March 2007 Archives

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Incomprehensible charts in the NYT

I very much admire the anonymous chart-makers at the New York Times. They generally do a magnificent job of presenting information in a clean, easy to understand, and often very clever manner. I wouldn't be surprised to learn that they'd hired Edward Tufte as a consultant. But boy did they screw up today.

The story that the chart is attached to is perfectly fine. It's by Damon Darlin, and it's essentially keyed off the Chris Cagan report which I blogged about a couple of weeks ago. But the chart is dreadful, and the first indication that it's dreadful is that none of the numbers in the chart are referred to in the story. So even if you read the whole thing, which is 1,500 words long, you're still none the wiser as to what the chart is supposed to mean.

Anyway, here's the chart: see if it makes any sense to you. I puzzled over it a long time before giving up – or, rather, before taking another look at Cagan's report to see if I could work out there what the chart meant.

I applaud the NYT's willingness to print charts which don't have time along the x-axis. Such charts are often very interesting, but a lot of newspapers think their readers won't understand them, and ban them entirely. That's a bad policy. There are lots of clear charts which don't have time on the x-axis. But if you don't have time on the x-axis, you need to take extra care that your chart is clear. And no one did that here.

Anyway, what are these two charts about? The headline should give us a clue: "Teasers Become Burdens", it says, and the text below it talks about mortgages which were originated between 2004 and 2006 and which are being "reset at higher rates". So presumably the charts show how people with adjustable-rate mortgages are going to see a spike in rates? Er, no. In fact, the charts don't even cover mortgages taken out between 2004 and 2006, as is implied by the text. They only cover mortgages taken out in 2005. How do we know this? Because at the top of each chart it talks about "mortgages originated in 2005 resetting through 2010". Except even that is not really accurate. In fact, the charts only show two things: mortgages originated in 2005 and resetting in 2005 (the yellow line) and mortgages originated in 2005 and resetting in 2007 (the red line). Mortgages resetting in 2006 or 2008 or 2010 aren't shown at all.

So what's going on in the first chart? Remember, it only covers loans taken out in 2005. The yellow line shows that over 400,000 such loans had a teaser rate of less than 2%. That's scary, right? Just think of what those borrowers will be paying when their loans reset! Oh, hang on, the yellow line is loans which reset in 2005 – two years ago. All those borrowers have already been paying the higher, adjustable rate for well over a year at this point. If you look at the red line, which is the loans resetting this year, it turns out that most of them already carry an interest rate of between 6% and 9%. Which means that when the loans reset to a market interest rate, the increase in mortgage repayments will be much smaller.

In no way does the chart show that "millions of borrowers took out adjustable-rate mortgages with low teaser rates that are being reset at higher levels" – if by "are being reset" you mean "are being reset this year" rather than "were already reset in 2005". In fact, the chart shows that most of the mortgages which are being reset this year had pretty normal initial interest rates in the 6% to 9% range.

A much more relevant chart would show the number of loans originated with teaser rates which are resetting in 2007 – without worrying about when those loans were taken out. But that's not the chart we're given.

And what about the second chart? That one actually makes even less sense than the first. It seems that loans with very high initial interest rates make up a very high percentage of loans resetting in 2007, and a very low percentage of loans resetting in 2005. Or something – it's incredibly unclear, and in fact I would say it's impossible to work out what the chart is really showing, unless you can see the chart from which it has been taken. (Which I'm helpfully providing below.)

The chart shows that if you take all the 2005-vintage loans with teaser rates below 2%, more than 80% reset that same year, in 2005, while none of them are resetting in 2007. In fact, if you take all the 2005-vintage loans with teaser rates below 5%, the vast majority of them have already reset, and very few are resetting this year. Meanwhile, if you're someone who took out an adjustable-rate mortgage in 2005 which carried an initial interest rate of more than 10% (!) then there's a very good chance it will reset this year. What use is this information? None, as far as I can tell. And it certainly isn't particularly germane to the subject-matter of the story.

What I fear is that people will look at that graph and panic, thinking that it means that lots of loans are resetting to interest rates in the double digits. But that's not what it means at all. In fact, if you look at it correctly, it's reasonably reassuring: it shows that people who are seeing their 2005-vintage mortgages reset this year generally do not have low teaser rates. But there's really no way to work that out just by looking at it.

In any case, here are the tables from which the charts are drawn. I honestly have no idea whatsoever why the New York Times chose these tables rather than any number of more germane other ones from Cagan's report. For instance, table 10 could have generated a chart of all the loans originated between 2004 and 2006 which are resetting in 2007, along with their initial interest rates. That would have been interesting and useful. These ones are neither.

Posted by Felix at 11:36 EST | Comments (1)

What would Goldilocks make of Q4 GDP?

Economists are pretty bad at predicting the future (how fast will the economy grow next quarter?). They're also pretty bad at predicting the present (how fast is the economy growing this quarter?). And, it turns out, they're equally bad at predicting the past (how fast did the economy grow last quarter?)

In January, economists reckoned that fourth-quarter GDP growth would be 3.0%, but in fact the advance figure came in at 3.5%. In February, that number was revised down to 2.2% – it seems that even in January we really didn't know what had happened between October and December. And then today, the final number came out. The markets were expecting 2.2% again, but in fact the number is 2.5%. Notes Barry Ritholtz:

Markets rallied on the news that 4 - 6 months ago, GDP was bad, but not quite as bad as previously believed. (So much for the market as a forward looking discounter).

Want to get even more confused? Read Kash Mansori explaining that the upward revision is actually a bad thing: a lot of the upward revision can be attributed to the fact that inventories rose at an annual rate of more than $22 billion. So companies were making things, which boosted GDP; they just weren't selling them.

Still, all these revisions do put me in mind of Goldilocks. The first report was too high, the second report was too low... could it be that 2.5% is just right?

Posted by Felix at 11:50 EST | Comments (3)

Stock or Not

Some kind of genius: Stock or Not? Josh Reich has written a lovely little web app which puts two charts side by side. One is a real stock, the other is randomly generated. Can you tell which is which? I couldn't:

Mathematically, one would expect half the people taking this test to get scores over 50%, and half to get scores under 50%. I wonder what it would mean if a significant majority of people, like me, got scores well under 50%? (In fact, I got only one of the first five right: at that point I was down at 20%.)

NB: The app never ends: You can keep on clicking for as long as you like, and it will give you a cumulative total. The more you click, the more accurately the percentage reflects your stock-chart-picking prowess.

Posted by Felix at 11:31 EST | Comments (1)

Alex Ross live!

If you're under the age of 35, reading this blog, and free on Sunday, I'm pretty sure that the last thing you want to do is schlep up to 92nd Street at the tender hour of 11 in the morning. But you should: the brunch with Alex Ross looks like it's going to be very good, and they have a special $10 for we young 'uns (yes, I'm under 35 for a few weeks yet). The 92y blog has a Q&A with Ross, who's also blogging himself on what the brunch will bring:

I will look at the poetic roots of two works that forever altered the musical landscape: Debussy’s Prelude to "The Afternoon of a Faun" and Schoenberg’s Second Quartet. In Debussy’s case inspiration came from Mallarmé’s gloriously enigmatic long poem “The Afternoon of a Faun" — “the motionless and weary swoon / Of stifling heat" — and in Schoenberg's case it was Stefan George's "Rapture": "I feel the wind of another planet.... I dissolve in sounds, circling, weaving...." I’ll discuss how conventional harmony crumbled underfoot as the composers chased these elusive images.

Ross's book, for which this event is a very early plug, looks like it's going to be really good; it grew, I believe, out of this piece of his, which is well worth reading. In any case, I'm the kind of person who judges books by their covers, and this one reminds me of one of my favorite books of all time. I suspect it will have the same great quality of being a reference one can dip in and out of, too.

(Full disclosure: I, too, was a bit hesitant about getting up to 92nd Street on a Sunday morning, but then I found out that Alex Ross had included me alongside such luminaries as Terry Teachout and Lizzie Skurnick as a Blogger Worth Inviting – so at that point I felt compelled to go.)

Posted by Felix at 12:08 EST | Comments (0)

Economics 101

I think we should implement a new corollary to Godwin's Law – call it McArdle's Law, after this blog entry at Free Exchange – saying that any time someone mentions "Economics 101" in a debate, they've automatically lost. The point of the Free Exchange blog is that people who criticize arguments as being "Economics 101" are generally on the wrong side of the argument. But then again, people who praise arguments as being "Economics 101" are generally equally wrongheaded. For instance:

With rising distressed sales of foreclosed homes and of homeowners unwilling or unable to service their mortgages, the future supply of existing homes will go up this year and next and, given downward price adjustment, the equilibrium level of existing home sales will increase over this year and next. Thus, observation of increases in the sales of existing homes over time - as long as existing home prices fall - will be signs of further distress in the housing market, not improvement. Basic economics 101 suggests that.

Yes, if you've taken Economics 101, then a rise in existing home sales is a sign of distress in the housing market. (Does this mean that a fall in existing home sales would be an indication that everything was tickety-boo?) I can see the argument: demand can rise as prices fall, so rising sales can be consistent with housing-market distress. But it's a bit of a leap from that to saying that they're a sign of housing-market distress. And it's a jump of Knievel proportions to say that such an inference is "Economics 101" – and I'm quite happy saying this despite the fact that I've never taken an Economics 101 course.

It seems to me that the housing market is not all that different from the stock market in some respects. If you want a good gauge of how the stock market is doing, you look at prices and volumes in the secondary market, not the IPO market. Similarly, existing home sales are a good indication of how the housing market is doing: it's worth remembering that every homeowner in the country lives in an existing home, which means that it's the market in existing homes that they're really invested in. And if existing home sales rise, surely that's a good thing, ceteris paribus, for the housing market as a whole: it shows that housing prices, even if they're depressed, are at least realistic and set at a market-clearing level.

Posted by Felix at 13:57 EST | Comments (2)

Felix Salmon to blog for Portfolio

It's in WWD, so I guess that makes it public: I've signed on as the finance blogger for portfolio.com, which goes live in mid-April. It's a big commitment for me – it really is a full-time job, although I don't need to go into the office, or anything like that – so from here on in blogging at felixsalmon.com is necessarily going to be more infrequent. More news on permalinks, RSS feeds, etc when it all happens.

UPDATE: Just to be 100% clear about this, I'm blogging for Portfolio, the new Condé Nast business magazine. I am not blogging for Women's Wear Daily. Sorry for any confusion.

UPDATE 2: Some people seem to fear that I will be hidden behind some kind of subscriber firewall. Fear not! Portfolio.com will be utterly free to all. And I have asked to have a full, untruncated RSS feed, too.

Posted by Felix at 7:03 EST | Comments (7)

Counterfeiting statistics, New Yorker edition

As any regular reader of this website knows, all counterfeiting statistics are bullshit. Larissa MacFarquhar's profile of Harley Lewin in the March 19 issue isn't online, but it's a prime example of the problem. I'm sure that what happened is that MacFarquhar got some numbers from trade organizations, and passed those numbers on to the fact checkers, who checked nothing beyond the fact that the trade organizations said what MacFarquhar said they were saying. Only the problem is that MacFarquhar doesn't attribute her statistics to trade organizations, she simply presents them as plain fact: 2% of all airplane parts installed each year are counterfeit, she says, and 10% of all pharmaceuticals are counterfeit. And, my favorite example of numbers pulled out of thin air suddenly transmogrifying into New Yorker-endorsed fact:

The world market in counterfeit goods in the mid-eighties was only a hundredth of the size that it is now.

Yeah, right. I'll happily give $1,000 to anybody who can plausibly demonstrate that.

Occasionally MacFarquhar will actually cite a named source, but even then she does so in an utterly credulous way:

"I don't think it's an exaggeration to say that counterfeiting is an enormous threat to the future economic health of the US," Rick Cotton, chairman of the United States Chamber of Commerce-led Coalition Against Counterfeiting and Piracy, says. "Industries driven by intellectual property account for nearly half of our economic growth and drive sixty per cent of the growth of our exports. If the counterfeiting trend continues, it is going to ravage our economy and undermine our future."

Which assumes, of course, that Rick Cotton knows what the "counterfeiting trend" is. He doesn't. No one does. But in any case, if these industries are really accounting for half of our economic growth, that's kinda prima facie evidence that they're not being "ravaged" by counterfeiting, no? Of course, MacFarquhar never presents any kind of skepticism. If I were being cynical, I'd say that was because she was writing in the Style Issue of the New Yorker, and that such sentiments might risk annoying advertisers. But actually I think that journalists in general simply don't bother to question these statistics – this is laziness, not conspiracy.

Posted by Felix at 14:33 EST | Comments (2)

Sell-side analysis wants to be free!

Merrill Lynch is worried that too many people are reading its research.

Yes, too many. Reports DealBook:

Merrill Lynch said it plans to eliminate all access to its research from nonclients and to put new restrictions on the media’s access to the research. It will also replace some licensing agreements that “erode the value of our written product” with new arrangements that put a fairer price on its reports.

[Update: The statement is here.]

In other words, Merrill is trying to put the toothpaste back in the tube. Rather than embracing the digital era, Merrill is trying with all its might to pretend that nothing has changed, and that it can distribute digital copies of its research to tens of thousands of clients while still somehow ensuring that no one else gets to read it.

How silly.

As for the "fairer price", does anybody, anywhere, actually pay for Merrill Lynch research? As in a simple cash-for-research transaction? I doubt it, somehow. This is a classic example of something being free to those who can afford it, and utterly inaccessible – at any price – to those who can't.

What Merrill should be doing is to follow the example of, say, Morgan Stanley's Global Economic Forum, which has been freely available online for over a decade now. The problem is that sell-side shops like Merrill like to think of their stock research as being actionable: if Merrill puts a "buy" rating on the stock, then the idea is that a large number of Merrill's clients, impressed with Merrill's analytical expertise, will rush out and buy the stock. If that's true, then they would rightly want the research to go to as few people as possible, so that the inevitable uptick in the wake of the rerating wouldn't move the stock too far. Or something.

The problem, of course, is that sell-side analysts aren't used as outsourced stock-pickers by buy-side clients. They're used as sources of information – analysts often have better access to corporate executives than the buy-side has – and as sources of interesting ideas. But the headline "buy" and "sell" ratings are largely ignored. Besides, the few sell-side analysts who do prove particularly adept at picking stocks usually find themselves lured to the buy-side sooner rather than later in any event.

I look forward to the day when the first large investment bank is bold enough to put all its research online for free. That would be the really smart move. Merrill, on the other hand, is simply wrong when it says that the value of its research goes down the more people who read it. That's not true of the Wall Street Journal, and it's not true of sell-side research either. Good information is often actually more valuable if it's widely read.

Posted by Felix at 14:30 EST | Comments (3)

Banks' real-estate exposure: Nothing to worry about

Whenever there's a banking crisis, there seems to be a very good chance that preceding it came some kind of property bubble. Banks have a habit of assuming that secured loans are secure loans, and loaning out enormous chunks of their balance sheets to property owners – if the property market crashes, banks can be left in a world of pain.

The problem is that banks never want to turn down large quantities of profitable business, and during a housing boom, mortgages are both profitable and very numerous. If they're not careful, banks end up with an uncomfortably large proportion of their assets in real-estate loans.

Kash Mansori put a very good post up yesterday entitled "Can Banks Weather the Real Estate Storm?". He's relatively sanguine about their financial strength: here's his conclusion.

Banks are reasonably healthy, though perhaps not as healthy as you might think; it will take a really big wave of mortgage defaults to hurt them significantly, though, unfortunately, not one that is beyond the realm of possibility given the current state of the housing market and household finances; and if the economy slows down more generally at the same time that the mortgage default rates climb significantly, it seems very possible that banks could be in for a rather rocky period.

I look at the same data as Kash and am actually even more constructive. For one thing, Kash includes about $1 trillion of mortgage-backed securities among banks' real-estate assets. That's fair enough, but he doesn't make allowances for the fact that most of those bonds are issued by Fannie and Freddie, and therefore very, very safe; a lot of the rest are likely to be AAA-rated too. So the risky part of banks' real-estate exposure is certainly smaller than Kash lets on.

Kash also uses a chart of bank equity divided by banks' total real-estate exposure – a ratio currently standing at about 23% – to conclude that "the huge amounts of capital that banks have at their disposal right now are not that huge compared to their real estate exposure". I don't know how he comes to that conclusion, however: the 23% figure seems pretty large to me. I have a feeling he's looking not at the number, however, but at its first derivative: back in the late 90s, the number was almost 26%. But if the number's high, it doesn't really matter if it's falling, and the propensity of banks to lend to businesses rather than into real-estate in the late-90s shouldn't be held up as some kind of really great idea. After all, the very next chart from Kash shows banks' loan write-offs soaring a couple of years later when all those non-real-estate loans went bad – and remember that recovery values on unsecured loans are always much lower than recovery values on secured loans.

Kash reckons that real-estate-related write-offs in a housing downturn could reach $50 billion per quarter, or $200 billion per year. Let's look at Kash's own numbers: total residential real-estate exposure is $1.89 trillion. Let's call it a round $2 trillion if you include risky MBSs. Let's say that overall delinquency rates reach 10%, and that 30% of delinquent loans go into foreclosure. Let's further say that the bank takes a loss of 10% on non-foreclosed delinquent loans, and a loss of 50% on foreclosed delinquent loans. (I'm taking all these numbers from the top of my head, so do feel free to offer something more realistic.) Then you have $200 billion of delinquent loans, which suffer a total of $30 billion of losses on the foreclosed loans, and another $14 billion in losses on the non-foreclosed loans, for a total of $44 billion. How Kash gets to $200 billion, I have no idea.

