THE COOL WINDS OF JUNE
Submitted by The Capital Spectator
The weather in June was cool and rainy in the New York region, and something similar prevailed over the capital and commodity markets last month as well.
As our table below shows, June was a month of mixed messages, ranging from a healthy rally in high-yield bonds to loss in REITs. Disappointing, perhaps, given the previous bout of good times. But the arrival of red ink is hardly unexpected. The March-to-May rally, after all, elevated all the major asset classes by dramatic levels. That couldn’t last. But what comes next?
The optimistic interpretation is that June was a month of backing and filling. The markets are reportedly digesting the recent gains and building a foundation to capitalize on the expected economic recovery. Prices got ahead of themselves in recent months, and bit of profit-taking was inevitable.
A less-forgiving outlook is that the recent rally in almost everything was a sucker’s game. The great bear market of 2008 is still with us, runs this line of thinking, and so the rest of the year will suffer.
Your editor tends to come down in the middle of these two extremes. As we’ve been pointing out in more detail in recent issues of The Beta Investment Report, the foreseeable future for returns in the major asset classes looks increasingly unexceptional. The sharp snapback in prices so far this year looks warranted as it became clear that the worst fears for the economy were overdone. All the more so as it appears that the technical end of the recession may be near.
Then again, we can’t be sure. There are still lots of reasons to remain cautious. Forecasts, after all, are created by mere mortals and so predictions are subject to revisions as new information arrives. Meanwhile, the stock market looks fairly valued at the moment, which is to say that it’s no longer undervalued, as it was as this year opened. Similarly, yield spreads, while still attractive, are no longer extraordinarily high.
In short, the markets have rallied on the expectation that the aggressive liquidity injections of governments around the world would bring stability and, eventually, expansion. That still looks like a good bet, but no longer are markets offering massive discounted prices tied to that outlook.
Then again, none of this is a surprise. Expected returns vary, as they must in order to attract buyers through time. No one would be willing to buy risky assets in January 2009 without an unusually high expected risk premium. Now that the macroeconomic risk looks lower, albeit still substantial, assets are priced accordingly.
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No rebound for autos
Submitted by Econbrowser
Autos are worth watching as one sector where economic growth could resume first. But despite what others are saying, I don’t believe that it’s happening yet.
Some analysts seemed to take comfort in the fact that the decrease in auto sales from June 08 to June 09 was more modest than the year-over-year decline for earlier months had been. But that’s primarily a reflection of the fact that June 08 had been a significant deterioration relative to earlier months of 08.
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Americans bought fewer light vehicles in June 09 than they did in May 09, and that holds for every category– car or light truck, domestic or import. You’ll have to look elsewhere for your latest “green shoot” fix.
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401k Investment Education
Submitted by Businomics Blog
In my spare time I’ve been working on a start-up business in investment education, initially focusing on helping employees learn about their 401k plans. Our new website is now up and running: www.abcInvesting.com. (Some features are not yet operational.) Take a look and let me know what you think. There’s lots of free information, plus a book available for sale. We’ll soon be offering subscription services that will make investment decisions easy.
A portion of our business is directed at businesses trying to save money. Here’s our value proposition:
If you are a corporate executive who has to cut the employee match, call us now. We can provide all of the retention benefits of a match, at a much lower cost.
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The Newest Data on Foreign Exchange Reserves
Submitted by Econbrowser
The IMF has released its estimates for 2009Q1 reserves (COFER data). Below I update and extend my recent post on the dollar as a reserve currency.
Figure 1: US dollar (blue, right scale), US dollar plus 60% of unallocated reserves (green, right scale), and log nominal value of US dollar against major currencies (red, left scale). NBER defined recession dates shaded gray. Source: IMF, COFER, June 30, 2009, Federal Reserve via FREDII, NBER and author’s calculations.Notice that the USD share has not declined, despite a decline in the dollar’s value against major currencies. Following Brad Setser’s observation that the reason the demand for the dollar as a reserve currency rose is because total demand for reserves increased, I also plotted the levels — rather than shares — for the most recent data.
Figure 2: US dollar reserves (blue), US dollar plus 60% of unallocated reserves level (green), and total reserves (black), in millions of US dollars. NBER defined recession dates shaded gray. Source: IMF, COFER, June 30, 2009, NBER, and author’s calculations.I think it’s an interesting that reserves have been shrinking for the past three quarters — and at a pretty rapid clip. They were declining by an annualized 10.3% in 2009Q1 (q/q in log terms; 9.8% in base terms). This development suggests that, even if the dollar retains its share of total reserves, demand for dollar assets might still decline.
While this might constitute a secular force for dollar weakness, it’s important that there are forces in working in the other direction, including cyclical factors. Deutsche Bank for instance projects 12.7% appreciation in the DB dollar index by end-2009 (16.1% against the euro, both in log terms). Their forecast implies only a slight depreciation in the dollar index by end-2010, and further appreciation against the euro (20.4% relative to June 26).
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Housing Affordabilty Index: 7.2 Point Drop in May From Rising Home Prices: Market Reached Bottom?
