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.
Friday, August 31, 2007
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.
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?).
Thursday, August 30, 2007
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%.
Wednesday, August 29, 2007
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.
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
Tuesday, August 28, 2007
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.
Monday, August 27, 2007
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.
Sunday, August 26, 2007
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.
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.
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.
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.
Saturday, August 25, 2007
The recent tragic forest fires in Greece got me thinking. Yes, global warming is playing a part in this. For instance, two years ago there were huge, deadly fires in Portugal, Spain and Greece.
But surely there are other, economic factors at play. This article in The Economist lays out some of them. Developers are under suspicion for starting some fires to clear forest for construction, a result of the inefficient justice systems and weak property rights in many Mediterranean nations. It even seems that "productivity pay" for firemen may not be a good idea, as some seek to "encourage" demand for their services.
There is another intriguing angle. While the word "forest" conjures images of untouched wilderness, in reality forest in many parts of the world (and certainly in the heavily populated Mediterranean basin) have been shaped by man for ages. People cleared undergrowth for pasture and fuel, which in turn greatly reduced the risk of fires. However, rural depopulation is cutting this link between man and tree (see here), increasing the risk of fires.
Of course, the European Unions policies often don't help. Its generous agricultural subsidies are oriented to large-scale intensive farming and reforestation schemes often involve non-native species that involve highly flammable trees (eucalyptus, certain pines).
In the end, what do you do? Encourage once again the traditional agricultural practices to reestablish the previous equilibrium? I doubt that many people would like to be shepherds, even if heavily subsidized. Or do you just let the fires burn and wait until a truly wild native forest slowly establishes itself?
It's amazing how the biofuels bandwagon has kept gaining strength despite the fact that it's one of the main factors behind the steep rise in food prices. (Note to The Economist: remember that oil is used to grow crops!).
People have tolerated this because biofuels have a warm, green image (not deserved in many cases). Who can possible be against the environment?
But its pretty clear that biofuels serve mostly one purpose: to benefit incumbent politicians. On production cost grounds, biofuels make no sense, with the possible exceptions of sugarcane and jatropha. Politicians love to subsidize non-viable industries with a good public image becase 1) not many objetct lest they be called anti-environment and 2) those subsidies come back as campaign contributions from agribusiness (which has no choice, given that it wouldn't exist without those politicians).
In other words, politicians subsidize themselves. Rent-seeking at its most perverse worst.
Don't ask how I came across this study. But it's one of the most hilarious and memorable abstracts I've seen in a long time (yes, I do have a peculiar sense of humor). It's worth quoting in full:
Abstract The study investigated 261 lottery winners of prizes of NKR 1 million (US $150,000) or more in the years 1987–91 in a postal survey. The modal Norwegian winners were middle-aged married men of modest education, living in small communities. Emotional reactions to winning were few, aside from moderate happiness and relief. Winners emphasized caution, emotional control and unconspicuous spending, e.g. paying debts and sharing with children. There was only a slight increase in economic spending. A wish for anonymity was frequent, together with fear of envy from others. Betting was modest both before and after winning. Experiences with winning were predominantly positive. Life quality was stable or had improved. An age trend was observed, accounting for more variance than any other variable. The older winners seemed to represent a puritan subculture of caution, modesty and emotional restraint. A slightly more impatient pattern of spending was characteristic of younger winners. The results support Kaplan's 1987 and others' findings that lottery winners are not gamblers, but self-controlled realists and that tenacious, negative cultural expectations to the contrary are myths, but perhaps also deterrents of uncontrolled behavior.
Culture is everything.
Thursday, August 23, 2007
"China: Recalled Toys Not Poor Quality"
In fact, you can see that the lead paint was applied flawlessly in each and every case.
Snark aside, the Chinese government really needs to apply the ancient sage's wisdom to the modern battlefield of damage control.
Posted by Andrés at 9:00 PM
That, in essence, is the message of Bill Gross's latest Investment Outlook. The top fixed-income guru (a well-deserved title, I might add) and head honcho of PIMCO estimates that house prices may fall 10% over this cycle, leading 2 million household to lose the roof over their heads.
It's a theme I've also insisted upon (see here). While the current market turbulence is worth undestanding and addressing, in the grand scheme of things the real danger lies in a housing-led spending collapse.
Gross discards the idea that rate cuts are the real remedy since their effectiveness is not guaranteed in the current panicky environment. Oh, there's also the small matter of a possible run on the U.S. dollar.
Instead, he proposes that the federal government implements a massive bailout for homeowners threatened by foreclosure.