In other words, the banks are fine. And we don't need to worry about a credit crunch.

Posted by Felix at 11:59 EST | Comments (4)

Classical music sales: booming or collapsing?

Journalism, like any other field, is shy when it comes to admitting ignorance. If a journalist wants to write about a subject, he'll search and search for a self-proclaimed expert until he finds someone who will opine with enough certainty to be able to form the basis of a story. But the truth, both ontologically and epistemically, is messier than that. And so three cheers for Alex Ross, who has done a serious investigation of the market in classical music, and concluded that "Nobody has the slightest idea what's going on."

Ross fingers Brendan Koerner and Bob Tedeschi as journalists all too willing to jump to the conclusion that classical music sales are plunging, even though there's quite a lot of reason to believe that they're not. Certainly things like Amazon's Classical Blowout store are almost irresistible for the classical-music lover: you can find popular fare like Itzhak Perlman playing Vivaldi for $4.99; you can find classic recordings such as Leonard Bernstein conducting the New York Philharmonic in Aaron Copland for $6.97; you can even get Carlos Kleiber conducting the Vienna Philharmonic playing Beethoven 5 & 7 for $8.97. There are dirt-cheap Chopin CDs for $2.98; there's even a 20-CD set of "Classical Masterpieces of the Millennium" for $29.97. Simon Rattle conducts John Adams for $9.97, and there's a 2-CD set of Yehudi Menuhin playing no fewer than 12 Bartok violin pieces for the ridiculously low price of $8.97. (That's a no-brainer for my mother.) If you want Rorem or Hindemith or even Heinrich Schütz's German Requiem, you'll find all that more obscure stuff here, too. No wonder that Amazon's classical sales are booming, especially, as Chris Anderson points out, since the store is expressly designed to carry classical music (with composers, orchestras, soloists, conductors and so forth) rather than trying to use an Artist-Album-Song paradigm.

The classical music world will surely never see another Karajan, who sold 200 million records (and rising). But my gut feeling is that it's far from dead.

Posted by Felix at 10:35 EST | Comments (2)

The $600,000 parking spot

In a post last year, I looked at the value of parking spaces in Manhattan – at least there was a lot of discussion on that subject in the comments. The general upshot was that parking spaces seem to be surprisingly cheap here.

Well, not at 200 Eleventh Avenue they're not. It's a new 16-unit condo development where 14 of the units have what the developers are calling an "en-suite garage". Check out the animation on the website – basically, you drive your car into the building, it goes up in an elevator, and you then drive it into your apartment.

There's about 300 square feet of apartment space devoted to this en-suite garage. The cheapest apartment in the development right now is priced at $4.7 million for 2,353 square feet – which would value the en-suite garage at $600,000. Now that's a serious amount of money to pay for a parking spot!

Posted by Felix at 9:52 EST | Comments (1)

Conventional wisdom debunker, cooking with wine edition

"Never cook with a wine you wouldn’t drink."

You know that, right? It's drilled into even those of us who don't cook very much, and from an early age.

But, it turns out, it's kinda – well, it's bullshit. The NYT's Julia Moskin, bless her, actually did some empirical testing, and it turns out that tannins, for instance, which can be great in wine for drinking, "become unpleasantly astringent when cooked". Hence this delight:

The final test was a three-way blind tasting of risotto al Barolo...
I made the dish three times in one morning: first with a 2000 Barolo ($69.95), next with a 2005 dolcetto d’Alba ($22.95), and finally with a jack-of-all-wines, a Charles Shaw cabernet sauvignon affectionately known to Trader Joe’s shoppers as Two-Buck Chuck. (Introduced at $1.99, the price is up to $2.99 at the Manhattan store.)
Although the Barolo was rich and complex to drink, of the seven members of the Dining section staff who tasted the risottos, no one liked the Barolo-infused version best. “Least flavorful,” “sharp edges” and “sour,” they said.
The winner, by a vote of 4-to-3, was the Charles Shaw wine, which was the youngest and grapiest in the glass: the tasters said the wine’s fruit “stood up well to the cheese” and made the dish rounder. “It’s the best of both worlds,” one taster said, citing the astringency of the Barolo version and the overripe alcoholic perfume of the dolcetto. The young, fruity upstart beat the Old World classic by a mile.

I love any situation where cheaper is better, and cheapest is best. They don't come along very often, but this is clearly one of them.

Posted by Felix at 16:52 EST | Comments (4)

Driving the wrong way down the street

Can New Yorkers drive the wrong way down one-way streets with impunity?

I've certainly seen this happen many times. One very frequent place it happens is the south side of Delancey Street, alongside the Williamsburg Bridge between Clinton and Ridge. There's a lot of free on-street parking on that block, and evidently quite a few of those cars want to go back over the bridge to Brooklyn. In order to do so legally, they need to drive down Delancey to Willett, down Willett to Grand, up Grand to Norfolk, and then finally turn from Norfolk back onto Delancey and over the bridge. If they're OK driving the wrong way up Delancey, however, they just cruise back to Clinton and make a U-turn straight onto the bridge. This happens all the time.

You also see cars driving the wrong way down Great Jones Street, between Lafayette and Bowery, although not all the way. The reason is that cars pull in to the car park on Great Jones and Lafayette, whose owners also run the smaller car park on Great Jones between Lafayette and Bowery. Rather than drive all the way around via 4th Street, they move cars from the bigger car park into the smaller by simply driving the wrong way down Great Jones.

And then there are the more one-off occurrences. Once, I was biking down Grand Street between Thompson and West Broadway when a car started coming down the street at me, driving west, the wrong way. It was on the other side of the street from me, but I was still startled, and ended up foolishly getting a few bruises when I tried to brake with my left hand (the front wheel) while signalling to the driver with my right hand that he was going the wrong way. Of course it turns out he was well aware of that: he'd just seen a parking spot on Grand, and didn't want to risk it being gone if he drove around on Watts and Thompson to get there legally.

All of these examples, while being illegal, are not particularly unsafe. But sometimes you hear of something really egregious – and there's a magnificent example on Streetsblog today.

At 5:52 pm, a heavy-duty truck, probably in the 20,000-lb class, made an illegal left turn from Hudson Street onto Duane Street in lower Manhattan and drove west, the wrong way, on east-bound Duane Street to Greenwich Street. I estimate its speed to have been 20-22 mph. At the T-intersection of Duane with Greenwich, the truck slowed only enough to negotiate a left turn. This block of Duane Street, where I live, is heavily pedestrianized, and in fact pedestrians had to scatter to avoid being struck in the striped crosswalk running from the southeast corner of the T-intersection to the northeast corner.

The crazy thing about this is that it actually makes no sense. Apparently the truck was "fleeing a traffic jam" on Hudson Street – which means that it was trying to go north. But Greenwich Street goes south – which means the truck would have been better off going east, the right way, on Duane over to northbound Church. Alternatively, if he was trying to get to the West Side Highway, he could have just stayed on Hudson a few more blocks until he got to N Moore, and then taken N Moore all the way over. As it is, he probably had to take Greenwich south to Chambers and then Chambers over to West Street, which I can't imagine saved him much if any time.

In any case, the good news is that there was a pair of traffic cops standing right there, on the corner of Duane and Greenwich, who saw the whole thing. What are the chances? Well, it doesn't really matter, because the bad news is that they did absolutely nothing about it. When Streetsblog reader Charles Komanoff wrote to the NYPD asking, essentially, "WTF???," he was told that the traffic cops "were assigned to enforce parking regulations and were not trained to issue moving violation summonses."

In other words, New Yorkers can drive the wrong way down one-way streets, even if they're passing traffic cops, with impunity – the only thing they have to worry about, it would seem, is traffic cops in cars or on motorbikes, who are presumably "trained to issue moving violation summonses". And people complain about cyclists behaving badly.

Posted by Felix at 15:12 EST | Comments (1)

How can a retail investor borrow yen?

An interesting comment just appeared on an old blog of mine:

Can you explain, how can a individual investor borrow yen to buy CAD$?

It's a good question. The fact is that there is a huge universe of investment opportunities which are simply not available to individual investors, and the situation is getting worse. The financial markets love coming up with interesting and innovative new structures for investors to buy, often based on credit default swaps or mortality indices or something equally obscure – and while hedge funds pile in, individual investors are left out in the cold, stuck with crappy old equities. It's weird – there's pretty much no riskier investment than buying an individual stock, but retail investors can do that pretty easily, and can even, with a bit more difficulty, buy options on individual stocks. But if they want a much lower-risk investment like an AAA-rated tranche of a CDO, fuhgeddaboudit.

The carry trade is a bit like that: while borrowing yen is a no-brainer for a hedge fund, it's much harder for an individual. And even if your local bank was willing to lend you yen, I'm sure they'd do so only at a ridiculously high interest rate.

Even if you had a bank willing to do some kind of JPY-CAD swap for you, I still can't see how an individual can really do this trade with nothing but a bunch of margin. The long side is easy, of course – just go along to Everbank and open a foreign-currency account. But the short side is much harder. You'd think with all the crazy mortgages on offer in the US, someone would have had the bright idea of offering mortgages in yen. But so far, to my knowledge, that hasn't happened.

Posted by Felix at 14:07 EST | Comments (11)

NYT factoid of the day

In the case of breaking news, especially during daytime hours, stories are edited through our Continuous News Desk, which has a separate editing staff but no designated copy editors.

Which just makes me want to know who writes the headlines online.

Apparently this is changing, and will change more when the NYT moves into its new building. Even then, however, the website and the newspaper will be very much separate organisations.

Posted by Felix at 12:52 EST | Comments (0)

Is wine really an investment?

Via Alphaville, I found myself today at Decanter's wine investment guide – something which made for a very interesting read, given that I have just finished a book on Robert Parker. Parker will tell anyone who'll listen that they should never buy wine as an investment, but that doesn't stop guides like this being written, and millions of dollars being "invested" in wine by people who have no intention of ever drinking it. You can see why, when Decanter supplies them with prose like this:

In the last 20 years fine wine has also outperformed a number of equity and fixed income indices including the FTSE 100. For long term investors (as opposed to shorter term speculators) a well chosen and balanced wine portfolio should provide annualised returns of 10-12% per annum.
Wine is less volatile than stocks and shares, making it a less risky investment.

That's right, I can get double-digit returns with lower volatility than the stock market – where do I sign up?

Of course, if you look at the guide with a critical eye, it seems much less impressive. Consider this kind of thing, for instance:

There are relatively few (perhaps only about 75 in total) investment grade labels... Bordeaux represents 90% of the wine investment market and should take the lion's share in any portfolio... the Rhone remains undervalued as a region and has yet to really establish its investment credentials... Port is no longer regarded as a good investment bet... New and Old World 'Cult' wines from California, Australia and Bordeaux 'garagistes' are not the darlings of the market that they once were and are best avoided in the current climate.

If you then look at Decanter's list of "10 great investment wines (and 10 not-so-good)", everything becomes a lot clearer. The great investment wines, by definition, are the wines which went up the most in price over the past two years. And – guess what – 2005 and 2006 were great years for anybody investing in Bordeaux, and were not so great for people investing in the Rhone, or in Port, or in New World wines. In general, the outperformers are the wines you've heard of (Lafite, Latour, Margaux), while the underperformers carry names like Conseillante, Valandraud, and Mondotte.

With hindsight, it's easy to construct a reason why this should have been the case: many of the newer buyers came from China and Japan, where buyers use Parker to pick the best vintages of the best Bordeaux, rather than to seek out obsucre garagistes. In California, a bottle of Araujo might have more cachet than a bottle of Lafite, because it's harder to find and, in California, being an international luxury brand is not necessarily considered a good thing. On the other hand, international luxury brands have no better market than Asia – so you can look at the recent rise in price of 1986 Lafite as a luxury-brand story as much as you can see it as a wine-investment story.

In any case, the idea that wine which is undervalued should not be bought as an investment just goes to show me, at least, that wine is not really an investment. A good investor tries to pick undervalued assets, while if you believe the Decanter article, the best thing to do in the wine market is to avoid them. In other words, wine investors are basically momentum investors, working on the greater fool theory. Which generally works until it doesn't.

But look on the bright side: at least all of this means that there are still lots of really good wines which aren't being "collected" and therefore bid up to $5,000 per case and beyond. Which in turn means that those of us who buy wine to drink it, rather than to make money, still have a wide range of very good values to choose from.

Posted by Felix at 22:59 EST | Comments (5)

Adventures in mortgage hype, Breaking Views edition

I popped over to Breaking Views just now to see what they had to say about Barclays buying ABN Amro, and what's the big top headline? "Subprime meltdown echoes dotcom death spiral".

The story itself is pretty smart and sober, as one would expect from its author (and friend of felixsalmon.com) Antony Currie. I have no idea whether Antony had any part in writing that headline, but for getting both "meltdown" and "death spiral" into one six-word hed, I hereby award Breaking Views the first Housing Hysteria Award (these, collectively, are known as the Nouriels). Congratulations Breaking Views!

Posted by Felix at 18:46 EST | Comments (4)

How long can nominal house prices fall?

Me, yesterday:

The chances of a nominal fall in house prices over the next five years are, I think, de minimis.

Well, I certainly seem to have got that one wrong. First dsquared and then BR, in the comments, pointed out that six-year periods of nominal house-price depreciation are by no means unprecedented. BR even points to a very useful page showing median house prices in Southern California, which is so interesting I've turned it into a graph:

Remember, this is Southern California, not bubblicious Japan. Indeed, compared to what's happened to prices over the past few years, the run-up in prices from 1986 to 1990 seems positively modest. And yet, between 1991 and 1996, the median home price in Los Angeles fell by 21% – and that's in nominal terms. In real terms, of course, the drop was even greater.

Now, one thing I really hate is people who look at charts and reckon they can work out what prices will do in the future based on what they have done in the past. They can't – and the chart above really tells us nothing about where house prices in Southern California or anywhere else are going. On the other hand, it does show, quite clearly, that house prices can fall quite a lot in nominal terms over a period of many years. If it's happened before, it can happen again.

Posted by Felix at 15:57 EST | Comments (3)

Glitches

My computer went to sleep last night, and never woke up! It was working great when I went to bed, but this morning it was quite dead, and refused all attempts at coaxing it into waking up. I was meeting the fabulous Megan McArdle for a coffee on 57th Street anyway, so I took the opportunity to take the computer into the friendly cube-shaped computer hospital on 59th and 5th. They muttered darkly about a logic board, and took the computer away for surgery; with any luck, I should have it back by the weekend, but until then I have to get used to working again on my old desktop. No great hardship.

I'm mostly backed up; the main things I lost were all the tabs I had open in Firefox, ready to get turned into fabulous blog entries today; and one half-written new blog entry about mortgage equity withdrawal, which I haven't the heart to rewrite. If you're interested, go here: Calculated Risk has everything you need to know. The upshot is that using CR's numbers, 2007 GDP is likely to be about 0.8% lower than it would have been if mortgage equity withdrawal remained at 2006 levels.

Posted by Felix at 15:23 EST | Comments (4)

Dean Baker vs Chris Cagan

I have a lot of respect for the research of Christopher Cagan at First American CoreLogic. His latest paper, a 118-page study of the impact of ARM adjustment, was picked up by the Wall Street Journal, in a story which itself was picked up by Dean Baker:

The WSJ decided to highlight a 3-month old study to tell readers that everything is fine with the mortage market... the problem with the WSJ assessment is that it is based on the assumption that house prices do not fall. If prices fall by 10 percent, then Cagan projects that the default rate would be more than 70 percent higher and the losses to the financial system would more than double.
How plausible is it that house prices don't fall from their December 2006 level? Well, the National Association of Realtors data show that the median house prices has fallen 3.1 percent over the last year...
Does anyone think that house prices won't fall in 2007?

I'd point out that the study is dated March 19, it's not three months old. And the assumption that house prices do not fall is not an assumption that they do not fall in 2007: it's an assumption that they do not fall over the next six years. Which, frankly, is an eminently reasonable assumption. Median house prices are volatile in the short term, and might well go down in 2007. But the chances of a nominal fall in house prices over the next five years are, I think, de minimis.

Baker also ignores a lot of pretty good news in Cagan's report. First, he shows how limited the reset problem is:

The analysis anticipates a total of 1.1 million foreclosures with losses of about $112 billion, spread over six years or more. Our mortgage lending industry extends about $2 trillion of loans yearly, so these losses represent less than one percent of total lending. This will clearly not break the mortgage industry.

Even if prices fall by 10% and foreclosures reach 1.86 million – over six years, remember – we're still not talking major systemic impact.

What's more, the problem of negative equity seems to be getting better, not worse:

As of December 2006, 6.9 percent of the properties had negative equity, which is better than the 9.4 percent having negative equity (as of September 2005) found in the previous study published in February 2006. Although values have fallen in some markets during the intervening time, they have risen in other places, particularly on a year-to-year basis.

There's another interesting datapoint, too: in the last study, 29% of the mortgages originated in 2005 had negative equity. In this study, just 9% of the mortgages originated in 2005 had negative equity, and less than 18% of the mortgages originated in 2006 had negative equity. Why is that? It's because, contra Baker, prices did actually rise in 2006. If you look at the NAR report he's citing, the 3.2% drop is from January 2006 to January 2007. But the same report says that the median sales price in 2006 was actually 0.6% higher than the median sales price in 2005, and there was even a 0.8% rise between January 2006 and December 2006. As prices rise, both foreclosure rates and negative equity rates fall.

(For much more on the old study and negative equity, take a look at this old post of mine from February.)

