Where does the IMF stand in the world's financial pecking order?

Apparently, one notch below a middle-tier, but prestigious, investment bank (see here).

Not good news given the real potential (albeit small) for a worldwide financial meltdown.

Johnny Biofuelseed's free lunch

It's certainly understandable that in a time of $100 a barrel oil many laud the promise of biofuels. Yet, Ricardo Hausmann, an economist at Harvard's Kennedy School of Government is guilty of overstating the case for them. For instance, he boldly claims the following:

Peering into the future seldom produces a clear picture. But this is not the case with bio-energy. Its long-term impacts on the global economy appear to be pretty clear, making many long-term predictions quite compelling, including the demise of the price-setting power of the Organisation of the Petroleum Exporting Countries and the end of agricultural protectionism.

While no one can deny that biofuels will be part of tomorrow's energy mix, that's a stretch. Let's begin with the following claim:

Second, the world is full of under-utilised land that can grow the biomass that the new technology will require. According to the Food and Agriculture Organisation, the world has a bit less than 1.4bn hectares under cultivation. But using the Geographic Information System database, Rodrigo Wagner and I have estimated that there are some 95 countries that have more than 700m hectares of good quality land that is not being cultivated. Depending on assumptions about productivity per hectare, today’s oil production represents the equivalent of some 500m to 1bn hectares of biofuels. So the production potential of biofuels is in the same ball park as oil production today

It is very unseemly for an economist to claim that there's a free lunch to be had. After all, why is all that land being underutilized? Maybe there are good reasons for that! It's not as if there's a shortage of land hunger in those countries. Also, let's not forget the inconvenient truth that some of that land is bound to be forested and turning into cropland is, shall we say, not an attractive proposition given our climate change worries.

Let's check out another of his claims:

Fifth, the increase in the price of agricultural land and of food will relieve governments from the current political pressure to protect the agricultural sector. Governments that, as a consequence of the land glut, have been protecting and subsidising farmers will see them grow rich either because they “plant” biofuels themselves or because other producers switch into them, lowering the supply and increasing the price of other crops.

The man clearly underestimates the power of the agricultural lobby. Even at today's high prices, farmers and big agro firms are set to push through a massive farm bill that leaves subsidies intact.

And last but not least, Hausmann dismisses the impact of higher food prices by saying that will create pressures to liberalize agricultural trade. Maybe. But it's not at all clear that liberalization would lead to lower prices, specially if, as he argues, subsidies are reduced. Let's not forget that even if a biofuel boom leads to higher rural incomes overall, some groups will be net losers due to high food prices, like landless agricultural workers.

Why come down so hard on Hausemann? I'm not against biofuels. But overselling their promise will lead to unnecessary policy mistakes, with long-term negative consequences. Yes, it's certainly worthwhile to promote R&D in this area, but subsidies, mandates and tariffs should not be used to promote their use.

Is PetroChina really worth 1 trillion dollars?

That's the firm's market capitalization as implied by its price in the Shanghai bourse following its IPO there (see here). But the price of its NYSE-quoted ADR's gives a market cap of "only" 398 billion.

This, of course, is the result of capital controls in China, leading to what is probably the biggest case of segmented markets in history. Of course, this is just a degree of insanity quibble, as there's no way PetroChina is worth a cool one trillion.

After all, ExxonMobil has three times the revenues PetroChina has, and twice its net income. Even if China keeps growing at its current rate, that's a big gap to overcome (and lets not forget the bulk of those profits come from upstream activities, which grow slowly if at all).

Employment: Bear trap

Stephen Colbert would be pleased by the pain the employment figures have been inflicting on bears. The October figures were impressive, posting a 166,000 gain in payrolls, nearly twice the level that economists were expecting.

I should stop here, but my inner grizzly won't let me. So once again I resume my hopeless crusade and take issue with some numbers, particularly those related to construction employment.

Construction is a study in contrasts. Residential building has collapsed, with real investment falling 23% between its peak in the 4th quarter of 2005 and the past quarter, with no improvement is sight (it fell 16.4% in 3Q07 versus the year-ago period). In the same time frame, non-residential construction investment has risen steadily, a total gain of 24.5% (and 13% versus 3Q06). But given the fact that residential construction is larger than its counterpart, total construction spending has fallen over 10% over the last 8 quarters (and 6.8% in 3Q07 vs 3Q06).



And yet, total construction employment rose 1.4% between the 4th quarter of 2006 and the past quarter. During this period, residential construction employment (including contractors) fell only 3.1%, while non-residential construction employment jumped 5%. In other words, one fell very little and the other didn't rise as much as it should have. The same holds over the past year.



This graph plainly shows that the response of employment to the fall in construction investment has been remarkably muted by past standards. This is and remains very odd, in a good way, but odd nonetheless.

Economic sugar rush and other treats

Well, there's no denying that the third quarter GDP advance was pretty impressive, with growth coming in at an annualized 3.9% rate. I don't want to put a bearish spin on the numbers, so let's start with the positives:

1. Consumer spending: The 3% annual growth rate is very solid. Based on modest employment growth and rising compensation, it was strong across the board. There's no sign that consumers are slowing down due to lower home equity.

2. Investment: Residential investment is still dismal, contracting at a 20% annual rate. But nonresidential construction is going very strong (12.3% growth) and equipement and software investment posted its best showing since the 1st quarter of 2006.

3. Net exports: Real export growth was a blistering 23%, more than offsetting an uptick in imports.

4. Government expenditures: They made a positive contribution by rising 3.7%.

Now, let's look at the caveats:
1. Inventories grew very strongly, adding 0.36 to the 3.9% growth rate, which may be a modest drag on growth looking forward.

2. Residential investment will fall some more and nonresidential construction has grown at what looks to be an unsustainable pace, specially considering faltering corporate profit growth.

3. Export growth looks too high, although the dollar's fall will make net exports a key contributor to growth for the near future.

4. Federal defense outlays jumped 9.7%, also an unsustainable rate, although this variable is extremely volatile.

The end result is that the 3.9% growth rate will probably be revised down. However, the underlying rate is quite likely above 3% which is still a good result. Last year's 3rd quarter GDP advance orignally came in at 1.6% and ended up revised downwards to 1.1%.

Where does all this leave us looking forward? Yesterday's 25 bp cut in the fed funds rate certainly was a signal that a significant slowdown lies ahead. How deep will it be?

The most recent analyst survey, from The Economist, places 2007 GDP growth at 2%. This would imply, given the current numbers, a contraction of 0.3% in the fourth quarter. Ouch. Given the margin of error and the fact that this year's forecast might be raised a bit, my guess is that 4th quarter growth will come in flat. The Fed is buying insurance against the possibility of the coming slowdown becoming entrenched.

As to 2008, it all depends on the consumer. So far, they have shaken off the twin blows of rising energy prices and falling home values. It seems they believe these are temporary phenomenons and are set on waiting them out. This will continue until it stops and it's impossible to forecast when that will happen (if at all). The key, in my opinion, lies in the labor market. If job growth falters, things will get uglier very fast.

The junkie's lament

Forgive me, for I'm about to rant. But I, Internet junkie that I am, can't help it.

I'll be blunt. Why do bloggers and MSM publications keep talking to and giving space to people who spout total nonsense? I don't mean opinion blowhards, although god knows there are way too many of them. My peeve is against pundits who say/write things that are objectively, evidently, painfully wrong.

The object of my wrath is this interview of Newt Gingrich by William Saletan in Slate. One paragraph is enough to illustrate my point:

The problem with regulation and taxes, he argues, is that they drive business overseas. Our auto emissions standards shift car sales to foreign manufacturers. European carbon caps push industries to Africa. But Gingrich is cursed with a brain that can see the big picture. He recognizes that overfishing, for example, requires collective action, since one or two countries can ruin the ocean for everyone. We have to think of the whole planet, he observes. Which raises the question: If undercutting by other nations foils unilateral regulation, isn't multilateral regulation the answer? Business can't flee emissions caps in one country if the same caps apply elsewhere. To this question, Gingrich clarifies that he's not against international remedies, as long as they're "functional."

It's amazing. The man reels of three, count them, completely false statements in a row, followed by several painfully obvious observations masquerading as profound insights. European carbon caps driving industries to Africa? I still can't believe I read that.

