Businomics Blog

Business Opportunities: Avoid the Glamorous

I'm staying at an Inn that's part of a vineyard/winery/spa.  My room is luxurious, with a view you wouldn't believe.  The food in the restaurant is top notch, and the wine excellent.  I'm enjoying myself, except for a nagging concern:  this joint don't cash flow.

There is no way on God's green earth that this business is making money.  Not even with strong appreciation of the land over the next two decades will it earn a halfway decent return.  It may not break even.  After the owner, who made his money the hard way, dies and passes this asset on to someone else, I can foresee it being shut down.  The beautiful cabins, lodge, tasting room, all falling into disrepair.

I don't begrudge the owner the opportunity to use his own wealth to be a vintner, inn-keeper and restarurteur.  But I do have some advice for the rest of you:  stay away from glamor industries.

The wine business in particular has attracted thousands of corporate refugees, loaded with stock-option wealth, who think it would be great to run a little winery.  If YOU get into this business, you'll be competing with people who are not making economic decisions, but rather lifestyle decisions.  One of the worst things that can happen to a business is to have stupid competitors.  Okay, maybe they are not stupid, but they certainly are not trying to maximize profits.

My advice to the young people looking for a career: how about wastewater treatment, portable toilet rental, drain un-plugging?  Think about something that nobody would go into except for profit motive.  Such industries have no excess capacity due to lifestyle choices.  It's just business.  Avoid the glamorous.

Why Did the Mortgage Crisis Happen, Part 5

In Part 1, I asked why the mortgage mess happened, and why did it happen when it did.

Part 2 explains the role of the Great Moderation and the mild housing cycle in the 2001 recession.

Part 3 explains the role played by securitization of mortgages.

Part 4 explains how the 2001 recession set up the trigger for the current crisis.

In this final segment, I look at the future and provide some suggestions for policy.

 

I think that the Great Moderation will continue, for reasons explained in the Mark Thoma interview on the Businomics Audio Magazine. However, it was not the Great Moderation alone that caused a sense of invulnerability regarding housing; it was also the strength of housing in the 2001 recession. All players in real estate and mortgages have lost the notion that housing is always stable. We've been slapped across the face by reality. It will be quite a long time before anyone in this country thinks that housing is a no-risk proposition.

Securitization is here to stay. It makes a lot of sense, especially compared to using the Savings and Loan industry model for funding mortgages. But investors in the mortgage market have learned a bit. First, they've learned that housing prices don't always go up. Second, they've learned that the senior tranches can take losses. Third, they've learned that the ratings agencies aren't very good at evaluating risk of complex instruments. Fourth, they've learned that combining a bunch of CMOs into a CMO-squared does not remove systemic risk. It may help reduce the risk associated with investing in mortgages originated in one location, but it does not eliminate the risk that the entire country's real estate market goes south.

What about the trigger? That will happen again. At some point in the future, mortgage interest rates will fall at a time when home prices have been firm. However, we will not have a mortgage mess of this magnitude again until the lessons of this cycle have been forgotten. I peg that time period - by unscientific judgment - at about 20 years.

Here are some tips for policymakers:

1. This mess is not as much about subprime mortgages as the overall housing market.

2. Fraud was present, but was not the cause of the mess.

3. The people who made big mistakes have learned from their experience.

4. Some of the practices that enabled the crisis are actually good.

Let me expand on that last point. We have three ways to finance homes, unless someone comes up with something smarter:

I) short-term mortgages, like five years or less.

II) long-term mortgages financed by depository institutions, which engendered the Savings and Loan crisis

III) securitized mortgages

Don't be overzealous in attacking securitization unless you want to return make mortgages unaffordable to the middle class, or you want another S&L crisis.

Why Did the Mortgage Crisis Happen, Part 4

In Part 1, I asked why the mortgage mess happened, and why did it happen when it did.

Part 2 explains the role of the Great Moderation and the mild housing cycle in the 2001 recession.

