Friday, May 29, 2009

Home Values Affect Foreclosure Rates More Than Defaults

Foreclosures indicate more about changes in past home values than they do about the current economy or mortgage underwriting standards.

The Washington Post is reporting that mortgage delinquencies reached record highs. Delinquencies resolve in three ways.
  1. The homeowner pays the arrears and the mortgage becomes current.

  2. The mortgage lender forecloses on the home.

  3. The homeowner sells the home and the proceeds pay off the mortgage including all arrears with a possibility of excess fund available for the selling homeowner.
Homeowners become delinquent for two reasons.
  1. They had the ability to afford the monthly payments but subsequent events occurred which changed their ability to pay. The common events for mortgage delinquency are unemployment, excessive medical expenses, death of a wage earner, divorce, or a reduction in income.

  2. The second reason is a household that never was in a position to pay its mortgage. It cannot manage its total debt, gets overextended and does not have enough income to pay all its debts. Eventually, it defaults on the mortgage even without any changes to total household income.
Due to the current recession and the high unemployment, many homeowners with mortgages have lost their jobs or seen a decrease in their income. Without a positive change to income, these homeowners will default on their mortgages.

If home values had not declined and home sales were strong, these households plus the overextended households would sell their homes, pay off the mortgage, pocket any excess funds and move into a more affordable space. Some possibilities for increasing affordability are to move in with relatives, to rent, or to buy a less expensive dwelling. In these cases, defaults would occur without foreclosures.

With the sharp drop in home values, many homes have mortgages in excess of their sale prices. Homeowners cannot sell their homes because they owe more than they would receive as the sales price. Additionally, many homes are not selling or are taking a long time to sell. While a home is up for sale, the arrears on the mortgage accumulate and increase the debt of the homeowner.

The only viable option, for a defaulting homeowner with a house value below the mortgage amount, is foreclosure. A homeowner sale would not payoff the mortgage. Foreclosures result from an inability to pay coupled with a sales price below mortgage value. There is no data to indicate that homeowners with homes worth less than their mortgages are walking away from mortgages that they can afford to pay and letting the home go into foreclosure. There are anecdotes that some people are not paying a few months of mortgage payments to qualify for mortgage modification programs.

Home values more than high unemployment affect the number of foreclosures. If home values had not declined, defaults would result in more home sales and fewer foreclosures.

The high foreclosure rates we are seeing during this financial crisis and recession is more a product of the decline in home values than any other factor. Even if unemployment and the economy improve, foreclosures will remain higher than normal until home values stabilize or increase.

Thursday, May 28, 2009

Single Federal Bank Regulator:
What About State Institutions

The Wall Street Journal in its Thursday, May 28, 2009, edition is reporting:

Top Obama administration officials are close to recommending that Congress create a single regulator to oversee the entire banking sector, people familiar with the matter said, a departure from the hodgepodge of federal agencies that failed to contain the financial crisis as it ballooned out of control last year.

A single federal regulator still leaves unresolved the regulation and supervision of state chartered and state licensed institutions. The states and not the federal government supervise insurance companies. Likewise, mortgage brokers and mortgage bankers are state licensed and regulated and not under the supervision of the federal government.

State mortgage entities are not federally charted or federally supervised institutions. They sourced most of the mortgages that went into early foreclosures and defaults at the beginning of our financial crisis. State chartered mortgage institutions originated most of the mortgages with affordability problems, i.e. subprime mortgages, no-documentation mortgages, no down payment mortgages, interest only and negative amortization mortgages.

The FDIC, the Federal Reserve and the OCC had warned the financial institutions under their supervision prior to the current financial crisis to limit their holdings and originations of these types of mortgages. For example, see the 1999 OCC examination guidelines for subprime mortgages.

Wednesday, May 27, 2009

Computing The True Costs Of Going Green

The comment I posted on Arnold Kling's blog, The Economics of "Going Green", follows:

Production costs do not adequately capture disposal, repair and part replacement "green" costs during the useful product life. These additional expenses can significantly increase the "going green" costs when included and in some cases show that the original process is more beneficial and eco-friendly than the "going green" process.

For example, compact fluorescent bulbs contain mercury, a neurotoxin and soil contaminant, while incandescent bulbs do not. The cost of properly disposing of CFLs to prevent mercury related illnesses and soil contamination exceeds the cost of disposing of incandescent. CFLs lower electrical use and their associated carbon output at the expense of increasing mercury contamination and side effects. These disposal costs (and possibly health costs especially for workers in high concentration areas such as garbage workers) are currently an externality not included in the purchase price of the more energy efficient CFLs. A correct comparison of the relative merits of incandescent bulbs versus compact fluorescent bulbs requires including these post production and post consumer use costs.

Hybrid and electric cars use batteries and sophisticated electronic components that are composed of heavy metals and toxic materials. In addition to the costs of proper disposal, auto accidents will potentially release toxic materials to the occupants, first responders, and the local community. The "green" costs associated with an accident are not part of the production costs or purchase price.

Likewise, hybrid and electric car parts will need replacement while the cars are still in use. A typical hybrid car may need to have its batteries replaced once or twice during its life. A "going green" process, even if adequately priced at time of production, will not be correctly priced for environmental effects after the "green" costs of replacements are included in its total costs.

Tuesday, May 26, 2009

Google, Auction Theory, and Ads

Wired Magazine has an excellent and interesting article about Google's hiring of economists who understand auction theory.

To quote a paragraph from the article:

But as the business grew, Kamangar and Veach decided to price the slots on the side of the page by means of an auction. Not an eBay-style auction that unfolds over days or minutes as bids are raised or abandoned, but a huge marketplace of virtual auctions in which sealed bids are submitted in advance and winners are determined algorithmically in fractions of a second.

Monday, May 25, 2009

Health Costs Do Not Affect US Competitiveness

Greg Mankiw blogged today about the fallacy of health care cost affecting US international competitiveness.

More recently, the Congressional Budget Office has done a nice job explaining why the idea of international competitiveness as a reason for health care reform is fallacious. The passage below, from page 167 of the CBO analysis, is written in the CBO's traditional understated way, but the point is clear:

International Competitiveness

Some observers have asserted that domestic producers that provide health insurance to their workers face higher costs for compensation than competitors based in countries where insurance is not employment based and that fundamental changes to the health insurance system could reduce or eliminate that disadvantage. However, such a cost reduction is unlikely to occur, except in the short run.

Sunday, May 24, 2009

Replacing The GDP Gap Focus

My comment to Arnold Kling's blog post, "What is the GDP Gap?"

GDP is a flow measure comparable to business revenue. Next quarter's GDP does not capture the long-term gains from the economy's current restructuring and capital investment.

In addition to revenue, businesses have a second measure; the present value of all future income streams. For business, it could be market value based on its publicly trading securities or it can be a business sale value based on comparable prices for similar businesses.

Furthermore, business owners consider future sales and profit prospects as part of their business decisions.

The goal of GDP management should be a present value decision, but as far as I know, there are no stock measures of future GDP available. A stock measure would capture the benefits of an economy's restructuring and reinvestment during recessionary times.

It seems that focusing on GDP gap is equivalent to a business owner worrying about next year's revenue without considering the ongoing stream of future revenue and the value of the business.

It reminds me of the occasional criticism we hear against business that it worries too much about next quarter's earnings and not enough about the long term.

