Thursday, October 30, 2008

Harvard/Princeton Paper on Mortgage Backed Securities

In my numerous discussions on the cause of the housing crisis, one of the ideas that I have come to believe is that human beings have a tendency to extrapolate. This might seem trivial, but it is where I differ from the Milton Freidman school of thought.

Not since the Great Depression had home prices fallen considerably nationwide, so believing that home price increases would stay positive even given the obvious bubble, was rational, but incorrect. Homebuyers, occupants and speculators alike, were extrapolating the recent abnormally high returns and assuming no downside risk. As I said here, “What naïve investors often do is look at trends (i.e. they extrapolate).”

In a May op-ed for Real Clear Markets, I wrote:

“Ratings are given to mortgage-backed securities based on backward looking analysis of defaults. In an environment where rapidly rising home prices mask foreclosures, risk premiums were too low and values too high on these securities. This practice had been a reliable model due to decades of steady trends. “

A paper from two professors of the Harvard Business School, and another from Princeton write a thorough examination of the credit crisis. (p. 21,23)

First, the securities’ credit ratings provided a downward biased view of their actual default risks, since they were based on the credit ratings agencies’ naïve extrapolation of the favorable economic conditions. Second, the yields failed to account for the extreme exposure of structured products to declines in aggregate economic conditions (i.e. systematic risk).

In March 2007, First Pacific Advisors discovered that Fitch used a model that assumed constantly appreciating home prices, ignoring the possibility that they could fall.

So we have homebuyers extrapolating, and we have rating agencies extrapolating. That's a whole lot of extrapolating going on, to ignore it as part of economic theory.


Summary of the Rest of the Paper

The paper is a little dense if you aren't familiar with higher finance, but the other main point they make reveals that the basic model for pricing risk was flawed. Mortgages were split up into two or more parts: The junior tranche, the risky part, and the senior tranche, the safe part. If someone defaulted, the junior tranche had to pay first. The junior tranche was like the deductible in an insurance policy. If defaults got too big, then the senior tranche would have to pay the rest.

Like life insurance, it was believed that defaults would be fairly well dispersed across the country and were caused by the same typical random financial problems that always cause people to foreclose. The pricing completely ignored the systematic risk of a broad national drop in home prices. Furthermore, the riskiest of sub-prime mortgages and their tranches were far more often to originate in California, Nevada, Arizona, and Florida, the worst victims of the housing crunch.

Subsidizing Irresponsible State Governments

Don't cut spending, increase your begging.

In recent months, a number of states, especially New York, have been cranking up the volume on their need for bailouts. Their tax revenues have fallen sharply and they are facing large budget deficits. As far as I am aware, no state allows itself a budget deficit. If revenues drop, they have to cut spending. Those who believe in Big Government don't think they should be bound by budget constraints. Now they have found powerful friends in Congress to help them out.

The Wall Street Journal quotes Congressman Charlie Rangel:

Our hope is that the leadership of both parties will be able to confer and come back after the election, and see what we can do to provide assistance to our local and state governments, as we have been able to do for our banking and finance industry

Moral Hazard is the result of removing the downside risks of personal behavior. In my industry, Insurance, we see this all the time. Even in Life Insurance, people are slightly more likely to commit suicide when they have significant coverage.

Now we have states that spent more during the good times, and don't want to have to cut back in the bad times. Bailing these states out will insure that their spending continues to climb in the future. What lesson does this provide for other states, like Texas, that have braved political fallout by ruthlessly cutting spending during previous downturns?

The simple message of this plan to state politicians is: If you cut spending you'll get bad press and your citizens will have subsidize the bailouts of states more wasteful than your own. Don't cut spending, increase your begging.

Wednesday, October 29, 2008

Nice Essay on Property Rights, Houston, and No Zoning

Brian Phillips at his Live Oaks blog has a nice essay about Houston and it's rejection of zoning. He makes the moral case of maintaining my home town's rejection of a rampant form of anti-market thought that has gone mostly unnoticed by most national economists.

His words:

Those in favor of tighter land use regulations voice numerous arguments in support of their proposals. Such controls will improve our quality of life, stabilize property values, and empower the citizens. But underneath all of these arguments lies one unspoken premise-- some individuals may impose their values upon others. Some individuals may use force to dictate the actions of others. Which means, the values of some may be sacrificed to others.


Houston has become the star of the Lone Star state because it has implicitly rejected this premise. Houston has largely respected property rights, and has thus not used political coercion to dictate the actions of individuals.

A Partial Victory for Mexico

The Houston Chronicle reports that Felipe Calderon's legislative attempt to allow foreign investment into Pemex operations has passed. I have tried to push a bilateral agreement between the U.S. and Mexico to liberalize their Oil industry in exchange for more open worker programs and citizenship agreements.

The pertinent excerpts.

"The measures also will create a plan for performance bonuses for drilling and production contractors and will permit Pemex to sell bonds to the public, according to George Baker, a Houston analyst who specializes on Mexico's energy industry."

"While infuriating many on the left, the package fell short of what free-market proponents and private companies had hoped."

"Mexico's oil industry, which funds nearly 40 percent of the government's budget, has seen its production plummet in recent years as the huge Cantarell field, in the southern Gulf of Mexico, has begun to play out."

"Baker said the reforms may be a step in the right direction, but he added that that they do little to improve the chances of attracting foreign companies to drill in Mexico's deep-water Gulf. And, he said, time is running out."

"They have declining production, declining prices," Baker said. "There's even a greater urgency now than there was before."

