Thursday, January 31, 2008

Consumption vs. Investment: A Real Difference?

Here’s a topic that has bothered me ever since it has been introduced in macroeconomics—consumption and investment. See macro slides these things in there without really ever explaining them and then doing fancy math to bust your balls. So you think, “geez, this guy is smart, he must be right.”

A version of the argument usually goes like this. Consumption just spends money on things without concern for the future. Consumption is wasteful by nature. Investment on the other hand builds future wealth through innovation. Investment employs a lot of really smart people that invent the next great thing. And finally, this results in more future growth. Consumption today sacrifices growth tomorrow. Macroeconomists love this kind of talk because it gives them a job in policy making. “People will naturally be irrational and spend too much, therefore, we need to rationalize them and create more incentives to invest.” And these top-down government economists eat this shit up. (Not to mention Wall Street firms love these sentiments).

But I have to say I have never found much sense in defining consumption and investment differently. Let’s think about it from the micro view for a second. Consumption decisions are personal optimization decisions just as investment decisions are. The individual says, “well, hell, I want to enjoy my time on earth right now so I’m going to spend some of my income right now.”And there is no more important time than the present due to future uncertainty.

Then he also saves money. He saves money because he is making tradeoffs between the present and the future. He needs an investment portfolio than saves and grows value in order to protect against future uncertainty (fluctuation in income streams, fluctuations in costs). Basically, the individual has decided that his present profitable spending opportunities have diminished relative to profitable investment opportunities (which are future profitable spending opportunities). [Profitable used in the sense of utility]

Although, it’s not important why he spends or saves. The decision is based on a hypothetically infinite number of preference issues. The bottom line is some spend more than save, some save more than spend (corporations included). Those that have high levels of consumption can be thought of to have less profitable opportunities to invest. They prefer more present spending to future spending. The money doesn’t vanish but eventually finds its way to someone who has different opportunities and preferences. This person has a comparative advantage in investments over consumption. Therefore, the consumption and investing decisions on the individual level lead to an outcome once again where those with the greatest comparative advantage find the money to use it most productively.

And where is this digression leading? To capital gains taxes of course. To preface, I think that lower taxes are always better than higher taxes. But that being said I am also worried about tax distortions. Different levels of taxes for different things incentivize people to engage in behavior not solely based on personal choice metrics. The deciding factor of a consumption vs. investment decision could very plausibly be a tax difference. The result would have been different if tax levels were equal. The government has distorted choice.

It hurts me to ever propose a tax hike (on capital gains here specifically), so I’ll just argue for the other tax levels (without getting into the difference between income tax and other taxes) to be lowered to the capital gains rate 15%. Hah, in a perfect world, right?

This will be a common theme for me. Taxing reduces incentives to work in all the traditional ways. But differential levels also have distortionary effects. Future examples: health care, debt, and others.

Friday, January 25, 2008

The Credit Crisis Explained (or at least a weak attempt); Part I: What happened?

**Disclaimer** The following is an analysis of the recent credit crisis throughout the last approx six months. It is really inappropriate to pick an arbitrary point and just start explaining. Everything at one point would need to be understood from the previous events, ad infinitum. Also, this story is overwhelmingly complex and I will inevitably leave out many relevant factors. I seek to create a framework for understanding the problems; past, current, and future. And finally, I realize that understanding the past holds no predictive power for future timing of investments. It is important to understand general themes, however, that show up time and time again. We can get a framework for how individuals will respond to certain incentives, and, indeed, predict these responses based on estimated future incentives.

So everybody wants to know what the hell is going on with a supposed credit crisis. What happened? What’s happening now? And, of course, what’s going to happen? Well the world will finally be able to rest easy because the answers are upon us. I present the first part in my three part series: What happened?

First off, let’s get the perspective of the homeowner throughout the past few years. As we all know home prices have been rising dramatically (and rising since about 1996, but I don’t know if this is in real or nominal terms as of yet). Low interest rates set by the Greenspan Fed put some fuel on the home price fire. This heroic rise in prices led to pretty easy borrowing terms for homeowners. No down payments, low rates, and the like.

These easy terms were partly responsible for the high prices. To illustrate, if borrowing costs are lower, individuals have greater purchasing power. Let’s say a home cost $100,000. But lower relative borrowing costs yield the individual an additional $5,000 of wealth. Well, someone who is able to purchase a $95,000 home (considering all relevant costs) can now afford this $100,000 home. The home will get bid up to the extra relative amount of purchasing power since everyone shares these lower borrowing cost conditions. The value of the home really doesn’t change, but easier money makes for greater purchasing power. At the margin, this effect may pull renters into the homeowners market, further increasing demand (which would presumably throw some of the new homeowners back into the renters’ market, and we’re faced with a circularity problem, but let’s not get bogged down in the details. We know in the real economy a million factors are changing at once. I don’t think anyone can say that equilibrium is reached at any given moment.)