Don't get me wrong. I'm not angry at Gingrich. In a way, I admire a man who, being little more than a pompous nitwit, manages to convince others that he's a profound thinker. I guess that's what narcissism can do for you!

But how is it possible that the interviewer let all of this pass unquestioned? And how did an editor publish this?
Sigh.

Home prices are irrelevant!

So argues Willem Buiter, a well-known monetary economist, in his FT blog. Why? The answer is that people usually live in their own house, hence:

As long as your endowment is positive, your wealth obviously increases when the house price increases. However, an increase in house prices means that the present discounted value of future rents has increased. As a consumer of housing services, now and in the future, you are therefore worse off. On average, in a country like the UK, people consume the housing services they own. Hence an increase in house prices does not make them better off. For financial assets like equity there is no corresponding “present discounted value of future equity services consumption” whose cost increases whenever the value of equity goes up. An increase in stock market values therefore unambiguously makes you better off.

But as regards house prices, regardless of whether a change in price is due to a change in risk-free discount rates, in risk premia or in expected future rents, you are neither better off nor worse off as a result of that price change, if you consume, now and in the future, the same contingent sequence of housing services whose present discounted value is part of the wealth you own. In that case, despite the increase in your housing wealth, once you have paid for the consumption of your initial contingent sequence of housing services, there will be nothing left to spend on anything else.

Great! So today's news of deepening falls in house prices in the U.S. can be happily dismissed. Move along, nothing to see here.

Back to reality, this is one of the most striking examples of ivory tower airy-fairy thinking I've come across in a while.

Now, Mr. Buiter's argument hinges on house prices being equal to the present value of future owner-equivalent rents. This simply does not hold up in real life. Judge for yourself:



There are many reasons for this. But in essence it comes down to the fact that people believe housing is real wealth. How else can one explain the decline ins the personal savings rate to almost zero in recent years?

So, yes, house prices do matter. How much? We'll find out soon enough.

Oil reaches $92 after Iran says "Boo!"

Attributing every single rise in the price of oil to some minor Middle East-related event has become one of the most tiresome parlor games in financial journalism. What's driving the jump in oil prices is supply and demand. Jim Hamilton of Econbrowser explains this eloquently.

Housing: Hope springs eternal

Today we learned that new home sales rose 4.8% in September. As was to be expected, many folks see this as a sign that housing is turning the corner. Needless to say, this is more a dead cat bounce than a true rebound. As this graph shows, similar monthly bounces have been registered in the recent past during the course of a dreadful secular collapse.

As Barry Ritholtz points out, the rise is not statistically significant and that compared to year ago levels, new home sales in September were 23% below the year-ago level.

Of course, we should also keep in mind that existing home sales --which make up the bulk of the residential market--fell 8% in September and are 19% below the year-ago level.

As for prices, both the new home and existing home sale median prices are not reliable indicators, as they're not seasonally adjusted and are affected by changes in the type of housing unit sold. Also, builders have so far resorted to incentives like free plasma TV's and the like to promote sales rather than price cuts. Clearly, the stickiness of prices has made sales volumes bear the brunt of the downturn.

Yet another shocking China fact

A year and a half ago, only one Chinese firm (Petrochina, at number 16) was included in the list of the 20 largest firms by market value (see here). As of mid-October, that proportion had risen to 8 out of 20, including 3 out of the top 6 spots.

While Facebook may have a crazier valuation, the sheer scale of the Chinese market's rise is breathtaking.

The socialist take on Merrill's writedown

I don't have much to add regarding Merrill Lynch's 8.4 billion bloodbath. But the good folks over at the World Socialist Web Site have been reading the Asset-Backed Alert Newsletter (I kid you not) and pass along a very relevant nugget of information:

While according to ABAlert, what Merrill did with investments in the subprime market estimated at $15 billion is not yet known. “One often-cited theory is that the bank transferred the banged-up investments from an available for sale account within its brokerage unit to a hold to maturity portfolio at affiliate Merrill Lynch Bank in late June.

“Such a move,” the article continues, “would have enabled the company to follow friendlier accounting procedures, since the contents of the for-sale portfolio must be marked to market [assigned a value based on what they would fetch at current market rates] on a routine basis and the values of assets in the hold book don’t have to be updated until they come due or are sold.”

“Thanks to this accounting maneuver, Merrill posted second quarter earnings that were stronger than expected,” according to ABAlert. Moreover, “The institution reported last month that its profits surged by 31%, to $2.1 billion, during the April-June stretch.”

Merrill is the largest underwriter of CDOs, or collateralized debt obligations—securitized debt instruments into which subprime mortgages are bundled together with other asset- and mortgage-backed securities. The global market in CDOs has soared from $160 billion in 2004 to half a trillion in 2006.

Merrill is by no means the only firm resorting to accounting ploys to hide losses. ABAlert reports that “Citigroup has been making moves resembling Merrill’s. The same goes for Lehman Brothers and Morgan Stanley,” who are also hunting “for internal accounting maneuvers that can lessen the impact of the market dislocation.”

The monies correspond to multi-billion dollar mark-to-market accounts opened by the major investment banks in their role as “warehouse lenders for unaffiliated CDO issuers. The plan was for the issuers to utilize the temporary lines of funding to build up inventories of subprime-mortgage securities that could serve as collateral for future CDOs, and then use the proceeds from those offerings to repay the banks. But as the subprime-mortgage business headed south in recent months, so did the issuers’ ability to complete new CDOs,” ABAlert said.

The move raised questions about the legitimacy of Merrill’s accounting procedures and “outsiders have been plumbing into the financial statements of those institutions, among others that somehow managed to avoid reporting losses, for clues about where they’re stashing the assets and what the true effect on their financial health might be.”

Furthermore, the ABAlert report sounds an alarming note regarding the “growing urgency by investment banks... to minimize the impact on their businesses or at least dress up their books.”

I must admit that this analysis explains recent events. Investment banks swept toxic securities under the carpet hoping that the whole subprime thing would blow over quickly. Interestingly, this clearly was an open secret and clearly the market freeze shows that suspicions about where losses lay were not mere paranoia.

Now the question is whether the banks have come clean. Chances are that they have reported a good chunk of their losses, although measurment issues may delay a full reckoning. However, by having held off on reporting losses for so long they may raise the levels of uncertainty and thus make the situation worse (at least compared to a scenario where they would've reported losses gradually as they happened).

Joe Torre, executive pay martyr?

Is executive pay destined to rise ever higher? The Economist's Business.view column thinks so and they turn to a rather unusual example, Joe Torre, the New York Yankee's former manager, to make its case.

To recap, Torre quit after a long, successful tenure (although his team hasn't reached the World Series for six years) after the Yankees organization offered to extend his contract one more year, reducing base pay but offering generous performance-based incentives. Torre called it an insult and quit.

The column argues that:

....Once a pay level has been reached, it becomes a minimum. Mr Torre may still have been the best paid manager in baseball under the new contract, but he would not have been as well paid as before. He is already wealthy and successful. He needs the extra money less than he needs respect—much like the typical boss of a big company after a few years in the job.

Perhaps the Yankees had decided that they really did not want to retain Mr Torre, but also did not want to be the target of abuse from supporters for firing a popular manager. So they hit on the brilliant reverse—“Godfather” strategy of making him an offer he was bound to refuse. But if they did want to keep him, they should have realised that the only executive who is likely to accept a pay cut is the one you don’t want to keep.

The same may be true when it comes to hiring a replacement—the best moment, in theory, to ratchet down excessive pay levels relatively painlessly. Of course, there is nobody available with a record like Mr Torre’s, so a little pay-trimming will be hard to quibble with.

But what self-respecting manager would settle for a pay package significantly less generous than his predecessor’s? Even if the market for executives functions better in future than in the past, when it comes to pay, the only rational way is up.

This just doesn't make any sense in any context. Here's why.

It's simply not true that a new CEO will demand, and earn, as much as a successful predecessor. GE provides a good example. This is just common sense. What high executive would not jump at the chance to run a firm even if he didn't earn as much as the previous CEO? Let's keep in mind that the gap between a CEO's pay and that of his top lieutenants is huge, so a CFO climbing to the top rung will make much more, even if pay at the CEO position is cut.

