H.G. Wells’ Things To Come (Movie), 1936.

• In the 21st century asset securitization undergoes a change of phase. It broadens out and unifies. It ceases to be a tangle and becomes plainly one story. There is a complete confluence of corporate destinies. A vision of previously unsuspected possibilities brings an immense readjustment of ideas.

After H.G. Wells, The Shape of Things To Come, 1933.

Below are my future and imperfect predictions.

1. Fannie and Freddie will be merged and their retained portfolio will be sold.

The combined “Frannie” will administer a nationwide conforming balance that will apply to non-urban areas. There will be a separate conforming balance for congested MSA’s, as well as the non-contiguous states.

The deductibility of mortgage interest will be limited to conforming loans with geographically varying maximums, and will also be subject to income-based “means-testing.”

When home prices decline, the conforming limit will be reduced – it will not be held at the prior years’ level. Existing mortgage holders’ interest deductions will be grandfathered and honored.

No interest will be deductible by borrowers who did not demonstrate and document their ability to pay – based on either assets or income.

Frannie’s $1.6 trillion retained portfolio [pdfs: Fannie: $770B; Freddie: $830B] will be offered to Eastern (either Mid or Far) sovereign wealth funds. The Treasury will provide these most-favored aggregations with a guarantee backed by the full faith and credit of the US government. State pension and nationalized automaker retirement funds will have the opportunity to receive equivalent terms.

In appreciation for the Eastern investors’ acquisition of the Frannie assets, their subsequent investments in US Treasuries will be enhanced:

• Eastern investors will be able to put back, at par at any time, a portion of their holdings of US Treasuries.
• The notional amount of their put option will depend upon their Frannie holdings.

Frannie will operate simply as a government-backed insurance company – guaranteeing timely payments of mortgages in exchange for a recurring guarantee fee that reflects the risks of the guaranteed loans.

2. Structured CMO’s will be securitizations of agency securities (Ginnie or Frannie), rather than whole loans.

While senior/sub or over-collateralized securitizations will not be disallowed, issuers will be required to retain the subordinated classes, and treat the entire transaction as a borrowing, rather than an untrue sale. Credit manipulation will be, as Al Gore once described his recreational drug use – “rare and infrequent.”

Financial engineering of residential mortgage assets will be limited to allocating the receipt – over time – of government guaranteed payments from mortgage obligations that conform to a mandated standard, with respect to underwriting and payment features.

Depositories will issue all securities. Regulators will raise “deposit” insurance premiums – based on assets, rather than deposits – of any insured institution that creates securities that do NOT conform to government standards.

3. Rating agencies (e.g., Fitch, Moody’s, and S&P) will have virtually no role in the private credit structuring of residential mortgage securities. But they will still serve a key function, as described below.

Due to the virtual elimination of private residential mortgage credit enhancement, rating agencies’ “credit rating” role (such as it was) will not be missed.

Regulation of bankers’ salaries will continue, even after the repayment of all TARP funding and the retirement of all FDIC-guaranteed bank debt.

Bankers’ salaries will be subject to limits reflecting the salaries received by similar rating agency employees, with regional cost-of-living adjustments.

Equalization of compensation, between the rating agencies, as gatekeepers, and bankers, as gatekeepees, will ensure that rating agencies no longer find themselves as out-classed as the thug who brings a knife to a gunfight.

Finally, the credit rating agencies will be absorbed into the US government and become part of the US Treasury. This transaction will NOT be pre-announced by the US Treasury, and will be a surprise to all.

The salaries of the unexpectedly federalized rating agency employees will be administered by the Civil Service System.

I used to work with numbers for a living. I will try to not be too tense as I consider the simpler imperfect future, and search for a new job, or at least my next idea. Till next time.

Both capitalism and Florida real estate (see my Spring Thawts) are out of favor. It’s time for a … fond tribute to both.

Before Anita Bryant cooed for all to “Come to the Florida Sunshine Tree,” before Walt Disney World gleamed in Mickey’s eyes, there was Henry Morrison Flagler.

He arrived in Florida from Cleveland, in 1876, tubercular wife in tow. Up north, Flagler had dabbled in the lubricant business. There’s not much to say about that Ohio firm, other than what was said by his Standard Oil partner. According to John D. Rockefeller, Flagler was the “brains” of the business.