There's much more in the study, which I would highly recommend to anybody who's seriously interested in the relationship between interest rates, adjustable-rate mortgages, and foreclosures. Here's Cagan's conclusion, which I think is decidedly solid:

In conclusion, this study shows that the time-honored truths of economics are true after all. Risky investments are in fact less secure than traditional investments, and should be valued as such. This sounds too obvious to mention, but it should be disregarded at one’s peril. For short periods of time, under special market conditions such as the surging prices of 2004 and 2005, the old adages stood away from the market in temporary abeyance; but as time went on the time-tested fundamentals of economics have reasserted themselves.
Another time-honored economic truth is that residential real estate is properly a matter for the long term. Traditionally, people purchase their homes to live in and enjoy for a period of several years or even for a lifetime. Strategies with a short time horizon, such as flipping, can produce great profits but also carry risks. People who undertake fixed rate loans that they are able to pay, and hold their homes for several years or more, can in most cases expect to do quite well.
It is legitimate to enter a home with adjustable-rate financing, but borrowers and lenders should consider what the payments are likely to be in a few years as well as initially. If the future payments can be sustained and not only the initial payments, and if significant negative amortization is avoided, buyers can use adjustable-rate loans with confidence. Those who purchase, borrow, lend and invest following basic and proven virtues are likely to be rewarded for their wisdom.

Posted by Felix at 0:44 EST | Comments (4)

LA question

I'm now back from LA. Everybody there loves it, and frankly they're welcome to it. The way that everybody needs to drive everywhere for everything is just not my style at all. But I do understand the attraction of LA, especially to Londoners who never get weather like that. One thing really puzzles me, however:

Why don't rich Los Angelenos have drivers?

The advantages of having a driver are obvious. You never need to worry about parking. You never need to worry about drinking and driving. You can get as engrossed in multimedia multitasking as you like – you can even watch dailies or shorts on your in-car entertainment system while stuck in traffic. And: you're automatically eligible for the carpool lane!

God knows there are loads of people in LA with more than enough money to hire a driver, but very few of them ever seem to do so. Any idea why that might be?

Posted by Felix at 23:21 EST | Comments (6)

Whither mortgages and housing?

Markets fell on Tuesday, on fears, we are told, about weakness in mortgages and housing; this prompted Brad Setser to ask me whether I'm still as sanguine as I used to be on such matters. I couldn't reply on Wednesday, since I went to Disneyland instead – I can highly recommend the Indiana Jones ride, if you find yourself there for whatever reason. While I was there, the market went back up again. As ever, my main conclusion from all this is that no one should ever draw any conclusions from one-day market moves.

All the same, I might as well get down here for the record what I think about mortgages and housing, because although I think that the bears have some enormous holes in their arguments, that doesn't necessarily make me bullish.

I basically start with the observation that the run-up in housing prices in recent years has been seen all over the world: from Spain to South Africa, from Ireland to Australia. Not everywhere has participated: there's been a lot more price appreciation in Shanghai than there has been in Stuttgart. But there's clearly some kind of global force – let's call it "liquidity", for lack of a better term – which has been driving asset prices in general, and housing prices in particular, upwards. What's more, by the standards of many of these countries, the run-up in US home prices has been relatively modest.

Let's now take another look at the US. I don't deny for a minute that the number of defaults on subprime mortgages, especially subprime mortgages of the 2006 vintage, is eye-poppingly high, and rising. What's more, given the fact that originators have tightened up their underwriting standards substantially (and correctly), many mortgage holders are going to find it hard to refinance their adjustable-rate mortgages when they reset. This could drive default rates even higher, if the rates on those mortgages go up a lot. Home prices are still substantially above their 2004 levels, however, so the real problem is largely confined to mortgages originated in 2005 and 2006.

Now, it's easy to paint a picture whereby defaults on recent-vintage mortgages cause a more generalized tightening in credit markets along with a plunge in housing prices as supply goes up and demand goes down. I do accept that, in theory, this could happen. But before I believe the prognostications of those who say it will happen, I want to see some indication that their model of supply and demand and housing prices actually reflects reality. Specifically, I want to see whether it explains the rise in housing prices over the past few years.

The big mistake that I think a lot of the housing bears are making is that they're confusing correlation with causation. Yes, subprime credit has increased substantially in recent years. And yes, housing prices have gone up. But that doesn't mean that the former caused the latter. Indeed, there are a good reasons to believe that the increase in subprime credit did not cause the run-up in housing prices. For one thing, housing prices started rising before the increase in subprime credit. For another, much of the increase in subprime credit was concentrated in depressed areas such as Michigan and Ohio, which accounted for 15% of all US foreclosures in January. And it's precisely those areas which did not see a run-up in housing prices. Meanwhile, the market in New York City co-ops, for instance, has been booming (and shows few if any signs of slowing down) despite the fact that because those units are "non-conforming", it has always been incredibly difficult to get a subprime mortgage on them. Finally, the rise in subprime credit in the US was not matched by a rise in subprime credit in places like South Africa and China, which saw much greater price increases – so whatever forces drove housing prices up globally are probably sufficient in themselves to explain the increase in housing prices in the US.

Now, one of those forces is doubtless an increase in the availability of credit generally, if not subprime credit in particular. If housing prices rose on a tide of global liquidity, then they can fall if and when that tide starts going out. For the time being, however, there are no signs that is happening. Yes, there are problems in one localized sector of the US mortgage market. But credit markets globally are still as tight as they've ever been. And the US subprime market is simply not big enough to affect global credit markets in any substantial way.

At the margin, then, problems in the US subprime sector will surely have some effect on the US housing market – although, obviously, the effects will be greatest where the concentration of subprime loans is at its highest. But I still think that the big drivers of the US housing market in the recent present will continue to be the big drivers of the US housing market in the near future – which does give me some cause for optimism.

One thing is certain, however: foreclosures will continue to rise, which will be personally devastating to hundreds of thousands, if not millions, of homeowners. These personal tragedies will resonate on Capitol Hill, and the federal government might step in to help those individuals out – which might, in turn, help mitigate the economic effects of the foreclosures. What's more, all the talk of hundreds of billions of dollars being "lost" in foreclosures is a mite misleading: all that equity has already been lost by the time the foreclosure proceedings begin.

The big losers will be the holders of the equity tranches of MBSs and subprime-backed CDOs, as well as those subprime originators who find themselves holding a bunch of scratch-and-dent loans they thought they'd sold already. So it makes perfect sense that subprime mortgage originators are closing shop. But I'm not shedding too many tears for them: they made a lot of money in the boom years, and then they relaxed their underwriting standards far too much at the end of 2005 and the beginning of 2006. They deserve to bear the consequences.

As for the holders of MBS and CDO equity, we're talking very, very sophisticated investors and financial institutions here, who are almost without exception both willing and able to bear those losses. I see no systemic risks there.

Looking forwards, the number of subprime loans originated will go down, which means that issuance into the subprime MBS market will fall. That's fine. As the yields on those subprime MBSs rise and the underwriting standards on them tighten, there will be enough demand for them to meet supply. So I'm not particularly worried there, either.

The one big event risk, which hasn't happened yet, is a mass downgrade of MBSs carrying BBB and BBB– ratings, to junk status. If that happens, there will be forced selling of those MBSs by institutional investors who are not allowed to own speculative-grade debt, and spreads are likely to gap out substantially. Given how the markets managed to cope with the Ford and GM downgrades, however, I think they could probably cope with this as well. (Remember that Ford and GM bonds are unsecured, and therefore have much more room to fall.) What's more, at this point there's no indication that such a mass downgrade is going to happen.

Overall, then, I'm sanguine about the US mortgage and housing markets. There will be large losses, which will generally be sustained by entities well able to afford them. On an individual level, there will be some tragic losses of much-loved homes. But on a systemic level, I think there is relatively little to worry about.

Oh, and one last thing: there's an argument that US GDP growth has been reasonably healthy of late mainly because of the amounts of equity that consumers are taking out of their homes and spending in shops. If they stop doing that, goes the argument, then the US faces recession – and house prices never do well in a recession. Again, my response is simple: show me, plausibly, the degree to which home equity withdrawal boosted GDP growth in recent years. Then we'll have a good idea how much it could affect GDP growth on the downside.

Posted by Felix at 12:41 EST | Comments (11)

Help me change my mind on mortgages!

Brad Setser asks whether I've changed my mind about the mortgage market in the wake of today's data and the market's reaction to it. I haven't really looked at either yet, and tomorrow I'm going to be spending the day at Disneyland. So do please use the comments section here to give me all the datapoints I need. Then I'll answer his question on Thursday, probably.

Posted by Felix at 23:37 EST | Comments (7)

Can the amount of alpha keep up with the number of hedge funds chasing it?

Whither alpha? Alexander Campbell, in fine form, officiates at a debate between David Rowe and Barry Schachter. All of them, refreshingly, reject the idea that there's some limited supply of alpha, and that as the number of hedge funds and others chasing it increases, there will be less to go round for the average hedge fund manager.

Campbell's blog entry is a fine introduction to the debate. My view is that alpha comes from global imbalances – things like currency pegs which cause distortions in the market. Right now, there are more global imbalances than ever before, which implies to me that there should be more alpha than ever before.

Specifically, I think there's a big delta in the financial markets right now. (I think delta is the right word...) You have the hedge funds and private equity types at one end, who are all about making money and generating alpha. And then you have the world's governments at the other end, who are all about accumulating reserves and who really don't seem to mind very much if they underperform the market. So long as this state of affairs continues, both can be very happy.

(One extreme example of this is Russia, where the government sold off its patrimony at fire-sale prices to ultracapitalist investors. Lots of alpha for the investors there – and the Russian people are the losers.)

More generally, there seems to be more money chasing low-risk fixed-income investments now than at any point in history – this is why private equity is making so much money by issuing vast amounts of cheap debt. There are lots of investors who want risk-free debt, and lots of hedge funds, investment banks, and the like who can make money off the fact that issuing debt can generate higher returns for equity investors.

So count me in with the people who think there's likely to be more than enough alpha to go round for the foreseeable future. That said, of course, there will always be a lot of hedge fund managers who think they're better than they actually are, and who end up just giving money away to the managers who really generate alpha.

Posted by Felix at 15:23 EST | Comments (1)

Simple bond mathematics

Dean Baker doesn't seem to quite understand how the inverse relation between price and yield works in practice:

Back in the summer of 2003, the interest rate on the 10-year treasury bond bottomed out at 3.05 percent. Today, it stands at around 4.6 percent. This means that the bonds China held back then have lost approximately one-third of their value. (The price of the bond is inversely proportional to the yield. The actual calculation of the bond price is a bit more complicated, since it does matter when they reach maturity.) If the yield on 10-year treasury bonds rises back to its avearge rate for the decade of the 90s (6.8 percent), then the value of the bonds would drop by another 30 percent.

Let's go to the SmartMoney bond calculator, and look at the price of a 10-year, 5% bond. (Feel free to use any other maturities or coupon rates: the results won't be all that different.)

If the yield is 3.05%, the price is 116.6.
If the yield is 4.6%, the price is 103.5. That's a drop of 11.2%, which is nowhere near "approximately one-third".
If the yield is 6.8%, the price is 87.2. That's a drop of a further 15.7%, which is nowhere near "30 percent".

But of course those drops overstate reality quite a lot. Because between summer 2003 and now, there have been 7 coupon payments, totalling 17.5 cents. So if you bought that bond at 116.6 in 2003, it might be worth only 103.5 today, but you will have received 17.5 cents in coupon payments along the way – which, added to the value of the bond, brings you to 121, or a 3.7% net gain.

Of course, there are lots of extra variables involved, including the fact that a bond's maturity goes down over time. But I really don't think it's possible for a US Treasury bond to lose two-thirds of its value, as Baker implies that it can – especially if you take coupon payments into account.

Posted by Felix at 14:35 EST | Comments (3)

Felix's high-powered bedfellows

I was quoted in an article by Alen Mattich of Dow Jones this morning. I certainly can't complain about the company I'm keeping:

Some like James Grant of the respected industry newsletter, Grant's Interest Rate Observer, have been warning about the wider implications to the credit markets of rising default rates. Collateralized debt obligations, made up of repackaged mortgages and sliced into various grades of creditworthiness, are likely to see defaults higher up the credit scale than investors suspect, according to Grant.
Not everyone is convinced.
Felix Salmon, an economics blogger, points out that you need to separate out the companies making subprime mortgages from the mortgages themselves. While equity in a number of subprime originators has collapsed, it doesn't follow that debt structured from these pooled mortgages will implode, he says.
That's the way the Federal Reserve seems to see things. Subprime doesn't represent a systemic risk to the financial sector. The problem will stay localized.

So there you have it. Me and the Fed, we're like this.

Posted by Felix at 13:31 EST | Comments (2)

Does Robert Parker's ego know no bounds?

I'm reading Elin McCoy's book The Emperor of Wine, on Robert Parker. Here's a chunk of page 153, as grabbed from Amazon:

I like that "Parker interpreted". Remember that this is the 1990s we're talking about here: How much of an ego does a man need to interpret a "sly introduction" as a winemaker essentially pimping out his own daughter for a higher score?

Posted by Felix at 12:54 EST | Comments (1)

The Frankfurter Allgemeine's overwhelming beauty

What's the most boring newspaper in the world? There are many, I'm sure, but I know a lot of people who would put the Frankfurter Allgemeine at the top of the list. Well, the Society for News Design has some news for you: it's just announced that the Sunday version of the Frankfurter Allgemeine has won its award for the best-designed newspaper of the year.

From classically formed fonts to page-dominating visuals, the Frankfurter Allgemeine exudes beauty, overwhelming beauty. This is a masterfully designed, visually intelligent publication. Turning the pages of this paper – with its great expanses of white – is like walking through a gallery that's filled with sophisticated photography, sensuous illustrations, and damn-near-perfect typography. There are surprises and special treats, too. Like graphic novel treatments and illustrations on the TV page. Clearly aimed for an educated audience, this paper is filled with nuance. It doesn't shout – it illuminates.

Wow!

My only question: Is the Frankfurter Allgemeine Sonntagszeitung a completely different paper from the daily version, like the Times and the Sunday Times in England? Or is it just a Sunday version of the same paper?

(Via)

Posted by Felix at 12:18 EST | Comments (1)

LA Times shows how to write sensibly about the housing market

I'm in California this week, which is why posting is rather light: the beach is rather more attractive than squabbling over mortgage-backed bonds. But of course California is the poster child for the housing market boom and bust, and so one can't get away from it entirely – and the LA Times leads this morning with a story headlined "As sub-prime lender implodes, housing shudders". It also has another story, headlined "Home woes don't hurt most bonds".

It's rare that I go out of my way to praise newspaper articles which have essentially no new information in them, but in this case both articles are clear, fair, and informative. The lead article explains that New Century Financial, which is based here in Orange County, "skidded closer to bankruptcy Monday, stoking fears that the mortgage industry's woes could further damage a sluggish housing market." It went on to explain that with refinancing options being taken away from them, many subprime borrowers are defaulting and could end up in foreclosure. With less demand from subprime buyers and more supply from foreclosures, the housing market is certain to be adversely affected to some degree. But the story also has a quote from Pimco's Scott Simon, saying that the MBS market – which is by no means the same thing – "should be just fine".

The bond-market article explains that subprime MBSs might be performing very badly at the moment, but that there's no sign of a more generalized flight to quality, nor any risk of a more generalized credit crunch.

So bravo to the LA Times, and its journalists David Streitfeld, E. Scott Reckard, and Tom Petruno. I've seen more than enough overheated scaremongering in recent months to know that writing sensible articles like these is harder than it looks.

Posted by Felix at 11:17 EST | Comments (0)

Is there a looming crisis in the mortgage market?

The world is full of people desperate to know what Gretchen Morgenson thinks about the market in mortgage-backed securities, or MBSs. The problem is that her column last week on the subject is hidden behind the Times Select firewall. So we can all be very grateful that she has now rewritten it, at even greater length, and republished it under a "News Analysis" slug. (No firewall!) The headline? "Crisis Looms in Market for Mortgages".

Or, you know, we can ignore it, on the grounds that Morgenson adduces no evidence whatsoever that any crisis is looming at all. For one thing, she doesn't seem to understand the difference between two entirely different types of investment: equity in subprime mortgage originators, on the one hand, and debt backed by pools of subprime mortgages, on the other. It's certainly true that originating subprime mortgages does not seem to have been a very good business to invest in over the past year or so. But Morgenson never connects the dots and explains why that means that the market in subprime MBSs is likely to implode.

Morgenson also talks at great length about the enormity of the market in MBSs, but never stops to point out that the vast majority of that market is in bonds issued by Fannie Mae and Freddie Mac, and that no one has any worries whatsoever about those securities crashing.

Here's a bit of typical overheated prose:

Wall Street firms and entrepreneurs made fortunes issuing questionable securities, in this case pools of home loans taken out by risky borrowers... Regulators stood by as the mania churned, fed by lax standards and anything-goes lending.

But here is Morgenson's own graph, showing the practical effects of that churning mania: MBS issuance more than $1 trillion lower in 2006 than it was three years earlier. It's very hard to look at this graph and see any evidence of a bubble: rather, it seems that private-sector MBS issuance has been rising only to make up for a large drop in issuance from Fannie and Freddie.

Morgenson's most substantive problem is that there's a ticking bomb in the MBS market, in the form of investors failing to mark their securities to market. First she says they don't, then she says they do, and then she says they don't – let's see if you can make more sense of it than I can.

