Friday, October 31, 2008

"The Obama Premium"

It's been amusing, if increasingly grating, to watch people like James Pethokoukis push the bonecrushingly stupid argument that Obama's rise in the polls is the real reason the markets have been crashing. John Authers of the FT points out that even if you accept the dubious premise that politics has been driving the markets, Pethokoukis and company are still wrong:

[O]ther global stock markets have suffered worse than the US in the past two months, and funds have flowed to the dollar. This implies, if anything, that the US is benefiting from an “Obama premium”.
Authers also rebuts the argument—currently being pushed by the RSCC—that if the Democrats control the presidency and both houses of Congress, life as we know it will end (or something like that):
[R]esearch by the CFA Institute shows that stocks do better when one party runs both branches of government.

The U.S. government, along with governments around the world, have taken extraordinary steps to unfreeze the credit markets. The government has, among other actions, recapitalized 25 banks to the tune of roughly $158 billion, guaranteed all senior debt issued by banks over the next 3 years, and extended unlimited swap lines to several other central banks. The G7 countries also made it very clear that they won't allow another big bank to fail ("no more Lehmans"). Yet despite the historic government actions, the credit markets have barely budged. The Libor-OIS spread, which the Fed uses to measure the perception of risk in the credit markets, remains extremely high—it's currently 255 bps. While this is down from its high of 350 bps on October 9, in normal times the spread hovers around 20 bps, so 255 bps is still absurdly high. Credit default swap spreads (CDX) also remain extremely wide, with the IG 11 trading at 199 bps. Why have credit markets been responding so slowly? A good deal of the delayed reaction is attributable to, oddly enough, all the government actions. Since Lehman went under the Fed and the Treasury have been creating new programs at a dizzying speed. For example, we've had the Troubled Assets Relief Program (TARP), the Commercial Paper Funding Facility (CPFF), the Money Market Investor Funding Facility (MMIFF), and the recapitalization plan. And, of course, who could forget the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (ABCPMMMFLF)! It takes a lot of time to work through the details of each program, determine who is eligible, weigh the costs and benefits of participating, assess the program's overall impact on the credit markets, etc. Most importantly, every financial institution has to adjust its risk models accordingly. This isn't a simple task, and in an environment where financial institutions are as risk-averse as I've ever seen, no one wants to start lending again until they're absolutely sure they understand the terms and ultimate impact of each new government program. The launch of the CPFF this week was a reassuring event for everyone. But every time a new story surfaces about a possible bailout for another industry (e.g., insurance companies, automakers) or another possible government program (e.g., the bailout for homeowners now being discussed), more uncertainty is injected into the credit markets. I'm not saying that the government shouldn't create new programs just because they'll cause temporary uncertainty and timidity in the credit markets—if a new program is truly necessary, then that kind of short-term pain should be worth it. I'm just saying that, based on what I've seen, a good deal of the delay in the improvement of the credit markets is due to financial institutions taking their time digesting each new government program.

Chicago Tribune columnist Steve Chapman is a hack. Everyone knows this. But this is bad even for someone as cartoonishly ignorant as Chapman. In this morning's column, he wrote:

For nearly a year, we've been told that the economy is on the verge, if not the thick, of a painful recession. But the traditional definition of a recession is two consecutive quarters of negative growth -- and we have yet to endure even one such quarter.
Yes, Steve, we have: GDP growth was negative in the fourth quarter of 2007. (Also, two consecutive quarters of negative growth isn't really the "traditional" definition of a recession, it's the "old" definition. It's "traditional" to use the NBER Business Cycle Dating Committee's definition of a recession, and the Committee long ago abandoned the "two consecutive quarters of negative growth" definition. Why would the Tribune's editors let Chapman use the old definition of a recession to argue about whether we're in a recession now?)

Tuesday, October 28, 2008

WSJ Catches On

Today's WSJ has an article that finally puts the "volatility spiral" I discussed in the previous post at the center of the post-Lehman rout:

Brokers and exchanges calculate the level of collateral required to trade securities on margin based on potential losses in stress tests, determined by historical volatility. But stocks, bonds and derivatives busted out of historical volatility ranges in the wake of Lehman Brothers Holdings Inc.'s failure in mid-September, and so brokers and exchanges had to change their assumptions. They increased the amount of collateral needed as the range of possible losses on trades grew. Every time the collateral requirement increased or the account lost a critical mass of money, it triggered a "margin call," forcing funds and investors to sell securities to come in line with the new requirement. So every successive drop in the stock market triggered another round of margin adjustments, another round of margin calls, and another round of forced selling.
At this rate, we should expect the New York Times to run an article on the volatility spiral in mid-November, and the Washington Post to deliver a front-page exposé on volatility around March 2009 (which of course will win a Pulitzer).