Part 3 explains the role played by securitization of mortgages.

Now I explain how the last recession set in place the triggers for the present mortgage mess.

Let's remind ourselves of the strength of the housing market thanks to the Great Moderation and the mild housing cycle of 2001. If a mortgagee could not make payments, there was no problem for the mortgage-backed investor. Home appreciation meant that borrowers could simply sell at a profit if unable to make payments--or they might refinance and use the cash for another year's payments. Or in a worst case, the mortgage servicer foreclosed, but there was no loss because the house sold for more than the principal due on the loan.

These were to two main ingredients of the mortgage mess. Now let's talk about how they came together in the early 2000s.

The recession of 2001 brought interest rates down. The Federal Reserve began cutting short-term interest rates in early 2001, and mortgage rates also fell. Mortgages had been running in the sevens in 1999, then hit eight and a half percent in 2000. With the recession, though, demand for credit fell. That, combined with falling short-term interest rates, brought mortgage rates way down. By the end of 2002, 30-year fixed rate mortgages were available at six percent, an interest rate not seen since 1965.

Low mortgage rates brought first-time homebuyers into the market earlier than normal. There was also a great deal of shuffling around of existing home owners, as they moved from one home to another. Keep in mind that transactions of existing homeowners just push the peas around on the plate: when a family buys a new home, it is typically selling an old home, so net demand is zero. Not so with first-time homebuyers.

There's a normal life-cycle for first-time homebuyers. Young families get their finances in shape, show that they can handle debt, and accumulate a little bit of down payment. Then they buy. Well, starting in 2002, first-time homebuyers were able to buy ahead of schedule. Mortgage rates were so low that families who had expected to wait until 2004 were able to buy their first home in 2002. This trend accelerated when mortgage rates hit their low point, five and a quarter percent, in mid 2003. This interest rate was even lower than the lowest rates of the 1960s.

So housing demand was stimulated by low mortgage rates, pushing home prices up. Builders started to meet the increased demand, but it took them a while to gear up construction schedules. In the meantime, home prices accelerated. In the prior decade, the 1990s, home price appreciation had averaged a mere three percent per year. Three percent per year! But low mortgage rates changed all that. National average price measures showed six to eight percent gains in the early years of the new century. Those price gains brought out investors.

Stock prices had peaked in 2002 and fell through 2002. Even after stock prices began to rise, the levels of stock prices failed to match the earlier peaks, so stock investors were disappointed. They looked around and said, "Gee, houses sure do well. They never seem to go down, they just go up." The three percent gains of the 1990s seem puny by Wall Street standards, but stock investments are mostly unleveraged; at most, they have a 50 percent loan to value ratio. Houses can be leveraged, with 90 percent or even higher loan-to-value ratios. Here's a bit of arithmetic: if you pay 10 percent down on a house that appreciates by three percent, your equity grows by 30 percent!

Investors constituted net new demand, along with first-time homebuyers. In response to the strong demand, prices appreciated at an even faster rate. Homebuilders took this as a challenge, and housing starts rose from 1.5 million - a typical pace - to 2.3 million units, a fifty percent gain.

The growth of net new demand from first-time buyers and from investors was helped by carefree attitudes engendered by the Great Moderation, along with mortgage securitization. Mortgage investors tested the waters with lower down payments, less documentation of loans, borrowers with lower credit scores - and the tests looked good. A more conservative sort of person would have continued the tests through a real downturn, but that sort of person lost business to the mortgage investors who went full bore ahead.

Our economic history includes periods of low mortgage rates that did not lead to a disaster like we are experiencing today. No disaster occurred in those earlier eras because they pre-date the Great Moderation and mortgage securitization. The 1990s had the critical elements of the crisis, but not the trigger: low interest rates and a weak stock market.

Everything came together in the perfect storm that we now call the mortgage crisis.

Given what we've learned so far, what does the future hold for economic cycles, mortgages and the housing market? We'll address that in our final segment.

