Sunday, May 31, 2009

Clive Granger

I was saddened to learn of his passing. His influence on me was enormous--I could not have written my thesis (here is a paper from a chapter)or at least one of my papers without his work. Although I never met him, I owe him a lot.

Fred Barnes, Bill Bennett, Jeff Rosen and Newt Gingrich are not very bright

Barnes predicted a McCain victory last fall. Despite going to an exclusive prep school and not having much competition from minorities and no competition from women, he did not go to Princeton.

Bennett has not figured out that on average, you lose at casinos. He must not be very good at counting.

Rosen teaches at George Washington. I used to teach at GW, and so am living proof that you don't need any special intellect or wisdom to teach there.

Gingrich taught at the University of West Georgia (the US one, not the Caucuses one).

The thing that makes them all really less than bright: they have made arguments even dumber than those I just made above.

p.s. Rush Limbaugh is not dumb. He is brilliant at parlaying the insecurities of white men (we are very sensitive) into gobs of money.

Mark Zandi worries about the Long-term Fiscal Picture

We at the USC Lusk Center put on a retreat every year, and our opening keynote speaker was Mark Zandi. I have admired Mark for some time because he has the rigor of an academic economists and the timeliness of a business economist. The combination is rare.

Although Mark advised the McCain campaign, he has supported the Obama stimulus package, except to the extent that it is not large enough. But he has concerns about the long-term fiscal outlook of the country, where according to CBO the federal debt-to-income ratio could exceed 80 percent. While crowding out is almost certainly not an issue at the moment (Brad Delong explains why quite nicely), I do worry that large amounts of government debt would over the long run push up interest rates and reduce private investment. I also found that I felt a great degree of satisfaction (i.e., utility) when in the late 1990s the US was reducing its debt burden quite rapidly.

The question, then, is what to do. Like others, I don't think Social Security is that worrisome, and that commentators who conflate Social Security with Medicare are basically trying to scare people in an intellectually dishonest way. For those of us who don't need to use our backs for our work, raising the retirement age a bit should be perfectly acceptable. For those of us who are lucky enough to earn more than the maximum on which social security is taxes, a rise in that maximum should also be perfectly acceptable.

It seems to me (and a lot of other people) that there are two big issues: the cost of health care and the inadequacy of tax revenue. The first point is especially thorny, and I should disclose two things: I support a single-payer option (it seems to me that private insurance creates loads of deadweight loss) and I am married to a primary care physician. I am not sure how to reduce health care costs in a politically acceptable manner, but I do know: (1) the current medical reimbursement system encourages procedures and does not encourage preventative care and (2)we have done a lousy job of coming to grips with end-of-life care issues. The second of these points will require a great deal of soul searching on the part of us all, and I don't particularly see a political "win-win" situation for dealing with it.

As for taxes, the issue is how to raise revenue without screwing up capital formation, which is necessary for growth. I should note that the tax code during the Clinton era seemed to work just fine. But as part of a grand bargain for putting the country on a sound fiscal footing, it might be worth revisiting some of the principles of the Hall-Rabushka Tax.

I wrote a paper with Dennis Capozza and Pat Hendershott for a Brookings Book on Fundamental Tax Reform on the effect of a Hall-Rabushka tax on residential real estate (short answer: it would cream values for awhile). But the only thing I really disliked in principle about the proposal was its best known feature: its flatness. I am reasonably sure that there is diminishing marginal utility in consumption, so a tax based on ability to pay must be progressive. But other aspects of it--that it essentially eliminates deductions, that it taxes consumption (which reflects living standards), and that it treats all consumption equally, regardless of the source of income used for consumption--makes it more neutral than the current tax code, and better at encouraging savings. I think a Hall-Rabushka tax with an Earned Income Tax Credit, a large exemption, and a couple of brackets might work quite well.

[Update: some sort of grand bargain should also involve Pigou taxes on gasoline, sugared sodas, etc. To the extent that they are regressive, one could use the revenue to reduce the payroll tax at the bottom of the wage distribution, provide better transit, etc.]