Get with it Mr. President and Mr. Treasury Secretary. This is your moment to one-up Barney Frank and the Democrats. Reestablish not the RFC or the RTC, but create an RMC – Reconstruction Mortgage Corporation. If not, make some modifications in the existing FHA program, long discarded as ineffective. Write some checks, bail ‘em out, prevent a destructive housing deflation that Ben Bernanke is unable to do. After all “W”, you’re “the Decider,” aren’t you?
Irony aside, even if we had a better president than the current one it would not be easy to design and get a program of this nature enacted. Start with the fact that U.S. is not in a good fiscal position, so offsetting spending cuts might be needed (Any volunteers? Didn't think so). But I wouldn't be surprised if this comes the top issue in the 2008 election.
Posted by Andrés at 4:36 PM
The chic contrarian position nowadays is to argue that financial bubbles do have benefits. First, Daniel Gross defended the tech bubble (it was not only good, it was great!) as a means to encourage lots and lots of investment and innovation which provide long-term gains to society. Hardly a scientific argument, but it does make some sense.
Now, on these grounds it is much harder to defend the real estate bubble. Yes, there was some financial innovation involved, as Gross mentions. But it certainly was not of the life-changing variety (as were the Internet or railroads) and it was mostly already in place before the party got underway.
So did it provide benefits? Mystery blogger Knzn argues that it was the only way to ensure that a recovery took hold after the 2001 recession.
He's right, to an extent. The purpose of lowering rates to 1% was to get people to spend (the government could only do so much and firms were hungover). In a very anemic job growth environment, such as the one from 2002-2005, the only way to do that was through asset reflation, mainly residential real estate.
The real problem was that rates stayed too low for too long. In 2004 and 2005, a period in which the recovery had evidently taken hold, house prices (measured by the Case-Shiller composite index) rose 18.7% and 15.9%, respectively. And it was in 2005 and 2006 when subprime mortgage originations rocketed. If the Fed and other financial regulators had acted sooner, things woldn't have gotten out of hand to the degree that they did.
Sure, there's a fine line between asset reflation and a bubble. But it is clear that real estate bubbles are much more dangerous (they affect most people) and have a much more negative effects (depleted savings, high debt, excessive investment in nonproductive assets, screwing future hombe buyers, etc.) than garden variety stock market bubbles, with no long-term upside.
Wednesday, August 22, 2007
There's no question that the Federal Reserve's response to the current market turmoil has been belated, clumsy and not terrible effective. Many attribute it to rookie mistakes by Chairman Bernanke. But I think it goes beyond that. To understand the Fed's actions, its worth exploring the way some of that institutions top officers look at these issues. From what I've seen so far (read on), no wonder we're f***d.
Let's begin with Frederic Mishkin, a noted economist and member of the Federal Reserve's Board of Governors and its Open Market Committee. Last January he gave a speech where he laid out his thinking of asset prices and monetary policy.
First, Mishkin states that he doesn't believe central banks should actively seek to puncture bubbles of any kind, but other central bankers hold the opposite position. Having said that:
There is no question that asset price bubbles have potential negative effects on the economy. The departure of asset prices from fundamentals can lead to inappropriate investments that decrease the efficiency of the economy. For example, if home prices rise above what the fundamentals would justify, too many houses will be built. Moreover, at some point, bubbles burst and asset prices then return to their fundamental values. When this happens, the sharp downward correction of asset prices can lead to a sharp contraction in the economy, both directly, through effects on investment, and indirectly, through the effects of reduced household wealth on consumer spending.
This is not complacency. He knows the danger. But what should central banks do when they see frothy real estate markets?
A special role for asset prices in the conduct of monetary policy requires three key assumptions. First, one must assume that a central bank can identify a bubble in progress. I find this assumption highly dubious because it is hard to believe that the central bank has such an informational advantage over private markets. Indeed, the view that government officials know better than the markets has been proved wrong over and over again. If the central bank has no informational advantage, and if it knows that a bubble has developed, the market will know this too, and the bubble will burst. Thus, any bubble that could be identified with certainty by the central bank would be unlikely ever to develop much further.
This brings to mind the joke about the economist who refuses to pick up a dollar bill on the sidewalk (see here). A rather lame argument, if I may say so myself. But let's move on to a key section of his speech (bold type is my emphasis):
A second assumption needed to justify a special role for asset prices is that monetary policy cannot appropriately deal with the consequences of a burst bubble, and so preemptive actions against a bubble are needed. Asset price crashes can sometimes lead to severe episodes of financial instability, with the most recent notable example among industrial countries being that of Japan. In principal, in the event of such a crash, monetary policy might become less effective in restoring the economy's health. Yet there are several reasons to believe that this concern about burst bubbles may be overstated.