The main problem with executive pay is that incentives are not meaningfully aligned with actual performance. As a result, underperforming CEOs (which logic dictates are 50% of the total) are usually paid way too much. In that sense, true compensation reform would probably not penalize success, but rather avoid rewarding failure.

Now, the tricky bit is measuring performance, which is difficult even in baseball, the most statistically-centered sport. How much of the Yankees remarkable success over the past 10 years is attributable to Joe Torre's coaching compared to the team's overall talent level? This ultimately involves some judgement calls, although the sabermetrics crowd has developed valuable objective indicators to measure this(see here and here). It's high time boards used similar methods to set executive pay.

As for Joe Torre, this argument sounds about right.

NY Times falls victim to Woody Allen Syndrome

The famous NY-centric director has a deep, long-standing dislike of all things California. Apparently and not surprisingly, so do the editors of the NY Times.

Look at today's front page. The three top stories are:
-Reports Assail State Department on Iraq Security
-U.S. Prosecution of Muslim Group Ends in Mistrial
-In Iraq, Conflict Simmers on a 2nd Kurdish Front

The first two are newsworthy items for sure, but not exactly of earth shattering importance. The story about the Kurds -placed in the most prominent position-is not fresh news and sounds more like Sunday paper fodder (although I must admit that the Kurdish guerillaette in the picture is pretty hot).

In the meantime, massive fires burn unabated in Southern California, destroying thousands of homes and forcing the evacuation of hundreds of thousands. Were does the Times inform us of this? As an item at the "INSIDE" box at the bottom.

Unmatchable as an example of obnoxious New York snootiness. Needles to say, all the other national papers do lead with the wildfires story.

Fed cut almost a done deal

That is, according to options on the federal funds contract. According to the Cleveland Fed's model, the probability of a 25 basis point cut is about 57%, while a 50 bp cut is assigned a 16% probability and the no change option is given a 26% chance.

It's worth noting that there was a dramatic shift in perception last week. The 25 bp cut's probability rose about 33 percentage points, while the 50 bp cut's odds rose by 13 percentage points.

Inflamatory question of the day

Why are almost all houses in the U.S. so similar? This has nothing to do with the real estate market, but with their layout and materials. From Maine to California, the typical home, built out of flimsy wood and stucco, is very similar (it seems almost centrally planned) regardless of climate or other considerations.

I ask because I live in San Diego and, while in no danger, I've seen on the television countless homes burn in minutes. Southern California has always faced severe danger from wildfires. Yet, houses are built in a manner that makes them highly flammable. Maybe wood is less expensive than brick or cement as a building material, but surely it can't be that much of a difference and, if the present value of fire insurance is added, the other options would be more attractive.

This is not the first time I've asked this. Americans build houses that the Big Bad Wolf would have no trouble blowing down in harm's way. Like the Gulf Coast. I have yet to see anyone even suggest a change in the way houses are built (in Mexico's Caribbean coast damage from hurricanes is much less severe precisely because buildings are made of sturdier stuff).

Why is this? Government doesn't help. By subsidizing catastrophe insurance and providing generous reconstruction funds it shields homeowners from the worst consequences. Nonetheless, my guess is that it's mostly a cultural thing. Americans simply can't conceive of houses build any other way. While the typical home may be well adapted to, say, New England or the Pacific Northwest, its totally out of place in West, where it would make much more sense to build the typical Mediterranean house.

Weird.

I promise not to talk about the lessons from 1987

I'm sure you've had enough of that today. But there is a related point worth mentioning.

Why did the crash have so little impact outside of Wall Street (particularly compared to the 90's bubble)? A 34% drop from peak to bottom in the S&P 500 a matter of months certainly packs a punch. Surely the Fed's timely intervention helped. But by and large, it was simply a matter of the stock market being so much less relevant than today.

While in the previous five year period before the 1987 peak it had gained around 24% annually, slightly more than the comparable rise before the 2000 peak, it came from a much lower base. In 1986, stock market capitalization to GDP was merely 60%, compared to 110% in 1999, while direct equity holdings represented only 14% of household financial assets, versus 29% in 1999. Also, valuations in mid-1987 were, with a P/E of 20 times, much more reasonable than the 30+ times seen in early 2000.

Greenspan on M-LEC

M-LEC, the new entity created by the nation's largest banks to provide liquidity to subprime-linked securities is off to a rough start. Many criticisms have been made, ranging from charges of possible self-dealing by banks to questions on who exactly will provide the funds. But even if you set those concerns aside, there's another issue that Alan Greenspan points out in an interview with Emerging Markets:

In the case of LTCM, “a single company” that was “excised out of the market”, there had been a potential for “a dangerous firesale of those assets”. When shareholders came in and took out LTCM, that “eliminated that aspect of market disruption”.

In contrast, “here we’re dealing with a much larger market,” he said. “They’re not talking about going in and absorbing sub-prime mortgage asset backed [securities]. They’re talking about essentially increasing the liquidity of those who have the SIVs [structured investment vehicles] and the like.”

JP Morgan Chase chief executive Jamie Dimon said on Wednesday that the fund – which will buy securities most notably ABS (asset backed securities) – could relieve some market pressure caused by the problems of SIVs. The plan is designed to prevent SIVs being forced to dump assets in a weak market because nervous investors are refusing to buy their new commercial paper.

But Greenspan argued that that a delicate market psychology could be speared by the move. “It could conceivably make [conditions affecting investor psychology] somewhat adverse because if you believe some form of artificial non-market force is propping up the market you don’t believe the market price has exhausted itself.

“What creates strong markets is a belief in the investment community that everybody has been scared out of the market, pressed prices too low and they’re wildly attractive bargaining prices there,” he said.

“If you intervene in the system, the vultures stay away,” he said. “The vultures sometimes are very useful.”

In other words, trying to inflate a punctured balloon is useless.

By the way, Yves Smith over at Naked Capitalism has covered this issue better than anyone. Do pay him a visit.

Brain-drained

I always thought that the term "brain-drain" referred to the emigration of people with high educational and skill levels from poor nations to rich ones. But maybe I'm too narrow minded. The author of The Economist's Europe.view column takes a much broader view of this concept:

A new study by the Lisbon Council, an incisive Brussels-based think-tank, highlights some ominous trends. The ex-communist east of the European Union has backward industries, a dire demographic outlook and, for the most part, out-of-date universities. A brain-drain may be irreversible.

The study should be mandatory reading for the stubborn, complacent and squabbling politicians of eastern Europe. Only two countries are above the western European average: Slovenia, thanks to its wealth, and Turkey, because of its booming birthrate. For most of the others, the human-capital gap is large, and likely to widen rather than narrow.

(Emphasis is mine)

Well, I do suppose that, technically, death does represent an irreversible brain-drain, at least to those involved, as does being bitten by a zombie or prolonged exposure to reality TV shows.

But it does seem odd to equate more brains with more brainpower (what's the antonym of brain-drain? Brain-fill?). On that score, places like Afghanistan, Burundi, Mali and Yemen (see here) are top generators of human capital. Maybe the EU should invite them to join!

(Ed. By the way, Turkey's birth rate fell from 33.7 per 1,000 population in 1980 to 16.6 per 1,000 population in 2006 according to the U.S. Census Bureau, hardly the stuff of booms).

The other energy story

The recent jump in oil prices into record territory has hogged the energy headlines. At the same time, many are wondering why sky high oil hasn't caused more economic damage. I believe part of the answer has to do with natural gas prices, which have held fairly steady for the past three years (as have coal prices). According to BP's Statistical Review of World Energy, oil represents 40% of U.S. primary energy consumption, with gas at 24%. While I'm not certain, I would guess that natural gas may actually have a higher indirect inflationary impact than oil prices.

Emerging like a volcano

Mostly unnoticed, the IMF published its semi-annual World Economic Outlook today (here's the press release), which is always makes for interesting reading. As expected, it slashed its growth forecast for the U.S. in 2008 to 1.9%, versus the 2.8% it expected as recently as July.