Submitted by CARPE DIEM
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Banking Fact of the Day
Submitted by CARPE DIEM
Number of bank failures this year so far: 45 (FDIC data here, click on “Produce Report”).
Total Assets of the 45 failed banks: $36.965 billion
Total Bank Assets of All 8,246 FDIC-insured banks: $13.542 trillion (data here)
Failed Bank Assets as a Percent of Total Bank Assets: .27% (or about 1/4 of 1%)
Bottom Line: The worst of the banking crisis is behind us, the percent last year was 2.69%.
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New Vanguard Economic Momentum Index: Economic Recovery is Near, Recession May Be Over
Submitted by CARPE DIEM
The general improvement in global financial conditions since March has fostered a marked improvement in investor sentiment and led many to inquire when (rather than if) the current U.S. recession will end. Increasingly, market commentary has focused on evidence of “green shoots” that would suggest the rate of economic deterioration is at least slowing. But how can we know that the right signals are being captured, and—more important—how accurate have such measures been in identifying the turning points of past business cycles?
In this brief, we unveil a proprietary Vanguard Economic Momentum Index consisting of more than 70 financial and economic indicators that in the past have anticipated (to varying degrees) the beginning and end of economic recessions. This new index is specifically designed to anticipate turning points in the business cycle, and it differs in important ways from several other widely tracked indexes of leading indicators. As of the end of May 2009, the Vanguard Economic Momentum Index indicated that a U.S. economic recovery likely will begin by the end of 2009.
Figure 1 below (click to enlarge) presents a “dashboard” of the individual components that make up the Vanguard Economic Momentum Index. The components are ranked in descending order based on their historical ability to forecast nonfarm payroll growth. For presentation purposes, they have been assigned colors based on these criteria:
Red: Indicator consistent with future employment losses at an increasing rate.
Yellow: Indicator consistent with future employment losses at a decreasing rate.
Green: Indicator consistent with future employment gains.
Components shaded either green or yellow in Figure 1 are considered evidence of so-called green shoots, since their most recent rate of acceleration is consistent with an eventual economic recovery. Yellow shading reflects a recent improvement in the component’s rate of change (i.e., its rate of decline has slowed, or its “second derivative” has turned positive).
Figure 1 shows a notable recent improvement in various economic and financial indicators, especially through May 2009. Some examples of such components are the S&P 500 Index, the shape of the Treasury yield curve, corporate bond spreads, and certain housing and manufacturing statistics. Encouragingly, the components near the top—those that have been the most anticipatory leading indicators of future economic conditions—have changed for the better ahead of those toward the bottom, although the improvement in individual indicators is far from unanimous.
Figure 2 below (click to enlarge) illustrates that after bottoming in November 2008, the index turned positive in February 2009 and continued that trend into March and April. This sharp reversal brings the index to levels that were associated with past economic recoveries. Indeed, by the end of May, the index was near the highs reached following the deep recessions of the mid-1970s and early 1980s. Based on historical patterns, the index’s climb suggests a high statistical probability that a U.S. recovery will begin by the end of 2009.
MP: Based on the pattern of this index over the last eight recessions, and especially in the four severe recessions of the 1970s and early 1980s, it looks very likely that the current recession might already be over, or will be ending shortly.
HT: Heather Brooks
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Markets in Everything: Backyard Urban Farming
Submitted by CARPE DIEM
MyFarm was started by Trevor Paque, a young mortgage broker, who decided in 2007 to get out of the office and take up farming. Hardly a new idea, but Paque took a new approach. His business plan called for building, planting, and harvesting vegetable gardens in small overgrown, weed-infested patches of soil that many people in San Francisco call back yards.
Pricing for each garden includes $50 for a site analysis to check sunlight and soil; $600 to $1,000 to build raised beds, install drip irrigation, and plant seeds; and $20 to $35 for weekly maintenance and harvesting. As part of the weekly maintenance, the farmer harvests a box of vegetables for the owner. To test the market, Paque posted an ad on Craigslist and within 20 minutes he had 200 responses.
~Down On The Urban Farm, by Linda Platts in Perc Reports
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Persistent Myths and Fictions in Feminist Scholarship: The “Scholarly” Merchants of Hype
Submitted by CARPE DIEM
Over the years, the feminist fictions have made their way into public policy. They travel from the women’s-studies textbooks to women’s advocacy groups and then into news stories. Soon after, they are cited by concerned political leaders. President Obama recently issued an executive order establishing a White House Council on Women and Girls. As he explained, “The purpose of this council is to ensure that American women and girls are treated fairly in all matters of public policy.” He and Congress are also poised to use the celebrated Title IX gender-equity law to counter discrimination not only in college athletics but also in college math and science programs, where, it is alleged, women face a “chilly climate.”
The president and members of Congress can cite decades of women’s-studies scholarship that presents women as the have-nots of our society. Never mind that this is largely no longer true. Nearly every fact that could be marshaled to justify the formation of the White House Council on Women and Girls or the new focus of Title IX application was shaped by scholarly merchants of hype like Professors Lemon and Seager.
