August 31, 2007 12:26
New column: In praise of banks and thrifts
My new column is up online, and in the issue of Time with Rosie the Peace Corps Conscriptee on the cover. It begins:
The last big mortgage debacle, the savings-and-loan crisis, was made mostly in Washington. The S&Ls were required by law to borrow short (via savings deposits) and lend long (via 30-year, fixed-rate mortgages). When that led to big losses in the inflation-racked early 1980s, Congress encouraged thrifts to grow their way out of trouble, in part by financing commercial real estate, with disastrous results.
This year's mortgage crack-up comes with a different story line. It was made not in Washington but in the strip-mall offices of mortgage brokers and on the trading floors of Wall Street. The general rule this time around has been that the farther away from the prying eyes of federal bank examiners a transaction occurs, the more likely it is to cause trouble.Does this mean we need more regulation? Maybe, maybe not. It does indicate, though, that the mortgage business might be due for a return to its roots. Read more.
By roots, I mean the bank and thrift industries. I wrote this with some trepidation, because I'm sure that in coming months we'll start hearing about some big problems in bank and thrift mortgage operations. But I think the basic point will still stand: This mortgage mess was not the making of the insured, depository financial institutions. It was the independent lenders and their Wall Street backers that drove it.
One thing that I couldn't go into much depth on in the column but that deserves more explanation is the regulatory structure for banks and thrifts and other mortgage lenders. Many people seem to have the idea that they're all regulated by the Federal Reserve. But as somebody who used to cover the OTS, OCC and FDIC for the American Banker, I know that this is not so.
Federal savings banks--a.k.a. thrifts, a.k.a. the former heart of the home lending business--are supervised by the Office of Thrift Supervision (OTS), a part of the Treasury Department. National banks are supervised by the Office of the Comptroller of the Currency (OCC), also part of Treasury. Bigger state-chartered banks are supervised by the Fed, an independent agency. Smaller state-chartered banks (the bulk of the country's banks) are supervised by the Federal Deposit Insurance Corporation (FDIC), another independent agency. This is serious regulation, with bank examiners coming in to look over the books, a lot of pressure to keep underwriting standards high, etc. The four agencies also work pretty closely together to keep their supervision consistent, although there's at least talk in the industry that the OTS might be a little more (take your pick) lax/flexible/understanding/sophisticated when it comes to real estate lending.
Next come the operations that are part of a bank or thrift holding company but not the bank or thrift proper. These are overseen by the Fed if it's a bank holding company, the OTS if it's a thrift holding company. But they're not subject to the same kind of regular prudential regulation as the actual banks and thrifts.
Then there are the independent mortgage lenders, which aren't subject to direct supervision at all by federal regulators. They are supposed to obey federal Truth in Lending Act and Home Ownership and Equity Protection Act strictures against deceptive and unfair lending, and the authority to write regulations to conform to both those laws belongs to the Fed. But this isn't the same as being regulated by the Fed. So I tend to wonder, when people say the Fed should have cracked down on all this earlier, how it could have done that, given that the most creative mortgage lenders were almost entirely outside its purview.
August 30, 2007 11:44
Hey Northern California, the Bay Bridge will be closed this weekend!
An important public service message from the Curious Capitalist (photo by Mrs. CC):
There are signs like this all over the Bay area. Have been for weeks. The Chronicle reports that Caltrans is spending close to $1 million to warn people. I'm very curious as to how many will nonetheless be shocked and surprised when they try to get into the City on Saturday.
They're closing the bridge for another major step in the replacement of the eastern span of the bridge. Here's how the Chron described it Sunday:
Workers will demolish a 350-foot-long, 90-foot-wide section of the Bay Bridge known as the Yerba Buena viaduct and replace it with a new structure. ...
Workers already have built the new concrete piece just south of the bridge, where it rests atop temporary columns, waiting for the demolition.Instead of using pneumatic hammers and wrecking equipment, crews will try to speed the demolition and cleanup process by using large concrete-saws to slice the existing bridge into 63 pieces. Then a huge crane will hoist the slabs onto trailers to be towed away by waiting trucks...
Once the demolition is complete, workers will use a unique roller system to push the new 6,500-ton viaduct into place. Rails will be installed beneath the structure, which will be lifted by jacks and slowly moved into position, and lowered onto permanent columns that have already been built. Then workers will apply the finishing touches and prepare it for the Tuesday morning commute.
I still don't entirely get what it is they're going to be doing. I tried visualizing it while driving over the bridge a couple of times when I was out there earlier this month. No dice. But I do know it's major infrastructure repair and replacement, and we need more of that, right?
August 30, 2007 10:03
Breaking news: Ben Bernanke and Alan Greenspan aren't the same person!
The indispensable Greg Ip, in today's W$J, tries to explain what makes the Bernanke approach different from the Greenspan one:
The Fed historically has had two major economic duties. Maintaining financial stability is one. Controlling inflation while preventing recession is the other.
To Mr. Greenspan, market confidence and the economy's growth prospects were so intertwined as to make the Fed's two duties almost inseparable. He cut rates after the 1987 stock-market crash and the near-collapse of hedge fund Long-Term Capital Management in 1998 to prevent investor reluctance to take risks from undermining the nation's economic growth.By contrast, Mr. Bernanke distinguishes between the central bank's two functions. So, on Aug. 17, the Fed cut the interest rate and lengthened the term on loans to banks from its little-used discount window in hopes banks would use the window -- or at least the knowledge it was available -- to lend to solid borrowers having trouble getting credit amidst the market turmoil. The action was aimed at restoring the normal functioning of disrupted credit markets, not primarily at boosting growth.