Tuesday, October 28, 2008

A Look Back At My Housing Predictions

In late February, I made some predictions on housing prices in five cities. I predicted that home prices in these five cities would continue to fall based on an assumption that property values would go back to their long-term trend using the S&P Case Shiller index. The starting values were those reported for December of 2007. Here are those predictions:

Miami – 32% drop
Los Angeles – 31%
Tampa, FL – 28%
Las Vegas – 28%
Washington – 24%

Here are the numbers today:

Miami – 21% drop
Los Angeles – 19%
Tampa, FL – 13%
Las Vegas – 23%
Washington – 11%

Conclusion: While prices in many markets are continuing to fall, Washington and Tampa will not reach the depth that I projected unless something else happens. The month-to-month numbers for those two cities show that prices have leveled out and are at or near their bottom. Miami and Los Angeles may approach my prediction. Las Vegas will almost assuredly meet my prediction as prices there are continuing to fall by 2+% per month with little indication that this rate will change soon.

Friday, October 24, 2008

Katy Freeway Needs a Bailout – Fast!

A little levity for today. If you’re not from Houston, the Katy Freeway (I-10) is home to major operational centers for Exxon, Chevron, Conoco and Royal Dutch Shell, amongst many other smaller firms.

From Kansas to Qatar, investors are pulling their money out of oil until they know how low oil prices will really go. The market is plunging as oil prices have fallen by over 50% in the last few months. If the government doesn’t act soon, this crisis will spread from the Katy Freeway to Main Street. Oil companies are quickly finding that no one wants to buy their oil at its true value.

There are already unsubstantiated rumors of some highly leveraged oil speculators shutting down production. The panic setting in on the Katy Freeway is spreading. Although, only two oil companies have declared bankruptcy so far this year for seemingly unrelated reasons, experts believe that dozens of oil companies are on the brink of bankruptcy. The fear gripping the market right now could lead oil companies simply to halt drilling and production until the bottom is reached.

The U.S. Energy Secretary has announced an $800 Billion plan to purchase oil wells around the country, and possibly outside of the United States, to drive up prices and get oil companies drilling again. The Secretary and Federal Reserve Chairman Ben Bernanke argued before Congress that the American taxpayer would not be left holding the bag, as they have already agreed to debase the value of the dollar to drive up oil prices and make a killing.

Ample evidence abounds that the “Energy Crunch” is spreading from the Katy Freeway to Main Street. Power outages from the shortage of oil have been widespread. Jim Boone, of Louisville, Kentucky, reports no power for up to three hours yesterday at his Burger Barn restaurant saying, “Power just isn’t available anywhere.” The fear on Main Street is just as palpable as it is on the Katy Freeway.

Many experts believe that if the government doesn’t marshal a plan to rescue the price of oil, we could see mass shortages soon. Bob Samuelson, President and Chief Strategist of BS Investments comments, “Prices at the pump may fall under $2, but there won’t be any gas to be had. It’s simple economics.” He also adds, “Some investors may want to consider melting down their cars to build bicycles to weather the current crisis.” However, Warren Buffet has tried to reassure Americans in an op-ed for the Wall Street Journal that, “In the long run, the automobile will get you where you need to go at a much faster pace than a bicycle.” Warren Buffet in another interview for CNBC reiterated this point by revealing plans to buy a grossly underpriced late model Buick he saw on Craigslist over the weekend.

Tonight, the President will deliver a speech to the American people to reassure them that the government will be able to solve this crisis.

Thursday, October 23, 2008

O'Grady Corrects Obama

Mary Anastasia O'Grady is one of my favorite columnists because she seems to be one of the few people on the planet with both a good knowledge of economics and South America. Obama being terribly misguided on the first and woefully ignorant on the second spewed some nonsense in the last debate, and she calls him on it. I have supported Colombia before and the Colombia FTA.

A few excerpts:

He reached into his memory bank for whatever he had been told to say about Colombia. He seems to have found his hard drive loaded with Big Labor talking points. Here's what it spit out: "The history in Colombia right now," he said, "is that labor leaders have been targeted for assassination, on a fairly consistent basis, and there have not been prosecutions."

By the time President Alvaro Uribe took office in August 2002, Colombia was almost a failed state. That year there were 28,837 homicides nationwide, making it one of the most dangerous places on planet Earth.

As a Journal editorial on Friday explained, from 2002 to 2007 the number of murdered Colombian union members dropped by almost 87%. By any fair standard that is progress, especially considering the pattern Mr. Uribe inherited. In 2000, 155 unionists were murdered and in 2001, 205 died. The numbers only started to come down when he took the helm.

We could help the economy a bit by passing the Colombia FTA, but I guess that helping a booming Colombia that has enacted rapid deregulation, free trade, and privitization would be an embarrassment for Leftist ideology.

Credit Crunch a Farce - Federal Reserve Agrees

Economist Mark Perry, at his blog Carpe Diem, comments on a working paper written by the Minneapolis Federal Reserve. I concured with Mr. Perry's evidence when he initially started expressing his doubts. It blasts a hole in what I referred to as the "false narrative told by those with vested interests and insular Wall Street viewpoints".

Here is an excerpt that he pulls from the paper:

The financial press and policymakers have made four claims about the nature of the crisis.

1. Bank lending to non-financial corporations and individuals has declined sharply.
2. Interbank lending is essentially nonexistent.
3. Commercial paper issuance by non-financial corporations has declined sharply and
rates have risen to unprecedented levels.
4. Banks play a large role in channeling funds from savers to borrowers.

