Felix Salmon

Airline Economics Datapoint of the Day

Posted on September 27, 2007 by Felix

Market capitalization of AMR, the parent of American Airlines: $5.4

billion

Value

of AMR’s AAdvantage frequent flier program: $6 billion

Posted in stocks | Comments Off

Misleading Chart of the Day

Posted on September 26, 2007 by Felix

The Wall Street Journal has a story entitled "Tech

Stocks Get Giddy 🙂" today – and yes, the smiley is in the headline.

It’s accompanied by a dreadful chart showing three stocks which are currently

at all-time highs: Research in Motion, Apple, and Google. Here’s the chart,

with Apple removed for clarity’s sake:

As you can see, the left-hand chart shows the nominal price of RIMM stock,

in Canadian dollars, over the past eight years. The right-hand chart shows the

nominal price of GOOG stock, in US dollars, over the past three years. The charts

are carefully aligned so that $0 and $100 and $200 are all along the same horizontal

line, as though nominal price in Canadian dollars and nominal price in US dollars

were really useful metrics. And they certainly make it seem as though GOOG has

done vastly better than RIMM.

In fact, GOOG has done better than RIMM, since the Google IPO, although not

by an enormous amount: it’s gone up from $100.34 to $569, which is an increase

of 467%. In the same time, RIMM stock has increased from $22.67 to $96.82, which

is an increase of 327%.

Over the past one year or two years, however – and this is something

you’d never work out from looking at the chart – RIMM has significantly

outperformed GOOG, rather than the other way around. Here’s a couple of charts

I made myself, rebasing the RIMM share price to the GOOG share price at the

time. Over the past 12 months, indeed, GOOG has pretty much gone nowhere in

comparison to RIMM:

Which is all to say that if you’re going to compare two or three different

stocks in the same chart, then you should compare all the stocks in the same

chart, rather than trying to compare them across different charts. Otherwise,

you can end up giving entirely the wrong impression.

Posted in charts | Comments Off

GE, the Old-Fashioned Lender

Posted on September 26, 2007 by Felix

Do you remember when commercial banking was all about knowing your client and

your clients’ industry and having strong relationships and parking billions

of dollars in loans in some dusty old part of the balance sheet which never

got marked to market or even really looked at? Neither do I, frankly. But today

I had a fascinating meeting with Tom Quindlen, the president and CEO of GE

Corporate Lending, who almost took me back to those halcyon days.

GE, it turns out, has a corporate lending department which is on track to lend

a lot of money this year – $20 billion – and even more

next year. It’s buried three levels down in the corporate hierarchy (it’s part

of Corporate Financial Services, which is part of GE Commercial Finance) and

it’s full of people who know their industry (steel, retail, timber, you name

it), and it’s been a major player in some very large syndicated loans, such

as the $1.9 billion debtor-in-possession facility for Delta Airlines and a $1.5

billion loan for Saudi chemicals company Sabic.

GE has a very old-fashioned attitude towards risk management: basically, it

involves GE lenders doing a lot of legwork before committing any capital, and

then trusting their own judgment. If GE underwrites a loan with the intention

of syndicating it out, then it will obviously keep an eye on the market value

of that debt – but if it’s going to keep the loan itself, it doesn’t mark

to market. GE also is very conservative: it deals only with senior secured loans,

which are the least likely to default.

There seems to be very little attempt to look at the bigger picture within

the GE Corporate Lending department. Talking to Quindlen, it sounds as though

his group is very strong on the bottom-up analysis of its portfolio companies,

but doesn’t spend much time on top-down analysis of where the US or global economy

might be headed, or even where the credit markets are going. Quindlen’s department’s

lending goals didn’t change at all during or after the credit crunch of July

and August, and they’re going to increase in 2008 no matter what happens to

the US economy. If spreads gap out, so much the better for him: it just means

more profits on the loans, especially since GE’s funding costs, given that it’s

a AAA-rated company, are extremely low. The fact that he might lose money on

his current portfolio if he had to liquidate it is irrelevant, since that will

never happen, and he holds loans to maturity (or to bankruptcy, in which case

GE can help with restructuring).

GE, then, is a very old-fashioned lending shop, with no prop desk and no real

way to hedge positions or to make a bet on spreads widening. But it’s solid,

and profitable, and creditworthy. And those are things in short supply these

days.

Posted in bonds and loans | Comments Off

Alan Greenspan, Comedy Mastermind

Posted on September 26, 2007 by Felix

The penguin nails

it.

Posted in fiscal and monetary policy | Comments Off

When a Property Bubble Isn’t Speculative

Posted on September 26, 2007 by Felix

Now that I’ve started noticing

the "speculative bubble" meme, I seem to be seeing it everywhere.

The latest person to use it incorrectly (IMHO) is none other than Robert

Shiller:

According to the Standard & Poor’s/Case-Shiller US National Home

Price Index, home prices were already rising at almost 10% a year in 2000

– a time when the Fed was raising the federal funds rate, which peaked

at 6.5%. The rapid increase thus appears to be mostly the result of speculative

momentum that occurred before the interest-rate cuts.