Apparently, the IMF is a strong believer in decoupling, as its global growth forecast for next year was slightly revised from to 5.2% to 4.8%. This reflects the strength of emerging market growth, which the IMF expects at 7.4% in 2008 (the July forecast pegged it at 7.6%), led by China's 10% expected surge.

The U.S. economy remains, by far, as the largest in the world. But at the margin (that is, in terms of its share of growth in world output) it will be eclipsed by China and even India this year. Just take a look at the following chart. One may know and understand the numbers, but it is amazing nonetheless.

Housing false starts

Even if you have a pessimistic bent, the latest housing starts figures are dispiriting. They fell 10.2% in September, to 1.19 million units, well below the consensus forecast of 1.28 million units. This translates to a full 31% drop from year-ago levels.

Are we near the bottom? Not quite. If the past is any guide, they could go as low as 800,000 units. The question now is how fast we'll get there.

A couple of additional points. First, it's hard to exaggerate just how far forecasters have been behind the curve. According to the Philly Fed's third quarter survey of professional forecasters, in the fourth quarter of this year housing starts would average 1.4 million units (annual terms). Needless to say, reality has rendered this outlook worthless and we should keep this in mind when assessing 2008 growth forecasts.

Of course, this also feeds into my current pet obsession: how can this collapse in housing construction be seen everywhere except in residential construction employment?

M-LEC Toxic Disposal Co.

It's a sign of the times that when the biggest banks of the land announce the creation of a fund to buy debt securities affected by the recent liquidy drought, the reaction is indifference or even outright hostility.

No wonder. The cartoonishly-named M-LEC (Master Liquidity Enhancement Conduit) will mop up securities, such as bonds backed by toxic mortgages, that would supposedly be dumped at fire sale prices, worsening the damage to balance sheets all over Wall Street.

Now, the banks in question won't put up a cent. M-LEC will sell debt to by debt to fund its purchases, although it seems that the banks will offer some sort of guarantee.

If this sounds fishy, it is. The suspicious securities are in danger of being dumped because their holders can't issue paper to fund their position. But often, it's the banks (or SIVs they sponsor) who are the holders. And if the banks can't or won't step up directly to buy them, why should anyone want to by M-LEC's paper?

Maybe there's some sense to this scheme for the banks. They don't want to buy these iffy securities because they don't want to weaken their capitalization by stretching their balance sheets. So they do a run around by creating an off balance sheet vehicle and pray that they won't have to make good on their guarrantees.

But this sound like a shell game and I simply can't see who would want to fund M-LEC given the reluctance of the banks

The one crucial issue this scheme doesn't address is the lack of transparency and information, which is what arguibly has done the most damage.

So color me skeptical. In the end, there are two possible solutions to this type of mess. One, Uncle Sam steps in by guaranteeing M-LEC's securities. Two, there's a classic reestructuring.

The Dario Fo of economics

By now you've probably heard that Leonid Hurwicz, Eric Maskin, and Roger Myerson won this year's Nobel economics prize. With all due respect to all concerned, they're to economics as Dario Fo, Elfriede Jelinek and Wislawa Szymborska are to literature.

If you even want to attempt to know why they got the prize, scoot over to Marginal Revolution.

Not that I'm complaining. Part of the charm of the Nobel prizes is that every two or three years the prize committees throw a wild curveball at us, coming up with the most unexpected winners. Of course, everyone is outraged that more deserving candidates were ignored, once again. Nonetheless, it keeps the world tuned in.

My favorite Nobel peeve is that those pesky Swedes evidently have a something against Spanish-language literature. Octavio Paz was the last winner, in 1990. Since then, there have been 8 English-language winners. Does anyone seriously believe that someone like Harld Pinter is more deserving than a Carlos Fuentes or Mario Vargas Llosa? Please. Not that this problem is recent. They let giants like Jorge Luis Borges, Julio Cortázar and Alejo Carpentier die without recognition.

Even executives agree their pay is ridiculous

What can I say? Lately, I've written a bit on executive compensation, noting that it seemed disproportionate and utterly unrelated to performance. But I would never have guessed that those same executives (as well as corporate directors) fully agree with all the above, as explained in this FT article (kudos for its wonderfully pithy header).

Four out of six chief executives or company presidents polled by the NACD in July and August said the compensation of top executives was high relative to their performance.

Only 2.2 per cent of the nearly 70 chief executives and presidents involved in the survey said compensation was too low, while a third deemed it “just right”.

Their views were backed up by outside directors, with more than 80 per cent of them saying chief executives were overpaid.

Why have we reached this sorry state of affairs?

Nearly 60 per cent of the directors polled by the NACD said the reason for excessive pay packages was the absence of objective ways to measure an executive’s performance. Nearly half criticised the use of options and equity awards that reward executives when the company’s share price goes up, rather than when its operations improve.

The real answer, of course, is that board members and executives make up a huge "old boy" network. No corporate director wants to take a hard line on pay because a) that would make for some seriously awkward times around the country club, b) all directors and executives make out nicely under the current scheme and c) no one likes to be subject to real scrutiny and, hence, everyone is reluctant to cast the first rock.

Saying that performance can't be objectively measured is pathetic. Sure, it's not easy, but that's what corporate directors get paid to do, along with the armies of compensation consultants they hire to design pay packages.

The Buddha as inflation fighter

Every once in a while an article comes along that is so wonderfully nutty that is just makes your day. The piece, by one Chan Akya in the always eccentric Asia Times ends with this gem of a conclusion:

Buddhism is forever associated with the principles of non-violence and kindness of human beings to each other, as well as to other animals. Whilst not prescribed as a basic principle of life in the holy texts, Buddhists generally abjure meat. Their pacifist principles are broadly applicable to solving the most intractable crises in the world, including those of the Middle East. The centuries of debate between Buddhists and other religions, including Hinduism, have produced more than adequate philosophical sophistication in dealing with intellectual challenges from the well-to-do. Then again, people don't have to convert to Buddhism to follow the principles laid out.

Accepting the religion or at least its principles therefore carries with it a steady decline in the demand for meat and related products, which will help the US Federal Reserve, the Peoples Bank of China and other central banks to cut inflation expectations at home. In turn, this helps to engender greater efficacy for monetary policy. Given that markets love to listen to the Fed chairman, perhaps it makes sense for him to be the first to recommend the Buddhist way of life, in some suitably informal chat - perhaps a quiet word to Maria Bartiromo (5) would do the trick.

Maybe this isn't too far fetched. After all, the spirit of the old Zen masters seemed seemed to live on in Alan Greenspan's cryptic comments, which could rival any koan in poetic amiguity.

More executive pay lunacy

The (mis)use of options is not the only problem with current executive compensation schemes. As this article explains, there's the issue of transparency. The SEC's chairman offers a pithy quote:

The rules significantly expanded the disclosures that companies are required to make about compensation for their highest-paid executives. Christopher Cox, SEC chairman, has said that investors "should not need a machete and a pith helmet to go hunting for what the CEO makes".

But it also presents a fact that is capable of shocking even a jaded veteran such as yours truly: CEOs often make as much as ten times as their top lieutenants. Wow. This is just plain nuts.

Kudos to the SEC for finally beginning to address these issues.

Executive pay: Out of the money

Nowadays, options make up the bulk of high-level executive compensation. They are hailed as an efficient way to align the interests of management with those of shareholders. But is this true?

This piece in The Economist presents evidence to the contrary:

Belatedly, the evidence is now mounting that share options are not all they were cracked up to be. Consider, for example, “Swinging for the fences: The Effect of CEO Stock Options on Company Risk-taking and Performance,” a study in the October issue of The Academy of Management Journal.

The authors, two economists, Gerard Sanders and Donald Hambrick, observe that options create asymmetric incentives: they pay out when a firm’s share price rises above the option exercise price, but once they fall below the exercise price, all further falls make no difference to the ultimate payout, which is nothing. This, posit the authors, gives an incentive to take big bets, by investing in risky activities with long odds on a high pay-off. They also posit that these bets will produce more extreme losses than extreme wins.

To test these theories, they examine the impact of the options awarded to the chief executives of some 950 American firms during 1993-2000. This showed that the bigger the role played by share options in the boss’s pay package, the more likely firms were to invest heavily in risky activities. It also confirmed that high levels of share options were associated with more extreme ups and downs in a firm’s share price, and that the big downs significantly exceeded the extreme highs.