If we had some readily available present value measure of all future GDP, I think the focus on next quarter or next year's GDP gap would diminish. Economists that now focus on GDP gap would switch to discussions about the present value measure of future GDP. Maximizing GDP, while maintaining some politically comfortable level of unemployment, would become the goal of economists and government.

Saturday, May 23, 2009

Time to Replace The US SEC

Yesterday, the US Securities and Exchange Commission announced that it strengthened "its internal compliance program to guard against inappropriate employee securities trading." In March, the SEC's inspector general sent a report to Chairperson Mary Schapiro indicating possible insider trading using SEC information by two SEC lawyers. A week ago, a US Senator released the report to show the lack of employee oversight at the SEC.

If there were every a reason to abolish the SEC and create a completely new oversight agency with new employees, the new restrictions are the reason.

The measures the agency is taking include:

* First, the staff has drafted a set of new internal rules governing securities transactions for all SEC employees that will require preclearance of all trades. It also will, staff for the first time, prohibit trading in the securities of companies under SEC investigation regardless of whether the employee has personal knowledge of the investigation. The rules have been submitted to the federal government’s Office of Government Ethics, which approves agency ethics rules.

* Second, the SEC is contracting with an outside firm to develop a computer compliance system to track, audit and oversee employee securities transactions and financial disclosure in real time.

* Third, Chairman Schapiro has signed an order consolidating responsibility for oversight of employee securities transactions and financial disclosure reporting within the Ethics Office. And, she has authorized the hiring of a new chief compliance officer.

The SEC has existed for 75 years. Insider trading is fraud and prohibited by US common law. In 1909, the US Supreme Court found under common law that a company director who traded with information about the company that he did not publicly disclosed committed fraud. Schapiro was a temporary SEC chairperson in 1993.

The new self-imposed SEC requirements are standard operating procedures at all the major brokerage firms and have been in operation in the industry for decades.

To not have in place, required codes of conduct and compliance and monitoring procedures at the SEC indicates that the agency's arrogance, self-deception, delusion and narcissism. Not to have an existing compliance officer at the SEC when the agency expects all the financial firms it supervises and monitors to have a compliance officer is the height of conceit. The entire structure of the SEC is dysfunctional and a new oversight agency needs to be built from the ground up.

Friday, May 22, 2009

CAFE Standards Are Perverse

CAFE is perverse. Politicians say it is supposed to clean the air and reduce our foreign oil dependency.

However, American cars are cleaner because other legislation and regulations limit the amount of harmful automobile emissions from cars and trucks. That is why we have catalytic converters in our cars and engines are designed to produce fewer harmful emissions. CAFE was a response to OPEC and the long gas lines of the 1970s. It predates global warming concerns.


Most of our imported foreign oil, about a third, comes from North America, i.e. Canada and Mexico. Include South America and we are at about half of our oil imports. Add the UK, Norway, Africa, and Russia (about 4 percent) and we are at 80-85 percent. 15 to 20 percent of our imported oil comes from the Middle East and about two thirds of that from Saudi Arabia. Additionally, a third of our oil comes from the US, which obviously does not count as an import. The Middle East represent about 10- 15 percent of our total oil use. Only, 3 to 5 percent of our total oil use is from the Middle East and is not from Saudi Arabia.

Furthermore, about 45-50 percent of oil is used for gasoline. The rest is used for jet fuel, petroleum products, asphalt, plastics, synthetic fabrics, etc.

Therefore, only 1-3 percent of our gasoline is from Middle East countries other than Saudi Arabia.

If we reduce our imported oil use, how will we know which country will reduce its exports to us. What if they sell it to another country that sells it to us?


CAFE is an average based on sales and not miles driven or types of driving, such as low mpg stop and go city driving, or high mpg long mileage highway driving. All cars sold in any year are treated equally.

Figuring the average of two cars is as complicated as those hated high school algebra work and mixing problems. The CAFE average of a 20 mpg car and a 60 mpg is not 40 mpg. It is 30 mpg. Trust me. If the second car got 100 mpg, the average with the 20 mpg car is 33.3 mpg, not 60 mpg. (Hint: The average is computed using gallons per mile and then converted into miles per gallon.)

The practicality of CAFE standards for mpg requires that most cars sold have to be above the average because the computation severely penalizes cars below the average. Significant changes to cars will be made to meet the new CAFÉ requirements. There will be less weight, smaller engines, and less use of heavy materials, such as glass.

CAFE mpg numbers are not the same numbers consumers see on the sticker of a new vehicle. It is based on a different methodology than the EPA uses to compute the mpg window sticker numbers for new cars.

CAFE numbers only apply to new cars sold in a given year.

A gasoline tax is much more effective at achieving our intended results of reducing oil use, and improving the efficiency of automobiles and trucks. A gasoline tax, unlike CAFE, affects all cars and makes mass transportation a better alternative.

Thursday, May 21, 2009

Is A Combination Of Old And New Vehicles Better Than CAFE?

President Obama proposed changes to CAFE standards that will increase the average mile per gallon of cars and trucks by 2016. The changes are expected to increase the price of a vehicle, on average, by $1300.

We will have a technological change and a price change, without a functional change. A car and truck will still be a people and goods transporter.

Analyses at this point, prior to actual vehicle prototypes, are assuming that carrying capacity in both weight and cubic feet will remain unchanged. However, this is speculative and carrying capacity may reduce per vehicle or on average. Vehicles are functionally used for business transport and multiple passenger transport.

It is too early to speculate on the physical vehicle changes and the effect they will have on number of cars/ truck needed in actual life situations. Prius and Insights are nice cars, but after a school sporting or social event, you need more of them to transport the kids home or to pizza, than if larger, less fuel-efficient 6-9 seat SUVs were used. Splitting a passenger to put into two cars is not a practical option. A similar logic applies to some cargo. Are there analyses of fuel use inputting real life situations to see what combination of old and new cars/trucks use the least fuel in actual, everyday usage? Since capacity is changing, it is not a price (or mpg) elasticity.

It is an optimization problem with real life inputs. Given the new vehicle and old vehicle characteristics, what quantity mix of the vehicles will minimize fuel use and CO2 emissions?

It could very well be that large, fuel inefficient cars/ trucks in the mix reduce total miles driven, fuel use, and CO2 emissions. It would mean not achieving the new CAFE standards, yet achieving all the end benefits. It is not difficult to imagine than in suburban and rural settings, large vehicles mean fewer vehicles per event, fewer total miles driven and less CO2 production. Does the benefit of higher mpg vehicles more than offset their possible increased usage in both miles and number of vehicles per event? Alternatively, are fuel use and CO2 emissions minimized with a combination of fuel-efficient and non-fuel efficient vehicles so that the combination does not meet CAFE standards?

CAFE standards are determined by car sales and not by actual vehicle usage. Cars that are 30 percent more efficient but get used twice as much, are less environmentally friendly than fuel inefficient cars.

Additionally, price increases per vehicle will make a used vehicle more attractive, in addition to less expensive new models. Moreover, dealers have more profit margin leeway to reduce used car prices to make their prices more attractive. Three times as many used cars and trucks as new ones are purchased each year. The total dollar valued of used vehicle purchases exceeds new ones and the average price of a used vehicle is about 30 percent of a new vehicle. Used vehicles are also more profitable per vehicle to dealers than new vehicles.

In addition to buying cheaper models or used cars, a price increase could also shift families to do more car sharing and to own fewer vehicles per household. One fewer car may or may not reduce total miles driven by two cars in a household.

