Why some classes are harder (and better) than others

One excerpt from the profile on Hoffman:

Hoffmann once asked Richardson, who has studied the 1956 Suez crisis in depth, to suggest some relevant readings because he was preparing a lecture that dealt with it. “I recommended five books,” she recalls. “And he read all five!—even though the Suez crisis was only a small piece of the lecture. Stanley takes scholarship and teaching very seriously. He reads an extraordinary amount.”

In true European style, he is also happy to ask his students to do the same, and compiled impressively long reading lists for full-year courses like “War,” which had three lectures per week, plus a section. War and Peace could be the assigned text for just one of those lectures. When asked if that was unreasonable, and if an excerpt from Tolstoy’s magnum opus might not suffice, Hoffmann asked, “Which part of War and Peace summarizes the themes?”

A Nice Profile of Stanley Hoffman

Go here:

http://www.harvardmagazine.com/2007/07/le-professeur.html

Hoffman was among my two very favorite professors in college (my Shakespeare professor, G.B. Evans, was the other) and this article does a nice job of capturing him.

Everyone in my vocation should aspire to be as good as Hoffman, and nearly everyone will fail to do so.

Reading we alluded to in Business Institute today

On college and future success:

http://www.irs.princeton.edu/pubs/pdfs/409.pdf

I have rarely heard such a famous economist be so modest...

From today's Washington Post:

When Edward P. Lazear, chairman of the White House Council of Economic Advisers, broached the idea of limiting the popular mortgage tax deduction, he said he quickly dropped it after Cheney told him it would never fly with Congress. "He's a big timesaver for us in that he takes off the table a lot of things he knows aren't going to go anywhere," Lazear said.

Lazear, who is otherwise known as a fierce advocate for his views, said that he may argue a point with Cheney "for 10 minutes or so" but that in the end he is always convinced. "I can't think of a time when I have thought I was right and the vice president was wrong."

hmmmm...

Why Rent-to-Price ratios vary

I was talking to my colleague Tony Yezer yesterday about measuring rent-to-price ratios for different zip codes for Washington. It got me thinking about why rent-to-price ratios vary so much from place to place.

First is expected growth in prices. Places that are losing population (Detroit, Cleveland) will not see prices go up, because they have excess supply of housing, and will for the foreseable future. They must therefore have igh rent-to-price ratio (or low Price-Earning ratios for housing). Places that are gaining population but have no brakes on development will also not see prices go up, because house prices will not rise above replacement cost. For example, when house prices in Dallas go up a little bit, developers rush in to supply the market until prices fall back to construction cost. The only exception are places like the Park Cities, which have excellent schools that are not easily reproducible. Because prices don't go up in Dallas, the rent-to-price ratio is high.

Conversely, San Francisco and Maui are not replacable, so while they are somewhat volatile, the underlying house price trends are upward. As Gyourko, Sinai and Mayer point out, as people in the upper reaches of the income distribution get richer, they outbid each other for these unusual places: they can be viewed as the Monets of real estate. But these places are unusual.

The other thing that can influence rent-to-price ratios is the tax code. Because mortgage interest is deductible, owning is relatively more valuable in places with high federal and state marginal tax rates (i.e., Cailfornia, New York, New Jersey, Maryland). The large place with the highest combined Federal and State Tax Rate is likely San Jose; that with the lowest is El Paso. Sure enough, rent-to-price ratios in San Jose are very low; in El Paso they are very high.

My Hard Drive Failed about a week ago...

On a Sony Vaio PCG-V505EX. I really like the machine, so I am currently making recovery disks (using safe mode) and hoping I can get the thing running again. If anyone has been through this, and managed to recover their system, I would love to hear about it.

Sweeney Todd - London National Theatre Cast

This is how imagine Victorian London--I think Dickens would love it.

