Tuesday, September 30, 2008
"Some may belittle politics but we who are engaged in it know that it is where people stand tall. Although I know that it has many harsh contentions, it is still the arena that sets the heart beating a little faster. If it is, on occasions, the place of low skulduggery, it is more often the place for the pursuit of noble causes."
I have been thinking about yesterday's vote in the House. Like Paul Krugman and Brad Delong and Mark Thoma, all of whom I admire, had I been in Congress, I would have held my nose and voted for the deal, which has many aspects I didn't like.
But the press today has been about the venality of members who were afraid to vote for the plan because it is unpopular with voters. Having had some conversations today with friends who are to the left of me, and who opposed the plan, I think that the votes against the plan may well have been sincere votes, dictated not by expediency but by principle. Many Democrats view the plan as having insufficient consideration for consumers, and many Republicans genuinely find the idea of socializing risk to be anathema. As it happens, I disagree with this Republican point of view, but in this instance it is honest and defensible (although I think the business about cutting capital gains taxes is nonsense).
So while I think Congress made a mistake yesterday, I find it entirely plausible that the vast majority of members, on this one particular occasion, voted with their heads and hearts,
The cause of the "housing bubble" associated with the sharp rise and then drop in home prices over the period 1998-2008 has been the focus of significant policy and research attention. The dramatic increase in subprime lending during this period has been broadly blamed for these market dynamics. In this paper we empirically investigate the validity of this hypothesis vs. several other alternative explanations. A model of house price dynamics over the period 1998-2006 is specified and estimated using a cross-sectional time-series data base across 20 metropolitan areas over the period 1998-2006. Results suggest that prior to early 2004, economic fundamentals provide the primary explanation for house price dynamics. Subprime credit activity does not seem to have had much impact on subsequent house price returns at any time during the observation period, although there is strong evidence of a price-boosting effect by investor loans. However, we do find strong evidence that a credit regime shift took place in late 2003, as the GSE's were displaced in the market by private issuers of new mortgage products. Market fundamentals became insignificant in affecting house price returns, and the price-momentum conditions characteristic of a "bubble" were created. Thus, rather than causing the run-up in house prices, the subprime market may well have been a joint product, along with house price increases, (i.e., the "tail") of the changing institutional, political, and regulatory environment characteristic of the period after late 2003 (the "dog").
This result is hardly consistent with the charge that the GSEs were the principal source of the problem. It also says something about having a purely private mortgage market.
Monday, September 29, 2008
-Interest rates on conforming loans have dropped substantially, helping both homebuyers and sellers in the conforming market. Underwriting standards, though., remain more stringent (good in the long run, perhaps not so good in the short run).
-Senior management got removed without golden parachutes
-Shareholders get largely, but not entirely, wiped out
-The taxpayer, holding 80 percent of the company, gets susbstantial particiation in any upside (which in F&F's case, I think likely).
On net, this looks pretty good. It also looks kind of like Sweden's temporary nationalization of its banking system in 1992, which worked pretty well.
Sunday, September 28, 2008
This was 2002 and 2003, so default risk was not a great worry: the company's underwriting practices at the time were sound, and mortgages were protected either by 20 percent downpayments or mortgage insurance, and property values were still rising, but not yet at a bubble like pace in places like Las Vegas and Florida. As for interest rate risk, the company purchased hedges so that its balance sheet would always have duration of less than a month, and so that duration risk was quite small too--although while hedging duration is pretty straightforward, convexity is more complicated (duration is basically the first derivative in how capital value changes with respect to interest rates; convexity is the second derivative). FWIW, I also thought the people who executed risk management at Freddie were very good at their jobs.
In these discussions, we failed to predict the principal reason the company got into trouble: we had no idea that senior management would recklessly gamble the charter through accounting that was both misleading and (it turned out) incompetent. I have arguments with William Poole, but when he said that management risk was a huge problem with having institutions like Fannie and Freddie, he was right.