When the Flaglers arrived, Florida was the poorest state in the country, “a swampy wasteland of alligators, mangroves and mosquitoes.” Just getting to Jacksonville from New York City took 4 days by rail – non-standard railroad tracks required frequent transfers. Hotel consultant Stanley Turkel relates an 1870 account of the journey’s final leg:

• There are two ways of getting to Jacksonville (from Savannah, Georgia) and whichever you choose you will be sorry to have not taken the other. There is the night train by railroad, which brings you to Jacksonville in about 16 hours; and there is the steamboat line, which goes inland nearly all the way, and which may land you in a day, or you may run aground and remain on board for a week.

Stanley Turkel, Henry Morrison Flagler in Great Hoteliers: Pioneers of the Hotel Industry, 2006.

Before Flagler began to develop Florida, less than 270,00 people lived in the state. Two decades later, the population had almost tripled to 750,000.

Flagler is the one man largely responsible for this growth. He would spot a promising location – St. Augustine, Daytona, West Palm Beach, Fort Lauderdale, the “muddy hamlet” of Fort Dallas (called “Miami” by the Seminoles, Flagler would not let the town change its name to “Flagler”) – and the transformation would begin. Flagler would:

1. Acquire land in a promising location;
2. Build a huge, exquisite hotel;
3. Extend his East Coast Railway southward to serve the hotel; and
4. Receive 8000 acres of land from the state government for each mile of railway track.

Cities would grow up around each hotel and resort.

By the time Flagler was done, he had:

• Pushed his railroad line all the way to Key West across more than 150 miles of open ocean;
• Acquired more than 2 million acres of land; and
• Dominated the east coast of Florida.

Flagler’s resort hotels demonstrated, according to travel writer Colette Bancroft, a genius for business along with a close attention to the tiniest detail.

He engaged the country’s leading architects (e.g. McKim, Mead, and White) as he invented the concept of a destination resort featuring dependable and consistent elegance. His resorts featured familiar hotel designs (“huge landlocked versions of today’s fantasy cruise ships”) that he color-coordinated with his railroad, with “interchangeable linens and dishes.” Flagler created a network:

• Offering guests the luxury and fantasy of the resort along with the sense of security of knowing what to expect from a Flagler hotel.

Colette Bancroft, St. Petersburg Times, The Founders of Florida Fantasy, 8 Dec 2002.

Flagler died at the age of 82 in 1913, one year after completing the Key West rail link.

While some of his hotels still function as resorts, others have been converted to county offices, a college, a museum, and a retirement home. His Key West railroad, destroyed by a depression-era hurricane, was eventually re-engineered into the Key West Highway.

At last count, the population of Florida was more than 18 million.

Like the best businessmen of his age – or the political and social architects of our own era – Flagler despised competition, viewing it as wasteful.

Flagler preferred “monopoly” enterprises. He used the term “cooperation” -  not unlike the planners meeting along Pennsylvania Avenue today, some 1200 miles north of Key West.

Throughout his business career, Henry Morrison Flagler’s desk featured a quotation from a 19^th century bestseller that remains  in vogue:

• Do unto others before they do it to you.

I used to work with numbers for a living. OK – no more penguin jokes – as I search for a new job, or at least my next idea. Till next time.

The California and Florida housing markets are as different as black and white.

That’s the view of real estate consultant John Burns, who notes that California housing markets have “less than 10 months supply” of homes for sale, while Florida is “still hugely oversupplied, with most markets currently maintaining more than 16 months of supply.”

Despite the improvement in the California market, Burns believes that it is too soon to call “the bottom” for California housing, due to the state’s fiscal problems, prospects for higher unemployment and taxes, and future impact of foreclosures on home prices.

As I’ve noted before (see Greed, Fear, and Loathing or Foreclosure Zombies) the foreclosure moratoria (that expired in March 2009) produced a false sense of well being. The moratoria temporarily halted foreclosure sales – which normally produce foreclosure discounts of roughly 30%.

This temporary halt can be most easily seen by comparing a) the 90-day delinquency trends with b) the pace of foreclosures in:

• California – The most populous state, with roughly 12% of the population and 30% of US housing market value; and
• Florida – The 4^th most populous state, with roughly 6% of population and 7% of US housing market value.

Figure 1: California 90-Day Delinquencies and Foreclosures (MBA)

Figure 2: Florida 90-Day Delinquencies and Foreclosures (MBA)

The dislocation between delinquency and foreclosure began in 2008 and continued until 2009Q1, and can be clearly seen in the above two charts. As the foreclosure production lines begin to roll, the pace of foreclosures will more than double … or triple.