The authors conclude that “not only does this asymmetry affect the selection of strategic initiatives, as we have discussed, but it may also cause CEOs to be inattuned to early signs of project failure and generally careless about risk mitigation.” Surely this is not the sort of motivational incentives that shareholders want.

These results are not suprising and my guess is that they would've been much more evident if there hadn't been a huge bull market for stocks during that period.

It's not just a question of asymmetrical payoffs. My main beef with options is that they only reward absolute rather than relative performance.

In lackluster or bear market conditions a firm may have outsanding operational and financial results and yet see its stock price fall simply due to macro factors outside its control. Conversely, in a bull market a firm's stock price may rise despite poor results relative to its competitors. Executives would receive a large payoff in the second case, but not in the first, an outcome that defies all logic.

Yet, I have yet to see a compensation plan that takes this issue (or others, such as favoring short-term appreciation versus long-term gains) into account. Strike prices are usually the price of shares at the time the options are issued.

Outrage about executive pay is misplaced. Focusing only on its level is not helpful. It may or may not be excessive. But the real problem is that the way compensation is determined makes no sense at all.

The problem with having too much money

With oil at $80 a barrel, the Gulf states are drowning in money. What do you do with it? You can put most of the estimated 628 billion windfall in boring Treasury bonds and you can splurge on neat stuff like building a massive Panama Canal-sized waterway to add 500 kilometers of waterfront. I hope they have fun while it lasts.

Would you let this man manage your money? Ian Wace edition!

Real asset managers should know better than to make bold, categorical statements about the future direction of stock prices. Alas, many still have to learn that lesson. Take this gem:

Ian Wace, co-founder of the $17 billion hedge-fund manager Marshall Wace LLP, expects an ``absolute explosion'' in share prices globally as company profits increase.

Given that the share of corporate profits in national income is at historically high levels in many countries and that the world economy is headed for a slowdown, that statement sounds pretty, hmm, unsound. What makes him say this?

Stocks ``offer phenomenal value,'' Wace said today at a conference in Milan. As some central banks lower interest rates, that will also help lift stocks, he said. Shares of the largest companies will benefit most, said the manager, whose MW Tops Fund Ltd. has returned about 18 percent a year since it started on Dec. 31, 2004, according to data compiled by Bloomberg.

There will be a ``massive splurge in major, liquid, large caps,'' Wace, 44, said. The money manager, whose firm bets on equities by compiling analyst research from 253 brokers worldwide, didn't say how much he expects markets to rise.

Where to begin? Central banks are cutting rates due to the risk of a falloff in growth, something hardly compatible with a jump in profits. Sure, dropping rates may provide some support for stocks based on asset allocation grounds, but it could hardly be deemed "massive". Of course, the key here is that this fund invests based on sell-side research which always, to put it kindly, has a vested interest in erring on the side of optimism.

P.S. By the way, Bloomberg states that the average P/E multple for the MSCI World Index (which has risen about 15% a year since year end 2004) averaged 29 times over the past ten years, compared to 17 times now. Needless to say, comparing valuations now to the average that includes the dot com bubble years is misleading. For the S&P 500, the 70 year average P/E is close to 16 times, close to the current level. Since when is it a reporter's obligation to support the subjects investment opinions? Shouldn't it be his job to be a tad more skeptical?

Would you let this man manage your money? Victor Niederhoffer edition!

This profile of Victor Niederhoffer in the New Yorker is pretty entertaining. Clearly, a fascinating guy who could star in an Axe Shower Gel or Dos XX commercial.

But it makes you wonder who'd be crazy enough to give this gentleman a dime to manage. He doesn't have anything resembling a minimally coherent investment strategy, placing large, exposed, short-term bets on whatever catches his fancy.

I guess they do it just to have the privilege of hanging around with him. (Not as crazy as it sounds if you have enough money).

Anyway, Niederhoffer --whose funds have blown up twice now--is a walking "famous last words" factory. He reels out three of them consecutively:

“The market was not as liquid as I anticipated,” he said. “The movements in volatility were greater than I had anticipated. We were prepared for many different contingencies, but this kind of one we were not prepared for.”

The construction employment puzzle, redux

Unbeknownst to me, during my summer break many bloggers commented on the construction employment puzzle (see yesterday's post). Brief recap: housing construction has, by all measures, fallen more than 40% from peak while residential construction employment has barelly budged.

Here's Nouriel Roubini's take and Jim Hamilton's is here. The WSJ's Economics Blog also has good info on this (see here and here).

Severl months onwards, the original mystery has only deepened and no one has provided a convincing answer.

I will say that the argument that states that employment hasn't fallen that much because the workers fired so far have been off-the-books illegals is nonsense. Construction employment rose sharply over 2001/2006 tracking housing construction and it should follow it on its way down.

Also take into account that the underlying force driving housing demand, household formation, is expected to be pretty steady over the next decade (a bit less than 1.5 million annually). Thus, it wouldn't make much sense to argue that residential construction employment registered a permanent jump in employment over the past few years and builders are "hoarding" employees while the storm passes.

Death according to the IRS

What is death? This question has occupied philosphers and religious figues since the dawn of mankind. Jack Bogdanski provedes us with his take on what our beloved tax authorities would define as "separation from life" (hat tip: Argmax):

[T]the Treasury will consider a service provider to be dead if the service provider’s death meets the criteria necessary for a separation from life. ... A service provider separates from life with the service recipient if the service provider has a termination of all mental and bodily functions. However, the service provider’s life is treated as continuing intact while the individual is temporarily unconscious, having an out of body experience, cryogenically frozen or experiencing another bona fide leave of absence from the individual’s conscious state, if the period of such leave does not exceed ten minutes, or if longer, so long as the individual retains a right to regain life and/or reanimation under an applicable contract (with the devil or otherwise) or other arrangement.

If the period of leave exceeds ten minutes and the individual does not retain a right to regain life and/or reanimation under an applicable contract or otherarrangement, the death is deemed to occur on the first minute immediately following such ten-minute period. Notwithstanding the foregoing, where a leave is due to any medically determinable physical or mental impairment that can be expected to result in death, where such impairment causes the service provider to be unable to perform the essential functions of life without mechanical support, a 525,600 minute period of absence may be substituted for such ten minute period. ...

Employment crow for breakfast

My gloomy outlook for today's payroll figures was, to put it charitable, quite misplaced. The 110k jump in September and the upwardly revised August figures certainly demonstrate a surprising degree of resilience. Which, I might add, is welcome news.

Yet....

My skepticism is not totally unfounded. Just take a look at the following graph, which charts residential construction employment and housing starts.



The relative strength of residential construction employment has been downright freakish considering that housing starts have pretty much fallen of a cliff. Yes, there are lags, but housing starts have fallen for a year and a half, while employment has fallen less than 5% from peak levels. Real estate sales and credit employment has held up just as well.

Something does not compute. In any case, Dr. Gloom himself, Nouriel Roubini, argues that the payroll figures hide some underlying weaknesses.

Unemployment Friday

Is poised to be more entertaining than usual, and I don't mean that in a good way. Apparently, the consensus expects payrolls to rise by 100,000. Now, this is not an outlandish possibility, given that unemployment claims have been pretty steady.

Nonetheless, as I argued last month, there's something very, very fishy about the employment numbers. Sooner or later they'll catch up to a rather unpleasant reality. Will it be this month? I don't know, but my hunch (yes, hunch) is that the payroll number will come in flat to slightly negative, like September. The carnage will probably start this quarter.

It'll be interesting to see how it plays out with long term rates and stocks. A flattish figure probably won't cause stocks or rates to fall much, given that most investors know that the balance of risks is tilted to the negative side.

Sexy dividends

In this age of massive stock repurchases, dividends have a distinctly stodgy, old-fashioned air about them, despite the fact that over the past few years they've been taxed at the same rate as capital gains. Yet, according this paper (PDF) published by fund manager Tweedy, Browne Company (ed. man, that's about the stodgiest, WASPiest name I've come accross in a long while).
(Hat tip: Abnormal Returns)

It concludes that there's plenty of evidence that high dividend yield stocks outperform market averages. (Not surprisingly, Tweedy, Browne recently launched a fund with this investmen strategy).

