Posts Tagged ‘panic of 2008’

Bad Ideas Result in Bad Outcomes

October 7, 2009

As regular readers know, I’ve been away from blogging for a bit while I’ve been in the middle of a job transition. In my month-long hiatus, it seems like little has changed: the health care debate continues, the deflation/inflation and economic outlook remains uncertain, and the stock market continues to “climb a wall of worry.”

As the immediacy of the financial crisis recedes, the question of what has brought us to our present state remains largely unanswered. Or rather, there are dozens of answers, not THE ANSWER.  Among the myriad causes that are put forth: the Fed, Wall Street greed, deregulation, excessive regulation, Chinese savings rates, the Democrats and the Republicans. In past posts, I’ve added my 2 cents by pointing to the culture of “overspeculation.”

Fundamentally, bad outcomes are generally the result of either bad luck, bad ideas, or some combination of the two.  It may well be that the “bad idea” from which our financial upheaval arose is the belief that homeownership is an unequivocably good thing.  I came across a prescient 2004 article in BusinessWeek that outlined some of the reasons why home ownership is not as advantageous to the poor:

  • a house is often a poor family’s sole investment: concentrating their assets in an a vehicle that combines the historically lackluster long term returns of housing with the high risks of leverage
  • the poor have a higher “cost of carry” in home ownership than the wealthy, because they often pay higher interest rates and their lower tax rate reduces the effective subsidy of a mortgage deduction
  • while a mortgage was once considered a means of “forced savings,” the growth of easy-to-obtain home equity lines, interest-only and negative amortization mortgages all have negated the (already dubious) savings argument

British economist Andrew Oswald has noted the correlation between high unemployment and high home ownership.  Although more recent work has created a more nuanced interpretation of that relationship (good overview in a Slate article here), this “Oswald Hypothesis” clearly has at least a grain of truth.  The theory argues that home ownership makes people “sticky” geographically, and therefore less likely to move to find a job or better employment.  This may be particularly true for the poor given that “borderline” housing is typically already less liquid than homes in upscale neighborhoods, further reducing labor mobility.  This lack of salability in poorer neighborhoods is particularly acute in economic downturns, just the time when geogrpahic flexibility for workers is most important.  

Those who defend policies that promote broader home ownership often point to social benefits — homeowners have a sense of “skin in the game” of American society.  These arguments are no doubt true and important.  But the advantages of reinforcing such a sense of inclusion should be weighed against the costs.   Moreover, there other ways to promote engagement with community without the consequences attached to distorting housing market incentives.

This is not necessarily to argue against such incentives for home owners.  Certainly, I and many others personally benefit from many of these.  But every policy that distorts market mechanisms has consequences, many of which are unintended and adverse.  We may not yet be through thoroughly testing the “Oswald Hypothesis.”  If that theory is correct, current real estate conditions, whereby many homeowners have negative equity, will make labor mobility particularly poor this cycle.  This, in turn, would suggest particularly intractible rates of unemployment and consequent sluggish economic growth.  If blind faith in the “goodness” of high home ownership rates is indeed a bad idea at heart, we may not yet have seen all the corresponding bad outcomes.


Farewell, TED… See you again?

May 28, 2009

I’ve written a few times about the TED Spread (e.g.,  here), that historically reliable indicator of systemic risk.  I’ve updated the chart:

The TED Spread: 3-month T-bill vs. 3-month Eurodollard Deposit (LIBOR)

The TED Spread: 3-month T-bill vs. 3-month Eurodollar Deposit (LIBOR)

The TED spread has now returned to about 50 basis points, levels I would associate with the “normalcy” that preceded the Panic of 2008.  There was always a question as to whether the TED would return to such low levels or would forever reflect some kind of unforeseen-event-risk (the “fat tail” of the probability curve that’s been much discussed in the trade).  Cynics might argue that the TED returning to such low levels shows that market participants have learned nothing from the financial system’s upheaval.  I prefer to see this as a recognition that the U.S. government does have the will and power to prevent a systemic meltdown (obviously, there are costs involved).