Ok, let’s talk about one more issue with the homeowner before we continue. No down payments. Not requiring a borrower to make a down payment is a dangerous thing. It essentially assumes there is no downside risk on home prices (“home prices have been rising for a while and will do so forever”). What this does create is a loan for the full price of the home. If the home declines in price, the homeowner owes more on the loan than the house is worth. He has negative equity in the home. This creates a substantial incentive to walk away from the home (and would be the rational choice expect for it affects your credit record). With no down payment, even the slightest depreciation of home price in the short term will lead to this result.

Next, let’s move onto the banks. Banking has two general areas commercial and investment banking. Both these operations may occur within one organization (per the repeal of the Glass-Steagall Act in 1999). In house or out of house, both areas definitely feed upon each other in a myriad of ways.

Commercial lending may be deemed to be the root of all this recklessness. Once again we’ll look back to home prices. With ever rising home prices, banks provided ever easing credit terms. Why do home prices correlate to lending terms? Well, the loans are mortgages, which means they have a lien on some asset. In the housing world this is the house. A mortgage is an asset-backed loan—collateralized. If the price of the house keeps rising, then the collateral is safe. Even if the borrower defaults, the bank can reposes the home and probably get its money back (maybe make some money, I’m not sure of the particulars, I think the homeowner keeps any equity in the home). So if prices are always going to rise, what the hell? Who needs a down payment? As this is what often happened.
But the funny part of it is that these no-down-payment mortgages were not made to borrowers of strong credit records, but rather to the least credit worthy—the subprime. Reason being is that the subprime became the competitive battle ground. Banks were flooded with capital and had no interest in building up reserves (and arcane notion in banking due to Federal Deposit Insurance). They had money and needed a place to use it profitably. It looked like these subprime borrowers were sure things because even if they defaulted, the collateral would be rock solid. Banks were competing for prime borrowers as well. Prime terms eased accordingly. But, it is in your interest to put up a down payment, despite the cash flow pain. A down payment lets you whether a storm (recession) and deceases your debt obligations. The reason many subprime borrowers provided no down payment is because they couldn’t afford one. A whole new market segment was opened up! But then again maybe you really can’t afford to buy a house if you can’t afford a down payment (which many of these borrowers found out through the foreclosure process). To top it off bankers provided adjustable rate mortgages and teasers (which have the similar effects—especially when the Fed is raising interest rates. A teaser is a common practice that has been over-publicized.), which gave less margin for downside risk of a homeowner’s income stream.

Ok, then lets package these babies up and splice them out into tranches and sell them to investors—creating CDO’s (collateralized debt obligations). The tranches all have different risk levels for different investors. Let’s go one set further and create complex securities using options on these things (SIV’s) that are so complex to value only the bank can do it. The credit agencies certainly don’t have a prayer. Furthermore, options are off balance sheet assets—therefore, under less scrutiny. This is the investment banking world. Really, these are great ideas, but when they are applied to heavily risky commercial loaning practices they too become very risky. The SIV’s even more so because of the valuation difficulties. They these become popular for a variety of reasons, but mainly because investors wanted to partake in this great housing bull market. So money flowed in and spreads shrank. Spreads between the Fed Funds rate and 30-year mortgages were reduced dramatically. This type of spread, generally speaking, is the key to profitability of a commercial bank. Banks borrow short and lend long to make a profit on the difference. The Fed Funds rate is the most short term rate there is (overnight holding rate for banks), whereas the 30-year mortgage is about the longest that a loan will go for. So as the Fed raises rates steadily, the commercial lending business is becoming less and less profitable.

Furthermore, for a period between the end of 2006 and the beginning of 2007, there was almost no spread between AAA rated corporate debt and the Fed Funds Rates. But the competition between banks surged on. This may be the root of the exuberance problem in commercial banking leading to credit cycles.