Monday, October 27, 2008

The Importance of Volatility

The most important financial market indicator right now is not the Dow, not swap spreads, and defintely not the TED spread. It's not even Libor (though Libor is still important, for obvious reasons). It's volatility. The most widely-used measure of volatility is the VIX, which measures the implied volatility of options on the S&P 500 index for the next 30 days. The VIX is commonly called the "fear index," which leads to the impression that the VIX is purely a measure of investor sentiment. But given the importance of volatility in financial markets, especially right now, it's much more than a measure of investor sentiment. Volatlity is important because it dramatically affects banks and hedge funds' value-at-risk (VaR). VaR estimates the maximum a bank or hedge fund can expect to lose over a specific time period at a given confidence interval. VaR is the primary tool of risk management. Low volatility leads to low VaR, and high volatility leads to high VaR. Banks and hedge funds' leverage ratios are generally tied to VaR—the lower an institution's VaR, the more it can lever up. More importantly for right now, the higher an institution's VaR, the less leverage it can use. The problem is that we experienced an unusually long period of low volatility this decade, which allowed banks and hedge funds to lever themselves to the hilt. In fact, the low volatility stronly encouraged banks and (especially) hedge funds to lever themselves to the hilt—profit opportunities get snapped up faster during boom years, so hedge funds need to lever small profit margins to maintain their high returns. But when Lehman failed, volatility spiked to unheard-of levels, and has remained there ever since. Just look at the five-year chart of the VIX:

Because financial institutions base their leverage on VaR, the ridiculously high level of volatility post-Lehman has forced them all to simultaneously raise huge amounts of cash to reduce their leverage. The result has been the mother of all coordinated sell-offs—everything must go, and no asset class is safe. Of course, the mass forced liquidation has just increased volatility, forcing yet more fire sales, and leading to still-higher volatility. And so on, and so on. Gillian Tett of the FT, who is the only mainstream commentator I've seen highlight the leading role of volatility in forcing the mass sell-offs, reported that banks are also reducing their leverage by slashing their lending to hedge funds. I haven't seen a whole lot of that, but given the current state of the markets, reducing lending to hedge funds would seem like a better way to reduce leverage than selling into illiquid markets. I wish I could say that this vicious cycle will end soon—or that it will end at all—but from what I've seen and what I hear from others, there's still no end in sight.

Sunday, October 26, 2008

Thomas Friedman: Not A "Details" Guy

Thomas Friedman warns his readers that having the government as a shareholder in banks might stifle innovation because the government might force banks to become overly cautious. If Friedman had taken the time to look at the details of the recapitalization plan, pesky though they are, he'd see that the government is only getting nonvoting shares. He also suggests that banks might become overly cautious because their CEOs will be worried about a scolding from a Congressional committee, which is an argument that only someone who has never worked in either finance or government would make. (Note that in Friedman's hypothetical example, the two young entrepreneurs walk into a bank and immediately talk to the bank president, who then personally evaluates their loan application. I wonder if Friedman has ever actually been to a bank before.) He also says that the thing we need more than anything is "better management" at banks. How does he propose that we accomplish this?

Save the system, install smart regulations and get the government out of the banking business as soon as possible so that the surviving banks can freely and unabashedly get back into their business: risk-taking without recklessness.
So in order to get better management at banks, Friedman thinks the government needs to get out of the existing management's way. Wow. Final score for today's column: Logic - 2; Friedman - 0.

Saturday, October 25, 2008

Not All Economists Are Created Equal

I very much agree with Ezra Klein:

One sidenote of the past few months is that folks turned to economists when what they needed were finance experts. But there are relatively few finance experts who aren't affiliated with financial institutions, and so much of their commentary is tainted. Economics, however, hasn't quite caught up to the size and centrality of the financial industry in the modern economy, and so though economist knew relatively more about what was going on than the median American did, they actually knew much less than people assumed. But it's hard to blame the profession. The growth of finance has been hard to keep up with.
Ezra is wise beyond his years. As a general rule, you should be initially skeptical of any academic economist who purports to provide expert analysis on the workings of the financial markets. The truth is, the financial markets are enormous, wide-ranging, and exceedingly complex, both on the macro and micro levels. The media constantly refer to credit default swaps as "esoteric" instruments, but in the financial world, CDSs are among the simpler instruments. Try getting your head around leveraged super senior (LSS) notes of synthetic CDOs. And that's only one of the thousands of instruments in the global financial system, all of which constantly interact with each other in a dynamic, multi-layered market. An academic economist who doesn't specialize in finance has likely never heard of quite a few of the securities and derivatives that are commonly used today—or, at least, they hadn't heard of them before the financial crisis. There are certainly some financial economists who are genuine experts, but they're few and far between. It has been funny, though a bit sad, to watch many academic economists weigh in on the financial crisis as if they had any clue what they're talking about. They truly live in their own little bubble, arguing about a model of financial markets that bears very little resemblence to the real-world financial markets.

