About today's awful Case-Shiller number

A month ago, David Stiff of Fiserve informed me, "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."

There are currently markets in which foreclosure sales make up 40 to 50 percent of all sales. These transactions are almost surely not representative of the housing stock, and so the CSI is currently a biased estimate of house price changes. I admire both Case and Shiller a lot, but they really need to fix this.

See Milk

Sean Penn is truly wonderful, and the story is both uplifting and tragic. MBA courses in organizational behavior could also use it as a teaching tool.

Ten favorite American Buildings

These are just personal favorites. One rule: no more than one building per city. There is no particular order to the list

1. Trinity Church, Boston (Richardson). Copley Plaza is among the best urban spaces I know.
2. Seagram's Building, New York (Mies van der Rohe and Johnson). It also has my favorite restaurant in it.
3. East Building, National Gallery, Washington (Pei)
4. Carson, Pirie, Scott, Chicago (Sullivan)
5. City Hall, Philadelphia (MacArthur and Walter) It is a silly, overdone, wonderful building.
6. IDS Building, Minneapolis (Johnson again). The rare, iconic, financially successful building.
7. Indiana University Campus, Bloomington. This is cheating, but I think IU has the nation's most beautiful college campus. And no, I never went or taught there.
8. Eastern Building, Los Angeles (Beelman). The city's best building is a lovely Art Deco number from 1930. The Wiltern Building is special too.
9. Coit Tower, San Francisco (Brown and Howard)
10. Terminal Tower, Cleveland (Van Sweringen brothers)

Why we need newspapers

The blogosphere likes to take pot-shots at the main-stream media, some of which the MSM has earned. Political coverage is often vapid, and the culture of "balance" ("some say earth is round, others disagree') is often self-satirizing.

But every now and then, the hometown paper here, the once-great and rapidly deteriorating Los Angeles Times, reminds us that there is o substitute for great, shoe-leather reporting. Ken Ellingwood has been reporting the tragic story of Mexico under siegeover the course of the fall. The story is vivid, and could only be told be someone on the ground, with the resources behind him to visit many places and interview many people. This is the sort of thing that only a major news organization could do.

Newspapers used to be closely held by families--the Ochs-Sulzbergers in New York, the Grahams in Washington, the Pulitzers in St. Louis, the Binghams in Louisville, the Chandlers in Los Angeles. When a family owns a business, it needn't worry about quarterly results--it can focus on other values. In the end, we may not all always like those values (those of Charles Foster Kane, er. William Randolph Hearst come to mind). Nevertheless, beyond that fact that technological change is undermining the newspaper business, it would appear that the publicly traded company model for owning newspapers is fundamentally flawed. And heaven help us if we need to reply on the blogosphere alone for news.

David E. Bloom David Canning and Günther Fink find that Urbanization has no impact on growth

Science last February had a special issue on cities.  Among the articles was the Bloom, Canning and Fink piece, which ran cross-country regressions that showed (1) that urbanization levels in 1970 did not predict economic growth in the years since then and (2) that urbanization did not Granger cause growth.  They therefore recommend that policy makers avoid promoting or discouraging urbanization.  

From a policy perspective, I am happy that an article in Science, perhaps the most prestigious place one can publish in the US, recommends the end of anti-urban policies.  But I worry that the regressions suffer from mis-specification.  

Around a year ago, I wrote:

"Every affluent country in the world is urbanized. Among OECD countries, 77 percent of people live in urban areas, and among World Bank-designated high-income countries, 78 percent of people live in urban areas. The poorest two countries in the OECD, Turkey and Mexico, are 67 percent and 76 percent urbanized, respectively. The least urbanized affluent country, Portugal, is 55 or 59 percent urbanized, depending on source. At the same time, the world’s lowest income countries are generally not urbanized: in 2004, the urbanization rate among the World Bank’s designated low income countries was 31 percent. All of the countries with urbanization rates of less than 20 percent, Burkina Faso, Burundi, Cambodia, Ethiopia, Malawi, Nepal, Papua New Guinea, and Uganda, are low-income countries, all with Gross National Incomes Per Capita of less than $660, and most with GNIs that are substantially lower than that.[1] The correlation between urbanization and PPP Per Capita GDP in 2000 was .70. In short, urbanization accompanies affluence."

I continue:

"That urbanization accompanies affluence does not, however, mean that urbanization causes affluence. First, it is worth noting that Latin America and the Caribbean are 77 percent urbanized, and the countries in that region are certainly not among the World’s richest (nor are they in general, among the poorest). There are also very poor countries in Africa--Cameroon, Mauritania, and Senegal--that are at least 50 percent urbanized. All of these countries have per capita GNIs of less than $1010.[2] Hence affluence does not necessarily follow urbanization."

The thing that strikes me is that all rich countries are urbanized, but not all urbanized countries are rich. This suggests to me the following hypothesis: that urbanization is a necessary but not sufficient condition for economic growth. A linear regression does not allow one to test this particular hypothesis.