But one among us (whose name I will reveal if he/she gives me permission to do so) did predict a major source of the current problem: counterparty risk. For example, Freddie Mac would buy instruments called swaptions, which would give the company the option to swap floating rate debt for fixed rate debt, and vice versa. These swaptions would allow Freddie to manage its balance sheet when interest rates changed in the future. Suppose, for instance, Freddie borrowed long-term in order to finance fixed rate mortgages. Now interest rates fall and borrowers refinance. Swaptions allowed Freddie to trade its expensive fixed rate debt into less expensive floating rate debt to match the lower return on its portfolio (and the converse when interest rates rise). But of course, swaptions would be useless if the institution with which Freddie contracted could not make good on its part of the bargain when interest rates changed.
In 2003, Warren Buffett called derivatives (such as swaptions) weapons of mass financial destruction. Like everyone else, I have long admired Buffett, but I though he got this one wrong. Derivatives allowed institutions to hedge and therefore reduce risk! Or at least, I thought this was the purpose of derivatives.
But of course, investors can also use derivatives to speculate, and when they do so (and particularly when they do so using leverage), derivatives become very dangerous. AIG, for instance, guaranteed against mortgage default. This meant that when defaults rose to levels not seen since the Great Depression, it didn't have enough capital to meet its responsibility to its counterparties. So the counterparties who thought they had hedged their risk found themselves exposed, which in turn ate into their capital position, and so a cascade was on.
Derivatives can be used for good, or for evil. Buffett understands human nature far better than I, and I should always remember that.
Friday, September 26, 2008
The comparisons are not exactly apple-to-apples, but because the MBA data are a little older than the FF data, it is actually likely the case that the GSEs have performed relatively better than the comparison above would suggest.
Thursday, September 25, 2008
I made many close friends at Freddie, and learned more about mortgages that I could have possibly learned had I never left academia. I also found myself very disappointed with the company in all kinds of ways, which is why I didn't stay very long (although I also didn't stay long because I missed being a professor). I think senior management there has made a series of awful decisions.
Readers may draw their own conclusions about how seriously to take my views in light of this.
Wednesday, September 24, 2008
Morris is currently at Wisconsin-Madison, and was formerly at the Fed.
Why I am opposed to the bailout, by Morris A. Davis
First, I've decided it is bad economics. Suppose the bailout costs 500 billion. Suppose the bailout is effective in avoiding a recession -- The bailout itself costs 3-1/2 percent of GDP. I think you have to go back to 1982, maybe further, to get that kind of contraction in GDP during a recession.
Second, Paulson and Bernanke have proven, repeatedly, they have no idea what is going on. For example, here is a published quote from Bernanke on June 5, 2007, available on the Federal Reserve Board web site: "At this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system." I can find similar quotes from Paulson.
If Bernanke and Paulson have been wrong, every time, why would they be right about the effectiveness or cost of a bailout now.
The reason I have no faith in Bernanke or Paulson is that they have no simple theory to explain what is going on. They know all the bits and details of current events, but they have no simple unifying underlying theory for events.
Third, what assets should be bought in a bailout? Mortgages? How about underperforming stocks? How will the government decide which markets are illiquid and which ones aren't? Forget the adverse selection problem for the moment. Just ask: Why would the government know which class of assets to buy and why?
Fourth and Fifth, the precedent this sets is terrible. This bailout means we have lost faith in free markets to allocate scarce capital to its most productive use. It also tells punishes responsible investors (who did not underwrite or hold high yield junk mortgages) and rewards exp-post the participants in financial markets who took the riskiest bets.
Tuesday, September 23, 2008
Hmmmm. The loan performance on Fannie's book of business is substantially better than the overall mortgage market. And starting in 2002, Fannie Freddie (pink line) lost market share to ABS (light blue line). The data underlying the graph is from the Federal Reserve,
|Table 1173. Mortgage Debt Outstanding by Type of Property and Holder. |
Monday, September 22, 2008
Could we please stop saying that it was the hybrid feature of Fannie/Freddie that caused them to fail?
Perhaps the new rule going forward is going to have to be that any financial institutions with assets of greater than $X billion will be required to have paid-in capital of greater than Y percent. I have no idea what X and Y should be, but the costs of making X a little too small and Y a little too big are almost surely smaller than the costs of the converse.
Saturday, September 20, 2008
We did manage to get through the early 90s with a fairly mild recession.