~From Christina Hoff Sommers’ commentary in today’s Chronicle of Higher Education (also at the AEI website here).
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Cedar Rapids, Iowa; One Year Later
Submitted by CARPE DIEM
Sorry for the light posting over the last few days - I’ve been on a road trip since Saturday, and for the last 24 hours or so many of the Blogger blogs have been unable to accept new posts (it’s still not fixed yet, I found a way around it). And I’m now staying at a Trappist monastery in Iowa for a few days (with no Internet access), before driving up to Minneapolis tomorrow to see Dr. John and the Lower 911 Band at the Dakota Jazz Club. I’ll be spending the month of July blogging from my hometown of Minneapolis (”returning to my native village,” as they say in India).
My first stop was Cedar Rapids, Iowa, where I lived for part of my grade school days, from kindergarten through 6th grade, and I toured the flood area on Sunday, and I was surprised at how devastated the area still looks one year later. The vast majority of the 4,000 homes that were affected are still abandoned, and will probably never get rebuilt (too old, too damaged, too expensive to rehab, no insurance, etc.). Scattered among those abandoned homes are a few that have been rebuilt with residents living there, and a few that are under construction. But it really looks pretty grim in “Iowa’s Katrina” neighborhood.
A few visible signs of how badly the area was devastated, besides all of the abandoned homes:
1. There are portable toilets scattered around the worst-hit neighborhoods, I assume for workers, displaced residents, inspectors, etc. in those neighborhoods, many of which must not have water or sewer.
2. The gas station above in the photos, which was under water on June 13, 2008 at the height of the flood. A year later, nothing has changed, including the year-old price on the sign: $3.87 per gallon.
Here’s a recent NPR report “Cedar Rapids, Iowa, 1 Year After Record Flood“
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Quote of the Day
Submitted by CARPE DIEM
The problem with socialism is that eventually you run out of other people’s money.
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Bondage in the Bond Age: A California View
Submitted by unsettling economics
In the midst of the Bush-Obama balance sheet bailout, one group stands out in its importance — bondholders. I know — a couple of times some bondholders have had to take a haircut to protect other investors.
Here in California, with our $24 billion deficit, it seems like nothing — absolutely nothing — and threaten bondholders. Yes, some bondholders are pension funds or charitable organizations. A minority of Republicans along with a movie star governor have adamantly refused to raise taxes, especially those taxes that might affect the class of people who are bondholders.
Education and healthcare are being slashed beyond recognition. My God, even prisons might be cut a bit. The state is also raiding the treasuries of cities and counties for funds. Their response will be the same as the state’s: cut back on anything that might help the poor and if necessary extend the cuts to the middle class. All this so that California can payback its bondholders. No haircut here. They must be paid back in full.
And the children, deprived of adequate education and health care, of course, they must make a modest sacrifice to protect the interests of bondholders.
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New Papers on International Finance: Crises, Puzzles, and Exchange Rates and
Submitted by Econbrowser
Summertime is conference season, especially for those of us who don’t live close to a major airport hub. The first conference I attended was the NBER’s International Seminar on Macroeconomics, co-organized by Lucrezia Reichlin and Ken West. The conference was broken up into several sections: Financial Crises, International Economic Puzzles, Exchange Rates and Financial Development. Lot’s of interesting papers, and plenty of stimulating discussion. I can’t do justice to the proceedings, but I can provide the summaries of the papers.
Figure 1: Legend: Each observation represents average equity market correlation coefficient in a group of 16 countries, for a four-year panels, 1890-2001. The sixteen countries in our dataset are Australia, Belgium, Canada, Denmark, Finland, France, Germany, Great Britain, Italy, the Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, and the United States. “Uncorrected” is the equity market correlation of a pair of countries, and is taken from Global Financial Data. The Forbes-Rigobon volatility adjusted equity correlation is proposed in Forbes and Rigobon (2002), and used here. Source: D. Quinn and H.-J. Voth, “Free Flows, Limited Diversification: Openness and the Fall and Rise of Stock Market Correlations, 1890-2001″. In the abstract to “Free Flows, Limited Diversification: Openness and the Fall and Rise of Stock Market Correlations, 1890-2001″, Dennis Quinn and Hans-Joachim Voth write:
Using a new dataset on capital account openness, we investigate why equity return correlations changed over the last century. Based on a new, long-run dataset on capital account regulations in a group of 16 countries over the period 1890-2001, we show that correlations increase as financial markets are liberalized. These findings are robust to controlling for both the Forbes-Rigobon bias and global averages in equity return correlations. We test the robustness of our conclusions, and show that greater synchronization of fundamentals is not the main cause of increasing correlations. These results imply that the home bias puzzle may be smaller than traditionally claimed.