Not all bubbles are speculative bubbles, and momentum can drive prices upwards

even in the absence of speculation. Consider a housing market which has been

rising at say 15% per year, or more. When a house comes on the market, a bidding

war ensues. Each house that comes onto the market sells for more than previous

comps. Sellers get greedy, ask for silly amounts of money, and, surprisingly

often, get what they ask for. Buyers get scared about being priced out of the

market, and desperately try to buy anything they can, just to get a foot on

the property bubble. You know the story: we’ve all seen it happen. But the point

is, there’s no speculation: the buyers aren’t buying to flip at a profit, and

aren’t motivated by the prospect of selling at a higher price in the future.

In fact, their real motivation is fear (of never being able to afford a house),

not greed.

For a prime example of a non-speculative housing bubble, look at Manhattan,

right now. Prices here are continuing to rise even as they’re falling elsewhere

in the country, and even after they’ve already risen much more than prices in

most of the rest of the country. And yet Manhattan has few if any condo flippers,

buy-to-letters, or other byproducts of a speculative mindset. For one thing,

most Manhattan apartments are co-ops, not condos, and it’s very hard to flip

a co-op. The vast majority of buyers in the Manhattan property market are simply

individuals who want to buy a home to live in. They’re not speculators a

la Miami Beach or Orange County.

So now cast your mind back to 2000, when Robert Shiller claims there was "speculative

momentum" in the US housing market. There was momentum, to be sure. But

2000 definitely predated the idea that speculating in property was an easy way

to make outsize profits. Back then, speculating in tech stocks was the easy

way to make outsize profits. The tech bubble had to burst before any kind of

speculative bubble in property really got started.

Posted in housing | 1 Comment

Who Won in the GM Strike

Posted on September 26, 2007 by Felix

Andrew

Leonard asks today whether anybody won in the showdown between GM and the

UAW. "There’s no triumph in this deal," he concludes. "Just resignation."

I’m slightly more optimistic, and I’d say that both sides won. After all, a

strike is economically destructive for both sides, which means that a speedy

resolution of any strike is always in both sides’ best interest. Often, anger

and resentment and mistrust between the two sides means that such a speedy resolution

is impossible. But when it does happen, that’s reason to stand up and applaud

the negotiators who prevented hundreds of millions of dollars being poured down

the drain.

In terms of the substance of the deal, it’s far from clear exactly what job-security

guarantees the UAW wanted (and went on strike to receive), and what they ended

up getting. Again, that’s good: it means that even after the union declared

a national strike, its leadership – as well as the leadership of GM –

was mature and disciplined enough not to go blabbing to the media about what

exactly was going on and how unreasonable the other side was being. After 48

hours, a deal was reached, and again neither side felt the need to crow the

media about the concessions they managed to win.

Obviously, a negotiation with no strike is better than a negotiation which

does end up with a strike action, no matter how short. But it seems to me that

this is the best possible outcome for all concerned, given that the workers

did actually walk off the job a couple of days ago.

Posted in labor | Comments Off

Why the Ratings Agencies Should Fear Congress

Posted on September 26, 2007 by Felix

There was a lot of bashing of the ratings agencies this morning at the Portfolio

subprime panel. It was timely, coming as it did ahead of Congressional hearings

on the ratings agencies and their role in the present mess. Investors and lawmakers

seem to be losing faith in the the ratings agencies – but it’s the latter

which the agencies should fear more, not the former.

The Wall

Street Journal says today that "if worries persist, ratings could be

viewed as less valuable, and issuers may become less willing to pay firms to

rate their bonds". But in reality, so long as the present regulatory regime

remains in place, the issuers essentially have no choice but to pay

firms to rate their bonds. The universe of bond investors is dominated by large

institutional investors who have a mandate to invest only in bonds with a certain

rating – and so long as those mandates exist, the ratings agencies will

continue to have a license to print money.

What’s more, a whole new universe of creditors is going to become very ratings-sensitive

in a few months’ time, as the long-awaited Basel II capital-adequacy regime

gets implemented across the international banking system. The amount of capital

that banks are required to hold against any given loan will now be a function

of the debtor’s credit rating – giving banks every incentive to lend to

highly-rated weak companies rather than stronger, lower-rated entities.

Is that possible? Can a highly-rated company really be more likely to default

than a credit with a lower credit rating? Yes:

According to Moody’s, corporate bonds rated Baa (their lowest investment

grade) had a 5-year average default rate of 2.2% over from the period between

1983 and 2005. However, CDOs with the same Baa ratings suffered 5-year default

rates of 24%. Investment grade corporate bonds and investment grade CDOs are

not the same, and a CDO with a borderline investment grade rating is really

the equivalent to a junk bond.

If you look at Baa-rated municipal bonds, the difference is even larger: the

default rate on Baa-rated munis was actually just 0.09%, according to one of

the panelists this morning. "There can be a 250x difference in the probability

of default for this given Baa rating," he said.

So it’s not the investors that the ratings agencies need to worry about: it’s

the regulators. If they stopped requiring pension funds and the like to invest

only in bonds with a certain rating, then demand for ratings would surely plunge.

