Sunday, November 30, 2008

Terrorists can't stand the best of us

Suketu Mehta writes about how to respong to the Mumbai terrorists:

"But the best answer to the terrorists is to dream bigger, make even more money, and visit Mumbai more than ever. Dream of making a good home for all Mumbaikars, not just the denizens of $500-a-night hotel rooms. Dream not just of Bollywood stars like Aishwarya Rai or Shah Rukh Khan, but of clean running water, humane mass transit, better toilets, a responsive government. Make a killing not in God’s name but in the stock market, and then turn up the forbidden music and dance; work hard and party harder.

If the rest of the world wants to help, it should run toward the explosion. It should fly to Mumbai, and spend money. Where else are you going to be safe? New York? London? Madrid?"

Mumbai is among the most cosmopolitan, dynamic, open places in the World. Walking around the city is like walking around the London described in Dickens, both in its wonders and its horrors. If fear undermines the dynamism, something wonderful will have been lost. My suspicion is that the citizens of Mumbai will be like the citizens of London--they will mourn and then shake off the results of the terror.

Thursday, November 27, 2008

John Taylor insists that Permanent Tax Cuts are the answer

In doing do, he leans on the permanent income and life-cycle hypotheses. While these are totems of economic theory, they do not stand up particularly well when tested against data.

As George Akerloff emphasized in his magnificent AEA Presidential address, the five famous neutrality results in macroeconomics don't hold up especially well when tested against data. Akerloff notes:

"Each of the neutralities is based on the assumption that the respective decision makers are utility maximizers. But in each case the utility functions of the decision makers have been very narrowly described. They depend only on real outcomes. For example, in the consumption- neutrality models, utility depends on consumption and leisure; in Modigliani-Miller it depends only on the discounted real return to shareholders.

But as early as the beginning of the Twentieth Century, Vilfredo Pareto pointed out that
such characterizations of utility missed important aspects of motivation. According to Pareto people typically have opinions as to how they should, or how they should not, behave. They also have views regarding how others should, or should not, behave. Such views are called norms, and they may be individual as well as social."

[I am having difficulty figuring out how to do block quotes in Safari].

The events of the past 18 months suggest to me that we should regard the neutrality results with more suspicion than ever--and that we should be most suspicious of policies whose foundation is in the neutrality results. (Paul Krugman and Mark Thoma have their own criticisms of Taylor's policy recommendations).

Sunday, November 23, 2008

FDR explains how liquidity crises happen

Worth a listen.

He had been in office for a week when he gave this fireside chat. 

Saturday, November 22, 2008

Public Works

I watched President-Elect Obama's weekly address this morning on You-tube, in which he called for a massive public works programs to help us crawl out of recession.

In principle, this is a very good idea.  One of the deficiencies of policy over the past eight years (and for 20 or the past 28) has been an ideological denial of the existence and importance of public goods--goods with high fixed costs, close-to-zero marginal costs (i.e., non-rival), and goods where it is difficult to exclude.  The Republican throwaway lines--you are always better at spending your own money than the government, and government doesn't solve the problem, it is the problem--represent the contempt Republicans have for public goods.

Many public goods, however, are manifestly beneficial to the economy.  Even George Will cites the Interstate Highway System as an unambiguous success.  Rural electrification, which has a heavily subsidized enterprise, was almost certainly a positive net present value investment for the country,  as were the California aqueducts (or for that matter, the Roman aqueducts).  The bridges and tunnels of New York City helped it become the world's leading city.  One could go on and on.

When one looks at the long term insufficiency of our roads, our water systems, our power grid, our ports and our airports, it is clear that there are many positive NPV opportunities for government now--particularly in light of the low cost of long-term Treasury debt.

