Thursday, May 29, 2008

Stated HELOC dischargeable

This write-up by Tanta on Calculated Risk underscores a key, obvious point on what drove the lax lending standards during the recent housing bubble, namely that ability to pay did not matter so long as the debt was collateralized by a rising asset. It did not matter if the borrower had a job, so long as the house the loan was secured against kept rising 20% a year.

That said, both the lender and the borrower to placing the same bet. Here, the borrowers lost, and will go bankrupt. Maybe the lender should do the same?

Wednesday, May 28, 2008

Rethinking capital flows

Brad DeLong has a good paper detailing how the reality of international capital flows has been different from what economists expected in 1990. In particular, economists expected rich countries (such as the US) to be net capital exporters to poor countries (such as Mexico and China) where low wages made the marginal return to capital favorable.

In practice this has not been the case. While the US has invested in factories in Mexico and China, those countries have found reason to send even more capital back to the US. Net net, money flows from poor countries to the US. Part of the reason for this is that the people with money in poor countries do not trust those countries, and so would prefer to bank their pesos in US$. While Mexico has a central bank, dollar/peso convertibility has rendered it dependent on the Fed. Another part of the reason is a "vendor financing" strategy by low wage manufacturers (China) to boost exports and support employment by giving money to Americans.

Brad is not sure what to do about this turn of event, and ends the paper tentatively suggesting that the US should boost aggregate demand by higher government spending, higher deficits, lower taxes, lower interest rates, and encouraging businesses to bear more risk.

Given that the US is in its current position because of low interest rates and excessive business risk, suggesting that the government tries to turn that handle again simply points to the damaging boom-bust cycle that's been instituted by the Treasury and the Fed. His other recommendations are flat out inflationary. Since the US has been able to manage it's enviable position by being the world's reserve currency, it seems risky to inflate it further. There are other reserve currencies waiting in the wings.

There is an excellent discussion of this dynamic on Naked Capitalism.

Thursday, May 22, 2008

Dilution vs Supply and Demand

Megan has a somewhat tortured discussion with Matt Steinglass on inflation, whether it should be targeted, etc. As I've mentioned before, I simply cannot understand Macroeconomics as it's taught in school. IS-LM, AS-AD, et al made no sense to me then, and don't make any sense to me now. I have come to suspect, however, that my confusion comes more from the fact that these concepts do not actually make any sense, than they simply lie outside my intellectual abilities. Others may agree.

I think that Megan, Matt (and even Joe Stiglitz, who I found very disappointing in person) would have a better conversation if they separated inflation into two parts: price changes as a consequence of currency dilution (print more dollars, each dollar is worth less, so prices go up) and price changes as a consequence of changes in supply and demand.

I don't think it is interesting or useful to talk about what the net effect of these two dynamics is. Who cares if the net impact of dilution (government printing money) and rising demand is 5%? I want to know 1) how much has the government diluted the currency, and 2) how much has demand risen (or fallen). In fact, netting out these two variables clouds dilution, which is at the very heart of the monetarism that Stiglitz and Matt say is "dead".

I do not understand why inflation is necessary to a healthy economy. Suppose you had a fixed money supply (no dilution) and rising technological productivity which drove lower prices. Would it really be so bad to know you would have to work less in the future because all the clever technologies humans came up with were actually making us all richer and better off? Isn't that how things are meant to work? Instead, we have a dollar which has lost 95% of it's value in three generations, and 40% in just the past 6 years (against the Euro. It's done even worse against oil and gold. And it's a mere 20% down against the Yen). A system that needs such dramatic transfers from savers to debtors on a permanent basis simply seems broken to me.

If people who want to save are fed-up with their money being taken from them and given to debtors, is it any surprise that they are moving out of fiat currency and into something with more tangible value? Cassandra decries this behavior as evil speculation and wants to see commodities no longer be a financial asset class and return to a market that treats them as actual physical goods to be traded between real produces and consumers.