The home price model developed in Greed, Fear, and Loathing provides another way to visualize the continued decline in home prices as foreclosures resume.

Regional versions of these models relate home prices to unemployment and foreclosures. Below are two charts – for CA and FL – depicting what could easily be rosy scenarios for unemployment and foreclosures in each state.

Figure 3: California Unemployment and Foreclosures

Figure 4: Florida Unemployment and Foreclosures

I’ve taken a wild guess at predicting unemployment and foreclosures in each state for the rest of 2009. I’m guessing that unemployment continues to worsen, and that foreclosures begin their relentless post-moratoria upward march.

Note: Last week’s spike in mortgage rates – if not reversed – will make things even tougher for the housing market (see Figure 5, below).

Figure 5: Fannie 30 Year Current Coupon, 2009

Let’s see what this might mean for home prices for the rest of 2009.

I’ll begin by aggregating the Radarlogic/RPX home price series for the MSA’s in CA and FL (using the market value MSA’s weights used in the RPX Composite) to produce indices for each state that reflect prices of homes financed by both conforming and nonconforming mortgages.

Then, I’ll relate home prices to factors similar to those described in Greed, Fear, and Loathing, using the CA and FL forecasts discussed above.

What do you get?

As indicated by the graphs below, perhaps you get something that’s not completely inconsistent with the views of more widely followed real estate consultants.

Figure 6: California Home Prices, Actual and Forecast

Figure 7: Florida Home Prices, Actual and Forecast

1. Continued declines in CA and FL home prices for the rest of 2009;
2. Moderation in home price declines – home prices continue to fall in each state, but at a pace that eventually moderates; and
3. The California housing market is more robust (i.e., it declines at a slower pace) than the Florida housing market.

I doubt that the above will be right. But if it is, I’ll be sure to dress up in my best formal wear to celebrate the New Year in which a real housing recovery might begin – Happy 2010.

I used to work with numbers for a living. I’m trying to keep cool as I search for a new job, or at least my next idea. Till next time.

 
  

After Roy Lichtenstein, TIME June 21, 1968.

I wish I could take full credit for my heist of Lichtenstein’s TIME ™ cover – but I can’t.

Credit belongs to Geetesh Bhardwaj and Rajdeep Sengupta, co-authors of two disturbing St. Louis Fed working papers:

• Where’s the Smoking Gun? A Study of Underwriting Standards for US Subprime Mortgages (WP 2008-36, Apr 2009); and

• Did Prepayments Sustain the Subprime Market? (WP 2008-39, May 2009).

Credit also has its place in a well-underwritten mortgage loan. But – as their recently revised works suggest – subprime loans replaced creditworthiness with transactions, riddling holes in the US economy.

I’ve previously observed (No News Is … No News) that there is a tight relation between home price appreciation and transactions – IF you measure the former by price change in excess of financing cost, or carry; and the latter by the percentage of existing homes sold, or turnover.

The following chart from that article depicts this relationship:

 
Figure 1: Scatterplot of Carry and Turnover, 1978 – 2008.

The two Fed working papers suggest how subprime lenders, borrowers, and regulators exploited this link between transactions and home price appreciation to create the appearance of a viable mortgage product, as long as home prices were increasing.

SUBPRIME UNDERWRITING STANDARDS

The first paper – Where’s The Smoking Gun? – tackles the shibboleth that:

• A dramatic weakening of subprime underwriting standards – beginning in late 2004, and extending into early 2007 – triggered the turmoil in financial markets.

Bhardwaj and Sengupta look at data from more than 9 million mortgages originated between 1998 and 2007, and ask two questions:

1. Was there a dramatic weakening of underwriting standards within the subprime mortgage market?; and
2. Did this weakening begin around late 2004?

Their detailed loan-by-loan analysis does NOT reveal any deterioration in underwriting standards for subprime originations, if “underwriting” is defined to include a variety of characteristics, such as LTV, FICO scores, and documentation.

Over the period, relaxed standards in one factor (such as documentation) were offset by tighter standards for other factors (such as LTV or FICO).

They conclude that if loans underwritten in 2005, 2006 or 2007 were originated in 2001 or 2002, then they would have performed significantly better on average than loans that were actually originated in 2001 or 2002.

So, if there was NO smoking gun, what hijacked the subprime market and caused it’s downfall?

SUBPRIME PREPAYMENTS

In the second paper – Did Prepayments Sustain the Subprime Market? – Bhardwaj and Sengupta reexamine their 9 million-loan dataset. They first observe that subprime loan features prevented borrowers from refinancing into a different mortgage for at least two years.