Owners of mortgage securities that have been pooled, for example, do not have to reflect the prevailing market prices of those securities each day, as stockholders do. Only when a security is downgraded by a rating agency do investors have to mark their holdings to the market value. As a result, traders say, many investors are reporting the values of their holdings at inflated prices...
Years ago, mortgage-backed securities appealed to a buy-and-hold crowd, who kept the securities on their books until the loans were paid off. “You used to think of mortgages as slow moving,” said Glenn T. Costello, managing director of structured finance residential mortgage at Fitch Ratings. “Now it has become much more of a trading market, with a mark-to-market bent.”...
Interestingly, accounting conventions in mortgage securities require an investor to mark his holdings to market only when they get downgraded. So investors may be assigning higher values to their positions than they would receive if they had to go into the market and find a buyer. That delays the reckoning, some analysts say.

Of course, Morgenson is missing two crucial points here. The first is that here simply isn't a market in most MBSs tranches – that's why so much of the recent activity has concentrated on MBS indices rather than the underlying securities. The liquid, mark-to-market activity that Costello is talking about is entirely in Fannie and Freddie bonds, not in individual tranches of securitized subprime mortgages. You can't mark subprime MBS tranches to market daily for the very good reason that most such tranches simply don't trade on a daily basis.

And the second point is that if you actually look at the prices for those subprime MBS tranches when they do trade, guess what? They haven't actually fallen much in price at all. If investors were marking to market, it really wouldn't make much difference. As Josh Rosner told me, the problem is not that existing MBSs are likely to default or drop in price. A default is much like a prepayment, from an investor's point of view, so investors only really care about default rates when they start approaching prepayment rates. And they're nowhere near those levels.

Anyway, here's my favorite bit from Morgenson's article. Before you read it, ask yourself what a scary loan-to-value ratio for subprime mortgages would be. 125%? 100%? 95%?

The rapid rise in the amount borrowed against a property’s value shows how willing lenders were to stretch. In 2000, according to Banc of America Securities, the average loan to a subprime lender was 48 percent of the value of the underlying property. By 2006, that figure reached 82 percent.

There you go: 82%, in the year universally considered to be the laxest year in the history of subprime mortgages. Now do you understand why investors aren't particularly worried about default?

Invidiously, Morgenson even hints darkly at nefarious conflicts of interest at the ratings agencies, saying that they might be soft-pedalling downgrades to save their own hides. I don't think they are. Mortgage pools are designed to be able to withstand a temporary drop in house prices or rise in default rates. I look at the tiny number of MBS downgrades and take comfort in it. I'm perfectly happy to concede that subprime mortgage originators who were active this time last year are going to be in a lot of trouble now. But I'm nowhere near convinced that there's any real problem in the market for the securities based on the mortgages they originated.

Posted by Felix at 11:33 EST | Comments (26)

Rent vs buy redux: Is buying a useful commitment device?

One of the things l love the most about having a blog is the way in which I often bring up a subject and then get a stream of commenters – many of whom know much more on the subject than I do – really move the topic forwards.

A prime example is my post from Friday on rent vs buy calculations, itself prompted by a previous comments stream. My back-of-the-envelope calculations only looked at the position after one year, but a number of commenters have looked out much further than that, and one even did a Monte Carlo simulation! What's more, my commenters didn't just pull numbers out of thin air, as I did, but gave me some very useful real-world datapoints.

Nicholas Weaver put a spreadsheet online for one property in California, assuming rent stays constant starts at $1325 a month and rises by 3% a year, and using a real-world purchase price of $400,000. Upshot? Renting was a lot cheaper. Now, he says, his rent is $1675, for a house worth more than $600,000.

And RichB, in England, came up with an even more elaborate spreadsheet for a UK place listed at £795,000 which is renting for £2750 per month. (Remember that the UK abolished mortgage-interest tax relief, with no appreciable effect on housing prices.) He assumed upkeep costs of 0.5% of the purchase price (about £330 per month), and rent rising at 3% per year. Again, renting was a lot cheaper than buying: if you held the house for 10 years and prices rose by 6% per year annualized that whole time, you'd still be £115,000 worse off by buying.

But. Buying is what economists like to call a "commitment device" – one of those situations where you can make yourself better off by reducing the number of options available to you. RichB, for instance, makes this crucial assumption:

The difference between the monthly mortgage payment and monthly rent, as well as all up front costs, are assumed to be invested at 5.5% (with a 40% tax rate).

This strikes me as both reasonable, in terms of the rent vs buy calculation, and also, at the same time, utterly unrealistic. People stretch themselves and bend over backwards and perform all manner of other metaphorical financial calisthenics to make their mortgage payments every month so that they can continue to live in their home. People buy homes at the outer edge of the affordability envelope because they value all that space and light and convenience in terms of commuting, and so on and so forth. No one will have the same kind of real and emotional attachment to a monthly plan involving paying a certain amount of money into a savings plan yielding 5.5% per annum. In other words, the difference between rent payments and mortgage payments, if the mortgage payments are higher, is not likely to get invested: it's likely to get spent.

So maybe there's a good reason why people buy houses even when it would be mathematically cheaper for them to rent: it's a forced savings device. All that money they save and scrounge up for the down-payment; all that extra money they find every month for a mortgage payment which they wouldn't bother doing if they were renting – it all goes towards building up equity in a very valuable home. Theoretically, they could do the same amount of savings with money rather than with property, but in practice very few people ever do. To take RichB's example, after 10 years someone who bought the house would have hundreds of thousands of pounds of equity in his house. While someone renting the house would have memories of great holidays and meals at restaurants, and would have a spiffier wardrobe, but would have much less total net worth.

Posted by Felix at 10:26 EST | Comments (12)

Why playing the lottery can be a rational thing to do

Benedict Carey finds a 2000 paper by Lloyd Cohen, which is well worth rediscovering. From the abstract:

The central purpose of this paper is to show that lottery play is not economically irrational and uninformed. The paper presents a theory of lottery tickets not as misguided inputs into wealth production as some critics believe but as valuable inputs in creating a sense of open-ended possibility, specifically the possibility of escaping one's current life by acquiring great wealth.

Cohen has some interesting ideas surrounding the idea that lotteries are a regressive tax:

The regressivity or progressivity of the tax implicit in the monopoly rents collected by the state turns on the question of whether it is the universe of lottery players who pay the tax or just the winners. Imagine that $10,000,000 is wagered at $10 a person from 1,000,000 people and a single winner is paid $4,000,000 and the state keeps $6,000,000 as a tax/rent. Who has paid this $6,000,000, the 1,000,000 purchasers or the one winner?

It's certainly true that people who play the lottery are almost certain to lose money. But Cohen's insight is that playing the lottery is not therefore automatically irrational. People like me love to calculate the expected gain or loss from buying a lottery ticket: back in 2005 I wrote a little post on the subject at MemeFirst. A commenter then came along:

Personally, I can afford a dollar (or equivalent) every now and then to keep the dream of international playboyery alive.

In other words, as Carey puts it:

Like a throwaway lifestyle magazine, lottery tickets engage transforming fantasies: a wine cellar, a pool, a vision of tropical blues and white sand.

People don't invest the money they spend on lottery tickets. They spend it, and get those transforming fantasies in return. Cohen even manages to put this in economic terms:

In all things economic, there is a diminishing marginal something. In the case of “ belief in possibilities,” the most initially steeply diminishing marginal utility is that of probability. That is, one requires some real finite probability to support a belief in the possibility of escape, and while the more the better, the falloff in gain from additional probability is precipitous. On the other hand what is indispensable is a scenario that could conceivably be realized that satisfies the conditions of the hoped for fundamental transformation of one’s life.

Cohen even manages to use his theory to explain not only why one would expect the poor to play the lottery more than the rich, but also why one would expect the middle-aged to play the lottery more than the young, and so on. It's all rather appealing – as a work of theory.

Does Cohen's argument stand up against the kind of people who would abolish lotteries? It's certainly true that those people rarely stop to spend much time considering the real benefit that lottery-players obtain from merely buying tickets even if they don't win the lottery. Economists, who like to assume that individuals are economically rational (more or less), will move quickly to the conclusion that playing the lottery can therefore be a rational thing to do. Such a conclusion has the pleasant side effect of avoiding the opposite conclusion, which is that poor people are stupid and should be protected from themselves.

On the other hand, the money which poor people lose spend on playing the lottery is large enough to really make a difference to the communities in which that money is lost spent. Maybe the solution is for local lotteries to be set up, with the help of insurance companies who will insure against a tiny chance of an enormous payout. Lotteries have historically been organised on a statewide or nationwide basis because they payouts have historically had to come directly from ticket sales. But it's very easy to envisage a lottery with an enormous jackpot ($100 million, say) which never generates anywhere near that amount of money in revenues. If such a lottery spent all its profits in the neighborhoods where the lottery tickets were bought, lotteries would be more defensible.

Posted by Felix at 16:13 EST | Comments (13)

Rent vs buy calculations

There's an interesting debate going on in the comments section of yesterday's housing post about the relative costs of buying and renting a house.

David Sucher is in Seattle:

We have had a great discrepancy between buying & renting since the early 1970s i.e. it has always been far more expensive to buy than to rent and very few (like show me one and I'll buy it) residential properties 'cash-flow' at a 20% down purchase. But people do buy when they can afford it. As markets are not likely to be wrong over such a long period of time, my conclusion is that the psychological value of owning is simply worth the extra $$$ and responsibility.

And Nicholas Weaver responds:

In terms of raw cash flow, buying costs more than renting under ALL conditions I've looked at. Even in a "sane" market, on a cash-flow basis, buying is expensive.
But notice that for "cheaper then renting", I only consider lost-money (interest, tax, HOA) as 'cost' for buying, the rest of that huge mortgage payment you should see again, evenutally, so I don't consider that a cost.

Well, maybe not all conditions. In fact, I've been doing some back-of-the-envelope sums and have come to the conclusion that buying is likely to be cheaper than renting. Take the example of someone who can buy their house with cash, and who doesn't consider themselves a particularly astute or successful investor. Let's say that the house costs $1 million, that renting it would cost $5,000 per month, and that property taxes and other costs of ownership are $500 per month. Let's also say that the interest rate on cash deposits is 5%.

Do you buy the home or rent it? If you buy it, after one year you are down $6,000 in taxes and other expenses, so the cost of buying is $6,000. If you rent it, after one year you are up $50,000 in interest on your $1 million, and down $60,000 in rent, so the cost of renting is $10,000. Then come taxes. If you rent, your rent payments aren't tax deductible, but your interest income is taxable. So if you pay 30% tax on that $50,000 interest income, that puts you another $15,000 in the hole. Meanwhile, if you own, those property taxes are tax deductible. Buying just became significantly more attractive still. Then, of course, you're better off still if the value of your house appreciates over the course of the year.

How does a mortgage affect these calculations? Let's say that you have $200,000 for a down payment, and the rest of the purchase price comes from a 6% mortgage. Now, if you buy, you're still down $6,000 in property taxes, but you also need to pay 6% interest on an $800,000 mortgage, which is another $48,000. Total cost of buying: $54,000, all of which is tax-deductible. If you rent, you pay $60,000 in rent, while earning $10,000 in taxable interest income. Total cost of renting: $50,000, plus another $3,000 in taxes. You're still better off buying, certainly if there's any kind of nominal house-price appreciation going on.

Of course, if you tweak the numbers, you get different results. Crucially, if you can invest your money and get a higher return than prevailing mortgage rates, then it becomes much less attractive to buy. But no one would lend money to homeowners if it was that easy to get a higher return elsewhere.

In my example, how much would that house have to cost before it became cheaper to rent? Let's say the house was $1.2 million, and we still had that 20% down payment. Cost of buying is $63,600, tax-deductible; cost of renting is $52,000 after taxes, which is over $74,000 before taxes at a 30% tax rate. How about $1.5 million? Cost of buying is $78,000, tax-deductible; cost of renting is $49,500 after taxes, which is about $71,000 before taxes. Finally, it's cheaper to rent than to buy – assuming, of course, that house prices have zero nominal appreciation.

I'm not intimately connected with the housing market, but my gut feeling is that it's not easy to find $1.5 million houses renting for $5,000 per month. Then again, depending on what state you're in, the property taxes on a $1.5 million house might well be vastly greater than $500 per month, and I'm unclear on the extent to which property taxes get passed through into higher rents.

Still, this is all highly theoretical; I'd love to see some real-world calculations.

Posted by Felix at 13:30 EST | Comments (15)

How much of Harvard's black population is descended from slaves?

Aditi Balakrishna, in the Harvard Crimson, looks at the reasons why recent immigrants are overrepresented among black Harvard students:

“In practical terms, immigrants, no matter what color they are, are a highly selective group of people,” [said Camille Z Charles, who wrote the study on which the article is based].
“At some level, there will always be an immigrant-native difference because you only get the most motivated, best prepared, cream-of-the-crop set of immigrants,” since their families have had to leave their native countries and start anew in the United States, she said.

Greg Mankiw, however, picks up the story and puts a very different spin on it:

It has been widely noted that Senator Barack Obama, while black, is not a descendant of slaves. Instead, his father was a recent immigrant from Kenya. An article in today's Harvard Crimson suggests Obama (Columbia undergrad, Harvard Law School) is representative of a common story.

It's true that most African-Americans are descendants of slaves. But it's not true that black immigrants are not descendants of slaves, as Mankiw implies. Many black immigrants come from the Caribbean, and Caribbean blacks are just as much descended from slaves as American blacks are. A good proportion of African immigrants are descended from slaves, too. Where else might black immigrants come from? If the UK, then they're probably descended from slaves, since they're likely of Caribbean heritage. You get the picture. It might well be the case that Obama is not a descendant of slaves – in fact, he's a descendant of slave-owners. But you can't extrapolate from his case to all the other black immigrants at Harvard.

Posted by Felix at 12:40 EST | Comments (3)

Private equity is the new banking, if the Rothschilds are any indication

Two interesting stories today: a big profile of Nathan Rothschild in the NYT, saying that his buy-side activities might make him the richeset Rothschild ever:

In five short years, the man in line to be the fifth Baron Rothschild is close to becoming a billionaire through a web of private equity investments in Ukraine, Eastern Europe and most significant, his partnership stake in Atticus Capital, the fast-growing $14 billion hedge fund.

Meanwhile, Nathan's father is making similar bets:

Lord Rothschild, the veteran City figure who is part of the banking dynasty, has agreed to back Darwin Private Equity, a new £250m private equity group founded this year by a trio of youngprofessionals from CVCCapital and Permira.
RIT Capital Partners, the publicly traded investment trust that is 17 per cent- owned by Lord Rothschild, will take a "significant minority" stake as well as making a £50m cornerstone investment in its maiden fund of up to £250m.

And, notes the FT, the other branch of the (English) Rothschilds is also heavily involved in private equity: Sir Evelyn de Rothschild and his wife own private equity shop EL Rothschild.

Meanwhile, NM Rothschild, the bank, has a new rival, known as JNR, which is owned by the 35-year-old Nathan Rothschild, and, according to the NYT, "run by a small crew of investment bankers". But JNR isn't an advisory shop like NMR; rather, it looks very much like a gussied-up investment firm. Why make millions on fees when you can make billions in investments?

Posted by Felix at 11:45 EST | Comments (0)

Barnes on England vs France

Julian Barnes on That Sweet Enemy, a book about Anglo-French relations over the centuries:

Although public opposition to the Iraq war in Britain is high, it would take a lot more fair-mindedness than most British (or Americans) are capable of for them to utter, instead of "Blair [or Bush] was wrong," the simple words "Chirac was right."

The Anglophone reader is made forcibly aware that, even at the basic level, each supposed fact and understanding about our conjoined cross-Channel history has an equal and opposite counter-fact and counter-understanding. Did the British hold the key German attack on the Somme in the spring of 1918, and then make the thrust that ended the war? Or did they collapse in shameful panic and have to be rescued by French reinforcements? Was Dunkirk an example of British heroism which, by prolonging the struggle, gave France hope and eventually liberation? Or was it a further demonstration of the traditional British willingness to fight to the last Frenchman and then decamp, leaving their ally to its fate?

It's a great review, well worth reading. And the final word – well, I shan't ruin it for you, but here's the setup:

For all the high military and diplomatic dramas described by the Tombses, the one I would have most enjoyed witnessing occurred during an official visit to Britain by General de Gaulle. The regular assassination attempts on the French President meant that he always traveled with a bag of his own blood, in case a sudden transfusion was required. When he arrived at Harold Macmillan's house in Sussex, his entourage handed the blood to Macmillan's cook, and instructed her to put it in her fridge...

Posted by Felix at 10:53 EST | Comments (0)

How convincing is Roubini's argument that the housing recession will only get worse?

Nouriel Roubini today blogs his new paper which argues that the US housing recession is far from bottoming out. In truth, however, the paper is really just a longer-than-usual blog: it generally asserts at least as much as it argues, and is written more colloquially than formally. Not that there's anything wrong with that.

There are basically two parts to the paper, which attempts to try to work out how much longer the current housing recession will continue. The first takes a basically chartist approach, looking at previous housing recessions and assuming that the present one will be similar. The second takes more of a supply-and-demand approach.

The problem is that a chartist approach is never particularly convincing, and certainly not in this case, where the charts themselves seem to disprove any attempt to demonstrate that the housing market has remotely predictable cycles. And the supply-and-demand approach has two big problems: it doesn't explain housing-market movements in the past, and it basically assumes its own conclusions.

It's also worth noting that nowhere in the paper does Roubini talk about housing prices, as opposed to housing construction. His definition of a housing recession is nowhere made explicit, but seems to be based on housing starts, and is certainly not based on house prices. So even if he's right about the future of the housing recession, that doesn't necessarily mean that prices will go down.