The abstract to “The Default Puzzle: Underwriters and Sovereign Bond Markets 1815-2007″, by Marc Flandreau, Juan H. Flores, Norbert Gaillard, Sebastian Nieto-Parra reads:
We provide a comparison of salient organizational features of primary markets for foreign government debt over the very long run. We focus on output, quality control, information provision, competition, pricing, charging and signaling. We find that the market set up experienced a radical transformation in the recent period and interpret this as resulting from the rise of liability insurance provided by rating agencies. Underwriters have given up their former role as gatekeepers of liquidity and certification agencies to become aggressive competitors in a new speculative grade market.
Romaine Ranciere and Aaron Tornell summarize their paper, “Systemic Risk-Taking and the US Financial Crisis”, thus:
The recent macroeconomic experience of the US resembles the boom-bust cycles of emerging markets more so than the tame postwar US business cycles. We present a model in which a feebdack loop between credit and prices generates the boom and the bust, and accounts for several stylized facts that characterize of the US experience.
The next section of the conference departed from the issues of crises, and moved onto puzzles. The first puzzle tackled was a prominent one in international finance, namely the Feldstein-Horioka finding that saving and investment are highly correlated, despite the fact that capital mobility is widely perceived to be high (see additional discussion here).
In “The Feldstein-Horioka fact”, Domenico Giannone and Michele Lenza, write:
This paper shows that general equilibrium effects can partly rationalize the high correlation between saving and investment rates observed in OECD countries. We find that once controlling for general equilibrium effects the saving-retention coefficient remains high in the 70’s but decreases considerably since the 80’s, consistently with the increased capital mobility in OECD countries.
The next paper addressed the reason for the famous Meese-Rogoff finding that ex post historical simulations using structural models cannot outperform a random walk (see discussion here). From the abstract of the paper “Can Parameter Instability Explain the Meese-Rogoff Puzzle?” by Philippe Bacchetta, Eric van Wincoop and Toni Beutler:
The empirical literature on nominal exchange rates shows that the current exchange rate is often a better predictor of future exchange rates than a linear combination of macroeconomic fundamentals. This result is behind the famous Meese-Rogoff puzzle. In this paper we evaluate whether parameter instability can account for this puzzle. We consider a theoretical reduced-form relationship between the exchange rate and fundamentals in which parameters are either constant or time varying. We calibrate the model to data for exchange rates and fundamentals and conduct the exact same Meese-Rogoff exercise with data generated by the model. Our main finding is that the impact of time-varying parameters on the prediction performance is either very small or goes in the wrong direction. To help interpret the fndings, we derive theoretical results on the impact of time-varying parameters on the out-of-sample forecasting performance of the model. We conclude that it is not time-varying parameters, but rather small sample estimation bias, that explains the Meese-Rogoff puzzle.
(This paper is closely related to a very interesting paper “On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals”, by Bachetta and van Wincoop). My comments are here [ppt], while my update (with Cheung and Fujii) of the Meese-Rogoff exercise is here [pdf].
In the final section, the first paper presented was by Kathryn M. E. Dominguez, entitled ” International Reserves and Underdeveloped Capital Markets”. From the abstract:
International reserve accumulation by developing countries is just one example of the puzzling behavior of international capital flows. Capital should flow to where its return is highest, which ought to be where capital is scare. Yet recent data suggest the opposite — net capital flows from developing countries to industrialized countries. This paper examines the role of financial market development in the accumulation of international reserves. In countries with underdeveloped capital markets the government’s accumulation of reserves may substitute for what would otherwise be private sector capital outflows. Effectively, these governments are acting as financial intermediaries, channeling domestic savings away from local uses and into international capital markets, thereby offsetting the effects of domestic financial constraints that lead to excessive private sector exposure to potential capital shortfalls.
For a slightly different perspective on reserve accumulation, see this post.
Next, in “The Nontradable Goods’ Real Exchage Rate Puzzle”, my colleague Lukasz Drozd, and Jaromir Nosal write:
This paper studies empirically and theoretically the decomposition of the real exchange rates into tradable and nontradable components, in the spirit of Engel (1999). Empirically, using an extended decomposition, we find that the contribution of the relative price of nontradable goods to local nontradable output to the overall real exchange rate movements is at best modest. Theoretically, we argue that this finding is a puzzle for the standard models in which the law of one price holds, and fluctuations of the real exchange rate for tradable goods are fully accounted for by the relative price movements of the differentiated home and foreign tradable goods. Specifically, we find that, in the best case scenario, the standard model overshoots the contribution of non-tradable goods to the overall real exchange rate fluctuations by a factor of two.
The final paper, by Lone Christiansen, Alessandro Prati, Luca Antonio Ricci, Stephen Tokarick, and Thierry Tressel, tackled a difficult issue, namely “Assessing External Equilibrium in Low Income Countries”. From the abstract:
This paper investigates empirically the external performance of low income countries, as measured by the real exchange rate, the current account, and the net foreign assets. The paper focuses on indicators which are specific to low income countries, such as the quality of policies and institutions, the special financing access, and the role of shocks. It also offers a metric for linking the external indicators via a calibration of trade elasticities.
The paper builds upon the research program at the Fund which uses the macroeconomic balance approach to inferring norms in current account balances; this approach is closely related to the methodology implemented in Chinn and Prasad (JIE, 2003) (discussed in this post.)