But while Bernanke/Paulson have more information than the rest of us, they have no foundation for calibrating a model to inform them how to move forward. We are completely outside the support of the data. As Charles Manksi describes it so simply and eloquently, because we are in a world of Xs we haven't seen before, we cannot possibly know how to relate those Xs to Ys. And so at the end of the day even our smartest policy makers must rely heavily on judgment. I am not reasurred when I remember that Isaac Newton lost a bunch of money in the South Sea Bubble .
I do think I support the RTC type plan that Paulson is proposing. My worry with it, however, is political more than financial. If we get the wrong sort of people (say those who went to grade school with the Vice-president, or those who were until recently running the interior department) running it in the future, it could produce cronyism and kleptocracy unlike anything we could have before imagined.
Friday, September 19, 2008
(1) From a user cost perspective, owning really does look pretty good in many SoCal markets right now, especially for houses that are inexpensive enough to use conforming loans. Mortgage rates are down about 75 basis points on Fannie-Freddie loans since they were placed into conservatorship. People have to live somewhere.
(2) Lots of sales are distressed sales (around 40 percent). This means the prices we are observing are not arms-length transactions, and may be below equilibrium market prices.
(3) While I am wary of anecdotal evidence, I have been getting a lot of anecdotes about bidding wars for modestly priced houses (modestly priced by California standards, anyway).
But there are a number of cautions:
(1) After rising sharply for the past four years, rents in Southern California are stagnant, and perhaps are falling a little bit.
(2) Unemployment has risen sharply in San Bernardino, Riverside, Orange and Los Angeles Counties.
(3) The overall sense of pessimism arising from the financial market crisis could keep buyers from buying.
Altogether this suggests to me that house prices won't be going up a lot anytime soon, they won't be falling much more either.
Tuesday, September 16, 2008
I also dropped my younger (by 45 minutes) daughter off at college today. It has been wonderful to see my self-confident, hard-working girls just bubble over with joy while starting out at great universities in great cities. But it has also left me, for the moment, profoundly sad. I am a little surprised at this. Some wisdom does indeed come only through experience.
Friday, September 12, 2008
Where I was mistaken was to think 2.5 percent capital was sufficient backing for the GSEs--I thought home mortgages were so safe, that 2.5 percent plus a stress test would be OK. I was wrong. And it is becoming increasingly clear that the GSEs' managements were reckless with the charters, which gives evidence that Robert Van Order's powerful argument that GSE management would never want to screw up a wonderful franchise was also incorrect.
So maybe the correct answer is a hybrid with more capital--say 5 percent. After all, thanks for FDIC and the Federal Home Loan Bank System, Banks are really hybrids too.
Tuesday, September 09, 2008
This argument makes no sense. The way to look at the issue is to consider households to be financial intermediaries. Financial intermediaries are most stable when their liabilities and assets have the same duration. Most households have two principal assets--their house, and their human capital. The house has long duration; the duration of jobs is variable. Fixed rate prepayable mortgages can have long duration, and because they have an embedded call option, the duration can be made variable.
Thus a prepayable fixed rate mortgage is a liability that matches well to a house's long duration and the owner's desire to have a free option to move to a new job. It helps stabilize household balance sheets.
First, I am sure that my statement that I would not vote for a creationist comes across as elitist. But the fact is that when someone identifies herself as a creationist, she is revealing something to me about her decision process--that she makes decisions based on faith, rather than evidence. I am uncomfortable with this, and have reason to think that decisions based on evidence tend to turn our better than those based on faith, or or one's gut. It is true that sometimes there is not all the evidence that one would like to make a decision, and then one must take a leap, but evidence first strikes me as a good rule. The Red Sox won World Series after they started listening to Bill James (who explicitly rejects baseball mythology when it conflicts with data).
Second, I grew up in what was then red state America--a town of 50,000 in Western Wisconsin. The benefits were real--I came to appreciate hunting and especially fishing, and I could ride my bike anywhere at any age in safety. But the town was homogeneous in a way that was stifling--when I was growing up, my guess is that there were maybe 50 African-Americans and 50 Jewish people in the whole town. The town, moreover, did not at the time welcome those who were different, and I remember at 17 being engaged in a debate with fellow Democrats (!) about whether it was appropriate to use government funds to support a battered women's shelter. I am happy to say that the place has since changed considerably: it is far more heterogeneous and far more welcoming than it was when I was growing up there. Nevertheless, even though I liked my family (by that I mean I liked hanging out with my parents and brother), and even thought I had three close buddies who were staying in Wisconsin, I took as many classes as I could in high school to get out of town as soon as possible, and left for college after my junior year. My "lack of respect" for the place I grew up arose from the fact that its values were different from mine. Is this elitist? Perhaps.