A few specifics, for those who care. First, his main chart:

A large amount of Roubini's analysis comes from looking at this chart and performing all manner of inductive feats on it. He looks at the size of the drops between arrows, the amount of time elapsed between them, and so forth, and then makes predictions as to the position of the next up arrow based on those old datapoints.

This last housing recession lasted 12 months so far. The average duration of the previous seven housing recessions was 32 months. Housing starts are down (as of January 2007) 38 percent from the January 2006 peak, but only 16 percent from their moving average peak. In past housing recessions starts bottomed, on average, after a 51 percent drop form the peak, and after a 37 percent drop from the moving-average peak. Thus, the past housing recession episodes tell us that housing starts could fall another 13 percent from their actual peak (or another 21 percent from their moving average peak) and that it could take another 21 months to reach that bottom.

Is all this of any use to anybody? If you'd tried that technique with the last housing recession, which lasted 84 months by Roubini's calculation, you'd have been well off base: the average of the previous six housing recessions was just 23.5 months. And you'd have been even more off base if you'd tried to predict the length of the last housing upturn, based on the length of previous housing upturns.

It does seem to me that Roubini is looking at an extremely noisy series and trying desperately to find patterns in that noise which simply don't exist. I mean, just look at that chart. Does it really strike you as the kind of thing from which any useful prediction can be extracted? A nice pretty sine wave it is not.

Nevertheless, Roubini is so bought in to the concept of housing-market cycles that he writes things like this, without any empirical support:

Inventories are as important as excess inventories are crucial drivers of demand and supply cycles.

To be fair, I have no idea how one would even start trying to demonstrate that a given series was a "crucial driver" of any economic "cycle". But whenever one reads a sentence like that, it's worth remembering that it comes entirely from the world of economic theory, as opposed to the world of empirical fact.

After all the cycle-based stuff, it's refreshing to get some real supply figures in the second half of the paper. After all, economic luddite though I am, I will concede that prices tend to go up when demand exceeds supply, and that they tend to go down when supply exceeds demand.

The problem is that although Roubini has supply figures dating back to 1968, he doesn't really have any kind of data series at all on the demand side. So all of his calculations are based on demand increasing steadily with population growth: he makes no allowances, for instance, for shrinking family size. And although he's happy projecting both supply and demand forward until 2010, he never stops to ask whether his model can explain the developments we've already seen in the housing market. After all, if the housing market hasn't been following his rules of supply and demand for the past few decades, then there's no particular reason it should start now. And all those crazy spikes in the housing-starts chart don't look to me as though they were perfectly predictable reactions to changes in supply and demand. Or, to put it another way, the changes in supply and – especially – demand which caused those crazy spikes are hardly the kind of changes which Roubini is modelling in this paper.

It also seems to me that all of Roubini's models assume what he's purporting to conclude: that various data series, such as the stock of housing inventories, will revert to mean over the next four years. Again, this is chartism, and I see no reason at all to consider that assumption a reasonable one. And while Roubini's predictions for supply in the housing market seem perfectly reasonable to me, I'm not at all convinced about his predictions with respect to demand. With prices stagnant and rents rising, it's making increasing amounts of economic sense to buy rather than rent – and even to buy for rental income. Add to that the effects of mortgage-interest tax deductibility, and the effects of a weakening dollar on demand from overseas, and I think it's quite easy to paint a scenario with rising, rather than falling, demand.

I should say that it's entirely possible that Roubini is right, and that both housing starts and housing prices are going to fall substantially over the next couple of years. I certainly don't have any privileged information on the subject. But he doesn't either. And I'm no more convinced that the sky is falling now than I was before I read his paper.

Posted by Felix at 19:20 EST | Comments (16)

Are "brain drain" effects real?

Greg Mankiw worries about the effect of a brain drain on the Indian economy, were the US to open its doors to skilled workers:

If skilled software engineers leave India for Silicon Valley, the unskilled workers left behind in India could well be worse off. Allowing more skilled workers into the United States might exacerbate global inequality, even if it enhances global efficiency.

I'm not convinced. "Brain drain" effects always seem to me to be more anecdotal than empirically proven. And if I recall correctly, one of the countries in the world which was most worried about a brain drain was Ireland. How did that work out?

Posted by Felix at 18:19 EST | Comments (1)

How derivatives could have saved the mortgage market

What went wrong with the subprime mortgage market? In a nutshell, a lot of the problem was that it wasn't as sophisticated, in terms of derivatives, as the rest of the bond market.

Let me explain. Investors demanded vast amounts of subprime mortgages in the form of MBSs, and Wall Street did everything it could to meet that demand. Unfortunately, Wall Street met the demand by happily securitizing anything and everything sent to it by originators using ever-laxer underwriting standards. Think of it as the mother of all reverse inquiries: CDOs and other investors essentially went to the originators and told them they would love it if they could originate vastly more in the way of subprime MBSs than they ever had in the past. And so the originators did just that – by writing mortgages which turn out, in restrospect, to have been very bad ideas for the homebuyers, for the originators, and for the investors.

How could all this have been avoided? Quite simply, in theory: Wall Street could simply have started issuing synthetic MBSs. Total subprime originations would not have risen nearly as much, underwriting standards could have remained relatively strict, and the investors would be much happier today. There would also have been less of a housing bubble, as individuals would have found it much harder to buy houses they couldn't afford.

But financial technology never really got as far as synthetic MBSs. And so we find ourselves in the situation we're in today.

Posted by Felix at 18:08 EST | Comments (12)

Is Federated Media worth $300 million?

Blog ad-sales network Federated Media is not for sale, says its founder John Battelle, although he does concede that "any startup has its price". And what would that price be? According to a MergerMarket interview with Federated COO Jason Weisberger picked up by TechCrunch, 8 to 10 times gross revenue, which in turn is likely to be $30 million in 2007. Let's say $270 million.

Weisberger also throws out the figure of 25 times Ebitda; if that was also $290 million, then that would put Federated's Ebitda in 2007 at about $11.5 million.

These are big numbers for a company which owns no IP of its own and essentially just sells ads for other people. On the other hand, Federated does seem to be doing very well, and now employs well over 30 full-time staffers, it would seem.

The sums actually add up. Federated takes 40% of revenues: if it pulls in $30 million in 2007, that would be $12 million. Let's say payroll and other overhead is $3 million: that still leaves Ebitda of $9 million. Plus, it's growing fast: it had 365 million monthly pageviews in January, up from 200 million in September.

Let's conservatively say that FM averages 450 million pageviews a month in 2007: that's 5.4 billion pageviews for the year. And let's say they manage to charge $10 CPM to their high-end advertisers. Revenue of $30 million for the year would imply 3 billion impressions, or less than one impression per pageview, on average. That's definitely doable. Even at $5 CPM they need to sell only 1.1 impressions per pageview, which I'm sure is much, much lower than their total inventory. And it's worth noting that their rack rates for BoingBoing, say, to pick a blog pretty much at random, range from $7 all the way up to $20, while GigaOm's rates are as high as $35.

So could Federated Media really be worth $300 million? There certainly seems to be no shortage of blogs out there which could be brought under the Federated Media umbrella, and I'm quite sure that advertisers aren't going to stop their migration from TV and print to the web any time soon. It's not unrealistic to see Federated Media serving 20 billion pageviews per year, 2 impressions per pageview, at $10 CPM, which would add up to total revenue of $400 million, of which FM would keep $160 million. Profits could approach $100 million per year at that point, which would make a $300 million purchase price seem eminently reasonable.

Of course, just because it could get there doesn't mean it will get there. Any of FM's authors can leave at any time for a richer deal from a rival network – although there's no sign that any of them are particularly discontented at the moment. If I were serious about monetizing felixsalmon.com, I'd first try to get my traffic numbers up a bit and then I think I'd try to sell myself to FM. Let's say I started at 5,000 pageviews per day, 2 impressions per pageview, $10 CPM – that would work out at $26,000 per year in total, of which I would receive $15,600. Not megabucks, by any stretch of the imagination, but this is the Long Tail of internet content, and FM would seem to be very well placed to sell it. And there are thousands of baby blogs like mine out there. FM can make minibucks off a lot of them, and then be in there from day one when, inevitably, a few of them really take off. And there are economies of scale for authors in the network, too: while I doubt all that many advertisers would want to advertise on felixsalmon.com specifically, they might well be interested if I was bundled in with, say, Marginal Revolution. (Which is actually with BlogAds at the moment.)

And although FM doesn't have any real IP of its own, that also means that it doesn't need to create compelling content, either – something which is becoming increasingly expensive, these days, in terms of staffing costs and getting websites successfully off the ground. Many try, few succeed.

Nick Denton reckons that FM is going to be bought by AOL, which would make quite a lot of sense: AOL's ad-sales team is strong, but FM has blog-specific expertise which would help sell Engadget and the other AOL blogs. What's more, buying FM would mean that AOL could bundle Engadget with all manner of other similar blogs . And it would also mean that rather than simply shuttering blogs which don't get a million pageviews per month, it could spin them off to their authors, who could make a decent living under the FM umbrella. 100,000 pageviews per month could mean income for the author of $300,000 per year.

So how much would AOL be willing to spend for FM? On that front, I have no idea. But I reckon Battelle would want at least nine figures.

Posted by Felix at 14:50 EST | Comments (0)

Adventures in real-estate terminology

If you got the hard-copy version of the New York Times Magazine last weekend, you almost certainly skipped past the advertising sections at the end: an eight-pager on El Salvador from our old friends Summit Communications, followed by a "Best of the West" real estate section from something called Andrew Kay Concepts but which was also, peculiarly, copyrighted by the New York Times.

In any case, I'm not sure how I noticed this, but clearly the world of "luxury apartments" is far, far too déclassé for the people being targeted to buy into the Waldorf=Astoria Residences Las Vegas. (Oh yes they did.) The blurb actually calls them – wait for it – vertical estate residences.

What does that even mean? I thought it meant they were triplexes, or at least duplexes, but looking at the floorplans, apparently not. The only vertical thing about them is that they're stacked on top of each other.

In any case, if you've got something over $3.2 million to spend on a Las Vegas apartment, go take a look and tell me what a vertical estate residence looks like in reality – or at least in a showroom. The mind boggles.

Posted by Felix at 12:33 EST | Comments (1)

What are the implications of Nick Stern's utility function?

Now here's a provocative paper, from the ever-astute Charles Kenny. In all the talk about Nick Stern's discount rates, he points out, there has been relatively little ink spilled on the fact that Stern uses a declining marginal rate of utility. But seeing as how he does, says Kenny, there are lots of other consequences we should be thinking about if we are to start thinking that way. For one thing, if what we want to do is maximize global utility, we should immediately and fully liberalize the global labor market. And for another thing, since it's a lot cheaper to increase the utility of the poor than it is to increase the utility of the rich, we should be funneling hundreds of billions of dollars a year at the world's poorest.

In fact, the numbers involved are not impossible by any means:

Raising the incomes of the poorest ten percent of the world’s population to the second poorest ten percent’s level (from $291/year to $577) takes $172bn. Raising the two lowest deciles to the income of the third ($829) takes $474 billion.

That's right: you could effectively double the income of the poorest 10% of the world's population, taking them out of the extreme poverty of living on less than $1 per day, for less than the annual cost of the war in Iraq. Well, maybe you couldn't: there are practicalities involved which would doubtless cost hundreds of billions of dollars themselves, if they didn't make the project downright impossible. But even if you took a decent stab at it, it's a no-brainer: global utility would go through the roof, while the opportunity cost (the global utility foregone by stopping the war in Iraq) might even be negative.

The problem, of course, is that we live in a world of nation states; there is no global government, and there is no politician who is primarily concerned with maximizing global utility. But if there were, would you be willing to pay an 82% rate of income tax to see the world's poorest brought out of poverty?

Posted by Felix at 2:03 EST | Comments (3)

Listing to port

Steve Cuozzo is so fed up with wine lists in New York he hankers for BYOB. Which I do, too – but since BYOB is technically illegal here, we have to all pay corkage, which is often unpleasantly expensive. (I'd be happy paying $30 corkage on a $100 bottle of wine, but I don't generally rock up to restaurants with $100 bottles of wine. If I have a perfectly good $10 bottle, I don't want to pay $30 corkage on it.)

I can solve the mystery for Cuozzo about why Pizza Fresca on East 20th Street has a ridiculously long and expensive wine list: the answer to the riddle is a certain Swiss bank whose US headquarters are around the corner and whose seven-figure bonuses have to keep more restaurants in gravy than just those owned by Danny Meyer.

But I do find it annoying, with Cuozzo, when you walk into a Greek restaurant and find an all-Greek wine list, and even more annoying when a wine list is so over-the-top that anything under $100 seems like slumming it. And as for Peter Luger – well, that's just atrocious.

In any case, Daniel Boulud seems to have found the answer to all our problems: rent out 36-bottle wine cellars to your patrons! That way they can be sure of having exactly the wine they want, and pay no corkage! Of course, this being Daniel Boulud, the rental isn't cheap: $15,000 per year.

I'll do the math for you. Let's say that a wine which retails for $150 sells at a restaurant for $400. Then a diner drinking such a wine would save $250 a pop by going into his own private cellar rather than ordering off the wine list. How many such bottles would he have to order to justify a $15,000 per year wine rental? 60 – or five per month. Which is doable. I certainly know people who order five $400 bottles of wine per month in restaurants, although I'm not sure I know that many people who do so in just one restaurant. But if you're not the kind of person who orders $400 bottles of wine on a regular basis, you're probably not the sort of person who Daniel wants to rent his wine cellars to in any case.

Posted by Felix at 1:31 EST | Comments (0)

I'm feeling lucky

The word for happiness is, often, the same as the word for luck. Today, I learned something about my own name, which I was always told meant "happiness" in Latin:

In every Indo-European language, the modern words for happiness, as they took shape in the late Middle Ages and early Renaissance, are all cognate with luck. And so we get 'happiness' from the early Middle English (and Old Norse) happ – chance, fortune, what happens in the world – and the Mittelhochdeutsch Glück, still the modern German word for happiness and luck. There is the Old French heur (luck: chance), root of bonheur (happiness) and heureux (lucky): and the Portugese felicidade, the Spanish felicidad, and the Italian felicita – all derived ultimately from the Latin felix for luck (sometimes fate).

–From the happiness of virtue to the virtue of happiness: 400 B.C. - A.D. 1780, Darrin M McMahon, Daedalus; Spring 2004

Many thanks to Nassim Nicholas Taleb for sending this to me!

Posted by Felix at 22:20 EST | Comments (2)

Jean Baudrillard, RIP

“The sad thing about artificial intelligence is that it lacks artifice and therefore intelligence.”
–Jean Baudrillard, June 20, 1929 – March 6, 2007

Posted by Felix at 21:23 EST | Comments (0)

Who was the economist on the Libby jury?

Here's the information that the New York Times decides to give us:

• Investment banker and PhD economist
• Has a PhD from MIT
• Worked at the Council of Economic Advisers for a year in the Clinton Administration

This is almost certainly the same person that fellow juror Denis Collins refers to as "Steve":

Does the fact that he also worked for the Clinton administration help his credibility? Steve, our numbers guy, gives us a number. "He only worked there four months."

At one point a few of us decide to change seats. It is a providential move because it put Steve next to the Post-it board. He immediately takes over the presentation of the five counts against Libby. For more than six weeks, Steve has been logical, self deprecating and unbiased. Now he uses that reservoir of trust to guide us through our hesitation. When count 3 the False Statement made by Libby to Time magazine reporter Matthew Cooper runs into a dispute over a technical point, he tables it before any rancor develops and moves to another.

Note that Steve "worked at" the CEA, he wasn't a "member of" it. But given how few investment bankers live in Washington, there can't be many people who fit the NYT's description.

(I have no idea if Collins has changed names in his report. My guess is that he hasn't, and that we're dealing with a Steve, Steven, or Stephen here.)

Posted by Felix at 20:28 EST | Comments (1)

Does philanthropy drive the American economy?

I went to a press conference today with Claire Gaudiani and Mario Morino on the subject of philanthropy in general and "venture philanthropy" in particular. Gaudani has a book out, called "The Greater Good: How Philanthropy Drives the American Economy and Can Save Capitalism," and she basically gave us her stump speech today. Basically, philanthropy is what makes America great.

Gaudani loved to talk about how various philanthropies helped the US economy: by allowing the poor to go to university, for example, by helping to develop a vaccine against polio, or just by creating businesses such as the big Chicago museums. She was particularly enthusiastic, being a former college president, about philanthropies in the education world, both at college level and for younger children, which she saw doing massive amounts of good.

Mario Morino then talked about his own philanthropy, called Venture Philanthropy Partners, which is largely education-based and which is aimed at low-income children. Morino explained that his father was an immigrant coal miner and that he grew up in a low-income household himself in he 1950s before eventually making his millions in the technology industry. Nowadays, he says, low-income kids don't have one one-thousandth of the opportunity that he had.

No one remarked on the obvious irony: that the past 50 years, which if Gaudiani is to be believed have seen a magnificent flowering of philanthropic fabulousness for the benefit of America's poor, have also, if Morino is to be believed, seen a massive drop in the opportunities afforded to those self-same poor.

One German journalist, however, did remark that one of the reasons that philanthropy was much less common in Germany than it is in the States was that taxes are higher there. People help the poor through taxes in Germany, and through philanthropy in the US – and it would seem that the former method is more effective. Gaudiani herself conceded that the US came near the bottom of the OECD rankings when it comes to most social indicators.