Why Did the Mortgage Crisis Happen, Part 3

Previously, I posed the question of why the crisis emerged when it did, then I explained the role of the Great Moderation.  Now I talk about how securitization formed a building block of the crisis.

The second factor enabling the mortgage mess was securitization. The first securitized mortgage transaction took place in February 1970, but primitive computers were not up to the many flavors of securitization that would eventually arrive. As the housing market boomed, securitization took off.

 

Securitization had some affects that helped form the mortgage mess. One was the growth of mortgage brokers. At first, the traditional lenders--savings and loans plus some banks--used securitization to help their balance sheets. It was a great move. No institution funded with deposits of five year maturity or less should hold 30-year loans.

Independent mortgage brokers, who could help consumers shop around for the best deals, came to dominate the industry. This business model came to dominate partly because consumers liked the idea of working with someone beholden to no one institution, and partly because the most successive (aggressive?) mortgage personnel gravitated to independent shops, where their compensation was totally on commission. The independent mortgage broker didn't much care what happened to the loan once the paperwork was finished and he got his fee. Furthermore, there was no mortgage-lender gossip ("Gee, we sure are originating a lot of crappy loans this days.") to rise to the executive suite. The independent mortgage brokers also enabled a more fraudulent environment, but fraud is not the dominant reason for the current mortgage mess--it's more a side dish than the main course of explanation.

Along with securitization came investors. The main funders of mortgages used to be lenders. Now they were investors. Investors think differently than lenders. Investors hold a security while it is doing well, selling when they sense that the prospects for that investment are weaker. They assume liquidity, because that's what they are used to. A lender, on the other hand, makes a loan and assumes he will hold it through thick or thin. The investor buys a mortgage-backed security thinking he can pawn it off on a "greater fool" if need be.

Now to top it off, mortgage securitization became very, very complex. Think first about a simple example of financial engineering: stripping Treasury bonds. Each bond has two coupons plus a maturity. A 30-year bond can be decomposed into 60 coupons plus the return of principal. A bundle of 30-year bonds can be combined into 60 different zero-coupon securities. No problem.

When the securities underlying the transaction are not issued by the United States Treasury, you want to think about credit risk. Some mortgages were guaranteed by Fannie Mae or Freddie Mac, so the mortgage risk was small. Or was it zero? Would Congress let these institutions fail if they guaranteed too many dodgy loans? Maybe yes, maybe no. An interesting issue. Other mortgage-backed securities had private guarantees. Nice--if the guarantor would survive a housing downturn. In a mortgage pool with multiple investors, who takes on the credit risk? It can be spread evenly among the owners, but that’s boring. More interesting is to create some low-risk segments, and some middling-risk segments, and some high-risk segments.

This is far from complicated enough, however. Let's add prepayments to the broth. When you buy a mortgage-backed security, is it backed by mortgages that may be refinanced in two years, or may stay on the books for the full 30 year term. That depends on interest rates, but not just on the level of interest rates. Refinancing is "path dependent," meaning that refinancing volume will be different at "seven percent down from nine" as opposed to "seven percent up from five." You really have to run a thousand possible interest rate paths in a Monte Carlo simulation to understand prepayments.

So far we're only thinking first mortgages. We could also securitize seconds. The value of a second mortgage depends on all the things we've discussed before, as well as on the characteristics of the first mortgage.

Now the securities get interesting. The basic mortgage-backed securities include different tranches. (One tranche might get the first 12 principal payments to come in, making it very safe. Another tranche might get some of the later payments, making it very risky.) Tranches from different mortgage pools can be combined into Collateralized Mortgage Obligations (CMOs). There are even CMOs comprised of CMOs, like a fund of funds.

All of this becomes very confusing and hard to analyze. The investors didn't really know what they were buying in many cases. They fell back (as we all do) on a few shorthand numbers, such as estimated duration (weighted-average maturity) and credit grade. The fact that both of these concepts were just wild guesses for complex CMOs was lost on the investors.