Monday, October 20, 2008

Volcker Supported Recapitalization?

The Wall Street Journal article on Paul Volcker becoming a key economic adviser to Obama says:

Like other prominent economists, Mr. Volcker also advocated early on for the recapitalization of banks. On this advice, Sen. Obama proposed direct-equity infusions in banks in his frequent conference calls with Treasury Secretary Henry Paulson.
Say what? Volcker was a prominent supporter of the plan to purchase illiquid assets from banks—that is, the original Paulson Plan. On September 17, Volcker, along with Nicholas Brady and Eugene Ludwig, wrote an influential op-ed in the WSJ that said:
There is something we can do to resolve the problem. We should move decisively to create a new, temporary resolution mechanism. ... This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management.
This op-ed was published on Wednesday of the Week From Hell—that night, Paulson and Bernanke had their famous come-to-Jesus meeting with the Congressional leadership, convincing them of the need for a bailout. By Sunday night the Treasury had unveiled Paulson Plan 1.0, which was—you guessed it—to create a mechanism to purchase illiquid assets from banks! Maybe Volcker did an interview, or wrote another op-ed that I'm not aware of, in which he advocated for recapitalization of the banks, but I find that highly unlikely. If anything, Volcker threw his weight behind the Paulson Plan—a plan that Obama supported, but considered second-best to directly recapitalizing the banks.

I neglected to mention in my last post that the one blog I actually did start reading last week is EconomPic Data. I'm one of those people who likes to visualize data, so the daily charts and graphs of relevant economic data is perfect for me. Highly recommended.

Sunday, October 19, 2008

Financial Crisis Coverage

Brad DeLong mocks the Washington Post for thinking that it has the ability to provide "authoritative" coverage of an event like the financial crisis:

[W]hen an episode like the financial crisis hits, nobody even half-informed with even half a brain looks to the Post for "authoritative" coverage. To the Financial Times, the Economist, and the news pages of the Wall Street Journal; to Calculated Risk, Marginal Revolution, Econbrowser, Economists View, Naked Capitalism, and The Big Picture; to John Berry, Paul Krugman, and Larry Summers. But not to the Post. Not for "authoritative" coverage. The presumption has to be that the Post's reporters are--like Neil Irwin last Wednesday--warping the story to please their sources, or simply out of their depth. The Washington Post crashed and burned long ago.
DeLong is, of course, right: on financial markets coverage, the Washington Post belongs at the kids' table. It has no one, at all, with the requisite intelligence and knowledge of financial markets. When no one at the newspaper actually understands what's going on right now in the financial markets, it's hard to provide "authoritative" coverage of the financial crisis. Where should people turn for truly authoritative coverage of the financial crisis? The Financial Times, the Wall Street Journal, Bloomberg, and Reuters. If you're getting your news on the financial crisis from anywhere else, then you're not actually following the financial crisis. Prior to this week (in which an associate spelled me as the resident 18-hour-a-day guy at the investment house, allowing me to rest up by working mere 10-hour days for a week!), the only times since the financial crisis started that I've been to read any of the econoblogs was when I was at the airport, so I don't really know who's been providing the best commentary. And unfortunately, on Monday it's once more into the breach, for me. Stack of Credit Derivative Master Agreements, here I come!

Via Robert Skidelsky, the foremost authority on all things Keynes:

"When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."

There's little doubt that the financial sector is about to be re-regulated in a serious way. This is sorely needed, and the conservatives and libertarians who say that increased regulation of Wall Street is a bad idea because regulation can't solve every problem, forever and ever, quite simply have no idea what they're talking about. (I'm looking at you, David Brooks.) Whatever regulatory reform we get will undoubtedly be watered-down, since the regulatory reform won't come until the worst of the crisis in the financial markets has passed, at which time the public outrage over the financial crisis—and thus the political will to re-regulate Wall Street—will have diminished. However, that doesn't necessarily mean that practices on Wall Street won't get better. One of the biggest reasons we're in this mess is our underestimation of tail risk—for example, banks' risk models were/are based on limited historical data (which didn't include a period of financial panic comparable to today's), so banks systematically underestimated the possibility of a financial panic. This led them to lever up excessively, use untested derivatives to circumvent capital requirements, etc., etc. Regulators were also guilty of underestimating tail risk—risk weights under Basel II severely overestimated the effectiveness of credit derivatives in hedging risk. Here's my point: Once this financial crisis has passed, the historical data used in risk models will include data from the current financial panic. The models will presumably estimate a much higher (and much more accurate) possibility of a global financial panic. That is, the risk models will be based on a much better understanding of tail risk. Similarly, regulators will also know much more about tail risk. Using derivatives like credit-default swaps to hedge risk won't reduce banks' risk weights under Basel II nearly as much, which will in effect increase capital requirements. We'll all benefit from knowing what a global financial crisis looks like. I call it the "now we know" factor. So even if the regulatory reform of Wall Street is severely watered-down (and knowing Congress, I expect it will be), we'll at least get some benefit from the "now we know" factor.