George Bailey explains bank runs

Within the past two weeks the New York Times has had two reviews (here and here, where you click on the AO Scott video) of it's A Wonderful Life. They point out the real reason to movie is great--it is an extraordinarily dark and in some ways tragic film.

Beyond that, this scene does a great job of explaining financial disintermediation. It is fun to use in class.

A Transportation Question

Last week, I picked up my wife (who will join me working at USC--she will be a physician-faculty member at Keck Med School), our two cats and our wine in Bethesda and drove across the country. It was the first time we had done so in more than 20 years, and other than the fact that it discomfited one of the cats (a nervous nelly about life in general), it was quite a lot of fun.

As we travelled I-66 to I-81 to I-40 to I-30 to I-20 to I-10, I couldn't help but admire the remarkable achievement that is the Interstate Highway system. But I also couldn't help but wonder whether it was sometimes overdone.

In particular, the drive across West Texas was striking for its lack of traffic. The speed limit there was 80, and it is fun to drive unmolested at that speed. The scenery is hauntingly beautiful, too. But I wonder whether a 4-lane superhighway is really necessary there. Wouldn't a 2-lane highway with passing lanes on up-grades and limited at-grade intersections do the trick for such places? Or are the network benefits of having four lanes everywhere worth the cost? I don't know the answer to this--perhaps there is some literature? If we are going to spend a lot on infrastructure, we need to think carefully about such things.

Flipping Signs

The purpose of regressions is to obtain conditional means (or medians), in part so that we don't draw incorrect inferences from spurious correlations. Thus regressions are especially useful when we see a significant bivariate correlation, and then the significance goes away after conditioning on other variables.

But what if the sign on an explanatory variable flips from significant and positive before conditioning to significant and negative after conditioning on other variables? Should we take that negative sign seriously? If the model is specified properly, the answer is yes, but my gut tells me such models are rarely specified properly.

One Data Point on the Current Value of Cash

Yesterday we closed on the sale of our Bethesda house.

We received two potential offers on the same day: offer X, which had a financing contingency, and offer .94X, which was a cash offer. We took .94 X.

The amazing thing is that the offers came within a week of listing the house. Consistent with Levitt's thesis, the agent encouraged us to take one of those first two offers. But there was an identification problem--we didn't need a lot of convincing.

30 years ago in Time Magazine

The more things change...

Politics and policy rend a big lender

The White House has become involved in a maneuver to oust yet another top-level holdover Republican appointee. He is Oakley Hunter, chosen by Richard Nixon as chairman of the Federal National Mortgage Association, known as Fannie Mae, the nation's largest provider of housing finance. As boss of Fannie Mae, Hunter has been feuding with Patricia Harris, Secretary of Housing and Urban Development. Largely to appease her, the White House acted last week on a HUD memo urging that an emissary be chosen to end the quarrel, perhaps by bringing about Hunter's "voluntary resignation." The memo named five men as possible mediators, including Bert Lance, but the White House gave the job to Robert Strauss, the President's special trade negotiator.

There is a personality clash between the liberal, Humphrey-style Democrat Pat Harris and Oakley Hunter, a former Republican Congressman from Southern California. Their deeper problems center on policy: Should Fannie Mae retain its semi-independence, as Hunter wants, or should it bow to HUD directives, as Harris insists? Specifically, Harris feels that Fannie Mae is far too concerned about making money—last year its profits rose from $127 million to $165 million—and too unconcerned with stimulating mortgage lending for low-income housing in the cities.

For its first 26 years, Fannie Mae was a Government agency. In 1968 Congress turned it into a private, profit-oriented company answerable primarily to its stockholders, both individuals and institutions. But the President was given the right to fire its directors "for cause," and HUD was granted some powers to limit Fannie Mae's borrowing. It raises billions of dollars a year in private markets and then buys mortgages from banks, savings and loan associations and other lenders, giving them money to invest in other mortgages. Currently, Fannie Mae holds about $34 billion worth of housing debt. In a war of nerves, Harris in recent months has not granted big new borrowing authority to Fannie Mae, but instead has doled it out in dribs and drabs.

Hunter, who earns $140,000 a year, also faces opposition within Fannie Mae's board; of its 15 directors, five are appointed by the President and ten are voted in by stockholders after being nominated by a management committee. Last October, one stockholder-chosen director, Julian Zimmerman, a mortgage banker who was head of the Federal Housing Administration under President Eisenhower, called for Hunter's resignation on the grounds that Fannie Mae's management had grown aloof and unresponsive to both its own board and the Government. In November a motion to censure Hunter barely lost, by an 8 to 6 vote.

The latest crisis was set off because HUD executives heard that Zimmerman and one other anti-Hunter director would not be nominated for re-election at a board meeting scheduled for this Tuesday. So the White House dispatched Strauss to settle the fight and get Hunter's terms for resigning. Meeting with Strauss last week, Hunter talked about quitting in the future, provided that the Administration would guarantee Fannie Mae's "fiscal integrity and independence." Hunter also wanted all of HUD'S authority over Fannie Mae transferred to the Treasury. But Pat Harris rejected any such deal, and so the White House remains in the middle of an ongoing fight.