Wednesday, May 27, 2009

Pleasant Surprise

Amazon sent me a recommendation a few weeks ago: a 38 disk box set of Karajan conducted symphonies for around $70. I like HvK's Beethoven and Bruckner sets, and didn't have either on CD (I still listen on vinyl), so the Amazon recommendation seemed like a good deal, because it also included Brahms, Mendelssohn, Schumann, Tchaikovsky, Mozart and Haydn.

HvK's Mozart has never worked for me, so when I stuck a Haydn CD (Symphonies 103 and 104) in my car's player last night, I wasn't expecting much. But on first listen, at least, it was quite wonderful: the playing was at once lithe and powerful. It appears that the dead Nazi could really do Haydn.

Tuesday, May 26, 2009

Has long term house price growth returned to normalcy?

Case-Shiller released their most recent indexes this morning. I used the data to graph annualized house price growth between 1989-2009 (I only use 1989 as the start date because this is the start date for the data series for some cities).

Nationally, house price growth has been about 3 percent per year. LA and San Francisco are also at about 3 percent. Phoenix and Las Vegas have (obviously) come back down to earth. Portland is obviously a high-flier, but it had a dramatic regime shift in land use planning.

Hat Tip to TPM for pointing out Andy Rooney video

Rooney On Lives Taken

I wish I had seen this before yesterday

Sunday, May 24, 2009

The Instability of Dynamic Consumer Credit Pricing

I am attempting to come up with a model demonstrating that dynamic risk-based pricing of consumer credit could well be unsustainable. The foundation of my thinking is a 27 year old paper by Sargent and Wallace entitled "Some Unpleasant Monetarist Arithmetic". In that paper, SandW show that when real interest rates exceed economic growth in the presence of deficit spending, tight monetary policy is not sustainable. I have only a sketch so far.

Suppose consumer credit markets price debt using some sort of Modigliani-Miller formulation: as the leverage ratios of households rise, the price the pay for debt rises. We can think of the leverage ratio as the value of household assets (including human capital) divided by assets less debt outstanding, or equity. For households operating at the margin, human capital may contain all assets.

Interest charges in each period is a function of the household's leverage ratio in the previous period. So

r(t) = rf + LR(t-1)(rh -rf)

LR(t)= LR(t-1) + f(Min payment - r(t-1))

Where r(t) is the interest rate on consumer credit at time t, rf is a rick free rate, rh is the return on assets for an unleveraged household, and LR(t-1) is the leverage ratio at time t-1.

Suppose a household is on a path where it is amortizing its debt. Then the cost of credit falls over time, which accelerates the point at which a household becomes debt-free.

But now suppose that household receives a negative permanant shock: a job loss, a health problem or a divorce. In the short tun, it can make a minimum payment on a credit card balance, but not enough to pay interest due, so the balance gets bigger. This raises the cost of interest in the following period, which in turn means that the minimum payment pays even a smaller share of interest costs. The leverage ratio increases.

Under these circumstances, the amount owed is increasing as rapidly as the discount rate, and so a traversality condition (where in the limit, the present value of debt goes to zero) is violated. This implies (I think) that some sort of interest rate ceiling might improve stability. Thoughts are welcome.

Friday, May 22, 2009


I am not crazy about the way Elizabeth Warren, Chair of the TARP Congressional Oversight Panel, looks at the world. I have heard her speak at conferences, from which it is clear to me that (1) she thinks consumer credit is generally a bad thing and (2) has no understanding of present value. I inferred the second of these points because she claimed that total interest paid over the life of a loan is the relevant measure of cost. In particular, she thought households should pay off their mortgages as quickly as possible.

Yet some of the reforms she is suggesting now make some sense to me. I find myself surprised at myself in now thinking that some sort of usury ceiling might make sense--one where, say, credit card rates may be no higher than LIBOR + 20 percent, or some such thing. The reason: there is a point at which it is not possible to map risk to prices, and therefore it is socially optimal not to have credit available. In particular, there is a point at which higher rate creates more risk which should lead to higher prices, etc. I am not sure that it is analytically possible to determine the threshold, so a government limitation would be a second best policy. But usury ceilings might have prevented the current crisis.