To begin with, the bursting of asset price bubbles often does not lead to financial instability. In research that I conducted with Eugene White on fifteen stock market crashes in the twentieth century, we found that most of the crashes were not associated with any evidence of distress in financial institutions or the widening of credit spreads that would indicate heightened concerns about default.5 The bursting of the recent stock market bubble in the United States provides one example. The stock market drop in 2000-01 did not substantially damage the balance sheets of financial institutions, which were quite healthy before the crash, nor did it lead to wider credit spreads. At least partly as a result, the recession that followed the stock market drop was very mild despite some severely negative shocks to the U.S. economy, including the September 11, 2001, terrorist attacks and the corporate accounting scandals in Enron and other U.S. companies; the scandals raised doubts about the quality of information in financial markets and ultimately did indeed widen credit spreads.
Most, Mr. Mishkin, is not good enough. And this argument is misleading. First, we're talking about real estate, not stocks. Second, credit spreads did jump dramatically in 2001-2002, as a lot of the excessive tech and telecom investments --which were made due to the wildly optimistic assumptions that were also reflected in stock prices---went bust. Things did not get very ugly because rates were quickly cut.
There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability. House prices are far less volatile than stock prices, outright declines after a run-up are not the norm, and declines that do occur are typically relatively small. The loan-to-value ratio for residential mortgages is usually substantially below 1, both because the initial loan is less than the value of the house and because, in conventional mortgages, loan-to-value ratios decline over the life of the loan. Hence, declines in home prices are far less likely to cause losses to financial institutions, default rates on residential mortgages typically are low, and recovery rates on foreclosures are high. Not surprisingly, declines in home prices generally have not led to financial instability. The financial instability that many countries experienced in the 1990s, including Japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices. In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble.
Yes, residential bubbles are not common. That's precisely why the Fed should've been much more worried! But what really shocks is that time has stood still for Mr. Mishkin. He still sees a world of bank-originated plain vanilla mortgages taken out by solid, creditworthy citizens which are then are sold to prudent investors through bonds packaged by Freddie Mac and Fannie Mae. It's as if the whole subprime/Alt-A thingy never happend.
Clearly, even Mr. Mishkin grants that bubbles can exist and burst. So what happens then?
Instead of trying to preemptively deal with the bubble--which I have argued is almost impossible to do--a central bank can minimize financial instability by being ready to react quickly to an asset price collapse if it occurs. One way a central bank can prepare itself to react quickly is to explore different scenarios to assess how it should respond to an asset price collapse. This is something that we do at the Federal Reserve.
Indeed, examinations of different scenarios can be thought of as stress tests similar to the ones that commercial financial institutions and banking supervisors conduct all the time. They see how financial institutions will be affected by particular scenarios and then propose plans to ensure that the banks can withstand the negative effects. By conducting similar exercises, in this case for monetary policy, a central bank can minimize the damage from a collapse of an asset price bubble without having to judge that a bubble is in progress or predict that it will burst in the near future
I have a word for this: GIGO. Yes, the universal law of garbage in, garbage out has proven itself once again. Is it any wonder that the Fed's response has been slow and not very effective when it has ignored the changes in the mortgage market? Evidently, their "stress tests" were based on unrealistic/deficient/naive assumptions.
This is very, very worrisome. The Federal Reserve is flying blind through a raging storm. Better buckle-up.
Tuesday, August 21, 2007
Iraqi growth 'unexpectedly slow'
Nothing else needs to be said.
It didn't take long for Warren Buffet's name to come up in relation to the current market crisis. It turns out, according to rumors cited by the Wall Street Journal, that Mr. Buffet might buy parts of Countrywide Financial Corp., one of the nation's leading mortgage lenders (and now stuck in the subprime quicksand).
While he's not regarded as a vulture investor, Buffet is no stranger to the fine art of purchasing distressed securities. During the Long Term Capital Management Crisis in 1998, he offered to purchase its assets, an offer that was apparently rejected (this very relevant study by the Federal Reserve summarizes the episode)
So far, the only direct, significant impact of the housing downturn on the economy has been the drop in residential investment. It's certainly been a nasty fall. After representing 6.3% of GDP in the 4th quarter of 2005 (a level not seen since 1951), it stood at 4.9% of GDP in the second quarter of this year. In real terms, it has fallen 18.6% during this period.
This drop subtracted 0.3% from total GDP growth in 2006, with an additional 0.9% and 0.5% over the last two quarters. So is the bottom in sight?
Yes, according to the median forecast in the Federal Reserve's Survey of Professional Forecasters. The forecasters expect an additional 4% drop in residential investment between the second quarter and the first quarter of 2008, after which it'll start a slow recovery. That roughly implies that it'll represent, at the bottom, around 4% of GDP.