The Fed, meanwhile, hasn't cut the far more economically important federal-funds rate, charged on loans between banks, which is the benchmark for all short-term U.S. borrowing costs.
This is that thin line I've been writing about. Bernanke doesn't want a financial collapse on his watch, but he also doesn't want to stand in the way of a long-needed repricing of risk. I've long thought that the people who call Bernanke Helicopter Ben were missing the point, and that he was likely to be more conservative about printing money in times of trouble than Greenspan was. Now we seem to be getting evidence of this, although Wall Street keeps getting its hopes up every time a member of Congress announces that Bernanke told him he's prepared to do his job, if necessary.
Update: Yves Smith has a very different take. (He thinks Bernanke is pandering to Capitol Hill, and Ip is pandering to Bernanke.)
August 29, 2007 12:22
The David Laibson plan for ending mortgage teaser-rate insanity
My post Tuesday on the evils of teaser-rate mortgages engendered a lot of comment. This probably had less to do with the actual content of the post than with the fact that it was linked to on the CNNMoney home page, but whatever. It's a topic folks are interested in these days, for good reason.
Now Harvard economist David Laibson, whom I mentioned in the previous post as an expert on "hyperbolic discounting"--academicspeak for the human tendency to pay too little attention to costs and benefits in the distant (and sometimes not so distant) future--has come forward with a simple proposal to end teaser madness. Here it is, a Curious Capitalist World Exclusive:
To prevent lending institutions from offering misleading deals that trap borrowers, we should require that all future mortgage loans be prepayable with no penalty. This is an easy, simple rule. The rule will have the effect of leading banks to stop offering many of the teaser rates that serve as loss leaders (pay too little interest for the first 18 months but then pay extra on the back end). These loss leaders are often confusing and tempting for borrowers. Banks won't want to offer loss leaders if borrowers can get out of the loan without paying a penalty after the subsidized payment period -- the teaser period -- ends.
My proposal would not discourage banks from offering sensible adjustable rate mortgages (those without a loss leader component). Borrowers should be allowed to take out a mortgage pegged to short-term rates. That's not a loss leader and such mortgages will still be offered if prepayment is made penalty-free. My proposal will only hit the mortgages with early loss leaders built into the payment stream.
I like it. Simple and elegant.
Update: Brad DeLong was kind enough to reprint this post in his blog (with a great headline). The ensuing discussion in the comments there is worth reading, if you're interested in this stuff.
August 29, 2007 9:54
The diagnosis for financial markets: Bipolar conditionally efficient
In his Maverecon blog, London School of Economics prof Willem Buiter, whose interesting ideas about what central banks should do in times like these have been getting a lot of attention lately, offers an explanation of why financial markets do that voodoo that they do. They're manic-depressive--or, to use what Buiter calls a "wimpish medical euphemism," bipolar:
I don’t mean to imply that those who operate in financial markets are bipolar to a greater degree than those in any other profession, from Amish ministers to zoologists. But if one were to model the aggregate behaviour of financial markets as representing the actions of a representative agent, the choice could only be a heroically bipolar Ayn Randian figure.
An even keel is just an ephemeral, transitional state of affairs between the depth of depression and the height of mania. The mood swings can be triggered by external fundamental events, by sun spots, or be intrinsic – like the rich dynamics of non-linear differential and difference equation systems.
I especially like Buiter's proposed cure: "a slightly more downbeat version of Aldous Huxley’s Soma." (Not to be confused with the muscle relaxer marketed under that name.)
August 28, 2007 12:09
Should teaser mortgage rates be illegal? (A hyberbolically discounted examination)
I keep getting offers in the mail from an outfit called Allied Mortgage that says it can cut my mortgage payments in half by refinancing at 6.125%. I don't see how that's possible, given that my current rate (on a 7/1 ARM) is less than that. I saw a similar offer in an ad online the other day (I think it was from Lending Tree, but am not absolutely certain), clicked through and learned that the low payments were the product of a one-year teaser rate on an interest-only mortgage.
My first thought is that it's remarkable that lenders are still trying to pull this kind of nonsense. My second is that maybe it ought to be illegal, because teaser rates and interest-only loans are so obviously structured to exploit a quirk in how the human mind works.
A rational economic man assesses future financial costs and benefits by applying a constant discount rate. If it's 5%, say, $100 twenty years from now is worth $38 today, $100 five years from now is worth $78 today, etc. (The formula for figuring this out can be found here.)
In real life, though, most of us do not apply a constant discount rate. We apply one rate for the present and near future, and a much-lower rate to the more distant future. If you plot the curve of these changing discount rates over time, you get something that looks like a hyperbola, hence that extremely catchy phrase "hyperbolic discounting."
It's not just humans who do this. The initial research on hyperbolic discounting was done on pigeons, by psychiatrist George Ainslie. Hersh Shefrin and Dick Thaler introduced it to economics in 1981. It didn't catch on back then, but in the past decade or so, thanks in large part to the work of Harvard's David Laibson, interest in the topic has taken off.