Posted in bonds and loans | Comments Off

Zhang’s High

Posted on September 26, 2007 by Felix

My friends don’t tend to collect art, but it seems that their friends

do. Yesterday afternoon, I found out that a friend of a friend had sold his

Zhang Xiaogang at Sotheby’s for $400,000; and then yesterday evening I found

out that a friend of an entirely different friend had sold his Zhang

Xiaogang at Sotheby’s, too, for $1 million. Both sales fell well short of the

$3.1 million that "Chapter of a New Century — Birth of the People’s Republic

of China" managed

to fetch, but I can tell you that the $400,000 painting is just 15 3/4 by

11 3/4 inches, or about the size of two pieces of standard letter paper. I can

also tell you that it was bought for $7,000 about 10 years ago, which gives

it an annualized rate of return of 50%, more or less.

As for the $1 million painting, it was bought for about $15,000, and then,

a few years ago, its owner moved cities. Not wanting the hassle of transporting

the canvas, he tried to sell it back to the gallery for the same price he paid

for it – and the gallery refused.

I can say with some confidence, then, that these paintings were not bought

with speculative intent. But a lot of Chinese collectors now want to repatriate

their country’s patrimony, especially with regard to important artists of the

1990s such as Zhang. And they way they can do that is by bidding up his values

to a level at which the paintings can get shaken loose from the grasp of collectors

who happened to be in the right place at the right time and got lucky.

It might make sense to consider the market in Zhang to be a bubble: certainly

his price appreciation would seem to be unsustainable. On the other hand, he’s

certainly an important Chinese artist, and with art it can be very difficult

to know exactly who and where owners of important works are. Often the only

way to get them to reveal themselves is to bid up the market for those works

until the prices are so silly that the original buyers consign their pieces

for sale.

Posted in art | Comments Off

How Giving to Charity Will Help You Get Rich Quick

Posted on September 26, 2007 by Felix

On Monday, I met Jim Whitton, a director of The

Hunger Project, in a midtown cafe. The Hunger Project (THP) is a well-run

non-profit which works efficiently and tirelessly towards sustainable poverty

reduction in the developing world. With Whitton was Roger Hamilton, the chairman

of something called the XL Group,

which has just announced

that it will give $5 million over five years to THP’s programmes in India. The

formal commitment is being made today, at the Clinton

Global Initiative.

The deal is a winning one for all concerned. The Clinton Global Initiative

has done what it was set up to do, which is catalyze commitments to improving

the planet. The Hunger Project receives a large donation. And Roger Hamilton

gets to be mentioned in the same breath as Bill Clinton, helping to give his

XL Group kudos and respectability.

Hamilton loves to talk about creating his network of "social entrepeneurs,"

who give at least 10% of their profits to charity, and who will be a powerful

force in terms of global poverty alleviation. In fact, Hamilton just loves to

talk. He talks with great conviction and at great length, and he has turned

his ability to talk into what I’m sure is a very lucrative business. For $3,300

you can hear him talk at his Entrepreneur

Business School ("a journey of self and entrepreneurial discovery"),

while for a mere $105 you can buy his 6-CD set called Wealth

Dynamics ("a revolutionary technology that will guide you on your path

to wealth"). Meanwhile, his magazine

is a peculiar mix of inspirational stories with advertisements for "franchising

opportunities" and the like.

Of course, there’s no shortage of get-rich-quick merchants, and I find it interesting

that Hamilton has hit upon giving money to charity as the way in which he distinguishes

himself from the rest of the pack. Every time you sign up for one of his products,

you feel good about it, because you know that he’s giving some of the proceeds

to charity and in fact that you and your fellow XL entrepeneurs are all pulling

together in the service of a greater cause – while making lots of money,

of course. The strategy seems to be working, too, at least for XL Group if not

for its members.

This, then, is one reason why I still feel a little uncomfortable about the

idea of for-profit philanthropy. In theory, and when it’s practiced by the likes

of Pierre Omidyar or Google.org or Richard Branson, it’s a great idea and can

work very well. But it can also create major conflicts of interest, as we

saw with Banco Compartamos. And I fear that if the idea really starts to

catch on then it risks being hijacked by the likes of Roger Hamilton, and people

will view it with even more suspicion than they do already.

Posted in development | Comments Off

Subprime: It’s Not About Creditworthiness

Posted on September 26, 2007 by Felix

A bit of a late start this morning, thanks to a Portfolio breakfast (of which

more later) hosted by Jesse Eisinger on the subject of the subprime meltdown.

Joe Mason of Drexel University was there, and was very rude about lending to

bad credits in general, not just in the housing market specifically. It doesn’t

matter what the product is, he said: it can be credit cards, or home-equity

lines of credit, or mortgages. Ultimately, poor people don’t care about interest

rates because they don’t have any money and won’t repay their loans in any case.

I don’t buy it, and neither did one of the other panelists, a hedge-fund manager

who pointed out astutely that the very labeling of the subprime crisis makes

it easy to delude oneself that the problem is at one remove. "Subprime

is a very convenient term used by elites in the media and on Wall Street because

it implies that there’s something wrong with the borrowers, and also with the

lenders," he said. "What you have in reality is just a broader mispricing

of credit."

The fact is that it’s wrong to simply paint all subprime lending as misguided.

Subprime borrowers can be responsible borrowers, and enlightened lenders can

make good money from them by helping them improve their credit and build themselves

a solid financial foundation.

When subprime lending goes bad it’s usually because lenders get greedy, and

move into the realm of predatory lending, trying to extract as much juice from

the borrower as possible before a bankruptcy made inevitable by usurious interest

rates.

