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.

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.

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).

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.

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.

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.

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.”

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.

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.

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.

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.

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

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?).