Let’s talk about investors for a second. China is a heavy investor. They have a huge trade surplus to the US, but also an equally huge capital deficit--which means they are investing big time in the US. This acts to pull interest rates down, allowing investment that once might not have been profitable to become profitable. Also, it’s a bull market in the US so people are looking to grab some of this return. Investors see the profit being made in subprime and want in. Naturally, risk premiums get bid down (probably below the actual level or risk, which always spells trouble). It is the bidding down of the risk premium that will fuel another industry—private equity. That the AAA corporate debt almost had no premium to the fed funds for a time is particularly telling of this story.
Onto private equity. These are presumably a bunch of smart MBA’s that look for undervalued or mismanaged companies and clean them up. They like leverage; maybe because they are real confident in their abilities (this is like the hot chick that knows she’s hot, smart people that know they’re smart). The bidding down of risk premiums opens up a lot of new doors for them. They will have a larger set of potentially profitable takeover opportunities. This story is fundamentally the same as the housing market. Easier borrowing terms led to company’s valuations being bid up. Acquisitions were all over the place. A heavy season of acquisitions is shown no place more dramatically than stock price indices. The indices steadily climbed upward. But maybe it got to a point where private equity overdid itself and took on opportunities that will be profitable only if market conditions experience no downside (much like mortgage lending). We’ll see how smart they are, or were.

Now we’ve done it—connected the debt story to equity. This is just a glimpse of the story of the bull market. Now for the interesting part—what can we learn from this situation? And where did it go wrong?

First of all, this is a credit cycle like any other. Credit cycles have been happening since time has been recorded and certainly since the US was founded. Lots of regulation or a little, they still happened. I would argue that more regulation usually leads to more distortion and larger swings. At the end of a long period of success, people seem to push the boundaries of profitability and, inevitably, fall off the edge. A realization must be made that individuals act according to incentives and constrains. Therefore, we need to structure a system which creates as accurate of feedback mechanisms as possible.

The basic problem was that lenders lent money that couldn’t be paid back. Investors then threw their money after these loans too. (Hindsight helps us judge these decisions.) Let’s take the mortgage industry for example. Somewhere in the bull market borrowing conditions eased to a point of unprofitability. Lenders seemed to stop asking questions like: What are the drivers of wealth and price appreciation for this geographical area? What are the risks in this borrower’s future income stream? What unexpected events might occur? What kind of leeway should we leave to deal with unexpected events? How much down payment should we require? How extensively should we check the borrower’s credit history? There is a time lag between this decision and the consequences of that poor decision, which enables poor decisions to persist. Pressure to make these decisions come from competition. Market share is a big driver of profitability in commercial lending since the banks products are very similar. The irony of these short term competitive pressure is that long term competitive pressures favor an opposite approach. If a bank would hold off for a period of time when things got excessively bullish they would lose profits/market share to their competitors in the short term. But they would pull dramatically ahead when the crash comes. Compensation bonus incentives on a one year timeline may partially explain this problem, since credit cycles certainly have a longer timeline than one year. But also it’s really hard to know exactly at what time things start to get hairy and then just pull out—especially with loan officers working for commissions. In a sense they are being rewarded for quantity not quality—but of course only in the short term. Many of the mortgage brokers probably lost their jobs.

My final thought will be a suggestion to remove the Federal Deposit Insurance. This insurance (or more properly insulation) has a large effect to increase bank lending. Therefore, leading bankers into every more risky areas. First of all, when your deposits are insured by the Federal government you don’t need nearly the reserves that you would otherwise carry without this distortion. The Federal Reserve is then charged with putting regulation on top of regulation (trying to fix their own problem) by requiring a certain amount of reserves. Who knows if this level is accurate or not. One thing that is for certain is that bankers will never worry about a bank run (this raises a myriad of incentive distortions). Therefore, they will use the least amount of reserves possible because there will be competition from other banks to do so. Banks use capital that otherwise wouldn’t have been lent and find the next best opportunity, which is certainly riskier than the previous best opportunity. Federal Deposit Insurance makes banks riskier institutions (but it’s “all right because taxpayers will just bail them out”).
Also, tax deductibility of interest makes no real sense. I will come back to this in further posts, but it distorts business into issuing more debt than they would otherwise issue.

Next issues:

Part II: “What’s going on now?” Uncertainty in the market

Part III: “What’s the future?” How does this lead to a recession? Do bad loans jeopardize good loans?

Tuesday, January 22, 2008

Goldman wins this time...the next?

Here is an interesting Michael Lewis article from Bloomberg:

You could expect firms to have variable exposure to sub-prime mortgages (and their eventual collapse). Goldman, however, (as far as we can tell right now) seems to be a bit of an outlier. Some banks did better than others but I don't know of any that actually made a pile out of this whole thing. Lewis presents evidence that two individuals were given large power to offset the rest of the firm's positions (basically as Lewis says, calling everyone else in the firm an idiot). It turns out this time they were right. The position must have been massive, and probably massively risky if they were able to overwhelm losses in other parts of the bank and produce substantial profits. This reminds me a bit of Long Term Capital. Really smart, maybe arrogant guys, given a ton of freedom to take on hugely risky positions. Will Goldman have an even bigger blowup in the future?