The problem is that government usually allocates investment funds via a political process, rather than a feasibility process.  Government officials also often prefer grand, ineffective projects to more pedestrian, effective projects (transit officials here in LA prefer extended light rail to synchronizing the traffic lights).  So if we are about to spend a lot on public works, I think we need some sort of non-partisan entity, such as the CBO, that develops a rigorous capital budget process for determining spending priorities.  In the absence of such a process, we will spend money on negative NPV bridges to nowhere.

Friday, November 21, 2008

Brad Delong Blogs on Luck and Laptops

Both of this posts his morning hit me where I live.

Although Brad writes about blogger luck, those of us with tenure at good universities are also very lucky indeed.  When I think about all the ways I was blessed with good fortune to get here...

He also writes about Macbooks.  My 5 year old Sony Vaio (which I actually loved) had slowed to a crawl, and no fix seemed to speed it up.  So I took the plunge and ordered a Macbook from  I have had it for three days now.  It really is a superior product. 

Thursday, November 20, 2008

Dick Cavett is a national treasure

His piece on Sarah Palin is hilarious.  It also brings to mind:

(1) There are many things about my parents for which I am grateful.  One was they allowed me to stay up late to watch Dick Cavett.

(2) A real estate developer told me the other day that he decided to pay the "Palin Tax": he voted for Obama (and therefore for a tax increase for himself) so that Alaska's governor would not be a heartbeat away.  Apparently this phrase has become common.  So now to Pigou Taxes and Ramsey Taxes we may add Palin Taxes as those that are welfare improving (or that at least avoid deadweight loss). 

Practical Greenhouse Gas Reduction/Transportation

Today Duncan Black states that cars are useful things.  Duncan Black also lives in central Philadelphia and does not own a car.  Cars simply have the advantage of flexibility and speed available in no other form of transportation, a fact that we need to keep front and center as we think about practical methods for curbing emissions and reducing congestion.

Some very non-sexy things that would help:

(1) Increase incentives to fill the right front seat of automobiles.  If the average number of vehicle occupants increased from 1.3 to 1.5, passenger miles per gallon would increase by 15 percent.

(2) Get out of SUVs and Pickup Trucks.  Hybrids are cool.  But if people would just continue to move out of SUVs that get 15 mpg to normal cars that get 20, passenger miles per gallon would increase by 33 percent.  That is a lot.  If they want to buy Civics and Corollas, even better.

(3) Encourage people to reduce the number of trips per day (we really started to see this happen when gas prices were north of $4 per gallon).

(4)  Synchronize traffic lights.  Ed Mills showed years ago that the bang for the buck of doing this is enormous.

The greatest challenge of these is (1).  But if money spent on light rail were instead spent on encouraging commuters to double up, my guess is we could get a lot more people moving a lot faster while consuming much less gasoline.

Bad manners

I was on a panel of four people yesterday.  We were all told to speak for 10-12 minutes; one person spoke for 25.  It was the second time I have been on a panel with this person over the past two months, and he did the same thing both times.

Small slippages in time happen to us all--very often the pace of our speaking changes with venue.  But someone who takes up more than double his allocated time is either unprepared or inconsiderate--probably both.

In defense of mortgage backed securities

Some time ago, Susan Wachter and I wrote an article about (among other things) the history of the US mortgage market. One of the points of the piece was that depositories are not capable of holding long-term fixed-rate mortgages, because it subjects them to too much duration risk: mortgages are assets with long duration (i.e., have values that are sensitive to changes in interest rates), while deposits are liabilities with short duration.  Hence, when short-term interest rates fall, depositories make large profits, but when they rise, depositories invested in mortgages can quickly become insolvent.  This is exactly what happened to Savings and Loans in the 1970s and 1980s.

Life-insurance companies and pension funds have long liabilities, and are therefore better candidates to hold mortgages, but they can be harmed by negative duration.  When interest rates fall, homeowners refinance their loans.  This means that insurance companies and pensions funds see the income they were going to use to meet their long-term obligations fall, and so must raise capital or premiums lest they become insolvent.