Ed Witte, father of Social Security

There is a rather silly article in today's Washington Post about Obama's choice of people from elite academic institutions from his adminstration. The gist is that while pointy headed professors may be smart, they may not have the other skills necessary to be effective at governing. I will stipulate that there are as many bad people in academia as everywhere else, but good academics have had at times made important and lasting contributions to the US government.

One of those was Edwin Witte. One of the many things that made me proud to teach at Wisconsin was the fact that Witte had taught there. He did take some breaks to be in Washington, where he helped invent the Social Security system. Indeed, he has been called the father of Social Security.

Wilbur J. Cohen, another UW faculty member, wrote the following wonderful obituary.

Reprinted with permission from the Industrial and Labor Relations Review, Vol. 14, No.1, October 1960, Copyright C. 196O by Cornell University. All rights reserved.



Many people have referred to Professor Edwin E. Witte as "the father of the Social Security Act." But, in his customary humility, Professor Witte noted that he merited "this title less than many others." In commemorating the twentieth anniversary of the act, Professor Witte said in an address published in the Social Security Bulletin (October 1955):

"Social Security, like most other major social advances, has been the product of the endeavors and work of many people over a long period of time. The contributions made by any one person have been so commingled with those of many others that the end-product cannot be attributed to any individual or group of individuals."

It is regrettable that Ed Witte did not live to participate in the twenty-fifth anniversary of the monumental program he helped to create. He died, at the age of 73, on May 20, 1960 in Madison, Wisconsin, just a few weeks before the law's silver anniversary. Although he had retired at the age of 70 from the university he loved, he worked diligently and consistently up to his final illness. Between periods of hospitalization and convalescence from several strokes, he was teaching, writing, speaking, arbitrating, attending meetings, and advising students. Ed Witte did not know how to retire and stop working. He left uncompleted a book on social security that he had planned for over twenty years and wanted so much to finish. It is ironical that the professor who played such an important role in the formulating of the social security program did not have time to publish a book on it in his lifetime.

To his former students and colleagues, Ed Witte was more than a man with a vast encyclopedic knowledge, more than a person with the unusual ability to draft single-handedly complex laws and reports on a wide range of labor, legal, social, and economic matters. He was a patient and helpful teacher, a man of humility, and a person of absolute integrity.

When Ed was named president of the American Economic Association in 1955, Merlyn Pitzele portrayed him in all his humaneness, generosity, and uniqueness in an unusual word and picture vignette in Business Week (November 26, 1955). Mel measured the man by noting that Witte, despite all his public service, remained a teacher, a man whose first and foremost interest was his students, and one who as an economist really taught 'political economy' now split so sharply among the social sciences.

Ed Witte was not a man who tried to impress anyone. He didn't use five syllable words or fancy concepts so fashionable today in the social sciences. He wasn't able to use mathematical formulas, and he did not invent any new vocabulary to describe prevailing ideas or to theorize about existing institutions. He didn't try to win an argument or to hurt people by showing how much more he knew or how much more he had accomplished than someone else. But he was tenacious in clinging to opinions and principles in which he believed. He was a rare spirit and was admired by his students and colleagues.

Ed Witte was born on a farm near Watertown, Wisconsin-- about 40 miles from Madison-- on January 4, 1887. He received his B.A. from the University of Wisconsin in 1909 in history and his Ph.D. in economics in 1927. Almost all of Witte's life was spent in Wisconsin, except for several brief periods of governmental service in Washington and, during World War II, in Detroit. He spent about half of his active life as a state or federal governmental official and the other half as a university professor. He was proud of his dual role as a public servant and a teacher.

It is important to note that Witte, although growing up on a farm and coming from a rural middle western background, was with Commons, Slichter, Perlman, and others part of a small group of Wisconsin liberal economists who interpreted and defended the trade union when such defense was dangerous. Witte was also a staunch advocate of social security and public health insurance despite attacks on these measures as leading to the 'welfare-state' or 'socialized medicine.' Witte saw himself as both a radical and a conservative; radical in espousing reforms and challenging the status quo; conservative in that these reforms, by moderating abuses, preserved the free-enterprise economic system, the federal-state political structure, and the democratic political process.

He entered the University of Wisconsin in 1905 where he majored in history under Frederick Jackson Turner, the author of the famous frontier hypothesis as an explanation of the unique economic, political and social development in the United States. It was Turner who, on leaving Wisconsin in 1910 for Harvard, advised Witte to study with Commons. Under Commons, Witte combined his interest in economic history with a pragmatic interest in understanding and solving immediate economic and social problems. It was Commons who guided and directed Witte into his life's work.

Witte was part and parcel of the 'Wisconsin Idea' of public service in a period when the University of Wisconsin was pioneering in this field. With Commons, Perlman, the La Follettes, E. A. Ross, the sociologist, Altmeyer, and a number of other distinguished people, he investigated

controversial social problems at firsthand and emphasized the importance of the university in making a major contribution to public policy issues.Witte combined the values and experience of a political economist, social reformer, and historian. He believed in the diffusion of economic and political power. He was influenced strongly by the La Follette progressive movement and worked closely with many of the Progressive leaders and legislators. He identified with the 'little man,' the individual farmer and worker, and the needs of individuals who were unemployed, sick, or aged.