We have the Great Moderation and a very mild last housing cycle, coinciding with the development of securitization. Next we'll see how the last recession sowed the seeds for the current mortgage mess.

Why Did the Mortgage Crisis Happen, Part 2

Yesterday I posed the question of why the mortgage mess happened, and why at the time that it did.  There were two fundamental building blocks of the crisis: the Great Moderation and Securitization.  The aftermath of the 2001 recession provided the trigger for the mortgage mess.  In this post, I explain the role of The Great Moderation.

The Great Moderation is the new world of macroeconomic cycles that began in 1983. In the United States and around the world, recessions became milder and less frequent. (There's a great interview with Mark Thoma about this topic in the Businomics Audio Magazine.)  The chart of rolling 20-quarter standard deviation of real GDP changes illustrates the calming of the economy:

 

Back in 1983, a business executive with 25 years of experience would have experienced five full business cycles. Today, an executive with a quarter-century of experience has only gone through two full cycles. We are less experienced in dealing with recessions because of the Great Moderation.

The Great Moderation by itself lowered fears of recession, but the nature of the most recent recession (not counting the current cycle) also reduced concerns about a possible downturn in housing values. The 2001 recession was triggered by a decline in business capital spending, especially in high tech and communications. Housing suffered relatively little; it was the mildest housing cycle of the postwar recessions.

As a result of the Great Moderation and the strength of housing in the 2001 recession, the housing sector appeared to be recession-proof. This was a mistake, and those of us who like to examine long data series knew it, but financial types prefer to look at recent data. When I attended my first Credit Policy Committee meeting as a bank economist, back in 1988, the experienced lenders priced consumer loans based on a five-year average loss rate. I was thunderstruck! The five-year period did not go far enough back to include a recession. In fact, credit policy coming out of a severe recession tends to be tight, so we were probably looking at abnormally good credit history. This is the kind of stuff that financial people should do a better job at.

Next: the role of securitization in the mortgage mess.

Why Did the Mortgage Crisis Happen?

Why did the mortgage mess occur when it did? The topic is prompted by a Fortune Magazine article which proposes a very naive reason:

"As margins shrank in traditional businesses like underwriting and brokerage, Wall Street looked for new places to make money," says Louis Pizante, a former investment banker at Goldman Sachs and Nomura .... In the process the firms took imprudent risks to make big profits."

Look, Wall Street can make foolish mistakes even when its profits are roaring away. In fact, profits in one area are more likely to lead to the idea that they can do no wrong. And when things are bad, companies (including Wall Street firms) tend to draw in their horns across the board, taking as little risk as possible.

If it wasn't thin margins in other areas, what caused the mortgage mess?

In this five-part series, I explain how this mortgage mess came to be. The key elements are

• The Great Moderation and the benign housing cycle of the 2001 recession, which made real estate appear to be safe

• Securitization, which changed the funders from lenders to investors, while making the products too complex for most anyone to understand.

• With these two factors in place, the mortgage crisis evolved from the last recession.

• With this understood, we can see what to expect next time round.

Economic Forecast Brighter for 2008

My new forecast (dated May 5, 2008) looks a little brighter: no negative quarters for GDP.

My bottoms-up approach has recently been giving me more optimistic forecasts than I expect.  Recently, more optimistic than I had expected has worked out well.  I think the Fed is about done cutting interest rates, and long-term bond markets will figure this all out earlier.

Inflation won't diminish too much, not with the Fed putting the pedal to the metal.  Look for continuation of four percent inflation, which induces the Fed to push rates up later this year.

Risks to the Economic Forecast: The tightening of credit standards could yet push Main Street business down, but in the near term, the greater potential is that the economy takes off, pushed by the Fed's stimulus.  Looking longer into the future, at some point the Fed will hit the brakes.  Soft landing?  Don't count on it.  But that next cycle is probably two years away.

