taking a big risk to reap a commensurate reward? He doesn't like free enterprise at all! I seriously don't get how anyone can propose this with a straight face. My take is he just doesn't understand option valuation. Equity gives you the exposure to future rising earnings from a company, at minimal cost as the debt of the company funds the bulk of its resources. There is an asymmetry here - if the business booms the upside is enjoyed by the equity holder and if it tanks you only lose what you put in, which is less than the assets of the company (which is financed also by debt), especially with limited liability. That asymmetry drives investment and risk taking. If all equity was the same as debt what would be the friggin' point?

2) It's all very well and good to talk about "limited liability" or "limited recourse" for lenders but what is the exact limit? Is he saying the debt should be "non-recourse"? I hope not for all the obvious reasons! If it is something else then he should propose it. For me the current situation in Australia is perfectly sufficient. The home buyer should be giving a personal guarantee if they want the money at reduced IRs. I can see an argument however for people being able to get a non recourse option at a (much) higher IR though.

3) How would that work for valuing vacant land exactly? Commercial valuations already do this as one of their three methods anyway. I have no problem with it being one method of valuing real estate but to make it the only one is nonsensical. Again, it shows a lack of understanding of option value and the asymmetry of upside vs downside. In any valuation there has to be a recognition that future earnings (ie rents) may be much higher than current rents, and that upside is a much greater financial outcome for the equity owner than the downside case of the same probability. Therefore current value should be higher than that indicated by current rents. Valuing property without recognition of this asymmetry is one of the classic mistakes of investing.

By the way ermen, I also agree with your points.

Sorry HiEquity - I just saw this but posted a very similar thread elsewhere... I cant believe that this guy actually wrote this drivel.... Points 1 and 3 especially are the sort of uneductated ramblings you would expect from an 8 year old - not from an academic!

On 1 - I wonder if this proposal is only for "greedy" ASX listed companies or also PTY LTD companies too!! I dont think he has thought through this proposal!! Not only as you point out would nobody invest in equity anymore under his proposal, suggesting such a thing shows a fundamental lack of understanding of (a) the legal aspects of the corporate form, and (b) financial theory regarding equity/debt relationship and investments.

Agree with all your other points - On 3 - I also wonder (if such a proposal in some crazy fantasy land did work, and somehow could be limited to just resi property - the very strong upward effect this would have on rents - they would skyrocket).

Sunfish · 23rd Oct, 2008

Did you think before you typed?

3. Is how we value commercial property in this country now.

2. Is how they write mortgages in the US now and logic tells me it should have prevented the sub-prime mess if Yanks had half a brain.

1. Is an interesting concept. I would need to talk about it a bit, but it may promote a "use it or lose it" attitude in the companies' boards. Currently boards become entrenched and run the companies as private clubs with the shareholders as a minor inconvenience. As a share investor it becomes obvious that our well-being is only considered when it parallels that of the board's.

He made it clear that they were radical ideas but without someone putting them out there, nothing ever changes. You obviously have a narrow view based on your vested interest but you are out-numbered by non-investors in property. It is not guaranteed that you will get your own way.

Max Carnage · 23rd Oct, 2008

Sunfish said:
3. Is how we value commercial property in this country now.

3) I think it was poorly worded, perhaps? Lending could be restricted to a reasonable multiple of income. That would not prevent people who had saved money from productive activity from paying more than they borrowed. But it would prevent (to a large degree) the kind of unproductive - and ultimately destructive - borrowing on hope of speculative gains.

2) I'm ambivalent about. Or maybe I just don't care?

1) I would be opposed to, but that's mainly because it would upset my personal applecart! I'd have to discover a whole new way of investing in companies...

boomtown · 23rd Oct, 2008

3. Commercial is not resi in the same sense that a fish is not a bicycle.

2. Liar loans are still enforceable in the US.

1. There was a concept of par value not too long ago. Companies just set the value at 1 cent and said they were responsible for anything that happened above that level.

HiEquity · 23rd Oct, 2008

Sunfish said:
Did you think before you typed?

C'mon Sunfish - that sort of baiting is beneath you - it does you no credit at all.

In case that comment was directed at me I will make the following points:
3 - As I mentioned before it is only one way commercial is currently valued and the other methods are equally legitimate. Still dunno how it would work for vacant land.

2 - Non recourse debt won't stop Bank's desire to grow their business and write loans - as you acknowledge from the US experience.

1 - Not much point being an investor under this proposal at all.

Trogdor · 23rd Oct, 2008

windy said:
Being a student of Steve's

Poor you. I wouldnt admit this!!

By the way - and out of interest, how much of his lectures are economics, and how much are left wing social rants?

Rolf Latham · 24th Oct, 2008

I think a one step solution with better outcomes is to remove all capital from private hands and give control of it to the government

Ohhh, forgot, thats been done before .................turned out it didnt work too well in real terms.

I can really only comment on the lending side .

There are in some cases, borrowers that are given too much rope.

The true problem is that one persons rope with exactly the same circumstances is fine , but for another

So where do u set the bar, how low do u go ? The old 35 % dsr ?????? Well that wont work all the time either, because some people just wont repay their loans.

Until we do psych profiling on borrowers and a 2 year pretend mortgage, the current UCCC iand related provisions are plenty good enough.

In the end, you can not legislate against stupidity !

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Steve Keen's proposed reforms

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