Here we examine these claims using data from the Federal Reserve Board. At least based on data up until October 8, 2008, we argue that all four claims are false.

I find #1 to be the most egregious, as it was the primary claim repeated incessantly by the press that convinced many Americans and their Congressmen to vote for the bailout.

Wednesday, October 22, 2008

Top Ten Reasons To Expect a Long and Ugly Recession

A few weeks ago, I wrote that I did not yet see a Depression coming. However, as the election becomes less and less in doubt, everything is pointing to a painful contraction. The horrid mistakes I thought might not come to pass are looking more and more certain.

The real damage will be caused by the destruction of capital. Financial capital, being the net savings held by individuals, is the lifeblood of economic growth. Without a growth in capital, there cannot be economic growth. If capital is contracting then growth will contract.

1. Second Stimulus – As I wrote before, the stimulus destroys capital. It borrows from the capital market and gives to lower income individuals who have a lower personal savings rate. Capital will disappear as it is used to consume and not invest. Odds of passing? Certain.

2. Health Care Plan – While Obama’s economists claim that this will only cost $60 Billion per year, it is likely to cost more than twice that amount. Furthermore, once it goes in front of a Democratic Congress the largess will balloon the price further north. This will require massive borrowing or higher taxes (which will certainly be on the “wealthy” holders of capital) capital will decrease as it is used to consume and not invest. Odds of passing? Certain.

3. Higher marginal taxes – The supply-siders are correct that this will reduce the incentive to work. Those at the top have a much higher savings rate and thus accumulate far more capital. Higher taxes means lower work incentive and lower savings rates. Capital will be taken out of the market and given to the government. The tax “cuts” are unlikely to offset this hike because lower income people will consume almost all the savings. Odds of passing? Certain.

4. Capital gains tax hikes – At the very least, higher capital gains taxes explicitly take away capital growth which reduces economic growth. However, they also have the effect of driving investment out of the United States. Ironically, history has shown higher capital gains taxes will produce little to no additional revenues for the government. Odds of passing? Very high.

5. No new free trade and renegotiated trade agreements – No new free trade reduces the potential growth of capital. As Al Gore is fond of saying, "there is a scientific consensus" that free trade improves the economy. Fair trade is a euphemism for less free trade. Any renegotiated trade agreements with fair trade ideas in mind will mean a contraction in the economy. Odds of passing? No new free trade agreements – Certain. Mostly worthless fair trade agreements – Certain. Renegotiations - Thankfully, unlikely.

6. Government spending – I don’t see how anybody in their right mind thinks that the party who wantonly spent ever increasing amounts of money whenever in power over the last 80 years is suddenly going to reform themselves. Until I see Pat Toomey baptizing Sen. Robert Byrd on the shore of the Potomac, I’ll remain skeptical. More government spending, more borrowing. Borrowing capital to use for consumption reduces growth. Odds of passing? More than certain.

7. Wall Street Bailout – Even though I believe this to be temporary, it is still a misallocation of capital. Government misallocations of capital happen all the time, but not of this size. This is $700 Billion dollars. Much of this will lie stagnant in banks to provide unneeded capital to restore confidence in the banking system for the next two years.

8. Lengthening unemployment benefits – I have talked about this one as well. Studies, and logic, show that lengthening unemployment benefits increases unemployment. A good guess is that the rate will increase by an additional 1%. Fewer workers means less output. Not only does the surplus labor pool slow growth, but becomes a net negative because the government allows them to continue to consume. Odds of passing? Certain.

9. Other job interferences – Expanding food stamps, free/subsidized housing, increased minimum wage, etc… None alone will create significant damage, but the accumulation of all the feel good bills will give enough incentive to stay unemployed so the rate will be higher than it needs to be. Odds of passing? Certain.

10. Another moronic Keynesian spending package that has yet to be announced – After the economy continues to stagnate next year another misguided Keynesian style “Stimulus” plan will be revealed. We’ll call it Stimulus 3. Paul Krugman, of the New York Times and patron saint of the Democratic economic thinkers, is already pushing for increased “infrastructure spending”, by which he means haphazard government consumption of resources. This will require more borrowing of capital. This will reduce capital, and reduce growth. Odds of passing? Likely.

The coming Pyrrhic victory for the Leftist ideology almost amuses me, if not for the carnage they leave behind.

Tuesday, October 21, 2008

Another Stimulus

Federal Reserve Chairman Ben Bernanke said yesterday that “consideration of a fiscal package by the Congress at this juncture seems appropriate”. President Bush is open to the idea, and Nancy Pelosi is chomping at the bit to pass it during the lame duck session after the election. It is almost certain the pass, and the size I have seen tossed around is $300 Billion.

What will the stimulus do?

I will assume for now that the stimulus is once again a simple mail out of checks. I have heard of other spending possibilities, but it has all been rather vague. Even some free market types who have not completed their Jedi training, would have you believe that all we are doing is borrowing future growth for present growth. The costs, they believe, are small to reduce the hardship of recession.

However, there is an additional problem with the “stimulus” that reveals that it will do nothing to help the economy, just like the first “stimulus”. To pay for it, the government will have to borrow funds from the capital market. To induce private holders of capital to loan money to the government they have to increase interest rates to gain a larger share of the capital market. This increased demand on capital causes all interest rates to rise as people and their businesses compete for the limited supply of capital. An increase in the real interest rate makes the rate of return on business investments lower, and thus fewer private business deals happen. In short, less economic growth in the private sector offsets the increase in the economic growth in the public sector.