The practical lesson from this work is that we make better choices (that is, choices more in line with our medium- and long-term needs and desires) if present and future benefits or costs are bundled together. That is, if you have to decide anew every year how much to set aside for retirement, you're likely to save a lot less than if you have to make a long-term commitment to saving that's hard to back out of. This is the genesis of Thaler and Shlomo Benartzi's semi-famous "Save More Tomorrow" plan to get workers to commit to funnel part of their future salary increases into their 401(k)s, and it's having a big impact these days on the structuring of corporate retirement programs.
Teaser rates are an obvious example of the opposite approach, unbundling. That is, the sales pitch focuses only on the immediate cost, exiling the real cost over time to the fine print. It targets our more irresponsible selves.
Now I can't really advocate banning the things. For one thing, where would you draw the line? I like to think my wife and I were making a totally rational bet about our future financial situation when we took out a 7/1 ARM (that is, an ARM with a seven-year fixed "teaser" rate) instead of a fixed-rate mortgage. My feeling is that most people with a one-year teaser rate aren't doing the same, but I wouldn't know how to back up that feeling empirically or theoretically.
I do think Truth in Lending laws ought to require that any ad or other sales pitch for a teaser-rate mortgage include in equally large print, on the same page, an estimate of what the monthly payment will go up to when the teaser period expires. I'm not so sure how to handle interest-only loans, other than maybe some big surgeon-general type warning about their risks. Anybody got any better ideas? (Non-hyperbolic ones, of course.)
Update: I've got another post on the topic, with David Laibson's plan for stopping the teaser-rate madness, here.
August 28, 2007 9:55
Weighing the merits of Bill Gross's plan to save us all
Bond guru Bill Gross's suggestion that we need a zillion-dollar federal bailout for homeowners who are having trouble paying off their mortgages is generating all sorts of talk in the econoblogosphere. No one seems to entirely buy Gross's notion that we need a "Reconstruction Mortgage Corporation" that would presumably buy up troubled mortgage securities and whisper sweet nothings into the ears of borrowers who can't make their payments, but the idea that Congress and the president--and not just the Fed--ought to do something to help America's homeowners isn't being dismissed out of hand.
NYU economist Nouriel Roubini has a good roundup of the arguments in favor of doing something, concluding that "political issues lead to fiscal solutions when there is a political consensus that the consequences of no action can be a severe economic and social fallout from the worst U.S. housing recession in decades." His former employee Felix Salmon Yves Smith has a smart take on the arguments against, one of the main ones being that no one really knows yet if the "economic and social fallout" from the mortgage mess will be all that severe. He also offers some interesting alternative approaches, all of which are too complicated to summarize here (or at least I'm too lazy to summarize them).
I don't know who's right, but my natural tendency is to side with the skeptical (that is, Felix Yves).
Update: Oops, I didn't get that Yves Smith of Naked Capitalism is doing the blogging at Felix Salmon's place this week. Error corrected.
August 27, 2007 2:10
If Countrywide is the root of all mortgage evil, why aren't its numbers worse?
Gretchen Morgenson has a big piece on Countrywide's mortgage-lending practices in Sunday's NYT. She makes them look really bad:
Countrywide’s entire operation, from its computer system to its incentive pay structure and financing arrangements, is intended to wring maximum profits out of the mortgage lending boom no matter what it costs borrowers, according to interviews with former employees and brokers who worked in different units of the company and internal documents they provided.
You could fairly say that the aim of virtually every large corporation in America is to wring maximum profits no matter what it costs customers, so that in itself isn't much of a revelation. Morgenson's article does make clear that, in trying to keep up profits and growth, Countrywide gave its salespeople incentives to push borrowers into higher-cost loans than they could have qualified for. That's bad, and it's also of sad in light of Countrywide's history: In its first go-round as America's biggest mortgage lender, in the early 1990s, Countrywide distinguished itself in part with its no-commission policy. Its salespeople were on salary, and thus presumably had no incentive to push people into bad loans. That changed in the late-1990s as bank and thrift mergers knocked Countrywide down the list of the biggest lenders and CEO Angelo Mozilo clawed his way back to No. 1 in part by turning his company into just another aggressive, commission-driven mortgage lender.
But were Countrywide's practices worse than the norm? Morgenson's article certainly leads one to believe so, but when I look at the delinquency and foreclosure rates Countrywide reported for July--delinquencies at 5.1% of loans serviced and foreclosures at 0.79%--and compare them to the national averages reported by the Mortgage Bankers Association for the first quarter--delinquencies at 4.84% and foreclosures at 1.28%--and they look, well, average. Better than average, given that they're four months further into the mortgage crunch.
Update: Paul Lukasiak points out in the comments that the Countrywide delinquency/foreclosure numbers are for its entire servicing portfolio, which includes lots of loans sold by other firms, so they don't really prove anything one way or the other about its loan sales practices.
One other interesting stat, from National Mortgage News. Countrywide's loan originations, both subprime and overall, were actually down in 2006. In subprime that was true of almost everybody: The only top-10 subprime lender whose originations were up for the year was GE's WMC Mortgage. But of the top 10 mortgage originators overall, CitiMortgage, IndyMac and GMAC-RFC were all up sharply while Countrywide's originations were down 7%. In low-documentation Alt-A loans, Countrywide was simply not a big player last year (it did become one in the first quarter of this year, as others fell by the wayside), and it was ratcheting back its use of interest-only loans. Who was headed in the other direction? Most dramatically it was IndyMac, in both categories.
