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,

Coleman, Lacour-Little and Vandell argue that house prices made sense until 2004

The abstract of their new paper:

The cause of the "housing bubble" associated with the sharp rise and then drop in home prices over the period 1998-2008 has been the focus of significant policy and research attention. The dramatic increase in subprime lending during this period has been broadly blamed for these market dynamics. In this paper we empirically investigate the validity of this hypothesis vs. several other alternative explanations. A model of house price dynamics over the period 1998-2006 is specified and estimated using a cross-sectional time-series data base across 20 metropolitan areas over the period 1998-2006. Results suggest that prior to early 2004, economic fundamentals provide the primary explanation for house price dynamics. Subprime credit activity does not seem to have had much impact on subsequent house price returns at any time during the observation period, although there is strong evidence of a price-boosting effect by investor loans. However, we do find strong evidence that a credit regime shift took place in late 2003, as the GSE's were displaced in the market by private issuers of new mortgage products. Market fundamentals became insignificant in affecting house price returns, and the price-momentum conditions characteristic of a "bubble" were created. Thus, rather than causing the run-up in house prices, the subprime market may well have been a joint product, along with house price increases, (i.e., the "tail") of the changing institutional, political, and regulatory environment characteristic of the period after late 2003 (the "dog").

This result is hardly consistent with the charge that the GSEs were the principal source of the problem. It also says something about having a purely private mortgage market.

LA House Prices again

Brad Delong has the Case-Shiller house price index for LA going back to 1987 on his blog today. Nominal house prices are now about double what they were in 1987, for an annualized growth rate of about 3.3 percent. Sounds reasonable to me.

The Fannie/Freddie Conservatorship seems to be working OK

Let' see:

-Interest rates on conforming loans have dropped substantially, helping both homebuyers and sellers in the conforming market. Underwriting standards, though., remain more stringent (good in the long run, perhaps not so good in the short run).

-Senior management got removed without golden parachutes

-Shareholders get largely, but not entirely, wiped out

-The taxpayer, holding 80 percent of the company, gets susbstantial particiation in any upside (which in F&F's case, I think likely).

On net, this looks pretty good. It also looks kind of like Sweden's temporary nationalization of its banking system in 1992, which worked pretty well.

Can't anyone play this game?

A few years back, I reads Robert Caro's Master of the Senate. The thing about the book that most stuck with me was the political genius of Richard Russell. While he was a racist old bastard, he knew how to count votes, and he knew not to showboat in order to get votes. We could use his skills (if not his worst attitudes) right now.

Is Lincoln Forecasting its own Demise?

So I'm watching the Bears-Eagles game, and I see this ad for a Lincoln featuring the David Bowie song, "A Space Oddity," a song that I really like. The idea is that the driver of the Lincoln is just like Major Tom. Of course, in the end, ground control says to Major Tom, "your circuit's dead, there's something wrong."

Note to Self: Always listen to Warren Buffett

During my brief stint at Freddie, an occasional question for discussion at lunch was the company's vulnerabilities. I think it is fair to say that those of us who were worker bees wanted to be sure that the taxpayer would never be on the hook for Freddie Mac debt and/or guarantees.

This was 2002 and 2003, so default risk was not a great worry: the company's underwriting practices at the time were sound, and mortgages were protected either by 20 percent downpayments or mortgage insurance, and property values were still rising, but not yet at a bubble like pace in places like Las Vegas and Florida. As for interest rate risk, the company purchased hedges so that its balance sheet would always have duration of less than a month, and so that duration risk was quite small too--although while hedging duration is pretty straightforward, convexity is more complicated (duration is basically the first derivative in how capital value changes with respect to interest rates; convexity is the second derivative). FWIW, I also thought the people who executed risk management at Freddie were very good at their jobs.

In these discussions, we failed to predict the principal reason the company got into trouble: we had no idea that senior management would recklessly gamble the charter through accounting that was both misleading and (it turned out) incompetent. I have arguments with William Poole, but when he said that management risk was a huge problem with having institutions like Fannie and Freddie, he was right.

But one among us (whose name I will reveal if he/she gives me permission to do so) did predict a major source of the current problem: counterparty risk. For example, Freddie Mac would buy instruments called swaptions, which would give the company the option to swap floating rate debt for fixed rate debt, and vice versa. These swaptions would allow Freddie to manage its balance sheet when interest rates changed in the future. Suppose, for instance, Freddie borrowed long-term in order to finance fixed rate mortgages. Now interest rates fall and borrowers refinance. Swaptions allowed Freddie to trade its expensive fixed rate debt into less expensive floating rate debt to match the lower return on its portfolio (and the converse when interest rates rise). But of course, swaptions would be useless if the institution with which Freddie contracted could not make good on its part of the bargain when interest rates changed.

In 2003, Warren Buffett called derivatives (such as swaptions) weapons of mass financial destruction. Like everyone else, I have long admired Buffett, but I though he got this one wrong. Derivatives allowed institutions to hedge and therefore reduce risk! Or at least, I thought this was the purpose of derivatives.

But of course, investors can also use derivatives to speculate, and when they do so (and particularly when they do so using leverage), derivatives become very dangerous. AIG, for instance, guaranteed against mortgage default. This meant that when defaults rose to levels not seen since the Great Depression, it didn't have enough capital to meet its responsibility to its counterparties. So the counterparties who thought they had hedged their risk found themselves exposed, which in turn ate into their capital position, and so a cascade was on.

Derivatives can be used for good, or for evil. Buffett understands human nature far better than I, and I should always remember that.

A readers asks where to get data about Fannie Mae loan performance

Every month, Fannie Mae (as well as Freddie Mac) puts out a monthly volume summary. The most recent summary, for July, has 90 day loan delinquencies at 1.36 percent. This compares with the Mortgage Bankers Association national delinquency number of 2.35 percent for prime loans, and 17.35 percent for subprime loans for the second quarter of 2008. In case you were wondering, the 90 day loan delinquency number for Freddie was 1.11 percent in August.

The comparisons are not exactly apple-to-apples, but because the MBA data are a little older than the FF data, it is actually likely the case that the GSEs have performed relatively better than the comparison above would suggest.

Full Disclosure

In light of some of my recent posts, I should repeat my disclosure that I worked at Freddie Mac between September 2002 and January 2004. I also own something like 200 shares of stock in the company (if it is important to anyone, I can check the exact amount). Those shares are of course not worth very much right now.

I made many close friends at Freddie, and learned more about mortgages that I could have possibly learned had I never left academia. I also found myself very disappointed with the company in all kinds of ways, which is why I didn't stay very long (although I also didn't stay long because I missed being a professor). I think senior management there has made a series of awful decisions.

Readers may draw their own conclusions about how seriously to take my views in light of this.

Morris Davis writes to me

Morris is currently at Wisconsin-Madison, and was formerly at the Fed.

Why I am opposed to the bailout, by Morris A. Davis

First, I've decided it is bad economics. Suppose the bailout costs 500 billion. Suppose the bailout is effective in avoiding a recession -- The bailout itself costs 3-1/2 percent of GDP. I think you have to go back to 1982, maybe further, to get that kind of contraction in GDP during a recession.

Second, Paulson and Bernanke have proven, repeatedly, they have no idea what is going on. For example, here is a published quote from Bernanke on June 5, 2007, available on the Federal Reserve Board web site: "At this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system." I can find similar quotes from Paulson.

If Bernanke and Paulson have been wrong, every time, why would they be right about the effectiveness or cost of a bailout now.

The reason I have no faith in Bernanke or Paulson is that they have no simple theory to explain what is going on. They know all the bits and details of current events, but they have no simple unifying underlying theory for events.

Third, what assets should be bought in a bailout? Mortgages? How about underperforming stocks? How will the government decide which markets are illiquid and which ones aren't? Forget the adverse selection problem for the moment. Just ask: Why would the government know which class of assets to buy and why?

Fourth and Fifth, the precedent this sets is terrible. This bailout means we have lost faith in free markets to allocate scarce capital to its most productive use. It also tells punishes responsible investors (who did not underwrite or hold high yield junk mortgages) and rewards exp-post the participants in financial markets who took the riskiest bets.