Needless to say, this is interesting. I must confess that I'm rather partial to dividends, as they're the most transparent way to return cash to investors. However, the paper solely emphasizes correlation and does not delve into causation, which is very unsatisfactory.

There are many possible explanations to account for the apparent success of a high dividend yield strategy. Maybe it's a sector effect. That is, perhaps firms in successful sectors happen to pay dividends. Or it could be that dividends are indicative of some positive trait, such as high capital spending discipline. I'm sure the academic literature has many other theories.

Also, the paper neglects to present studies that fail to support this conclusion (such as this this one).

As always, beware of research with deep conflicts of interest, no matter how academic it may look.

What mutual fund flows say about rising stock prices

Given all the negative economic news, many are wondering why stock prices are rising (the S&P 500 has jumped 10% from its August 15th low and has gained 6.3% from its end of July level).

Valuation factors certainly don't seem to justify this rise. After all, many forecasters are slashing U.S. growth forecasts significantly. Goldman Sachs reduced expected 2008 growth from 2.6% to 1.8%. And long term interest rates haven't changed much, although certain credit spreads have eased.

Most likely, stocks are benefiting from asset allocation changes, as noted here. Lower short-term interest rates make money market investments less attractive, while corporate bonds don't look very attractive given the recent turmoil. That leaves stocks as pretty much as the less ugly alternative.

Capital flow data from mutual funds (a less than perfect indicator, but the only current one we've got) backs this up, to a degree. In August, according to AMG Data, equity funds received a net inflow of 5.7 billion, while taxable bond flows saw an outflow of 0.8 billion. However, money market funds saw a staggering inflow of 156 billion.

In the second quarter, taxable bond inflows were twice as big that equity inflows.

More recent weekly data has been seen similar trends, although it seems that taxable funds are attracting some interest again.

No wonder I'm not rich: Grooming edition

As a proud customer of $7 a haircut shops, who spends around 3 seconds a day combing and believes that shoes need shining every couple of weeks (give or take 4 weeks), this article is rather distressing.

Then again, on your death bed would you regret having spent insufficient time grooming?

Nokia's content gamble

Nokia announced yesterday that it was spending a cool 8 billion to acquire Navteq, a provider of digital maps and navigation solutions. This is just part of a shopping spree that has seen the Finnish giant buy a mobile ad firm and a provider of navigation software.

The deal will only make sense if the value added to Nokia's phones and mobile services derived from the Navteq purchase outweigh the value destruction resulting from clients (existing and potential) turning away from Navteq as a Nokia subsidiary. In other words, I doubt that Motorola, Samsung or Sony Ericsson will be very enthusiastic about purchasing Navteq's maps from now on (Gamin, a leading GPS device maker, saw its stock drop sharply after the announcement).

I don't have an answer. However, these hardware/software synergies are often elusive. Just ask Sony how the Columbia Pictures acquisition worked out. But they're not doomed to failure, as the IPod/ITunes combo has shown, although ITunes is more a distribution platform than content per se.

Having said this, there is a wilder, intriguing possibility. Maybe Nokia wants to reinvent itself as a mobile services and software firm, eventually selling its hardware biz. This is not as crazy as it sounds. Competition in the handset market is intense and all firms have seen wild variations in their market share. Services are a higher margin, more stable business. And Nokia has undergone a radical transformation before (it used to be mainly a manufacturer of forest and rubber products).

GM: The free lunch that isn't

Last week, the deal between GM and the UAW to end the strike was hailed in the press almost as a miraculous solution that will save health benefits for current and retired workers and resotre the automaker's competitiveness.

The UAW will manage the health benefits plan as a trust separate from the firm, which won't have to pay those crippling health care contributions from now on. This article by The Economist illustrates the tone followed in much of the coverage.

Sounds like a free lunch? We should know better and so should the press.

To get rid of its health care obligations, GM will have to deposit a lot of money into the VEBA trust. Where will it come from? From its shareholders' pockets, as its contribution will be paid in GM stock (thorough convertible notes).

Would it be any different if the firm made a secondary share offering and kept managing the health plan? Nope, unless I'm missing some sort of fiscal angle. Nor are workers much better off risk-wise, since they will still be tied financially to GM's stock performance.

Actually, the fact that this deal wasn't struck long ago (it's not as if this problem is a recent one) is telling. It's another sad reminder of the low quality of most financial journalism that even The Economist falls for this smoke-and-mirrors trick so easily.

The euro kicks sand in the dollar's face

There's hope for the greenback yet! Sure, by reaching 1.42 against the euro, the dollar sure looks like a 90 pound weakling at Muscle Beach. But take a look at this 30 year graph (before 1999, the ECU --the euro's shadow predecessor--is used):



It looks like 1.4 dollars per euro (approximately) is a pretty hard ceiling!

Just kidding. It's most likely coincidence, unless some strange technical analyst voodoo is taking place.

But there's a real pattern here: dollar lows coincide with U.S. recessions AND oil price surges (in 2001 the first condition is met, but not the second). Correlation is not causation, but this certainly seems to support the dollar-oil price link many have been talking about lately.

I forgot to mention that.....

If the 23% fall in house prices in the 10 largest metro areas that housing futures are indicating comes to pass, that spells recession.

Wondering how low house prices will fall?

Some interesting results are coming out. Moody's expects prices to fall, peak to trough, 7.7% nationally (hat tip: Calculated Risk).

According to Moody's, the bulk of the adjustment will be over by late 2008. This does not square with previous housing downturns, which played out over many years (check this post).

Sounds nasty? Moody's seems positively euphoric compared to the prices quoted in the CME's recently introduced housing price futures, based on the Case-Shiller indices (hat tip: Housing Wire). The 10 city average (includes the largest urban areas) will accumulate a drop of 23% over the next four years.

Scary stuff indeed.

Robert Lucas doesn't get it

Via Mark Thoma, we learn that Robert Lucas, Nobel laureate, wrote a rather incoherent opinion piece on the WSJ. This paragraph left me dumbstruck:

It ... is all too easy for easy money advocates to see a recession coming and rationalize low interest rates. ... [But] I am skeptical about the argument that the subprime mortgage problem will contaminate the whole mortgage market, that housing construction will come to a halt, and that the economy will slip into a recession. Every step in this chain is questionable and none has been quantified. If we have learned anything from the past 20 years it is that there is a lot of stability built into the real economy.

Where to begin? Sure, housing construction won't drop to zero, but housing starts have fallen from 2 million in 2005 to just 1.3 million (annual rate) this August, dragging down the economy. And then there's the slight detail of falling house prices and negative payroll growth.

It's amazing how many people are still in denial about the severity of the housing-led threat.

Cutting rates on 'potential' economic slump? The horror!

Sarcasm is hard to avoid after reading a Bloomberg article titled "Bernanke Cuts on Slum 'Potential', Adopting Greenspan Approach"

After all, isn't avoiding 'slumps' the main job of central banks? Or do they have to wait until a full-blown recession to start cutting rates?

The problem, as always, is semantics. As George Orwell noted long ago, sloppy language leads to sloppy thinking. This is very much in evidence in this article, as in most financial journalism. Concretely, one has to determine what is understood by 'potential slump'

I'm pretty sure that the author meant was that Bernanke sought a rate cut to insulate the economy from the turbulence in financial markets, much as Alan Greenspan did by cutting rates after the Russian debt/LTCM debacle in 1998.

But that analogy is incorrect. In 1998, the U.S. economy was cruising along, growing at an annual rate well over 3% in the first half of that year. Thus, the rate cuts were purely preventive in the sense that market turmoil might have led to a downturn if no action had been taken.

The situation is very different this year. A sharp slowdown, though not a recession, in the economy was pretty evident well before turmoil hit the markets. In fact, while the credit crunch will certainly aggravate the recession in the housing sector, this downturn mostly reflects an imbalance in housing supply and demand that, while obviously related to financial factors, is not determined solely by them.

Thus, the rate cut is not 'preventive': the threat of a housing-led recession is very real and growing, with the current market turmoil clearly contributing to it.