The final segment involved a panel discussion on “Monetary Policy in a Low Interest Rate Environment,” chaired by Athanasios Orphanides (the Governor of the Central Bank of Cyprus). The participants were:
- Huw Pill, European Central Bank
- Vincent Reinhart, American Enterprise Institute
- Volker Wieland, Goethe University Frankfurt
- John Williams, Federal Reserve Bank of San Francisco
This was a fascinating panel discussion, which covered among other things quantitative easing/credit easing, whether QE can occur even above the zero interest rate bound, and the lessons from Japan’s (successful) experience in QE without inflation.
Some representative pieces here: For Pill; for Reinhart; for Volker; and for Williams.
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VALUE JUDGMENTS
Submitted by The Capital Spectator
It’s been a tough year for value stocks. Is that surprising? No, although it reminds that Mr. Market prices certain slices of the equity market differently throughout the business cycle.
For the year through June 26, the rebound in equities has been powered mostly by growth stocks, according to Russell indices. As the chart below relates, growth stocks in general have been the conspicuous leaders through the first half of 2009.
This is hardly surprising in light of the unfolding story in financial economics over the past generation. Return premiums are linked with macroeconomic risks, which means that investors are compensated over the long haul for taking certain risks. Some of those risks pay higher rates than others and if you wait long enough, you’ll probably realize the higher returns. All the more so if you pay attention to the fluctuating price of risk in the short term.
The small-cap value (SCV) factor (as originally outlined by Professors Eugene Fama and Ken French) is among the most widely known return factors beyond the market overall. The source of SCV’s higher return through time is higher risk linked to the business cycle. Economically, there can be no free lunches, at least in the long run and so any expectation of earning a higher return must be connected with assuming a higher risk.
Since 1928, small-cap value stocks have posted a clear return premium over U.S. equities generally, as defined by the S&P 500 and its predecessor benchmarks, based on analysis of data from Ibbotson/Morningstar (see graph below). Even over somewhat shorter periods, although well beyond “trading” horizons, small-cap value has held up well. For the 10 years through the end of last week, for instance, the small-cap Russell 2000 Value Index posted a 5.4% annualized total return, comfortably above the 1.4% loss for U.S. stocks overall, as measured by the large-cap Russell 1000 Index over that stretch.
Why should investors expect to earn higher returns in SCV? Chart 1 above offers a clue, namely: In the short run, small stocks trading at low prices relative to book value and other accounting metrics tend to be more vulnerable in tough economic times. There are a number of reasons for this, as many economists discuss in the literature published over the years. The simple answer is that small firms trading at low valuations tend to be shaky operations to begin with and so the arrival of a macroeconomic headwind makes the prospects for success even more remote.
Individual companies perish, but as an asset class small-cap value shares survive, although not without a roller coaster ride in the interim. For obvious reasons, most investors shun risk during recessions, especially one that’s been as deep as the current contraction. But as Professor John Cochrane at the University of Chicago likes to say, someone holds these stocks, even in the worst economic recession since the Great Depression. The question is why? The answer is intimately tied up with the connection between economic cycles and how Mr. Market prices assets.
Of course, investing and risk management are always about the future. That leads to the perennial question: What comes next? Will small-cap value stocks continue to outperform? That’s always a topical question when this slice of the equity market is suffering, as it is currently. Looking backward is one thing; committing real money today in anticipation of a repeat performance is something else.
In fact, no one can be sure that SCV will remain true to its historical trend. Yes, there are persuasive arguments for expecting the long-run future will look like the long-run past, but in the short term there’s risk–considerably more so than the long-run past suggests. That’s one reason for being cautious about betting the farm on SCV, which is to say holding lots more of these equities than the market-cap equity indices do.
On the other hand, if you’re persuaded that there’s an economic logic to SCV’s historical return premium, owning a bit more of these stocks above Mr. Market’s asset allocation looks reasonable. Just remember, even if your bet pays off, it’ll come at a price, as the first chart above reminds.
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Credit Default Swaps: Self Regulating?
Submitted by Businomics Blog
One common proposal for the new financial regime is regulation of credit default swaps. A CDS is like life insurance on a bond. (Here’s my simple explanation, and my view of what went wrong with CDSs.) A good example of a call for regulation is an article by my friend Bert Ely, generally a supporter of market forces. He proposes that CDSs should only be bought by parties with an “insurable interest.” The analogy is to life insurance. If you and I are not related, you are not allowed to buy life insurance on my life.
I’m about to tell you how the CDS problem is becoming a non-problem, but first let me quibble about the life insurance parallel. There’s a reason that you cannot buy insurance on my life: it would give you a big financial interest in bumping me off. That would be bad for the insurance company, and bad for my health.
I don’t see the problem with respect to corporate bonds. I buy a CDS that will pay me if Chrysler goes bust. I guess that gives me an incentive not to buy a Dodge, but I honestly wouldn’t know how to go about killing the corporation. (The owners, though, were able to do it.) So there doesn’t seem to be the risk involved here that there is with respect to life insurance.