He was often critical of the power of the large impersonal corporation, the political influence of private insurance companies, the control of 'Wall Street,' and the influence of professors from eastern universities in government, business, and labor. Yet Witte was never hostile or bitter to those who were critical of him. He was an optimist and he believed in 'progress.' He saw social and economic institutions in a continual process of change.

The respect for his integrity and humanity was demonstrated by his selection as the first president of the Industrial Relations Research Association (1948) and as president of the American Economic Association (1956). His abilities as a conciliator and mediator among men with strong opinions led him to be used extensively in labor mediation boards. This same quality was instrumental in his being selected to be chairman of the Department of Economics at the University of Wisconsin from 1936-1941 and 1946-1957. Witte's whole approach was to find the area of agreement in economic, labor, and social questions.

Witte was also strongly influenced by his experience with legislators and with drafting legislation and getting legislation enacted into law. As chief of the Wisconsin Legislative Reference Service (1922-1933), he aided countless state legislators on a wide range of legislation. As a secretary (1912-1914) to Congressman John M. Nelson, he had the opportunity to get to know the congressional mentality and the legislative processes in Congress. This intimacy with both the state and federal legislative mind and machinery led him to respect the process of political democracy and to be wary of grandiose schemes which would be impossible of legislative acceptance. In addition to his contribution to drafting the Social Security program, he was also instrumental in drafting the Norris-La Guardia anti-injunction act.

As the executive director and research synthesizer for the President's Committee on Economic Security in 1934, Witte undertook the major responsibility for writing the entire report of the Committee on Economic Security to President Roosevelt and also for explaining and defending the proposed legislation before both the House Committee on Ways and Means and the Senate Finance Committee in 1935. He sat in the executive sessions of both committees, on the floor of the Senate and in the conference committee, helping to mould the technical and legal modifications and policy compromises. Here Witte was exercising the highest art of combining economics, politics, and conciliation in the crucible of hard reality. It is to be hoped that Witte's unpublished manuscript on, "The Development of the Social Security Act," which he wrote in 1936, will soon be published. It presents an accurate insight into the entire legislative process and should become a major reference source for all students of social security.

Although Witte was a prolific writer of articles and speeches, he published only one major book in his lifetime: The Government in Labor Disputes (1932). Social Security in America (1937) represents a summary of the studies and staff reports prepared under his direction as executive director of the Committee on Economic Security. Witte preferred to allocate his energies to the current labor and social issues of the day rather than writing systematic volumes. He gave unselfishly in time and energy to students and to his colleagues. He wrote extensive letters to his students and to anyone who inquired of him. He was conscientious in his administrative and teaching responsibilities and his many advisory roles, which resulted in his constantly postponing the text on social security he hoped so much to publish.

Witte admired and respected Commons and Perlman and was proud of being a member of the institutional school of economists.

In a ringing defense of institutional economics in 1954, Witte defended and explained his approach and his objectives. "All or most of the institutional economists have been pragmatists, studying facts, not for their own sake, but to solve problems and to make this a better world to live in."

Ed Witte is gone, but he made a significant contribution to the labor and social legislation of the nation and to teaching these subjects to students he hoped would carry on the work he loved.

Are 4.5 percent mortgages worth the gamble?

The federal government can raise long-term debt right now for around 3 percent (actually less--10 year Treasuries are right now yielding less than 2.7 percent). So a 4.5 percent mortgage gives a spread of more than 150 basis points.

If the government-backed mortgages require 20 percent down payments, strong FICO scores from borrowers and full documentation, this is a good deal for the government. The default rate on 30 year-fixed rate, prime, 80 percent LTV and below mortgages remains quite low. Even if life-of-loan default rates for these types of mortgages triple, the taxpayer would earn a positive return on the program. And the value of the call option (ability to refinance) to the borrower would be low, because the program would apply only to purchase money mortgages.

On the other hand, the downpayment requirement, which is essential to making the program sound, will continue to prevent many potential buyers from getting into the housing market. So how effective it would be at stimulating housing demand is questionable.

We need to teach MM better

I was listening this morning to a Morgan Stanley investment banker say that in the early part of the decade, companies' stock prices got hammered if they didn't have enough leverage. Now they get hammered if they don't have sufficient cash to pay off any potential bullet loans.

We try to teach that financing should be irrelevant to business valuation (until the cost of financial distress comes into play). We try to teach that as one takes on more debt, the cost of equity should go up just enough to offset the benefit of debt's lower cost. We just must not teach it sufficiently well.

Football Playoffs and College Education

Among my guilty pleasures are big time college athletics. I prefer both college football and basketball to their professional counterparts, and when at Wisconsin, I enjoyed having varsity athletes in class (I begin teaching USC classes this spring, and I assume I will have a similar experience here).