With all due respect, the persons that question the rate reduction on moral hazard (bailout) grounds are nuts, as they're asking the Fed to not do its job. The other set of critics, who state that the Fed is underestimating the risk of inflation, are on firmer ground, but not much. After all, core PCE inflation is below 2%, within the Fed's informal range, and the economy is growing below potential.

Ben's Soothing Tonic

It seems Dr. Ben decided that the patient was best served by having the patient down his medicine in big gulps rather than sips.

With short-term Treasury rates near 4.2% at the end of last week, the markets were pricing a full percentage point cut in the Fed's reference rate over the next few months. So today's decision was merely a question of how quickly the Fed would deliver. Apparently, it is alarmed enough (not surprisingly given the run on Northern Rock in the U.K.) to prescribe a large, 50 basis point dose, even if that means losing some face.

The statement offered little insight. More surprising was the massive reaction in stock prices (the S&P 500 ended 2.9% higher). I think there are two possible explanations for this reaction:

1) Lowering the cost of credit will ease losses and restore liquidity to the markets. Everything will be sunny and it'll be like the two past months never happened.

2) The economy is in danger due to the woes in the housing sector. It's good that the Fed recognizes the magnitude of the threat and is beginning to act accordingly.

Obviously, numero 1 is mucho more likely than 2, as far as investor opinion is concerned. Needless to say, I'm in the #2 camp.

Actually, make that #3: the economy is in much worse shape than generally assumed and things will get a lot worse before Ben's Magic Tonic begins to take effect in a few months. Today's reaction in stock prices was not warranted.

Before calling me Dr. Tangible Gloom, chew on this: everyone has massively, consistently underestimated the problems in the real and financial sides of the housing market, as well as their impact, over the last couple of years. I don't see that changing, yet.

The logic of bank runs

As it turns out, there is anarchy in the U.K.! The run on Northern Rock has intensified and threatens to expand to other financial institutions. As a result, the British government has had to step in and guarantee the value of all deposits in Northern Rock. The full story is here.

This is not a surprise. I predicted that the Bank of England's credit lifeline wouldn't stop the crisis. This is not the result of special insight, but of having lived through the 1995 Mexican financial crisis, when the whole system went belly up. A key lesson was that once confidence was lost in a bank, the government has to step in massively and decisively, taking over the institution or lining up an emergency buyer.

Why? Well, if everyone knows the bank is insolvent, there will be a run. And runs, even in fairly small banks, tend to undermine confidence in the whole system, specially in unsettled times like these. Without confidence, a bank is worthless.

The question is why did the government/regulators wait so long to take action? There is nothing so dangerous as a bank in desperate trouble. Facing bankruptcy, executives and directors only have one course of action: double down the bets to gamble for salvation (or, as happened in Mexico, looting the bank mercilessly). Of course, this usually fails, but not before hugely increasing the losses.

Thus, either they were inexcusively asleep at the wheel or, as usually happens, forgot the lessons of past banking crises.

Could it happen elsewhere?

As a consequence of the housing/mortgage crisis in the U.S., suspicious glances are being cast to other countries that have seen big rises in housing prices over the past few years. Will it prove contagious?

As I've argued before, the fundamental problem in the U.S. was a disequilibrium in housing supply and demand. Too few houses were build in 2002-2003 when demand boomed due to rock-bottom rates, leading to huge price rises. In 2005/2006, too many houses were built given underlying demand. Normally, temporary excess supply or demand is no big deal. The problem turned nasty due to subprime mortgage financing, which artificially boosted demand, made prices jump higher than they would've and now are corroding the markets.

Subprime financing is, as far as I can tell, mostly limited to the U.S.. But that doesn't mean that other countries will be exempt from falling prices due to overbuilding and excess demand. This week, The Economist summarizes a Morgan Stanley study which concludes that many countries have seen house appreciation far in excess of what fundamental factors justify, including the U.K., Spain and Sweden.

Let's compare the U.K. to the U.S.. Now, this is tricky because they have very different demographic profiles, circumstances and tastes. Nonetheless, I believe we can get some idea of housing trends comparing the number of housing unit completions to the estimated increase in the population (people have to live somewhere).


This graph shows that since 2004, more housing units have been built in the U.K. than the increase in population. While it can be argued that foreigners may be buying second homes in London, this situation obviously cannot last. The last time this happened house prices tumbled.

In the U.S. there's a clear, secular downwards trend in housing units per change in population (probably reflecting smaller families and more immigrants, who tend to be single upon arrival). Nonetheless, excess housing demand has obviously contributed to this ratio's fall over the last few years.

I don't know about the other countries, but things look bad for both the U.S. and U.K. Yet, maybe the fallout in Britain will prove less damaging due to less use of "creative financing". We'll see.

Anarchy in the U.K.!

Well, ok, not quite. But in the case of Northern Rock, a British mortgage lender, a liquidity shortfall has led to and ol'fashioned bank run, complete with people queuing in the street to withdraw their money. The Bank of England is stepping in with an emergency loan. This is probably a waste of time and money, as it will not likely stop the panic; only a full-blown rescue/buy out will.

A humorous aside from The Economist:

Customers queuing up in its home town of Newcastle reportedly burst out laughing when bank staff asked if anyone wanted to deposit money

Oil at $80 is no surprise

Oil at a (nominal) record of $80 a barrel? Shocking! So say many OPEC members and ExxonMobil chairman Rex Tillerson, who are most puzzled that prices stay so high given that the market is well supplied with crude. Must be those pesky financial speculators!

This, of course, is nonsense (and predictable self-interested nonsense at that). While it's possible that investors may affect the price of oil in the short-run, prices have been high for many years, which surely means that the fundamentals are really in command.

And speaking of those fundamentals, let's see what the International Energy Agency expected for all 2007 back in January. Basically, demand was forecast at 85.77 millon barrels per day, while non-OPEC supply was expected to be 50.6 million barrels per day. In the most recent forecast, demand is now set at 85.9 mbpd, while non-OPEC supply is estimated at 50 mbpd.

In other words, demand has been higher than forecast, while supply has come up short (OPEC output has been broadly flat). That sounds like an Econ 101 recipe for higher prices to me.

I don't believe

That the payroll numbers released today, bad enough as they were, bear any resemblance to reality. It's simply not possible. To see why, let's just review some numbers related to construction and real estate activities.

First, a quick review of the most recent housing and residential construction data:

Housing starts: -20.9% (July 2007/2006)
Housing units under construction: -16% (July 2007/2006)
Housing units completed: -22.2% (July 07/06)
New residential sales: -10.2% (July 07/06)
Existing home sales: -9% (July 07/06)

And yet, the Bureau of Labor Statistics (BLS)wants us to believe that employment in real estate services rose in August (600 new positions) and is up 1.5% versus year-ago levels?
Am I expected to think that residential construction employment has only fallen 3.5% in this period?

It gets worse. BLS data shows that employment in the offices of real estate brokers and agents has kept on rising, growing 3% in July over the year-ago level.

My head feels like exploding.

But even if we take these figures at face value, it's clear that eventually payrolls will catch up to activity levels, meaning that over the next few months and quarters the employment numbers will look very, very grim. And if analysts were surprised now, I can't imagine how they'll react then.

Bubble dilema for central banks

Morgan Stanley's Richard Berner reports on the ongoing debates in the Fed's annual Jackson Hole powwow. My heat-impaired self hasn't gotten around to reading all the speeches, but Berner does touch a very important point: should central banks preemptively try to prevent bubbles from appearing?

Historically, the Federal Reserve has taken the hands-off approach, just standing by to clean up the mess once bubbles burst. Fed governor Frederic Mishkin has been an outspoken defender of this asymmetric intervention policy.

Yet, as the current and previous episodes illustrate, "cleaning up" is easier said than done. One mistake and you're into "Japanese lost decade" territory. Hence, some European central bankers have come around to the intervene-early camp.

There are no easy answers, but this is a crucial debate. Let us hope it doesn't fade away as it did after the last bubble was cleaned up (sowing the seeds of the current one).

Subprime mess good for stocks?