This seems a bit optimistic given recent events and historical precedent. In previous housing downturns, residential investment has bottomed at around 3.3% of GDP. In addition, housing starts are still around 1.4 million and traditionally they fall to below one million during rough times (actually, the median forecast sees this level as the bottom and sees a slow rise in 2008).
Needless to say, forecasters seem unduly optimistic on residential investment. Although they've already cut the GDP forecast for this year from 2.6% late last year to 2% currently, negative surprises seem to be, unfortunately, quite likely. (And this is not even taking into account the possible impact on consumers).
Monday, August 20, 2007
Yes, it's back with a vengeance. From every corner of the kingdom (see here and here), analysts are screaming "Bailout!" in response to the Fed's reduction in its discount rate and change in policy stance.
But is it? The premise of the criticism is that the Fed has rescued Wall Street and well-heeled investors in the recent past (the 1998 LCTM debacle, the tech bubble), thereby encouraging even more reckless behavior, such as that associated with the subprime mess.
Excuse me, but this doesn't make sense. LCTM did go bust, many persons lost fortunes speculating on Russian debt, and the Nasdaq is at half the level it reached in its 2000 peak. And cutting rates now won't do much to reduce the losses in bonds backed by junk mortgages. So it's not a question of rescuing investors, but of making sure that speculative excesses don't spill over to the economy. I don't blame the Fed for doing what it's doing (albeit in a rather clumsy way).
The hissy fit over alleged bailouts is unhelpful, as it distracts from asking the truly important questions:
1) Why have there been so many speculative excesses in such a short period of time?
2) Should central banks actively try to nip bubbles in the bud?
3) Do hedge funds and other highly-levered investment vehicles need to be regulated more strictly as potential sources of financial destabilization?
Have you seen anybody discussing these points lately? Neither have I.
Now that everyone has had a couple of days to digest the Fed's actions, many have come to condemn them as the latest edition of the "Greenspan put", that is, bailing out Wall Street's scoundrel speculators. None other than the great James Surowiecki dixit.
Trends in credit spreads support this view. As James Hamilton points out, they've certainly risen, but only towards their long-term average (BAA-rated corporates are only slightly above 200 basis points above Treasuries).
While I do believe this view has a lot going for it, there are two big caveats.
First, we still don't know (and won't know for many months) where the weakest link is in the financial system and the disruption it may cause. The Fed obviously has a lot more inside info than any analyst and is in a better position to judge this. If it's worried by what it sees, a down payment on further easing makes sense.
Second, there's still the fundamental issue: house prices. While so far the adjustment is in line with the last big housing downturn in the early 1990's, leverage is much, much higher today, so things could get uglier. Certainly, the Fed foolishly downplayed the whole supbrime mess over the past few months, as many are pointing out. Nevertheless, some monetary easing might be justified to avoid a vicious circle from developing.
Talking about bailouts is not helpful. The losses for investors and homeowners are real, justified and won't disappear even if the Fed eases rates some more. The Fed's job is simply to make sure they are absorbed in an orderly fashion and we should judge it by this parameter.
Saturday, August 18, 2007
Recently, there was a run on a bank. Didn't hear about it? Maybe it's because it had nothing to do with the current subprime mortgage crisis and because it took place in ....Second Life. Yes, the much-hyped virtual game does have a financial system of sorts and apparently it's facing very real growing pains (hat tip: Byrne's Eye View)
Tim Hartford describes some very interesting work being done by physicists and economists to map out the relationship between products at global and national scale (hat tip: Marginal Revolution). The idea seems to be that poor countries have different product clusters (say, tropical agriculture and mining) from rich nations and it's not easy moving from one to another.
"The physicists' map shows each economy in this network of products, by highlighting the products each country exported. Over time, economies move across the product map as their export mix changes. Rich countries have larger, more diversified economies, and so produce lots of products—especially products close to the densely connected heart of the network. East Asian economies look very different, with a big cluster around textiles and another around electronics manufacturing, and—contrary to the hype—not much activity in the products produced by rich countries. African countries tend to produce a
few products with no great similarity to any others."
That could be a big problem. The network maps show that economies tend to develop through closely related products. A country such as Colombia makes products that are well connected on the network, and so there are plenty of opportunities for private firms to move in to, provided other parts of the business climate allow it. But many of South Africa's current exports—diamonds, for example—are not very similar to anything.
If the country is to develop new products, it will mean making a big leap. The data show that such leaps are unusual.
This is a pretty compelling argument for industrial policy (paging Dani Rodrik!). The question, of course, is what type of industrial policy is best and how it can be implemented. Needless to say, this debate has been going on for nearly 50 years and, curiously, but it's striking how little we know.