In general, the stimulus will be a net drag on the economy. It’s really a stretch to believe that forgoing long-term business investments in hopes that individuals will profligately gobble up our limited resources is good for the economy. Don’t gripe at AIG for spending precious funds on spa treatments for sales reps, when your economic plan relies on Americans doing the exact same thing.

Saturday, October 18, 2008

Government Run Health Insurance: More Hope than Reality

In 1993, President Clinton tried to pass a single payer government run healthcare system, derisively labeled “HillaryCare” as Hillary became the first First Lady to take on such a public role. This system was to move the United States to a system like the U.K. where the government owns all the hospitals and clinics, and employs all of the doctors. Because of the failure of HillaryCare and the truly abhorrent stories that come out of Canada and the U.K., Democrats have now switched to pushing government run health insurance. Barack Obama is pushing his own version on the campaign trail.

The question then becomes, did these arrangements cost as little as promised where they have been tried in the United States.

Romney Care

Mitt Romney, former governor of Massachusetts and Republican Presidential Primary Candidate helped craft a universal health care plan for that state. Included in that plan was a subsidized health care insurance program called Commonwealth Care. It was designed to offer competitive insurance for those currently without insurance and incomes below 300% of the federal poverty line. (For a family of 4 that would be $63,600 a year.)

The insurance program was supposed to be relatively inexpensive. Like Obama’s plan there is a fine for not signing up for insurance. The theory went that if they could pool all the uninsured, including a large number of young people who use very little medical services, the premiums wouldn’t have to be very high. This is the essence of Barack Obama’s plan as well.

Did the plan stay in budget? Not by a long shot. According to Massachusetts Governor Patrick’s new 2009 budget, how big will this next year’s budgeted amount and increase have to be?

“$869 million for Commonwealth Care, an 84 percent increase over the fiscal year 2008 General Appropriations Act”

Furthermore, according to an article from the Boston Globe:

“...the state expects to spend substantially more for insurance subsidies than the $869 million Governor Deval Patrick proposed in his 2009 budget just two months ago, because of increasing enrollment and higher payments to insurers. In private briefings, she has told coalition members that the cost could be $100 million more, according to several who were present.”

If you do the math, that’s a 105% increase in costs for the program in a single year.

Keiki Care

In 2007, Hawaii created a free insurance program called Keiki (Child) Care. Like the SCHIP expansion championed by the Democrats and vetoed by President Bush in the same year, children who’s parent(s) made too much to qualify for Medicaid could get free basic health insurance.

The Washington Times quoted the President after vetoing the SCHIP expansion:

"If this bill were enacted, one out of every three children moving onto government coverage would be moving from private coverage."

When Hawaii passed a very similar program, what happened? According to the Associated Press:

“State health officials argued that most of the children enrolled in the universal child care program previously had private health insurance, indicating that it was helping those who didn't need it.”

"People who were already able to afford health care began to stop paying for it so they could get it for free," said Dr. Kenny Fink, the administrator for Med-QUEST at the Department of Human Services. "I don't believe that was the intent of the program."

So, President Bush was wrong. It was not going to be just 1 out 3 children dropping out of private coverage to get the free government insurance, it was more than 1 out of 2.

What did Hawaii do once they figured out that the insurance plan was going to cost far more than estimated? They ended it, after a mere 7 months. How refreshingly responsible.

Obama’s Plan

What will Obama’s plan cost? Whatever you hear them quote, it could easily be double. Will people drop their private health care coverage to get on the government dole? By the millions. Can we really believe that Obama and his fellow skeptics of the free market could so blindly underestimate the costs of their plans? Everyone together: YES, WE CAN!

My Long Lost Twin

I happened to be doing a little surfing of Econ blogs and found this blog post at The New Yorker Magazine by James Surowiecki. His post is virtually identical to one I posted on Friday. Even though the article was an AP story available in many locations he linked the exact same yahoo news source that I used in my post.

October 17, 2008
No, This Is Good News

Trying to explain why markets are acting in a particular way on a particular day is a classic mug’s game (although I should say that it’s a game that I myself will play in another post later today). Nonetheless, it’s good that everyone in the financial media is constantly trying to do it, because it helps clarify the assumptions that shape their view of the economy.

Take, for instance, this headline from this morning’s A.P. story on pre-market action: “Stocks open lower after data show larger-than-expected drop in new home construction.” The assumption in that headline is that a big drop in new home construction is a bad thing for the economy. And it’s true that in the short run, the drop in home construction is not great for construction companies, homebuilders, equipment manufacturers, etc. But for the economy as a whole, this drop is actually a very good thing. In fact, it’s precisely what we want.

One of the biggest problems the economy faces is the mismatch between supply and demand in the housing market, because of the lingering effect on prices of the housing bubble (prices are still too high in much of the country), and because there was massive overbuilding in much of the country. So things that get supply and demand back into sync—like steep cutbacks in the number of new homes being built—are good things. This really is a case of short-term pain leading to long-term gain. And I suspect that investors probably understand that, even if the A.P. thinks they don’t.

Friday, October 17, 2008

Fewer Housing Starts is Good News, Not Bad

Another AP article. This time at Yahoo!Finance. The lead story on their site says "US stocks set to open lower after housing data". In their imbecilic efforts to attribute every stock movement to a news story they misunderstand that this is good news for the financial panic.

Home prices across the United States are still falling. Not as quickly as they were earlier this year, but most major markets are still dropping. The price of anything falls for the sole reason that there is more of the product than people want to buy at the current price. What would be truly scary is if home construction was increasing during a glut.