Wednesday, October 15, 2008

Recommended Readings

1. Kenneth Arrow argues that a main cause of the financial crisis is asymmetric information. A new NBER working paper by Gary Gorton makes the same argument. 2. Brad Setser sees little evidence of the nightmare scenario I mentioned last night (i.e., China broadly redirecting its monetary policy away from foreign exchange interventions):

China’s trade surplus remains very large – and that it is still adding to its reserves at a fast clip. ... And while there is good reason to think that the growth in Russian and GCC foreign assets is poised sharply, evidence that China’s surplus is about to fall remains, for now, rather thin.
3. On VoxEU, Virginie Coudert and Mathieu Gex provide empirical evidence showing that correlations do, in fact, go to one in financial crises. 4. Check out all the economic data on tap for tomorrow. If it's half as bad as today's data, we could be in for a truly wild day on the markets (even by today's standards). If tomorrow's data is really bad, then all I can say is: God help us.

Peter Boone, Simon Johnson, and James Kwak have an op-ed in today's WaPo, titled, "How to Manage the Banks." What's their proposal? Here it is, the sum total of the proposal that merited a place on the Post's op-ed page:

Congress should create a consolidated and powerful regulator that can stand up to the banks.
Umm, yeah, because OFHEO did such a bang-up job as Fannie and Freddie's own personal regulator. We should go with that approach again.

Tuesday, October 14, 2008

What Scares Me

What could still cause a complete meltdown of the global financial system? Economic growth in Asia slowing so much that the Asian central banks -- particularly the People's Bank of China -- decide that monetary policy should be focused on fighting possible recessions rather than intervening in the foreign exchange market (i.e., buying U.S. government debt). Yes, China would just be hurting itself, and it would be an objectively irrational decision. But that doesn't mean they won't do it anyway. That scares me. And it should scare you too.

The Treasury taps Simpson Thacher to serve as legal adviser for the recapitalization plan. Good firm with a top-notch PE practice (they represent KKR), so it definitely has the necessary expertise to advise on the recapitalization portion of the bailout. My wife knows more about Simpson Thacher than I do. Here's what she had to say about the appointment in an email:

Very professional and no-nonsense but still congenial and respectful overall. Excellent transactional. A little inconsistent in lit[igation]. Mostly diligent litigators but I remember a couple jerk showboaters who dragged negotiations down. Not indicative of the firm though.
Hopefully they can craft a program with a decent legal foundation. And by "a program with a decent legal foundation," I mean "a program that doesn't totally screw any of my clients."

UPDATE: Barry Ritholtz notes in the comments that he "took the vitriol down a notch," so I've replaced the old excerpt with Barry's new and slightly less vitriolic version. It's still pretty scathing though, and it calls out the hacks for their idiocy and/or mendacity. And they richly deserve it. Barry Ritholtz lays down the law on the Fannie/Freddie/CRA line:

Those who continue to blame the CRA, Fannie Mae, etc. reveal their fundamental misunderstanding of how credit operates in general, what the financing process was like from 2002-07, and how this situation came to pass. Or worse, they understand it, and choose to lie about it anyway for partisan political purposes. You either understand these simple facts, or you don't. If you cannot comprehend this, well, then, I am at a loss as to what that says about your cognitive functioning. But if you understand this, but spit out the nonsense anyway, then you are merely a partisan with no respect for the truth. And that seems to be the main people blaming the CRA and Fannie/Freddie for the credit/housing crisis -- those folks who either can't think -- or wont.
Preach it, Barry.

[UPDATE: Upon reflection, I was way too hard on David Bernstein in this post, and I shouldn't have been so mean-spirited. I had been working for 15-16 hours and was impatiently waiting for Westlaw to get its act together when I wrote this post, so my frustration level was, umm, high. That, combined with the fact that for the past week I've had to write uncharacteristically measured responses to motions that deserve mockery and ridicule, left me itching to tee off on somebody. I happened to disagree with something Bernstein wrote last night, so he was the unfortunate recipient of my frustration. I still disagree with Bernstein, but the personal insults were unnecessary and immature, and I've therefore removed them. In the future, I'll try not to write posts on the tail-end of all-nighters.]