The goals of Obama's proposal are to reduce fuel consumption and CO2 emissions. However, the metric is CAFE standards and not actual fuel usage or emissions. CAFE is based on sales and not actual vehicle usage. It is not like a water meter. It is a proxy for the desirable results and as such can be achieved without actually producing the intended results at the lowest cost or with the most benefit. Inputs of real life usage of vehicles under different situations into an optimization model are needed to see what combinations of vehicles, old and new, efficient and inefficient, will produce the minimum fuel use and emissions.

Just using economics and engineering could produce results that meet CAFE, but do not achieve the intended objectives.

Wednesday, May 20, 2009

Benefits of Higher Auto MPG Will Not Occur

The US government is increasing the fuel economy standards for new automobiles. It raised the automobile standard to 39 miles a gallon for cars and 30 for trucks (or a fleet wide average of 35.5 mpg) by 2016.

Unfortunately, economic analysis show that much of the expected benefits will not occur anywhere near the amount announced or expected. (For another, much more detailed analysis reaching the same conclusion, see Keith Hennessey's Blog).

Increasing miles per gallon is the same as lowering the price of gasoline. Increasing a cars mpg from 30.2 mpg to 39 mpg means that for every 100 miles driven, the car will use 2.56 gallons instead of 3.31 gallons of gasoline. It is a savings of almost 3/4 gallons or about a 23% savings in fuel and fuel cost.

Gasoline has two price elasticities. A lower gas price means both more cars on the road, i.e. more traffic, and more miles driven per vehicle. Studies show that a 10 percent decrease in gasoline prices increases traffic by 3 percent and increases driven miles by 6 percent. (Elasticities of Road Traffic and Fuel Consumption with Respect to Price and Income: A Review, Phil Goodwin, Joyce Dargay and Mark Hanly, Transport Reviews, Vol. 24, No. 3, 275–292, May 2004)

A 23 percent decrease in gas prices (by increasing mpg) means that there will be about 7 percent more cars (.23x.3) on the road and about 14 percent more miles driven per car (.23x.6). In total, it is about a 22 percent increase in miles driven. (107 percent number of cars times 114 percent miles driven).

Since fuel use, due to new mpg, will decrease by 23 percent but total miles driven will increase by 22 percent. In effect, this change will have no effect on gasoline usage or CO2 emissions. It is strictly a political move to placate parts of the electorate, but it will have no effect on the environment, global warming or oil imports.

As fuel becomes cheaper, its total usage increases. It is called the Jevons Paradox and has been known since 1865 when it was studied to explain the increase in coal use in England as steam engines became more efficient.

Additionally, higher mpg leads to people driver further and therefore willing to live farther from work and shopping. It increases sprawl.

Since population will increase and GDP will grow in total, production efficiency is a much better way to control CO2 emissions and to drive fuel efficiencies. The relationship between growth and CO2 is known as the Kaya Identity and is used by world organizations concerned about decreasing global energy use and preventing global warming.

Tuesday, May 19, 2009

Alternative Causes For High NYC Minority Mortgage Foreclosure Rates

A New York Times' recent article claims that the mortgage default and foreclosure rates are higher for minorities than for non-minorities. Alternative causes for higher minority mortgage defaults exist and data needs adjustment to make NY Times article's claim of higher mortgage default and foreclosure rates statistically valid.

Minorities' percentages of home ownership were increasing so have greater percentage of minority homeowners with mortgages and with higher remaining principal balances as percentage of home value and in dollars than in non-minority group.

Unemployment, loss of income, and uninsured medical expenses are also primary causes of mortgage defaults. Minorities have higher unemployment rates during this recession and are more likely not to have health insurance. Also, maybe more likely to work in jobs where hours are cut backed in recession and their weekly wages have declined.

Need to compare minorities against similar group. Need to adjust non-minority default rate for lower unemployment, lower mortgage balances and lower unexpected medical expense costs.

When two groups are balanced, default rate will most likely be the same, which is why just about every time Fed researchers look at problem they do not find a minority, mortgage discrimination problem.

Higher mortgage foreclosures are not as much due to a subprime problem as it is due to other social and economic factors.

Additionally, credit scores are not a very good way to judge what a loan's interest rate and default rate should be across demographic groups. Credit scores have more validity for assessing risk of default within demographic groups.

An August 2007, a Federal Reserve study, "Report to the Congress on Credit Scoring and Its Effects on the Availability and Affordability of Credit" received a lot of press.

The report found, "Consistently, across all three credit scores and all five performance measures, blacks, single individuals, individuals residing in lower-income or predominantly minority census tracts show consistently higher incidences of bad performance than would be predicted by the credit scores. Similarly, Asians, married individuals, foreign-born (particularly, recent immigrants), and those residing in higher income census tracts consistently perform better than predicted by their credit scores." (p. 89).

PDF version of Federal Reserve report

HTML version of Federal Reserve report

Monday, May 18, 2009

House Financial Services Committee Discourages Dissenting Free Speech

The US House of Representatives Committee on Financial Service does not believe in free speech and the Committee attempts to bully those who oppose its legislation. (HT: Don Boudreaux of Café Hayek,

Last October 24th, the Committee sent a letter to William Frey, President of Greenwich Financial Services. The letter stated:

We are outraged to read in today's New York Times that you are actively opposing our efforts to achieve a diminution in foreclosures by voluntary efforts....

We very much hope that you will be able to tell us very soon that you have reversed you position of trying to obstruct the operation of the bill that was overwhelmingly passed by Congress and signed by the President this summer….

Sunday, May 17, 2009

The US Medicare Financial Problem

Population Effects

According to US Census Bureau data and projections, the fundamental problem of Medicare is that the over 65 year old population and the over 85 year old population will increase in both absolute numbers and as a percentage: of the US. The US will have a doubling of Medicare enrollees by 2030. The high cost users, those over 85 years old, will quadruple by 2050.

The over 65 group will be twice as large. It will grow from 35 million, 12 percent of the US in 2000, to 71.5 million, and 20 percent of the total US population in 2030.

The US Census Bureau projects that the population age 85 and over will grow from 5.3 million in 2006 to nearly 21 million by 2050. Some believe that the 85 and over number will be higher due to longevity improvements. From 2030 onward, the proportion age 65 and over will be relatively stable, at around 20 percent.

Medicare Costs

More users equal more cost. More high cost users, those over 85 years old, means even more costs. A higher percentage of seniors in the US mean less tax revenue to pay for Medicare costs.

Even if medical costs per person do not grow, the total cost for Medicare will grow due to the doubling of the over 65 age group and the quadrupling of the over 85 age group.

The Medicare Trustee report states that Medicare costs for the over 65-age group is about $11,000 per person. Subtracting Medicare enrollees and Medicare expenditures from total US numbers shows that non-Medicare enrollees', (the under 65-age group less the few other Medicare categories), medical costs average about $8200 per person.

However, the 35 percent difference is due to more than the higher costs per person of a user of medical services. Medicare has a higher utilization of its services than the non-Medicare population. There are fewer non-users and low volume users to subsidize the typical medical service user in Medicare than in the non-Medicare population.

Add medical cost inflationary increases at a rate above the average US inflation rate and the US government faces a difficult problem. The US government cannot afford to continue Medicare as it is currently financed and structured. The senior citizen lobby and voting bloc, whose base is growing as a percent of the US population, makes changes to Medicare structure and costs politically difficult.