What's more, almost everything that Gaudiani said seemed to be rooted solidly in the anecdotal, rather than the empirical. I asked whether she was saying that the returns on philanthropic capital, broadly calculated, were greater than the returns on capital generally, as her book title implied – and she backed off from that. The idea that there is an opportunity cost to philanthropic capital never seems to have occurred to her.

So, color me unimpressed. Of course, I'm all in favor of individuals doing good. But if I were a low-income individual looking for opportunity, I'd much rather have certain opportunity from the government in Germany than hope for some friendly philanthropist to come along in the US. I daresay that if I found the right philanthropist in the US, my outcome might be better. But given that the odds of my doing so are well below unity, I'm not at all convinced that the US system is better than the German system.

Posted by Felix at 17:53 EST | Comments (0)

Adventures in EM investing: Defaulted fake Venezuelan development-bank debt, anyone?

Question of the day, part 2. Skye Ventures: vultures, or just patsies?

It seems that Skye got sold a bunch of paper ostensibly issued by a now-bankrupt Venezuelan development bank – paper which, it would seem, was fake. So are they suing the people they bought the paper from? No. They're suing Venezuela, on the grounds that in a now-reversed opinion which may or may not have been public, the Venezuela solicitor general (not even the finance minister) ruled that the bonds were valid.

But it seems to me incredible on its face that a court could grant a judgment to a "creditor" if no one ever lent any money to the supposed debtor in the first place.

Venezuela, naturally, seems to be cocking up the US legal case (in Ohio, of all places), and has recently fired its Florida-based law firm. But even the world's most atrocious lawyer would have a pretty hard time losing this case.

Posted by Felix at 13:21 EST | Comments (1)

Are there any activist mutual funds?

Question for the day: Why aren't there any activist mutual funds? (Or are there?) One big difference between equity hedge funds and long-only mutual funds is that the hedge funds often seek out underperforming companies, and then agitate for some kind of a shake-up. Today, for instance, we learn that the UK's Toscafund has amassed a significant stake in ABN Amro, and would love to see the Dutch bank taken over by a more efficient rival.

Interestingly, Toscafund in this respect differs from the other big hedge fund with an ABN stake, TCI – which is looking more for a breakup than an acquisition by a competitor.

Either way, both funds are taking large long-only stakes – something no mutual fund is enjoined from doing. As hedge funds and hedge-fund replicators become increasingly popular among increasing numbers of investors, many of whom can't invest in hedge funds or fund-of-funds directly, one might expect to see more mutual funds charging high fees for their own activism.

The only problem: Why would a fund manager go down that road, when setting up a hedge fund would be so more lucrative? If such managers do exist, I suspect they might emerge from the socially responsible investing space.

Posted by Felix at 10:06 EST | Comments (0)

How to make an economist happy

From an interview with Guillermo Calvo, excerpted at the Bayesian Heresy:

I joined the central bank and worked under Julio H.G. Olivera, whose orders to me were, essentially: Go to the library, get a copy of Allen’s Mathematics for Economists and Hicks’ Value and Capital and don’t leave your room until you are done with them. I felt like I had reached Nirvana!

Posted by Felix at 14:05 EST | Comments (0)

Josh Rosner clears up my MBS questions

There's not going to be a lot of new stuff on felixsalmon.com today, mainly because I have to do my taxes. But I did get a phone call this morning from mortgage expert Josh Rosner, and I learned quite a lot.

For one thing, I can now answer the question which has been bugging me for months: What is the relationship between default rates and MBS prices? A vast amount of the commentary about the MBS market has been centered on skyrocketing default rates in the subprime market, and there's been a decided implication there that if default rates on subprime mortgages go up, then the value of MBSs based on subprime mortgages will naturally go down.

Turns out, it's not that simple. For one thing, as we saw on Friday, rising default rates can, in theory, actually be good for MBS prices. Rosner didn't go that far. But he did say that as far as the cashflows from any given MBS are concerned, the default rate on the pool of underlying mortgages is very unlikely to have any real effect on the cashflow to the MBS investors. Ever and always, MBS investors are worried about prepayment first and prepayment second.

Indeed, if you look at what happened to the MBS market in the wake of Hurricane Katrina, pools which were concentrated in the affected states didn't noticeably underperform pools which weren't. Investors, it seems, simply don't worry about the default rates in their MBS pools.

Now this doesn't mean that MBS investors shouldn't be worried about default rates. There are two main reasons why they should. The first is that default often ends up as a foreclosure, and a foreclosure is essentially a prepayment. The second is that MBS investors aren't interested solely in the MBSs they've invested in; they're also interested in the health of the MBS market as a whole. And the future of the MBS market looks a little unhealthy if default rates continue to rise.

Why? Two big reasons. For one thing, if default rates rise, the housing market goes into reverse, and underwriting standards tighten up, then naturally the total supply of MBS coming to market will fall. But for another thing, there's also the question of all those workouts.

When borrowers go into default, lenders are likely to try to come to some kind of workout agreement, rather than foreclose immediately. That's because foreclosure often involves loss of principal, and also because of HUD guidelines. Typically, the arrears will be capitalized, and a new mortgage will be written. Now, as Morgenson pointed out in her piece on Sunday,

Academic studies suggest that within the first two years of a workout, re-defaults can approach 25 percent.

Now that's good, right? You've gone from certain default to a mere 25% chance of default. Not so fast: according to Rosner, those workout mortgages are pooled and securitized just like any other mortgages, and often carry the original FICO score as well, and the original underwriting. Investors who buy the new MBSs, says Rosner, have no idea that they're buying a pool which includes mortgages with a 25% default probability.

Finally, on the ABX index: Rosner looks at it with disdain. It doesn't, right now, reflect the price movements of any underlying securities, and because it's the only easy way to play the mortgage market, it attracts volatility like a super-magnet, drawing it away from the rest of the mortgage-backed world. There are lots of reasons to be worried about the future of the mortgage market, but the ABX index is not one of them.

Posted by Felix at 11:16 EST | Comments (3)

Tanta on Morgenson on mortgages

Note to self: Make sure that Josh Rosner reads this, by the inestimably fabulous Tanta, before I talk to him about the mortgage situation. The poor chap deserves a right of reply, I think. But right now it's Tanta 1-0 Morgenson/Rosner.

Posted by Felix at 0:04 EST | Comments (0)

Is the stock market a haven for speculators? And is that a good thing?

I wasn't a big fan of Paul Krugman's column on Friday, and his responses to readers today make him seem even more thin-skinned an arrogant than usual. (Dean Kloner: "What's the point of the column? Anybody can concoct a scenario under which the global economy slides into a recession, no?". Paul Krugman: "Um, the reason for writing it this way was as a slightly more reader-friendly way of describing the risks than you usually read.")

But down at the bottom of the column is a very interesting letter from Jim Krupp, in Amherst:

Historically, when stocks paid dividends tied to profit, one could argue that buying stock was an investment in a company and that the buyer wanted to participate in its profits. But for the vast majority of speculatively priced stocks today, there is clearly no return from owning a stock unless someone else at a future time is willing to pay more for it than you did. A company's success or failure is immaterial as an owner of shares you neither gain if a company is successful, nor lose if it is not, until you try to sell. This is a straight gamble as to whether at some future time demand will be higher or lower than today...
Perhaps the origin of the meltdown was not a bad day on a Chinese market. Perhaps it was several generations ago when stock ownership became a speculative gamble and not a prudent bet on the success of the company?

Although Krupp automatically loses my respect by talking about the stock market as a "pyramid scheme", I'm actually rather sympathetic to the bit of his letter that I quoted. The overwhelming majority of stock investors don't consider themselves part-owners of companies, but rather full owners of securities which they hope to see go up in value. Stocks are somewhere to put risk capital to work, rather than somewhere to truly invest your money and, literally, reap dividends. The time horizon for stock-market investors (large-business owners) is often much shorter than the time horizon for small-business owners. And, insofar as there's a difference between investors and speculators, the stock market is dominated by the latter: people who buy something with the intention of flipping it to someone else at a higher price.

Whether all this is a bad thing, I'm not sure. I've got most of my knowledge and understanding of financial markets in and around the bond markets, rather than the stock markets, so I'm not particularly comfortable opining on this sort of thing. Who are the best people I should talk to if I want to understand stocks the way I understand bonds? Or is that just not possible?

Posted by Felix at 23:34 EST | Comments (1)

Can private equity still get away with the leverage-and-flip play?

Jonathan Nelson of private equity shop Providence Equity had this to say at the Super Return conference in Frankfurt:

The model in our industry today is far different than the headlines would lead you to believe — and it’s far more sophisticated than it was 10 or even five years ago. In today’s environment, you have to improve businesses, not just arbitrage public and private capital structures. Or said another way, you must work on the income statement as well as the balance sheet.

Now I don't doubt for a minute that private-equity shops are very sophisticated and that they don't just buy, leverage, and flip. But I do think that in today's environment of abundant liquidity and razor-thin spreads, it's easier, not harder, to buy, leverage, and flip than it was five or 10 years ago. What makes Mr Nelson think that such a strategy can't work any more? It certainly seems to be the main ingredient in most of the PE deals which hit the headlines, and which are nearly all funded with vast amounts of debt to layer on top of the debt which already exists in the target company.

Posted by Felix at 21:09 EST | Comments (1)

Top women artists

I'm a little late to this game, but I just found the New Economist blog entry on David Galenson's paper on the subject of women artists. Galenson added up the number of times that women artists' work appeared in textbooks of art history, and came to the conclusion that Cindy Sherman was the greatest artist of the 20th Century, with Georgia O'Keeffe, Louise Bourgeois, Eva Hesse, and Frida Kahlo rounding out the top five.

Says New Economist:

I like Sherman's work. But I doubt it retain its dominance over the next few decades. These days, there are just too many imitators, wherease O'Keeffe and Kahlo were both one of a kind (and with amazing bios too). Let's face it, how many leading women actors want to make a film about Cindy's life story? As for Bourgeois, while at times her work is very innovative, most of it leaves me underwhelmed.

This is ridiculously far from the mark. The fact is that Sherman is the only artist on the list with a real claim to significant innovation, influence, and importance. O'Keeffe's work has not aged well, I'm afraid, and although Bourgeois and Hesse have both done truly great work, neither of them have the kind of obvious place in any history of 20th Century art that Sherman does. If anything, I'd've expected to see at least some of Bridget Riley, Rebecca Horn, Nan Goldin, Barbara Kruger, Rachel Whiteread, and Jenny Holzer further up the list. (My own favorite, Agnes Martin, is just my own favorite: I don't expect her to top this kind of list.)

For me, though, the really interesting competition is not between Sherman and O'Keeffe, but between Sherman and her ex-boyfriend, Richard Prince. Prince has now handily overtaken Sherman in the auction market, with at least one piece topping the $2 million mark – and increasingly I'm seeing him considered one of the very few "must-have" artists in any serious contemporary-art collection.

I think it's advantage Prince right now, despite the fact that Sherman's Untitled Film Stills are significantly better than anything that Prince has ever done. The reason is that Sherman refuses to simply do the same thing over and over again, while Prince revels in doing just that. And the art world loves an artist it can happily pigeonhole, especially when a large part of what he does involves cocking a snook at the art world itself.

Of course, it'll be a long time before there's any consensus on how the history of 20th Century art really played out, and in future years re-runs of Galenson's methodology might throw up the likes of Elizabeth Peyton, Yoko Ono, Laurie Anderson, or, if auction results have meaning, Marlene Dumas.

As for artists of the 21st Century, it's obviously early days yet. But Julie Mehretu and Pipilotti Rist are already on the shortlist.

Posted by Felix at 21:01 EST | Comments (7)

How much of ResMae's liabilities is Citadel taking on?

Even a spectacular subprime wipeout like ResMae has value: Citadel is buying it out of bankruptcy for $180 million.

I don't see any answer to the biggest question of all, though: Will Citadel still be forced to buy back loans which ResMae originated and which went immediately into default, or loans which were fraudulently misrepresented by ResMae to investors when ResMae securitized them?

It seems to me that originators going bust is one of the biggest risks in the subprime MBS market at the moment. How big is that risk, now, in the wake of the ResMae outcome?

(Incidentally, do not, under any circumstances, confuse Citadel and ResMae with Cerberus and ResCap. I know, it can get confusing.)

Posted by Felix at 20:23 EST | Comments (2)

The US has an optimal mortgage market, Part 2

Back in January, I found a wonderful paper by the New York Fed's James Vickery which showed that homebuyers are very, very sensitive to the details of the mortgages offered to them by banks. If fixed-rate mortgages rise by just 10bp, that reduces their market share by more than 10 percentage points. Though they may not know it, mortgage buyers turn out to be incredibly sophisticated financial consumers – at least, they certainly act as though they are.

Now, thanks to Christian Menegatti, I've found another paper, this time by Tomasz Piskorski and Alexei Tchistyi of NYU. This one shows that the explosion in option-ARMs and other exotic mortgages actually makes perfect sense, from an economic point of view:

This paper studies optimal mortgage design... We show that the optimal allocation can be implemented using either a combination of an interest only mortgage with a home equity line of credit or an option adjustable rate mortgage. Under the optimal contracts, mortgage payments and default rates are higher when the market interest rate is high. However, borrowers benefit from low mortgage payments and low default rates when the market interest rate is low. Thus, our analysis provides theoretical evidence that these alternative mortgages, which have recently generated great controversy, can benefit both lenders and borrowers.

In other words, maybe the very low default rates of the past were actually economically suboptimal. I'm sure that the default rate on 2006-vintage subprime loans has swung the pendulum too far in the opposite direction. But let's blame underwriting standards for that, not the structure of the underlying mortgages.

Posted by Felix at 17:17 EST | Comments (0)

Where's the safe haven these days?

Brad DeLong asks a question and then, well, doesn't answer it:

If an investor today did wish to insure against geopolitical catastrophe, how would he or she do so?...
The principal risk I see today is that being borne by investors in dollar-denominated debt – and I don’t believe they are charging a fair price for what they are doing. But a quarter of my brain wonders how investors should attempt to insure against the lowest tail of the economic-political distribution, and that quarter of my brain cannot see which way somebody hoping to insure against that risk should jump.

He does note that there's even, theoretically, some upside risk to an uptick in global risk aversion:

If people are risk-averse enough that increased fear of the future causes them to save more, rising global uncertainty will raise bond and stock prices, and lower interest rates and dividend and earnings yields.

In any case, let's say that DeLong is right, and investors in dollar-denominated debt should get out early while they can. Where should they go in a world where "uncorrelated assets are not correlated"? If you believe the likes of Jerome Booth, at Ashmore, the answer's easy: domestic-currency emerging-market debt. But that's pretty hard to invest in, outside Mexico – and Mexican local debt is down 4.3% this year. Maybe we should all invest in euro-denominated bonds instead. But are they really uncorrelated with US bonds? And are they really a good bet in a rising-interest-rate environment?

Posted by Felix at 15:47 EST | Comments (0)

And to think that Thomas Aquinas had to make do with figs

I am an atheist, and I don't have nightmares. Obviously I've been laying off the bananas.

(Via)

Posted by Felix at 15:20 EST | Comments (1)

If you run a housing company, of course you won't want to own property

As chief executive of HSBC USA, Martin Glynn was at the forefront of the mortgage revolution: his company brought the joys of homeownership to thousands of individuals who might never have been able to get a mortgage in the past. With ownership comes equity, a place on the property ladder – and, of course, the prospect of serious price appreciation.

Which is why it's kinda interesting that we find out today from Footnoted that Glynn's own mortgage was – well, he didn't have one. And not because he bought in cash. But rather because he clearly thought it smarter to rent his apartment, at a cost of $14,800 per month. Did he think that the housing market was going to crash and that he'd be better off renting? Did he know that he'd be canned at the end of 2006? And what of his lieutenant, Brendan McDonough, who also rented his apartment – and got a bargain price of just $6,250 per month?

McDonough and Glynn even managed to get HSBC to pay their rent for them – nice! By the time that the bank threw in a "tax gross-up" and a "housing and furniture allowance", Glynn got $327,600 and McDonough got $259,000 towards housing they didn't even own. I wonder what their borrowers thought of the fact that their lenders were staying well away from the housing market themselves.

Posted by Felix at 14:01 EST | Comments (1)

Why would anybody want to buy Palm?

Palm, the maker of the Treo, has long been rumored to be a takeover candidate. The latest rumblings started last Wednesday, with a story saying that Palm might be bought by Nokia, or by a private-equity shop. Weirdly, the stock went absolutely nowhere either on Wednesday or on Thursday, but gapped up on Friday morning, prompting coverage in today's WSJ – just in time to see the shares plunging 7.5% in early trading.

Why the fall? Well, since the world revolves around me, it's clearly because I spent far too many fruitless hours on Saturday stuck in both the Apple Store and at home, trying to get my MacBook to sync with my Treo. Even Missing Sync, a $40 piece of software designed to fix all the horribles built in to the Mac-Treo interface, couldn't fix my problems, and I'm now more determined than ever to get an Apple iPhone the minute they're released. And that's not an easy decision to make, given its price ($500) and the fact that I'll have to return to the Satanic Cingular AT&T.

The Treo was a great product when it was released, but has only seen minor improvements since then, while competitors such as Nokia and Motorola – not to mention Apple – were storming ahead. Given that the forthcoming Treo 750 won't even have wifi, I'm not sure why anybody would want this lemon of a company. But there's no doubt in my mind that new ownership and new management can only improve matters.

Posted by Felix at 12:24 EST | Comments (0)

Subprime math is hard

Roddy Boyd tries to do some subprime math in the New York Post today, but I don't quite follow his thread:

The subprime mortgage market collapse just might give private-equity titan Cerberus a headache for the forseeable future.