An unfortunate consequence of the financial crisis taking center stage in the news is the barrage of commentary and opinion-pieces on the financial crisis from people who know absolutely nothing about financial markets. The offending commentary has come predominantly from the political arena—amateur political commentators (a category that includes political journalists and columnists, despite their claims of expertise) know even less about finance than they do about politics, and that's saying something. I make it a rule not to read any commentary on the financial crisis from a political commentator.

But some people who I do still read (though not specifically for financial commentary) are apparently afflicted by the same "speaking without knowing" syndrome as the political commentators when it comes to the financial crisis.

For example, on more than one occasion Will Wilkinson has confidently asserted: "We don't need more regulation or less. We need better regulation." Really? Wilkinson is a smart guy and I enjoy his philosophical writings, but I'm gonna go out on a limb and say that he doesn't know the first bloody thing about the regulatory structure currently governing the financial markets. It's incredibly complex, and something casual observers simply cannot pick up in a matter of weeks. It takes years for even financial market participants to learn, and most people on the investment side (as opposed to the legal side) still don't really understand a lot of the regulatory requirements. So how in the world does Wilkinson know that "[w]e don't need more regulation or less"?

Another example is the Volokh Conspiracy's David Bernstein. Commenting on how the Treasury made recapitalization of the 8 biggest U.S. banks with public funds mandatory, Bernstein wrote, "If any of the relevant banks is already well-capitalized, I hope its CEO tells Paulson to take his capital injection and shove it up his you-know-what." If any of the relevant banks isn't well-capitalized, and they accept Paulson's capital injection while another bank rejects the government money, the market will know that the banks that took the government money are weak. Those banks' lenders will then run for the hills, potentially forcing the banks into bankruptcy.

Later, in the comments, Bernstein writes, "[A]pparently Paulson has decided that the issue is not banks that 'need' the money, but that the feds need to inflate the money supply, and pronto, and the mechanism to do so is by giving money to major banks." Say what? The TARP isn't about recapitalizing the banking sector, but is instead about inflating the money supply? Even if Paulson was really trying to inflate the money supply (and I'm quite certain that's not the true goal), there are much better ways to accomplish that goal. Inflating the money supply by recapitalizing the banking sector would be about as roundabout and ineffective as it gets.

So far, here's what we know about the U.S. recapitalization plan (with my commentary sprinkled in): Preferred Stock: The government will buy $250 billion of perpetual preferred stock in U.S. banks. $125 billion has already been committed to 8 large banks—$25 billion to BofA/Merrill, Citi, JPMorgan, and Wells Fargo, $10 billion to Goldman and MS, $3 billion to Bank of NY Mellon, and $2 billion to State Street. The other $125 billion "will be used to recapitalize other financial institutions around the country"—according to the WSJ, "potentially thousands of banks." The preferred stock "will carry a 5% annual dividend that rises to 9% after five years. ... [F]irms returning capital to the government by 2009 may get better terms for the government's stake."

  • Most people expect the preferred stock to be nonvoting, but will the government give itself back-door voting rights by making the stock noncumulative with contingent voting rights? I doubt it, but it's something to watch out for.
Executive Comp "Limits": "All of the banks involved will have to submit to compensation restrictions as mandated by Congress."
  • So basically, no meaningful executive comp limits.
Guarantee New Senior Unsecured Debt: The FDIC will "offer to temporarily guarantee, for a fee, certain types of new debt called senior unsecured debt issued by banks and thrifts. This would apply to debt issued by June 30 with maturities up to three years." More FDIC Insurance: The FDIC "will offer an unlimited guarantee on bank deposits in accounts that do not bear interest — typically those of businesses."
  • This is apparently "voluntary for banks," but without charging a fee for this guarantee (and no one is reporting that a fee will be required), every bank will presumably accept the FDIC's offer.
Goals of Recapitalization Plan: The Treasury is focused on "getting the participation of the firms most important to the financial system, according to people familiar with the matter. Treasury's main goal is to attract private capital."
  • My sense is that the Treasury wants to inject capital into healthy, solvent banks as much as possible, in order to: (1) avoid rewarding the most reckless and irresponsible banks, and (2) allow the banking sector to triage itself by allowing the prudent banks (e.g., Goldman) to start taking over failing institutions.
  • The word is that there's a lot of private capital sitting on the sidelines. I'm a bit skeptical that there's as much capital on the sidelines as some people claim, but I do think there's a lot. The Lehman CDS auction on Friday went well, so some of the cash that was being hoarded in preparation for the Lehman auction will undoubtedly go to work now. How much of Monday's surge was attributable to the Lehman CDS auction being behind us? We'll never know.
Favorable Terms for Everyone!
  1. WSJ: Terms Will Be Favorable for Banks: "To make sure private investors aren't scared away, it is expected to structure its investment on terms favorable to the banks and will inject capital in exchange for preferred shares or warrants, these people said."
  2. NYT: Terms Will Be Favorable for the Government: "The investments will be structured so that the government can benefit from a rebound in the banks' fortunes."
I'm guessing the Treasury won't be able to thread the needle on the preferred shares that well.