Thursday, May 21, 2009

California is a fiscal mess: it needs a grand bargain that will never happen

Californians just voted down ballot initiatives whose purpose was to bring fiscal balance to California. While I voted for them, I understand why the electorate (thhe small share that voted anyway) didn't like them. They were poorly worded (as are many initiatives), and still didn't get at the fundamental problems facing California. California ranks fourth in the country in per capita state and local government spending, and yet government services--particularly schools--are disappointing.

But voters themselves are partly responsible for the mess California finds itself in. Proposition 13, passed 31 years ago, leaves California with a property tax system that is inequitable, and a school funding mechanism that decouples funding from performance. Bill Fischel and others have shown that schools funded with local revenues--particularly property tax revenues--perform better than schools that are funded remotely. Because property taxes are so limited in California (one pays property taxes based on the value of a house at the time of purchase, rather than current value), a large share of school funding flows through Sacramento. When people's houses are paying for school, they have a strong incentive to make sure the benefits provided by the schools are larger than the taxes they are paying, lest their property values fall. I have little doubt that one of the reasons California public schools--once among the best in the country--have fallen so far is because of how they are funded (note: using property taxes to fund schools does create a problem for those places where property values are low, so there is a role for some state funding of schools. I will write more about this in another post).

On the other hand, it is also striking how hide-bound and inflexible public employees unions behave in California. When I ask long-term Californians why the state has such large fiscal problems, they almost inevitably list the Prison Guards Union toward the top of the list. When Mayor Villaraigosa suggested that city employees in Los Angeles take pay cuts so that he wouldn't have to lay people off, the unions balked. When I listen to union officials on the radio, it is clear that they place the interests of the median voter in their union above those of the state (this is only natural).

For California ever to return to fiscal stability, it will need to repeal Proposition 13 and reign in its unions. To put it crudely, the right would dislike the first of these ideas, the left would dislike the second. This is why the ingredients of a grand bargain would be to do something about both. Unfortunately, because both have strong constituencies behind them, it is doubtful that anything ever will happen, and California will lurch from crisis to crisis.

Despite this, I like living here...

Wednesday, May 20, 2009

Cap Rates and Commercial Real Estate Default

Commercial real estate mortgages are different from residential mortgages in a number of dimensions. One of the most important is term: while residential mortgages are generally self-amortizing, commercial mortgages usually have "bullets" or balloon payments arising from terms that are shorter than amortization schedules. For instance, a commercial mortgage might have a ten year term with a 40 year amortization schedule.

Many of these commercial loans are currently due or will soon be due. Many of them are performing well, in the sense that buildings, even after rent reductions, are producing sufficient cash flow to cover debt service. But because expectation have changed, capitalization rates have risen. This creates a problem.

Real Estate may be valued similarly the way stocks are values using the Gordon Growth Model. Income gets capitalized into value via a capitalization rate, which has two basic terms: a required rate of return, or discount rate, and an expected rental growth rate. The formula for valuation is simply V = Income/(r-g), where V is value, r is the discount rate and g is the expected growth rate.

Five years ago, a high quality office building would have a cap rate of 5.5 percent. The ten year treasury rate at the time was around four percent, so the 5.5 cap rate might have reflected that four percent rate plus a three percent risk premium less a 1.5 percent expected growth rate in rents (4+3-1.5).

Now, the ten year treasury rate is around 3 percent (actually 3.24 at this writing), which would tend to push down cap rates. but risk premia have widened, and rents are expected to fall. Suppose the risk premium is now 5 and rents are expected to fall one percent per year (they don't change that much from one year to the next because long term leases are in place). Now we get a cap rate of 3+5+1, or 9 percent. This would imply property values falling by (1-5.5/9), or a little less than 40 percent. This may overstate what is happening--as best as I can tell, values have fallen by about 1/3.

Consider a loan originated 5 years ago at a 5.5 percent cap rate and a 70 percent LTV. The loan to value ratio would have been conservative, and yet if the loan had no amortization (certainly a possibility), the building owner would be upside down, with a loan due greater than the value of the real estate. These are the properties that are extremely difficult to refinance, and may produce the next credit crisis.

Of course, had the mortgages been self-amortizing without a bullet, many of the loans would not have turned into problems.