Way to a Solution

Politically, universal healthcare dilutes the senior voting bloc and gives the government an opportunity to modify Medicare under another rubric, but successful solutions to control costs that do not limit or ration medical services are not obvious. Additionally, the President and Congress also do not trust the capitalistic, market pricing based system to cost effectively meet the needs of the medical consumer.

When delivery solutions of a business service problem are unknown, the best route for success is the competitive market. Profit-motivated, competitive, market based pricing with costs borne by the end user drives all producers and deliverers to become as efficient as possible. This is what capitalism is all about and how the US standard of living has grown substantially since its founding to become the highest in the world.

Without a well-functioning pricing mechanism, investments in medical services are misallocated and users do not limit their use by need or seek lower cost effective alternatives.

Even the poor and uninsured will have their needs met in a market base system. The delivery system and provider cost per patient will change. There maybe fewer doctors and hospital in an area and longer wait times to increase their volume and profit per doctor and hospital. There will probably be more use of nurse practitioners and other low cost providers, but the medical providers will meet all the demand. Even surgeries will change to become more efficient and less costly. For example, right now surgical procedures have the highest profit margin in the medical profession due to high reimbursement rates. Under a market pricing system, this profit margin will narrow and procedures will become efficient. There will be many other changes that the government cannot even envision, but cheaper delivery systems and other cost-cutting changes are the strength and power of capitalism and market based pricing.

The government should focus on the best way to transition to a market based system for medical services. The government should also remove all the laws and regulations that drove medicine away from a competitive, market based system, such as the employer medical benefit tax deduction and many other misdirected government policies.

See my previous post, "Health Care Is A Pricing Mechanism Problem Not An Insurance Problem"

Saturday, May 16, 2009

Low Number Of US Job Openings:
Is There A Structural Problem?

In addition to unemployment, layoffs and new hires, the government has another statistic, unfilled non-farm job openings.

The preliminary number is 2.0 percent for March 2009 versus 3.6 percent for March 2001. It is the lowest since the series began in 2000.

There are two possibilities for the unusually low demand for workers. Low end user product demand or high worker productivity, which requires fewer workers per unit.

Structural changes during the Great Depression accounted for some of its continuing high unemployment. Manufacturers were switching to a mass produced, assembly line method of production, which decreased the need for workers.

If, there is an equivalent structural production change currently occurring in the US economy, end user demand and GDP can grow without an increase in employment and a decrease in unemployment. The US will have a long-term high structural unemployment rate. Worker retraining will not solve the problem because there are few openings, which indicate a low level of openings with unmet skills in the workforce.

Friday, May 15, 2009

Regulatory Arbitrage Did Not Cause The Current Banking Crisis

Banks Need Adjustable Capital Amounts Sensitive To Future Economic Conditions

Regulatory capital ratios capture firm specific events but do not capture economy wide events. Regulatory arbitrage did not cause the current banking crisis and its complete elimination would not prevent a repeat of the current banking crisis.

Regulatory capital is set by lending and investment categories, such as mortgages, but the computed capital ratio is formulaic, static and does not vary by regional or US economic conditions. Additionally, it is in part dependent on outside ratings by credit rating agencies, especially SEC approved NRSROs, which are lagging indicators of changing riskiness and default rates instead of leading indicators.

Holding $100 million of residential mortgages outright or holding the same dollar amount of securitized residential mortgages does not change the risk the institution faces. The regulators compute regulatory capital by form instead of the substance of the asset, and the institution can free up required capital by modifying the form of its holding and use the extra capital to increase its holdings and concentration in that asset, i.e. engage in regulatory arbitrage. Effectively, the increase risk comes from increased leverage and loss of diversification through an increase in a particular asset concentration.

Additionally, since regulatory capital ratios do not change to reflect changing economic conditions, the regulators require banks to hold the same amount of regulatory capital in growth as in recessionary economic times. We know asset default risk is not constant and changes based upon different regional and US economic conditions, e.g. during periods of higher regional unemployment, regional residential mortgage default rates will increase. Similarly, area home values decline during regional economic downturns and the decline in value increases an area's mortgage default rates.

High unemployment rates along with a substantial decline in home values are the cause of the high mortgage default rates. A lingering, worsening recession was the underlying cause.

There are areas of the US where the decline in home values is 20-50 percent from their highs. In many areas of the US, unemployment is at 25-year highs, if not higher. If banks did not arbitrage from direct holdings of residential mortgages into securitized mortgages, banks would still face substantial write-downs. Residential mortgage defaults would still be higher than usual or expected (by capital set aside) due to substantial home value declines and high unemployment.

Weak US and regional economic conditions and their effects severely affected the value of all residential mortgages and their default rates. It is extremely likely that banks would need to raise capital, face heightened regulatory scrutiny and increased risk of government takeover independent of the form of their mortgage holdings. Even if we had restricted the amount of residential mortgage holdings of any form prior to this economic downturn, the banks would have invested their funds in other earning assets, such as credit cards, commercial loans or commercial real estate. All loans face higher default rates in bad economic times and just about all assets lose value.

What we need is a more sensitive, adjustable capital ratio to future economic conditions. Requiring capital based on sensitivity analysis (stress tests) requires banks to hold more capital than necessary in good times, acts contra-cyclically by restricting lending in good economic times, and lowers the earnings of banks.

Since economic forecasting of turning points in the economy is notoriously poor, market based solutions, such as market valued balance sheets, are probably the best but they are not fool proof. Market values of long-term assets, such as mortgages, reflect all expected losses including those several years in the future. The market value accelerates the future expected default into the present. For example, suppose an apartment building has a 20-year balloon mortgage with a constant yearly interest payment. The likelihood of default during the early years of interest payments may be quite low, but the market may have high expectations of default at the end of the twenty years on the final balloon principal payment. The market could easily value the mortgage at 60 to 70 percent of its face value. The discounted value would force the bank to either increase its current capital base or decrease it lending. The bank would feel the effect of the future default now, many years before it would realize the default and be necessary for it to replenish its capital base. Asset based market valuations for long-term assets could affect lending and investment in a counter-cyclical fashion.

One would have to rerun recent banking history under an alternative, proposed regulatory structure and reconstruct a bank's new balance sheet. We could see, based on new, proposed restrictions, prior to going into this recession, if there is anything that would be different now under a different set of rules and if the banking industry could have avoided its current crisis by lending and investing differently.

Thursday, May 14, 2009

Financial Crisis Was Not A Pure Market Failure

An interesting Financial Times Comment on the financial crisis with an eastern European perspective.
"The argument that we have witnessed a pure market failure fails the most elementary tests. Financial institutions and markets operate within the macroeconomic, regulatory and political framework created and maintained by public bodies, and it is empirically not difficult to point to the serious deficiencies of this framework that contributed to the present crisis…. Mises, Hayek, Schumpeter, Nozick and other thinkers have noted that under democratic capitalism there are always influential intellectuals who condemn capitalism and call for the state to restrain the markets. Such an activity bears no risk and may be very rewarding. (This contrasts strongly with the consequences of criticising socialism while living under socialism.)

Dynamic, entrepreneurial capitalism has nowadays no serious external enemies; it can only be weakened from within. This should be regarded as a call to action – for those who believe that individuals’ prosperity and dignity are best ensured under limited government,"
writes Leszek Balcerowicz in the Financial Times. He is a former Polish deputy prime minister and governor of the National Bank of Poland, and a professor at the Warsaw School of Economics.