Charles Calomiris and Peter Wallison blame Fannie Mae for the Subprime Mess

Hmmmm. The loan performance on Fannie's book of business is substantially better than the overall mortgage market. And starting in 2002, Fannie Freddie (pink line) lost market share to ABS (light blue line). The data underlying the graph is from the Federal Reserve,

Table 1173. Mortgage Debt Outstanding by Type of Property and Holder.

Could we please stop saying that it was the hybrid feature of Fannie/Freddie that caused them to fail?

I think we have enough failures across enough different types of financial institutions (Investment Banks, Commercial Banks, Thrifts,Insurance Companies and GSEs), and sufficiently (ahem) large rescue packages for them that we can say that the US financial system has very few purely private financial institutions (sorry Lehman Brothers).

Perhaps the new rule going forward is going to have to be that any financial institutions with assets of greater than $X billion will be required to have paid-in capital of greater than Y percent. I have no idea what X and Y should be, but the costs of making X a little too small and Y a little too big are almost surely smaller than the costs of the converse.

Demanding some Accountability is not Partisan Squabbling

The TED Spread (still above 200 bp at this writing) tells me that something must be done quickly to restore investor confidence. But something doesn't have to exclude oversight of the Treasury Secretary or the elimination of golden parachutes for executives whose companies have failed.

How big could a new RTC be to remain comparable to the old RTC?

When the Resolution Trust Corporation was created in 1989, nominal GDP was about 40 percent of what it is currently. That RTC took over about $400 billion in assets. So a current RTC could take over around $ 1 trillion and would be the same relative to the economy as the old RTC.

We did manage to get through the early 90s with a fairly mild recession.

Degrees of Freedom

I am reluctant to weigh in on proposed solutions to the financial crisis, because Ben Bernanke and Henry Paulson are a lot smarter than I and have a lot more information than I. Based on publicly available information, I thought Fannie and Freddie would be OK (and in the end, I think there is still a chance that the conservatorship will actually benefit taxpayers), but it is now clear that public information was not sufficient for making a judgment.

But while Bernanke/Paulson have more information than the rest of us, they have no foundation for calibrating a model to inform them how to move forward. We are completely outside the support of the data. As Charles Manksi describes it so simply and eloquently, because we are in a world of Xs we haven't seen before, we cannot possibly know how to relate those Xs to Ys. And so at the end of the day even our smartest policy makers must rely heavily on judgment. I am not reasurred when I remember that Isaac Newton lost a bunch of money in the South Sea Bubble .

I do think I support the RTC type plan that Paulson is proposing. My worry with it, however, is political more than financial. If we get the wrong sort of people (say those who went to grade school with the Vice-president, or those who were until recently running the interior department) running it in the future, it could produce cronyism and kleptocracy unlike anything we could have before imagined.

Are we at the Bottom in SoCal?

For the second month in a row, Dataquick shows pretty robust sales growth for housing sales in Southern California--along with sharply lower prices. I think this may be a bottom (despite what is going on more generally this week) because:

(1) From a user cost perspective, owning really does look pretty good in many SoCal markets right now, especially for houses that are inexpensive enough to use conforming loans. Mortgage rates are down about 75 basis points on Fannie-Freddie loans since they were placed into conservatorship. People have to live somewhere.

(2) Lots of sales are distressed sales (around 40 percent). This means the prices we are observing are not arms-length transactions, and may be below equilibrium market prices.

(3) While I am wary of anecdotal evidence, I have been getting a lot of anecdotes about bidding wars for modestly priced houses (modestly priced by California standards, anyway).

But there are a number of cautions:

(1) After rising sharply for the past four years, rents in Southern California are stagnant, and perhaps are falling a little bit.

(2) Unemployment has risen sharply in San Bernardino, Riverside, Orange and Los Angeles Counties.

(3) The overall sense of pessimism arising from the financial market crisis could keep buyers from buying.

Altogether this suggests to me that house prices won't be going up a lot anytime soon, they won't be falling much more either.

I should write something about Lehman...

... and I will, but probably not for a few days. There is a lot I need to think through.

I also dropped my younger (by 45 minutes) daughter off at college today. It has been wonderful to see my self-confident, hard-working girls just bubble over with joy while starting out at great universities in great cities. But it has also left me, for the moment, profoundly sad. I am a little surprised at this. Some wisdom does indeed come only through experience.

If not a hybrid, then what?

I kind of liked the hybrid model of mortgage funding. The pure public sector doesn't do that well (FHA underwriting is not all it should be); the pure private sector also doesn't do so well (beyond the subprime mess, there is very little liquidity even in the prime jumbo market right now).

Where I was mistaken was to think 2.5 percent capital was sufficient backing for the GSEs--I thought home mortgages were so safe, that 2.5 percent plus a stress test would be OK. I was wrong. And it is becoming increasingly clear that the GSEs' managements were reckless with the charters, which gives evidence that Robert Van Order's powerful argument that GSE management would never want to screw up a wonderful franchise was also incorrect.

So maybe the correct answer is a hybrid with more capital--say 5 percent. After all, thanks for FDIC and the Federal Home Loan Bank System, Banks are really hybrids too.

The Power of Simplicity

I gave a talk in New York yesterday morning, and then spent the afternoon/evening with my daughter. We were walking down Park Avenue, and caught the two light beams arising from Ground Zero. We both felt our throats catch at the sight.

Megan McArdle doesn't like fixed rate mortgages.

She argues that because house prices are more volatile than interest rates, variable rate mortgages make more sense.

This argument makes no sense. The way to look at the issue is to consider households to be financial intermediaries. Financial intermediaries are most stable when their liabilities and assets have the same duration. Most households have two principal assets--their house, and their human capital. The house has long duration; the duration of jobs is variable. Fixed rate prepayable mortgages can have long duration, and because they have an embedded call option, the duration can be made variable.

Thus a prepayable fixed rate mortgage is a liability that matches well to a house's long duration and the owner's desire to have a free option to move to a new job. It helps stabilize household balance sheets.

Paul Soglin has a blog

He was my mayor for many years. He was a good one, too.

Elitism

I like both Mark Thoma and Megan McArdle's blogs very much, and recently both have posted on the issue of elitism. And I feel the need to chime in (and perhaps ramble on).

First, I am sure that my statement that I would not vote for a creationist comes across as elitist. But the fact is that when someone identifies herself as a creationist, she is revealing something to me about her decision process--that she makes decisions based on faith, rather than evidence. I am uncomfortable with this, and have reason to think that decisions based on evidence tend to turn our better than those based on faith, or or one's gut. It is true that sometimes there is not all the evidence that one would like to make a decision, and then one must take a leap, but evidence first strikes me as a good rule. The Red Sox won World Series after they started listening to Bill James (who explicitly rejects baseball mythology when it conflicts with data).

Second, I grew up in what was then red state America--a town of 50,000 in Western Wisconsin. The benefits were real--I came to appreciate hunting and especially fishing, and I could ride my bike anywhere at any age in safety. But the town was homogeneous in a way that was stifling--when I was growing up, my guess is that there were maybe 50 African-Americans and 50 Jewish people in the whole town. The town, moreover, did not at the time welcome those who were different, and I remember at 17 being engaged in a debate with fellow Democrats (!) about whether it was appropriate to use government funds to support a battered women's shelter. I am happy to say that the place has since changed considerably: it is far more heterogeneous and far more welcoming than it was when I was growing up there. Nevertheless, even though I liked my family (by that I mean I liked hanging out with my parents and brother), and even thought I had three close buddies who were staying in Wisconsin, I took as many classes as I could in high school to get out of town as soon as possible, and left for college after my junior year. My "lack of respect" for the place I grew up arose from the fact that its values were different from mine. Is this elitist? Perhaps.

So college was the ultimate elitist experience: the fanciest of fancy-pants Ivy League Schools. Intellectually, the place was at times truly thrilling: I still can remember specific sentences from lectures on Shakespeare, on moral reasoning, on international relations, on Japanese-US relations, on Public Finance (where Malcolm Gillis made me realize that I wanted to be an economist). It also was the place where I met my wife, one of the most remarkable people I have ever known, and for that I will always be grateful.

But for all that, it could be truly insufferable and provincial. Harry Lewis inadvertently underscored this phenomenon when he wrote in Excellence without a Soul, "if I hadn't been able to teach at a place like Harvard, I would have gone into the computer industry." So whatare students who don't go to "places like Harvard," chopped liver?