In light of this, there is a role for un-leveraged investors to hold mortgages.  But these investors may not wish to hold individual mortgages, because individual mortgages carry idiosyncratic risk.   A mortgage backed security stitches together the cash-flows of multiple mortgages, and as such diversifies risk: an investor should prefer owning 1/30 of 30 mortgages to owning a single mortgage.  

At the same time, Fannie Mae and Freddie Mac, because of their (perhaps unfair) market advantage, could impose common underwriting standards on all the mortgages they purchased and placed into securities.  This turned the securities into commodities, and so they traded in deeply liquid markets.  Even now, Fannie-Freddie MBS are performing reasonably well under very difficult market conditions.

Problems arose when Wall Street became overly enthusiastic about developing derivative products based on MBS.  I will post more on these at another time (I actually think the CMO structure is basically fine; it is the CDO structure that reflected hubris).  But the basic MBS was and remains an ingenious product, and will continue to be an important instrument of housing finance in the years to come.

Wednesday, November 19, 2008

More on regional differences

As much as I love California, I do prefer Five Guys to In-and-Out Burger.

Sunday, November 16, 2008

Biggest Loser since 1950

The New York Times this morning had a story about the unhealthiest city in the United States: Huntington, West Virginia. The story was disturbing in all kinds of ways, but one number in it really stuck out to me--the decline in population in that city between 1950 and 2000 was more than 44 percent.

This brought to mind a conversation I had with John Weicher some years ago about which city had lost the most population. Just to be clear, we were talking about municipalities, not metropolitan areas. I went to the census web site this morning, and generated the following growth (loss) rates between 1950-2007 for the 50 largest municipalities in 1950:

Jacksonville 293.91%
San Diego city 278.82%
Houston city 270.40%
San Antonio city 225.38%
Dallas city 185.53%
Fort Worth city 144.57%
Oklahoma City city 124.75%
Columbus city 98.92%
Los Angeles city 94.60%
Indianapolis city 86.21%
Long Beach city 86.04%
Memphis city 70.21%
Omaha city 69.04%
Miami city 64.36%
Atlanta city 56.69%
Louisville/Jefferson County metro government (balance) 51.11%
Portland city 47.31%
Denver city 41.50%
Seattle city 27.08%
Norfolk ciy 10.41%
New York city 4.85%
Oakland city 4.40%
San Francisco city -1.34%
Kansas City city -1.37%
Toledo city -2.83%
Milwaukee city -5.52%
St. Paul city -10.95%
Richmond city -14.14%
Worcester city -15.15%
Jersey City city-18.94%
Chicago city -21.66%
Akron city -24.28%
Boston city -25.22%
Washington city -26.66%
Minneapolis city -27.66%
Birmingham city -29.52%
Philadelphia city -30.02%
Providence city, RI -30.18%
Dayton city -32.02%
Baltimore city -32.88%
Syracuse city -33.22%
Cincinnati city -34.04%
Rochester city, NY-34.29%
Newark city -36.16%
Detroit city -50.42%
Cleveland city -52.12%
Buffalo city -53.01%
Pittsburgh city -54.02%
New Orleans city-58.08%
St. Louis city -59.06%

[sorry for the formatting--if anyone has good ideas for table formatting in blogger, I would love to hear them].

Some striking things emerge. First, only 22 of the 50 top 50 from 50 gained population. And among the 22, Jacksonville, Los Angeles and Oklahoma City had lots of land within their municipal boundaries in which to grow, and Louisville, Nashville and Indianapolis merged with their counties. Denver and Miami are quite remarkable stories, because their boundaries were both fixed and pretty tight in 1950. But keep in mind that the country doubled in population between 1950 and 2007, so if a city's growth is anything less than 100 percent, it is underperforming. By this standard, only 7 of America's top 50 in 1950 has matched or surpassed the country. This illustrates starkly how the country's population has spread.

That said, the cities on the bottom of the list are those that have suffered the most stress. New Orleans does reflect Katrina: before Katrina is population loss was actually fairly typical of a city from the top 50 in 1950.