I am also sympathetic this morning to the football players at Texas, who must be upset that a computer formula has placed them behind a team that they have beaten on a neutral field. All that said, I think a playoff system for college football is a bad idea.

The reason is varsity athletes already sacrifice enough for their schools, and seasons have already been extended well beyond what they once were. Forty years ago, a typical college team played nine games a season, and there were many fewer bowl games. Now the typical season lasts 11 to 12 games, and BCS teams with 6-6 records are eligible to go to bowls.

The upshot of this is that it is very difficult for players to actually go to college. Going to college means more than showing up to class and doing homework; it also means interacting with other students (some of whom might not even be athletes!), faculty and staff; it means hearing from outside lecturers, and attending musical performances and plays; it means growing intellectually and learning how to think independently. As it is, varsity athletes have what amount to difficult full-time jobs along with their class obligations, and I think it remarkable when they can just meet their class obligations. Of course, very few college athletes, even at a place like USC, will be able to go on to make a living as professional athletes.

I tell employers that they should jump at any opportunity to hire a varsity athlete who graduated in four years with a B average and a real major. The time management skills of these young women and men is remarkable. They needn't be tested any further.

A Montgomery County Anecdote

My family spent its last Thanksgiving in Montgomery County, Maryland this past weekend. Montgomery County has among the ten highest median household incomes of any county in the country, and unemployment here remains low., at 3.3 percent. The county's bond rating is AAA (for whatever that is worth nowadays).

But when we went to White Flint Mall yesterday, the Sunday after Thanksgiving, it was nearly empty. I bought myself an unexpected little gift--a Banana Republic shirt that lists for $79 was selling for $27 (I like their shirts, but I think at list price they charge too much for them). But even with deep discounts, we did not have to wait in line to check out.

Fundamentals are strong here, and yet people aren't buying stuff. Paul Krugman is telling us to turn to Keynes for an explanation, and so I have been rereading the General Theory. It is a slog of a read, but Keynes' insights apply to our time more than those of any economist since his time.

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.

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).

FDR explains how liquidity crises happen

Worth a listen.

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

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.

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 JR.com.  I have had it for three days now.  It really is a superior product. 

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.

More on regional differences

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

This morning on NPR

I am interviewed about the mortgage crisis.

http://media.vmsnews.com/MR.pl?id=111808-896263-U001574416

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.

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.

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]

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...

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.

Streets

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.

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.

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.

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.

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.

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.

Counterparties

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.

Matt Kahn Celebrates the Spirit of Cooperation

He does so here:

http://greeneconomics.blogspot.com/

Gary, Raphael and Stuart do a painstaking job of combining multiple data sets to get a sense of the wealth effect of housing, and find that it is real; the implication is that it could be a substantial drag on consumption for years to come.

When combined with the fact that consumption has been an extraordinary share of GDP (around 72 percent, which compares to a historic norm in the high 60s) and his been funded with home loans and consumer debt, it is highly likely that the next recovery will be driven from something other than consumption--such as exports or capital goods spending (for exports).

As for cooperation, let me point to a post I wrote around a year ago:

...if one looks at the top 50 research Universities as measured by The Center for Measuring University Research Performance at Arizona State, the leading metropolitan area for number of top research institutions is not Boston, nor is it Chicago, Philadelphia, or New York. It is LA, which has four in the top 50 (UCLA, USC, Cal Tech and UC-Irvine). If one stretches another 100 miles or so, UC-San Diego and UC-Santa Barbara get added to the mix.

Southern California rarely gets credit for being an intellectual mecca, but after spending a pleasant morning at UCLA and a pleasant afternoon at USC last week, I couldn't help but think that it is. Then again, Thomas Mann, Arnold Schoenberg and William Faulkner all managed to enjoy life in LA. Randy Newman might have been onto something...

It is nice to be here.

Somebody needs to do a new hedonic regression

I came back to Washington this weekend to help my wife prepare for putting our house on the market. Per the instructions of the Realtor, we are working on "staging" it.

I wonder how much this really matters. Once one gets beyond structural and neighborhood characteristics, does "staging" matter to the ultimate sale price? One would need to collect data on sold houses (including some index of how well presented they were) and then run a hedonic regression that included the presentation index in order to find out.

Paul Carrillo at GW has a nice working paper where he finds that houses that are marketed on line with pictures get better outcomes than those that don't. But the pictures could just reflect the fact that Realtors are more likely to present pictures of houses that are better looking (and therefore more valuable) in the first place.

The Northern Urban Fringe of Los Angeles

Here are two pictures from the Northeast side of Lancaster:




In general, I saw fewer for sale signs than I was expecting, although there was one entire subdivision (near the place photographed above) that was in default. Retail real estate is more obviously suffering. I saw many nearly empty strip shopping centers.

Equipment or Learning?

The idea of a "best orchestra ever" is silly; many orchestras, such as Szell's Cleveland, Reiner's Chicago, Karajan's Berlin and Ormandy's Philadelphia were pretty much perfect (I actually am not crazy about Karajan or Ormandy as interpreters of music, but they had magnificent bands, for which they are due considerable credit).