So when Harvard disdains the heartland, and when the heartland disdains Harvard, they both have some basis for doing so. Interestingly, both places have trouble dealing with the "other," but my sense is that both places are getting better at doing so.

FWIW, among the Universities where before this year I spent time (Harvard, Wisconsin, George Washington and Penn), my favorite by far has been Wisconsin (although after a month at USC, I think it likely that it will match Wisconsin--and the weather is a lot nicer here. The sushi is better here too--oops, that's elitist!). Wisconsin is also an intellectually thrilling place--it doesn't have as many superstars as Harvard, but it has plenty, and it was a treat to hear lectures from and talk with Harold Scheub, Dave Demets, Stanley Kutler, Arthur Goldberger and Buz Brock, among others. At the same time, because the students were predominantly Midwesterners, and generally quite good, there was little if any disdain for the heartland. Indeed, one of the striking things about the atmosphere in Madison is how modest very accomplished people there tend to be. It is almost is if Berkeley were crossed with Lake Wobegon.

Finally, I need to say something about the South (I have lived on both coasts and the Midwest, but never the South). Anyone who stereotypes Southerners as dumb should be ashamed. In the first place, such generalizations are always wrong, and in the second place, the region has produced Faulkner, Tennessee Williams, Martin Luther King, Thomas Jefferson, etc. and has many great universities, such as Chapel Hill, UVA, Duke, etc.

But two facts remain about the South that are truly problematic. The states with the lowest high school graduation rates in the country are in the South. This is not because the South is rural--the states with the best high school graduation rates are in the Midwest, and are generally rural. And if people are looking for respect, waving the Confederate flag is not the best way to do it. Southerners who do so will argue that they are celebrating a heritage, but it is a heritage in which a large group of people were deemed subhuman. African-Americans rightly feel disrespected when they see that flag, and people who want to wave that flag should understand that.

Just because one might not like NASCAR, or country-western music, or, heaven forbid, football doesn't mean he needs to look down on it. But that flag is something else.

Lifted from Comments: Scott corrects my History

He writes:

I think there may be a bit of anachronism here although I am not entirely sure. Bryan ran for president in '96, '00 and '08 with national debut "Cross of Gold" speech catapulting him into prominence in 1896 much as Humphrey, Reagan, and Obama would later be sent into orbit (Reagan literally) by their national debuts. The Scopes trial was in 1925, and Bryan had started to vehemently attack Darwinism after WWI. He had spoken out against it earlier as well, but after his initial run.Bryan was not a young earth creationist and not really one in the modern sense. And it was not really uncommon to reject Darwinism at the turn of the century. Indeed, most scientists did. They didn't reject evolution, but they did reject Darwinism, primarily because a workable theory of heredity was lacking. This was rectified from 1900-1918 from the rediscovery of Mendel to Fisher's crucial paper integrating Mendelism and Darwinism. But it really should be emphasized that many major scientists rejected Darwinism before 1900. Now they probably rejected it for different reasons from Bryan, but the Darwinian mechanism of evolution certainly wasn't a settled fact at the time. Did Bryan have contempt for the evidence at the time that he ran (which is when you could have voted for him)? Very unclear. How far was he willing to integrate evidence into his biblical worldview? I don't really know, but at least one historian (Ronald Numbers) claims that he was willing to accept a geologically old earth and read 7 days figuratively.So while it is true that at the end of his life (or a few days before the end) he rejected Darwinism because he was very worried that the mechanism of natural selection (espcially as seen through the light of Social Darwinism) led to the moral decay he saw in WWI, he may not have held that view 3 decades before and certainly the science wasn't settled at that time.

Of course, current politicians have no such excuses.

Just wondering

Is the demand curve for US debt perfectly elastic? Or was GSE debt already assumed in markets to been part of the supply of US debt? Or are we going to see Treasury yields materially rise this week?

What has been the real benefit of Fannie and Freddie?

It is almost certainly not homeowning, and it is almost certainly not funnelling money into underserved neighborhoods or toward underserved borrowers.

Rather, is has been the transfer of interest rate risk from households to investors. So far as I know, the US is the only country in the world with long-term, fixed-rate, 95 percent LTV loans that do not have prepayment penalties. When interest rates rise, borrowers are protected; when they fall, they are not mad e immobile by yield-maintenance and lockout clauses.The low down payments (and five percent equity seems to be OK) effectively give households with modest incomes access to capital markets. I have written elsewhere that I believe that the peculiar structure of Fannie and Freddie has helped bring about the unique American mortage.

One could argue that the current environment shows that none of this has been worth it. But I would disagree with that argument.

Why I will never vote for a candidate who thinks creationism is arguable

William Jennings Bryan was a Democrat. I am quite sure that had I been alive at the time he was running for President, I would have voted Republican, because of Bryan's know-nothing, anti-scientific views.

I cannot vote for someone who has contempt for evidence. A suggestion that creationism is an arguable alternative to evolution is equivilent to a suggestion that Ptolemy's Earth-centered model of the universe is an arguable alternative to Copernicus' deplacement of the Earth from the center (although to be fair, Ptolemy was a great empiricist, and his views had much stronger scientific foundations than creationism).

We have now experimented with government that does not care about evidence. I don't like it, and I fervently hope that it doesn't continue.

A new paper from Francois Ortalo-Magne and Morris Davis on Housing Expenditures and Wages

Morris reads my observations about rents in Greenwich Village, and sends me a paper that concludes:

We use micro data from the 1980, 1990, and 2000 DCH to document that the expenditure share on housing is remarkably constant across MSAs and over time. We study the equilibrium properties for housing rents of a simple model consistent with this observation. A key distinguishing feature of our general spatial equilibrium model, relative to many papers in the urban economics and local public finance literatures, is our use of Cobb-Douglas preferences. This assumption yields a constant housing expenditure share in equilibrium, consistent with the evidence we uncover. The same assumption has been used to explain the distribution of population across places(Eeckhout 2004) and to study the internal structure of cities (Lucas 2001 and Lucas and Rossi-Hansberg 2002).

Our multi-location model predicts that in the aggregate, the ratio of rental price-
per-unit to per-capita income is constant as long as the aggregate stock of housing
per capita is also constant. This is a common result of macroeconomic models when
households have Cobb-Douglas utility. We show that this result does not hold at the
MSA level; instead, rental prices disproportionately reflect income differentials. We
conclude that the intuition – commonly assumed by policy-makers and housing-market commentators – that local house price indexes should increase at the same rate as local per-capita income is incorrect whenever income growth differs across MSAs.

Mattresses and Mortgages

My wife and I bought a new mattress the other day. Mattresses are about as opaque a product as one can buy--the stuff that really matters to you is sewn inside. To some extent this is true of other products, such as automobiles.

But the thing about autos is that a Toyota Corolla is the same, regardless of who sells it. Once can test drive it and read reviews on Edmunds about it, and then go from dealer to dealer to get the best deal possible on it (the web allows you to do this very efficiently). Mattresses, however, change names from one store to the next, so you can't really comparison shop to get the best deal possible.

In this mattresses resemble mortgages. Unless one gets a zero closing cost mortgage, it is hard to shop from one broker to the next. Many brokers, moreover, will not offer a rate lock until they have gathered a lot of information, meaning that one needs to do a lot of work before he can even get a price. There may be some value of having a regulation that says that mattress companies must sell all comparable mattresses under one brand name. And there may also be value to requiring mortgage companies to offer mortgages that have just two prices--a rate and a closing cost.

Is it a bottom? Or just one strange month?

Last week, the California Association of Realtors put out the July EHS numbers for the state. Prices had fallen 40 percent from a year ago, and sales increased by 43 percent. Inventories were whittled down to about six months, which is very close to an equibilibrium level (a nice rule for real estate--when inventories for a type of building are about equal to the length of time it takes to build that type of building, the market is more or less in equilibrium). I have talked to people at CAR to make sure that there isn't some quirk in the data to explain the extraordinary change.

As I have written before, prices in California have fallen so rapidly that in many markets it is now just as sensible financially to own as it is to rent--assuming one can get her hands on financing. There are, moreover, many cash buyers in places like the Inland Empire right now, and cash buying is a powerful indicator of a bottoming market. Finally, I am hearing lots of anecdotes about multiple offers on properties for sale.