The present subprime crisis is similar, in that lenders were extending credit

without much if any regard for borrowers’ ability to repay the full amount over

time. It wasn’t worth worrying about whether or not the borrower could afford

the interest rate on the loan once the teaser rate expired, because by that

point both borrower and lender expected that the loan would be refinanced. The

lender would make money anyway, because its large fees were capitalized into

the loan, and because it would charge a substantial repayment penalty. But that

model is clearly unsustainable no matter what the creditworthiness of the borrower:

option-ARMs were essentially bridge loans, and bridge loans fail when they can’t

be taken out, leaving the lender with large losses.

So let’s not delude ourselves that the subprime problem is just another example

of poor people being bad with their finances. What happened in subprime is actually

very similar to what

happened in commercial real estate, or in private-equity

buyouts: the loans were so large that they can never be paid down, only

ever refinanced. If and when the value of the underlying assets falls, both

borrowers and lenders will suffer greatly.

Posted in bonds and loans, housing | Comments Off

Angus Maddison’s New Book

Posted on September 25, 2007 by Felix

I have very few books in my office, which is quite small, but in pride of place

on my reference shelf stands Angus Maddison’s masterful reference work "The

World Economy". No one has spent more time or effort trying to put

together reliable economic statistics for different parts of the world over

the past thousand years (!), and the results are invaluable.

Now comes news

that Maddison’s "Contours

of the World Economy 1-2030 AD: Essays in Macro-Economic History" is

being released in November. This book is just as ambitious as his last, drier,

tome, and looks to be aiming at Jared Diamond territory:

This book seeks to identify the forces which explain how and why some parts

of the world have grown rich and others have lagged behind. Encompassing 2000

years of history, part 1 begins with the Roman Empire and explores the key

factors that have influenced economic development in Africa, Asia, the Americas

and Europe. Part 2 covers the development of macroeconomic tools of analysis

from the 17th century to the present. Part 3 looks to the future and considers

what the shape of the world economy might be in 2030. Combining both the close

quantitative analysis for which Professor Maddison is famous with a more qualitative

approach that takes into account the complexity of the forces at work, this

book provides students and all interested readers with a totally fascinating

overview of world economic history.

I can’t wait.

Posted in economics | Comments Off

The Price of Luxury

Posted on September 25, 2007 by Felix

The Economist notes the

evolution of the economics of luxury goods over the past year: while the

goods themselves have increased in price by 6%, twice the rate of inflation,

the income of the rich has increased by 9%, or three times the rate of inflation.

So a question for any economists reading this: what should happen to demand

for luxury goods in such a situation? (Assume that only the rich buy luxury

goods, for the sake of argument, and assume also that these aren’t Veblen goods

which are bought because they’re expensive.) On the one hand, when

the price of a good goes up in real terms, then demand falls. On the other hand,

the price of the good is actually going down in percentage-of-disposable-income

terms, which implies that demand will rise.

But I think there’s another, subtler question lurking in the background, which

has to do with the psychoeconomics of purchasing decisions. If you want a certain

good, there are two reasons why you might not buy it. The first is simply that

it’s too expensive for you: you can’t afford it, or buying it will eat up too

much of your disposable income. The second is unrelated to the amount of money

you have: if someone tries to sell you a biro for $300, you’ll refuse to buy

it, even if you want a disposable pen and even if you’re so rich that you wouldn’t

even notice the loss of $300.

I ask this because right now I’m torn about a forthcoming meal. There’s a certain

restaurant I want to go to. It’s a very good restaurant, and it’s rather expensive,

and frankly it’s well outside my normal budget for such things. But I’ve heard

amazing things about the place, and I have a special occasion coming up, and,

if I only go there once this year, I can afford it. So half of me (actually,

a bit more than half, since I’ve made the reservation, and will be going there)

says, well, this is what it costs, you want it, you can afford it, so just spend

the money already.

But part of me is rebelling, too, and saying that the restaurant is overpriced,

even if it is excellent, and that therefore I shouldn’t be going. The

restaurant in question makes it essentially impossible not to spend

a lot of money: there’s a prix-fixe menu with no a la carte option, the wine

list is expensive, and their corkage fee is very high too. There’s no way a

meal for two is going to cost less than, say, an 80GB

iPod, or a 13"

x 19" Mike Monteiro print in an edition of 20. And that’s excluding

whatever I spend on a bottle of wine, if I bring one with me. If there are other

things which are cheaper and which I’m not buying and which I value more, should

I not go to the restaurant?

Posted in consumption, economics | Comments Off

Bonds Without Price Quotes

Posted on September 25, 2007 by Felix

Paul Kedrosky has found a Greenwich Associates report saying that "more

than 60% of participants active in corporate bonds say they have experienced

trouble getting a simple price quote from dealers on these usually liquid products".

Is this, as he says, "an

eye-opening statistic on the credit crunch"?

On its own, I think the answer is no. If we could compare the 60% number in

a time series with the answer to the same question at various more liquid times,

then it would be more useful.

Even then, however, one would expect that most bond investors own one or two

issues which are likely to suffer from illiquidity when credit markets seize

up as they did this summer. They (should) expect as much. It’s not like anybody’s

saying that 60% of corporate bond issues are suffering from illiquidity, or

even 6%. Anybody who invests in corporate bonds knows that they’re investing

in an asset class which suffers in any flight to liquidity or quality. And during

a credit crunch, there’s really no such thing as "a simple price quote".