But the orchestra I have really liked since I was in high school (so for more than 30 years) is the Amsterdam Concertgebouw Orchestra. I write this because tonight I was listening to a recent Concertgebouw concert on KUSC, and damn if they didn't have many of the same qualities they had during Haitink's and even Van Beinum's days. In particular, the woodwinds--especially the double-reeds--have a very specific sound. They best way to describe it, I guess, is at once rich and transparent; it is kind of like getting the best of Berlin and Cleveland wrapped into one sound.

I went to the Orchestra's website to make sure the players weren't all 70 years old; they are not. Indeed, the principal oboe player has only been with the orchestra for about a year; the principal flute player looks like a rather young woman.

So what brings this consistency of sound over the years? Is it learning a tradition? Or is it just the unique sound of the wonderful hall?

Principles of economics, translated

Bill Gross says to Invest in Fannie-Freddie Debt

More generally, he says to invest close to the "government umbrella:" agency securities and government guaranteed debt. He also says that he thinks LIBOR will decline sharply once the various government programs actually start getting put into operation.

Gross is the Warren Buffet of fixed-income: for example, his bond funds avoided subprime (just as Buffet avoided the tech bubble). But one thing he doesn't mention in this Bloomberg interview is the prepayment-market risk embedded in GSE securities. I do wonder whether the increasingly tough underwriting standards for home borrowers will remain around for awhile. If they do, we should see a structural shift in prepayment behavior for a long time, with conditional prepayment rates (or PSAs) remaining low for years to come.

So which is it?

The McCain campaign argues:
er
(1) Obama is a socialist

(2) Obama is the second coming of Herbert Hoover

I am not an historian, but I am pretty sure that the intersection of (1) and (2) is the null set.

I was wrong about Karl Rove

I used to think he was an evil genius. An item in his WSJ column this morning undermines the genius part. He writes:

The Investor's Business Daily/TIPP poll (which was closest to the mark in predicting the 2004 outcome -- 0.4% off the actual result) now says this is a three-point race.

Before he wrote this, I thought Rove understood data. But polls are (more-or-less) random samples, and a group of pools will produce a distribution of outcomes. It is of course the case that one poll will come closest to the population outcome; the fact that a particular poll does says nothing about the skill of the pollster. Now, if one pollster comes closest ten times in a row, we can be sure that something real is going on--that she has insights about sampling that the others don't. But one correct call is nothing but luck.

Every quarter, the Wall Street Journal picks a "best economic forecaster," which is based on close an economist's forecast to predicting economic conditions in a quarter. Check out how well that forecaster does in the following quarter. If you made any decisions based on who wins the award for one quarter, you may well be disappointed in the following quarter.

I really want to be good, but...

If I leave my house before 7:30 or after 9, I get to USC in 15-20 minutes. I used transit today--it took 70 minutes to get to work, and an hour to get home tonight.

In DC, the trade-off was a 40 minute drive against 50 minutes door-to-door with metro/walking. That was a good trade--the ten extra minutes were small price to pay for the exercise, the ability to read/listen to music on the train, and the opportunity to avoid DC drivers. But a 40-50 minute difference is a whole different story. And LA radio is good, and the drivers are better here.

Atrios makes an important point

He says:

H

owever given that we're in a financial crisis which has at its foundations declining home prices, now would not really be the right time to do away with that particular [i.e. mortgage interest] deduction. And I'd prefer that before we scrap the employer based health care system we... come up with something else!

I have published papers pointing out that the mortgage interest deduction does little, if anything, to stimulate homeownership, is distortionary, and is inequitable. But I think we can wait awhile now before we do anything about it...

I think my next plane trip will go faster.

John LeCarre has a new novel out. It is reviewed here by my second favorite spy novelist.

Capital and Prime Mortgages

At this morning's panel, I commented that I had been mistaken in thinking that 2.5 percent was a sufficient capital cushion for prime mortgages. One of the panelists, Don Ankeny, wisely noted that Fannie-Freddie's troubles did not arise from prime mortgages, but from Alt-A loans. So for true prime mortgages, 2.5 percent may indeed be enough.

A potential positive NPV earmark?

I was in San Diego this morning to moderate a ULI panel on (what else) the financial crisis. The panelists (Don Ankeny, Westcore Properties LLC, Rajiv Patel, Spear Street Capital and Sean Flannery, Wells Fargo) were excellent, and while the mood was generally pessimistic, I think everyone agreed the policy is moving in the right direction.

But this post is not about that. It is rather about the Surfliner, the train that runs from Los Angeles (actually San Louis Obisbo) to San Diego. The scenery along the Pacific Ocean is very beautiful, but the train is sloooooow. The tracks have lots of curves, and are largely laid on wooden, rather than concrete, ties. Despite the slow speed (2 hours 50 minutes from LA to San Diego), it was full.

As we search for infrastructure investment to stimulate the economy, it strikes me that upgrading this route might work as an investment--it certainly makes more sense to me than a bullet train from LA to San Francisco. But I am not exactly a disinterested party on the matter...