Tuesday, May 19, 2009

Karen Pence Showed that TALF may be working

Karen Pence of the Fed gave a talk at the Homer Hoyt Institute meetings the other day. She had a couple of interesting points:

(1) With respect to auto loans, the Term Asset-Backed Securities Loan Facility (or TALF) seems to be working. Spreads on Auto-loan related ABS, while still high, have come down considerably since the autumn. Auto relted lending has also loosened since December.

(2) The availability of auto credit has an important impact on auto spending. As bad as the demand for autos is, it would be even worse in the absence of TALF.

I would post Karen's graphs, but I don't have a copy of a paper yet. They are pretty interesting and revealing.

TALF is an awfully good deal for investors, because they can lever up without recourse to buy pretty good securities. It is not alas available for retail investors.

Thursday, May 14, 2009

Means, Variances, and Coaching.

Malcolm Gladwell writes that basketball teams with inferior talent should run full court presses. The full court press is a high risk defensive strategy: it raises the likelihood that a defensive team gets a steal and an easy basket, but it also raised the likelihood that the opponent will get an easy basket. It is a higher variance strategy than a standard defensive strategy.

Such a strategy makes sense for a team with little talent. Such a team wants to raise the variance of outcomes, because it is the only way it can win. If an inferior team pursues a variance minimizing strategy, it will always lose, because its mean outcomes are lower than those of superior teams.

The worst coach I ever saw in any sport was the football coach for the Wisconsin Badgers before Barry Alvarez, a man named Don Morton. He was a horrible recruiter, so the team's talent was poor. He also ran a minimum variance strategy: three rushes in a row (around 2 yards per rush) and then a punt. During his time at Wisconsin, the Badgers won three Big Ten games in three years.

On the other hand, superior teams should attempt to minimize variance in the game. It is why I am not sure Brett Favre was a net plus to his teams over the past few years--he probably added too much variance. Mike Holmgren was a genius at reducing Favre's variance. I think had he stayed with the Packers, the two of them would have won a couple of more Super Bowls.

A study I would like to do at some point is a determination as to whether Walter Payton was more valuable than Barry Sanders. Sanders yards per carry average was much high than Payton's, but he surely gained the yards with a lot more variance. Someone needs to measure the two variances and run simulations. Perhaps after I retire.

The ideal back would get 3.5 yards per carry with no variance: such a back would guarantee scores and burn clock, giving the defense an opportunity to rest.

Tuesday, May 12, 2009

My colleague Richard Little makes me revisit my view on High Speed Rail

He writes to the Wall Street Journal:

The decision by the Obama administration to add more funds for high-speed rail needs to be read in the context of the Environmental Protection Agency's intention to regulate greenhouse-gas emissions ("U.S. Commits $13 Billion to Aid High-Speed Rail," U.S. News, April 17).

High-speed electrified trains, properly designed and located, could provide much needed interurban passenger capacity while minimizing these emissions. Although high-speed rail probably won't "pencil out" financially in the short term, in the longer view the rail transportation system won't be competing with cheaper options from the past. The EPA decision could place significant limits on additional highway capacity and the ability to add to the number of flights at already overcrowded urban airports.

Under these conditions, what appears too costly today may, in fact, be a prudent investment for tomorrow.

I had not considered his counter-factuals before. Such is always the problem with benefit cost analysis.

Sunday, May 10, 2009

If investors are rational, why are they willing to buy airline stock?

On Thursday and Friday of last week, I went back to Washington to take care of a last bit of GW business: two of my students, Leigh Ann Coates and Theresa Diventi, successfully defended their Ph.D. dissertations.

I flew on United Airlines, and the plane was stuffed in both directions. Clearly United (as well as others) have done a good job of reducing capacity such that they fly very few empty seats.

Yet even while flying full airplanes, the airlines are losing money. This is perhaps because the airline business is essentially impossible: the fixed costs of running an airline are high, while marginal costs (particularly for the last seat on the plane) are low. The airline business has something pretty close to free entry, and so prices get driven down to marginal cost, which is below average cost, which means airlines on average over time lose money.