Phoenix and Las Vegas are not on the list because they were not among the top 50 cities in 1950.

Saturday, November 15, 2008

Larry Summers for Treasury

I met (as in had a brief conversation with) Larry Summers once. It was in 2000, and the setting was a cocktail party for business people in Madison who had donated money to the Gore campaign.

He was, to say the least, socially awkward: he stood in a corner of the room, by the food, and kept his mouth solidly stuffed with cheese and crackers. This was no politician.

But then he gave a ten minute speech explaining the five great economic accomplishments of the Clinton Administration (rising wages for all, budget surpluses, etc.) and the five things a Gore Administration would do (reduce income inequality, health care for children, etc.) to make things even better. It was a brilliant, inspiring, and visionary ten minute speech. His valedictory speech as Harvard president was equally good.

Lots of people I know do know Summers well. They all say that he sometimes forgets to think before he lets words come out of his mouth. They also all say that when he doesn't forget to think, the words that come out of his mouth are smarter than anyone else's. When it comes to deciding who should be running Treasury right now, that should be the only criterion that matters.

Regional Attitudes

This week I had dinner with a real estate executive. As it happens, he graduated a year ahead of me from the same snooty, suburban Boston college as I. We both remembered how the place looked down its nose at California (with the possible exception of San Francisco).

These attitudes had been around for awhile. Addison DeWitt (George Sanders) in "All about Eve:"
San Francisco. An oasis of civilization in the California desert. Tell me, do you share my high opinion of San Francisco?"

Alvie Singer (Woody Allen) in "Annie Hall:"

In Beverly Hills ... they don’t throw their garbage away. They make it into television shows

So I am now curious as to whether these attitudes remain as strong as ever, or whether they have attenuated over the years. As I am writing this from my back deck, next to my kumquat tree, on a glorious, sunny, warm, slightly breezy day in mid-November, I suppose I really shouldn't care.

Thursday, November 13, 2008

I am Gloomy about the future of Shopping Centers

At the Urban Land Institute meeting in Miami a few weeks ago, I gave a presentation on the future of retail real estate. The Quick Points:

(1) We have built a lot of shopping center space over the past 15-20 years. According to ICSC, there was 38 percent more space in 2005 than 1990.

(2) Depression era cohorts are savers; boomers are spenders. According to Pew Surveys, Depression era cohorts think they owe their kids an inheritance and are far less stressed about their finances--even though they made less money.

(3) As depression era cohorts leave us, spending should on average rise, except for the fact that

(4) Boomers have borrowed like crazy in order to spend. Even though median incomes have not risen over the past eight years, consumer spending as a share of GDP has. This is because household debt levels rose dramatically. The Mortgage Debt Outstanding to GDP ratio grew from the high 60s to 100 percent; other consumer credit outstanding to GDP grew from 12 to 18 percent. Boomer households borrowed to spend; it will be years before they will have such access to credit again (which is not at all a bad thing--it just means that the mechanism that has allowed for substantial retail spending has disappeared for awhile).

(5) Retail margins reached historically high and therefore possibly unsustainable levels recently.

(6) The current weakness in retail will likely last a lot longer than the weakness in housing.

(7) We need to hope that inheritances and immigration can bail us out.

(8) Consumption cannot lead us out of this recession--which means it will need to be Investment and Net Exports.

[Note: this is the first time I have tried linking to a Google App; I would appreciate it if someone in comments would let me know whether it worked. rkg]

Wednesday, November 12, 2008

On my Reading List for 2009

Matt Kahn came over from UCLA to give a talk yesterday. He plugged his new book with Dora Costa:

Social Science and the Civil War. Doesn't get any better than that...