The Nikkei closed up 14.15%, the DJ Euro Stoxx 50 is currently up 10.7%, and futures indicate a 174-point gain in the Dow tomorrow morning. Technicians assured me that we would see modest gains, followed by a retesting of lows, and would crawl our way back to more reasonable levels in fits and starts. An L-shaped period would slowly morph into a U-shaped recovery, they insisted. I know it's only been 1.5 days, but this looks pretty friggin' V-shaped to me!

Sunday, October 12, 2008

Financial Crisis Jokes

My favorite joke floating around right now:

The financial crisis is worse than a divorce: I have half my money, but I still have my wife.

Tuesday, October 7, 2008

Chris Cox

It was obviously a political stunt, but John McCain was right. Fire Chris Cox. Right now. From Bloomberg:

An unedited version of the 137-page study [by the Inspector General of the SEC] posted to the Iowa Republican's Web site Sept. 26 showed that Bear Stearns traders used pricing models for mortgage securities that ``rarely mentioned'' default risk. ... The [SEC] removed a section of the publicly distributed report showing that the Division of Trading and Markets knew Bear Stearns's capital ratio had dropped to 11.5 percent in March from as high as 21.4 percent in April 2006. The ratio measures assets, adjusted for risk, relative to a firm's equity. Ten percent is the minimum standard under international banking regulations.

Monday, October 6, 2008

Prescient

William Poole, writing in 1991:

[A]ny policymaker who is unwilling to play chicken with the markets on the issues will be conceding a lot in Washington infighting over policy. This is another reason why it is so important to change the incentive structure in private markets to promote stability. Government policy involves conflict, and conflict inevitably brings surprises and disappointments to the markets.
From The Risk of Economic Crisis (Martin Feldstein, ed., NBER 1991).

I apologize for the lack of posting. As I'm sure you can imagine, things have been beyond crazy for the past 3 weeks. My firm represents a large hedge fund, and I've been at the fund's headquarters in Connecticut for about 2 weeks now (I'm still in CT). Being in an office directly off the trading floor (and with a Bloomberg!) for the past 2 weeks, let me just say: things are very bad, and only getting worse. I'm honestly scared for the future of the financial system. How did we get here? There are lots of reasons, but to me, the most important reason is that traders, CEOs, and even risk managers all seem to have forgotten one extremely important thing: In a financial crisis, the correlations always go to one. From a legal perspective, I forgot how God-awful the ISDA's 1992/2002 Master Agreement and 2003 Definitions are (the standard contracts for credit derivatives). Seriously, I have summer associates who could draft better contracts. This legal clusterfuck will be working itself out for the next 20 years.

Thursday, October 2, 2008

Beware of Hackery

I see that Columbia Business School professor Chris Mayer is making the rounds on the op-ed pages (last week in the New York Times, and today in the Wall Street Journal). It's worth reminding people that at the height of the housing bubble, Mayer was prominently denying that a bubble existed at all. Here's what Mayer wrote in late 2005:

"Bubble Trouble? Not Likely," Wall Street Journal: "For the past several years, Chicken Littles have squawked that the sky -- or the ceiling -- is about to fall on the housing market. And it's tempting to believe them. ... "Yet basic economic logic suggests that this apparent evidence of a bubble is anything but. Even in the highest-price cities, housing is, at most, slightly more expensive than average."
Bear this in mind when reading Mayer's proposed solutions. A couple months ago I compiled a list of pundits/experts who were wrong on the housing bubble (which Mayer was on). Now that the financial crisis has reached a new level, it's worth re-posting the entire list: 1. Alan Reynolds, Cato Institute:
"No Housing Bubble Trouble,"Washington Times (January 8, 2005): "In short, we are asked to worry about something that has never happened for reasons still to be coherently explained. 'Housing bubble' worrywarts have long been hopelessly confused. It would have been financially foolhardy to listen to them in 2002. It still is." "Recession Fairy Tales," Townhall (October 5, 2006): "When it comes to homes . . . many people have spent the last four years fretting that the 'housing bubble' might end. That is, they worried that overpriced homes might become more affordable. This is not quite as nonsensical as worrying the price of oil might fall too much, but it's close."
2. Kevin Hassett, American Enterprise Institute:
New York Times (July 25, 2004): "Another bubble-skeptic is Kevin Hassett, director of economic policy studies at the American Enterprise Institute and co-author of the fabled 'Dow 36,000,' which was published in 1999 when the Dow Jones index was around 11,000. Mr. Hassett says there is an ideological component to the belief in bubbles. Liberals, who tend to believe that government must step in to protect people from market imperfections, will likely see more of them. Conservatives, who like their markets unfettered, will see less. ... "Mr. Hassett of the conservative American Enterprise Institute thinks housing prices will be pretty much O.K. He acknowledges there might be some bubble dynamics at play in some regions. But he argues that for the most part people are paying more for homes because their incomes are higher and interest rates are lower, reducing the cost to own a home. "Mr. Hassett expects that rising interest rates would raise this cost and home prices would then decline proportionately. But he sees no reason to expect a catastrophic decline. 'I don't think a catastrophe is very likely,' he says.
3. James K. Glassman, American Enterprise Institute:
"Housing Bubble?," Capitalism Magazine (May 24, 2005): "[W]hile such signs of speculation are troubling, there is little solid evidence that a real estate bubble is puffing up. ... "Even in places where prices are soaring, worries of a bubble could be overblown because higher prices appear grounded in good old fundamentals."
4. Jude Wanniski, journalist/hack:
"There is No Housing Bubble!!," The Conservative Voice (August 13, 2005).
5. Jerry Bowyer, author of The Bush Boom:
"Hate to Burst Your (Housing) Bubble: But there isn't one," National Review (July 5, 2006).
6. Nicolas P. Restinas, director, Harvard Joint Center for Housing Studies:
"More Than a Bubble Keeps Housing Prices Sky-High," LA Times (May 20, 2004).
7. Jim Cramer, host of CNBC's "Mad Money":
"House Beautiful," New York Magazine (December 8, 2003): "Housing bubble? What housing bubble? The signs are in place for a further run-up in real estate. Breathe easy, mortgage holders. There’s still no place like home."
8. Neil Barsky, Alson Capital Partners, LLC:
"What Housing Bubble?," Wall Street Journal (July 28, 2005): "There is no housing bubble in this country. Our strong housing market is a function of myriad factors with real economic underpinnings: low interest rates, local job growth, the emotional attachment one has for one's home, one's view of one's future earning- power, and parental contributions, all have done their part to contribute to rising home prices. ... "What we do have is a serious housing shortage and housing affordability crisis."
9. Chris Mayer, professor of real estate, Columbia Business School, and Todd Sinai, professor of real estate, Wharton:
"Bubble Trouble? Not Likely," Wall Street Journal (September 19, 2005): "For the past several years, Chicken Littles have squawked that the sky -- or the ceiling -- is about to fall on the housing market. And it's tempting to believe them. ... "Yet basic economic logic suggests that this apparent evidence of a bubble is anything but. Even in the highest-price cities, housing is, at most, slightly more expensive than average."
10. Jonathan McCarthy, senior economist, New York Fed, and Richard W. Peach, vice president, New York Fed:
"Are Home Prices the Next Bubble?," FRBNY Economic Policy Review (December 2004): "Home prices have been rising strongly since the mid-1990s, prompting concerns that a bubble exists in this asset class and that home prices are vulnerable to a collapse that could harm the U.S. economy. ... "A close analysis of the U.S. housing market in recent years, however, finds little basis for such concerns. The marked upturn in home prices is largely attributable to strong market fundamentals: Home prices have essentially moved in line with increases in family income and declines in nominal mortgage interest rates."
11. David Malpass, chief economist, Bear Stearns:
"So This is a Weak Economy?," Wall Street Journal (June 28, 2005): "[T]he litany against the U.S. economy is so ingrained and familiar that few disputed this spring's 'slowdown.' When strong data on income, employment, consumption and profits showed 3.5% first-quarter GDP growth and a continuation into the second quarter, the headlines shifted to other attacks -- adjustable-rate mortgages, a housing 'bubble,' the distribution of income -- rather than revising the slowdown story."