When asked how one became a millionaire, Richard Branson famously answered, "be a billionaire and start an airline." So why do people invest in them? It is hard to square this behavior with rational expectations.

Relationship Lending

An essay in a new University of Michigan Dissertation by Ben Keys finds evidence that "soft information" about borrowers might matter. The essence of the essay's findings is that banks underwrote mortgages they were forced to keep in portfolio more stringently than mortgages they packages into securities.

The instrument is clever: generally speaking, loans from applicants with FICOs of less than 620 were more difficult to secularize than loans with FICOs of more than 620. Keys and his colleagues found that loans with FICO scores of 619 performed better--substantially better--than loans with FICOS of 621. The argument is thus when banks are forced to keep loans in house, they underwrite more carefully, using soft information that securities holders (as opposed to underwriters) cannot observe.

This gives support to the view that securitization produces sloppy underwriting, and undermines "relationship" lending. There is some truth to this, but it doers not mean we should go back to the days when relationships dominated hard information. It was, after all, the reliance on relationships that allowed white men easier access to mortgage credit than women and minorities (not to mention single people).

The issue may not so much be the importance of soft information, but rather the quality of hard information. Securitized loans--which were based on well-documented credit histories, income and assets--performed quite well until maybe six or seven years ago. That is the point at which the quality of the hard information began to deteriorate.

Tuesday, May 05, 2009

A World Bank Talk

A talk I gave on Feb 2.

Dan Gross on my Old School

He nails it:

Living and working in the New York region's financial-media complex in 2009 means daily, compulsory attendance at a gathering of the glum. The economy may be shrinking at a 6 percent annual rate, but finance and media have contracted by about 30 percent. For the past year, the daily routine has meant sitting in a depopulated office (assuming you still have a job); following the latest grim news of magazine closings, buyouts, and layoffs; and commiserating with friends, family, and neighbors. And, of course, the angst extends far beyond directly affected companies. Finance dominates the area's economy to such a degree that everybody—lawyers, accountants, real estate brokers, waiters, retailers, and cab drivers—have all been affected.

Of course, one can try to get away to sunnier, more mellow climes. But the usual havens aren't offering much succor. Florida—like New York, except the catastrophe is real estate. Mexico? Um, not now. But last month, I found an unexpected haven: the Midwest. Each semester, the University of Wisconsin School of Business brings in a journalist-in-residence for a week, usually from New York. The theory: Students and professors benefit from the perspective of someone who is chronicling the workings of the world they are studying remotely.

But the benefit was greater for me than for the students. The four days in Madison functioned as a kind of detox. I left thinking the university should turn the Fluno Center for Executive Education into a sort of clinic. It could do for stressed-out financial and media types what Minneapolis' Hazelden does for the drugged-out: offer a safe, friendly (if chilly) place to escape the toxic influence of New York.

Madison struck me as blessedly detached from the ailing financial sector. Of course, Wisconsin is suffering along with the rest of the nation. Its unemployment rate in March was 8.5 percent. But Madison, with its three-legged economic stool of education, state government, and health care, is faring somewhat better. More significantly, the business school isn't having a dark night of the soul, as so many of its Eastern counterparts are.

Columbia Business School and the University of Pennsylvania's Wharton are basically satellites of Wall Street. Half the students have memorized the partnership roster at the Blackstone Group the way I once knew the lineup of 1970s-era Cincinnati Reds. An MBA from Columbia or Harvard or Wharton is basically a leveraged bet on a student's ability to make it in finance. You pay a ton of money, most of it borrowed, so that you can land a really high-paying job with one of the big investment banks or private-equity firms that visit campus. By their second year, most MBA students at Wharton are already scoping out the Hamptons for the second homes they know they'll be able to buy in a few years. But with the gilded pipeline to Wall Street temporarily shut down, the rising MBAs are suffering the kind of existential crisis more generally associated with comparative literature majors. The New York Times last month ran an article about students at Wharton who were suddenly at sea. Some were considering working for nonprofits!