For all of these mortgage backed securities to attract investors we need the price of the underlying assets (houses) to stop falling. Few want to buy these securities because they are uncertain what they will eventually be worth (Well, security holders are also hoping the Hank Paulson is going to give them an above market price). The more rapid the decline in home construction, the sooner we hit the bottom of the contraction. In short, not only is it good news that home construction is declining, but it is better news that home construction is declining faster than originally predicted.

Shock! Free Gov't Healthcare Had Bad Incentives

This is just an AP article, but I think it illustrates well the problems with offering free healthcare to certain citizens who "need" it for free. The state of Hawaii quickly figured out that providing free health insurance for middle class children was a bad idea. This also proves that President Bush's reasons for vetoing the SCHIP expansion was completely accurate when he said that it would encourage those with coverage to drop it in favor of the cheaper government subsidized health care.

"People who were already able to afford health care began to stop paying for it so they could get it for free," said Dr. Kenny Fink, the administrator for Med-QUEST at the Department of Human Services. "I don't believe that was the intent of the program."

State health officials argued that most of the children enrolled in the universal child care program previously had private health insurance, indicating that it was helping those who didn't need it.

The universal health care system was free except for copays of $7 per office visit.

Wednesday, October 15, 2008

Irrational Investors?

Today, I wanted to talk about something a little more philosophical. In the world of economics there seems to be quite the debate over people behaving rationally versus irrationally. We are told repeatedly these past few weeks that investors are behaving irrationally. That we humans are digressing into the primitive parts of our brains and basing decisions on emotion and not on reason. This is where I disagree. I do not think that irrational behavior is even possible.

First, let’s define rational and irrational behavior. If, like some seem to think, that rational behavior is based on facts and irrational behavior is not based on facts, then this makes it difficult for me to conceive of an irrational thought. Do investors panic for no reason at all? Is it merely a phenomenon where many people randomly panic and start to sell everything? Not likely. As has been the case in recent weeks, dark clouds have been slowly growing for months. People were acting on facts.

Now the retort will be that people oversold in the market, and that they were selling stocks whose true value is more than current prices. More simply, that people are acting on a limited number of facts, but not on the full truth. If the definition of rational behavior requires omniscience, this creates an impossible hurdle and no thought can be considered rational.

As an example, imagine that you are in the middle of a crowded theater and a teenage boy yells “Fire!” Should you race to the rear exit, or stay in your seat assuming the kid is just pulling a prank? I would say that either choice is rational depending on what you know. Is it irrational to flee a burning building? Is it irrational to ignore some teenager yelling “Fire!” when you can’t see it or smell anything? Neither is irrational given the information that you have at the time. If in reality there was an unlit exit at the side of the theater that no one else could see, this would not make the other thoughts irrational.

Many people invest without much knowledge of finance or economics. They generally stick to a few rules about their choices. Their brokers tell them to “buy and hold” and not to try to time the market. These are nice rules, but in 1929 in the U.S. and 1989 in Japan these were horrible strategies. It took 23 years for the DJIA to recover its losses and the Nikkei is less than a quarter of its 1989 high (was 38957 is ~9600).

What naïve investors often do is look at trends (i.e. they extrapolate). Extrapolation is a very important and rational approach to life, but it is a very inaccurate way to judge stock prices. If floodwaters are rising, extrapolation tells you to get the heck out of there. We don’t call people irrational because they didn’t know that a 5 inch rain event in their watershed would leave them 3 or 4 feet above the flood waters. When time is of the essence we have to rely on less information. This is rational and pragmatic.

In the long run, those who base their decisions on more precise techniques and more complete sets of information are going to make fewer mistakes, but all decisions are based on limited information and imprecise techniques. The difference between rational and irrational investing in the common lexicon is arbitrary. I conclude that irrational investing does not exist.

In essence, we have economists on the left trying to help protect those who are “irrational”. What they truly are doing is rewarding ignorance by taxing the prepared.

Tuesday, October 14, 2008

One Crisis Begats Another

Unemployment rates have been rising, which is unfortunate. I have lost my job before and I think that these people should do exactly like I did. Namely, mail out dozens of resumes, make phone calls, send e-mails, contact recruiters, and start looking at other cities where you might consider work. My wife was pregnant at the time, so I had a big incentive to quickly find another job. However, our unemployment insurance system eases the pain and lessens the incentive for many to quickly take another job.

Here in the United States we get a small percentage (bigger if you don't make much) of our previous salary for 26 weeks. Every week you have to file information showing that you applied for a certain number of jobs. In Germany, they have had an unemployment insurance system that paid 80% of previous salary for 2 years. They required no evidence that re-employment was being pursued by the recipient of funds. Not too surprisingly, America's unemployment rate hovers around 5%, while Germany's unemployment rate hovered around 9 or 10%.

Now, Barack Obama and Nancy Pelosi have both suggested that we extend unemployment benenfits and temporarily eliminate income tax on those benefits. CBS News quotes Obama as saying "we should extend expiring unemployment benefits to those Americans who've lost their jobs and can't find new ones." This summer, the Democrats added a rider to an Iraq War Funding bill that extended unemployment benefits by 13 weeks to a total of 39. Now, Obama is asking for an additional 13 weeks. What do you suppose will happen if we extend unemployment benefits? Higher unemployment? You are correct.

John Lott, whom I've had the pleasure of conversing with a few times, has an op-ed at Investor's Business Daily writes about the effects of the first extension of unemployment benefits driving up unemployment:

Indeed, dozens of economic research papers predicted this outcome. When you extend or increase jobless benefits, you extend unemployment. If you set a date certain for getting rid of benefits, people find jobs. You get more of what you subsidize, and here we are subsidizing unemployment.