Who knows, maybe its a stupid question since its based on speculative evidence and they surely will have a big loss sometime in the future given their business of relatively high risk (lots of proprietary investments), but the loss may not be caused by risk management structure.

One final thought. I don't think arguing that this could be interpreted as a hedging strategy works, unless they wildly miscalculated the hedge. You could argue that from a risk management standpoint, it might be a good idea to go market neutral when an area looks especially uncertain or irrational. But this position seems to have made a bunch of money. Not a hedge at all but an outright call. (Although it was probably a sophisticated set of trades in order to isolate the specific risk they were looking for.)

Monday, January 21, 2008

Good Guys vs. Bad Guys

Tonight I watched a bit of a democratic debate featuring Clinton, O'bama, and Edwards. Needless to say I was disgusted very quickly. The fundamental problem I have with their answers (to a question about stimulus in the economy) is their perspective that given the right people in office, he or she will be able to guide the nation to prosperity (certain angels exists which don't respond to incentives). Thats not a realistic expectation in my view. What we must aim for is to set up the most appropriate incentive structure between individuals. This is summed up in a quote from a book I am currently reading "Knowledge and Decisions" by Thomas Sowell.

"Much discussion of the pros and cons of various 'issues' overlooks the crucial fact that the most basic decision is who makes the decision, under what constraints, and subject to what feedback mechanisms. This is fundamentally different from the approach which seeks better decisions by replacing 'the bad guys' with 'the good guys'--that is, by relying on differential rectitude and differential ingenuity rather than on a structure of incentives geared to the normal range of human propensities."

Friday, January 18, 2008

Favorite Albums Exemplying the Quality of "Albumness"

A new feature has been added to the blog: “Favorite Albums Exemplifiing the Quality of Albumness.” Listening to music through albums presents differences from an alternative of lets say a mix of your favorite songs. I believe music should be listened to in albums rather than randomly. Its purely an opinion, but I think a perspective that can lead to a greater understand and appreciation of the artist or the work. One view of an album is that it should have something different to say from the rest of the work. Each artist’s album should come at you from a different angle whether it be musically, lyrically, or some different message. And within this album there should be some unifying themes that tie it all together (once again either musically or lyrically). A great album should be as The Who say an “amazing journey”—an experience from front to end which creates greater musical experience somehow from just listening to songs in isolation. It also shows great thought and intention behind the work—a sort of orchestration or mastermind behind the work. A sign of a great album is that if you took a song by the same artist from a different album B and put it in album A it wouldn’t make sense—and indeed might ruin the album. In other words the album stands out from the rest of the artist’s work. Well in homage to the idea of “the album” I have arranged a list of albums which I considered to epitomize “albumness.”

(*As a disclaimer some of my favorite artists won’t make the album list even though some of their albums are my personal favorites, yet they don’t necessarily display “albumness”)

This list is subject to change of course. There will certainly be additions. One album in particular that stands out to me is “Quadrophenia” by The Who. The Who tried in both “Tommy” and “Quadrophenia” to create a sort of “rock opera.” These albums are narrations two adolescents, Tommy and Jimmy. “Quadrophenia” may be considered superior through its complexity of themes (four themes interwoven throughout the album representing the four bands members as well personality traits in Jimmy) as well as musical complexity. It tells the story of a movement in England in the 60s between Mods and Rockers. Whether or not the story interests you or not, its uses artistic expression to tell something real, which I highly value. “Quadrophenia” has a bit of a niche following and if you’re interested you will find much information about its story throughout Wikipedia and its links. But anyways, enjoy the list of albums and, hopefully, have some musical experiences a cut above the norm.

Fiscal Policy Implies Monetary Policy

Today the president announced an initiative to launch a stimulus package for which I condemned yesterday. The good news is it’s a tax cut plan rather than a spending plan. Needless to say though we can be assured that no equal reduction in government spending with accompany these cuts. The question was never raised to either the president or Hank Paulson (I guess it’s unheard of). So how are these cuts going to be financed? Well, by selling government bonds of course. If this were the end of the story, the government would have supplied individuals with more income (money) while at the same time removing money from the system through the sale of its bonds. Net effect is more of a reallocation then some “injection” of money to the system. But maybe this is not the end of the story.