As many have noted, it is becoming increasingly difficult telling apart ordinary newspaper pieces from content published by The Onion. Just take a look at this headline found in the Washington Post:
N.C. Waitress Applauds Minimum Wage Hike
So what's next? "Will from Des Moines criticises Hillary on Rush Limbaugh's show". Beyond belief.
Friday, August 17, 2007
Today's rate cut was not exactly a surprise. Rumors were already flying about yesterday.
While I understand the need for the Fed to sometimes work in secrecy to avoid tipping-off people as to impending policy changes, it's silly for central bankers to start playing James Bond.
Everybody and their second cousin has already commented on the Fed's "surprise" cut of their discount rate and their change in outlook (summary here)
So, what's the deal? Enter the proverbial glass.
The half full interpretation: The Fed is only soothing irrational panic in the markets that could, if left unchecked, turn into a full-blown credit crunch. Once everyone realizes that the world isn't coming to an end, things will get back to normal, investors will be a bit wiser and credit spreads will return to saner levels.
The half empty interpretation: The Fed knows that there's going to be a major blowup one of these days that could maybe pose a systemic risk to the capital markets. Hence, it's paying the first installment in what promises to be a series of cuts to avoid a total meltdown. Cutting now makes sense in order to avoid a huge cut later on that will give the impression of true panic.
Which is true? I don't think anyone really knows (not even Ben Bernanke), but I lean towards the half-empty version.
Thursday, August 16, 2007
As was to be expected, the bond rating agencies are catching a lot of (deserved) flack over their (abysmal) performance in the subprime mortgage mess (see here). But then again, what else is new? Ratings have been lagging indicators for as long as I can remember. After every crisis --Mexican, Asian, Russian, Enron, etc.--there's been an outcry over why S&P, Moody's and Fitch where asleep at the wheel.
The answer is obvious: incentives. Issuers pay for ratings. Thus, the agencies have a vested interest in being as nice to them as possible to keep the fees rolling in (this Portafolio piece describes this point well). As Barry Ritholtz notes, it's fundamentally the same problem that brought disrepute to sell-side research after the dot com bubble burst (if you think things have changed, just read this).
What can be done? Politicians may huff and puff, but research can't be regulated, other than by inserting ever longer and totally useless disclaimers after each report.
The only possible solution is for large institutional investors to bankroll serious buy-side ratings research. Of course, putting this into practice wouldn't be easy, as there are obvious collective action/free rider problems, but they're much smaller than those faced by individual investors (hence the private equity racket). If they can't do this, the same old rotten ratings system will continue after the storm passes and politicians get back to the latest Middle East crisis.
So why haven't they stepped up? Fear of changing a century-old system? Fear of retaliation by issuers and the investment banks (both profit from the current arrangement? Your guess is as good as mine.
Wednesday, August 15, 2007
It is very easy for spin to mutate into full self-deception. Just ask any politician. Spin will only work in the long run if it is used sparingly and doesn't involve transparent falsehood. Otherwise it destroys credibility and undermines the ability to achieve long-term objectives.
Somebody should tell this to the National Association of Realtors. The other day I documented how their "house prices haven't fallen since the Great Depression" meme, which is fundamentally false, is coming back to bite them in the ass. But it seems they just can't help themselves. See for yourself at Freakonomics' real estate quorum.
By many accounts, Robert Nardelli is a jerk. But he's a jerk with pretty goood timing. After being pushed out of Home Depot for failing to deliver a rising stock price despite strong growth in January, he landed a new gig as head of Chrysler. While no one can deny that this is a challenging job, expectations are low (anything other than bankruptcy will be considered a success) and being head of Home Depot right now is not much fun at all.
Today HD published its second quarter results, which where appropriately dismal. Sales fell 3% versus 2Q06 and the operating profit sank 12%. Things will only get uglier, as the second quarter is traditionally the strongest (sales rose only 2.8% versus the first quarter, compared to 21.3% in the same period last year). Needless to say, 2008 isn't looking good either. Besides, it's having trouble selling its wholesale building materials division to a group of private equity firms.
The not so bad news: its profit margin held up surprisingly well.
If trading was motivated not by differences in attitudes and preferences but by differences in information and understanding, risk would gravitate not to those best able to bear it but to those least able to comprehend it.
As true today as ever. Read the whole article here.
Tuesday, August 14, 2007
Southern California is a sunny, optimistic place. I guess that's why people here keep thinking that the bottom of the real estate market is just around the corner.
DataQuick analyst John Karevoll interpreted the prices and sales as a sign that San Diego real estate may be nearing the bottom of the post-boom period.
“Most of the declines in San Diego have happened,” Karevoll said. “Now it appears to be re-establishing a balance that we have yet to see for the (Southern California) region.”