For the benefit hike that just took effect, these research papers imply a rise in unemployment to 6.4% from 5.5% in June. So, for the next month or two expect to see repeated bad news from labor markets. Perfect timing for the Democrats for the election.

Now, if unemployment rises another 0.9% to 7.3%, what do you suppose the Democrats will do at that point? Almost assuredly they will use the high unemployment rate as an excuse to expand government intervention in the economy. Their cure for the "unemployment crisis" will only exacerbate the situation and the failed results will be used to justify even more market distortions.

It's Crisis and Leviathan.

Saturday, October 11, 2008

Jonathan Macey Nails It

Jonathan Macey, a law professor at Yale, absolutely nailed the cause of the market collapse in recent weeks. While the market was down, it was panic by the government that caused panic in the private sector. Your average American is not a market expert, so they take their cues from "qualified" individuals. When those that are supposedly in-the-know panic, we all panic.

Some excerpts:

Despite all the hard work and good intentions on the part of our public officials, when economists and historians look back on the current financial crisis they are likely to conclude that government intervention prolonged and deepened it. In particular, officials at the Federal Reserve, the Securities and Exchange Commission and the Treasury Department are to blame for publicly losing confidence in the very economic system they are supposed to protect.

The original Treasury plan -- which called for the transfer of virtually unlimited taxpayer dollars and unlimited spending discretion to Treasury with no judicial or congressional oversight -- sent a very bad signal to the markets. Instead of restoring confidence, this approach to the crisis instilled more fear and panic in the markets.

The Bear Stearns bailout, the restrictions on short-selling and the government's new $700 billion commitment to buy toxic mortgage-based assets all share the same fundamental flaw: They prevent the market from imposing discipline on banks guilty of massive over-leveraging and excessive risk-taking. Moreover, they punish prudent managers who invested conservatively, kept their companies' debt at reasonable levels and worked hard to raise new capital when necessary. The SEC's attack on short-selling punishes savvy traders who invested resources and effort in identifying companies with too much debt and unrealistically valued assets.

Preach on Mr. Macey, preach on.

Thursday, October 9, 2008

Book Review - The Forgotten Man, Amity Shlaes

Amity Shlaes, columnist for Bloomberg, has written an accessible and well paced book chronicling the myriad mistakes of Herbert Hoover, but more significantly, Franklin Roosevelt. While it didn't always dig into the deeper economic consequences with a more academic approach, there was still enough depth to weave a concise narrative of America's misteps during the 1930's. I would likely have torn through the pages of a libertarian polemic, but it was probably better for my blood pressure that she presents a more evenhanded presentation. However, do not fear that she wallows in any left wing apologetics. She does not coddle any of the actors in power.

If you are only vaguely familiar with the events before and during the Great Depression I would recommend picking up a copy. A paperback version is available here at Amazon.

My only warning is not to read this book right after reading Jonah Goldberg's Liberal Fascism and Robert Higgs' Crisis and Leviathan. In his speeches, Barack Obama might as well be quoting some pretty notorious people from the 1930's. It will scare the crap out of you.

Wednesday, October 8, 2008

Lies about AIG

Doing a little bit of research from my Bio, you would be able to determine that I am currently an employee of AIG. I am not an executive, nor do I even work in the division that set up the retreat. I am also not one of those odd individuals with immense loyalty to my employer. Having said that, there have been several news reports like this one. In the article they report the White House's comments on the events:

The White House said on Wednesday it was "despicable" that American
International Group Inc. executives spent hundreds of thousands of dollars on a
posh California retreat just days after getting a federal bailout.

The problem with the news story and the wildly inaccurate statements of Sen. Obama, is an enormous ignorance of how insurance is sold in America. Virtually every company that sells life insurance annually offers free trips to the agents that sell the most insurance policies. Think of those crappy fundraisers in grade school where you could get a Nintendo if you sold $5,000 in wraping paper. If an insurance company tried to skip out on these prizes we would likely lose our best sellers to other firms. If we can't sell our insurance products we go out of business. The ruckus compelled our new CEO to send a letter to Hank Paulson, Treasury Secretary. Employees received a copy of the letter at work, but I wasn't sure if it was meant for public distribution so I have not included it.

However, this link here provided an accurate description of the letter.

Executives did not attend the trip. The trip, while costing over $400,000 was attended by over 100 people. My job is in jeopardy, but I hold no ill towards those who attended this event.

Shoulda, Coulda, Woulda

How McCain could have trounced his way to victory.

As I watched the debate between McCain and Obama last night, I began to realize that if McCain had voted against the bailout he could completely slaughtered Obama. Had he kept his vote close to the vest and rebuked the bailout at the very end, it would have passed the Senate and likely the House, and Obama would be left holding the blame.

What we now know is that even with the bailout passing, the stock market has tanked anyway. It has fallen over 1200 points since the moment the bailout passed in the House (as of close 10/7/08) . The S&P has fallen almost 14%. McCain would have been called reckless, but with the stock market plunging even with it passing, it would be hard to defend the bailout with evidence. There would be some risks, but it would be a defensible position.

However, the rhetorical gain that McCain could have achieved would have been absolutely lethal. Obama would now be in a position of handing hundreds of billions of dollars to Wall Street to save the greedy and evil CEOs and “Fat Cats” he has been attacking for months. Any use of his class warfare rhetoric would blow up in his face. Tax hikes on the rich, but bailouts for the rich?