As the headlines mount about woes in the subprime sector, Park Avenue-based Cerberus' 51 percent stake in GMAC - the owner of a massive subprime mortgage portfolio - is looking increasingly problematic.
With its GMAC stake, Cerberus also got one of the largest subprime players: a lender named ResCap Capital.
Cerberus, along with Citigroup and Aozora Bank, acquired the GMAC stake in November for $7.9 billion...
ResCap has $57 billion in subprime loans on its books as of Sept. 30, or a staggering 77 percent of a $73 billion portfolio...
Late last week, a Lehman Brothers analyst argued in a statement that GMAC* might have to reduce its book value by up to $950 million because of mortgage delinquencies.
If Cerberus' consortium used standard financing, then the consortium likely put up around $1.58 billion in equity. If GM takes a write-down of $900 million to $950 million, Cerberus and its investors might have to write down up to $990 million - more than 50 percent of the initial equity investment.

Let's say for the sake of argument that the Lehman report is spot-on. That would mean that probably the largest subprime portfolio in the world has total losses of less than $1 billion: big, to be sure, but hardly a systemic threat. After all, $950 million is just 1.3% of a $73 billion portfolio.

What I don't understand is how a $950 million write-down at GMAC could correspond to a $990 million write-down for investors owning 51% of GMAC. Surely if they own half the company, they should take half the write-down? What am I missing here?

(Via)

*UPDATE: jck, in the comments, finds a CNBC piece which explains things: it's GM, not GMAC, which is could see the $950 million write-down. So if GM, with 49%, writes down $950 million, then Cerberus, with 51%, could be forced to write down almost $990 million. Problem solved!

UPDATE 2: Murray, in the comments, has actually gone to the trouble of tracking down and, you know, reading the famous Lehman report. Go read his comment for the full skinny, but the upshot seems to be that (a) Cerberus's downside is actually de minimis, and that (b) Roddy Boyd "Just. Doesn't. Get. It." So, basically, ignore the whole thing. GM might lose money on GMAC, Cerberus won't.

Posted by Felix at 12:02 EST | Comments (6)

Giuliani Capital sold for undisclosed sum

Giuliani Capital Advisors, the boutique investment bank which Rudy Giuliani bought from Ernst & Young 27 months ago for $9.8 million, has now been sold, to Australia's Macquarie. We knew this was going to happen; the big question was how much it would go for.

Dealbook recycles an old NYT story which said, implausibly, that the bank could sell for more than $80 million. But the WSJ doesn't even hazard a guess. As for the press release, it says only that "the transaction will not have a material impact on

Macquarie's balance sheet".

Posted by Felix at 11:08 EST | Comments (0)

What do you want to know about the mortgage market?

There's a great deal I don't understand about Gretchen Morgenson's column on Sunday, about mortgages. If nobody understands the mortgage market, how is she so sure that it's a train wreck, and that the decline in the mortgage securities index is not an overreaction? She concedes that MBSs are "far tougher to value than other securities" – but she seems pretty darn confident that she knows what way the mortgage market is going. She also seems convinced that loss mitigation procedures – where mortgages in default are renegotiated – are a bad thing. Here's how her column ends:

Academic studies suggest that within the first two years of a workout, re-defaults can approach 25 percent...
No one likes to face ugly realities like financially ailing borrowers who are so strapped that nothing can save them. Not the lenders, not the Wall Street firms that sell the securities, not even the holders. But experienced investors know that a reliance on fantasy will only prolong the pain that is racking the huge and important mortgage market.

If re-defaults are less than 25%, doesn't that mean that workouts succeed more than three-quarters of the time? And does Morgenson really think that all of Wall Street is deluding itself, because it doesn't like "to face ugly realities"? The one thing that you can be sure of is that if Wall Street smells blood, nothing will stop its sharks from attacking. And so far MBSs have been relatively unscathed: the triple-B indices are down, to be sure, but the underlying securities are doing much better. Is it really true that the MBS market, as opposed to the mortgage-origination business, is racked with pain?

I'm not sure myself of the answers to these questions, but I'm told that Josh Rosner, the chap who seems to have been Gretchen's main, if not only, source for this column, might be willing to talk to me too. So if you have any questions for Mr Rosner, let me know. First on my list: What is the relationship between default rates and MBS prices? Most of the commentary on the MBS market seems to be predicated on the idea that it's very simple, and that if default rates go up, then MBS prices should plunge. Is that true?

Posted by Felix at 2:14 EST | Comments (3)

When economists shave

John Quiggin is getting his razor out; the least you can do in response is get your wallet out. I will be most disappointed if the blogosphere doesn't propel him easily into the Top 30.

Posted by Felix at 1:54 EST | Comments (0)

The Greenmarket loses a couple of customers

A special guest post from Michelle Vaughan:

It's a beautiful pre-spring day in Manhattan and we're having guests for dinner tonight. I dust off my bicycle and make my way over to the Green Market in Union Square. I needed a few items for my menu plus some kind of pie or fruit crumble for desert. I make my way to the first stand... I pick up some loose shallots, 4 small onions and leeks. I walk up to the cashier, he weighs it, then eyeballs it - "seven dollars!" I say to him, "Are you kidding? Weigh it again." He does... "seven dollars!" The person behind me gives me a look, I'm holding up the line. "That's outraqgeous!" I say, and pay him the money. Annoyed, I walk over to the flower stand, I pick up 3 small groups of flowers for $18.00. They smell amazing and are definitely pretty. Then I look for a fresh pie for our desert, that puts me back another $12.00. A grand total of $37.00.

But I'm not done shopping, and the green market doesn't have everything I need, so I bike over to Trader Joe's on my way home. I immediately see some of the things I just bought at the Green Market: a bag of shallots $1.69, a bag of 7 large onions $2.69, apple pie (it looked good too) $6.99 and then finally large bouquets of flowers for nothing over $7.99. A grand total of $19.36.

I definitely admit there's certain reasons to visit the Green Market when specific items are in season. But with Trader Joe's around the corner and many local grocery stores catching up with the organic trend, the Green Market starts to look like a rip off. I remember one time my husband and I were haggling over a gorgeous frozen lamb roast at the Green Market - and finally ended up going to the Whole Foods butcher instead for a fresh cut of lamb - Whole Foods was CHEAPER! And it tasted out of this world. I am not a chef, but I definitely like to cook. I make certain choices in the markets regarding price. I ask myself, what will my guests really get excited over... is it the shallots from the Green Market or shallots from Trader Joe's? I can promise you no one will be able to taste the difference tonight. And I would have saved some cash. Cash, I might add, that my husband promptly pointed out that could have been invested into cheese at Murray's instead of some schmuck at the Green Market making up prices out of his head while brainwashed shoppers like me pay up.

Here is a photo of what $7 of onions looks like:

By the way, I was given a strict $30 budget for cheese – which, I might add, I managed to stick within, despite going to Murray's, where double-digit shopping expeditions are rare. Their Taleggio is only $12 per pound, and they had an amazing sweet and strong raw-milk blue called Persille du Beaujolais for $14/lb. But if I'd had the extra $20 that Michelle ended up spending at the Greenmarket... let's just say we'd be in even cheesier heaven than we are.

Also: Never mind Trader Joe's, Essex Street Market is absolutely amazing these days. I got some beautiful swordfish there for the eye-poppingly low price of $8/lb, and I'm sure it's at least as good as anything costing over twice as much in Soho or Tribeca.

To be fair, the first week of March is hardly the optimal time to get fresh anything from a greenmarket. And certainly the one at Union Square is permanently packed: no one else there seems to be particularly price-sensitive, so I can hardly blame the growers for jacking their prices into the stratosphere. But they've lost a couple of customers who would love, in theory, to support local agriculture – but who simply can't afford to, at these prices.

(Related.)

Posted by Felix at 16:04 EST | Comments (9)

Some CIOs are motivated by more than money

Rob Cox, at Breaking Views, reckons that Warren Buffett (read his annual letter to shareholders here) is going to have difficulty finding someone to replace him as chief investment officer.

Here's Buffett:

I intend to hire a younger man or woman with the potential to manage a very large portfolio, who we hope will succeed me as Berkshire’s chief investment officer when the need for someone to do that arises. As part of the selection process, we may in fact take on several candidates...
Being able to list Berkshire on a resume would materially enhance the marketability of an investment manager. We
will need, therefore, to be sure we can retain our choice, even though he or she could leave and make much more money elsewhere.
There are surely people who fit what we need, but they may be hard to identify. In 1979, Jack Byrne and I felt we had found such a person in Lou Simpson. We then made an arrangement with him whereby he would be paid well for sustained overperformance. Under this deal, he has earned large amounts. Lou, however, could have left us long ago to manage far greater sums on more advantageous terms. If money alone had been the object, that’s exactly what he would have done. But Lou never considered such a move. We need to find a younger person or two made of the same stuff.

And here's Cox:

Though Buffett has not revealed what Berkshire would be willing to pay to fill the post, he hints it will not be commensurate with the industry: "he or she could leave and make much more money elsewhere." It's easy for Buffett to say this. As the owner of so much Berkshire stock, for decades he has essentially given his prowess at allocating assets to the rest of the company's shareholders more or less for free.

Cox then compares Buffett's investing acumen with that of Edward Lampert, whose 1-and-20 hedge fund made him the first hedge fund manager to make $1 billion in one year. "Surely," says Cox, "this would fly in the face of Berkshire's anti-croupier culture."

Cox is half-right: Buffett will not get, nor does he want, a would-be billionaire, let alone someone who aspires to earn $1 billion in one year. But that does not mean he won't find what he's looking for – I'm thinking here of someone like David Swensen, of Yale, who seems to be perfectly happy making $1.3 million per year.

It might seem weird to Rob Cox, but there are in fact people who understand the concept of diminishing marginal utility. Once you have $20 million or so in the bank, especially if you're a halfways-decent investor, you're very unlikely to spend all your money – certainly if you live the kind of life that Warren Buffett would admire. So from that point on you really don't need to make any more: the money stops being something to spend, and starts being a way to keep score. There are many people out there who value a great job at Berkshire Hathaway and their own personal happiness above that desire to beat the next guy in the personal-wealth stakes. And if anybody can find them, Buffett can.

Posted by Felix at 15:35 EST | Comments (1)

Why rising default rates might not be bad for subprime MBSs

Understanding mortgage-backed securities is hard. They don't behave like normal fixed-income instruments: even now, with subprime defaults soaring, the big risk on MBSs is prepayment, not borrower default. And research on MBSs frequently includes passages like this:

6-wala FN 6s have a gross WAC of 6.66%, while 10-wala FN 6s have a gross WAC of only 6.46%. But could 20bp of WAC explain why the 6-wala pools are prepaying at 19 CPR while the 10-wala pools are prepaying at 13 CPR? The short answer is no.

Got that? I'll explain it to you if you want: people with mortgages written 6 years months ago are much more likely to refinance or otherwise prepay their loans than people with mortgages written 10 years months ago. Part of the explanation is that they took out their loans at higher interest rates, so they have more incentive to refinance. But that can't be the whole explanation.

But all that is pretty much beside the point. My bigger point is that MBSs are a world unto themselves, and you can't just jump willy-nilly from the fact that default rates are rising to the conclusion that the world of MBSs is doomed. In fact, the fact that default rates are rising is consequence largely from the fact that it's becoming increasingly difficult for subprime borrowers to refinance. And fewer refinancings means fewer prepayments – and fewer prepayments could mean that subprime MBSs are actually more attractive than they were. Here's Merrill Lynch:

Remember the good old days when lower credit borrowers were assumed to be slower in speed? When borrowers with high LTVs found it difficult to refinance or take cash out? When alt-A premium mortgage pools traded with a premium in price?
All of these ideas were predicated on the concept that a borrower who had low documentation, worse credit, or high LTV, either did not have as many opportunities to refinance or were on average less financially sophisticated and consequently less aware of movements in interest rates.
Over the past few years, however, this principle was stood on its head. With home prices rising relentlessly and lending standards generally easing over time, these borrowers became among the faster prepaying loans. They were eager to take cash out and/or trade up, and they were certainly the target of numerous mortgage solicitations by brokers. In contrast, more traditional prime borrowers who had less need for cash were likely to prepay slower during this period.
Are we drawing to the close of this rather remarkable period? Now that everyone is promising tighter underwriting standards, it seems likely to us that prepayments on more marginal borrowers are likely to decline as well. This suggests that premiums backed by these pools may once again turn out to have value.

I'm not saying that subprime MBSs are a screaming buy – and neither, I hasten to add, is Merrill Lynch. But this kind of dynamic is worth bearing in mind before anybody starts jumping to conclusions about the effect of rising default rates on the market in mortgage-backed securities. Norris, I'm looking at you.

Posted by Felix at 13:32 EST | Comments (1)

Does the SEC regulate the CDS market?

Lars Toomre (via Alexander Campbell) thinks that yesterday's SEC actions are just the first shoe dropping:

Toomre Capital Markets strongly suspects that more forthcoming enforcement actions will be filed in connection with the use of credit-default swaps and the use of inside information. The SEC's unprecedented sweep of Wall Street's equity trading records for the last two weeks of third quarter of 2006 coupled with information requests about prime brokerage funding activities during that period strongly suggests that certain leverage players (i.e. hedge funds) are going to have to explain why they were trading in certain securities just ahead of market moving corporate actions. TCM has no idea whom exactly is involved. However, CDS spreads have been moving too much ahead of unusual corporate events.

The issue of CDS spreads moving ahead of private-equity deals is known, and is a big one. To quote myself:

LBOs, by their very nature, need a lot of debt. That debt comes from banks and, increasingly, from hedge funds. And when those banks and hedge funds provide debt financing for an LBO, they hedge their positions in the CDS market, driving prices up.

But I am far from sure whether this kind of thing is likely to get prosecuted by the SEC. For one thing, it won't show up in a "sweep of Wall Street's equity trading records," since equities aren't involved in these trades. But much more to the point, hedge funds aren't "going to have to explain why they were trading in certain securities just ahead of market moving corporate actions," because CDSs aren't securities.

So I'd love to ask the question, if anybody can help: Let's say, for the sake of argument, that there was a cut-and-dried case of a hedge fund loaning money into a private-equity deal, and hedging that exposure in the CDS market before the deal was made public. First, does such activity fall within the purview of the SEC, and second, in any case, is it actually illegal?

Posted by Felix at 13:05 EST | Comments (2)

Just how big was that insider-trading scheme, anyway?

You can't have missed the insider-dealing news at this point. Just look at the SEC go!

Federal authorities said that they had exposed one of the most far-reaching insider trading schemes on Wall Street in decades, involving four investment banks and a web of hedge funds, day traders, lawyers and even a few supervisors, who upon discovering evidence of insider trading, blackmailed the traders to keep quiet about it...
Linda C. Thomsen, chief of enforcement at the Securities and Exchange Commission, described the scheme as one of the most “pervasive Wall Street insider trading rings since the days of Ivan Boesky and Dennis Levine.”

But what's missing here? It takes over 600 words before the NYT bothers to tell us how much money is involved in this "far-reaching case" – and DealBook never tells us at all. Do you think that's because, well, the amounts of money involved are pissant? The biggest crimes netted $6 million over 5 years; the smallest, just $9,500.

Check out the video of the SEC's press conference: the deals they talk about netted profits of between $10,000 and $50,000. No wonder you've never heard of any of the hedge funds involved in this scheme: that kind of money might be nice for an individual, but it's not going to do much for a big hedge fund's total returns.

In other words, this is not Boesky II, no matter how hard the SEC tries to spin it that way. Of course, the SEC has a mandate to go after insider dealing no matter how big or small. But this particular scheme looks like it's more the latter than the former.

Posted by Felix at 12:18 EST | Comments (0)

Protectionists take over the front page of the NYT

Dean Baker is upset at the New York Times today. Apparently it's running an article

which reports without comment Treasury Secretary Paulson's assertion that free trade has been a cornerstone of U.S. prosperity and warning against protectionist barriers.

Baker doesn't like this: He thinks that every time such comments are reported, the NYT should step in and note that the US could have even freer trade, especially in white-collar services.

But the really weird thing is that Baker is studiously avoiding a front-page article by Steven Weisman with the headline "A Cry to Limit Chinese Imports Rings at Paper Mill". Here's the lede:

For years the residents of this economically distressed hollow in the Appalachians have watched textile mills, glass factories and tire makers close down one after the other. Now its lone remaining big factory — “the last man standing,” as the production manager at the paper mill here put it — is threatened by imports of cheaper paper made in China.
“We’re still the economic engine for this whole area,” said Scott Graham, the production manager, referring to the river valley and forested hills surrounding the mill. “But our operations cannot compete with these below-cost imports.”

The story continues in a similar vein for over 1,700 words, and is very, very sympathetic to the protectionists. Here's Weisman a bit further down, for instance:

Many lawmakers say it is time to stop treating China with kid gloves, arguing that Beijing no longer deserves a free ride in which it benefits from a special exemption generally forbidden to Japan, Europe and other advanced industrial powers.

He quotes lots of people on that side of the debate, but not a single individual on the other side. The closest he comes is quoting a lawyer for China, near the end of the article, saying that if the paper tariffs are imposed then steel tariffs are likely to come next.