A Good Day for the Economics Profession

Paul Krugman today won something he long deserved to win. I remember especially enjoying his work on increasing returns to scale and patterns of trade when I was in grad school. And a few weeks ago, he produced a lovely, simple theoretical model of why capital infusion would be a more effective mechanism for bailing out banks than asset purchases (link to come).

Krugman's genius resides in his ability to develop simple models that are remarkably powerful at explaining a complicated world. Besides that, he is the rare economist who can write a graceful English sentence.

An Urban Economics Puzzle

I have now been at USC a couple of months, and it is a terrific place. Last night we put on a panel on the financial meltdown for the USC community (see link to a webcast below); the staff here pulled it together (organization and marketing) in less than a week, and we nearly filled a room that held about 450 people with our students, faculty and alumni. The ability of people here to cooperate across schools and functions is truly astonishing, and the level of collegiality is quite wonderful.

But I have discovered a fault of the place--no street food. Both Madison and Philadelphia have lots of great street food options--Falafel, Thai, Chinese, Vietnamese, Southwestern, etc. But there is nothing like that around USC. We have 33,000 students here. Why no market for food carts?

Finance & Real Estate Market Meltdown

Finance & Real Estate Market Meltdown

Jane Albrechtsen says America is dumb for having 30 year fxied rate prepayable mortgages.

In yesterday's Wall Street Journal, she writes:

This is made worse by the fact that traditionally many American mortgages were typically set at a fixed rate for the 25- or 30-year life of the loan and the borrower often has the nifty ability to refinance without penalty. Most Australian mortgages are usually subject to a variable rate of interest. Fixed-rate loans are limited to around five years. So when Australian lenders offer a fixed-rate loan for five years, they fund it by borrowing five-year money. If borrowers want to repay a fixed-rate loan early, sensible economics require that they pay the lender a "break" fee, which compensates the lender for the lost interest the loan would have brought in had it been carried to term.

Prepayment penalties are either prohibited or severely restricted in the U.S. Thus, an American lender who makes a 30-year fixed rate loan that the borrower can prepay at any time without penalty is simply making a bet about the average life of a loan. And while it's true that there are good quality statistics about how long American loans usually last, these are necessarily averages. Averages don't reflect actual experience and are especially misleading when real outcomes are at the extreme. If market interest rates fall below the fixed interest rates, borrowers will simply refinance at lower rates. Another fine deal for borrowers. If market rates rise above the fixed interest rates, borrowers will stand pat. So loans are terminated by borrowers when they are profitable for lenders and loans last longer when they are unprofitable for the banks. Who would want to be an American lender?

American lenders, in one form or another, have been making these loans since the 1930s. The whole idea is that lenders are more expert in managing interest rate risk than households, and that we don't want labor mobility inhibited by prepayment penalties.

But of course, the irony is that fixed rate mortgages are not the problem right now. According to the Mortgage Bankers Association, foreclosures on prime fixed rate mortgages happen at less than one-fifth the rate of foreclosures on prime ARMS; the subprime fixed rate default rate is one-third the ARM default rate. But in the eyes of the editors of the WSJ op-ed page, fixed-rate mortgages have been dangerously good for consumers.

I liked Cokie Roberts years ago when she was on NPR

But I just read that she said this last August on ABC's This Week:

ROBERTS: Yeah, that he has certainly come nowhere near closing the deal. As we've talked about before, in this year that should be such a Democratic year given all the other indices, he is tied in the polls and stage-sided in the polls and going off this week to a vacation in Hawaii --

VICTORIA CLARKE (former Pentagon spokeswoman): Right.

ROBERTS: -- does not make any sense whatsoever. I know his grandmother lives in Hawaii and I know Hawaii is a state, but it has the look of him going off to some sort of foreign, exotic place. He should be in Myrtle Beach, and, you know, if he's going to take a vacation at this time.

Roberts is from Louisiana. Once upon a time the principal language there was French. So it, too, must be foreign and exotic, right?

A Paragraph in Today's NYT story on Fannie Mae stands out to me

Specificially:

Mr. Mudd added that it was almost impossible during most of his tenure to see trouble on the horizon, because Fannie interacts with lenders rather than borrowers, which creates a delay in recognizing market conditions.

FWIW, I came late to the group of people who thought there was a housing bubble. But by 2005, it was clear to me that things were out of whack in San Diego, the Inland Empire, Las Vegas, Arizona, and Florida. If it was obvious to me, it should have been obvious to the CEO of a company in the mortgage business.

If you are in LA next Tuesday

More from Morris Davis

This morning he writes to me:

Now that a week has passed, I'd like to restate my original points on the
bailout as first proposed: (1) a blank check of $700bn to Paulson seems
irresponsible since he has been wrong about the crisis from day 1; (2) we
have not adequately forecasted and compared the cost to GDP of doing nothing
versus the cost to GDP of doing something; and (3) are we sure that free
markets aren't going to work? I've heard there is quite a lot of private
equity waiting on the sidelines. More on this in a bit.