So argues Jeremy Siegel. Key paragraph:

I think the Fed made the right moves at the right time. But the fallout from this crisis will be with us for a long time. Stocks are thought to be riskier than bonds and much riskier than mortgage bonds. Those that believed they could automatically make junk bonds safe by "backing" them with assets, be they homes or railroad cars, have been proven wrong. It turns out that the best credits are general obligation bonds based on all the firm's income and assets, not debts backed by dubious assets.

In the long run, all this is a good development for the stock market. In the last decade, more than one trillion dollars has migrated to hedge funds and untold billions to complicated debt and derivative securities. Who will buy those assets in the future? I believe quite a few investors will return to stocks and general obligation bonds - assets that they can buy and sell at any time they want.

Wall Street has rediscovered liquidity and transparency. Stocks and old-fashioned bonds have them; new-fangled collateralized debt obligations and hedge funds do not. A return to basics will be good for both the economy and the financial markets.

While he's obviously exagerating a bit, the point is taken.

When the U.S. gets a cold, the rest of the world.....

Stephen Jen tries to complete that sentence in an interesting note that reviews the academic evidence on contagion. Historically, U.S.-based shocks have had very different impacts on the rest of the world. For instance, the 1990-1991 recession hardly affected Europe or emerging markets, while the 2000-2001 shock certainly did.

While trade is the most obvious channel for contagion, evidence suggest that confidence and financial markets have a greater, and certainly speedier, impact.

In the end, Jen believes that any U.S. slowdown will only have a limited impact on the rest of the world. I hope he's right.

Bwana, me no understand that swap thingy

The World Bank has a problem. Its list of clients is rapidly diminishing as many middle-income emerging economies have put their financial house back in order and, in any case, prefer no-strings-attached financing from the capital markets to heavily-conditioned loans form the World Bank.

Under new president Robert Zoellick, the Bank is looking to for a new line of business: getting emerging nations to use more extensively risk-management tools, such as insurance, futures, swaps, etc. Examples cited are risk pooling among Caribbean nations for hurricane damage and currency swaps.

Pretty tame and sensible stuff, much along the lines of what Robert Schiller, he of bubble-busting fame, has promoted for helping individuals hedge macro risks like, say, falling real estate markets (see here).

But that's not how Andrew Leonard of Salon sees it. He links these products, stangely, to the current subprime meltdown. This makes no sense, as derivatives haven't really played much of a role in it, as it has been a case of bad lending practices, misjudgin risk and excessive leverage. With a very, very patronizing attitude --quite unbecoming in a liberal, I must say-- he questions the capacity of emerging nation governments to understand and properly use these financial products. (One would hope the World Bank can provide adequate advice on this, in an case).

Talk about throwing out the baby along with the bathwater. But it does remind one of the seemingly innate suspicion that even smart lefty types (such as Leonard, whose work I admire most of the time) have regarding financial markets. Sure, derivatives can be abused and misused, but they haven't been around for hundreds of years for nothing.

That said, it doesn't help the World Bank's case at all to have a treasurer named Kenneth Lay (any relation to Enron's disgraced founder?).

How low will house prices go?

According to an FT/Thomson poll of economists, median house prices will fall a total of 3% between 2006 and 2009. This is an unprecedented fall.

Unusually for the FT, the article is very confusing. Median house prices is a statistic put out by the National Association of Realtors, not the government as they imply. In addition, the figure they give on median house prices for 2009, 235 K, makes no sense, as it is substantially higher than current or past levels.

Anyway, the point stands. Of course, this is only one out of a series of house price measures (see my guide). For example, the Case-Shiller index has already posted a decline of over 3%.

Not all bubbles have popped

At least modern art seems to be going strong, judging by the $100 million paid by an unidentified investment group for Damien Hirst's famous diamond-studded platinum skull (which I like, truth be told). It will be interesting to see whether these prices hold up, as Wall Street bonuses are set to drop sharply in the coming months.

Woe is carnivorous short persons

At least as far as intelligence is concerned. Steve Levitt of Freakonomics refers us to a paper which "establishes"* a clear link between height and intelligence, which would explain the long-observed correlation between how tall you are and how much you make.

But here's hope for the vertically-challenged. You may not be able to do much about your height, but according to this research, you can be smarter if you become a vegetarian!


*Skepticism is always warranted in these studies, even if the authors are academics in good standing

Comparing real estate cycles

Today's news form the housing front is rather grim. The Case-Schiller national index fell 3.2% in the second quarter versus the same year-ago period, the steepest drop in the index's 20 year history (write up here, PDF press release here).

What does the future hold? I don't have a formal forecast model, but I believe it's useful to compare the current cycle (with a peak in the second quarter of 2006) to the previous one (rising prices in the late 80's, reaching a peak in the 2nd Q 1990).



Comparing the periods before and after the peaks clearly shows that during this cycle prices rose much more steeply. Interestingly, after a moderate decline, prices moved laterally in the previous cycle before starting the definite uptrend began in 1994. I doubt that this will be the case now. The price curve shows every sign of taking a nasty parabolic shape.

Inexistent sales of existing homes

Forgive the exageration, but no amount of NAR (National Association of Realtors) spin could soften the grim existing home sales numbers published today. In July, sales fell 9% year-on-year, couples with a 0.6% fall in the median price of homes sold and a rise in unsold home inventories to 9.6 months supply (compared to 7.3 months in July 2006). Notwithstanding, these numbers were in line with market expectations.

To give some perspective, here's the annual series of existing home sales:



Clearly, this series has seen extraordinary growth, expanding at an annual clip of nearly 3% since 1987, far above population growth. How sustainable is this? I don't have a good answer, but a good starting point is adjusting those sales by population growth (existing homes sold per 1,000 persons).



Taking the latest figure, sales per 1,000 persons stand at 19. If they fall closer to the 14-15 level seen in the early 1990's, sales could still fall another 20% or so (maybe the equilibrium level is higher due to demographic and income factors, but there's bound to be an undershoot and this was another period with soft market conditions).

This ain't over yet.

Behind the numbers: House prices

House prices have never fallen since the government started keeping records in 1950, according to this NY Times piece. Actually, they have never fallen since the Great Depression, according to the National Association of Realtors. But they have, in the early 1990’s and since June 2006, according to the Case-Shiller composite index. Confused?

I am (and so is the Times, as they confuse the NAR and OFHEO measures, see below). This is not surprising. The various home price measures differ greatly in coverage and methodology. Here’s a handy guide to the main ones:

OFHEO House price indexes

Calculated by the Office of Federal Housing Enterprise Oversight (the folks who regulate Freddie Mac and Fannie Mae), this index starts in 1975 and has national coverage. It geometrically weighs changes in the price of single family homes on which at least two mortgages have been taken out and bought by Freddie Mac and Fannie Mae. These This helps ensure that the houses included have comparable characteristics over time, avoiding biases resulting from changes in the composition of sales.

It does have two main limitations. VA and FHA mortgages are not included, as are those that exceed the federal loan limit of $417,000. More info can be cound here.

Case-Shiller indexes

Methodologically, they're very similar to the OFHEO indexes (weighted repeat transactions on single family homes). However, they're based on transactions as recorded in county assesor and recorder offices. The geographic coverage is much more limited, as only the largest 20 metropolitan areas are included. It does have the advantage that it covers high-end homes. More info can be found here.

New Home Prices

Published by the Census Bureau, these prices are by definition not comparable to the previous two indexes, as they only cover new houses (a small part of the total real estate market). Information can be found here.

NAR Indexes

The National Association of Realtors publishes information on median and mean prices of existing homes sold (for both single-family houses and condos/co-ops), based on a sample of national transactions. It is subject to biases resulting from changes in the type of units sold and does not adjust for quality (comparable characteristics, as the C-S and OFHEO do by using repeat transactions). The methodology is presented here.

Summary

The Case-Shiller indexes seem to offer the most accurate measure of trends in house prices. However, it does have the drawback of having limited geographical coverage. OFHEO indexes don't have this problem, but the exclusion of high-value housing is a very big flaw. Lack of quality adjustments clearly makes the NAR median home price indicator a much inferior alternative. In the end, they're fairly complementary and should all be analyzed. The following graph shows that the NAR and OFHEO measures produce similar results that are very different from the Case-Shiller index.



This Fed paper (PDF) provides much more information on this topic.