The problem is that a very large number of the sales are foreclosure sales or short sales--properties that lenders are trying to dispose of, and are therefore selling at extremely low prices. Whether this tendancy will extend to the rest of the market is very much an open question. But if the next few months are similar to July, we may well be at bottom out here.

Just dropped a kid off at NYU--and thought about the real estate.

So we just had the first one leave the nest for Greenwich Village (second one leaves in two weeks for Evanston). Two real estate thoughts hit me:

(1) NYU dorms are the bargain of the century. They are very nice (four young women share two bedrooms, a living room and a kitchenette) and have views that would command double the price per square foot in the standard, un-rent-stabilized NYC housing market. The hallway gives a great view up Lexington Avenue (you can see the Chrysler Building) and over the Williamsberg Bridge.

(2) People need to get over considering price-to-household-income as the key fundamental. Density in lower Manhattan is so much greater than nearly anywhere else in the country, it will of course be the case that the relative price of housing to anything else--including wages--will be higher there than elsewhere.

Getting a California Mortgage in 2008

My wife and I close on a house here today. It is our fourth house--we bought two in Madison, and one in Washington, and then one here in LA.

The first three houses were a piece of cake to buy; this one was a lot harder. In the process of doing it, I think I spoke with half a dozen lenders, including CNB, the bank that is funding the mortgage. The experience included:

(1) a broker who tried to get my business by trashing his competitors

(2) a broker who dangled an impossibly low interest rate loan from a lender whose balance sheet is in such bad condition, it is likely not able to make loans anymore

(3) a bank that told me that investors are not much interested in California

(4) lenders are reluctant to count any income beyond salary income for underwriting purposes.

The last point is almost certainly true, as rates on California mortgages seem to be about 50 bp higher than in other parts of the country.

In the end, CNB was quite professional, but I have to say that the level of scrutiny--particularly with respect to the appraisal--was mich higher than I had ever experienced before. Perhaps in general this is a good thing. But if conditions remain this way, potential homebuyers are going to have to understand the need to keep excellent documentation about their income (keep those W-2s!) and buyers and sellers are going to need to understand that transactions will take longer than it did a couple of years ago. And to get the housing market unstuck, lenders are going to have to think about how to underwrite self-employed people, rather than just rejecting them.

The Mystery of Airlines

Other than Southwest (which hedged its fuel costs), they are all losing money. Yet every flight I take is packed. The obvious solution is for them to raise prices, except that they fear losing market share--in a market that loses money. Perhaps there is some sort of Nash game that explains this behavior...

Alan Greenspan has an Idea

In an interview in today's Wall Street Journal:

He also offers a novel suggestion to bolster the housing market: Increase the number of potential home buyers by admitting more skilled immigrants.

I have actually wondering whether enforcement of immigration laws within the last year has worsened the housing situation in Arizona, Nevada, and the California Inland Empire. While overbuilding, undisciplined lending, and speculation are all at fault for the mess we are in, I can't help but wonder if lower levels of immigration in the Southwest haven't matter as well.

Neither McCain nor Obama seems particularly interested in keeping immigrants out of the country, so it will be interesting to see what happens to housing absorption in 2009.

How much should gas prices be capitalized into SUV values?

Let us say that the baseline car gets 20 mpg, and an SUV gets 13 mpg (this is for in-town driving). If the average person drives 15,000 miles per year, this means the SUV driver uses about 400 gallons per year more than the baseline car. Let us suppose the equilibrium price was determined when gas was $2 per gallon.

Now that gas is $4 per gallon, the SUV driver is paying $800 per year more relative to the baseline car than expected. Suppose the real discount rate for a car is .05, and that cars depreciate on a straight-line basis over 10 years. This means that SUV values should fall by $800/.15 or about $5300. Seems to work....

Just thinking out loud

Wells Fargo has a market cap of about $100 billion; Freddie Mac's is under $4 billion.
Wells Fargo has been well managed for years; Freddie, not so much.
Wells Fargo has long had a higher standalone credit rating than Freddie.

Might it make sense to allow a GSE to become a subsidiary of a bank? As I said, just thinking out loud...

In LA

I suppose it is time to resume blogging...

Bldgblog on my new town

I like his take:

I got back from Los Angeles last night and my head is still spinning. I'd move there again in a heartbeat.
There are three great cities in the United States: there's Los Angeles, Chicago, and New York – in that order.
I love Boston; I even love Denver; I like Miami; I think Washington DC is habitable; but Los Angeles is Los Angeles. You can't compare it to Paris, or to London, or to Rome, or to Shanghai. You can interestingly contrast it to those cities, sure, and Los Angeles even comes out lacking; but Los Angeles is still Los Angeles.

[Image: L.A., as photographed by Marshall Astor].

No matter what you do in L.A., your behavior is appropriate for the city. Los Angeles has no assumed correct mode of use. You can have fake breasts and drive a Ford Mustang – or you can grow a beard, weigh 300 pounds, and read Christian science fiction novels. Either way, you're fine: that's just how it works. You can watch Cops all day or you can be a porn star or you can be a Caltech physicist. You can listen to Carcass – or you can listen to Pat Robertson. Or both.
That's how we dooz it.

L.A. is the apocalypse: it's you and a bunch of parking lots. No one's going to save you; no one's looking out for you. It's the only city I know where that's the explicit premise of living there – that's the deal you make when you move to L.A.
The city, ironically, is emotionally authentic.
It says: no one loves you; you're the least important person in the room; get over it. What matters is what you do there.

I agree with his assessment about the three great American cities--San Francisco and Boston are wonderful, but then so is Madison. None of them are as consequential as the big three. I think he gets Washington right--it is perfectly pleasant, and has become far more international in the years I have been coming and going to and from it, but I have never been able to fall in love with it, as I have Madison--and Chicago, New York and Los Angeles (and Rome and Tokyo and Hong Kong and Mumbai, but that is for another time).

In any case, Randy Newman's song is not ironic, and neither am I--I love LA, and am looking forward to many happy years there.

Wow

I wake up this morning to read:

In an interview, Freddie Mac’s former chief risk officer, David A. Andrukonis, recalled telling Mr. Syron in mid-2004 that the company was buying bad loans that “would likely pose an enormous financial and reputational risk to the company and the country.”

I left Freddie at the beginning of 2004. At that time, I believed that it excelled at mortgage underwriting--it had very serious people who constructed careful, sophisticated models of default prediction.

Dave A. was among the most highly respected people in the company. Apparently, things changed after I left.

I hope this is a quiet week

I move to California on Thursday. My guess is that I will not be posting again until after I get out there.

Robert Van Order on Fannie and Freddie

When I left Madison for Washington six years ago, it was to follow my wife, who was offered a terrific job practicing geriatric medicine for under-served communities at the Washington Hospital Center. I decided to go to Freddie Mac at the time, in large part because I admired many people there, including Ed Golding, who was in charge of financial research, and Bob Van Order, who was the chief economist for many years.

Bob wrote the following on the raison d'etre for Fannie and Freddie, and with his permission, I am passing it along:

UNDERSTANDING FANNIE AND FREDDIE
By Robert Van Order
University of Aberdeen and University of Michigan
July 2008
Financial markets are different from other markets. They deal intensively in information and misinformation. Most of the time information is good enough and financial markets work fine, but when there are serious doubts about the quality of information entire blocks of investors, e.g., institutional investors who are not confident about information, exit and markets break down. In the case of lending markets borrowing rates go up abruptly and some borrowers have trouble getting loans at any price. Something like this has been happening in mortgage markets, especially subprime markets, and it seems to be spilling over into other markets.
Since the Great Depression when financial markets really went crazy we have developed institutions to try to control financial panic. A big part of this development has been deposit insurance, which provides bank depositors with assurance that they can get their money no matter what their bank does. Most of the time deposit insurance has served us very well. We don’t see bank runs to any great extent; in 1987 when the stock market crashed in a way that was not that different from 1929 we saw not a whiff of a bank panic. Of course the security has come at a cost. Banks can use deposit insurance as a basis for risk-taking and cause large costs to tax payers and distort resource allocation, as was the case with the Savings and Loans in the 1980s.
Fannie Mae and Freddie Mac (FF) are a part of this apparatus. They are usually referred to as Government Sponsored Enterprises or “GSEs.” That is, they are enterprises (they are privately owned), but they have special charters and benefits primarily in the form of implicit guarantees, for which they do not pay, and regulation (for instance, FF are limited to the mortgage markets and have regulations on their capital and on lending to targeted groups) which constrain their operation. They buy mortgages from lenders and they fund the purchases by issuing their own debt and (most often) mortgage backed securities (securities backed by particular pools of mortgages). They take credit risk because they are responsible for paying off investors in their securities in the event of default. They also take interest rate risk to the extent their debt funding is out of sync with their assets’ cash flows. Interest rate risk has not been the issue recently, but credit risk certainly has.
The GSEs have several purposes. Much of the recent focus has been on subsidizing homeownership, but the really important function has been to provide “liquidity” to the mortgage market, which basically means that they keep the market open even when times are tough, like now. Along with this they provide an element of standardization, which helps lenders and investors better understand what they are originating and buying. They can do this in part because their implicit guarantee allows them to raise money in bad times in the same way that deposit insurance allows banks to raise money even when they are in trouble.
Guarantees involve a subsidy, if they are not paid for. In FF’s case their debt has been rated AAA or AAA+ because of the government connection; whereas on its own it has been rated in the low AA range. The difference in borrowing rates between the two is around a quarter of a percent to .40%, which is a rough measure of their subsidy. Banks get a similar subsidy, which varies from bank to bank. The subsidy is probably larger now.
The analogy with deposit insurance is deliberate. Banks are de facto GSEs. Indeed, so are most major financial institutions around the world, which is in part why we have had relatively stable financial markets for decades. That does not mean that all GSEs are good things or that regulation can’t be improved on, but we’re not in uncharted water here. Nor are we looking at unprecedented support for mortgage markets. Since at least the 1950s almost all U.S. mortgages have benefited from guarantees: initially direct insurance like FHA and deposit insurance, especially via the Savings and Loans, and more recently via GSEs. The only part of the market without substantial government presence has been the subprime market.
What we have is a trade off. The GSEs provide stability. A measure of some of the current benefit from having FF in the market can be seen from a natural experiment that comes from the way the GSEs are regulated. There is a limit on the size of loan that FF can buy (It has been changed recently; at the beginning of this year it was $417,000. The limit is indexed to house prices over time). For years the loans above this cutoff (so called “jumbo” loans) paid rates about a quarter of a per cent higher than on loans below the limit (on 30 year fixed rate mortgages). The loans above the limit are not much different from those below; they are prime loans (the borrowers have good credit histories) with similar characteristics. However, at the end of last summer, as the subprime news hit the fan, the spread rose by over 1% and has stayed in that neighborhood. Again there is nothing in the data to suggest anything like that big a difference in credit risk on these loans. The difference is due to the existence of FF as liquidity providers in their part of the market. There is every reason to believe that without FF interest rates would have gone up in a comparable manner in most of the market.
The trade off is that the GSE structure, particularly the implicit guarantee, invites risk-taking in the same way that deposit insurance invites it. This distorts resource allocation (in this case diverting resources toward housing and homeownership). Perhaps more important, politically, it risks bail-outs (like with the S and Ls in the 1980s). Both the benefits and costs of GSEs are real and need to be balanced.
Right now the two GSEs are in trouble, and it is important to understand why. We can think of their business as having two parts: the “core” business of buying and funding prime mortgages, mostly 30 year fixed rate mortgages, and a portfolio of other “non Agency” mortgage-backed securities, which are not backed by prime loans, but rather by riskier loans like subprime and “Alt-A” mortgages. FF bought pieces of subprime and Alt-A deals that had insurance and subordination (meaning there were other investors in the loan pool that took risks first (e.g., the first 15% of the pool losses), which were supposed to protect them, so their parts of the deal (tranches) were rated AAA. These have performed worse than AAA and have fallen sharply in value. The non Agency portfolio is less than 10% of the combined $5 trillion in mortgage related assets held by the two, but it has been most of the recent controversy.
The core business of FF has been experiencing large defaults, almost certainly larger than either has ever experienced. This does not appear to have been due to changes in risk-taking or growth in the companies: the prime mortgages they bought have not changed much over time, and their performance has actually been better (lower delinquency rates) that those for prime mortgages in general. Nor was excessive growth a problem; the FF market share and level of purchases dropped sharply after 2003, as the subprime share rose. As far as one can tell so far the answer to “why?” is mostly that house prices have declined faster than at any time since these two have been around (It may have been worse in the 1930s). Both companies have taken write downs from this and more is likely to come. However, while this will certainly cut sharply into profits for several years it is likely that the two will weather the storm.
How do we know this? Well, we don’t know for sure, but we can get some ideas from history. Comparable declines in prices in some recent bad regional declines suggest that there is room for quite high default rates without collapse. An underappreciated tool that the FF regulator uses to assess FF capital is a series of “stress tests, which simulate the companies’ performance under stressful (in this case large credit loss situations). While the tests are a bit complicated the principle is simple: take the worst regional experience in recent history (for which we have data; this is the “oil patch” states in the 1980s) and project it nationwide and ask if the institution has enough capital reserve to survive ten years (leaving positive capital behind). The tool has not gotten much publicity because the institutions have generally (this includes the first quarter this year) had no trouble passing . It is important in part because the stress test appears to be actually happening. It looks like the two still pass (they had considerable excess in the first quarter of this year) but not without considerable pain. They will need added capital cushions both to make sure they get through the stress and so that they can grow. This part of their problem is a little controversial, but not a lot.
It is the non agency portfolios that are the big issue. A problem in assessing the non Agency portfolio, and the economic position of the two GSEs in general, is that the two standard measures of their position—two measures of their net worth- are both wrong. Standard accounting measures are almost always wrong because they are (generally) too slow to adapt to changing economic conditions. Hence, while accounting net worth of the two has worsened as they have set aside reserves for future losses, accounting rules do not do this fast enough to anticipate the full extent of future losses, so accounting (GAAP) net worth is probably too big.
The other measure, “mark to market” net worth, which estimates the market value of assets and liabilities of the two and takes the difference as their net worth, errs in the other direction. Right now mark to market net worth is around zero or negative for the two companies, primarily because the mark to market value of the non Agency securities has fallen sharply. This has been the genesis of much of the recent news about the two. It is certainly the case that if FF had to liquidate their portfolios they would be in trouble. However, they don’t have to; they are in a position of being able to hold them and fund their assets. Normally the mark to market value would also reflect the value of holding the assets as well as the value if sold; that is how competition in the market among buyers of securities works. But that only works if the market is working.
The problem is that there has been a liquidity crunch in the “non Agency” markets for mortgage-backed securities that is worse than the one we know about and can measure in the “Jumbo” market. The market for buying these has more or less evaporated, so it is hard to get the kind of clear read on the value of the securities that we would get in a market like the one for Treasury bonds. This is what is most controversial: the argument is that the senior, would-be AAA, subprime pieces are being priced at discounts that are way above any reasonable estimate of default loss. If that is the case, then holding the securities and using the proceeds to pay off the debt that funded them has a good chance of working—certainly it is better than selling the securities into a very thin market and trying to use the proceeds to pay off the debt.
Should we worry about this? Of course, but we should not overdo. Stress test tests run by FF and by outside analysts suggest that these securities are certainly not AAA, but they are not junk bonds either, and losses will be manageable. This is probably why the Congressional Budget Office opined recently that there probably will be no cost to the recently passed “bailout” bill.
But the “probably” part matters. Things could turn south, and that could be costly. Indeed, a problem right now is that FF would get most of the upside if things improve, but Treasury (taxpayers) would be stuck with a large part of the downside. This is the balance part. Guarantees, both for GSEs and banks, give financial institutions incentives to take risks because they get the upside benefits, but not all of the downside costs, and the market does not make them pay for it. On the other hand, the situation we are facing now, a possible financial meltdown, happens infrequently, but when it does it can cause a great deal of damage, a small glimpse of which we are seeing in the Jumbo market.
The short run response, in the recent Housing Bill, to this has been to shore up the perception of a guarantee, so that it is more or less certain that FF can continue to raise money. That is what the so-called line of credit is about (Ditto for opening the Fed discount window). It gives Treasury authority to extend its ability to make secured loans to FF (at Treasury’s discretion, not FF’s). Right now it is not necessary; FF are liquid and raising money easily, but knowing that the line is there probably makes it less likely that it will be used (for the same reason that the existence of deposit insurance mitigates bank runs). A separate part of the Bill allows Treasury to buy FF stock. This makes less sense. From a public policy perspective the issue is keeping the market open, and the line of credit can do this without helping shareholders. If FF fail, the line of credit will be the main vehicle for paying off the implicit guarantee.
Longer term, the balance will most likely come from limits on risk-taking and on capital reserves. The risk-taking of FF has not been a major issue, but the capital reserve has. Reforms going forward will probably raise the minimum levels of capital. The stress tests have not been mentioned much. That is unfortunate for two reasons: One is that as house prices fall and losses get paid out the ability to withstand the stress test going forward will diminish and there will be built in need to raise capital. Second the stress tests can be revised. The 1992 law that set up FF regulation required taking the stress test from the worst regional downturn in the data. We shall surely have a region (the southwest? Florida?) from the current period that will best the oil patch states. As a result simply updating the stress test will increase required capital, and it will do it the right way—related to the risk the institutions take.
If you want to get an idea of how the two are doing, forget the accounting net worth and the mark to market net worth and look at what is happening with stress tests.
A dimension of the problem that has not been seriously addressed is that FF, like banks, do not pay for the insurance they get. A way of solving this is via user fees. Charging fees would really solidify the guarantee and take it out of the conjecture box. To some extent this is a question of the extent to which taxpayers want to subsidize mortgage rates. It is not likely to be as good a way of controlling risk as are capital requirements and stress tests.
More broadly: there are four likely ways that housing finance will get done in the U.S:
1. GSEs.
2. Non Agency (“private label”) securitization.
3. Banks (and S and Ls)
4. Government owned institutions like FHA and Ginnie Mae
These all have benefits and costs. The second is the only 100% private (without guarantee) model. It runs the risk of fragility—probably not as bad, going forward, as the subprime debacle, but at least like the current Jumbo market. The third has many similarities to the GSEs. In principle the GSEs and banks are hard to separate; in practice the GSEs have won the market, but innovations like “covered bonds” can allow banks to do almost the same thing as securitization. Both have incentives for risk-taking and risk of bail out. The fourth presents the problems of government management and inflexibility (For instance, pricing by both FHA and Ginnie Mae are fixed by statute), and it is not clear that there is less risk.
Going forward, there is no doubt that there are risks, but not the sorts of catastrophes that have been floating around the press, blogs and newsrooms. The current zero or negative mark to market net worth is more a figment of a broken market than a judgment about future prospects. In any event the last thing we should want to do now is take away the liquidity role of FF. Around 90% of all adults are homeowners at some time in their life and almost all homeowners take out a mortgage at some time. The mortgage market is important, and keeping it open is important. Sometimes you need someone to bring the punch bowl back to the party when the guests are threatening to leave.