Besides, with the advent of the CDS market, you don’t actually need

a price quote in order to hedge your positions in corporate bonds: you can just

buy credit protection instead. So I think there’s less to this particular datapoint

than meets the eye.

Posted in bonds and loans | Comments Off

Intellectual Property Among Magicians

Posted on September 25, 2007 by Felix

In my Q&A

with Susan Scafidi, I asked about Jim Surowiecki’s assertion that the world

of magic tricks manages to be innovative despite a lack of copyright protection.

Susan replied that there might be no copyright protection, but that didn’t mean

that magic tricks didn’t have their own, idiosyncratic, protection mechanisms:

Since my father is a serious amateur magician (and I confess to having performed

a bit myself years ago), magic tricks are my favorite inapposite example.

Not only is the literature copyrighted, but many effects are deliberately

kept secret by magicians, and unlike fashion can’t be torn apart at the seams

by interlopers. Penn & Teller’s antics aside, there’s a guild –

and it takes some effort to reach the inner circle.

Now, Alea has found

a wonderful

paper by Jacob Loshin which explains in fascinating detail how magic tricks

are protected in practice. Here’s a taster:

“Popular magic” remains easy to find. Anyone can go to the library

to learn it or walk into the local magic shop to purchase it. This gives the

false impression that the magic community does a poor job of controlling access

to its secrets. In fact, however, the easy availability of “popular

magic” brilliantly achieves what magicians call “misdirection.”

“Popular magic” serves to satisfy those in search of the cheap

secret. And “popular magic” gives them just that—cheap secrets.

These secrets are harmless in the hands of the general public, since they

tend not to compromise the more valuable secrets that magicians aim to preserve.

And here’s an excellent example of the magicians’ enforcement mechanism, from

a magician named Walter Zaney Blaney:

[A] company in England, Illusions Plus, was selling still another rip-off

of my illusion. When I protested to the owner, James Antony, he told me there

was no court in the world which could stop him from what he was doing. I explained

I had no intention of going to court. I instead simply told my many friends

in [London’s] Magic Circle about it…

When the word spread, soon Mr. Antony ‘had a problem.’ As things

turned out, there was indeed a court which promptly put him out of business…

the bankruptcy court.

Go read the whole thing: I promise no magic-trick secrets are revealed!

Posted in intellectual property | Comments Off

Labor Market Datapoint of the Day

Posted on September 25, 2007 by Felix

Bo Peabody’s companies pay

their ad sales staff well, it would seem:

Digital ad sales at the entry level are getting multiple six figure salaries.

I tried checking this with my friendly neighborhood digital entrepeneur, who

told me that a junior digital ad sales person who actually gets out of the office

and sells can easily make $150,000 a year. Which isn’t necessarily a "multiple

six figure salary", unless you consider 1.5 to be the multiple that Peabody

had in mind, but it’s still a fair chunk of change.

By contrast, the average sales person on a magazine, according to Folio’s

latest salary survey, makes somewhere between $71,000 and $83,000 in total

compensation.

Posted in pay | Comments Off

Why the GM Strike Makes Sense

Posted on September 25, 2007 by Felix

The

GM strike makes sense to me. The key issue for the union, quite properly,

is the jobs of its members. The last time the UAW went on national strike, in

1970, it had 400,000 members; now, it has 73,000. It has failed to prevent the

loss of over 300,000 jobs, even as GM has been creating new jobs overseas. So

despite coming to an agreement on the crucial healthcare issue, GM wants to

be able to reduce its US workforce even further, and it’s hard to see how it

would be in the union’s interest to allow that to happen.

Note that this strike is not about pay, and not about benefits:

it’s about job security. So I’m puzzled when Matt Cooper says

that inflation hawks "will look at any settlement as pressure on prices".

They won’t, for two big reasons.

Firstly, GM does not have pricing power. It competes against Japanese manufacturers

who are perceived by the public as being higher quality than GM’s offerings.

If GM tries to charge significantly more than Honda and Toyota, it simply won’t

sell cars.

Secondly, a settlement would not imply higher car prices anyway, and neither

would it imply higher unit labor costs. The outcome of this strike will affect

one big thing: where the extra marginal dollar of GM revenue goes. Now Matt

might like to see that money to GM’s shareholders; personally, I’d rather see

it go to GM’s workers. But either way, the net effect on inflation is the same.

And in general, wage inflation is a good thing, if price inflation

remains controlled: it means people are being paid more money, in both nominal

and real terms. This strike might be a big deal for GM, but it has very little

in the way of macroecnomic consequences.

Posted in labor | Comments Off

Mortgage Prepayment: Economically Suboptimal

Posted on September 25, 2007 by Felix

Greg Mankiw reckons that prepayment

penalties are a Bad Thing, and approves of David

Laibson’s plan to abolish them. Writes Mankiw:

When I refinanced my mortgage not long ago, one of my first questions was,

Are there any prepayment penalties? I figured that as long as the answer was

no, I was less likely to be hit with strange, hidden provisions down the road.