The TED’s narrowing is good news for the economy as it typically leads other credit spreads and allows the Fed to once again be in control of short-term interest rates.  In this low rate environment, this translates to lower interest rates for borrowers, starting with adjustable rate mortgages tied to LIBOR.  Corporate borrowers using short-term instruments are also direct beneficiaries.  Those who borrow at longer term rates have a mixed picture — higher Treasury yields but narrowing credit spreads — by and large, the credit spread factor is now the more important ingredient so those borrowers are beneficiaries. 

I’ve now been following the TED Spread for 23 years.  For many, many years, the wisdom was that “the TED is dead,” forever locked in a narrow range (call it 30 to 50  basis points).  I, like many others, simply stopped watching this important intermarket relationship.  Has the TED gone back to this dormant state?  I’m not so sure.  For one, the TED has historically been impacted by the general interest rate level — that is, the higher the interest rate environment, the greater the TED spread, even given the same perceived credit risk.  Given the inflationary forces that the monetary and fiscal stimulus may unleash, I can easily envision a scenario where the TED widens on the back of Fed tightening.  Moreover, our ability to successfully fend off a financial meltdown was partly due to the flexibility available in an environment with relatively manageable levels of government debt and limited inflation.  Our ability to fix an unforeseen future crisis may be constrained by the costs of the policies we’ve employed to address the current situation.  Given the advance warning the the spread signaled in 2007, I’ve made a promise to myself to keep an eye on the TED Spread for the rest of my career.  I wish I could say, “goodbye” to TED, but fear it may really just be, “au revoir.”

Addressing the Compensation Issue

December 1, 2008

Regulators have an enormous challenge ahead.  It’s relatively easy to formulate rules that will prevent a repeat of this specific crisis.   However, it is unlikely that Wall Street would make the identical errors in our lifetime.  The regulatory reformers are charged then with two major tasks: 1)preventing the type of mass loss of judgment which we saw, and 2) should that fail, limiting the damage done.  Both are dismayingly complex, but the more the first can be accomplished, the less the second will be needed.

There’s no doubt that the compensation system of Wall Street played a role in bringing about the Panic of 2008.   Regulators seeking to prevent the next crisis of systemic risk must address Wall Street’s bonus culture.  Salaries are an extremely small portion of the total compensation of even mid-level managers at these firms.  I knew many $1MM+ earners whose salaries were less than 15% of their total comp.  This orientation to “performance pay” skewed employees towards risk-taking, particularly because the easiest metrics were financial measures — profitability prime among them.  Employees were paid for immediate financial results, not long-term prudence.  This created an incentive to “swing for the fences” in risk-taking, particularly since it was the shareholders’ capital at stake, not their own. 

Various firms have sought to incent longer-term thinking by including restricted stock and stock options in the compensation mix.  While this has some benefits, employees still are biased to what puts money in their pockets short-term, so more innovation is needed.  UBS has taken a stab at correcting this problem by deferring portions of employee bonuses and tieing them to future consequences.  A bonus earned this year might be lessened by results next year.  While there are numerous deficiencies to this approach, it is a step in the right direction, and one worthy of praise.

The real challenge is to get universal industry buy-in to such an approach.  Otherwise, firms trying to rein in compensation will simply lose their best employees to less responsible firms.  Intra-industry cooperation risks charges of collusion, so this may be an area where regulators must take the lead.

A Bailout Too Far?

November 28, 2008

A Reuters story from Wednesday on the Citigroup bailout caught my eye.  The reporter interviewed commuters at New York’s Port Authority bus terminal for opinions on the recent government support program for Citi.  While only a random sampling, there was a great deal of hostility toward the initiative.  This is particularly surprising since Citigroup is the second largest employer in New York City.

The huge sums thrown at Wall Street, the vision of a bailout for Detroit, and the prospect of a potentially endless stream of industries with their hands out, is all starting to alarm taxpayers.   I think “Bailout Fatigue” is setting in rapidly.   By and large, this is undoubtedly a good thing.  The Federal government may (or may not) need to inject more money into the economy, but any future infusion should not be biased towards assisting the weakest companies and industries.  The initial TARP package may have been necessary, but that doesn’t mean it was a “good” thing — just necessary.  Extending assistance in cases where it is not an absolute necessity is just a bad idea.  The American taxpayer understands this — will our policymakers?

A Calendar of Crisis

November 25, 2008

It’s hard to believe but it has been less than 3 months since the Federal seizure of Fannie Mae and Freddie Mac.  It has been difficult to keep up with the speed of the events, but the Washington Post has a handy, if depressing timeline.  Not for the faint of heart.