A web site for bridge geeks who grew up near the Mississippi River

John Weeks provides a treasure trove of pictures and stories about bridges that cross the Mississippi River.

He dedicates one page each to the two highway bridges at La Crosse. He notes quite correctly that the Dresbach Bridge is remarkably pedestrian given its spectacular location (it is just south of the widest spot for the upper-Mississippi). The dual bridges five miles further south are far more interesting.

I think all government capital projects should be subject to cost-benefit analysis. But there is something to be said for spending something to make such permanent fixtures as bridges beautiful.

Cities as Museums

When I was a kid, my father told me that the way to get to know cities was to walk and take the bus. I have followed his advice ever since, which I think explains why I like thinking about cities, and about why some are more successful than others.

In any case, I had an afternoon to kill in San Francisco the other day, and managed to take in a wide variety of sites and people by simply taking the N car to the beach, walking on the beach, walking from the beach along Lincoln Way to 19th Street, taking the 71 bus through the Haight, getting off at Larkin and Market, walking north up Larking to Clay, and then east to near the top of Nob Hill, and then down through North Beach and back to the financial district where I was staying.

The whole thing took around 3-4 hours, and yet enabled me to observe and enjoy the many different and idiosyncratic aspects of San Francisco.

New to the top of the reading list

I need to go get Rick Perlstein's Nixonland. It is not just that Brad Delong recommends it (and I think the most valuable service Brad Delong provides is reading recommendations--if only I could read as voluminously as he). I have long had something of a Nixon obsession. According to my parents, when I was one, during the Kennedy-Nixon debates, Nixon's presence on TV would make me cry. And then he went and died on my birthday in the city where I was born.

I have read a lot of Nixon books--I think Wills' Nixon Agonistes is my favorite to this point. But I need to read Perlstein.

Is William Poole kidding?

He gets some things right in his op-ed piece in today's New York Times. Fannie and Freddie should have higher capital requirements and they should stop lobbying. Beyond this, I think something should be done about executive compensation for senior management at both institutions. But when Poole says:

In fact, there has already been a test case for how the mortgage market would function without Fannie and Freddie. After an accounting scandal in 2005, regulators severely constrained their activities. The nation’s total residential mortgage debt outstanding rose by $1.176 trillion in that year, even though Fannie’s and Freddie’s stakes rose by only $169 billion, just 14.4 percent of the total. In essence, the market barely noticed that the two agencies’ private competitors were providing 85 percent of the increase in mortgage debt in 2005.

The market barely noticed???? I think we have been noticing quite a lot about mortgages generated in the "pure" private market over the past 18 months or so. And of course, the non-conforming (i.e., private) market for 30-year fixed rate mortgages is, shall we say, problematic at the moment.

Mark Thoma thinks housing supply elasticities may be assymetric

The basic point is that in markets with lots of land, housing may be supplied elastically during booms, but takes a long-time to adjust during price declines. I have reason to think Mark is right.

My 2005 paper with Mayo and Malpezzi found evidence of this; cities that appeared inelastic included Pittsburgh, Toledo, Albany, Buffalo and Providence. None of these cities had upward pressure on housing production; rather, they were losing population and the housing stock took a long time to adjust to the loss.

Never mind

From the National Association of Realtors today:

Total housing inventory at the end of June rose 0.2 percent to 4.49 million existing homes available for sale, which represents an 11.1.-month supply2 at the current sales pace, up from a 10.8-month supply in May.

What is normalcy?

gaius marius writes:

fwiw -- and i realize this is but anecdotal, but it is illustrative of the general condition -- i live in suburban chicago, renting a house. i pay $2000/mo, property taxes are $550/mo. my rental payment then would support (ignoring upkeep/insurance/etc) a $1450/mo payment.at today's 30-year fixed rate (~6.5%), that would support a $230,000 loan. with 20% down, call the purchase price $290,000 -- and generously, as we are excluding all expenses but taxes.this house sold in 2005 for $460,000. houses in the neighborhood still list for $410,000.

Actually, this suggests to me that houses in your area are priced at something like fundamentals. Let us say the marginal tax rate of the typical buyer is 25 percent, that property taxes (which are deductible for most people) are at 1.5 percent, that maintenance costs about 2 percent, and that expect rent growth is 2.5 percent (i.e., a little less than recent CPI growth). Then the user cost of owning would be
410,000*(.065*.75 + .015*.75+ .02 -.025) = 22,550, or a little less than the $24,000 you are paying in rent right now.
Two financial advantages of owning that you are not considering are the tax benefit and the immunization from future rent increases. Of course, should interest rates rise to 8 percent, or tax policy change, these calculations change.

OFHEO HPI and long term trends.

The new OFHEO house price index came out yesterday. At the moment, I like OFHEO better than Case-Shiller (I worry that Case-Shiller is now giving too much weight to REO properties in its index). In any event, it is fun to play with some long term trends.

According to yesterday's OFHEO press release, since 1991, house prices have risen about 4.5 percent per year; since 2000, they have risen by 5.5 percent per year, even taking into account the recent decline. This means that between 1991-2000, prices rose about 3.6 percent per year (take (1.045^17/1.055^8)^(1/9)-1).

Suppose that 3.6 percent is the long-term nominal house price growth trend. By how much are house prices overvalued? The answer is (1.045^17)/(1.036^17)-1= .158. So house prices would have to fall by about another 13.6 percent immediately to stay in line with the long term nominal trend, after which they should rise by 3.6 percent per year.