August 27, 2007 12:21
Nightly Business Report: Ben Bernanke yada yada yada
I'll be doing a commentary on PBS's Nightly Business Report this evening. Actually, I've already taped it, but whatever. It's a shorter version, adapted for TV, of my column in the current Time about the Fed and its role as stopper of modern bank runs. I'll post the text of it after it airs. If you feel compelled to watch, check your local listings.
Update: Here's what I said:
The Federal Reserve, and other central banks around the world, have spent the past few weeks combating the modern equivalent of an old-fashioned bank run. Bank runs happened when depositors got worried and wanted their money back. If it was a few, no problem. If it was a lot, an otherwise perfectly solvent bank could go belly up in hours.
The same dynamic has been at work in the huge global market market for mortgage securities and other asset-backed debt. Investors who for years had been willing to buy whatever strange new concoctions Wall Street dreamed up have suddenly turned suspicious. They're right to be suspicious, but if every investor around the world who owns mortgage securities decides he'd rather have cash, the whole system goes bust.When just such a thing seemed to be happening a couple of weeks ago, Fed Chairman Ben Bernanke and other central bankers stepped in, lending cash in exchange for mortgage securities. Now things are calmer, but many on Wall Street and in the business world are clamoring for more, for a cut in short-term interest rates to boost the economy.
It was super-low interest rates, though, that got us into this trouble in the first place. Investors looking for higher yields bought ever-dodgier securities backed by mortgages and other assets. The Fed shouldn't be in the business of bailing them out, or encouraging such speculative excess.
That's the fine line Ben Bernanke and the Fed have to walk. If they're too stingy they might bust the global financial system, or at least bring on a bad recession. If they're too generous, they risk inflating another bubble. I sure hope they get it right.
August 27, 2007 8:08
Is the American economy in need of a good cold shower?
In one of the most entertaining of the many entertaining passages in Robert Heilbronner's The Worldly Philosophers, Austrian-born economist Joseph Schumpeter regales his Harvard students in the mid-1930s with these encouraging words:
Chentleman, you are vorried about the depression. You should not be. For capitalism, a depression is a good cold douche. [By which he meant shower.]
I'm certainly not going to argue that the U.S. economy needs a 1930s-style depression. But I've been wondering for a few days now whether a standard-issue recession would really be such a terrible thing. Belts would be tightened. The thrifty and responsible would gain at the expense of the profligate and reckless. The trade deficit that preoccupies so many politicians these days would quickly shrink. The groundwork would be laid for a lasting expansion.
Of course, lots of perfectly decent, hardworking people would lose their jobs. Heck, I might lose my job, too. Still, we haven't had a full-fledged recession since 1991--the 2001 version was a sharp corporate downturn that, largely because of the Fed's super-loose monetary policy, never really hit consumers. Aren't we due?
It turns out the people at the Economist have been thinking similar thoughts. "Does America need a recession?" asks the Economics Focus columnist:
The economic and social costs of recession are painful: unemployment, lower wages and profits, and bankruptcy. These cannot be dismissed lightly. But there are also some purported benefits. Some economists believe that recessions are a necessary feature of economic growth. Joseph Schumpeter argued that recessions are a process of creative destruction in which inefficient firms are weeded out. Only by allowing the “winds of creative destruction” to blow freely could capital be released from dying firms to new industries. Some evidence from cross-country studies suggests that economies with higher output volatility tend to have slightly faster productivity growth. Japan's zero interest rates allowed “zombie” companies to survive in the 1990s. This depressed Japan's productivity growth, and the excess capacity undercut the profits of other firms.
Another “benefit” of a recession is that it purges the excesses of the previous boom, leaving the economy in a healthier state. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place. A recession now would reduce America's trade gap as consumers would at last be forced to trim their spending. Delaying the correction of past excesses by pumping in more money and encouraging more borrowing is likely to make the eventual correction more painful. The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be a choice between a mild recession now and a nastier one later.
The Economist concludes that it would be "political suicide" for Fed Chairman Ben Bernanke to follow such a course, but I'm not so sure. Openly advocating a downturn and praising the virtues of an economic cold shower would be problematic. But moving slowly enough that the housing correction is allowed to take its natural course and possibly steer the economy into recession might prolong Bernanke's career rather than end it. That's if you assume that a Democrat is likely to win the 2008 election. A recession late this year and/or early next would make such a victory even more likely, and give the winner even more leeway to push whatever economic policies he or she might prefer. Which might in turn endear him or her to the idea of reappointing Republican Bernanke when his term as chairman runs out in January 2010.
Hey, it worked for Alan Greenspan, didn't it?
Update: Economist Mark Thoma does not buy the recessions-are-good argument at all. And neither does Paul Krugman.
August 24, 2007 11:50
A CDO manager finds himself living in Chapter 12 of Keynes' General Theory
Barry Ritholtz reprints a scary e-mail from a friend in the collaterized debt obligation business (don't you have a friend in the CDO business?):
I was talking to CDO managers in mid-'05 that were saying how rich sub-prime MBS was and how wrong everyone was for buying that stuff at the spreads they were. To a man, they all agreed they were paying too much for the risk, they all believed that HPA [ED: home price appreciation] was going negative soon. But, sadly, they had to buy the stuff because they needed to accumulate collateral for their CDO issuance. F*&%, we all knew we were overpaying, even back in 2005. We knew it was essentially a bet that home price appreciation was going to continue at levels that couldn't be sustained. No way that could keep going on.