Wednesday, May 13, 2009

What Good Is Modern Finance

Many, particularly the media and elected officials, blame financial institutions and new, sophisticated products for the current financial crisis. Congress will look to pass legislation to increase the oversight of derivatives and financial intermediaries. Additionally, there is the prospect of new regulations for the firms in this industry.

Modern finance added something to the traditional methods of finance. It improved banking, corporate governance and investment risk management. However, it is not foolproof.

A primary objective of modern finance is about improving efficiencies of capital markets, by lowering the costs of raising capital and investing. Modern finance is also descriptive, mathematically and economically.

Modern finance shows why for example owning no load, low expense ratio mutual funds with holdings in a wide breadth of industries is safer that putting all your money in one company and why the low cost fund gets better returns than a fund with high investor expenses. By the way, mutual funds are more than stocks and bonds. Investors buy participation in an entity that owns investments, such as stocks and/or bonds. They are very similar to mortgage back securities, or collateralized mortgage or debt obligations.

Modern finance also allowed the development and issuance of TIPS, US Treasury inflation protection securities. These securities do not lose value if future inflation increases.

A few of the theories that allow for these improvements are the Black-Scholes-Merton option and contingent claim pricing model, the Sharpe-Lintner capital asset pricing model, and Markowitz mean-variance. There are also many other significant concepts, theories and research in other important areas of modern finance that have also helped in improving banking, corporate governance and investment risk management. Such as work by Akerlof, Spence, and Stiglitz on information asymmetry in markets. Work by Samuelson and Fama on efficient markets and many others in many other important areas of finance.

The ability to lower the costs of issuing debt or equity has been one of the most important benefits of modern finance. It also includes lowering the costs of obtaining information, including information about risk, about debt and equity that has tremendously benefited our economy. The lower cost alternatives to traditional banking has been the reason high cost banks' market share of corporate financings has decline significantly since 1950.

Improvements in information about debt and equities include improvements in corporate governance. While the public, a populist president and populist elected officials may object to high corporate salaries, bankers and corporate bondholders could stop this practice almost immediately if they felt it was a cause of concern about either the business health of the company or the company's ability to meet it debt obligations. I do not believe there is a single debt covenant in any public company's loans or bond agreements that prohibits competitive salaries to senior management. If these high salaries did broad based economic harm to our economy in other ways, every corporate bond covenant would have a clause prohibiting the practice to protect bondholders to reduce the risk of an economic downturn and the corporate inability to pay debt holders.

Derivatives exist because they are lower cost than alternatives to these types of transactions. Without options, one would have to use futures, which are more expensive because they require purchasing the underlying. Without futures, one would have to use forward contracts, which are even more expensive than futures. Without forward contracts, one would need partners or vertical business integration.

As an aside, mutual funds use a tiny portion of their funds to buy some options or futures that mimic the fund, to offset the zero return of cash they hold to meet redemptions or they have received from investors but they have not yet been able to invest.

The most surprising thing about the topic of the benefits from modern finance is how much knowledge macro-economists will impart about general equilibrium, GDP, Keynes, etc., but how little of their knowledge ( I presume) they have about capital markets and derivatives they are willing to show. For some reason, many macro-economists become populists and resort to public perceptions instead of financial economic wisdom about markets.

Tuesday, May 12, 2009

Health Care Is A Pricing Mechanism Problem Not An Insurance Problem

The US health care problem is not an insurance problem. The crisis is that Americans want more health care than they can afford. In 2003, the US per capita medical expenditure was $5700. Today, it is estimated at about $8200 per person. The under 65 age group medical expense per person is about 70 percent of the 65 and above average or about $7700. The 65 and above is about $11,000 per person over 65 years old.

Obviously, these are averages. If we do not put people into different health risk categories, then the average family of four has to pay almost $31,000 per year or about $2500 per month for health insurance just to cover the actual medical expenditure in that group. An individual would pay almost $650 per month.

An individual average senior citizen medical cost is about $1000 per month.

Many people find these amounts unaffordable and outrageous. Many users of medical services, government employees, union members, teachers, and other employees with health benefits, are used to having most, if not all, of the cost medical services paid for by a third party. To these users, health care became like air. It became both a necessary item and a free to use item, or at least a very low cost in comparison to benefit item.

The pricing mechanism for health care broke down because users did not bear anywhere near the full cost of the service. In effect, health care became an externality in economic terms to the users. The whole society is paying the costs of those who are heavy users of medical services and it drives non-users to use the service more often.

Most users only have to consider their want of healthcare and do not have to budget and allocate their resources to get it. Without consumers allocating their income for healthcare, the economy's pricing mechanism for allocating investment resources is broken and dysfunctional. It is over allocating investment and resources to the medical industry that otherwise would go to other industries with a better return. Consumers are also using more medical services than they would with a functioning price mechanism.

Any government program must be funded, but to most people their actual expected cost of medical services is higher than they want to or can afford to pay. If people were willing to pay for medical services out of pocket, they would only need insurance for catastrophic illnesses with extraordinarily high expenses.

Most government solutions attempt in part to keep the cost borne by the average user low by subsidizing and shifting some of the unpaid cost to a few others who pay more through higher taxes. This resolution does nothing to restore the pricing mechanism, and usage and cost will continue to grow. When costs are shifted and not borne by the end-user, the government is forced to delay, ration, deny and otherwise restrict services to contain growth in costs and use. The experience of most countries with a government health care system is rationing, delays and denials of services.

The true long-term solution to our healthcare problems is to repair and restore the pricing mechanism for consumer use of health services. One way to do it is to remove the employer tax deduction for health benefits and to end all government employee healthcare benefits. These changes will reinstate the pricing mechanism at the user level. However, the government will need to develop backstop programs for catastrophic illness and catastrophic injury and for consumers who are too poor to pay for healthcare or health insurance.

Once there is a fully functioning pricing mechanism for medical services, most of the problems will disappear. Usage will slow down without any ill effects. Producers will have tremendous incentive to lower costs of services. Consumers will decide how to best allocate their income between health services and other uses of their income. Medical services as a part of GDP will decline. Only cost effective drugs and treatments will be developed and promoted. With a proper government program, the poor and those with catastrophic illness will have medical care at a much lower cost than now.

Our current problems of excessive cost and excessive usage are the result of a broken pricing mechanism. A government program, whether it is government healthcare, government insurance, cost effective restrictions on usage, or other restrictions, will not fix the pricing and medical system. They will create new problems. Only a complete reinstatement of the pricing apparatus at the consumer/user level will solve our healthcare industry problems.

Sunday, May 10, 2009

Review Of Two Books On Mortgage Crisis has an interesting review of two books about the mortgage crisis that turned into our financial crisis. One book is "Busted: Life Inside the Great Mortgage Meltdown," by Edmund L. Andrews. The other book is "Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis," by John B. Taylor.

"We are a very long way from having a broadly agreed-upon story of the crisis that quietly commenced on the afternoon of June 20, 2007. That was when two Bear Stearns real estate hedge funds began to come apart, ushering in a long period of nervous waiting for fear eventually to subside (it didn’t) or panic to break out (it did). Nevertheless, a couple of unusually interesting accounts have appeared recently, one by the New York Times reporter who was covering the Federal Reserve Board, the other by a Bush appointee who, conceivably, might have defused the crisis altogether had he been heeded."