Economic News: Not So Bad

I'm back from vacation, surveying the news of the past week and a half.  (I had planned on blogging throughout the vacation, but instead ... just vacationed.)  Here's my take on the data:  not so bad.

Gross domestic product is our broadest measure of the economy, and it's growth rate was certainly anemic, but it was not negative, as I had expected.

Positive is certainly better than negative.  Some of the pessimists noted that final sales were down.  (That's GDP that actually got sold, excluding the buildup of inventories.)  And it's true that there was a small buildup of inventories that prevented GDP from declining.  But you can make the same point about every positive contribution to the economy: GDP would have turned down if not for exports, GDP would have turned down if not for consumer services, GDP would have turned down if not for everything that turned up.  The truth is that the economy is growing, but just barely.

Employment declined again, but not by too much.  (A drop in jobs is consistent with total production that's flat, thanks to improved productivity per person.)

The latest monthly decline in total employment was 20,000 jobs, on a base of 138 million.  In fact, such a small drop is far less than the reliability of the official employment statistics.  (The standard deviation for month-to-month changes in total employment is 65,000 jobs, so a 90% confidence interval for the latest report goes from minus 117,000 jobs to plus 97,000 jobs gained.)  My conclusion: bad, but not so bad as we feared.

We also got data on new home sales: down, at about the same rate of decline we've seen in recent months.  Non-residential construction resumed its expansion:

Strength was surprisingly widespread, with notable gains in hotel/motel, office, power production and manufacturing.  Yes, construction of manufacturing buildings expanded, despite the drop in manufacturing employment.  Somebody is optimistic out there.

Consumers continued to be gloomy, according to various polls.  I'm not too concerned about their attitudes, because once the fundamentals turn up, attitudes will follow.  Actual consumer spending was good in March.  Car sales don't follow that pattern, though:

The detail is interesting.  Over the past 12 months, total light vehicle sales (what the chart shows) dropped by 4.3 percent.  The worst component: domestic trucks, down 8.6 percent.  The best component: import cars, down only 0.4 percent.  What I think we're seeing is the abandonment of gas-guzzlers more than anything else.

The theme of these comments is that the news has not been as bad as I had feared.  I'll work up a new forecast after a sojourn to Starbucks.  (Why, of why, are the Europeans incapable of brewing a decent cup of coffee?  Why does Starbucks not have a single store in Amsterdam?)

The Stressful Effects of a Weak Economy: What's a Business Manager to Do?

The weak economy is causing stress for many workers. In the Businomics Audio Magazine, Dale Collie, a former Army ranger and corporate executive talks about how to deal with stress, including lessons from both his business experience and Vietnam service.

        Dale's website is Courage Builders.

Immigration and Assimilation

Our taxi driver from the Amsterdam airport longed  to return to Turkey.  He had lived in the Netherlands 36 years, since age 2, but would  go back to Turkey in two years, when his son graduated from high school. He had nothing good to say about Holland:  too expensive, to many kids hanging out in bars and coffee houses.

He had returned to Turkey to visit  family, but had not lived there since he was a toddler.  I couldn't help but think that he might be disappointed by Turkey.  Yes, it's cheaper to live there, but a prosperous northern European city has many amenities that he may miss in a poorer country.

I think he--and the Netherlands--are missing out in something because he has not assimilated.  He says he is a Turk.  If you ask my wife, who moved to America from Sweden as a young girl, she'll tell you she's an American.  Fully assimilated (except that on Thanksgiving she tells me that if we're  having turkey, I have to do  the cooking because "it's not a Skandinavian dish.")

If this is what it means to have foreign immigrants in your country, I would be skeptical about immigration.  However, our record has been much more positive:  most immigrants have come to think of themselves as Americans.

Is Your Leadership Team Recession-Ready?

That's the title of a short article from Tatum Group.  My first reaction to the title: it's a little late.