So why did they keep buying?
The answer is quite simple: DEAL FEES. I gotta keep buying collateral, in order to keep issuing these transactions as a CDO manager. Its my job: I gotta keep accumulating collateral, and I gotta issue the liability against that collateral.
This is an important element of what's called the "limits of arbitrage" (Andrei Shleifer and Robert Vishny, Journal of Finance, March 1997) or "career risk" (Jeremy Grantham, in various investor letters) explanation for why markets get so crazy sometimes. Brad DeLong has pushed this argument lately in his blog, and I'd like to second his endorsement: The smart professionals we rely on to keep market prices sane (or "efficient") sometimes face career incentives that make it almost impossible for them to act on their own rational judgments. The most famous and eloquent account of this can be found in Chapter 12 of John Maynard Keynes's General Theory of Employment, Interest and Money:
Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; — human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.
August 24, 2007 8:31
New column: Bernanke walks the line between bailout and bust
My new column is in the issue of Time with Mother Theresa on the cover and online here. It begins:
Much of what Ben Bernanke spends his days doing oscillates between the incomprehensibly arcane and the unspeakably dull. Lately, though, the Federal Reserve chairman has a stark, even exciting task at hand. He's been imitating Jimmy Stewart in It's a Wonderful Life and trying to halt a bank run.While Stewart's George Bailey had to make do with his powers of persuasion and his honeymoon fund to save the Bailey Building and Loan, Bernanke has the full faith and credit of the U.S. government behind him. The Fed can effectively print U.S. dollars at will. It can even, as Bernanke famously suggested in 2002, drop them out of helicopters, if that's what it takes.
Unlike Bailey, though, Bernanke doesn't know all his customers or even his loan officers. He cannot reassure nervous depositors (a.k.a. lenders) by telling them exactly where their money is invested, because he has no clear idea himself. He probably suspects that many borrowers and lenders have been up to no good and richly deserve the bad things that are happening to them. And while he can manufacture cash, he knows that if he overdoes it, hyperinflation and a dollar crash could result.
So Bernanke walks a thin line. Too far in one direction, and he bails out all the irresponsible people and institutions that have gotten us into the subprime mess and subsequent debt-market crunch. Too far in the other, and the global financial system collapses on his watch. Read more.
My editor, Bill Saporito, thought the It's a Wonderful Life reference was pretty old hat and wanted me to try starting the piece with a colorful account from the Panic of 1907, which comes up later in the column. It was late Tuesday, I was very tired, and the thing had to go to the printer that night. Plus I thought the Wonderful Life parallel nicely set up the quandary faced by Bernanke: He has a lot more wealth at his disposal than George Bailey, but a lot less information. So I left things the way they were. Let me know if you think I made a terrible mistake. And I hope to write a post soon about the Panic of 1907, and the entertaining new book about it that I cite in the column.
I personally sorta like the way Bernanke is handling things. But then what would I know; I'm no Jim Cramer.
August 23, 2007 2:33
Ben Bernanke doesn't like gold and doesn't hate the New Deal
I checked out Fed Chairman Ben Bernanke's 2000 book Essays on the Great Depression at the library the other day. It's not what you'd call a page turner, but it does offer some cool insights into his thinking. It's a collection of lectures and journal articles, some going as far back as the early 1980s, but as he doesn't disavow any of them in the introduction I think it's safe to assume that they fairly reflected his thinking in 2000 and, presumably, now.
First, gold bugs are right to distrust Bernanke. Alan Greenspan had at least pined in 1981 for a return to the gold standard (although his actions as Fed chairman indicated that he subsequently changed his mind). Bernanke had this to say:
[S]ome governments responded to the crises of the early 1930s by quickly abandoning the gold standard, while others chose to remain on gold despite adverse conditions. Countries that left gold were able to reflate their money supplies and price levels, and did so after some delay; countries remaining on gold were forced into further deflation. To an overwhelming degree, the evidence shows that countries that left the gold standard recovered from the Depression more quickly than countries that remained on gold. Indeed, no country exhibited significant economic recovery while remaining on the gold standard.
Bernanke is a Republican, appointed by that George Bush guy, but he makes clear that he doesn't share the belief held by many conservatives that the New Deal was a complete bust:
Summarizing the reading of all of the evidence by economists and by other students of the period, it seems safe to say that the return of the private financial system to normal conditions after March 1933 was not rapid; and that the financial recovery would have been more difficult without extensive government intervention and assistance.
He also seems to think it wouldn't hurt the economy for workers to get more money and corporate shareholders less:
Maybe Henry Ford and Herbert Hoover were right: Higher real wages may have paid for themselves in the broader sense that their positive effect on aggregate demand compensated for their tendency to raise costs.
Finally there's this observation, which is a little cryptic but seems to fit some of the summer's events:
Institutions which evolve and perform well in normal times may become counterproductive during periods when exogenous shocks or policy mistakes drive the economy off course. The malfunctioning of financial institutions during the early 1930s exemplifies this point.