He even implies that the tariff-raising policy might be coming from – wait for it – Hank Paulson:

Some in Congress also see the China actions as a sign that Mr. Paulson, who resigned as chief executive of Goldman Sachs to become Treasury secretary last summer, realizes that his policy toward Beijing is faltering...
“When Paulson came in, he thought all you have to do is talk logic with the Chinese,” said Senator Charles E. Schumer, Democrat of New York and a vociferous critic of China. “They talked very nicely and gave him ice in the winter. Now he’s learning that you have to be tougher. It’s not like doing a deal with Goldman Sachs.”
A spokeswoman for Mr. Paulson, Brookly McLaughlin, said that the dialogue was “not designed to replace other bilateral negotiations or the necessary enforcement of our trade laws.”

Now, I don't know what Dean Baker thinks of this article, or whether he thinks that punitive tariffs on Chinese paper imports are a good idea. But I think that today, of all days, is not the best day for bashing the NYT for being too cozy with the "free trade" brigade.

Posted by Felix at 12:05 EST | Comments (2)

Equity bridges: Not as risky as they seem at first blush

There seems to be a lot of bellyaching from various pundits about equity bridges – one of the more startling innovations in the world of private-equity capital structures. Here's Andrew Ross Sorkin explaining it, and putting the knife in at the end:

The arrangement allows leveraged buyout firms to buy companies with even less cash upfront. The idea is that the leveraged buyout firms will find other investors to ante up cash after the deal is announced.
These bridges can lead to trouble, however. If the private equity firms cannot find new investors — and it is their job, not the banks’, to find them — or if the value of the asset falls sharply, the banks are left holding the bag.
“This is how things blow up; people take more risk,” said Andy Kessler, a former research analyst and hedge fund manager who has written books about Wall Street. “If you go back to the crash of 1987, all the banks had huge bridges that went bust.”

Blogging Stocks, Dealscape, and many others are taking much the same line: look at this risky risk! Which isn't even being priced properly! Here's Breaking Views:

Only a few deals have had equity bridges. So investment banks haven't really learned how to price them. Some banks have charged close to nothing - what bankers facetiously call "fee break-even." Some have syndicated equity for free just to get the other deal fees.

But Sorkin eventually comes clean on why equity bridges in fact aren't nearly as risky as they look at first sight:

In the case of TXU, Kohlberg Kravis and Texas Pacific are expected to invite their limited partners — the investors in their own funds, like big pension plans — to invest directly in this deal. By investing alongside the private equity firms, these investors can share in the rewards if the deal pays off without paying the same enormous fees to the firms that they typically do to invest in their funds. Private equity firms offer direct investment as an inducement to also invest in their funds that do carry fees.

The point here is that the limited partners in private equity funds, pretty much by definition, expect to get impressive returns net of those funds' fees. And now those limited partners are being offered the opportunity to get gross returns on top of that. Given that private equity funds are having zero problems raising capital at the moment, I can't for a minute see how any of them are going to have any difficulty syndicating the equity. It's much more likely that their problem will be with aggrieved limited partners who aren't able to get in on the deal.

If the bridge were to public equity, then it would be far riskier, since it would involve trying to syndicate something which was already traded on the markets. But that's not an issue. So the only real risk here is that between the deal closing and syndication, some kind of huge event will hit the sector concerned, and that the limited partners will balk at coming into the deal at its initial valuation. But my guess is that the amount of time between the deal closing and syndication will be measured in days. The investors aren't really buying into the specific equity risk, so much as they're buying into the private-equity shop's reputation for generating high returns.

Posted by Felix at 11:39 EST | Comments (1)

Krugman channels the Book of Revelations

Krugman's lost it today, with a bizarre column which would makes Michiko Kakutani on a bad day look sensible. Not only is it all predicated on a silly conceit ("if we’re going to have a crisis, here’s how"), but he can't even get that much right. Here's the weirdest bit:

There was still one big unknown: had large market players, hedge funds in particular, taken on so much leverage — borrowing to buy risky assets — that the falling prices of those assets would set off a chain reaction of defaults and bankruptcies? Now, as we survey the financial wreckage of a global recession, we know the answer.

Maybe I'm being idiotic here, but can someone explain to me how falling "assets" (that's stock prices and bond prices) cause "defaults and bankruptcies"? It seems to me that Krugman's missing at least one crucial link in the chain – a credit crunch – and that even a credit crunch wouldn't necessarily lead to "the financial wreckage of a global recession".

The fact is that profitable companies need to issue neither equity nor debt to keep on going, and that unprofitable companies are much more likely to be bought by profitable companies than they are to default or to declare bankruptcy. I'm not saying that a market plunge wouldn't hurt hedge funds – although I'm not saying that it would, either. I'm just saying that it wouldn't obviously and necessarily send the real economy into a disastrous tailspin.

(By the way, for fans of Krugman Predictions, here he is on January 29, 2002: "I predict that in the years ahead Enron, not Sept. 11, will come to be seen as the greater turning point in U.S. society.")

Posted by Felix at 2:49 EST | Comments (8)

Housing prices: Up!

Just in case you thought that US housing prices were falling: er, not so much. Kash Mansori has the details, but suffice to say that the US House Price Index rose by 5.9% in 2006, and by 1.1% in Q4.

“These data show that, on the whole, prices are still rising, albeit at a much slower pace,” said [OFHEO Director James B] Lockhart. “This suggests that house price appreciation is, for now, more in line with historical norms.”

49 of the 50 states saw prices rise in 2006; Utah prices rose by 17.6%. The only state to see a fall was Michigan, where prices fell just 0.4%. Another surprise: the Miami metropolitan area – supposedly home of the frothiest speculative bubble and the hardest consequent bust – actually saw prices rise by 15.3% in 2006. (Of course, the Miami metropolitan area is much more than South Beach. But still.)

Does this mean there's nothing to worry about? Of course not. Maybe it just means, in Kash's words, that "the housing bust has some way to go yet." And it's worth noting that the index is based on "conforming mortgages" for the purposes of Fannie and Freddie – which means nothing over $417,000, for starters, and certainly no co-ops. But if you're in the market for a house and you're wondering where the housing bust is, here's your answer: it hasn't fed into prices yet.

Posted by Felix at 2:07 EST | Comments (2)

What does yesterday's money buy today?

Never mind those inflation calculators you find all over the internet – Free Exchange and Brad DeLong both have posts up today asking pointed questions about what yesterday's money can buy today. First Brad DeLong, resuscitating an old post of his about the income of Fitzwilliam Darcy: apparently £10,000 a year in 19th-Century Britain is equivalent to either $300,000 a year today or perhaps $6 million a year today, depending on how you look at it.

And then Maybe Megan McArdle quotes Matthew Yglesias quoting Robert Farley:

Why is it that the United Kingdom, which is in an absolute sense far more wealthy now than it was in 1930, having difficulty maintaining a foreign deployment of about 10,000 total in Iraq and Afghanistan, while in 1930 it deployed many multiples of that total all over the world, plus colonial auxiliaries who were partially paid for by the Crown?

Yglesias continues:

Farley gives some good answers to the question, but it's worth noting that this is part of a perfectly general situation. As technology improves, the average level of productivity goes up. And as productivity goes up, wages go up as well, at least over the long term. The wages go up, however, more-or-less across the board whereas productivity has only actually improved in the select areas that have seen meaningful improvement. As a result, things that are intrinsically labor-intensive tend to get more expensive and rarer over time, even as overall living standards go up.

And Maybe McArdle explicates:

Occupying foreign nations being one of those labour-intensive things. The technical name for this phenomenon, with which Mr Yglesias didn't want to bore his readers, is Baumol's cost disease; it is thought to infest areas like health care as well as military operations.

But of course not everything which is labor-intensive has gotten more expensive over time – the obvious exception is anything which can easily be outsourced to foreign labor. A pair of shoes, for example, or a cup of rice.

The problem with foreign wars is not that they're labor-intensive, but that the labor can't be outsourced. Annoying as it must be to the Bush Administration, if you want to invade and occupy a foreign nation these days, you just have to do it yourself.

I'd also note, as a journalist, that productivity in journalism has barely improved over the past few decades, but that the cost of journalism has been plunging all the same. Word rates have barely budged since the 1940s, and, in the case of most bloggers, they've come all the way down to zero. Meanwhile, the cost to consumers of journalism has also dropped to zero. How come we hacks aren't afflicted with Baumol's cost disease?

Meanwhile, a DeLong commenter notes:

A good bit of the basket that a Darcy, had one existed, would have bought would have been personal service. You probably can't buy the sorts of levels of personal service nowadays that a rich man during the Napoleonic wars could. Certainly not for $300K. And Schumpeter reminds us that no labour saving device is as good as the attentions of one body-servant.

And another does the math:

I think that in those days the wage for a live-in servant might be about 10 pounds/month. Applying the 600:1 ratio that would translate to $6,000 plus board but no other benefits. Sounds about right.

It's worth noting here that the 600:1 ratio comes not from prices but from looking at relative income to the rest of society.

There are certainly a few things which have gone from middle-class commonplaces to upper-class luxuries within the space of a couple of generations: tailors and cobblers spring easily to mind. Live-in "help" is much less common than it used to be, and even something as non-obviously labor-intensive as a dozen oysters is vastly more expensive now, in real terms, than in the 50s or 60s.

I'd also be fascinated to look at the history of hotels through this lens. It strikes me that most hotels in the past were what we would consider luxury hotels today – luxury, in this sense, basically meaning "having a lot of staff". As staff costs rose, and hotel-room prices started rising beyond the reach of much of the middle classes, a whole new set of mid-priced and low-priced hotels, which weren't as labor-intensive, started to come in to being. On the other hand, there seem to be just as many luxury hotels today as there ever were in the past – which implies that between the rich and the on-expenses, the demand for such lodgings has remained strong even as the price has risen enormously. (The number of tailors and cobblers, on the other hand, has declined precipitously.)

Posted by Felix at 18:31 EST | Comments (0)

Can carbon offsets backfire?

Al Gore and I both try to offset our carbon emissions. Are we actually making things worse when we think we're making things better? The Economist and Tyler Cowen both try to make the case, and both are quickly slapped down by commenters including Joshua Gans. I'm not going to try to work out who has the better economics here, but I do think that organizations such as Climate Care, which sell such offsets, would do well to examine in some detail any possible unintended consequences associated with the areas they spend their money.

Posted by Felix at 16:54 EST | Comments (0)

Private equity grows up fast

Adventures in private equity: Remember how the Blackstone bid for EOP – at the time, the biggest private-equity bid ever – was quickly topped by another bid, from Vornado? Well, the same thing might happen to KKR's bid for TXU. Credit Suisse, TXU's bankers, have promised any potential rival bidder that they'll be able to rustle up the same $40.2 billion in debt that KKR and Texas Pacific have already lined up elsewhere. Alphaville provides some color:

Credit Suisse would probably lend only about $13bn to $15bn of that sum, syndicating the rest to other banks, people familiar with the matter said.

"Only" $13bn to $15bn, indeed. That's a hell of a lot of balance sheet to tie up in one client's debt, no matter who the client is.

So might Blackstone or Carlyle get into a private equity vs private equity bidding war? Such things are very rare – there seems to be an unspoken rule that when private equity shops start bidding against each other, they all lose out in the long run.

On the other hand, maybe such a bidding war would help prevent such funds turning into the “unacceptable and unaccountable face of capitalism”, in the words of Guy Hands, who knows a thing or two about private equity. Interestingly, at the same conference, Carlyle's David Rubenstein said that "We are so large and therefore need to operate like a public company.” Could the distinctions between public equity and private equity be disappearing as quickly as they appeared?

Posted by Felix at 16:01 EST | Comments (1)

Why don't billionaires give their money away?

Austan Goolsbee wonders in the NYT today why billionaires don't give more of their money away, given that they can't spend it (there's just too much of it to spend) and that even their children can't realistically spend it either: "their fortunes are growing far faster than their number of heirs, so each of the children will have the same problems spending the money that their parents had". He concludes:

In a few weeks, you will see the list of the world’s wealthiest people and how vastly their wealth has increased. Warren Buffett will probably be the only one pledging to give his fortune away. The other billionaires will probably think he’s crazy, but it may make him the most rational person on the list.

Greg Mankiw points out that Goolsbee is assuming that billionaires' wealth increases at a rate of 10% per year, which might not be realistic, especially after accounting for inflation and taxes:

At a more modest return, say 4 percent, providing for heirs is a somewhat more plausible motive than Austan gives it credit for being. Remember that the number of heirs is approximately doubling every generation--a rate of about 3 percent per year. So consumption smoothing among you and your heirs would allow you to annuitize your wealth at a rate of only 1 percent. And if you want your family's consumption to grow over time, the annuitization rate would be even lower.

But I see the question slightly differently. The real question facing billionaires, as I see it, is whether to give their money away now or later – specifically, after their own death. Buffett has clearly found a compelling use to which he wants his money to be put, and given the specifics of that use – poverty reduction, mainly – it makes sense to front-load the spending while he's still alive. Other billionaires, by contrast, might not be nearly as convinced that they know today for certain where they want their money to go.

So the solution is to write a will. Your family gets what you want them to get, your favorite charities likewise – and if you ever change your mind, you can. You can increase your expenditure today and leave less money for your beneficiaries; alternatively, you can invest your money today and, if all goes according to plan, leave more money for your beneficiaries. If the fancy takes you, you can even do something halfway between the two, like trying to buy the LA Times – newspapers in general being very bad investments, but very gratifying toys for the ultra-rich. Meanwhile, as Goolsbee says, you get to "lord it over the other families who have less".

Bankers never say they're doing nothing; they say they're "preserving optionality". Maybe billionaires think the same way.

Posted by Felix at 13:45 EST | Comments (8)

What the markets did this week really isn't important

Should we care about what the markets did on Tuesday? The news made the front page of just about every newspaper in the world, so it's clearly important, right?

Well, let's keep things in perspective. Here's a stock chart for the Shanghai Composite, which crashed on Tuesday and brought the world down with it:

See the crash? It's that little blip which sent the index tumbling all the way back to where it was in mid-January: the Composite is still up 7.7% since the beginning of 2007, and up 148% since the beginning of 2006.

Now, here's the S&P 500 over the same timeframe:

Clearly, the S&P 500 hasn't more than doubled in the past year. But equally clearly it's recovered more than once from much bigger falls than it saw on Tuesday. The only remotely unique thing about what happened on Tuesday is that it happened in one day, rather than happening over the course of a week or two.

The problem is that because of the news cycle, things which happen quickly are more newsworthy than more important things which happen slowly. So a big fall in the stock market over the course of one day makes front pages around the world – and if you're going to make a big deal out of why the stock market fell, then you're going to have to come up with some kind of reason for it.

Enter the bears. You want an explanation for why the market went down? Econobloggers from Roubini to Ritholtz to Baker have been telling you for months why the market should be going down! It all starts with the housing market: homebuilders have stopped building homes, which means that manufacturers have had to stop making stuff for all those homes, and that both the building and manufacturing industries are in recession. And given the huge rise in employment in those industries of late, it stands to reason that there's going to be a pretty big fall in employment in those industries pretty soon. Meanwhile, suppliers of mortgages have stopped writing the crazy mortgages that were driving the housing industry, which means that it's harder to buy a house than it used to be, and that prices have stopped rising and in fact have started falling in many areas. Because those crazy mortgages are no longer available, people who have them can't refinance, and are defaulting in unprecedented numbers – which means their homes coming back on the market, which only serves to make the broader housing market worse. And high default rates also hit mortgage-backed securities, which make up a large chunk of the US bond market, raising fears of a credit crunch. Add it all up, and you get Recession – which is more than enough reason for a market "priced for perfection" to fall – and fall a lot.

Now, this story really hasn't changed over the past 6 months. The same people are telling the same story that they have been telling for a long time – and, truth be told, those of them who made forecasts for when the market and the economy would turn south have seen those dates come and go. Now, it's entirely possible that, finally, their time has come – that February 27 will be seen, in retrospect, to be the beginning of a nasty bear market where spreads widen out, credit contracts, stocks fall, and the economy slides into recession. But it's way, way too early to tell. But at least the story makes for a good explanation for the fall in global stock markets. (And remember, journalists love compelling explanations for such things.)

In truth, one-day movements in the stock market are nearly always meaningless. OK, there was the crash of 1929, which was hugely important. And the crash of 1987, which was of minor importance. But as a general rule, anybody who tries to extrapolate a general stock-market direction from what the market does in one given day is on a fool's errand. So the market might go down over the next few months, and it might go up over the next few months. But either way, what happened on Tuesday is not going to be particularly important in terms of the bigger move.

And what about the economy? Are we headed for recession or not? Here, the important market players all seem to be on more or less the same page. Ask Wall Street economists, or Fed governors, or the US Treasury what they think, and they'll nearly all say that the economy might be slowing down, but they don't see much risk of a recession or any other type of "hard landing". On the other hand, there seems to be an equally compelling unanimity among newspaper columnists and econobloggers that the markets are delusional and cruising for a nasty crash.

Now it's true that market economists, and the market in general, never seem to see a crash coming until it's too late – so the fact that they don't think there's going to be one is hardly reassuring. Quite the opposite, in fact. On the other hand, no one ever made money by listening to macroeconomists.

As Brad DeLong says, "the macroeconomic outlook rarely changes suddenly". Whatever is true today was true last week. So if you thought things were going fine last week, the release of a durable goods report and a one-day blip in the markets should not be enough to change your mind. Similarly, if you thought markets were overpriced last week, you should resist the temptation to believe that the markets have now suddenly come around to your way of thinking.

One last chart for you:

That's the VIX volatility index. It's spiked up – last at 16, from typical levels between 10 and 12 of late. But the spike looks bigger because Yahoo charts make their y-axes logarithmic. We're still a long way from the Great Unwind that so many people fear.

Posted by Felix at 11:59 EST | Comments (2)

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