Robert Waldmann on Redistribution

This is worth reading (and is relevant to our discussion today in the GW Business Institute).

http://rjwaldmann.blogspot.com/2007/06/possible-efficiency-gains-due-to-taxes.html

Francois Ortalo-Magne is on the front page of the NYT

I just saw yesterday's story, which is about a study Francois did with two Northwestern colleagues on whether houses sold through MLS command a premium over houses sold through FSBOMadison.com, a low fee-for-service Web site for do-it-your-selfers. The answer is, in the case of Madison anyway, no. I saw an early version of this paper (one that only discussed methods, rather than results), and it is extremely well done. It is also noteworthy how generous the MLS in Madison and FSBOMadison.com were in sharing data.

The story is of interest to me for its own sake, but also because I brought Francois to Madison when I was Chair of the Real Estate Department there. It was one of the smartest things I ever did.

Commercial Mortgage Lending and the Macro economy

This is something I wrote some years ago, and have revised a bit. It light of recent events in the commercial lending market, I thought it worth resuscitating.

Mera and Renaud (2000) demonstrate that the phrase “Asian Financial Crisis” was misleading. Green’s (2001) review of the book noted[1]:

[Asian Financial Crisis] suggests homogeneity: that “Asia” is one place, and that the financial crises faced by various countries there in the late 1990s were fundamentally similar. The fact that so many countries that were geographically close faced crises that were temporally close makes it easy to conclude that the crises had common roots.

Nevertheless, real estate did have a role in many of the countries that experienced a crisis, and the size of that role likely explains differences in the relative magnitudes of the crisis. In Japan, crises resulted in part from changing demographics and central bank regulatory and monetary policy, but also because of poor commercial real estate underwriting.

In Taiwan, land prices rose and then stabilized, and never crashed as they did in other Asian Economies. In Hong Kong, land prices fell, but because of the lending system there, which required property investors to use substantial equity funding, real estate had little effect on the overall health of the economy. The Chinese office market became badly overbuilt—especially in Shanghai—but the economy there continues to chug along, at least for now. But in Indonesia and Thailand, poor understanding of real estate fundamentals, along with collapsing currencies, caused real estate markets to fail. In contrast, Korea’s crisis arose largely from an unsustainable system of corporate lending. Real estate likely played a fairly small role in Korea’s crisis, and the country recovered almost immediately. It is worth spending a little time talking about the large real estate crises in Japan, Thailand and Indonesia, as well as the ability of Korea to avoid such a crisis.

Edelstein and Paul (2000) explain the sources of the extraordinary run-up in land prices in Japan in the 1980s, and the government’s response to that crisis. They maintain that the run-up in land prices from 1984 to 1991 was not the product of a speculative bubble, but rather of fundamentals of the Japanese economy. As Mera (2000) points out, Japan managed to survive many challenges to its economy quite well, including the second oil shock and the Plaza accords of 1986, which caused the yen to appreciate substantially and thus rendered Japanese exports less competitive. At the same time that Japanese incomes were rising sharply, interest rates in the country remained quite low. If we think about the Gordon Growth Model, i.e. R = i-g, where R is the capitalization rate, i is the discount rate and g is the growth rate, we would expect rents to be capitalized into high property values.

Moreover, as Edelstein and Paul point out, land in Japan is much scarcer than it is in other places: Japan’s population is a little under half of the United States’, yet its land area is only 4 percent that of the United States, and its habitable land in an even smaller percentage than that. Japan’s population density is thus 25 times larger than the United States’, and its GDP per square mile is 15 times large. Again, this is entirely consistent with Japanese land price levels being substantially higher than in the United States.

The property bust arose, according to both Mera and Edelstein and Paul, because of changing and with government policy.

With respect to fundamentals, we know that the Japanese economy slowed sharply in the 1990s. Part of the reason for this had to do with real estate related problems in the banking system, but part of the reason for this had to do with broader issues facing the Japanese economy. As to the former, Edelstein and Paul note that banks in Japan were allowed to count corporate stock holdings as reserves. This, of course, is the exact opposite of how banking is supposed to operate: reserves are supposed to be assets in which the financial institution has a risk-less position, such as cash and high quality government securities. Instead, Japanese banks counted very risky assets--equity--as reserves. Much of the underlying value of that equity was in the form of real estate, some of which was highly leveraged. Consequently, even a small downward turn in real estate markets had a profound effect on the banking system, which in turn had large repercussions for the financial system as a whole.

