Paul Krugman wins the Econ Nobel

October 18, 2008 at 10:24 am | Posted in economics | Leave a comment

I gues this is a couple of days late – I’m still backpacking in Northeast India – but I must say I am really pleased Paul Krugman won the “Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel”.

Krugman is one of my favorite columnists at the NY Times, and I regularly read his blog. In particular, I think he has been spot on in terms of identifying the drivers of the current financial crisis. I also think he is absolutely right in claiming that the next president will have to boost  government spending significantly.

I think that the choice is either a deep and lengthy recession – even, perhaps, a Second Depression – or a new New Deal – which may not work either.

Expect consumer retrenchment to worsen

October 18, 2008 at 10:14 am | Posted in credit, economics, Uncategorized | Leave a comment
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With Wall Street volatility increasing day by day, and -at the very least – delays to the bailout plan, I believe the consumer retrenchment we have seen so far this year will only deepen. Consumer spending has been under pressure from a variety of factors, from high gas prices to increasing food inflation to weakening job prospects.

Since about September 2007, I’ve been expecting consumer sentiment and spending to both weaken significantly. While the latest data points are weak, I still believe the bottom is still some way away – At the very least 2Q 2009 – with a very slow recovery after that, but I am increasingly inclined to believe that the bottom may be in 2010.

What should we rescue? And what can we rescue?

October 5, 2008 at 5:06 am | Posted in economics, Housing, regulations, Uncategorized | Leave a comment
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The housing and related market has several layers to it. There are a whole lot of individual mortgages. Many of these are sensible mortgages on affordable terms made to people who have been reasonably prudent. Some of them were risky, for a variety of reasons, including individuals who got greedy for more house than they could afford, or lenders / brokers who put buyers into unaffordably large mortgages or with onerous terms. Some of the risky mortgages have defaulted or are otherwise in trouble, and things will continue to worsen for some time.

Tightening credit norms are making it difficult for buyers to buy homes now, even as prices are slipping and inventory is rising, further causing prices to spiral downward.

Most of these individual mortgages were put together into pools of mortgages, and investors bought securities created out of these pools. The idea is that each mortgage-backed bond represents tiny fractions of thousands of mortgages, and so should be safe even if a few of those mortgages go bad. These securities are then broken up into tranches, with the worst tranches the first to absorb any losses from defaults, and the best tranches only taking a loss if the lower-ranked tranches were wiped out.

So far, so good. The value of these mortgage backed securities is similar to the value of the mortgages underlying these securities. But then, we add derivatives on these MBS’s. There is no real limit to the number or value or complexity of derivatives. We can bet that one security will be worth more than another, or that the defaults in one security will exceed (or be below) a certain level, or a host of other such bets. And we can then create securities that pay off based on the outcome of other bets. The size of the derivatives market has been estimated at nearly $700 trillion – A thousand times the size of the proposed bailout, and ten times the size of the global economy.

I guess thats a bit like horse racing – The amount of money that changes hands based on the outcome of a single race is many times the amount of money spent by the breeders, or the prize money they may win.

I think that if the bailout money was used to buy mortgages, the price support is more likely to buoy the prices of the derivatives, than if the attempt was to either support the derivatives directly, or to rescue the bank after the derivatives caused big losses. After all, with the money, one could buy up over 5% of mortgages, and thus support the value of derivatives that depend on the value of the underlying mortgage for their own value, or make the tiniest dent in the derivatives market. If the derivatives got support from underlying values, there wouldn’t need to be as much of a writedown.

Obviously, every trade has a counterparty. For everyone who bought a derivative, someone sold it. If the value of the derivative tanks, someone loses big, and someone makes a killing. Supporting the derivatives market via underlying mortgage action will reduce the change in the derivative value. People won’t lose as much, or make as much.

Clearly, this is distortionary – If the investors believed the government would rescue the derivatives, they would not have made the same trades. But I think that the only area where a rescue could work is at the underlying mortgage level – and if derivative investors see bets they called correctly going against them because of the rescue, I feel for them, but still think the economy is better off than if the bailout money was used to rescue the financial sector from the results of mortgage defaults.

My proposal for the rescue

October 3, 2008 at 2:23 am | Posted in credit, economics, Housing, regulations | Leave a comment
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I’ve said all this before, but I’m collecting all my thoughts in one place with the following article.