Tuesday, November 11, 2008

I think I have a new hero

Her name is Michelle Rhee. From today's WSJ:

The school system is doing "an abysmal job," said Ms. Rhee, who has been on the job for 17 months. According to Department of Education data, about 60% of the district's high-school students finish in four years with a diploma. By comparison, nearby suburban districts have a graduation rate of 78%. More telling: In some Washington, D.C., high schools, only about 6% of the sophomores can read or do math on grade level.

While she is realistic that children in her school district come to school with "significant challenges," Ms. Rhee said it is "complete crap" that those students can't perform at a high level because of their environments. "It's easy to blame external factors as the reason why poor minority kids aren't achieving at the same level. It's a false premise. You have to put supports and mechanisms in place around those kids, but I refuse to allow the adults in the system to use that as an excuse."

Transit Authority Thinking

The person who runs Los Angeles Metro was on KPCC the other day, to discuss what Metro will do with funds raised through Proposition R--a proposition that raises the sales tax in LA County to pay for traffic relief. He said the first priority would be to extend the Gold Line (a light rail line in the San Gabriel Valley).

A caller noted that light rail in LA had a serious problem--that its average speed (with stops) is about 15 mph. The transit guy responded that it was OK, because the average speed of buses in LA was 8 mph.

What this fails to note is that it is easier to change bus routes to get buses close to where people live and work than it is to change rail lines and stations. The issue is not the speed of the mode; the issue is the speed of the total trip. This is why rail must be fast for it to be a desirable mode.

To give an extreme example, when I commuted from Washington to Philadelphia, I had the choice of driving at 60 mph on average or taking a train that had a top speed of 120 mph and made stops at 3 places. The door-to-door trip was a toss-up, because I could drive directly from home to Penn, instead of having to go to and leave from a rail station.

John Kain taught us about all of this years ago, and I have never seen evidence that he was wrong, and yet the people who run public transportation for us seem to pay him no attention.

Sunday, November 09, 2008


John Norquist was Milwaukee's mayor for many years, and he was a good one. One of the things I liked about him was that he was willing to think about unglamorous policies for making the world better. Among these was the need for narrower streets.

Wide streets within residential areas do three things: they make developments less compact, they add to the impermeable area and therefore accelerate run-off, and they encourage drivers to speed through neighborhoods, thus reducing their attraction for walking.

Many of the world's most successful cities have narrow streets. Here is an example of a one:

Paris has pretty much the same residential density as Manhattan. The reason that it doesn't need many high-rises to accomplish this is it wastes so little land on things like excessively wide streets. Compare it to Anaheim from the same elevation:

You get the idea.

People love doing "green things," such as building LEED certified buildings and harnessing solar energy. These are indeed wonderful things. But doing simple things such as building more compact places would almost certainly have at least as large an impact as more glamorous pursuits.

Saturday, November 08, 2008

Brad Delong explains why things will get better

He writes:

Here are the talking points for Obama-Biden administration personnel selections. They have the added advantage of being true:

1. The bench is very deep right now. Practically everyone competent and qualified for high executive office has come over to the Democratic Party over the fourteen years since the coming of Gingrich. Thus there are a huge number of superb choices available for every position.
2. Everyone being considered for high federal office is intellectually honest: they understand not just the advantages of their own views, but their flaws and disadvantages as well; they understand the pluses of views opposed to theirs. Policy will be realit-based: it will depend upon our collective best guesses as to the way the world works, and not the idiosyncratic intellectual hobbyhorses of ex-AEI staffers.
3. Everyone knows that the American people have elected Barack Hussein Obama and Joe Biden--not their staffs. Everyone knows that the jobs of staffers will be to present Obama and Biden with the options, their pluses and minuses, and then strive to implement their choices as best they can. The policies of the Obama-Biden administration will be Obama-Biden policies.
4. Everyone thinks it would be a great honor to work for the Obama-Biden administration.
5. Everyone knows that the bench is deep, and that their chances--however qualified they are--are low.
6. Everyone's knows that this is bigger than any of us, and that the right attitude is to ask for an oar, find a place on a bench, and start rowing. There is an awful lot to do.