But in Madison, the vibe is much different. The television in the business school's lobby was set to Headline News, not CNBC. The only mention of toxic assets was an ironic one—on a T-shirt. When I walked into undergraduate finance classes and asked, "How many want to go get a kick-ass job on Wall Street and make a ton of money?" not a single hand was raised. The students are mostly kids from Wisconsin studying the basics—management, accounting, corporate finance. Some plan to stay in-state and find a job with a small business or with one of the big local firms: Kohler, S.C. Johnson, Kohl's, Harley-Davidson. Many head to Minneapolis or Chicago for jobs with consumer products companies. The University of Wisconsin boasts of having as many alumni who are CEOs of big companies as Harvard does. Yes, Chicago has its big options exchanges. But the Wisconsin students don't seem interesting in moving money around. That happens in the East. ("Instead of being the warm center of the world, the Middle West now seemed like the ragged edge of the universe," as Midwest native Nick Carraway put it in The Great Gatsby, "so I decided to go East and learn the bond business.")

The finance graduate students I had lunch with knew about CDOs and hedge funds but mostly as academic subjects. When I met with a small group of undergrads in an entrepreneurship course, they presented interesting ideas about online businesses, not financial engineering. Private-equity magnate Henry Kravis, CNBC anchor Erin Burnett, and JPMorgan Chase CEO Jamie Dimon could probably sit down at State Street Brats and chow down unnoticed and unbothered.

While the faltering economy has dampened job prospects, the meltdown on Wall Street hasn't caused these students—or their faculty—to reconsider the utility of studying accounting or corporate finance. It could be because they haven't been asked to risk as much personally as MBA students back East. At one forum, a student groused about rising tuition, much to the disbelief of the business school Dean Mike Knetter, who knows from expensive education. (He was trained as an economist at Stanford and taught at Dartmouth before returning to Wisconsin.) Knetter, a Wisconsin native, pointed out that even if it was rising, tuition here is still a huge bargain. In-state MBA students pay $11,500 per year, plus living expenses, while undergraduate tuition is about $8,000 per year. (At Wharton, by contrast, tuition for MBAs is $50,000, and total costs are $80,000.)

Compared with the costs of high-end executive detox retreats, like the one run by former Time Warner CEO Jerry Levin, Wisconsin is a bargain.
Daniel Gross is the Moneybox columnist for Slate and the business columnist for Newsweek. You can e-mail him at His latest book, Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation, has just been published in paperback.

Article URL:

Wisconsin's Dean, Mike Knetter, is among the most visionary administrators I have ever known. So is Steve Sample, USC's president. I have been most fortunate in my employers.

Program Note

I will on on Airtalk with Larry Mantle this morning at 10:06.

Monday, May 04, 2009

Las Vegas is a metaphor for the broader economy

Ernst and Young has an annual Builders CFO conference, to which I was invited to speak. It was in Las Vegas. Overall, the experience was terrific: I enjoyed interacting with the audience during the breaks, and E&Y was kind enough to put me up in the Encore Hotel, which has very nice rooms. And now that I live on the West Coast, I am coming to appreciate the efficiency of Southwest Airlines.

This has been my second trip to Vegas this year, and I can't help but be astonished by its, well, soullessness. It is a city whose core value seems to be to separate people from their money. People are lured by the (false) possibility of getting rich quickly. As the cabbie that drove me to the airport noted, service is not important to people here, because there is an assumption that relationships are ephemeral.

It is therefore no accident that Las Vegas' social indicators are poor. Nevada (three quarters of which lives in Metropolitan Las Vegas), ranks among the bottom quartile of states in life expectancy and population share with a bachelor's degree. It now appears that the spectacular growth in population and employment in Las Vegas was a chimera.

And so perhaps it was with the US financial sector. The sector's share of profits and GDP reached unprecedented--and clearly unsustainable--levels. The profits were also a chimera. Investment banks held junior tranches of mortgage backed securities that paid spectacular returns--so long as the mortgages remained current. But quarterly, and even annual, profits did not reflect a reasonable expectation about the long term performance of the assets. Part of the problem was that mortgages were originated independent of relationships--including even relationships with rigorous automated underwriting.

I can't way I saw this coming--I did not. But the ex post similarities between Wall Street and Vegas (beyond the old shibboleth that they are both casinos) is striking.