Adding to his maverick image, McCain could have stood out as a dogged defender of his principles. When the bailout failed the House, it was then sent to the Senate where it was loaded up with over $100 billion in “sweeteners”, i.e. Pork. Imagine the albatross hanging on Obama’s neck when trying to defend this monstrosity.

Imagine the comebacks…

“You believe that $700 billion is too much to help our troops win in Iraq, but it’s not too much for Wall Street fat cats?”

“Let me get this straight. He has $700 Billion for Wall Street, $800 Billion in new spending on top of a $500 Billion budget deficit, tax cuts for virtually everyone, and he’s going to balance the budget. Does someone have a calculator? I don’t see how this adds up. Because it doesn’t add up. You know it. I know it. He knows it.”

Grrrr…Shoulda, Coulda, Woulda

Note – I do not propose that these rhetorical points are factually precise, but Presidential campaign strategy demands generalities or you will be crushed.

Tuesday, October 7, 2008

I Don't Mean to Brag, but...

Since September 23, the S&P 500 Index has dropped over 11%. What’s interesting about September 23rd? Nothing, except that was the day that I decided to sell half of my stocks (which are almost entirely in S&P 500 index funds) and move the money into an interest bearing account. My strategy until that date was buy and hold. I have never tried to time the market, so why would I start on September 23rd? My faith in the free market led me to fear that the single largest intervention in the history of the American economy could only lead to stagnation in the stock market.

Let me explain in a little more detail, however, why I did not and do not like the bailout. The bailout, eh hem, excuse me, the “rescue plan” is specifically designed to attract capital away from successful uses and put it back into failing financial services firms. This misallocation of capital will slow the economy’s recovery.

The theory for the bailout says that panic set into the first circle of financial services firms and spread to other institutions. The panic would continue to spiral in a vicious circle until all commerce stopped and no credit would be offered anywhere. Those on the Left allege that this cycle of greed and bust is an endemic problem of an unbridled free market and could become permanent, holding the economy back for years and years. Washington, being beset by that other human frailty, panic, simply had to pass the bailout. Investors, seeing the brilliance of Congress, proceeded to pull money out of the market in droves, dropping the Dow Jones Industrial Average down 1,200 points in the next 8 hours of trading.

The problem that I have with the bailout thinking is three fold. To have a “credit freeze”, enormous amounts of capital must be withdrawn and hoarded metaphorically if not literally under the mattress. Eventually, people are going to use that capital again. People won’t forget how to make medicine, drill for oil, or program computers. The incentive to exchange what I can produce, but don't need today, for what you can produce and I do need today will still be there. The economy will go on.

Second, as the panic pushes prices down the opportunity to make a killing gets bigger. I suspect that if the Porsche dealer in town were panic selling Carreras at 20 cents on the dollar, I would not be the only person in line. Many of the “toxic” mortgage backed securities already offer fantastic rates of return with little risk if you hold them to maturity. Now the government plans to borrow $700 Billion from the public. To get us to lend them the money they have to convince us, with higher interest rates, that loaning them money is better than loaning money to other businesses. This moves capital away from companies with sound business models and moves it to those without sound business models. This decision to move capital away from good companies will slow economic growth and the rate of return available in the market.

Lastly, banks are not necessarily the best arrangement to help capital find its most productive use. With the advent of the internet, we have seen the demise of many a middleman. The music industry is in shambles because entertainers no longer need the lumbering distribution companies thanks to iTunes. Venture capital funds capitalize the tech industry in Silicon Valley, not banks. The next Google does not dress up and go down to First National of San Jose to get a small business loan. Even the news industry is dying because bloggers connect average people with news and ideas that need no filtration and distribution. If someone in Minnesota wants to find out about a news conference at a NASA, they don’t have to read a reporter’s opinion, they can watch it on YouTube. Innovation should not be stifled by helping the old guys stay in business.

Banks are inherently unstable by design. They guarantee a rate of return to depositors and then loan out the money to someone else. A bank invests on the margin, also known as leverage. Banks have a nasty habit of getting over leveraged leading even small panics to become meltdowns. Maybe banks should be allowed to fail because they are simply risky relics that have passed their prime.

You might ask, “How will companies who need loans get money? Where would I put my savings?” Just look at mutual funds. A mutual fund company doesn’t borrow and lend, it only recommends to average people where to put their savings (i.e. their capital) and then charges a fee for the advice and administration. There are hedge funds that allow individuals to lend mortgages directly to other individuals, skipping the whole mortgage bank model. Maybe financial experts should be giving advice instead of taking risks. If we allowed banks to fail the financial services industry might be forced to evolve to a more stable system. What have we chosen to do instead? We have decided to bailout the banks so we can keep doing things the way they have always been done. The bailout keeps the big banks big and status quo humming.

To help you wrap your head around this, let me use a metaphor from nature. When someone yells “Help, help there's a fire!” it's likely to send a chill down the neck of the steeliest men. For years, the forest service instinctively reacted this way trying to douse every fire. They finally realized, however, that nature needs those fires to clear out the dead wood, prevent disease, and allow the forest to bloom in new splendor. This bailout, like all meddling, keeps us loaded down with dead wood. It slows growth and reduces opportunities in the economy and the stock market.

Monday, October 6, 2008

2009 State Business Tax Climate Index

The Tax Foundation recently put out their annual state business tax climate index. I reproduced a graphic found in the pdf that sums up the findings.

HT: Club for Growth

Did Low Interest Rates Cause the Housing Boom? No.