Can't blame people for hoping, but this just goes to show how short our memories are. For example, take a look at this graph on San Diego residential real estate prices. It compares the 1987-1996 cycle (whith a peak in July 1990) with the current one (peak in November 2005) using the Case-Shiller price index.
Cycles are never identical, but they sure do seem similar so far! In the 1990's the peak-to-trough price fall took six years to be completed, so it's quite likely that the downward part of this cycle still has quite a ways to go.
P.S.: I promise that there'll be no more snarky biblical-themed titles!
I've heard the meme that "house prices are falling for the first time since the Great Depression" quite a few times recently (examples here and here). The source cited is the National Association of Realtors (the phrase appears in many of their documents).
I'm not sure how these folks came up with it, but its clearly nonsense. We only have to go back to.....1991 to find widespread falling real estate prices. The Case-Shiller indices, probably the most realiable data around, show that nationally prices fell 6.8% between the peak in October 1989 and the trough in February 1994.
Ironically, the NAR has been parroting this line for quite a while now, obviously expecting people to believe that home values hardly ever drop and only do so in the most extreme circumstances. Well, the lie has come back to bite them in the ass. Nowadays, it's more likely to inspire (unwarranted) panic than confidence.
Monday, August 13, 2007
I think this graph captures it:
While the data on households seems much to noisy (taken from the Census Bureau), it is clear that starting on 2004 housing completions began to seriously outstrip demographic demand. So why did price growth take until mid-2006 to cool? Because the market had taken a life of its own with so much cheap financing availible. And it seems to me that to keep the party going, lenders had to agressively recruit ever more unsound borrowers. This explains why recent vintage subprime mortgages have much higher default rates.
The bad news is that the market will undershoot on its way down, just as it overshot on the way up.
Saturday, August 11, 2007
Which stock market sector has had the worst performance so far in August? If you answered financials, you (and I) were wrong. Taking the S&P Global 1200 as reference, it turns out that materials, energy, industrials and consumer discretionary all performed worse than financials.
This is not as strange as it may seem. Look at year-to-date results (YTD). Financials are the worst performing sector, as expected. This means that the damage inflicted by this crisis had been reflected in valuations before the lates news. Which is fairly good news. The bad news is that the sectors who fell most this month are cyclicals, which means that worries about global growth are rising.
Geographically, so far this month emerging markets have donde worse than developed markets and the US has done better than Europe. This has identical meaning to the sector breakdown above. The bad news is already in US stock prices (well, as long as more unanticipated bad comes along) and worries about growth are spreading to the stronger economies (Europe, emerging markets).
Friday, August 10, 2007
Far from being an expert on mortgages or fixed-income markets, as most people, it's not easy fully understanding what's going on. So the only thing I can offer is to share what I'm learning.
First of all, if you really want to understand these mortgages, go read this IMF study, a true eye opener. For starters, it turns out that this is the second subprime crisis. In 1998-1999 most subprime lenders went bankrupt after the Russia/LTCM crisis. The difference between this crisis and today's situation is that the total amount of subprime mortgages was much, much smaller, which is why it didn't receive much notice.
A few additional points:
1. It's rather silly blaming securitization per se for the subprime mortgage meltdown. All sorts of loans have been securitized into bonds, including risky ones such as credit card debt. So why did the supply chain break so badly in this case? It probably has to do with the bubble mentality that set in over the last few years and a lack of a coherent regulatory framework. That said, I do wonder what will happen when the loan originators/services, who supposedly manage these mortgages, go bankrupt. Who collects? This can be very tricky.
2. The real problem, as this BIS report shrewdly noted in 2006, is that subprime mortgages are a fairly recent product (mid-1980's) that came into being during a period of high economic growth, only two mild recessions, rising house prices and declining interest rates. Hence, the models for valuing likely can't handle/didn't take into account high stress scenarios, such as falling home prices, leading to over-optimistic pricing and, thus, losses when they materialize.
3. As I noted yesterday, given the lack of credible valuation models and ratings for these bonds, somebody has to step in. It could be financial firms, although they disturbingly show no inclination to do so even when their own funds and reputations are on the line. Enter the lender of last resort, aka the Federal Reserve.
4. Call me Cassandra, but I will say it once again: the current mess in the markets is serious, but its danger pales besides the one posed by the nexus between increasing foreclosures and falling house prices. I second Paul Krugman in calling for the Fed and other regulators to step in and coordinate borrowers and lenders (via Economist's View).