August 23, 2007 12:50
A more detailed view of the Great Quant Meltdown of 2007
The collective wigging out of the quantitative hedge funds earlier this month has been one of the most fascinating stories to come out of the market's summer troubles. Joe Nocera wrote the best layman's explanation in his NYT column on Saturday (a column that, I feel obliged to note because it makes me sound important, could not have happened without me, as I introduced Joe to his main source, AQR Capital's Cliff Asness). Frank Ahrens had a less informative piece in the WaPo Tuesday (it's a lot to ask of a man who covers the media and entertainment industries, and does it really well, to suddenly be an expert on quant investing). And today Barry Ritholtz has done the world the great service of collecting and posting the semi-apologetic letters the quant managers sent to their investors.
But all the coverage has been shrouded in mystery because these are hedge funds and they like to be mysterious. There are numbers about how much some of the funds were down, and talk that some of them have recovered most of the lost ground, but very little of the kind of hard information you could get if these things were run as mutual funds. But it so happens that there are a few quant mutual funds, several of them run by one of the pioneering firms in the field, Axa Rosenberg. I know because I own a couple thousand dollars of one of them, Laudus Rosenberg Global Long/Short Equity (RMSIX), and I've paid a couple of visits over the years to Axa Rosenberg's headquarters next to the freeway in the lovely but dull San Francisco suburb of Orinda (just down the hill from the tennis courts where frequent Curious Capitalist commenter "Dad" spends a significant percentage of his waking hours).
So I checked out the charts on RMSIX and the older and larger Laudus Rosenberg U.S. Large/Mid Cap Long/Short Equity Fund (RMNIX), and they are indeed very interesting:
The percentage drop isn't nearly as dramatic as the ones you heard about at some hedge funds, because the Rosenberg mutual funds aren't loaded up with debt like the hedgies are. Then again, the annual returns of the Rosenberg funds aren't so amazing either: RMNIX is up 5.11% a year since its launch in 1998, RMSIX up 4.08% a year since its launch in 2001. But they've been steady returns, mostly uncorrelated with the overall stock market, during a tumultuous time for the market. Against the benchmark Rosenberg judges the funds by, 90-day T-bills, they've done quite well over time. I'm most curious as to why the global fund (the one I own, natch) still isn't close to recouping all its losses while the domestic one is. (I'll check with AXA Rosenberg to see if they have a clue and are willing to share it with me.)
This performance hasn't attracted a lot of small investors--RMNIX has only $10.4 million in assets, RMSIX $3.3 million--and Charles Schwab, which markets the Laudus Rosenberg funds, is now planning to hand RMNIX over to Vanguard, whose customers presumably might be more inclined to buy such a product. (Axa Rosenberg will still manage much of the money, although Vanguard's in-house quants will get part of it, too.) The quant hedge funds, with their leverage-enhanced returns, have had far more success in attracting big money from pension funds, college endowments and the like (as has Axa Rosenberg's institutional side).
So here's the big question: Does this stuff work? Or does the big drop demonstrate that the geniuses have failed yet again?
I lean toward the first answer, because the animating principle behind most of these quant funds, that you buy securities you like and sell short ones you don't, has such a long and impressive pedigree. But just because a strategy works most of the time doesn't mean it's going to work all the time. And if you goose it with enough leverage, and don't have a long enough track record to reassure your investors and lenders, you can be out of business before you know it, as Jeff Larson of Sowood Capital learned this month.
Famous long-shorters of the past include Alfred Winslow Jones and Benjamin Graham. Jones was a former Time Inc. employee who called the investment partnership he launched in 1949 a "hedged fund" because he followed such a strategy, and the name stuck. The great Graham was following a hedged strategy of selling common stocks short while holding the preferred shares of the same companies when the crash hit in 1929. He was convinced that the market was overvalued, but owning the preferred shares, which are less volatile than common stock, gave him some insurance in case he was wrong. He was right about the market being too high, and made a bunch of money in the crash. But afterwards he couldn't bring himself to sell the preferred shares because they were so danged cheap, and when the market kept dropping he lost a lot. (This is all from Benjamin Graham: The Memoirs of the Dean of Wall Street.)
The quant version of this strategy, which I date back to math professor Ed Thorp's entry into the investing business in 1969 but didn't begin to gain many adherents until the 1980s and only really took off in the past decade, simply spreads the same approach over far more stocks or other securities, and involves much more frequent trading. My impression from the quants I've spent time with (Asness and the people at Axa Rosenberg, Barclays Global Investors, and Analytic Investors, among others), is that they're basically value investors with a healthy respect for the market's momentum.
This stuff is all very complex and computer driven, which makes it mysterious to laypeople, but because it involves fewer judgment calls it's actually much easier to replicate on a large scale than the style of, say, Warren Buffett. There's even a standard primer telling you how to do it, if you're enough of a geek to understand it: Active Portfolio Management, by Barclays Global's Richard Grinold and Ronald Kahn. (Grinold used to teach alongside Axa Rosenberg founder Barr Rosenberg at UC Berkeley and work for him at risk-assessment firm Barra, and Kahn worked at Barra too.)
What happened in early August was that too many people with copies of that book next to their Bloombergs did the same things at the same time. It was, as Goldman Sachs's CFO later put it, a case "of the crowded trade overwhelming market fundamentals." Which would seem to mean that the quant game might need to get a bit less crowded before it becomes a big winner again.
Update: Thanks to the alert reader (and quant) who informed me that I had the labels on my chart mixed up. It's fixed now.
Update 2: The FT weighs in this (Thursday) afternoon with a story updating some of the performance data on the hedge fund quants.