Michael Spence, a 2001 Nobel Laureate for economics wrote a column for Forbes today. In it, he makes this spurious claim, as have a few others:

“One should ask why a housing bubble caused by low interest rates…”

His article “Will the Bailout Work?” goes on to defend the current narrative on the glorious bailout. The problem is that his above statement fails to match reality as I suspect he simply hasn’t done his homework.

This thinking is wrong. It fails to explain differences in geography and historical evidence that contradicts the logic in previous periods of falling interest rate.

Using national average mortgage rates, we find that prime mortgage rates were at a peak of 8.64% before the boom on May 19,2000 (which really began in earnest in 2001), and then hit an all time low of 5.21% on June 20, 2003. That seems dramatic, so let’s do the math. Assuming that all mortgages were at 8.64%, but were all refinanced at 5.21%. This would imply a 41% increase in purchasing power. That seems to correlate to the increasing prices, but let’s dig a little deeper.

The problem with this thinking is that it would imply no increase in the housing supply. People did not merely bid up the existing housing stock; they built new and bigger houses, remodeling older ones. Furthermore, increased purchasing power does not immediately drive up the cost of construction. In a city with ample supply of land and few development entanglements, there is no reason why an increase in debt purchasing power would be wiped out by a commensurate inflation in the price of building materials. Home construction is a very competitive market, and the price of homes should approximate the cost of construction plus a muted profit margin.

There is also the notion of cross-price elasticity. That is, when people gained debt purchasing power, many chose to refinance and pocket or spend the savings on other things. While this interest rate assumption may correlate well to housing price behavior in California, it doesn’t explain why home prices increases in Atlanta ran at a fairly smooth rate of 4% a year between 1991 and 2007 (S&P Case Shiller). Of course, in California, it also doesn’t fully explain why prices surged by 147%. In short, the cross-price elasticity effect would water down the effects of lower interest rates.

Another problem with this line of thinking is that significant drops in interest rates should have caused housing bubbles in the past. If mortgage rates dropped by 3.5% during the this decade, why wasn’t there a huge bubble after mortgage rates fell from 18% in 1981 to 10% in 1987? Or when they fell from 10% to 7% between 1990 and 1993? In fact, home prices in Los Angeles declined significantly between 1990 and 1993. There is little historical correlation between interest rates and housing price swings.

Explanations for the housing boom and bust:

Interest rate changes – Bogus

Greed – Nice and vague and conveniently impossible to measure

Deregulation – So far, I have seen few specific deregulations mentioned, so I will relegate this to ideological rhetoric until I see evidence

Government mandated sub-prime lending through the Community Reinvestment Act along with Fannie Mae and Freddie Mac – Bingo!

Local and state residential development restrictions that constrained the market and drove up prices – Bingo!

Friday, October 3, 2008

After the Bailout - Dow DOWN 470 pts

I added the area shaded in gray around the time the bailout passed at 1:22 pm.

I thought that the bailout was supposed to help the markets prevent a sell off. Oops! I guess the media got it wrong again.

Credit Crunch is a Farce - No to the Bailout!

I began to believe within the last few days that the "Credit Crunch" was an illusion, and the more I have dug the more I have come to the conclusion that the Crisis Does Not Exist. It is a false narrative told by those with vested interests and insular Wall Street viewpoints.

According to the FDIC, only 13 banks have failed so far this year. This compares to 11 in 2002, and thousands after the Savings and Loan debacle. We have yet to reach a level of bankruptcies to warrant dramatic action.

Looking at total bank lending according to the Federal Reserve, again I do not see contraction of loan activity as is claimed. Link here. Lending is flat over the last few months, but similar events happened in 2003, 2002, 2001, and 1999. Furthermore, Commercial and Industrial loan activity has not contracted at all. Link here. The press keeps claiming that businesses can't get loans. Between 2001 and 2004, Commercial and Industrial loan activity contracted by around 18%, but we have yet to see any fall in recent history.

Mind you, the links I provide only show data up until the beginning of August. However, Alan Reynolds has written a piece for Forbes that includes data up through September 17th. (Includes a nice table) He is coming to the same conclusion that I am.

If all the recent hysterical chatter about lending being "frozen" or "shut down" refers to anything real, it is not about banks loans (through Sept. 17) but about such arcane financial markets as asset-backed commercial paper or loans between banks. But this too is mainly about financial firms, not Main Street.
Adding to the case is anecdotal evidence from my hometown paper, the Houston Chronicle.

"It has not had any change to the way we offer and extend credit to our customers," Mike Poppe, chief financial officer for Beaumont-based electronics and home furnishings retailer Conn's

"Everything is the same," said Mike Even, Finger Furniture's general manager. "I don't see any changes anytime soon."

To top it all off is economist Alex Tabarrok of Marginal Revolution blog:
There is also a consensus among economists that the bailout bill is not the right policy. None of the above economists, for example, is enthusiastic about the bailout. My bet is that all of us think that the bailout has a substantial likelihood of failing. The support that exists is born out of hope and fear not judgment and experience. Nevertheless, the political consensus is that a bailout is what we will get whether it is likely to work or not. (bold is mine)
The above economist are: Paul Krugman, John Cochrane, Luigi Zingales, Douglas Diamond, Raghuram Rajan

The bailout will not work. The "Credit Crunch" is a farce. This is a Wall Street problem, NOT a Main Street problem. Encourage your Congressman to Vote NO to the bailout.

Update: - Unfortunately, it passed. Not good for the economy. What do we do in 3 months when the bailout clearly did not work.