Thursday, August 09, 2007
They're doing surprisingly well, thank you for your concern. In one of those strange twists of history, after a series of accounting and management scandals Freddie Mac and Fannie Mae were placed under a short leash, which seems to have greatly limited their exposure (see here and here) to the subprime sector. Just look at the performance of their stocks (FRE, FNM):
This is very good news. The markets will need all the help they can get and Freddie Mac and Fannie Mae can play a crucial market making (and thus liquidity-providing and price-creating) role, hopefully coordinating with the Fed. I'm sure we'll be hearing a lot more from them very soon.
I somehow missed this earlier today. When central banks start injecting money into the system, you know it's getting really ugly, really fast.
Will this wall of money do any good? Well, sure, in the short run, although arguibly the signal it sends will work in the opposite direction.
What's really hurting the market is that nobody knows what those securities backed by subprime mortages are worth. If the meltdown continues, I wonder if the Fed will be willing to buy those bonds at a certain price.
Apropos the latest chapter in the subprime saga, Felix Salmon asks what's the big deal about BNP Pariba's announcement that its freezing some funds with investments in bonds backed by subprime mortgages. After all, the money involved belongs to others (unless the bank feels compelled to bail out investors).
He has a point, although in full-blown panics these fine distinctions tend to get lost in the rush for the exits. In this type of situation, it's worth keeping a cool head and listing the possible scenarios:
1) Systemic crisis due to the collapse of a large, well-known financial institution. Very unlikely, but not impossible. After all, the virtue of securitization is that risk is spread more widely. Just imagine how bad it would be if banks had held on to these securities.
2) Credit crunch caused by panic among lenders. This would mainly affect the US (and UK) economy, leading to further losses in the credit and stock markets and perhaps a recession. However, given the strength of the world economy, wide availibility of capital and a starting point of low risk spreads, it probably wouldn't be too bad.
3) Full collapse of house prices in the U.S., consumer retrenchment and recession if a vicious circle between asset value losses and spending establishes itself.
My take is that scenario 3) is the one we should really worry about, yet its been largely ignored. In that sense, Felix's instincts are correct; the collapse of a few funds is mostly a sideshow whose consequences are psychological. But, needless to say, psychology does play a role in the markets. If the gloom bug jumps from them to home owners, then we're in deep doo doo.
Posted by Andrés at 3:20 PM
This game is about guessing which financial institution turns out to be holding lots and lots of bonds backed by subprime mortgages. There are, by some accounts, over 700 billion dollars worth out there (maybe more). Everyone knows where these mortgages come from, but after spinning the wheel of the markets, nobody knows where they are now.
To win, you must not fall for unfounded rumors and look for valuable clues.
Today's squeaker is BNP Paribas's . France's largest bank by market value is certainly not your usual suspect, but it hasn't been the first European victim.
I won't hazard a specific guess at this time, but the next victim is likely to come from a yield-hungry environment with a checkered history of risk control, such as, say, Japan. Oink!
Posted by Andrés at 11:54 AM
Wednesday, August 08, 2007
Dani Rodrik's blog has become a must-read for those interested in economic development. Recently, he's been writting quite a bit on the merits of industrial policy. Contrary to most orthodox economists, he argues that extensive market failures do justify intervention, at least in some cases (see here).
Now, industrial policy models come in many flavors. There's the East Asian development model, based on exports, and the old import substitution model (ISI)followed in Latin America and in India from the 1950's to the 1980's. Results were, obviously, very different.
But, as Rodrik points out, industrial policy falls within the realm of the micro. While it does have macro repercussions, it's absurd to blame it for events such as the Latin American debt crisis of the 1980's. After all, some countries with open economies, such as Chile, experienced severe crises at that time, while ISI-followers such as Colombia and India did not.
That makes The Economist's economics blog's screed against import substitution so bizarre. One can debate ISI's merits, but arguing that ISI caused the debt crisis because it hampered the recovery that came after (which is obvious) makes no sense.
This doesn't mean the two are completely separate. An argument can be made that by the 1970's the ISI model had run against diminishing returns, lowering growth. Facing acute political and social pressures, many Latin American governments worked to raise growth by massively (and recklessly) increasing public spending. This was possible because of the abundant liquidity in the 1970's, which enabled governments go get abundant, low-cost foreign currency loans. If Latin American nations had opened their economy earlier or developed more efficient ways to combat unrest, things may have turned out very differently.
Posted by Andrés at 5:37 PM
Sad, but true. Supermarket cashier lines will be a duller, sadder place after Weekly World News recently ceased publication, although it retains a web site. Those furtive glances (it took rare courage to actually grab a copy) always brought a smile. Now, we're left only with humorless, unimaginative gossip and soap opera rags.
I did enjoy this, perhaps unintentionally poignant, op-ed by one of its contributors.