Making things worse was the fact that Japanese banks failed to recognize their real estate losses on their balance sheets: non-performing assets effectively drove equity levels in Japanese banks to levels below zero, and consequently created perverse incentives for Japanese bank managers.

At the same time, as the Japanese economy slowed, changes in expectations led to an increase in the underlying capitalization rate for real estate and other assets, and has therefore causes the values of all those assets to decline sharply. The existence of leverage has exacerbated this phenomenon further.

The most spectacular failures in the banking system with respect to real estate: Thailand and Indonesia, and especially Indonesia. Chapters by Bertrand Renaud (on Thailand) and Dominique Fischer (on Indonesia) give us harrowing stories of how poor underwriting, abetted in part by the “unholy alliance” between lenders and developers, can lead to a full fledged financial crisis.

The US has no cause to be smug about this, of course, as it invented the process with the Savings and Loan crisis of the 1980s. Both the Renauld and Fischer stories can be told simply enough: lenders assume rent and property value growth at some extremely high rates, which in turn produces very low capitalization rates. This in turn causes appraisers to assign high values to properties. These high values provide the support lenders need to advance loans, which typically have higher loan-to-value ratios. The high-loan-to-value ratios are justified by the fact that property values “always” rise, and that therefore the equity in the loan will quickly get sufficiently large to discourage default. At the same time, the financial institutions had reason to believe that governments (or NGOs) would prevent them from failing, meaning that the downside risk to the risky loans was attenuated. This led to a classic moral hazard problem, where risk was not appropriately priced.

The problem with this, of course, is that sometimes values and rents stop rising, particularly when building outpaces demand. All that needs to happen is for the real estate sector to grow more rapidly than the economy; at that point, everything can come unglued. And so it did: interruptions in rising rent trajectories caused real estate loans to become delinquent. But then things got even worse. The embryonic financial crisis in Thailand and Indonesia caused foreign, and especially Japanese, capital to flee. This led to currency devaluations. Because real estate loans were often denominated in foreign, rather than home currencies, the debt obligations of borrowers got much larger, which in turn led to more defaults. It was thus the combination of poor underwriting and a lack of understanding of currency risk that contributed to the downfalls of the two economies. In Indonesia, GDP fell by a stunning 15 percent in just one year.

---

[1] Much of the discussion of the Asian financial crisis below closely follows Green (2001).

Blogging Brooklyn

This is really nice:

http://builtenvironmentblog.blogspot.com/

The only problem is that while he (quite rightly) mentions Peter Lugar's, he doesn't mention Totonno's Pizza in Coney Island. The Pizza is so good it's worth the trip.

Susan Wachter has a mortgage payment index

It is at http://smartermi.genworth.com/mortgage-index.html. It tries to show borrowers how much trouble they can get into if they use Adjustable Rate or Payment-Option mortgages. Simple but useful.

A Nice Paper for GW Business Institute

By Carol Graham, who has done some of the best work on this stuff.

http://www.nd.edu/~adutt/activities/documents/GrahamInequalityAndHappiness2.pdf

Note that as we discussed in class today, Marriage makes people happy, and unemployment makes people REALLY unhappy. All else being equal, people in Venezuela, Honduras and Costa Rica seem to be the happiest in Latin America, while Peruvian, Ecuadorans, and Bolivians are least happy.

You might want to check out the GINI coefficients for these countries (and also try to find what a GINI coefficient is).

Stand-up Economist on Mankiw

http://youtube.com/watch?v=VVp8UGjECt4

One reason to become a parent

I took my daughter Hannah to hear the Philadelphia Orchestra at the Kennedy Center yesterday. We agreed the playing was awesome. But while I found Eschenbach's Brahms 1st fussy, she really liked it a lot, and argued it was consistent with the romantic tradition. I disagree, but it was fun to have the conversation.

George Akerlof's Presidential Address

This is well worth reading:

http://www.aeaweb.org/annual_mtg_papers/2007/0106_1640_0101.pdf

Apparently, a fair number of economists didn't like this, because it states that empirical findings undermine a number of neoclassical totems, such as the Permanent Income Hypothesis. But if we want to be a reality-base profession...

