High-profit Prisons & Low-profit Mortgages

As Lily Tomlin says, no matter how cynical I get, I can’t keep up. Here’s an example of why: two judges from Pennsylvania were just charged with taking millions in bribes from owners of a private prison to send juveniles away for such terrible crimes as making fun of their principal on Myspace. Obviously lots of people stand to profit from the preposterously high incarceration rates in the US but I always figured overly harsh and discriminatory laws for drug possession and other blue-collar crime was enough to bring in the sort of profits shareholders in these prisons demand. Apparently not. This just might beat the story I read once (which I can’t immediately find online) about the efforts one warden took to incite riots in the women’s prison he ran so as to keep up ratings of the reality TV show he produced using security cameras, which would often coincide with ‘accidents’ with the overhead sprinkler system just to keep things interesting. Really.

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Speaking of cynicism: whose 10-year forecast of Canadian housing price trends would you believe, that of the Canadian Real Estate Association, the government’s Canada Mortgage and Housing Corporation, or investors in the futures market in Canadian housing prices which was just set up by the National Bank? I’ll give you a hint: the National Bank has also just launch Canada’s first independent national house price index (a sort of Canadian Case-Shiller index, which you’ve probably heard of if you’re obsessively following financial news like I am). For the record, the guesses: the CREA says a drop of 8% nationally in 2009 with full recovery by late 2010, the CMHC predicted a 3% rise in 2009 six months ago but is now saying the market’s moving too fast to call (although they’re working on it), and the futures market is guessing a 20% average national drop in 2009 with full recovery to take about seven years.

As Sh. pointed out when we were talking about this, a house is worth exactly what everyone thinks it’s worth (just like everything else on the market). In this way, the new housing futures market1 gives Canadians a way to communicate quantitatively with each other their impressions of where housing prices are going, allowing interested parties to learn the opinions of those investors certain enough in their guesses to literally put their money where their mouth is. But at the same time, by providing a forum for that exchange of ideas, it will inevitably reinforce dominant trends, speeding up the boom/bust cycle by increasing the pace of communication. It’s a fine example of the observer effect. In other words, if every investor in Canada predicts that the price of houses will fall 20% this year, their prophesy is bound to fulfill itself.

This futures market is even more significant than that, though. Quick economics primer: People don’t just bet on house prices because the local race track closed down; rather, the point of a market for housing prices is to hedge one’s other investments in the real estate market. It’s a way to bet both on prices going up and on prices going down. For example, let’s say you were a US bank that wanted to invest in a whole bunch of highly risky mortgages given to people with no income, job, or assets because regardless of whether they defaulted on their loans there was a vast profit potential if housing prices continually rose, as they seemed to be doing. (This is just hypothetical, of course; no one would ever be so stupid.) You could fulfill your fiduciary duty to soundly invest your clients’ money by also betting on housing prices falling in the futures market, thus fully hedging your investment, as you’ll win either way. You thus have no incentive to only give mortgages only to people likely to pay them back, in the absence of government regulation to the contrary, even if by doing so you could cause the collapse of the entire financial system of your country.

Man, capitalism is great. Now that we’ve got this economics thing figured out, I think we’re ready to start screwing around with systems we didn’t make up ourselves. I know — let’s go manage the environment!

  1. Yes, technically speaking it’s a forward market, but that’s besides the point.