The sale of these bonds will result in the previously stated contraction of money supply relative to the target level that the Fed had previously set. Well assuming that this action doesn’t change the Fed’s target money supply or interest rate target, they will engage to counter this contraction. Their exact methods may be through different instruments than the same specific government bonds sold to finance the tax cuts, but the effect is the same (as I understand it the Fed primarily works with about 22 banks, or primary dealers, to distort overnight rates of bank “repo” agreements). The Fed has thus engaged in an inflationary measure which has devalued all outstanding money prior to their actions by the exact amount of the tax cut. In conclusion, there is a lot of hoopla about nothing. Unless there is an equal cut in spending this fiscal stimulus isn’t going to do shit.

Thursday, January 17, 2008

Stimulus Package

The idea of stimulus in recessionary times inevitably ties into the popular manta of the consumer found in popular economic reporting (and in fact used by successful investing and asset management firms). Usually it goes something like this “Will the US consumer ever stop?” or “US consumers are 2/3 of the economy” or “We will whether the storm because of the resilient US consumer” or “Economic predictions are subject to variability due to the possibility consumers will significantly change their spending habits.” We have all heard it, but what really annoys me is the assumption that consumers spend exogenously (in a vacuum) or that if consumers decided to spend less this would be irrational.

What follows from this belief is policy makers decide that since these consumers are so irrational about their spending preferences let’s take away some of their income through increased taxation and spend it for them on areas throughout the economy. These areas are in my view random but “experts” have determined them to be areas of optimal growth for the economy as a whole. Sweeping assumptions like this have many weak points but I will elaborate on one. Economic phenomena like efficiency, innovation, low prices, and increased standard of living are all attributable not to experts with a top down view over the economy, but to individuals making self-interested decision about their everyday lives. It is truly nobler economic work displayed by the poor single mother of two than the government bureaucrat invoking massive governmental funds to employ stimulus to the most relevant sectors based on the latest research.

But back to the consumer. There is no reason to think that consumers’ preferences in the broad economy have recently gone from rational to irrational due to expectations of recessionary times. Certainly consumers can display irrational behaviors and crowd mentalities, which may account for natural business cycles. It seems the only cure for such irrational exuberance or gloom is to let these irrationalities bear their consequences, which all irrationalities will, given time. But the greater point here is who knows if consumers are being irrational? Maybe circumstances in their daily lives are signaling to them that a change of behavior is in order for which only their avoidance would be irrational. Taking this prospective a stimulus package of spending declares “the consumers must be irrational,” therefore, let’s correct them. When in actuality the government has then forced an irrational policy that will certainly have equal, and more likely, greater negative effects then the reduced spending would have in the first place. For where daily livelihood is concerned, especially among the poor, people can be expected to behave much more rationally than say the investing community. Why? You might ask. For “the investing community if filled with some of the best and brightest with outstanding educations.” Yes, indeed but they have a greater leeway to be wrong. They can shoot for risky actions that may turn out to be irrational in hindsight and still have an insurance policy to fall back on (their education for one, ever if they are reaped of their money). However, the poor person is forced to become rational and less risky. The poor and middle class have real decisions to make. The poor quite frankly might not be around if they display repeated actions of irrationality. Their likely destination will be jail, death, or homelessness. The middle class have important consequences too all though maybe not so grave, “Will I be able to send my kids to college?”, “Will I have money for retirement?”, and many other issues that may lead the consumer to say: “maybe I will need to save now in order to be able to ensure goals in the future.” In conclusion, I find it hard to believe that there is great evidence to suppose that consumers are heavily irrational in times of recession. Why take money from the ground level where consequences are concrete and measureable in order to reallocate it into the sky where it will drop down to more specific beneficiaries with consequences vague enough to establish an industry of academics trying to discern the benefits. Aren’t concrete and measureable consumer choices the key to our efficiency, flexibility, innovation, and wealth creation?

Granted this is one kind of fiscal stimulus option—the other being cutting taxes. Cutting taxes would have a rather opposite allocative effect. More consumer choice with concrete and measurable consequences would ensue. However, in the interim this is a fool’s goal since this effect will only produce this result with an equal CUT in spending—which seems increasingly difficult for our federal government to accomplish in general not to mention in a short enough time period to ease a recession. But who says this would ease the recession anyways? If given more of their own money the consumers may choose to save it all. Unlikely, but possible if imminent recessionary times are forecasted. Even if this measure didn’t ease the recession it would in fact be a more appropriate response since individuals would make a more accurate allocation of their income based on their subjective expectations of future economic prospects.