Doomsayers Getting Bad TIPS

November 18, 2008

Nouriel Roubini and other prominent economists have argued for aggressive measures to head off an impending deflationary disaster.  As evidence of this looming threat, these doomsayers are pointing to the yield on 5-year TIPS (Treasury Inflation Protection Securities) relative to the yield on 5-year traditional Treasury notes.  TIPS typically offer a lower yield than conventional bonds because they also adjust both principal and interest payments with inflation; the adjustment factor, which changes daily and is based on the CPI, is known as the index ratio.  The difference between equivalent maturity TIPS and conventional treasuries is said to be a measure of the market’s expectation for inflation.

For several weeks at least, the traditional relationship between TIPS and conventional treasuries has been inverted.  TIPS actually yield more than government bonds with fixed interest rates.  Roubini has been vocal in identifying this as a critical piece of evidence: “the TIPS market is now signaling that investors expect inflation to be negative over the next five years, as a severe recession is ahead of us.”  Although Roubini’s economic outlook may, or may not turn out to be correct, he is wrong to point to TIPS as evidence of a long-term deflationary trend.

What the doomsayers are missing is that TIPS may anticipate expected changes in price levels in different ways.  To start, the crucial index ratio by which TIPS are adjusted lags actual CPI by three months.  Sophisticated market participants therefore know with certainty what the index ratio will be in three months.  In most environments, the rate of consumer inflation varies little over a 3-month period and would have little impact on the “inflation reading” offered by TIPS.  However, we live in unusual times. 

The collapse of commodity prices has changed this game dramatically.  The current TIPS index ratio, because of the 3-month lag factor, is tied to a CPI that is likely to be close to the high water mark for some time.  Regardless of whether we have a sharp recession or a shallow recession, the CPI will come down as the sharp decline in commodity prices filters through to the CPI.  The chart below shows a five year history of the CRB futures index, a good proxy for commodity prices.  Buyers of TIPS know with near certainty that the CPI will decline over the short term to reflect today’s reality of lower commodity prices.   TIPS pricing must reflect today’s knowledge even though one of the technical aspects of their structure, the index factor, is based on information known to be outdated.  A proper analysis needs to incorporate this dichotomy.

Reuters Jefferies CRB Index

With the insight and collaboration of my friend, economist Stan Carnes, I analyzed both the much-discussed 5-year TIPS, as well as the 10-year security.  In each case, we made one critical assumption, namely that the index ratio would reflect a CPI that will have declined by 6% over 6 months.  Given commodity prices have reversed over half a decade’s gains in a matter of months, this seems if anything, a conservative assumption.  Holding the dollar investment in TIPS constant, we adjusted the current index ratio down 6%, set the date forward by 6 months and solved for yield (prices as of 11/14/08).

The 5-year conventional treasury (2.75% of 10/13) yielded 2.33%, while the 5-year TIPS (0.625% of 4/13) yielded 2.41%, on the surface suggesting a long-term flat/deflationary outlook.  However, making the above commodity-linked adjustment to the index ratio and looking out 6 months, the 5-year TIPS yield is 1.28%, suggesting a more realistic long-term inflation expectation of 1.05%

Going through the same exercise with the 10-year securities shows a similar, if less dramatic pattern.  On the surface, the comparison between TIPS (1.375% of 7/18) yielding 2.84% and the conventional note (3.75% of 11/18) yielding 3.74% appeared to suggest a very low inflation rate of 90 basis points.  Adjusted by the same hypothetical 6% drop in CPI over 6 months, the TIPS yield is 2.43, implying a higher long term inflation rate of 1.41%.

This analysis, particularly for the shorter maturity TIPS, is sensitive to assumptions regarding expectations of the impact of today’s lower commodity prices on CPI over time.   To the degree the expected adjustments to the index ratio are greater, the larger the actual implied inflation rate.  In addition, the 5-year comparison may also be skewed by the general flight to quality and liquidity which has beset the short end — this would no doubt lower the conventional bond yield more than the TIPS, further distorting the apparent “deflation” reading. 