The housing crisis has caused a series of writedowns, leaving the financial sector seriously undercapitalized and averse to further lending – even if their balance sheets permitted much lending. The resulting unwillingness or inability to lend money is threatening the entire economic system, as otherwise sound businesses find themselves unable to raise or refinance debt.

While a number of ad hoc actions have already been taken, with a major bailout plan proposed, they have tended to focus on supporting financial institutions while not tackling the real housing problem or the value of the actual mortgages underlying the mortgage backed securities and various related derivatives. However, as mortgage defaults increase, the value of these securities falls, often precipitously for some MBS tranches and for some derivatives.

I would like to propose an alternative workout that could simultaneously support the institutions while also providing some relief to Main Street.

I propose creating an agency empowered to buy near-foreclosure mortgages from the banks / debt holders, at a modest 3-5% discount to the outstanding principal balance, provided the homeowner agrees to a) transfer over the title of the property to the agency without a foreclosure and, b) continues to reside in the property as a tenant for at least a two year period at a reduced rental rate.

This would serve two purposes – First, by taking distressed mortgages off banks’ balance sheets at or near par value, this recapitalizes the banks and restores equity – basically by overpaying for the mortgages at taxpayer expense. You could prop up the prices of all mortgages, and thus restore the health of all balance sheets, as opposed to current policy of letting the value of mortgages slide, and then rescuing banks piecemeal, as they fail, without supporting underlying mortgage prices. Second, by keeping the erstwhile homeowner in the property, it reduces the supply of vacant homes -and the attendant security / vandalism problems for the neighborhood and unsold / auctioned / bank-owned home inventory, which eases the downward pressure on home prices, hopefully keeping more people in their homes.

How would this be structured, and how much would it cost? Here’s a back of the envelope calculation with some simplifications: Let’s say home ownership declines from near two-thirds of all households down to a 64% historical average level, which would translate into 3 million fewer home owners, with an average of $300,000 in outstanding debt (above the $203,100 median home price, to be conservative, as defaults are more likely in urban and suburban areas). At about a 5% discount, these mortgages could be purchased for $850 billion in capital ($900 billion face value). This money could support home prices and help keep other homeowners in their homes.

The homeowner must commit to a two-year rental on the property to be eligible for this scheme, with the rent set at a level that can recover the cost of capital for the agency. I assume a 4% cost of capital, the average tenant with a $300,000 loan would pay $12,000 a year towards capital cost. Assuming a $4000 annual property tax, the monthly rent could be set at just over $1300 for this average property – almost certainly more affordable than their current payment. If the tenant can make payments for two years, they avoid a foreclosure on their credit record. This brings the agency $36 billion in annual cash inflow, after paying $12 billion in property taxes (thus bolstering the local communities as well).

Some tenants will still be unable to make these rent payments on time, and will fall behind – Let us assume 20% of them fall behind, on average halfway through the two-year rental period. This would create a $10 billion shortfall in rental cash inflows over the two years. While these places can be rented to another tenant, let us assume they are sold at 25% below the debt value. Since the properties were bought at a 5% discount, the actual loss to the agency would average $60,000 per home, or $36 billion in capital.

Finally, if the remaining properties were sold after twoyears at a 15% loss to the debt value (10% loss to purchase price), the agency would lose a further $72 billion. In addition, the agency would incur various legal, administrative and property management expenses. Let us assume the annual cost to manage the entire process is 15% of the annual rent, above conventional propoerty management fees, considering the complicated transactions and higher default risk. This totals to about $10 billion. The total cost comes to $128 billion, or ~$56,000 per acquired house. Private sectors investors could be attracted to this scheme either in place of a federal agency, or in competition with it, by offering a $43,000 (14%) taxpayer-paid subsidy per average house, and acquiring it a 5% discount to outstanding principal. In fact, the government could auction the subsidy, granting the contracts to bidders who require the lowest percentage subsidy.

The government would need to create the legal framework, structure and guidelines to ease acquiring mortgages as well as to create a new “tenancy” alternative to foreclosure.

With a capital outlay of $850 billion, and a conservatively estimated cost of $128 billion to the taxpayer, this scheme can help homeowners in trouble, support housing prices and ease excess inventory, and support the mortgage backed securities’ and derivatives’ prices, restoring bank balance sheets. Hopefully, this could restore liquidity and some return to normalcy for the credit markets and the broader economy as well.

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