Based on the little I know (I did a modest amount of work for the campaign), this is exactly right.

Friday, November 07, 2008

I paid $2.50 for a gallon of gas in Upland yesterday

And so the externality problem returns.

How about a $1 per gallon tax that is used to fund a cut in the payroll tax?

Talking Heads Live - Cities - Germany

An Urban Economics Anthem?

Should we worry about the deficit?

I was listening last night to a radio program on which Robert Kuttner said that the deficit was nothing to worry about, because the ratio of national debt to GDP is around 1/3 of its level at the end of World War II.

What he failed to note is that during WWII, households saved like crazy, in part because materiel was needed for the fight against fascism. Because there was plenty of personal savings with which people could buy bonds, the run-up in the debt was quite manageable. The US doesn't have such savings right now. It is fortunate for us (but perhaps dangerous from a political point of view) that the rest of the world has done a better job savings.

David Stiff of Fiserv Writes (important update for S&P Case Shiller Discussion)

He writes:

I am responsible for quantitative research at Fiserv Lending Solutions, the company that calculates the S&P/Case-Shiller indexes.

Your recent blog entry "What Do House Price Indices Currently Mean?", contains some incorrect information regarding the S&P/C-S indexes.

The Case-Shiller model does not include a foreclosure dummy. In general, sales of bank-owned (REO) properties are included in the repeat sales pairs used to estimate the indexes if they occur at least 6 months after a previous arms-length transaction. (Note: Bank repossessions of properties that are recorded at deed offices are not included in the repeat sales pairs, because they are not arms-length transactions.) I am not sure how this misconception about a foreclosure dummy started -- I need to talk to Chip Case about the details of this discussion at the Berkeley/UCLA conference.

If you don't mind, could you please modify your entry to indicate that there are no foreclosure dummy versions of the S&P/C-S indexes? This misconception is generating a lot of confusion for our index customers. Thanks.

A less consequential misunderstanding -- the Los Angeles S&P/C-S index only covers Los Angeles and Orange counties. Data from Riverside and San Bernardino counties are not included in the S&P/C-S index for Los Angeles.

Wednesday, November 05, 2008

Morris Davis Answers a Question

He is asked, “Obama has espoused changes such as a 90-day foreclosure moratorium, allowing bankruptcy judges to modify mortgages, and other ideas to prop up the housing crisis. What are your thoughts? “

He replies:

The underlying issue for both the high foreclosures and big bank failures we’ve observed is that house prices are falling. When the price of any asset (such as housing) falls, losses are incurred.

Equity holders suffer the first losses. In the case of housing, the equity holders are the homeowners. If the losses are large enough to wipe out the equity, the ownership of the asset is transferred from the debt holder to the equity holder. (In the case of housing, this is foreclosure). Debt holders then absorb any other losses. With housing, the holders of the debt are the institutions or people that own the mortgage notes.

The price of housing has fallen rapidly enough that many homeowners had their equity wiped out -- leading to high rates of foreclosure. The losses were steep enough that in many cases the debt holders have also taken losses, which led to the high rate of failure of mortgage holders (such as Lehman Brothers, etc.).

The point of all this is to say that someone needs to take losses because of falling house prices. A “foreclosure moratorium” or widespread “mortgage modification” would reduce the losses suffered by homeowners (equity holders) and increase the losses suffered by mortgage holders (banks and financial institutions). Thus, a moratorium does not correct the fundamental problem, the decline in house prices. It just shifts losses around.

A policymaker might say, “Let’s just let those ‘greedy’ banks and financial institutions absorb the losses.” There are two problems with this. First, our banking system appears quite fragile right now. Many economists are worried about a deep recession because lending institutions, i.e. banks, are not lending very much right now because of the losses they have already absorbed. Any future losses absorbed by banks might make them even more hesitant to lend. Second, because of FDIC insurance, the government is effectively a large debtholder in many financial institutions. Thus, any moratorium on foreclosures or widespread forced mortgage modifications would effectively shift losses from many households engaged in somewhat speculative behavior (i.e. zero-down mortgages) to mostly responsible taxpayers (i.e. those households that chose not to refinance their housing with zero-down).