Regardless of these technical aspects, the point is that TIPS are not clearly signaling frightful deflation.  Based on reasonable expectations, the TIPS/Treasury inversion can be seen as a reflection of today’s commodity prices rather than tomorrow’s deflation.  Before our policymakers embark on the type of fiscal spending spree that true deflation might warrant, we need to get our facts straight.

James Grant understands Wall Street

November 18, 2008

James Grant has been a keen observer of the financial markets for decades.  Bloomberg Radio did a brief interview with him, excerpts of which were printed in the October 2008 issue of Bloomberg Markets magazine.  For those who couldn’t understand how so many smart people could act so recklessly, creating our financial mess, consider Grant’s insight:

“Wall Street firms are not really businesses as we know business.  They are not in a pharmaceutical trade.  They’re not in the metal fasteners line.  They are in the business of generating bonus revenue for themselves.  That is their line of work.  And to do this, they take extraordinary risks with astounding amounts of financial leverage.”

Roger Babson updates us on Panics (dateline: 12/25/1910)

October 30, 2008

While doing some research on past market “panics,” I came across a wonderful article in the NY Times archives, written by Roger Babson and published on December 25, 1910.  Babson, the founder of Babson College, was a pioneer in keeping market statistics and financial history.  He wrote a series of articles outlining the path of recovery from prior panics — following in the wake of the Panic of 1907, this was no doubt a hot topic.   The article detailing the recovery from the “Panic of 1837”  is available online (click here, and a pdf file will open).  This is a great reminder that, although in distant memory, we’ve survived panics before, just as we’ll survive today’s.   And speaking of keeping perspective, the year the article was written, the Dow Jones Industrial Average was still below it’s 1906 peak and had fallen 17.8% over a volatile year — ending at 81.36 — today the market closed at 9,180.69.

 This article caused me to look up the bio of Roger Babson, of whom I knew nothing — his is a wonderful, and very American, story of entrepeneurship, overcoming adversity, and generosity — found here on Babson College’s website.

Anna Schwartz Schools Hank Paulson

October 27, 2008

Anna Schwartz is the co-author with Nobel laureate Milton Friedman of A Monetary History of the United States, one of the most important economic treatises to be written in the last century.  The book is absolutely critical to our understanding of the Great Depression and the role that poor monetary policy played in turning a market downturn into an economic debacle.  To be honest albeit crass, I thought she was dead.  Professor Schwartz appears in this week’s Barrons (subscription required) and at age 92 is very much alive and (intellectually) kickin’. 

She takes great issue with the government’s response to the current crisis: “It’s like there’s a bunch of guys that are making it up as they go along. They talk about transparency and what they present is opacity, programs that don’t make sense, or are not yet fully laid out. This only increases the already high level of uncertainty and anxiety.”   Prof. Schwartz further highlights the inflationary risks in the current approach: It’s like the only lesson the Federal Reserve took from the Great Depression was to flood the market with liquidity. Well, it isn’t working. Professor Friedman would have enough stature to get them to listen and stop pooh-poohing any notion of possible inflation.”

One more point caught my attention.  Schwartz lamented the demise of the Shadow Open Market Committee, a private group of academic and industry economists that issued critiques and alternative policy prescriptions to the Fed.  My own experience in Washington this summer taught me that our regulators could use more citizen advisory panels instead of relying so heavily on industry input and lobbyists.

Brava, Professor Schwartz!

How Could They? – Foreign Edition

October 27, 2008

One of the aspects of the financial crisis that caught me off guard was the widespread exposure of foreign banks to the U.S. subprime market.   A close friend who worked in fixed income derivatives for a major U.S. institution told me it was a simple, 3-point sales pitch: a) “These are rated AAA,” b) “they yield more than Treasuries,” and c) here’s the money quote- “We investing alongside you, putting this on our balance sheets too.”  Ouch!  So a key aspect of the pitch was essentially an admission of building systemic risk — “we’re all in this together.”  This should give pause to those who believe that requiring issuers to retain a portion of every securitized deal will be a cure-all;  Wall Street is a sales business at heart, and the best salesman always believe their pitch.  With many mortgage-backed securitizations, retaining interest in the pool was not a solution, but part of the problem.  There’s an interesting story on Bloomberg today which goes into greater depth on this important story.  The title gives you a sense of where the author is coming from: “Evil Wall Street…”