Alternatively, if house prices just stayed flat for four more years, they would return to their long-term trajectory--assuming that the trajectory before the year 2000 was the long-term trajectory.

What does it mean?

Obama has 1.1 million fans on facebook.

McCain has 170,000 fans on facebook.

Of course, McCain doesn't know what facebook is.

Perspective on Fannie and Freddie (update)

I should have looked at the 10Qs (duh) for the first quarter. Credit losses for both companies were around 12bp (although survivable), which is high by historical standards (see below). Still, the first quarter financial statements came out in May, so it is hard to understand exactly what happened a couple of weeks ago.

Perhaps we can start looking for a bottom

I have long said that so long as the months supply of housing available for sale is rising, it is not possible to know then the housing market will reach bottom (in terms of price). But the months supply measure has fallen pretty substantially since this winter, from a peak of 11.4 months to a current rate of 9.4 months. The inventory needs to get down to 5-6 months before inflation adjusted prices become stable. But the derivative finally has the right sign.

A little perspective on Fannie and Freddie

Above are charts of 90-day delinquencies (based on the Monthly Volume Summaries and the OFHEO Report to Congress) through the first quarter of this year and credit losses through 2007 (these are the most recent public data that I can find).

Like many others, I eagerly await the companies' first quarter financial statements. But what do
others know that we don't?

Inflation and the Development of Mortgage Markets in Emerging Economies

Rising commodity prices have not just placed upward pressure on inflation in the US. In emerging markets, the impact is, in many cases, larger, with double digit inflation returning to places such as South Africa and Russia.

Inflation harms mortgage markets. Because nominal interest rates are high during periods of high inflation, payment-to-income ratios for even modest houses move beyond the means of what households can afford (and what lenders are willing to lend) in the short run. This problem is known as mortgage "tilt."


There are workarounds--for instance, price level adjustable mortgages (or PLAMS) charge real interest rates and then adjust the loan balance each period to reflect inflation. Unless these mortgages are carefully constructed, however, and unless the "correct" price index is known (and it rarely is), they are highly risky, because they have a negative amortization feature by construction. They are particularly problematic when house prices do not rise as rapidly as the general price level. The current US experience (as well as the 1980s) show that gaps between consumer prices and house prices can at times be large.


So the mortgage market is a case where nominal price changes can have real effects. It is no accident that the American mortgage market nearly disappeared during the late 1970s--a period of double digit inflation in the US.

Unhappiness (again)

From Greg Ip:

For decades, the typical college graduate's wage rose well above inflation. But no longer. In the economic expansion that began in 2001 and now appears to be ending, the inflation-adjusted wages of the majority of U.S. workers didn't grow, even among those who went to college. The government's statistical snapshots show the typical weekly salary of a worker with a bachelor's degree, adjusted for inflation, didn't rise last year from 2006 and was 1.7% below the 2001 level.

Greg Mankiw's Economics Platform

He tries to list the things for which there is a consensus among economists. It is actually quite good.

I have two problems with the list. First, raising the retirement age for people like me (i.e., those who have cushy jobs) makes a lot of sense. But I think we need to treat truck drivers, miners, linemen, etc. differently. They are often physically incapable of continuing work until an old age. And to ask a 60 year old to retrain is, I think, naive.

Second, I would like to see something about fiscal responsibility. Deficit spending during recessions is fine. But it would be nice to go back to the good old days of the late '90s and run surpluses when the economy is surging.

A Modest Proposal for Richard Syron and Dan Mudd

The two CEOs would take compensation of $1 per year plus restricted stock that doesn't vest for, say, two years. By doing this, whey would show that they have confidence in the long term futures of their companies, and that they are willing to risk-share with taxpayers.

Mark Zandi says the Price-Rent ratio is returning to the fundamentally correct level

He is quoted in today's WSJ.

Also coming into balance, though not there quite yet, is the ratio of home prices to rents. The lower the ratio, the more people are likely to buy a home than rent one. Mr. Zandi estimates that this ratio dropped to 20.02 in the second quarter from a high of 24.90 during the boom. The average ratio from 1985 to 2002 was 14.44. "If you just look at affordability indices, we would say we are probably close to a bottom," says Ivy Zelman, a housing and homebuilding analyst. "But these are not normal times."

FWIW, I am in the middle of buying a house in Pasadena (when it is a done deal, I will write a little history of the transaction). It is because owning looks like a very fair deal relative to renting; also, LA is likely the place we will live for the next 20+ years, so short term house price fluctuations don't mean much to us.

Now that I will be driving to work most days

I will swap my minivan for a Toyota Corolla. I love the Prius, but the price premium in California is too high--assuming you can even get one.

It does bring to mind my first car that was not a hand-me-down from my parents--a Honda Civic that my wife and I bought in 1985. It had a 76 hp engine mated to a 5-speed manual transmission. It seemed adequately fast to me. It had no gadgets on it--riders rolled up the windows by hand, and I had to install the radio by myself. It got 30 mpg around town, and between 35 and 40 on the highway.

Here's the thing--it was not a "sacrifice:" I loved the car. It was fun to drive, and pretty much flawless--we spent very little on maintaining the car. We kept it for 12 years, and only then replaced it because Wisconsin winters took their toll on its body (and Hondas tended to rust back then). But the engine and drive train still ran beautifully.

So my question is--why is it not easy to buy cars like the middle-80s vintage Civic anymore? It seems like a great solution for reducing emissions and congestion. And no new technology is necessary.

Paul Krugman on the GSEs

He writes:

But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.

So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.

In that case, however, how did they end up in trouble?

Part of the answer is the sheer scale of the housing bubble, and the size of the price declines taking place now that the bubble has burst. In Los Angeles, Miami and other places, anyone who borrowed to buy a house at the peak of the market probably has negative equity at this point, even if he or she originally put 20 percent down. The result is a rising rate of delinquency even on loans that meet Fannie-Freddie guidelines.

Also, Fannie and Freddie, while tightly regulated in terms of their lending, haven’t been required to put up enough capital — that is, money raised by selling stock rather than borrowing. This means that even a small decline in the value of their assets can leave them underwater, owing more than they own.

Ex post it would appear that Fannie-Freddie should have had higher capital requirements, if for no other reason than to bolster confidence during periods of stress. But ex ante, stress-testing models showed that Fannie was well capitalized and that Freddie was very well capitalized. Ironically, most of us who followed the companies worried a lot more about interest rate/prepayment risk than default risk.

This is not to say that past Fannie/Freddie senior management did not behave badly with respect to financial reporting, and I find it maddening that some of the worst actors wound up walking away with millions of dollars. While I made good friends at Freddie and learned a lot, the moral obtuseness of company leaders at the time (2002-03) made me very uncomfortable and I looked for a way out (I also discovered within about a week of being there that I really missed being a professor). Daniel Mudd's current silence also makes me wonder if there is a shoe to drop that has not yet appeared in the monthly volume summaries.

But for the reasons Krugman gave, moral hazard did not produce lax underwriting at Fannie-Freddie--regulation (and to be fair, I think corporate culture at Freddie) prevented that from happening. To the extent they are in trouble, it is because of market conditions outside the realm of historical experience. It is, after all, their job to be in the market at all times--no matter what. They is why they have their charters. A government backstop will not it their cases reward bad behavior; it will assure that they can do a job that purely private participants are unwilling to do at the moment.

I spent the afternoon flying back to DC from California

I just read the Paulson press release. Tomorrow will be an interesting day. I'll be watching the repo market.

I was going to say this, but...

Brad Delong said it first:

The chance that American taxpayers will actually lose any money if Ben Bernanke and Henry Paulson decide that Fannie and Freddie need government support is very low:

* The interest payments they have coming in are greater than the interest payments they have going out.
* Their government guarantee is itself a very valuable asset that they have made a lot of money off of in the past and will make more off of in the future.
* They are not even in liquidity trouble--unless they begin to have problems rolling over their discount notes...
* As long as it is generally understood that they are too big to fail, they should not even have liquidity problems--absent a depression that bankrupts many currently-solvent homeowners, that is.

I would like to mention three other things based on the 15 months or so that I worked at Freddie.