Mankiw’s commenters (and Brad

DeLong’s, too) get into a healthy debate about this proposal, but now Tomasz

Piskorski and Alexei Tchistyi have a

long paper out which claims with great empirical rigor that in a perfect

world the exact opposite would be true. Instead of no mortgages having prepayment

penalties, all mortgages would ban prepayment altogether, or at least have very

large prepayment penalties.

Peter Coy tries

to explain, in English:

The economists say the optimal loan contract would outright ban getting a

new loan from a different lender. There are no such bans. But they say that

the prepayment penalties that are common in subprime loans are a good second

best. How could that be? Because lenders will offer more favorable terms if

they know that they’ll be able to hang onto the loan long enough for it to

be profitable. If they fear that the borrower will refinance at the drop of

a hat, they’ll give less favorable terms.

In fact it’s slightly more complicated than that. Here’s what the paper says:

The optimal contracts do not allow borrowers to refinance their mortgages

with another lender. Offering this option would increase the borrower’s reservation

value, which would limit the ability to provide him incentives to repay his

debt, resulting in a decrease of efficiency of the contract.

I’m not going to try to get into the specifics of reservation value (see page

11 of the paper for all the details), but it’s basically homeowner’s equity:

the amount of money that the borrower would have left over if he sold the house

and moved.

Indeed, the paper says that not only prepayment but even renegotiation is a

bad idea in an economically-optimal mortgage:

We also did not allow for contract renegotiations, because a possibility

of renegotiation would lead to a suboptimal contract.

I have to say that I’m having a lot of difficulty with this idea: since a successful

renegotiation has to be acceptable to both sides, what’s not to like about it?

If the lender would be better off with the original contract, it can simply

refuse to renegotiate.

In any case, I’m sure that Greg Mankiw, who recently refinanced his mortgage,

is happy that he was able to do so. But it is interesting that in some kind

of ideal world, there would be enormous-to-the-point-of-insurmountable obstacles

preventing him from doing just that.

Posted in housing | Comments Off

Speculation in Art

Posted on September 24, 2007 by Felix

Callen Bair, responding to my post

on speculative bubbles, tells me that there

is speculation in the art market after all. Who are these speculators?

They’re rich; they want to spend their money; and it might as well be on

something that broadens their social horizons and might even make them some

money. Potential profitability is one of those niggling factors in the back

of this kind of collector’s mind. So why shouldn’t we assume that if art prices

take a swan dive — or threaten to do so — these collectors will

be less likely to buy that sculpture?

Callen is quite right that an imploding art market will definitely put the

dampeners on buyers’ appetite for art. But she’s wrong if she thinks that’s

evidence that a speculative bubble exists.

One clue is when Callen says that these purported speculators "want to

spend their money". Spending money is what Steve Schwarzman does

on crab claws or birthday parties; it’s not what speculators do with tech stocks

or Miami condos. Those are bought, or invested in: there’s no implication that

once the money is spent, it’s gone.

Art is expensive, and anybody spending a lot of money on art is likely to want

some kind of reassurance that it has a good chance of retaining its value, and

maybe even of appreciating. People feel much better about their Warhol, which

is worth ten times what they paid for it, than they do about their Fischl, which

is worth a quarter of what they paid back in 1989.

Certainly, people are willing to pay more money for a painting if they think

it has a good chance of rising in value. If that happens, you see, they haven’t

really spent any money at all: they’ve just converted it from cash

into art, just like buying stocks doesn’t (in their mind) count as spending

either.

But none of this means that such people are speculators. A typical art buyer

wants to buy something which will increase in value – that’s perfectly

normal. But when the purchase is made, there’s no specific intention to sell

the piece at a profit within the next couple of years. The "potential profitability"

that art buyers are worried about is theoretical profitability –

how much is the art going to be worth. It’s not real-world profitability

– how much the buyer would be able to receive for the piece, in practice,

if they sold it in a couple of years’ time.

Which isn’t to say that if the art market goes through the roof, and their

dealer asks them nicely, the buyers won’t part with the work for a substantial

profit. But for a speculative bubble to exist, you need much more than that:

you need people buying art in the sole hope and expectation of selling it at

a profit, and you need those people to have visibly succeeded to the point at

which other people start to crowd into the market in an attempt to replicate

those money-making strategies.

But there are precious few art collectors (as opposed to art dealers) who have

made a lot of money in the art market. Perhaps David Geffen might be one, insofar

as he bought well and then took the opportunity to sell when he thought he might

need a lot of cash on hand to make a bid for the LA Times. But he’s no speculator,

and I don’t think many people are trying to follow his lead.

Posted in art | Comments Off

Subprime: Reasons to be Thankful

Posted on September 24, 2007 by Felix

Ten years ago, the GBP/USD exchange rate was 1.61. Today, it’s 2.02. Over that

timeframe, the

Economist tells us, UK housing prices have risen by 211%, compared to just

120% in the US. Which means that in dollar terms, UK house prices have actually

risen by 265% in the past ten years – more than double the rate of appreciation

in the US.

As the Economist explains, the prick which caused the US bubble to burst was

not overstretched valuations, but rather subprime mortgages:

What sets America apart is the time-bomb laid by subprime mortgage lending

in the late stages of the housing boom. The way many of these deals were structured—two

or three years of low “teaser” rates, which then switch to much

higher tariffs—gave homebuyers with tarnished credit records a free

option on house prices. If prices are expected to rise enough, borrowers may

be willing to pay higher interest charges in order to keep the equity gains.