But the article may be very valuable because they point out that at this stage, the signs of distress may be very subtle.  If your financial statements don't look too bad, it may be time to look more carefully for the first signs of trouble.  Of course, it's quite possible that you really are not in bad shape.  But if there's ever a time to milk all possible insights from your financials, that time is now.  The article offers some warning signs:

• Declining gross margins and/or operating margins
• Inability to meet forecasts
• Increasing debt
• High turnover among employees and/or management
• Declining market share

Then the folks at Tatum offer some valuable insight: "Early corrective action denotes strong leadership."  I'll say!

Tatum has provided many companies with CFO services (and they do other stuff I have not bothered to delve into).  They have a strong basis for understanding financial management.  Heed their advice.

Inflation: Why Trucking Costs Are Not Pushing Prices Up

Here's a little puzzle for you: why are energy prices NOT bleeding over into core inflation?  Most goods on the shelf are delivered by truck, and fuel costs have skyrocketed.  Yet inflation outside of food and energy isn't so bad.  Yes, it's edging up, but still is below the inflation rates of 2006.

The answer is within the transportation industry.  Tonnage has generally been declining since late 2006, according to the American Trucking Association.  The chart shows a surprising bump up in the last two months; I'm still pondering that.

The Association of American Railroads reports a decline in rail tonnage.

Here's why inflation is not spreading due to fuel costs.  At the peak of the transportation boom, truckers and rail companies boosted prices in response to soaring demand.  One truck company president told me that his fuel surcharge was larger than his total fuel bill.  He did not say higher than his incremental fuel bill, he said higher than his total fuel bill.  So the "fuel surcharge" of two years ago was simply a way to raise prices.

Now costs are up for truckers and railroads, but freight volumes are down.  The transporters are not able to boost prices, because excess capacity in a competitive industry pushes prices down.  The companies are facing lower profit margins, so inflation is NOT bleeding over into the non-fuel sectors of the economy.

Business planning implications: if you ship goods, you'll be very vulnerable to a freight cost increase when the economy rebounds.  At that time, look for the double whammy: higher fuel costs and rising profit margins.  In the meantime, enjoy this temporary respite.

Are Financial Markets Really Calm?

I recently posted a comment to the effect that banking markets have calmed, as evidenced by the return to normal spreads between LIBOR and the Fed Funds rate.  Now the Wall Street Journal has a story (subscription required) suggesting that LIBOR may not be accurately reported these days, as banks decline to admit how high an interest rate they are paying in bank-to-bank transactions.  If this is the case, then there's more nervousness than I had thought.  We don't have the full story at this point (and maybe never will).

Latest Economic News Not That Bad

The newspapers are featuring dreadful stories about economic hardships.  Keep in mind when you read the news that at ANY time it's possible to find people in hardship.  To know whether you are seeing a trend of just an unfortunate anecdote, you have to look at the data.  Today's data is 1) bad but expected, 2) bad but not as bad as expected, and 3) so-so.  Let's start with bad but expected:

New housing construction continues to fade.  Bad news, but a necessary correction in a land with significant excess supply of housing (note: if you hit that link, the first chart's Y-axis is mislabeled).

Now for the not as bad as expected:

The inflation rate outside of food and energy is not as bad as I expected.  I'm very worried that we'll see inflation rising not just in food and energy, but generally across the economy.  This isn't happening right now.  (Reminder: we look at inflation excluding food and energy because those two categories have a lot of transitory changes.  I'm not saying they are unimportant.  Please don't rant on the subject.)

Finally, let's get to the so-so news:

Manufacturing production is basically unchanged in recent months.  That's not good, not bad, but consider this:  Any news that isn't bad these days, is good.

The economy is NOT collapsing, despite all the doom and gloom in the press.  The economy is certainly not booming, and some folks are in distress, but overall things are not so bad.  Yesterday about four million people in the United States went to McDonald's to eat.  That wasn't news, because most days there are about four million people going to McDonald's.  It's not an economic boom, but neither is it a bust.

Business planning implications:  don't hunker down too much.  In fact, it's time to do your economic contingency planning for an upturn in the economy.