I'm on board with this, and would consider extending this to a whole host of other financial arrangements which now exist as financial assets classes only, not real products to be bought and sold by real produces and consumers. One example would be the 30 year bond, the 20 year bond, the 10 year bond, and heck, even the 5 year bond. What is the real demand for a financial instrument that pays out after 30 years, but not before, and cannot have its term changed through maturity mismatching? Does anybody really believe that the yield on a 30 year treasury bond reflects in any way on what the market expects in the year 2038? How meaningful is the yield curve if everything from year 5 onwards is really just an artificial construct enabled by maturity mismatching, which guarantees bank runs, and destroys any information on what the demand 5 years out really is.

Waldman lays it out very clearly:
Some of us think that some thing's wrong, and these guys we're drinking with aren't serious enough to fix it. We know that trillions of dollars in presumed housing wealth have disappeared, but we don't know who's ultimately going to bear the loss. Americans know that as a nation, we cannot afford our clothes, furniture, or gas, unless the people who are selling it to us lend us our money back. Economists fret about "imbalance" and "adjustment", but we've yet to see a serious plan, other than let's-keep-this-party-going.

So, we lose faith. When we lost faith in Northern Rock, Bear Stearns, Citigroup, or Lehman, the central bankers stepped into the fray, and stood behind them. So, we ask, who stands behind the central bankers? We take a peek, and all we see is our own money. Which we quickly start exchanging for something else.
Right now there is no ETF that is a perfectly hedged basket of major planetary fiat currencies. That leaves us with GLD

Thursday, May 15, 2008

Interest rates and qualification

The chat I linked to in a recent post on what better regulation of the financial sector might look like has a table showing at a combination of lower interest rates, lower down payment requirements, etc. all combined to massively increase a home buyer's ability to spend money on a house. This increase was completely captured by existing homeowners who saw the prices for their property skyrocket, new homeowners just took on additional debt at the same monthly payment.

I had thought that the Fed was complicit in the 1% interest rate, but that other parameters were driven by mortgage lenders. I was wrong, lower credit standards was also driven by the financial industry as a response to the Fed's (near) Zero Interest Rate Policy (nZIRP). Hear the whole story on This American Life.

Monday, May 12, 2008

Closing the window, opening the corridor

I strongly recommend reading both the post, and the comment thread regarding the Fed's recent request to begin offering (and taking) interest on bank reserves.
Last week, the Fed decided to ask Congress for the right to pay interest on bank reserves. (Hat tip Barry Ritholtz, see also William Polley, Mark Thoma, Brad DeLong) This is a very big deal.

Don't be misled into thinking that the Fed's proposal is just some arcane, technocratic change. The Federal Reserve is asking taxpayers for a big pile of signed, blank checks. That's far too much power to put in the hands of a quasipublic organization with little democratic accountability. This authority should not be granted without some strong strings attached.
I don't share Steve Waldman's optimism that democratic accountability will help the situation at all. We are talking about a highly technical area in the field of financial regulation, which is probably as arcane as it gets from a policy perspective, and. I cannot fathom how inviting The Mob to the table will help anything.

That said, the ongoing financial crises is making some informal rules formal, and that can only be good (even if, or especially if, the informal rules were bad ones).

1) The Fed will extend essentially FDIC insurance to all deposit holders, not just those keeping their money in commercial banks. The TSLF makes that explicit.

2) The Fed will shift financial losses to tax payers by swapping good collateral for bad collateral. This is more formal than saying they will not shift losses to tax payers by swapping good collateral for bad collateral, and then doing it anyway, but it is not as formal as simply writing out a check to Bear Stearns bond holders, JP Morgan, Lehman Brothers, Goldman Sachs. So I see this as an improvement, but it still has a way to go.

3) The US has the latitude to do what it wants monetarily because of "vendor financing" (great analogy) from PBOC and GCC. Both countries have taken significant amount of their citizen's wealth and given it to Americans. This may actually be the right thing to do since employment is more important than amenities (gotta keep them off the streets!)

4) Risk management in finance is pointless. They key variable ends up being political risk (how big will my bailout be?) Consider this: financials are trading at where they were back in 2000, just coming out of the Internet bubble with 8 record years of profitability in front of them.

5) The Internet bubble gave us Google, Amazon, eBay, Yahoo!, and a whole host of new services and technologies that create real value. What new service or technology that's created real value has come out of the housing bubble, or associated financial bubble of the past 8 years? Does this matter? The US economy seems to need a leading sector -- what will the next one be?