Update 3: Guess I'm out of the quant investing game. Morningstar reports (second and third items) that the Vanguard Market Neutral Fund will require a $250,000 minimum investment and that my Laudus Rosenberg Global Long/Short fund will liquidate and return its money to shareholders on Sept. 24.
August 22, 2007 4:20
Should the Fed really be in the business of pricking investment bubbles?
In the NYT this morning, David Leonhardt writes that the Federal Reserve should do more to push against inflating investment bubbles:
The Fed could have tightened financial rules, like the amount of cash that must be put up for a given investment. It also could have used the bully pulpit. Imagine what might have happened in 2005 if Mr. Greenspan or Mr. Bernanke had explained the obvious risks with adjustable-rate mortgages and just urged home buyers to be more conservative.
The argument that the Fed should get into the bubble-pricking business is a popular one these days. Morgan Stanley's Steve Roach just made it in the pages of Fortune, PIMCO's Paul McCulley has been making it for a while, etc.
And I guess, in some Platonic (or Bagehotic) ideal world of central banking, that's exactly what the Fed should do. But the real world is a bit more complicated. Martin Wolf has a column in today's FT explaining why this particular housing bubble would have been hard for the Fed to prevent (because of the global "savings glut," he says), but I'm thinking more of two timeless factors.
One is Alan Greenspan's claim that even Fed chairmen can't necessarily recognize bubbles until after they've popped. He's only partly right about that: I think it's fair to say that the preponderance of smart people who pay attention to these things knew the stock market had gone mad in 1999 and the real estate market in 2005. The complication is that some of those same people thought the stock market was crazy in 1996 and the real estate market in 1999. It's really hard to get the timing right, and if as Fed chairman you get the timing wrong you can end up in a whole lot of political trouble.
Which, in the end, is the biggest complication. It's just not politically realistic to think that Fed chairmen can get away with leaning against the wind a whole lot more than they do now.
University of Delaware economist Burton Abrams documents in a Fall 2006 Journal of Economic Perspectives article how much pressure Richard Nixon put on then Fed chairman Arthur Burns to go easy on monetary policy in the runup to the 1972 election. The subsequent inflationary spiral, and the successes of Paul Volcker at ending it and Greenspan at keeping it down won for the Fed a greater measure of independence.
But it's a very conditional sort of independence, and I think a Fed chairman who continually railed against prevailing political and economic trends would soon find himself losing clout and maneuvering room. Harry Reid famously called Greenspan "one of the biggest political hacks we have here in Washington," and he wasn't entirely wrong. But somebody without good political instincts and a willingness to follow them could never have survived in that job for 19 years. And by staying on the job for so long Greenspan was able to gain for himself a measure of independence in setting monetary policy that Arthur Burns could only have dreamed of. Which was a good thing.
August 22, 2007 12:30
Schadenfreude alert: Subprime execs get poor, Wall Street bonuses headed down
Businessweek.com has a lovely slide show (link from Harold Maass) of mortgage industry executives who used to be really rich and now aren't so much.
Meanwhile, Bloomberg has an article (via Trader Daily) on how the credit crunch "may cut Wall Street bonuses for the first time in five years."
Hooray for that, I say. I'm not at all opposed to people getting rich. But I have a big problem with the size of the paychecks on Wall Street and elsewhere in the financial services business, because I think they usually fail to adequately reflect the risks being incurred. As Dennis Berman wrote in a really smart W$J column last month:
Bankers and traders get their big bonus checks every 12 months. But the risks created by their work are spread over a longer time frame. By the time the risks are revealed, be they bad loans or bad deals, it's too late for real accountability. The checks have been cashed, and the charters booked for Nantucket.
Berman didn't have any answer for how to fix this, and instead offered some career advice:
If you're ever offered a chance to make short-term profits without any long-term risk, grab it and don't let go. It can be a beautiful gig.
Well, I have a little advice for those of us unable to land such gigs: By all means kick these people while they're down. Because most of them were probably wildly overrewarded on the way up.
August 21, 2007 8:42
Why Dutch people wrapped their TVs in aluminum foil in 1969
The big news in Holland Tuesday is that a TV report claiming that soccer star Mark van Bommel is planning to become a German citizen was a hoax that Van Bommel helped manufacture. This is very funny stuff in Holland, I think. (You want to become a ... German?!? Ha ha ha ha ha.)
Anyway, I didn't find it all that funny, but a roundup of classic Dutch media hoaxes in the NRC Handelsblad (they're a "Dutch tradition," the headline reads) included these two items that did make me laugh (loose translations mine):
* 'Rudi Schokker Cries No More' was the name of a fake documentary broadcast on VPRO in 1974 ... about a baby born near a runway at Schiphol airport who cried like a fighter jet.
* Perhaps the best April Fools' joke of the (Youth) Journal [a news program] came in 1969. Special cars would drive around with scanners to track down television owners who hadn't paid the license fee [it's like in the UK, where you have to pay a fee to the BBC]. But if you wrapped the TV in aluminum foil, you could fool the scanners. Before long there was no foil to be found in stores.
August 21, 2007 2:47
Is the Wall Street Journal's editorial page really 'right-wing'?