Personally, I think a brief foreclosure moratorium is worth considering as a method for developing an orderly process for dealing with the large number of defaulted mortgages. We just don't have the servicing infrastructure to deal with them all right now.

Tuesday, November 04, 2008

When School Districts become Financial Intermediaries

Bad stuff happens. I was listening to a remarkable NPR Story this morning about the Whitefish Bay School District.

The school district borrowed $165 million to purchase Collateralized Debt Obligations. Now that the CDOs are failing, the district may have trouble paying its loan back. So the bank holding the loan will have its capital position erode...etc.

This sort of thing happened to Orange County in the early 1990s. It sure would be nice if we didn't have to learn the same lessons over and over again.

What Do House Price Indices Currently Mean?

At the Berkeley-UCLA conference last week, audience members queried Bob Shiller and Chip Case about how they adjusted their price index for foreclosure sales. Chip's answer was that they had a regression that contained a foreclosure dummy, but that only paying customers S&P-Case-Shiller customers got to see it.

This is a problem. CS is a repeast sales index, with the idea being that by looking at houses that sell twice, and seeing how their value changes across time, one has a constant quality house price change. The problem with including foreclosures is that the constant quality feature is almost certainly eliminated--foreclosed houses are almost certainly undermaintained (there are newspaper reports about this--I would be curious to know if there is a rigourous study), meaning that they are no longer constant quality houses. This feature will bias estimate downward.

My colleague Chris Redfearn notes another problem with the current index. For the LA area, the index is being disproportionately influenced by Riverside and San Bernardino counties, where foreclosure sales have produced big upticks in sales volumes. In stable neighborhoods with financially stable households, people are simply not putting their house on the market, so the relative stability is not reflected in the index. If one looks at any real estate web site, one will find that the number of listings in Santa Monica, for instance, is quite small.

All of this suggests that the CS Index is currently biased downward. While there can be no doubt that house prices here in Southern California have fallen a lot, they have almost certainly not fallen as much as the CS index suggests.

It is going to be hard to think about work today

I wonder how much labor productivity will fall because of people trying to sneak looks at exit polls.

Sunday, November 02, 2008

A Post on the Growth Commission Blog

It is here. I wrote:

One of the villains of the current financial crisis is "securitization." The alphabet soup of securities structures--CMOs, CDOs and SIVs--is roundly blamed for the current financial world's mess.

The irony is that it was not so long ago that emerging countries looked to securitization as a savior for the problems that they faced in developing capital markets. Specifically, many countries (particularly in Latin America) looked to Fannie Mae/Freddie Mac Mortgage Backed Securities as models for instruments for providing housing finance, and others (such as India) looked at special purpose vechicles as a potential method for getting around the poor financial conditions of local government attempting to finance infrastructure.

So which is it: villain or savior? Well, of course the answer is neither. Securitization is just an instrument, and when applied appropriately under appropriate circumstances, is a useful instrument. So let's begin by dispensing with the notion that securitization is it self a villain, and then talk about why it is not a savior either.

I believe investors made two fundemental mistakes about subprime mortgages. First, some investors thought US house prices would never fall nationally, in part because they never had (in nominal terms) in the post-was era. So long as house prices rose, these investors reasoned, mortgage borrowers would retain a powerful incentive not to default; consequently, default risk for all mortgages was deemed to be low. True story--around 2005 I was in the elevator of a large investment bank, and one person said to another, "you can't make a bad real estate loan." That happens to be the moment that I began to worry about the subprime market.