So how does the CDS market learn to behave? The same way we humans learn most lessons: by getting hurt. The Wall Street Journal has an interesting account of a CDS deal that taught a number of traders an interesting lesson. Here’s the gist of it:
There were some debt securities backed by subprime loans. The principal (after some losses and prepayments) amounted to $27 million. The volume of credit default swaps written against the securities was $130 million. Obviously, most of the folks buying the CDS on this security did not have an insurable interest, they were simply speculating that the bonds would default.
One investment firm, Amherst Holdings of Austin, was writing many CDSs on the securities. They probably had sold CDSs that in aggregate far exceeded the $27 million of bonds outstanding. They were paid a high price, often 80 to 90 cents on the dollar. That is, the investor who wanted to speculate that these bonds would not be paid off made an upfront payment of 80 cents, in the hope of receiving one dollar later. Take these numbers and multiply by millions, of course.
Then Amherst did a very clever trade: they bought the underlying mortgage bonds at full value, 100 cents on the dollar, a price that was tremendously higher than a fair market price. Why would they overpay? So that the bonds would not go into default. All of the CDS money, the 80 or 90 cents times millions of dollars, that Amherst received for writing the swaps? Amherst kept that money. They lost money on the bond purchase, but more than made up for it by pocketing the CDS payments.
I love a clever trade that is entirely legal and honest. The folks on the other side of the trade are crying foul, but I don’t see the basis for their complaint.
Why is this trade good for financial markets, and good for the economy? It reins in the use of CDS by those without insurable interest. If a CDS had been bought by a bondholder, he would have shrugged. He doesn’t care whether the bond pays off or whether the CDS pays off–he’s in the same position either way. It is only those who were simply gambling that got hurt. Now they have a reason to be cautious. And their caution comes without a government regulation preventing the instruments from being used.
Why not simply outlaw them? CDSs have a role. They make financial markets deeper, and more liquid. It may be easier for a bond-holder to reduce his risk by buying a CDS than selling the bond. Or he may not want to eliminate his risk entirely, just reduce it a little. The CDS offers flexibility. Why allow unrelated parties to be involved? It deepens the market. More transactions, more volume, and generally more accurate pricing.
The bigger principle, as I explained recently, is that many of our past financial mistakes will not be made again. Re-read what happened to AIG in my earlier post. Ask yourself how many companies are doing the AIG think now. I think we’ve learned that lesson.
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THE GREAT EXPERIMENT BEARS FRUIT…SO FAR
Submitted by The Capital Spectator
One day we’ll look back on 2009 and wonder what all the confusion was about. All will become clear and we’ll know when the recession ended, when the bull market began anew and how and why the cycle turned. Meanwhile, we’re wondering if the data du jour can be trusted.
Judging by the numbers of late, clarity is upon us, or so it seems. Income and spending are up among consumers. What’s not to like? If this keeps up, we’ll be back to the good old days by, oh, let’s say the third week of September.
As for what we know today, disposable personal income jumped 1.6% last month on a seasonally adjusted basis, the Bureau of Economic Analysis reports this morning. That’s the biggest monthly gain in a year. Not bad for what we’ve repeatedly been told is the deepest recession since the Great Depression.
That’s only half the fun. The government also advises that personal consumption expenditures gained 0.2% in May, the best since February.
Is it a miracle? No, it’s just your tax dollars at work. As the BEA noted in its press release today, “the pattern of changes in personal income and in DPI reflect, in part, the pattern of increased government social benefit payments associated with the American Recovery and Reinvestment Act of 2009.” In other words, the guys and gals in Washington continue to print money and distribute it, creating a revival that otherwise doesn’t exist. The extent of the government’s intervention can be surmised once we recognize that wages and salaries actually fell by 0.1% last month.
There are two ways to interpret the news. The optimistic view is that the government’s stimulus efforts will steady an otherwise anxious consumer. By putting more money into his pocket, the incentive to spend is heightened and the odds improved that a return to old consumption habits is near. The government payments are a bridge until the day when the private sector can resume more of the burden of financing consumption.
The darker view is that government-financed consumption is a tenuous lifeline that’s a pale replacement for the real McCoy. As such, the burning question is one of asking when the labor market will revive? By that standard, there’ still reason to be cautious about the remainder of 2009. The recession may be technically over, as we’ve discussed. But even making that leap of faith offers no short cut to good times.
The job market, after all, is typically the last to show convincing signs of recovery. For that reason, the National Bureau of Economic Research shuns employment trends for putting official dates on business cycle turning points. Minting new jobs, in other words, is usually the response to other economic stimuli. Conventional recoveries, then, don’t begin with the labor market. Then again, this isn’t a conventional business cycle.
Clearly, the government has moved heaven and earth to keep the economy afloat. Ours is an era of triumph for public-financed consumption. In both magnitude and timeliness, no government has ever acted with greater speed and depth in keeping the forces of contraction at bay. But that raises a question of whether Washington can keep the engineered consumption going long enough to wait for a bonafide economic recovery. We’ll have an answer, perhaps soon. But at the moment we’re still knee-deep in the first great macroeconomic experiment of the 21st century.