If prices fall short of their hopes, borrowers have an incentive to default.

Or, to put it another way, if Alan Greenspan had wanted to burst the housing

bubble, he probably couldn’t have come up with a better way of doing it than

to encourage the widespread sale of subprime mortgages.

(This also, by the way, helps to explain why the New York housing bubble hasn’t

burst: there are basically zero subprime mortgages in Manhattan.)

So the US might be going through some nasty housing-related pain right now.

But if this pain has prevented the bubble getting much, much bigger, then maybe

it’s not such a bad thing. Because if and when the bubble bursts in places like

the UK and Ireland (+251% in 10 years, in local-currency terms), the aftermath

there could be much worse than it currently is on this side of the pond.

Posted in housing | Comments Off

Welcome Econospeak

Posted on September 24, 2007 by Felix

I’m late to this game, I know, but in the wake of links from Mark

Thoma, Tyler

Cowen, and Megan

McArdle, let me be the latest to welcome Econospeak

to the blogosphere. Anybody who will join me in defending

cap-and-trade against carbon taxes is a hero in my book!

Econospeak is a left-leaning group blog which serves, inter alia,

as the successor blog to MaxSpeak.

It’s a bit wonkier, a bit more wide-ranging, and a bit less politically partisan,

all of which are good things. It’s in my blogroll already.

Posted in climate change | Comments Off

In Defense of Credit Derivatives

Posted on September 24, 2007 by Felix

You can always tell when the newsflow slows down in the financial world, because

invariably some columnist will trot out another brave

reëvaluation of credit derivatives. Here’s Scott Patterson:

The power of these derivatives — most of which were launched just in the

past few years — is scrambling the way some investors think about financial

markets. Brian Reynolds of M.S. Howells & Co. says he would be more bullish

about stocks, except for pesky credit derivatives.

They "add a whole level of complexity" to the market, he says, due

to the ability of bearish investors to make bets that credit markets will

deteriorate. If they start to turn lower again, that could reignite fears

of a credit crunch, hitting stocks.

Credit markets also are dancing to the tune of these derivatives, experts

say. Earlier this year, several Dow Jones indexes based on derivatives of

high-yield bonds started selling off before an index tracking the cash market

for high-yield bonds dropped. In other words, moves in the derivatives foreshadowed

the turmoil that gripped global markets…

Investors such as Mr. Reynolds worry that since credit markets are sensitive

to swings by these often volatile derivatives, the broader market may become

more vulnerable to panic attacks like this summer’s.

Let’s take these one at a time. Firstly, credit derivatives aren’t "launched".

Indexes based on credit derivatives are launched, but those indices,

even if they’re tradeable, reflect underlying trades in the CDS market, which

spring up of their own accord as demand for such instruments rises.

Next, blaming "bearish investors" for markets falling is a bit like

that old saw about how it’s always short-sellers’ fault when a stock drops in

price. Markets go up and down, and bulls make money in up markets, and bears

make money in down markets. Just because it’s easier to make a bearish bet does

not increase the chances that a market will fall.

And there’s a very good reason why credit indices started falling before bond

indices: the CDS market is more liquid than the bond market. Many bonds barely

trade, which is why it can take a while for bearish sentiment to show up in

bond indices. But because the CDS market is more liquid, credit indices can

spot that bearishness earlier. This does not mean that bonds are "dancing

to the tune" of the CDS market: it just means that you can’t trust bond

indices during times of market volatility, because the pricing data underlying

those indices might be days old.

Finally, what is meant by "these often volatile derivatives"? We’ve

had one period of extreme volatility in the CDS market, which happened

to coincide with extreme volatility in a lot of other markets, too. In fact,

the CDS market, as it became increasingly important and liquid over the past

few years, surprised everybody with a decided lack of volatility.

Markets do sometimes panic. When they panic, liquidity dries up, and it becomes

impossible to buy or sell certain assets. At times like that, asset classes

which retain some modicum of liquidity are more important than ever. So I’d

be inclined to say that the CDS market, far from making the broader market more

vulnerable to panic attacks, in fact has served as a sort of escape valve: a

market where panicked traders can let off steam, and important pricing information

can be obtained.

To be sure, the CDS market is not perfect. For one thing, credit default swaps

aren’t securities, and they aren’t traded on any exchange, so there’s a decided

lack of transparency in the market. And yes, at the margin, increased liquidity

in the CDS market means decreased liquidity in the bond market, which is not

a good thing. But when people start blaming the CDS market for something like

a plunge in stock-market prices, treat their claims with a lot of skepticism.

Posted in derivatives | Comments Off

Headline of the Day

Posted on September 24, 2007 by Felix

The

Publisher of Forbes Magazine, a Regular on Fox, Blames the Mortgage Meltdown

on Sex Ed

Yes, really.

(Via Dealbreaker)

Posted in housing | Comments Off

USA 2008 as Russia 1998

Posted on September 24, 2007 by Felix

Now here’s an interesting recipe for growth: how does utter financial

collapse and skyrocketing inflation sound? Writes

the Grouse today:

When the Russian debt markets blew up, there was a massive devaluation of

the ruble, which made it hard for Russians to keep snapping up all the imports

they had been favoring. This meant that the final years of Yeltsin’s administration

bolstered Russia’s declining industrial base and laid the groundwork for a

redevelopment of payrolls and confidence under Putin. Could a similar fate

await Detroit and the rest of the industrial heartland as the dollar continues

its slide? Will Bentonville look to Biloxi rather than Beijing for extruded

goods?