So college was the ultimate elitist experience: the fanciest of fancy-pants Ivy League Schools. Intellectually, the place was at times truly thrilling: I still can remember specific sentences from lectures on Shakespeare, on moral reasoning, on international relations, on Japanese-US relations, on Public Finance (where Malcolm Gillis made me realize that I wanted to be an economist). It also was the place where I met my wife, one of the most remarkable people I have ever known, and for that I will always be grateful.
But for all that, it could be truly insufferable and provincial. Harry Lewis inadvertently underscored this phenomenon when he wrote in Excellence without a Soul, "if I hadn't been able to teach at a place like Harvard, I would have gone into the computer industry." So whatare students who don't go to "places like Harvard," chopped liver?
So when Harvard disdains the heartland, and when the heartland disdains Harvard, they both have some basis for doing so. Interestingly, both places have trouble dealing with the "other," but my sense is that both places are getting better at doing so.
FWIW, among the Universities where before this year I spent time (Harvard, Wisconsin, George Washington and Penn), my favorite by far has been Wisconsin (although after a month at USC, I think it likely that it will match Wisconsin--and the weather is a lot nicer here. The sushi is better here too--oops, that's elitist!). Wisconsin is also an intellectually thrilling place--it doesn't have as many superstars as Harvard, but it has plenty, and it was a treat to hear lectures from and talk with Harold Scheub, Dave Demets, Stanley Kutler, Arthur Goldberger and Buz Brock, among others. At the same time, because the students were predominantly Midwesterners, and generally quite good, there was little if any disdain for the heartland. Indeed, one of the striking things about the atmosphere in Madison is how modest very accomplished people there tend to be. It is almost is if Berkeley were crossed with Lake Wobegon.
Finally, I need to say something about the South (I have lived on both coasts and the Midwest, but never the South). Anyone who stereotypes Southerners as dumb should be ashamed. In the first place, such generalizations are always wrong, and in the second place, the region has produced Faulkner, Tennessee Williams, Martin Luther King, Thomas Jefferson, etc. and has many great universities, such as Chapel Hill, UVA, Duke, etc.
But two facts remain about the South that are truly problematic. The states with the lowest high school graduation rates in the country are in the South. This is not because the South is rural--the states with the best high school graduation rates are in the Midwest, and are generally rural. And if people are looking for respect, waving the Confederate flag is not the best way to do it. Southerners who do so will argue that they are celebrating a heritage, but it is a heritage in which a large group of people were deemed subhuman. African-Americans rightly feel disrespected when they see that flag, and people who want to wave that flag should understand that.
Just because one might not like NASCAR, or country-western music, or, heaven forbid, football doesn't mean he needs to look down on it. But that flag is something else.
I think there may be a bit of anachronism here although I am not entirely sure. Bryan ran for president in '96, '00 and '08 with national debut "Cross of Gold" speech catapulting him into prominence in 1896 much as Humphrey, Reagan, and Obama would later be sent into orbit (Reagan literally) by their national debuts. The Scopes trial was in 1925, and Bryan had started to vehemently attack Darwinism after WWI. He had spoken out against it earlier as well, but after his initial run.Bryan was not a young earth creationist and not really one in the modern sense. And it was not really uncommon to reject Darwinism at the turn of the century. Indeed, most scientists did. They didn't reject evolution, but they did reject Darwinism, primarily because a workable theory of heredity was lacking. This was rectified from 1900-1918 from the rediscovery of Mendel to Fisher's crucial paper integrating Mendelism and Darwinism. But it really should be emphasized that many major scientists rejected Darwinism before 1900. Now they probably rejected it for different reasons from Bryan, but the Darwinian mechanism of evolution certainly wasn't a settled fact at the time. Did Bryan have contempt for the evidence at the time that he ran (which is when you could have voted for him)? Very unclear. How far was he willing to integrate evidence into his biblical worldview? I don't really know, but at least one historian (Ronald Numbers) claims that he was willing to accept a geologically old earth and read 7 days figuratively.So while it is true that at the end of his life (or a few days before the end) he rejected Darwinism because he was very worried that the mechanism of natural selection (espcially as seen through the light of Social Darwinism) led to the moral decay he saw in WWI, he may not have held that view 3 decades before and certainly the science wasn't settled at that time.