(1) One reason Freddie got in trouble about how it reported its earnings is that Senior Management did not believe that GAAP treatments of earnings reflected the economics of the company, and so it needed to fudge (the company's self-investigation, called the Baker-Botts report, made this quite clear). This does not excuse its behavior--publicly traded companies must comply with GAAP. The correct thing would have been for management to explain the problems with GAAP in the MD&A Statement.

But Senior Management was correct that GAAP earnings did not (and does not) give meaningful metrics of GSE corporate performance.

(2) Just my two cents, but I don't think the company's mortgage underwriting could be characterized as reflecting moral hazard. The company was quite conservative about loans that qualified for purchase, and perhaps would have been more conservative were it not for the Affordable Housing Goals (and BTW, there is no evidence that the Affordable Housing Goals in any way helped channel mortgage credit to underserved communities or families). In any event, the people running Freddie were not the Savings and Loan cowboys who would lend to anyone for anything.

(3) It is very hard to measure corporate cash flow at Fannie-Freddie, because funding and amortization are both happening constantly.

One other disclosure, I own something like 300 shares of Freddie stock that I received as compensation when I worked there. Feel free to discount anything I say about these matters as a result of this.

I don't get it

The last real "news" about Freddie Mac is the May Monthly Volume Summary, which came out more than 2 weeks ago. Delinquencies on their book have been rising, but at .81 percent are not at anything like an alarming level.

Could the word of a former Federal Reserve Bank President really have such a strong impact on the market?

Christopher Mayer, Tomasz Piskorski and Alexei Tchistyi Show that Prepayment Penalties Benefit Borrowers with Poor Credit Histories

Their paper find there is a separating equilibrium under which borrowers with blemished credit want prepayment penalties, while those with perfect credit do not. More particularly, they show:

Subprime borrowers with FICO scores below 620 obtain rates as much as 0.7%
lower than similar borrowers with fully prepayable mortgages and default at a lower rate (13% default rate) than comparable borrowers with no prepayment penalties (18% default rate). Our …findings suggest that regulations banning re…financing penalties might have the unintended consequence of raising interest rates, increasing mortgage default, and limiting available credit for the riskiest borrowers.

The paper does only look at fixed rate mortgages, and so it is not clear whether the argument applies to 2-28s. But the finding is well worth considering in light of the current policy debate.

Shopping for Mortgages

I am currently shopping for a California Mortgage. It is a little weird--the best pricing relative to the yield curve seems to be a 5-1 ARM. 30-year fixed rates are absurd--around 350 bp above 30 year CMT. While part of this is pricing the prepayment option, it also implies a truly implausible default probability for a prime mortgage.

One would think five-year ARMS would have higher default risks, so it must be about interest rate risk--perhaps buyers of 30-year Treasuries are not so worried about duration matching as buyers of 30-year mortgages? Anyway, the mortgage market in California currently strongly resembles the Canadian Mortgage market.

Jefferson had his problems, but boy could he write

When in the Course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature's God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. --That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, --That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness. Prudence, indeed, will dictate that Governments long established should not be changed for light and transient causes; and accordingly all experience hath shewn, that mankind are more disposed to suffer, while evils are sufferable, than to right themselves by abolishing the forms to which they are accustomed. But when a long train of abuses and usurpations, pursuing invariably the same Object evinces a design to reduce them under absolute Despotism, it is their right, it is their duty, to throw off such Government, and to provide new Guards for their future security. —Such has been the patient sufferance of these Colonies; and such is now the necessity which constrains them to alter their former Systems of Government. The history of the present King of Great Britain [George III] is a history of repeated injuries and usurpations, all having in direct object the establishment of an absolute Tyranny over these States. To prove this, let Facts be submitted to a candid world.

He has refused his Assent to Laws, the most wholesome and necessary for the public good.

He has forbidden his Governors to pass Laws of immediate and pressing importance, unless suspended in their operation till his Assent should be obtained; and when so suspended, he has utterly neglected to attend to them.

He has refused to pass other Laws for the accommodation of large districts of people, unless those people would relinquish the right of Representation in the Legislature, a right inestimable to them and formidable to tyrants only.

He has called together legislative bodies at places unusual, uncomfortable, and distant from the depository of their public Records, for the sole purpose of fatiguing them into compliance with his measures.

He has dissolved Representative Houses repeatedly, for opposing with manly firmness his invasions on the rights of the people.

He has refused for a long time, after such dissolutions, to cause others to be elected; whereby the Legislative powers, incapable of Annihilation, have returned to the People at large for their exercise; the State remaining in the mean time exposed to all the dangers of invasion from without, and convulsions within.

He has endeavoured to prevent the population of these States; for that purpose obstructing the Laws for Naturalization of Foreigners; refusing to pass others to encourage their migrations hither, and raising the conditions of new Appropriations of Lands.

He has obstructed the Administration of Justice, by refusing his Assent to Laws for establishing Judiciary powers.

He has made Judges dependent on his Will alone, for the tenure of their offices, and the amount and payment of their salaries.

He has erected a multitude of New Offices, and sent hither swarms of Officers to harass our people, and eat out their substance.

He has kept among us, in times of peace, Standing Armies without the consent of our legislatures.

He has affected to render the Military independent of and superior to the Civil power.

He has combined with others to subject us to a jurisdiction foreign to our constitution and unacknowledged by our laws; giving his Assent to their Acts of pretended Legislation:

For Quartering large bodies of armed troops among us:

For protecting them, by a mock Trial, from punishment for any Murders which they should commit on the Inhabitants of these States:

For cutting off our Trade with all parts of the world:

For imposing Taxes on us without our Consent:

For depriving us, in many cases, of the benefits of Trial by Jury:

For transporting us beyond Seas to be tried for pretended offences:

For abolishing the free System of English Laws in a neighbouring Province, establishing therein an Arbitrary government, and enlarging its Boundaries so as to render it at once an example and fit instrument for introducing the same absolute rule into these Colonies:

For taking away our Charters, abolishing our most valuable Laws, and altering fundamentally the Forms of our Governments:

For suspending our own Legislatures, and declaring themselves invested with power to legislate for us in all cases whatsoever.

He has abdicated Government here, by declaring us out of his Protection and waging War against us.

He has plundered our seas, ravaged our Coasts, burnt our towns, and destroyed the lives of our people.

He is at this time transporting large Armies of foreign Mercenaries to compleat the works of death, desolation and tyranny, already begun with circumstances of Cruelty and perfidy scarcely paralleled in the most barbarous ages, and totally unworthy the Head of a civilized nation.

He has constrained our fellow Citizens taken Captive on the high Seas to bear Arms against their Country, to become the executioners of their friends and Brethren, or to fall themselves by their Hands.

He has excited domestic insurrections amongst us, and has endeavoured to bring on the inhabitants of our frontiers, the merciless Indian Savages, whose known rule of warfare, is an undistinguished destruction of all ages, sexes and conditions.

In every stage of these Oppressions We have Petitioned for Redress in the most humble terms: Our repeated Petitions have been answered only by repeated injury. A Prince whose character is thus marked by every act which may define a Tyrant, is unfit to be the ruler of a free people.

Nor have We been wanting in attentions to our British brethren. We have warned them from time to time of attempts by their legislature to extend an unwarrantable jurisdiction over us. We have reminded them of the circumstances of our emigration and settlement here. We have appealed to their native justice and magnanimity, and we have conjured them by the ties of our common kindred to disavow these usurpations, which, would inevitably interrupt our connections and correspondence. They too have been deaf to the voice of justice and of consanguinity. We must, therefore, acquiesce in the necessity, which denounces our Separation, and hold them, as we hold the rest of mankind, Enemies in War, in Peace Friends.

We, therefore, the Representatives of the united States of America, in General Congress, Assembled, appealing to the Supreme Judge of the world for the rectitude of our intentions, do, in the Name, and by the Authority of the good People of these Colonies, solemnly publish and declare, That these United Colonies are, and of Right ought to be Free and Independent States; that they are Absolved from all Allegiance to the British Crown, and that all political connection between them and the State of Great Britain, is and ought to be totally dissolved; and that as Free and Independent States, they have full Power to levy War, conclude Peace, contract Alliances, establish Commerce, and to do all other Acts and Things which Independent States may of right do. And for the support of this Declaration, with a firm reliance on the protection of divine Providence, we mutually pledge to each other our Lives, our Fortunes and our sacred Honor.