12. Steve Forbes, CEO, Forbes, Inc.:
Global Leaders Speakers Series (November 10, 2005):"[Forbes] maintained that there was no 'housing bubble' in the U.S. but there was an “oil bubble” driven by speculators."
13. Brian S. Wesbury, chief investment strategist, Claymore Advisors:
"Mr. Greenspan's Cappuccino," Wall Street Journal (May 31, 2005): "These nattering nabobs expect a housing collapse to take down the U.S. economy. But excessive pessimism is unwarranted: Fears of a housing bubble are overblown."
14. Noel Sheppard, economist, Business & Media Institute:
"Media Myths: The Housing Bubble is Bursting,"Business & Media Institute (Nov. 30, 2005): "The increase in real estate values the past five years has not resembled the rapid rise typically seen in a bubble."
15. Carl Steidtmann, chief economist, Deloitte Research:
"The Housing Bubble Myth," Economist's Corner (July 2005): "When you strip away all of the white noise around a housing bubble, what you find is a robust market for housing that is undergoing several profound changes all of which manifest themselves in higher home price indexes, none of which adds up to a housing price bubble."
16. John K. McIlwain, senior resident fellow for housing, Urban Land Institute:
"No Housing Bubble to Pop," Washington Post (March 2, 2005): "[T]he housing markets will cool as interest rates rise and as affordability declines, but they won't crash. Most markets will flatten for a while or increase at lower, more historical, rates. A few may decline for a year or two. But we won't have a crash."
17. Margaret Hwang Smith, professor of economics, Pomona College, and Gary Smith, professor of economics, Pomona College:
"Bubble, Bubble, Where's the Housing Bubble?,"Brookings Papers on Economic Activity (2006): "Our evidence indicates that, even though prices have risen rapidly and some buyers have unrealistic expectations of continuing price increases, the bubble is not, in fact, a bubble in most of these areas in that, under a variety of plausible assumptions, buying a house at current market prices still appears to be an attractive long-term investment."
18. Charles Himmelberg, economist, New York Fed:
"Assessing High House Prices: Bubbles, Fundamentals, and Misperceptions," Federal Reserve Bank of New York Staff Reports (September 2005): "As of the end of 2004, our analysis reveals little evidence of a housing bubble. In high appreciation markets like San Francisco, Boston, and New York, current housing prices are not cheap, but our calculations do not reveal large price increases in excess of fundamentals."
19. Jim Jubak, investing columnist, MSN Money:
"Why There is No Housing Bubble," MSN Money (June 10, 2005): "Housing bubble? What housing bubble? With the 10-year U.S. Treasury bond yielding below 4% and 30-year mortgages available at 5.1%, there isnt a housing bubble."
20. James F. Smith, director, Center for Business Forecasting:
"There is No Housing Bubble in the USA: Housing Activity Will Remain At High Levels in 2005 and Beyond," Business Economics (April 2005): "There is no evidence of a housing 'bubble' in the United States and housing demand should stay strong for years to come."
21. Kathryn Jean Lopez, editor, National Review Online:
"Don't be Myth-Understood," National Review (December 21, 2005): "[T]he so-called housing bubble has yet to pop, and likely won't as long as home ownership remains a tax-advantaged event. Even the New York Times — no parrot of White House talking points — has had to admit that the economy is 'booming.'"
22. Samuel Lieber, president, Alpine Woods Capital Investors:
"Housing Bubble? The Market Won't Pop, Experts Predict," Wall Street Journal (April 12, 2006): "We don't see a bubble. Historically, home prices just don't go down nationwide unless we are in a significant recession. The last time home prices fell nationwide was in 1990. It's employment that really counts. The underlying fundamentals of real estate are still very positive. Job creation and household formation drive housing."
23. Mark Vitner, senior economist, Wachovia:
"There is No Housing Bubble, Says Senior Economist," The Virginia-Pilot (January 19, 2006): "'Everybody is looking for evidence of a housing bubble,' [Vitner] said. 'There is not a housing bubble. The supply had not kept up with demand.'"
24. George Karvel, professor of real estate, St. Thomas University:
"Housing bubble?," Minneapolis Star Tribune, October 4, 2005 (via LEXIS): "'There's no housing bubble,' said George Karvel, a professor of real estate at the University of St. Thomas. 'This is a media-induced frenzy. If I wanted to say there is a housing bubble, I'd have Time and Money magazine camped on my door. They've called, and I've told them there's no bubble. Panic sells." ... "There is absolutely nothing in any market in the country to indicate there'd be any kind of collapse in housing prices,' he said."

Wednesday, October 1, 2008

I Guess We Live In Fantasy Land

Not to pick on Thomas Friedman too much, but this is just a perfect example of why his columns should never be taken seriously. Ever. Here's Friedman:

We're all connected. "Decoupling" is pure fantasy.
And here's the IMF:
There is evidence of business cycle convergence within [both industrial countries and emerging economies], but divergence (or decoupling) between them.
I wonder if Friedman's trademark over-the-top optimism will turn into over-the-top pessimism if we go into a deep recession.

Thomas Friedman has never been the most eloquent writer, and he's not exactly known for his scholarly intellect, but no professional columnist should ever write something like this:

The story cannot end here. If it does, assume the fetal position.
If the story cannot end here, then why advise people on what to do if the story does end here? Ah, logic.