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On grilling the Fed Chair
Submitted by Econbrowser
I got a bit angry at accounts of the latest appearance of Federal Reserve Chair Ben Bernanke before the U.S. Congress.
The Wall Street Journal reports:
Bernanke faced open hostility from lawmakers who barraged him during a Congressional hearing over his handling of the financial crisis and the central bank’s role in reshaping the banking system.
Setting aside the deferential tone usually reserved for Fed chairmen, members of the House Committee on Oversight and Government Reform repeatedly interrupted Mr. Bernanke at Thursday’s hearing to review the Fed’s role in engineering a government aid package for Bank of America Corp. The lawmakers pored over internal Fed emails subpoenaed by the committee and projected on a screen in the hearing room.
It is one thing to have different views from those of the Fed Chair on particular decisions that have been made– I certainly have plenty of areas of disagreement of my own. But it is another matter to question Bernanke’s intellect or personal integrity. As someone who’s known him for 25 years, I would place him above 99.9% of those recently in power in Washington on the integrity dimension, not to mention IQ. His actions over the past two years have been guided by one and only one motive, that being to minimize the harm caused to ordinary people by the financial turmoil. Whether you agree or disagree with all the steps he’s taken, let’s start with an understanding that that’s been his overriding goal.
These interrogations reveal more about those doing the grilling than they reveal about Bernanke. I see this as pure political theater, and I don’t like it.
If Congress wants to explore more usefully the wisdom and motives behind some of the decisions that have been made, it might want to investigate why some legislators are now pushing for Fannie and Freddie to guarantee a riskier category of mortgage condo loans.
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Links for 2009-06-26
Submitted by Econbrowser
The Federal Reserve Bank of New York has put together some very useful timelines of the financial crisis, if you want a handy reference for what happened when in both the United States and around the world.
The BEA reported that disposable personal income increased 1.6% between April and May. In the absence of the stimulus cuts to personal taxes and increases in social benefit payments, the number would have been 0.2%. Real personal consumption expenditures were up 0.2% for the month, though that leaves the April-May average 0.1% below the January-March average. Calculated Risk, always your go-to source for these matters, sums it up this way:
Usually PCE and Residential Investment (RI) lead the economy out of recession, and right now both remain weak. As households increase their savings rate to repair their balance sheets, it seems unlikely that PCE will increase significantly any time soon.
And via Craig Newmark, earn $11 a day by working in hell.
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New Financial Regulations: Trying to Fix Self-Correcting Problems
Submitted by Businomics Blog
In the midst of the banking crisis, the Obama administration is considering sweeping financial regulations. But before fixing problems with a sledgehammer, let’s assess which of these problems have fixed themselves. It turns out that many of the private sector errors that helped trigger the financial crisis are not going to be repeated; at least not for many years. These mistakes are only part of the problem, of course, but the new financial regulations focus on them, yet most of the private sector errors have already self-corrected.
The greatest private sector error was over-optimism in the housing market, which led first-time homebuyers to purchase larger homes than they needed or could afford. It led people with marginal credit to strive to qualify for a home mortgage. It led individual investors to buy homes either to flip or to rent out. It led institutional securities investors to believe that mortgage pools were as good as gold, and it led ratings agencies to put AAA labels on bundles of sub-prime mortgages. However, we do not need new regulations to solve this problem, for now everyone knows that real estate prices can go down. That memory will last many, many years.
The second private sector problem was a willingness by institutional investors to buy securities they did not understand. The collateralized mortgage obligations and collateralized debt obligations became terribly complex. A full understanding requires computer simulations that would dim the lights of a major city. Investors simply accepted the results of the ratings agencies. Investor appetite for these securities helped to fuel the lax mortgage lending practices, but what’s happening today? Securitization has come to a standstill (aside from federally guaranteed issues), not because of regulation but because investors are now scared of anything they do not understand. When the market for asset-backed securities returns, it will return only for plain vanilla transactions, deals simple enough that anybody can easily understand them. No one will buy complex pools of sub-prime mortgages for many years to come.
The third private sector mistake was the high leverage of investment banks and hedge funds. Companies that had historically operated with 10 to 1 debt-to-equity ballooned up to 30 to 1 or higher. Although the large investment banks have all become bank holding companies to qualify for federal money, even unregulated companies would be more conservative now. Everyone has seen what happened to Bear Stearns, Merrill Lynch, and Lehman Brothers. Moreover, the leverage they attained required a willing lender. In the current environment, no one will lend money to an investment bank or hedge fund that has too much debt already.
Private sector individuals and businesses are not immune from mistakes, but they adjust their behavior to avoid further losses. In contrast, public sector errors tend to continue. Fannie Mae and Freddie Mac continue to have government backing with a misguided mission. The Community Reinvestment Act continues to encourage banks to make high risk loans to people with poor credit. The tax code continues to encourage excessive leverage, including to homeowners. Congress and the President should focus their attention to an area in which they can do some good: public policy. They need not concede that only the private sector made mistakes. They need only acknowledge that the private sector errors are self-correcting.