6) The US government will subsidize mortgages, no matter what. $900K homes in California are now underwritten by taxpayers.

7) I expect to see Fannie Mae and Freddie Mac nationalized before all of this is over -- there is an informal arrangement that should certainly be formalized post-haste.

Wednesday, May 07, 2008

Tax incidence

The WSJ op-ed says that the housing crises is over, and prices will stop dropping. Why is that?
[I]f one buys a house with a mortgage, the most important factor in deciding what to pay for the house is how much of one's income is required to be able to make the mortgage payments on the house. Today the rate on a 30-year, fixed-rate mortgage is 5.7%. Back in 1981, the rate hit 18.5%. Comparing today's house prices to the 1970s or 1980s, when mortgage rates were stratospheric, is misguided and misleading.
I'm not sure if this is actually true (would you pay more for a stock of if your broker gave you a great deal on your margin account?) but it certainly is how people have behaved. All of the cheaper financing that financial "innovation" created for house prices went directly into the price of those assets, so buyers were no better off before, and all the benefit was captured by previous owners. Similarly, when you hear about new government plans to help the first time homebuyer, all they will do is transfer more money to current homeowners, since the benefit will directly be factored into a new (higher) price. See this in action in my favorite graph below:

The other part that's kinda neat is how expected future appreciation makes current cash flow considerations unimportant. In the Real Bay Area, where I live, you cannot make up the price of a house in rent, buying a house and renting it out is a cash flow negative exercise, but price appreciate has more than made up for that. What happens when price appreciation stops, or goes negative? (Note: that has not happened in the Real Bay Area yet) No one knows, the graph only goes to 3% annual appreciation.

Monday, May 05, 2008

Better regulation

As the US housing bubble deflates, there is an outstanding question of what different regulatory environment would have 1) kept the housing bubble from appearing, but 2) supported "good" financial innovation. Two points on this.

Firstly, the chart above shows how borrowing power increased from 3x leverage to 9x at the peak of the bubble in 06. You can see how a combination of low interest rates, lower down payments, interest only loans all played their part in fueling the boom.

Secondly, I recommend this piece on VoxEU. Key points:
1) Better disclosure does not help to prevent financial crises. They were called "subprime"!
2) Prudential controls never work either, certainly not at a system level
3) Risk management does not work, as it ignores "off model" events which end up being the problems.

Instead, he recommends:
1) Capital controls should be counter-cyclical. So as the risk premium falls, the capital charge should rise
2) Forget about "bank" vs "non-bank". Look at maturity mismatch and leverage. The more an organization has of both, the more it should be regulated. A zero leverage, maturity matched lending institution, for example, would probably need zero regulation. Hmmmm.
3) Banks should pay an insurance premium so taxpayers do not get fleeced too much when they bail banks out.
I think this last suggestion is unworkable as we've seen what a good job social security and medicare premiums have done keep future tax increases down. Any premium collected will be, instantly, spent.

Friday, May 02, 2008

Traffic in Dubai

As horrific as this story is, I also find it quite believable. It seems the morning was foggy


Warren Buffet has entered the monoline market. Best line:
Connecticut Attorney General Richard Blumenthal said in an interview yesterday that he is investigating possible conflicts of interest since Buffett's company owns almost 20 percent of Moody's Corp., parent of the credit ratings service.

Thursday, May 01, 2008

My experience with Notes

Joel complains about how architecture astronauts, like Lotus Notes' Ray Ozzie, is now building the same useless technical toy at Microsoft.

Lotus, of course, began its life with 1-2-3, and then became the sales and marketing arm for Notes, that was developed by Iris. The Iris group kept some of their old offices and signage and continued to work on the convolution that is Notes. I worked there for a summer, and still have no idea why it's anything other than a crappy version of Outlook (not a high bar).

The technical culture at Lotus was exactly like what Joel describes -- people fiddling around with toys and no thought to actually solving real problems. Any solution began as a small, useful idea, and then had layers and layers of architecture wrapped around it until it became a Network Operating System, or whatever. It's not surprising that Ray tried to build the same thing at Groove (which I tried and failed to us) and will try, one more time, at MSFT.