The complete review is at

Saturday, May 9, 2009

Neither Irrational Behavior Nor Animal Spirits Caused Home Prices To Rise

Many believe that house prices were in a bubble that eventually burst. The drop in home values, with its tremendous wealth losses and foreclosures, caused politicians and the public to look for scapegoats in the financial services industry, including the Federal Reserve. Investigators will need the passage of time from the current crisis to understand its likely causes, but neither irrational behavior nor animal spirits, as some economist claim, caused home prices to rise prior to the significant nation-wide decline.

Use of the terms "animal spirits" and "irrational behavior" as economic explanations reminds me of the patient with a red rash who goes to the doctor and is diagnosed with an ailment that is the Latin phrase for red rash. In both the economic and medical cases, the new terms do not contribute to our understanding and do not assist us in finding preventive or corrective measures. They are just linguistic placeholders until we learn more.

Furthermore, the spirits and irrationality are as likely to be coincident or lagging as leading, and if correlated, not causative. If my neighbors sell their house for a price that surprises me and makes me feel paper wealthy, am I irrational to think that at a future date, I could also sell for that or a higher price. If so, which caused which? If unexpectedly I must relocate and sell my home, am I relying on animal spirits when I buy my new home?

Furthermore, controlled laboratory behavioral pricing and trading experiments may show irrational pricing among the participants, but the lab situation tends to give equal weighting to all participants. It is comparable to going to a party and finding out that everyone there thinks the price of a certain company's stock is going to double, but nobody has either enough money or insight to be a price setter as opposed to a price taker. In the world outside of the experiment, there are many pools of available funds ready to take advantage of over or under pricing of investment opportunities and shrink the mispricing. Additionally, there are real world pricing constraints, such as short selling and signaling from informed sellers or buyers, and other equivalent markets, such as derivatives, etc.

For example, during tender offers, shares become unavailable and on occasion Put Call Parity will break down because shares are unobtainable for shorting or purchasing. In investing and trading markets even in time of "animal spirits," arbitrage relationships do not break down.

In 2005, residential housing was 15.6 percent of GDP. In 20091Q, it was 13 percent. Clearly, the decline in the residential housing sector is contributing to the decline in GDP. If we understood the decline in home prices, which caused the decline on housing related activities, we would understand a lot about our current economic downturn.

Residential housing is composed of two assets, the structure and the land. During the recent housing price run up and collapse, the price to rent ratio increased about 60 percent from 1999 to 2005. From 2005 to 2009, the price to rent ratio declined about 20 percent, so that it is still about 30 percent higher than 1999. Home prices rose faster than rents.

A renter does not have the legal rights of the owner to the land, but both have rights to the occupation of the structure. Since owners did not raise rents in line with residential value increases, is it illogical to conclude that home price increases were either in the land or in the cost of developing and regulatory approvals of a building lot, and not in the structure?

Furthermore, since homes are durable goods with an intergenerational life, expectations about future events that would significantly influence house prices can change and affect prices, both upwardly and then downwardly, before the events reveal themselves to the participants. Home prices would appear to be irrational unless one looked for economic or governmental signals that would modify expectations about events affecting future land prices. Expectations about future regulatory development restrictions, expensive government mandated costs associated with development, such as schools, sewers, roads, etc., or changes in estimates of developing high cost land, such as steep slopes, etc. would modify home prices without the occurrence of any direct home price related event. The fact that expectations about a future event change affects home prices and then reverts prior to that event actually happening, does not indicate irrationality or animal spirits. It could be rational response to anticipated events, still anticipated.

We will need time for events to unfold to show us the causes of the decline in house value. It could be many future factors, such as lower population growth, lower rate of household formations, lower household income growth, deflation, changes in the cost of home building, and many others.

Friday, May 8, 2009

New Regulations And Capital Requirements Will Not Prevent Too Big To Fail

Banking is a highly concentrated industry. There are about 5500 FDIC insured banks in the US with the top 10 banks holding most of the assets, loans, and deposits.

There are certainly economies of scale in banking in the larger institutions, but the next lower size tier of banks also probably benefit from many, if not all, of the same economies of scale. Economies do not explain by themselves the extreme concentration of banking. There may be even diseconomies and extra costs for the very large banks in comparison to the next lower tier, smaller banks.

There is a too big to fail size that some large banks strive to reach that offsets the extra costs and diseconomies of the top banks’ size. The extra costs of proposed new constraints and regulations have to be so great as to completely negate the benefit of being too big to fail. We do not have the quantitative data to be sure what kind of new requirements will effectively do the job.

Breaking up big banks is OK if most of the positive benefits of the scale economies remain. Otherwise, we are imposing new banking costs on the customer. The change and extra costs will force an unpredictable behavioral effect at the consumer level of banking with unintended economy wide results.

Stringent regulations and higher capital requirements will not prevent too big to fail banks. Larger banks that can realistically reach a too big to fail size have too much risk taking incentive. These banks will find the weaknesses in the new regulations through analysis or trial and error. Then, these banks will take additional risks in less well-regulated, costly areas until they reach a too big to fail size.

The incentive to become a too big to fail bank is huge. Once a bank reaches a too big size, the bank can take an inordinately large amount of business risk in an attempt to produce a very large amount of income. It becomes a gambler that can bet its entire stake, the whole bank, on a single risky bet without fear that if it loses, it will no longer be able to continue gambling, i.e. the bank will be closed.

The best alternative may be to phase out the too big to fail doctrine completely. However, the banks and the government are then playing a game of chicken, or poker. Will the government really let there be a very large bank failure? Could a bank grow very large just to see if the government is bluffing?

Thursday, May 7, 2009

Hedge Fund Manager Criticizes Obama's Chrysler Plan

Below is a widely published, circulating, irate hedge fund manager's letter criticizing President Obama's stance on the Chrysler bonds. There are several excellent points in the letter.

Unafraid In Greenwich Connecticut
Clifford S. Asness
Managing and Founding Principal
AQR Capital Management, LLC

The President has just harshly castigated hedge fund managers for being unwilling to take his administration’s bid for their Chrysler bonds. He called them “speculators” who were “refusing to sacrifice like everyone else” and who wanted “to hold out for the prospect of an unjustified taxpayer-funded bailout.”

The responses of hedge fund managers have been, appropriately, outrage, but generally have been anonymous for fear of going on the record against a powerful President (an exception, though still in the form of a “group letter”, was the superb note from “The Committee of Chrysler Non-TARP Lenders” some of the points of which I echo here, and a relatively few firms, like Oppenheimer, that have publicly defended themselves). Furthermore, one by one the managers and banks are said to be caving to the President’s wishes out of justifiable fear.

I run an approximately twenty billion dollar money management firm that offers hedge funds as well as public mutual funds and unhedged traditional investments. My company is not involved in the Chrysler situation, but I am still aghast at the President's comments (of course these are my own views not those of my company). Furthermore, for some reason I was not born with the common sense to keep it to myself, though my title should more accurately be called "Not Afraid Enough" as I am indeed fearful writing this... It’s really a bad idea to speak out. Angering the President is a mistake and, my views will annoy half my clients. I hope my clients will understand that I’m entitled to my voice and to speak it loudly, just as they are in this great country. I hope they will also like that I do not think I have the right to intentionally “sacrifice” their money without their permission.