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Home Prices and Consumer Spending
Submitted by Businomics Blog
Some friends have been debating the role of housing prices in consumer spending, stimulated by two recent articles in the Wall Street Journal’s Real Time Economics blog. First, Charles Calomiris, Stanley Longhofer and William Miles wrote that effect of housing wealth on consumption is about zero. Then, Atif Mian and Amir Sufi of the University of Chicago offered a differing view.
I am very cautious before throwing out conclusions that have been tested in multiple ways over many years. The wealth effect on consumption has been studied since the 1930s, with fairly consistent findings of low elasticity (one to three percent is common). I quickly scanned some macro-econometric books on my shelf (Michael Evans, Macroeconomic Activity, 1969; Otto Eckstein, The DRI Model of the U.S. Economy, 1983, and Ray Fair, Estimating How the Macroeconomy Works, 2004). All these guys, very familiar with past research and deeply hands-on in their own model development, have negligible to low wealth elasticities in their models. Their work also spans several decades.
We must differentiate an actual wealth elasticity from the method of funding consumption. A person who chose to increase consumer spending and who was acting in accordance with a mainstream consumption function might well have used home equity financing so heavily that it looked like it was housing wealth that enabled consumption. That’s because mortgage finance was a cheaper (especially net of taxes) way to fund car purchases than car loans. Also cheaper to use an HEQ or cash-out refi to buy furniture or take a vacation than run a high balance on credit cards. In addition, many consumers consciously leveraged up their balance sheets: lots of mortgage debt to fund investments, not just consumption.
Mian and Sufi’s most interesting conclusion is:
It surprising that they find such a large macro effect from this one segment of consumers. If they are right, here’s the interpretation I’d give: normally housing wealth has a negligible effect on consumption. Then for a few years it had an unusually positive effect, as it allowed otherwise credit-constrained families to spend more. But now that’s over and we’re back to normal The transition back to normal is tough, but we will resume the old fashioned consumption function. However, the Calomiris et al research disputes this view. It’s quite possible that their analysis, which covers a large swath of post World War II economic history, misses the Mian and Sufi effect because it wasn’t just housing prices that stimulated consumer spending, but the combination of rising housing prices and readily available sub-prime debt.
In any event, I think we’re headed back to a normal relationship now. Consumer spending will move independently of housing price changes in the future.
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More on the Male-Female SAT Math Test Gap
Submitted by CARPE DIEM
It’s well known that for the SAT mathematics test, a) male high school students in the U.S. have higher scores on average than females, b) the gap is large and statistically significant (+30 points), and c) the male-female math test score gap has persisted over time, since at least 1971, and probably much longer (see chart above, data here from the Dept. of Education).
One explantion for the female-male math test score gap is summarized here by Janet Hyde et al.:
Using
Census Bureau data, the chart below shows that females taking the SAT exam as a percent of the total increased from 50% in 1975 to 53.6%, as the male percentage has decreased from 50% to 46.4% over that period (see chart below).
According to the reasoning above, as the number of females taking the SAT exam increased over time (along with the percent of total) relative to males, the mean female score should have decreased relative to the male mean score, and the male-female gap should be INCREASING over time, theoretically.
But that is exactly the opposite of what has actually been happening. The chart below shows that the male-female gap has actually been decreasing over time, even as more females took the test relative to males, from a high of 46 points in 1977 to a gap of 33 points in 2008.
Bottom Line: The gender gap appears to be more than just a sampling artifact, since the decreasing male-female math test score gap is exactly the opposite of what the Hyde et al. hypothesis would predict.
Update: Additionally, if the number of females taking the test increases over time, the Hyde hypothesis would also predict a falling mean female math test score over time, when in fact we see the opposite: a rising female mean SAT math test score.
Comments welcome.
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Chart of the Day: Med. Equipment, Canada vs. U.S.
Submitted by CARPE DIEM
Source: Fraser Institute
“Advocates of single-payer health care systems tend to promote the allegedly lower monetary costs, but they ignore the lack of access to medical resources,” said Brett Skinner, Fraser Institute Director of Health, Pharmaceutical and Insurance Policy Research and lead author of the peer-reviewed study: “The Hidden Costs of Single Payer Health Insurance: A Comparison of the United States and Canada.”
The study shows that health care in Canada appears to cost less relative to the United States because Canadian public health insurance does not cover many advanced medical treatments and technologies, common medical resources are in short supply, and access to health care is often severely delayed.
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Reason.tv: Obama Care
Submitted by CARPE DIEM
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Reason.tv: What If Government Ran Health Care?
Submitted by CARPE DIEM
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New Blogs
Submitted by CARPE DIEM
News from 1930: A daily summary based upon news from the Wall Street Journal from the corresponding day in 1930.
John Stossel’s Take: ABC News’ Co-Anchor of “20/20″ offers his libertarian views on the economy, education, health care and politics.
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