Businomics Blog

Latest Federal Stimulus Program Will NOT Help Housing Market

The government's latest plan (as of today, November 26, 2008) has the Fed buying mortgage-backed securities from Fannie, Freddie and the gang.  I'm OK with the program in general, but here's a bit of hubris I cannot tolerate: the claim that it will help the housing market.

Housing consists of owner-occupied (or increasingly owner-unoccupied) plus rental housing.  The proportions are roughly two-thirds owned, one-third rented.  Bringing down mortgage interest rates will help one sector of the market, but only at the expense of the other.  As I showed with charts in this post from a couple of weeks ago, we have an excess supply of both types of housing.  There is no solution to the excess supply of housing other than to have a good-sized fire, or grow our population.  The latter solution works, and works well, but at a slow pace.  We grow our population by about one percent per year, so we'll eventually grow to fit our housing stock.

Here's what I like about the plan:  it silences critics of the Fed who say that they don't have much room to ease monetary policy.  Sure, the Fed Funds rate is less than one percent, so the usual interest rate that the Fed influences cannot be moved much further.  But the Fed can conduct monetary policy in any number of instruments, including mortgages.  (Many years ago, the Swiss wanted to conduct open market operations but there were no Swiss treasury bonds outstanding, because the country had been running a balanced budget.  So their central bank conducted monetary policy buying and selling mortgages rather than treasuries.  No problem.)

Malcolm Gladwell's Outliers

Maybe the book will be disappointing, but this extract, published in the Guardian, is fascinating.  It explains a lot of success.  I like to think that it explains why I'm a pretty good economist and why I'm not a very good Laser sailor. 

 

(I say the book may be disappointing because many books are good articles expanded into a book, becoming tedious.  This is done, I suspect, because there's a lot more fame and prestige associated with a book than an article, even if the article has 99% of the substance and can be read quickly.  Why don't we reward people who write short books? )

Some comments for after you read the article:

1) People like Bill Gates may be the product of their time, but don't forget that there will millions of people who were in his age group who chose not to spend thousands of hours programming.  Some were smart enough that they could have been him, but they chose to drink beer, have a social life, and have hobbies other than programming.  So Gates deserves some respect for his effort.

2) The people who tried to be Bill Gates but were not in exactly the right circumstances: I bet they have been terrifically successful, even if not in Gates's league.  Ending up with millions of dollars may seem to pale in comparison to Gates's billions, but it's not shabbby.

Economic Outlook: Interview of November 2008

I was interviewed recently by Lacy Turner for several local CBS affiliates (KUFO, KVMX, KUPL, KLTH, KCMD).  It's mostly about the national economic recession and financial crisis, with some discussion of the local economy at the end. You can listen here.

Did We Economists Miss the Housing Problem?

A reporter called yesterday for a retrospective on my forecast of a year ago.  I groaned, thinking the headline would be "Gotcha!"  Be the actual quotes he had weren't so bad.  Apparently I said that we had overbuilt housing and that it would take a couple of years at least to work off the excess supply.  Boy, that sounds right.

Confirming that is an interesting article from the Wall Street Journal's Real Time Economics which says in 2005 there was a burst of stories about a housing bubble.  Here's their chart, based on 50 major daily newspapers and how often stories refer to a housing or real estate bubble. (Hat tip to Arnold Kling at EconLog.)

By the way, the peak month for housing starts was January 2006, so the bubble stories in the press really gave you some lead time.  In the fall of 2005 I was titling my economic outlook speeches, "Bubble Trouble?"

The other quote the reporter cited was my statement that there was one chance in four of a recession in the coming year.  OK, I wished I had said there would definitely be a recession, but here's what I added to that one chance in four remark:

"If you heard that there was one chance in four of your building catching fire, you'd work out evacuation plans and you'd buy insurance.  Well, one chance in four of a recession means you should develop a contingency plan for an economic downturn."

I feel good about having said that.  So here's the takeaway for business leaders:  It's hard for us to get all the details right, but when we economists say there's a bubble, get worried.  When we tell you it's time for some contingency planning, get to it.

Global Meltdown: Implications for Oregon

I'll make a public presentation on this topic to the World Affairs Council of Oregon in Portland on Thursday, November 20.  Information and registration here.

Consensus Economic Forecast Takes a Dive

The Federal Reserve Bank of Philadelphia has just released its latest Survey of Professional Forecasters.  No real surprise; the prior survey was taken just before the financial crisis hit hard.  The new consensus forecast is pretty close to my forecast:

I always take a the revision direction as a separate piece of economic data.  So in addition to knowing that the consensus is gloomy, the fact that it was revised down from last quarter is another piece of bad news.

However, the mood of the country seems to be that the world is coming to an end.  It's not.  The consensus anticipates a spring recovery, as do I.  We can argue a bit about the timing, and a bit about the magnitude of the decline, but there really is no disputing that the economy will recover from this recession.

TARP: Banks Give Congres the Right to ^*&*^! Them

TARP is, of course, the Treasury plan to provide capital to banks.  There are terms of the deal described in the press and in official documents from the Treasury.  However, the deal is subject to any modification that Congress wants to make.  Section 5.3 says that Treasury may unilaterally change the terms of the deal to conform with laws passed by Congress.  This is a huge danger.