I was, at first, confused about whether I was supposed to write true offbeat news, general satire or complete fabrication. So I asked. The response was loud and clear: "complete fabrication." (In case this wasn't clear, the paper started running a disclaimer in 2004: "The reader should suspend disbelief for the sake of enjoyment.")
Yet each piece was written as if completely real. So when, for example, Bigfoot got married, launched his acting career and became involved with Kabbalah, each story got a dateline, quotes from "sources" and "experts" and followed a typical Associated Press structure. In fact, much of the original staff came from mainstream newspapers. The standard? It had to seem true.
"Half the readers realize the stories are tongue-in-cheek; the other half believe they're all true," my editor explained. "You have to write the stories to satisfy both groups."
Without such whimsy, the world is a little bit diminished.
Tuesday, August 07, 2007
Mexico-based Cemex, the world's leading construction materials firm, certainly qualifies as a victim of the U.S. housing collapse. The U.S. market represents a quarter of its sales and in the second quarter its sales fell 16% year-on-year, following a similar drop in volume. Spain, another big market facing housing woes, also saw a more modest volume contraction.
Yet, Cemex managed to squeeze out a 6% rise in sales during the second quarter. How? Well, a strong euro (the RMC acquisition gave it a strong presence in Europe) and booming emerging market sales, including Mexico, managed to compensate its troubles in the U.S.
So, its vaunted diversification is finally proving its worth. But curiously, Cemex is not the Mexican cement firm you want to be invested in. That honor belongs to Grupo Cementos Chihuahua, a much smaller produccer that has also entered the U.S. market in a big --and much more succesful--way. Just compare the performance of their stocks.
Thursday, August 02, 2007
It's not every day that a company with a market cap of $100 billion plus sees its stock price jump 8% in one session. Today Nokia did just that after reporting its 2Q results.
Were its numbers that good? Yes, despite the fact that one of its four engines is not working (its network equipment division, Nokia Siemens), a strong euro and so so performance in its biggest division (mobile phones).
Leaving aside the network division numbers, which are not comparable to previous periods due to the Siemens merger, sales jumped 13% over the year-ago period. But what's extraordinary is that they rose nearly 14% compared to the first quarter. That's 40%+ annual growth going forward. It was driven by strong growth in multimedia devices (fancy 3G phones and PDA's) and enterprise solutions.
I have no idea whether they can keep up this growth rate. And it's certainly a feast and famine industry, with long stretches of little or no growth (2002-2004). Yet, at 21 times earnings, while no bargain, it's certainly not too expensive to cash in on one of the world's leading growth markets.
After all, worldwide cell phone penetration standas at 40%, according to the ITU, with Asia at 30%. So there's still a lot of room for growth.
Posted by Andrés at 4:40 PM
Wednesday, August 01, 2007
Over the nearly 200 years since the good Rev. Malthus published his famous hypothesis that food supply can't keep up with population growth, the facts have shown, over and over again, that he got it wrong. Yet, every time food prices rise, neo-Malthusians rise up and say that this time it'll be different.
Well, today's Malthusian Chicken Little is none other than celebrity Harvard professor Niall Ferguson (see here, hat tip to Economist's View). Sure, food prices have risen over 20% as he states. And yes, per capita grain production has not kept up with world population growth over the last two decades. So, is he right that food will be increasingly scarce and expensive in the future?
Nonsense. The IMF's commodity food price index has risen 23% over the last 24 months. (Not all atributable to ethhanol, weather and oil prices have also played their part). But they're only 7.7% above their level in 1980. So even if we assume a modest world inflation rate of 2% a year on average over the last 27 years, in real terms food prices are actually 37% below the 1980 level.
How about the grain supply? According to the FAO, world grain production rose 32.5% between 1979-1981 and 1999-2001, while the world's population rose 45% over the same period. Yet, during this time, meat production jumped 72% and fruit/vegetable production rose 91.7%. Folks, this is a sign of greater affluence and better nutrition.
While there's no denying that climate change will pose challenges, I have no doubt the world will be able to feed itself in the future, as yields rise in many emerging economies and the genetics revolution spreads. And I'm just as sure that uninformed doomsayers like Dr. Ferguson will keep appearing every time food prices rise.
Posted by Andrés at 4:16 PM
Last week, developed world stock markets fell 5%, according to MSCI. Traditionally, emerging markets would fall twice as much on your average market panic (like this year's China scare or 2006's big May sell-off). But last week the MSCI EM index fell just 5.7%.
While I would be reluctant to declare the end of emerging market crises, this certainly shows just how much their risk levels have fallen due to fundamental improvements and, just as important, that developed nation investors have come to know and recognize this fact. As a veteran of nearly 30 years of economic upheavals in the developing world, this is as welcome as it was unexpected a decade ago.
Posted by Andrés at 4:07 PM