I’m pretty sure he’s not serious. But just for the record: the ruble went from

6.29 to 21 to the dollar in the space of just

over a month. An equivalent move would take the euro/dollar exchange rate

from 1.40 to 4.67. Inflation in Russia hit 84% in 1998, after the devaluation.

And the "bolstering of Russia’s declining industrial base"? Are you

driving a Russian car right now, or looking covetously at Russian washing machines?

Er, no. Russia has no industrial base to speak of: its newfound wealth is entirely

commodities-based, and is the consequence not of devaluation but rather of the

fact that prices for everything from oil and gas to nickel and gold have been

soaring over the past decade.

Oh, and did I mention that just about every Russian credit defaulted on its

debts in 1998?

On the other hand, I’ve long been of the opinion that Vladimir Putin and Rudy

Giuliani were somehow separated at birth. If Rudy can build a respectable political

campaign on the strength of his response to a single terrorist attack, just

imagine how attractive he would be in the wake of utter financial and economic

collapse!

Posted in economics | Comments Off

The Oil Price Denomination Fallacy

Posted on September 24, 2007 by Felix

Repeat after me: The fact that oil prices are denominated in dollars means…

absolutely nothing. Dean Baker has been banging

this drum for a few days now, most recently attacking

the Washington Post for saying that "since crude oil is priced in dollars,

a weak dollar makes oil cheaper abroad and high prices in dollars more sustainable."

Dean likes to show how ridiculous this kind of commentary is by saying that

it wouldn’t matter if oil were denominated in gallons of peanut butter. But

obviously that isn’t working, so let me try another tack.

There are two things making headlines for hitting all-time highs right now:

oil, and the euro. Both of them are denominated (measured) in dollars. So let’s

see what the Washington Post’s sentence would look like if we substituted "the

euro" for "crude oil":

Since the euro is priced in dollars, a weak dollar makes the euro cheaper

abroad and a high exchange rate more sustainable.

A weak dollar makes the euro cheaper abroad, in places like Japan

or Brazil? I don’t think so. And of course the sustainability of the exchange

rate has nothing to do with the level of the exchange rate.

(By the way, it’s not just the Washington Post and NPR who are making this

mistake: Ben

Stein does it too. Which should in itself persuade journalists across the

nation that they should stop talking such nonsense forthwith.)

Posted in foreign exchange | Comments Off

Four Reasons Why Time Warner Might Not Spin Off Time Inc

Posted on September 24, 2007 by Felix

Sean

Elder kicks off his guest-blogging stint over at Mixed Media in fine style

this morning, with the story that Time Warner is thinking about an IPO of its

magazine-publishing arm, Time Inc. I’m not convinced this will happen, for a

number of reasons.

Sean sources his story to "people in the banking business", rather
than anybody at Time Warner. Which means that this could be an attempt by

bankers to get Time Warner brass to take the idea seriously. Such attempts

do actually work, some of the time. But they can also backfire, as well.
It’s not clear how much money Time Warner might be able to raise by selling
Time Inc, but it’s unlikely to be enormous in the context of a company with

an enterprise value of over $100 billion. The magazine-publishing arm has

some very profitable franchises, but it’s also – and possibly more importantly

– a source of prestige. Without Time Inc, Time Warner becomes a failing

internet company (AOL) with a cable company (Warner Communications) attached.

The only vaguely glamorous bit of the company would be Warner Brothers.
Even if the proceeds of an IPO wouldn’t be enormous, the profits from Time
Inc are very useful to Time Warner right now. Last

quarter, Time Inc accounted for 11% of Time Warner’s sales, but 24% of

Time Warner’s net income.
Finally, an IPO just doesn’t make a lot of sense as a way of selling Time
Inc: stand-alone magazine publishing companies don’t tend to stand alone for

long. If Time Warner were really serious about selling Time Inc, it could

probably get more from a strategic buyer than it could from an IPO –

assuming, of course, that the buyer could line up the financing right now.

If it couldn’t, then maybe it would make sense for Time Warner to hold off

on the divestiture until credit markets become a bit more liquid.

Posted in Media | Comments Off

Airline Economics Datapoint of the Day

Misleading Chart of the Day

GE, the Old-Fashioned Lender

Alan Greenspan, Comedy Mastermind

When a Property Bubble Isn’t Speculative

Who Won in the GM Strike

Why the Ratings Agencies Should Fear Congress

Zhang’s High

How Giving to Charity Will Help You Get Rich Quick

Subprime: It’s Not About Creditworthiness

Angus Maddison’s New Book

The Price of Luxury

Bonds Without Price Quotes

Intellectual Property Among Magicians

Labor Market Datapoint of the Day

Why the GM Strike Makes Sense

Mortgage Prepayment: Economically Suboptimal

Speculation in Art

Subprime: Reasons to be Thankful

Welcome Econospeak

In Defense of Credit Derivatives

Headline of the Day

USA 2008 as Russia 1998

The Oil Price Denomination Fallacy

Four Reasons Why Time Warner Might Not Spin Off Time Inc

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