Back in the savings and loan crisis, Congress changed the terms of deals made between the government and banks.  The Supreme Court said that whenever Congress does that, the government may owe damages to the banks for violating the contracts.  (I was an expert witness in two of the damages lawsuits.)  This time round, it won't be a violation of contract for the terms to be changed, because the contract says the terms are whatever Congress wants them to be.

The biggest fear is that the many people in Congress who want to do good deeds with someone else's money will legislate that banks in TARP must make lots of loans to people who are not credit-worthy (again), that banks have to forgive bad mortgages, or that they not adjust adjustable rate mortgages, etc.  Banks that have not yet decided whether to participate in TARP should be very wary.  Other  citizens should be concerned about this kind of behavior.

General Motors Job Loss: Don't Believe It

If General Motors is allowed to fail, won’t we lose three million jobs? That multi-million job loss comes from both GM’s own employees, plus the suppliers and dealers.  However, the economics behind that idea is pretty bogus.

 

The number of auto jobs we have is tied to the volume of cars we produce and sell in the

United States

.  If GM fails and then the economy recovers, the jobs will recover.  They may not be GM jobs.  They may well be Honda or

Toyota

jobs, but still located here in the

United States

.

 

Or consider the alternative: that after GM fails, car demand never recovers.  In that case, subsidies to GM continue forever.  The

U.S.

taxpayers continue to do what GM has done for so long: pay auto “workers” to not work.

 

It is possible to produce high quality cars fairly inexpensively, and in

America

.  The Japanese companies do it.  GM cannot.  If GM fails, someone else will take up the slack.

How to Solve the Housing Problem: Latest Mortgage Proposals

Allan Meltzer is the latest to develop "a plan to rebuild the housing market."  Although I have tremendous respect for Professor Meltzer, he don't think his plan addresses the real problem.  He writes, "The main problem in Britain and the US is an excess supply of unsold houses."  More accurately, the main problem is an excess supply of housing units of all types.

Here's a chart of the unsold homes Meltzer is worrying about:

But there's another excess supply:  rental units:

(data for both charts come from the Census Bureau.)

A mortgage-focused plan to help people buy homes can reduce the first vacancy rate, but only by worsening the second.  Those people who might buy a house are currently living somewhere.  If we move them out of rental housing into owned housing, we aggravate the high rental vacancy rate.

Owned housing constitutes about two-thirds of the housing stock, with rentals one-third.  So to reduce that owned vacancy rate down to a more reasonable level, changing the vacancy rate by one percentage point, we would add about two percentage points to the rental vacancy rate.  Rental vacancy is already pretty high, and another two percentage points would clobber it.

So what's the solution to the excess supply of housing?  Fire would be one solution, but we don't use that too much outside of Detroit.  The other solution: a larger population.  We add about one percentage point to our population every year, so we'll eventually grow our way out of this problem.  But there are no fast solutions.

Credit Default Swaps: What Went Wrong with CDS

Yesterday I explained the basics of a credit default swap.  Now let's explain how they sunk AIG.

The obvious risk of the CDS is that the original bond issuer (Barb in the simple explanation) cannot repay her debt.  In AIG's case, they did extensive computer modeling of this risk.  They felt pretty good about the risk.

However, there were two additional risks not considered in the computer models.  First, the CDS contract had provisions that could require the guarantor (like Sid in yesterday's example, or like AIG in real life) to put up collateral.  That collateral would ensure that the guarantee would be solid.  AIG received several calls for collateral from its counter-parties.  That placed a significant burden on its balance sheet.

The second risk was marking the contract to market prices.  For the guarantor, the CDS is a liability on the balance sheet.  When other folks are trading credit default swaps, they establish a market price for this liability.  AIG was forced to recognize larger liabilities on its CDS portfolio, even before it had sustained an actual loss.

Imagine this scenario:  you've done a great job assessing risk, but the rest of the market is nervous.  They start pricing CDS's as if they are very risky.  You are right, they are wrong.  What happens?  We would like to live in a world in which the folks who are right profit, and the folks who are wrong lose money.  But in this scenario, the guarantor gets in trouble even if its right about the credit risk, simply because it has to recognize losses on the market value of its portfolio, even though it has not had to actually pay off on any claims.

If the guarantor has a lot of staying power, it simply accepts a hit to its balance sheet while waiting to be proved right.  As the CDS's expire over time, it can recover the reserves it booked when it marked the liabilities to market, showing huge profits.  That is, if it has staying power.

However, it that guarantor is highly leveraged, the financial losses it has to report (before it has any genuine losses) cause its own credit rating to suffer.  It has to post more collateral with its counter-parties.  Its borrowing costs go up.  Nobody wants to do business with it anymore, because its finances are shaky.  Eventually, the company goes bust.  Or gets bought by the U.S. Treasury, which may be even worse.  And all of this bad stuff can happen even if the guarantor is ultimately right about the risks of the borrowers it was guaranteeing.

Listen to any of the radio personal finance shows, such as Clark Howard or Dave Ramsey.  They'll tell you not to co-sign credit card applications or car loans or mortgages, not even for your own family members.  If you're a corporation with a very strong balance sheet, you can co-sign a few notes and make a little easy money.  But if you start doing this on a large scale, a large enough scale that it really helps your company, then you are piling up risk that ultimately could sink your company.

There's an old saw in investments:  The market can stay irrational longer than you can stay liquid.  Be careful.