Here's a shock. When hedge funds, pension funds, mutual funds, and individuals, including very sweet grandmothers, lend their money they expect to get it back. However, they know, or should know, they take the risk of not being paid back. But if such a bad event happens it usually does not result in a complete loss. A firm in bankruptcy still has assets. It’s not always a pretty process. Bankruptcy court is about figuring out how to most fairly divvy up the remaining assets based on who is owed what and whose contracts come first. The process already has built-in partial protections for employees and pensions, and can set lenders' contracts aside in order to help the company survive, all of which are the rules of the game lenders know before they lend. But, without this recovery process nobody would lend to risky borrowers. Essentially, lenders accept less than shareholders (means bonds return less than stocks) in good times only because they get more than shareholders in bad times.

The above is how it works in America, or how it’s supposed to work. The President and his team sought to avoid having Chrysler go through this process, proposing their own plan for re-organizing the company and partially paying off Chrysler’s creditors. Some bond holders thought this plan unfair. Specifically, they thought it unfairly favored the United Auto Workers, and unfairly paid bondholders less than they would get in bankruptcy court. So, they said no to the plan and decided, as is their right, to take their chances in the bankruptcy process. But, as his quotes above show, the President thought they were being unpatriotic or worse.

Let’s be clear, it is the job and obligation of all investment managers, including hedge fund managers, to get their clients the most return they can. They are allowed to be charitable with their own money, and many are spectacularly so, but if they give away their clients’ money to share in the “sacrifice”, they are stealing. Clients of hedge funds include, among others, pension funds of all kinds of workers, unionized and not. The managers have a fiduciary obligation to look after their clients’ money as best they can, not to support the President, nor to oppose him, nor otherwise advance their personal political views. That’s how the system works. If you hired an investment professional and he could preserve more of your money in a financial disaster, but instead he decided to spend it on the UAW so you could “share in the sacrifice”, you would not be happy.

Let’s quickly review a few side issues.

The President's attempted diktat takes money from bondholders and gives it to a labor union that delivers money and votes for him. Why is he not calling on his party to "sacrifice" some campaign contributions, and votes, for the greater good? Shaking down lenders for the benefit of political donors is recycled corruption and abuse of power.

Let’s also mention only in passing the irony of this same President begging hedge funds to borrow more to purchase other troubled securities. That he expects them to do so when he has already shown what happens if they ask for their money to be repaid fairly would be amusing if not so dangerous. That hedge funds might not participate in these programs because of fear of getting sucked into some toxic demagoguery that ends in arbitrary punishment for trying to work with the Treasury is distressing. Some useful programs, like those designed to help finance consumer loans, won't work because of this irresponsible hectoring.

Last but not least, the President screaming that the hedge funds are looking for an unjustified taxpayer-funded bailout is the big lie writ large. Find me a hedge fund that has been bailed out. Find me a hedge fund, even a failed one, that has asked for one. In fact, it was only because hedge funds have not taken government funds that they could stand up to this bullying. The TARP recipients had no choice but to go along. The hedge funds were singled out only because
they are unpopular, not because they behaved any differently from any other ethical manager of other people's money. The President’s comments here are backwards and libelous. Yet, somehow I don’t think the hedge funds will be following ACORN’s lead and trucking in a bunch of paid professional protestors soon. Hedge funds really need a community organizer.

This is America. We have a free enterprise system that has worked spectacularly for us for two hundred plus years. When it fails it fixes itself. Most importantly, it is not an owned lackey of the oval office to be scolded for disobedience by the President.

I am ready for my “personalized” tax rate now.

Tuesday, May 5, 2009

My Comment To "First, Blame the Regulators"

A comment that I posted today, May 5, in the New York Times Economix Blog. It was in response to Catherine Rampell's piece called, "First, Blame the Regulators." In the blog, she mentions what Gladwell, Taleb, Kuttner and Steiner blame for the cause of the current economic and financial crisis. My post was in response. Also, see my previous post on regulations.

My complete comment is republished below:

Only journalists, writers, academics, politicians and others that have not managed or owned a business in a challenging economic environment could believe that a single, simple solution, a finger in the dam, could have prevented the financial crisis and recession. When a stressed economic and financial system reaches its breaking point, it will break. Afterward, the obvious cracks need repair, but other cracks, just as likely, could have occurred in their place. Only looking at the aftereffect cracks in the wall will miss the accumulated winter snow on the roof that contributed to the problem.

Our economic and financial system cracked under stress and was on the verge of breaking from, among other things, a credit lockup. It will be many years, if ever, that the causes of this worldwide economic downturn will be understood. Experts still debate the causes of The Great Depression, let alone the best preventive and corrective measures. No knowledgeable person believes that causes of recessionary economic cycles are fully understood or preventable.

No one really has a consensus, confirmed idea as to what happened with sufficient economic impact to cause the excessive stress to our financial system or what caused the housing market to overheat and then collapse. To use terms such as "bubbles" or "animal spirits" are not explanations, but they are a linguistic trick that rephrases the problem. It is like a doctor who diagnosis a red rash by telling you that you have a disease that is just the Latin phrase for red rash. It says nothing about causes, treatments or solutions.

Strengthening a weak link of an overloaded tow chain, does not stop the chain from snapping. It just snaps at another point. Strengthen every link in the chain and under enough force, the items attached at the ends of the chain will tear apart, instead of breaking the chain. Continual structural reinforcement will eventually just push the overloading stress to cause the engine doing the pulling to burn out, etc. Extremely stressful forces are too great for any system, including our financial and regulatory systems. Extreme stress will always find the breaking points.

To believe openly that thousands, if not millions, worldwide were lemming-like, economically suicidal, self-destructive and too dumb is beyond arrogance and naiveté. Do these self-aggrandizing pundits think that their simple solutions, such as different probability distributions, different regulations, or wiser elected officials were enough to avoid the crisis, and save the jobs, wealth, prestige and institutions of those affected? Are we so unwise in the ways of the world to believe that if we had only worn the blue shirt (blouse) instead of the white one on that important day, we would be happier today? Did the prospects of a golden calf lead the millions of residential construction workers, bank-lending officers, mortgage originators, homebuyers, mortgage borrowers, investment bankers and the regulatory examiners astray? If only we had listen to the sage advice of these chosen few who saw the light before it was too late, we all would have been saved.

Of course, I wonder how many of these wise men lost money in their home values, retirement accounts and investments. None I would guess. Most of these wise men make some money in the struggling newspaper, magazine or book publishing industries. I cannot wait to hear the great advice they have to tell the struggling companies in this industry. Aw shucks! I forgot. I have to wait until these publishers go out of business to hear the correct solution to the industry's problems. If only publishers had used a cheaper blue ink instead of black and a different font.

Monday, May 4, 2009

Signaling And Mortgage Securities

My response to Arnold Kling's post "that securitzation depended on false signals of soundness."

Signaling is important in finance, but there were economic incentives to misread the signals of mortgage securitization. Additionally, there were regulatory structure issues that prevented corrections to the misread signals. Both problems are fixable.

Both investment banks and commercial banks must maintain capital against their assets. In both, the amount of capital (not identical for the two types of entities) for mortgage securities was determined by formulas that used the credit ratings of the SEC recognized credit rating agencies, NRSROs. A better credit rating required less capital.

Mortgage originators derive their income from fees, which need a continuing volume of new mortgages. Originators did not hold mortgages for their interest income and a principal agent problem occurred. As long as there were buyers of packaged mortgages (securitization), including lower quality mortgages, originators could replenish their limited amount of lendable funds and continue to generate fee income without regard to the deteriorating quality of the new mortgages.