In an e-mail that came in while I was on vacation, reader Mike Mitchell wrote:
Just curious about something I see you and others mention frequently, especially in light of Rupert Murdoch’s takeover of the Wall Street Journal. The phrase typically invoked is “right-wing editorial page”. I read the WSJ every day – read the editorial page every day. Just curious as to what makes it so right-wing. I certainly wouldn’t object to calling it a pro-business editorial page, or a defender of free markets, but right-wing? Are things like free trade and open borders so reactionary? On many issues, I see a libertarian slant.
Have you read their editorial defending Louisiana congressman William Jefferson? What is so “right-wing” about that?
http://www.opinionjournal.com/editorial/feature.html?id=110010445It just seems to me the description is a crude caricature adopted by the political left that people mindlessly repeat. Yes, it may describe a percentage of what they do, but doesn’t come close to capturing the entire picture.
This was my response:
Have I in fact called the WSJ page “right wing”? I’m not saying I’m sure that I haven’t, but it doesn’t sound like a term I’d use. I do have two main problems with the WSJ page:
1) It went kinda bonkers with crazy conspiracy theories, and seemed at times to be overtly partisan, during the Clinton years. I think that has receded a bit under Gigot (and under a Republican president), but I still often get the feeling that some Journal editorialists see themselves as part of a political movement. And movement propaganda bores me.
2) On some economic and foreign policy issues, its approach is what I would call faith-based. When writing about tax policy in particular, the Journal editorialists seem entirely unaware of most economic theory and empirical evidence on the issue.In any case the page is definitely not reactionary or consistently conservative. And while I don’t think it’s as thought-provoking as it was when I first began reading it in the early 1990s, I still read it and learn from it.
An editorial page should have a strong point of view, and that for years has been one of the Journal page's great strengths. Its architect, Robert Bartley, called it "the only editorial page that sells newspapers," and it wasn't an idle boast. Apart from when I was an editorial writer at The Birmingham News in the early 1990s and felt obliged to do so, I don't think I've read more than four or five New York Times editorials (I'm not counting columns, or those bylined pieces by editorial writers that they sometimes run) in my life. But for years I have found the Journal's editorials compelling or at least infuriating enough to glance at. Although I haven't been doing that as much lately.
I'll go with the mixed verdict Jack Shafer delivered in the excellent Bartley obituary/appreciation he wrote for Slate in 2003. On the one hand, he argued:
Journal editorials tend to speed-metal their way past inconvenient facts, topple straw men, and blame societal or political ills on the page's hobbyhorses.
On the other:
Wherever editorial pages take a genuine stand on an issue instead of pondering the complexity of the world for 600 words before recommending further study, you have Bartley to thank. Wherever editorial pages report a story or break news, wherever editorials read as if they were written by a human instead of an institutional voice, you probably have Bartley to thank, too. And wherever an editorial page serves red meat instead of tapioca, no matter what the page's politics, its writers should pay royalties to the Bartley estate.
August 21, 2007 11:32
The 'It Made Me Miss My Subway Stop' award
Every once in a while (more often than really is appropriate, but not what you could call frequently), I look up from what I'm reading in the subway to discover that I've missed my stop. Sometimes I've even missed two stops.
Anyway, as I rolled into Times Square on the downtown 1 train Monday morning (I was supposed to get off at 50th Street), it occurred to me that I ought to give public praise to the reading material engrossing enough to make me forget I was on the subway.
And so the first winner of the It Made Me Miss My Subway Stop award is ...
Jonathan Cohn's Sick: The Untold Story of America's Health Care Crisis--and the People Who Pay the Price
in particular Chapter 3, about the history of HMOs and the mean things some HMO did to a nice couple in suburban Austin.
August 21, 2007 8:37
Warren Buffett's long journey from 'oversexed guy' to 'Imelda Marcos,' and other market thoughts
Warren Buffett is quoted in this morning's W$J saying that "I can spend money faster than Imelda Marcos when things are right." The implication of the Heard on the Street column in which he appears is that after several overpriced years, things are getting to be "right," athough Buffett himself never says this.
All in all it's a weaker and decidedly chaster repeat of Buffett's famous quip in the depths of a bear market in 1974 that he felt like "an oversexed guy in a whorehouse." (Forbes, which had interviewed him, substituted "harem" for "whorehouse," but Roger Lowenstein resurrected the original wording in his great Buffett biography.) Plus, it's worth noting that while Buffett's Berkshire Hathaway began its ascent into investing heaven not long afterwards, the overall stock market didn't really come back until the early 1980s.
All of which is a way of saying that there's no telling where we stand in the current repricing, to use a nice neutral term, of global financial markets. Fortune has a cool portfolio of opinions from investing gurus, in which Legg Mason's Bill Miller declares that "these events represent opportunities" and bankruptcy king Wilbur Ross says he's preparing to "make a major move into mortgages." Then again, Jim Rogers, Jim Chanos and Jeremy Grantham all contend that it's way too early for that kind of hopeful talk. My favorite quote from the whole Fortune collection is from economist Bob Shiller, who points out that this whole mess may be great news for the young folks:
My more optimistic thought is that lower housing and stock prices wouldn't necessarily be a bad thing. It makes housing more affordable and provides better opportunities for younger investors. It's not any kind of big disaster. It might slow down the economy and put us in a recession, but we'll emerge from it, and many people will be better off.
August 20, 2007 6:15
Lester Thurow says China won't overtake the U.S. anytime soon
Curious Capitalist reader YMM alerts me to an interesting Lester Thurow colum