The problems with this line of reasoning were two: just because house prices had never fallen nationally didn't mean that they couldn't, and even if house prices did rise nationally, if they fall regionally (as they did in the US Midwest in the 1970s, in Texas in the 1980s and in New England and California in the 1990s), one will still see defaults. This was an underwriting issue, not a securitization issue.

The second problem is that Wall Street Ph.D.s thought they could outsmart bad underwriting. This reflected insufficient modestly about how confident we can be about parameters. The idea behind Collatoralized Debt Obligations was that one could combine subordinated securities (those that were in the first loss position) and use diversification to get a very precise estimate of the losses that one could expect from those securities. Suppose that the expected loss of a security was ten percent with a standard deviation of ten percent. By combining 30 securities, one reduces the standard deviation by 1/(sqrt(30)), or by more than 1/5, so investors can have confidence that the actual realized loss would fall within a narrow band. Investors could then use the knowledge to further slice and dice.

For this to work, however, one needs to know that the parameter estimates for expected losses and standard deviaion of losses are correct. For a whole host of reasons, we didn't have remotely enough information about parameter stability to make these sorts of judgments. Something we need to remember is that as our models get cleverer, we start losing degrees of freedom. But we also need to remember that the vanilla MBS security structure, and even simple senior-subordinated tranching, worked very well for a very long time. Securitization is a good way to match up households with capital markets, and remains true today.

But the recent crisis suggests that securitization is no magic bullet for emerging countries. For securitization to work, investors need to understand the loans that are being securitized, and that means the loans must be underwritten robustly and consistently. For this to happen, emerging economies will need stronger financial infrastrucure (such as well developed banking systems) and property rights infrastructure (so investors can have confidence in collatoral). I remember when I did a Bank mission in one very low-income country, I was asked about whether it should develop a Fannie Mae. This was a country whose courts couldn't enforce foreclosure rules, and that had no long term sources of finance. If any good news arises from the current crisis, it is that emerging countries might focus on getting fundementals right, instead of hoping for a magic securitization scheme to solve all their problems.


I participated last week in a Berkeley-UCLA conference on the Mortgage Meltdown.

Two distinguished scholars said things that surprised me. One noted that the net position of derivatives was zero (a correct statement) and therefore derivatives were nothing to worry about. The other said that the size of the subprime losses would likely be around $400 billion, which should have been managable. I should note that I made a similar statement about subprime losses around a year ago, but I didn't really think through the implications of it.

Had the $400 billion of subprime loan losses been held with equity, the implications of the crisis would have been much smaller. This is why the collapse of the tech bubble, while meaningful to the economy, resulted in only a mild recession. The problem is that the $400 billion in losses on subprime mortgages and the derivatioves they support are being realized by highly levered institutions, and so losses precipitate a chain of events that go well beond he original losses.

Let's start with the loans themselves. Suppose a bank owns subprime loans, and assumes a loss rate of 5 percent, and holds sufficient capital to bakstop those loans. Now suppose the loss rate doubles. The bank may still be solvent (i.e., have positive value), but its capital position has been eroded, perhaps to the point that it can no longer make loans. This is not hypothetical--I have recently talked to some community bankers who have told me this is exactly their position.

The inability to make loans means the value of the banking business falls--and so share prices fall. This means it is difficult for banks to recapitalize, because issuing stock is expensive. Credit markets freeze up, and the implications of losses arising from subprime get transmitted to the general capital stock--banks lose the ability to finance P&E. The reduces the future value of the broader economy beyond the initial subprime loss.

But now let's consider a bank that was smart enough to buy credit default swaps so that its balance sheet would remain healthy in the event of poor subprime performance. The bank gives up cash flow to pay premiums to insure against future problems. But the bank is assuming that the counterparty with which it has contracted can make good on its obligations. If the counterparty is highly levered, a subprime meltdown will produce bankruptcy. It is here that the ex post net derivative value goes negative: the payouts from the insurance company are smaller than the losses incured by the bank, because the value of the insurance company is truncated at zero. This creates its own set of multiplier effects.