The fourth point I made is that Paulson offered no simple and convincing
explanation of the problem. To talk about a solution requires knowledge of
the problem. Let me now offer two things: 1. My beliefs about the core
problems and 2. What I think we should be discussing.

1. I've learned that our financial accounting statements are inadequate.
Example: John Oros gave a talk here at Wisconsin last week. Oros is a
director at JC Flowers, a private equity firm, and they had the option to
try to buy AIG. (JC Flowers has also had the option to buy Bear Stearns,
Lehman, Morgan Stanley, ...). Last week he told us that, before his team
went in, AIG HAD NO IDEA HOW MUCH CASH THEY HAD. AIG brought in stacks of
books for Oros's team to look at to try to figure out what was on their
balance sheet. This is AIG, the company with 150,000 (?) employees and the
world's largest insurer.

2. The government has created and is creating confusion in the marketplace.
Bearn Stearns and AIG bondholders were paid in full; Lehman and WAMU
bondholders got nothing; maybe the bill will pass, maybe it won't; etc.

In addition, there is a failure of analysis at the top levels of government.
For example, has anyone outlined what happens to GDP if we do nothing (i.e.
just let the banks sort it all out) and what happens to GDP if we do
something. We should know best-guess costs and benefits.

Unfortunately, right now most of what we hear from the government and the
news media looks like fear mongering: Look at Japan! Look at the Great
Depression!

That is not analysis. I could say: The US economy had a stock market crash
in 2000, in 2001 there was 9/11 and an anthrax scare, and in 2003 we had a
hurricane wipe out New Orleans, and GDP barely noticed. Why is this episode
fundamentally different? And, how do these differences translate to GDP
loss.

One reason I am opposed to (more) government intervention is that I
fundamentally believe that the U.S. economy is more resilient to shocks and
disruptions than most acknowledge.

3. My understanding of the problem of financial institutions, from those I
trust, is that banks and financial institutions do not have enough capital,
and are therefore hesitant to originate new loans. If true, then if we are
to do something (debatable), then maybe we should inject equity into the
banking system. The government could partner with a set of private equity
firms to inject equity and claim ownership.

I realize the twice revised Paulson plan tried to do something like this in
a back-door fashion. What I couldn't figure out is if the revised plan
essentially created enough equity to be successful in recapitalizing the
failed institutions.

5. Many analysts, myself included, think house prices are going to fall
another 6 to 10 percent over the next 12 - 18 months. This will create more
distress in the financial system, since it implies that defaults and
foreclosures will rise and not fall. Thus whatever solution we come up with
now should be forward looking, in the sense that it should expect more
distress in the future.

My previous posts should make clear that I do not agree with Morris--the TED spread tells me that there is some urgency here, and if frozen credit markets inhibit capital formation, the pain from our current problems will last for a long time. I don't like the plan passed by the Senate last night either, but my view is the same as Krugman, Thoma and DeLong--Congress should hold its nose and pass it.

But I have enormous admiration for Morris' intellect, and so (with his permission) pass along his thoughts.

Europeans can sure be parochial

From today's LA Times:

Bad news for American writers hoping for a Nobel Prize next week: The top member of the award jury believes the United States is too insular and ignorant to compete with Europe when it comes to great writing.

As the Swedish Academy enters final deliberations for this year's award, permanent secretary Horace Engdahl said it's no coincidence that most winners are European.
"Of course there is powerful literature in all big cultures, but you can't get away from the fact that Europe still is the center of the literary world . . . not the United States," he said in an interview Tuesday.

He said the 16-member award jury has not selected this year's winner and dropped no hints about who was on the short list. Americans Philip Roth and Joyce Carol Oates usually figure in speculation, but Engdahl wouldn't comment on any names.

Speaking generally about American literature, however, he said U.S. writers are "too sensitive to trends in their own mass culture," dragging down the quality of their work.

"The U.S. is too isolated, too insular. They don't translate enough and don't really participate in the big dialogue of literature," Engdahl said. "That ignorance is restraining."

Geez!

Harold Augenbraum, executive director of the foundation that administers the National Book Awards, said he wanted to send Engdahl a reading list of U.S. literature.

"Such a comment makes me think that Mr. Engdahl has read little of American literature outside the mainstream and has a very narrow view of what constitutes literature in this age," he said.

Barack Obama is a Smart Guy

His speech on the financial crisis is here as well as other places.


I think it is terrific.

As it happened, I watched it with a former cabinet secretary. I gave a talk to a group about the financial mess today, and he was there. The speech was on TV just outside of where I spoke, so I stopped to watch, and the official stopped along with me.

I said I thought BO possibly had the stuff for restoring confidence.

The official said, "well, he certainly is smart."

I said, "smart would be a nice change."

The official laughed.

A quote from Tony Blair's last day as PM

I think of Blair very much the same way as I think of LBJ--as a great man of many important accomplishments who made a tragic mistake with respect to a war whose implications he didn't understand. On his last day in office, he said:

"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,