The commercial banks and investment banks (buyers) preferred securitized mortgages with lower capital requirements, which were the higher NRSRO credit rated securitized mortgages. The buyers could put up less capital against these assets, purchase more of them with their existing capital base and derive a higher income.

If the buyers, the commercial banks and investment banks, monitored and analyzed the quality of the securitized mortgages correctly and read the signals, these buyers would have had to put up more capital against theses investments, purchase less of them and reduce their income.

The regulators accepted the credit rating agencies' ratings and their lower capital requirements. For a buyer to question the ratings, the buyer would have to accept lowering its income, putting higher capital against the assets and investing in fewer of them. To the commercial banks and investment banks, it was a clear cost benefit decision. The benefits were lower capital versus higher capital, higher income versus lower income, and more securitized mortgages versus fewer securitized mortgages. The costs were higher potential defaults and higher potential losses. Post WWII history made the benefits appear to outweigh the costs even on a risk-adjusted basis.

The NRSRO rating agencies depended on the volume of their ratings of mortgages to produce a continuing fee income stream. A lower rating meant the buyers would use more capital and there would be fewer mortgages for ratings. Each of the rating agencies jeopardized their reputations and brands through lowering the quality of their rating methodology for securitized mortgages. However, the SEC's NRSRO limitations and designation hurdles protected the ratings agencies, limited competition and ensured the existing NRSROs that they would not lose their current or future business clients or ratings income stream.

The regulatory structure for NRSRO designation prevented customers from turning to other rating agencies for mortgage securities ratings. The regulatory structure for capital, which depended on NRSRO ratings, economically inhibited the commercial banks and investment banks from doing their own analysis of the potential for losses in the packaged mortgage securities.

The problem that occurred was not lack of proper signals of the deteriorating quality of mortgage securities. There were many, including who was sourcing the mortgages, the existing decline in home prices and the increasing level of defaults. The buyers ignored the signals.

The prevalent signals were overridden and ignored due to the structural problems created by the regulatory structure for NRSRO designation and the NRSRO credit rating used for determining capital levels.

A successful securitization process does not need credit ratings and NRSROs. However, since commercial banks and investment banks are required to hold capital against their investments, a new methodology for determining capital levels without NRSROs and credit ratings is needed.

The problem was not false signals, but structural and regulatory issues that prevented buyers from reading and using the available correct signals.

Sunday, May 3, 2009

Heavy Cost Of The Principal-Agent Divide

Good article in Financial Times, "The heavy cost of the principal-agent divide" by John Authers on how principal agent problem contributed to the current financial crisis and mortgage mess.

"When we invest or borrow, we are at least one remove from the producer. The person who decides to lend you a mortgage will not bear the risk of your failing to repay it. Instead, that risk is securitised and sold in the form of a bond on the securities market.

But the splitting of principal and agent over the past few decades has exacerbated the financial problems that now bedevil us. Most obviously, this affects mortgage lending. The people who authorised “toxic” subprime mortgages in the US did so knowing that they would not have to bear the risk. They had an incentive to lend as much as possible but not to ensure that as much money as possible came back."

Saturday, May 2, 2009

Global Warming And Cap And Trade Markets Are Not Like Other Markets

Global warming trading markets are not identical to a typical goods, commodities, equity or debt trading market. A US Cap and Trade market in CO2 must overcome several, not so easily resolved, problems.

While all trading markets that have regulatory oversight will have some distortions due to their governing regulatory process, the costs of market distortions and failure of a trading market intended to protect the continuing habitability of our planet are potentially more devastating than failures in other pricing markets. The result of one is inhabitability of the planet versus the investors' wealth losses result of the other.

Arbitrage is a part of all trading markets. It occurs not just in identical goods in different markets, but also in equivalent and substitutable goods. Additionally, there is the potential for regulatory arbitrage.

Some and certainly not all of the known problems needing solution for a successful US Cap and Trade market in CO2 are:

Imported Goods

Identical and substitutable products produced outside of the US and sold in the US must have identical or higher greenhouse gas pricing per unit of greenhouse gas emission as US produced products. Otherwise, the US buyer (industrial, government or consumer) will substitute the cheaper foreign produced goods with a higher greenhouse gas emission than US produced goods, and worldwide greenhouse gas emissions will increase.

Process Substitution

The pricing in a cap and trade market may create undesirable substitution into other greenhouse gases so that the result is a greater global warming effect. For example, methane is about 25 times more potent than CO2 in its global warming effect. If the total cost of substituting into a methane emission process is not at least 25 times greater than the costs to obtain a CO2 permit purchased in a Cap and Trade system, a producer of CO2 could cost effectively substitute a methane process. However, there will be no reduction in the effect of global warming greenhouse gases and there might even be an increase in a detrimental effect. Since the market will determine the permit prices, how do we prevent economically beneficial substitutions that hurt the climate?

Producers will continue to look for processes than emit gases that are believed neutral for global warming based on our current knowledge and that do not need a Cap and Trade permit. Of course, scientific knowledge is always expanding and changing. These alternative emissions may be discovered subsequently to be detrimental to global warming or other as potentially harmful climate effects. In other words, we may reduce CO2 but not global warming or climate harm. This is a societal benefit, proxy mismeasurement problem.

Permits As Investments

Any Cap and Trade system must not interfere with process innovations that decrease CO2 (and other greenhouse gas) output. In other words, producers of some particular goods may have no incentive to invest in new equipment that will lower greenhouse gas emissions because all the manufacturers of those goods will see a wealth loss in their permits greater than the cost savings and benefits of the new lower greenhouse process.

Price Increases

It is likely, but not certain, that the additional cost of purchasing a permit in Cap and Trade will increase prices to buyers of the produced goods. Price increases are not certain because competition does not always allow production cost increases to be passed on to buyers. If the industry cannot achieve pricing that allows for a fair return on its investment, the industry will disinvest and eventually go out of business. However, if the price is increased, competitors with alternative lower greenhouse gas emission, equivalent processes and products will see an opportunity to enter the business whereas before the additional costs of Cap and Trade, the lower pricing did not give these new competitors an economic incentive to enter the business. It is uncertain how government will respond to a price increase or to industry competition. Based on the likely political effects of a price increase, especially if it is significant, politicians will chastise the industry and call for it to lower prices or as likely, the politicians will enact price controls. Both could be detrimental to the survivability of the particular industry. Another potential political outcome could be that the industry with a high cost cap and trade permits may not be competitive against a new competitor that either does not need a permit or can produce at a lower level of greenhouse gas emission. Will we see a replay of the current auto industry crisis in a different industry and how will the politicians respond? Will the political reaction ensure the continuation of a high level of greenhouse gas output?

Incentive to Decrease CO2

Since Cap and Trade fixes the amount of unwanted emissions output, how will we allow for innovations that decrease detrimental emissions over time that matches industries' abilities to innovate without negatively affecting output? Will a fixed allowable amount of CO2 and other greenhouse gases distort and remove the incentives for process innovations that lower CO2 and other greenhouse gas emissions?

Alternative Energy

Will the US allow investment into alternative processes that lower greenhouse gas emissions but have other practical and political problems, such as nuclear energy, wind energy in the visual landscape, etc.? Won't permit prices have an additional price volatility related to changes in potential government energy policies?

Permit Price Volatility

How will industry respond to the normal Cap and Trade permit price volatility that exists in all trading markets? Will the volatility have unwanted effects?


Will industry use hedges to offset changes in permit prices and will government desired outcomes be different with hedging than without hedging?