Of course, current politicians have no such excuses.
Sunday, September 07, 2008
Saturday, September 06, 2008
Rather, is has been the transfer of interest rate risk from households to investors. So far as I know, the US is the only country in the world with long-term, fixed-rate, 95 percent LTV loans that do not have prepayment penalties. When interest rates rise, borrowers are protected; when they fall, they are not mad e immobile by yield-maintenance and lockout clauses.The low down payments (and five percent equity seems to be OK) effectively give households with modest incomes access to capital markets. I have written elsewhere that I believe that the peculiar structure of Fannie and Freddie has helped bring about the unique American mortage.
One could argue that the current environment shows that none of this has been worth it. But I would disagree with that argument.
Thursday, September 04, 2008
I cannot vote for someone who has contempt for evidence. A suggestion that creationism is an arguable alternative to evolution is equivilent to a suggestion that Ptolemy's Earth-centered model of the universe is an arguable alternative to Copernicus' deplacement of the Earth from the center (although to be fair, Ptolemy was a great empiricist, and his views had much stronger scientific foundations than creationism).
We have now experimented with government that does not care about evidence. I don't like it, and I fervently hope that it doesn't continue.
We use micro data from the 1980, 1990, and 2000 DCH to document that the expenditure share on housing is remarkably constant across MSAs and over time. We study the equilibrium properties for housing rents of a simple model consistent with this observation. A key distinguishing feature of our general spatial equilibrium model, relative to many papers in the urban economics and local public finance literatures, is our use of Cobb-Douglas preferences. This assumption yields a constant housing expenditure share in equilibrium, consistent with the evidence we uncover. The same assumption has been used to explain the distribution of population across places(Eeckhout 2004) and to study the internal structure of cities (Lucas 2001 and Lucas and Rossi-Hansberg 2002).
Our multi-location model predicts that in the aggregate, the ratio of rental price-
per-unit to per-capita income is constant as long as the aggregate stock of housing
per capita is also constant. This is a common result of macroeconomic models when
households have Cobb-Douglas utility. We show that this result does not hold at the
MSA level; instead, rental prices disproportionately reflect income differentials. We
conclude that the intuition – commonly assumed by policy-makers and housing-market commentators – that local house price indexes should increase at the same rate as local per-capita income is incorrect whenever income growth differs across MSAs.
Wednesday, September 03, 2008
But the thing about autos is that a Toyota Corolla is the same, regardless of who sells it. Once can test drive it and read reviews on Edmunds about it, and then go from dealer to dealer to get the best deal possible on it (the web allows you to do this very efficiently). Mattresses, however, change names from one store to the next, so you can't really comparison shop to get the best deal possible.
In this mattresses resemble mortgages. Unless one gets a zero closing cost mortgage, it is hard to shop from one broker to the next. Many brokers, moreover, will not offer a rate lock until they have gathered a lot of information, meaning that one needs to do a lot of work before he can even get a price. There may be some value of having a regulation that says that mattress companies must sell all comparable mattresses under one brand name. And there may also be value to requiring mortgage companies to offer mortgages that have just two prices--a rate and a closing cost.
Monday, September 01, 2008
As I have written before, prices in California have fallen so rapidly that in many markets it is now just as sensible financially to own as it is to rent--assuming one can get her hands on financing. There are, moreover, many cash buyers in places like the Inland Empire right now, and cash buying is a powerful indicator of a bottoming market. Finally, I am hearing lots of anecdotes about multiple offers on properties for sale.
The problem is that a very large number of the sales are foreclosure sales or short sales--properties that lenders are trying to dispose of, and are therefore selling at extremely low prices. Whether this tendancy will extend to the rest of the market is very much an open question. But if the next few months are similar to July, we may well be at bottom out here.