C Students

I think C students can be divided into roughly three types.

The first type sees the universe through a different prism than most of us, and often has wonderful insights that do not translate well to the stylized task of exam writing. I am grateful for these C students.

The second type must deliver pizza and clean bathrooms to pay for tuition, and so has compromised time and energy with which to do school work. I am grateful for these C students as well.

The third type is lazy, arrogant and uncaring. I was thinking about this third type while sitting on the lawn at Wolftrap for Prairie Home Companion the other day. Garrison Kieler was reading hellos to service members in Iraq and Afghanistan from their family members in the audience, and I found myself misting up a bit as I listened. The habits of the third type of C student has placed more than 150,000 young men and women in far more danger than they need to be, and those same habits are keeping them in danger longer than necessary.

When is the bottom of the housing market coming?

I don't know--and neither does anyone else. Here are three things to consider, however:

(1) A good harbinger of the housing market is the months supply measure. When the months supply rises beyond six months, it is hard to make a case for house prices going up anytime soon, unless builders stop building altogether. The reason: it takes about six months to build a house in most markets (i.e., to get from the beginning of the permitting process to the finished product). Thus prices have to fall until the inventory is absorbed.

The good news is that homebuilding has slowed down a lot, and that the months supply measure for new homes fell well below six months in April. The bad news is that the months supply of Existing Home Sales continues to rise, and is currently at 8.4 months. The other bad news (in a sense) is that the Existing Sales number is much less prone to revision than the New Sales number, and reflects actual closed sales, instead of sales contracts. Until the Existing Home Sales months supply number turns around, it is hard to see when the bottom will come.

(2) While the national number is important from a macroeconomic and mortgage securitization standpoint, it is not helpful to buyers in local markets. Some markets have supplies of less than six months, and buyers in these markets, particularly those who are planning to live in one place for awhile, just shouldn't worry about short-term price fluctuations. But other markets have huge supply gluts; in these markets, potential first time homebuyers are better off renting for awhile.

(3) Housing markets have substantial intrametropolitan variation. The detached housing market can be considerably different from the Condo market; housing near transportation lines can retain its value better than housing in far-flung suburbs. Moreover, there are some opportunities in weakness. I was looking at the San Diego MLS listings recently. Houses that would have been out of range for a finance professor a few years ago (i.e., houses with ocean views) are now within range. The principal reason to buy a house is the consumption benefit of the house--when an opportunity arises to obtain a great place to live, it is worth considering. Just don't be naive about it--make sure you plan on living in one place for a long time (in which case resale value doesn't matter so much), that you can afford the place with a fixed rate mortgage, and that you don't mind knowing that its price might go down for awhile before starting back up again.

It's been too long

The past two months have passed too quickly. One week I spent teaching finance in Busan. Korea is a remarkable place. When first I visited in 1992, it was clearly a place on the rise, but also one that retained a large number of very poor people, many of whom lived in very poor housing conditions. I have been back three times since then. The extreme poverty seems pretty much gone now, as its per capita GDP has risen from about 1/4 US and Japanese levels in 1990 to 1/2 US and 2/3 Japanese levels today. At the end of the Korean War, per capita GDP was roughly a dollar a day.

Korea is an exilerating place, because it has come so far so quickly, and as such, is an example for poor countries all over the world. It is hard to know the "secret," though, other than the fact that education has been an important part of the culture for a long time, and Korean parents probably care even more than Montgomery County parents about how well their kids do in school.

The infrastructure in Busan is quite remarkable, with a wonderful metro system, good roads, and one of the most beautiful suspension bridges I have ever seen. (The image below is from Slate). The city is the second largest in Korea, and trying to become the financial services center of the country. But it is still off the beaten path--as a Westerner I felt quite conspicuous.

Casino Royale

Tonight, for the first time, I made myself the drink James Bond creates in Casino Royale:

"Just a moment. Three measures of Gordon’s, one of vodka, half a measure of Kina Lillet. Shake it very well until it’s ice-cold, then add a large slice of lemon-peel. Got it?’”

It is actually very good.