1. Over seventy percent of subprime originations for each origination year were refinances;
2. A significant majority of these originations were hybrid-ARMs designed to reset into a fully indexed rate after two or three years;
3. Contrary to conventional wisdom, teaser rates on hybrid ARMs were not low and not significantly different from those of fixed rate subprime loans; and
4. Most subprime originations included prepayment penalties with the prepayment term expiring on or after the ARMs’ reset date.

The economists conclude that that the viability of subprime loans depended upon continued home price appreciation:

1. The subprime mortgage design sought to benefit from short-term home price appreciation;
2. When home prices rise, borrowers can build up equity in their homes and become “less risky” on subsequent mortgages;
3. This allows borrowers to refinance at a lower interest rate (on their subsequent loan), reducing their likelihood of default;
4. Subprime loans functioned, to some extent, like a bridge loan, providing temporarily credit-impaired borrowers with access to short-term financing; and
5. The majority of all subprime loans were only viable as long as home prices continued to appreciate – once home prices slowed or declined, the borrowers no longer had a viable “exit option”, that they could trigger either by refinancing their mortgage or selling their home.

Once home prices failed to increase in 2006, subprime borrowers could not economically cover their debts by rolling over their old subprime loans.

It was the lack of a profitable “exit option,” rather than any late-stage underwriting failure, that shot a hole through the heart of the subprime mortgage market.

I used to work with numbers for a living. I’m giving it my best shot as I search for a new job, or at least my next idea. Till next time.

I have a modest proposal. I believe it will rein in the banks, and compel them to behave properly. Here it is.

• If any bank fails to comply in the future with federal capital or lending guidelines, then the US Treasury receives an option to acquire warrants in the common stock of that bank or its parent company.

• This option will be granted to the US Treasury for each reporting period (either year or quarter, to be determined) that the bank is NOT in compliance.

• The tenor, or term, of the warrants will be ten years. The warrants’ strike price will be the average stock price for any 20 consecutive trading days selected by the Treasury.

• The twenty-day period must fall within a two-year window that begins one year before the Treasury announces that the bank is not in compliance; and ends one year after the Treasury’s non-compliance announcement.

• The number of warrants will be set as a percentage of the average number of outstanding common shares of the non-compliant bank or parent company, for the 20 consecutive trading days used to establish the “strike.”

• The actual percentage will be a small but not insignificant positive percentage that is fixed for all companies, by statute. The specific percentage will be determined by a bill originating in the US House.

• The Treasury will have the ability to hold the warrants until their expiration. It does not have to exercise the warrants that it holds on behalf of US taxpayers.

• The Treasury may also elect to sell the warrants that it holds – in whole or in part, at any time – to private parties in a public competitive auction.

• The Federal Reserve and a private company will jointly administer the auction. The private company would presumably be BlackRock, unless BlackRock warrants are being offered, in which case Goldman Sachs would be the private auction co-administrator.

• The Secretary of the Treasury will report to the US House and Senate, twice a year, on the status of its warrant holdings. This report will include a full accounting of the warrants held, acquired, auctioned, or lapsed. The Secretary will report on the gains – or profit – if any, that the Treasury earns on the warrants.

If portions of the above sound familiar, that would be because the terms resemble those of warrants granted to the US Treasury under the 2008 TARP Capital Purchase Program [“CPP”], as I described in The Real Options Monster.

Since I penned that Monster piece, events have moved swiftly.

Even the US Congress realizes that they would have left a lot of money on the table – more than $4 billion – if they had botched the disposition of taxpayer CPP warrants for more than 300 banks. As reported by Bloomberg on 20 May 2009:

• [Treasury Secretary Timothy] Geithner … reiterated that the government can sell the [TARP CPP] warrants back to the bank or to a third party.

• New legislation, passed by Congress late yesterday, removes previously imposed deadlines for extinguishing the warrants once a bank repays the government’s main equity stake, allowing the government more flexibility.

• The Treasury says banks can choose whether to negotiate over the warrants or not. If the bank refuses or can’t agree on a price, then the government will sell the warrants to a third party, as outlined in the original contracts [emphasis added].

Source: R. Christie, Bloomberg, Geithner Says Treasury May Move ‘Quickly’ to Sell TARP Warrants, 20 May 2009.

If Congress enacts the Bank Annual Optional Warrant Acquisition Operation (BAOWAO, pronounced “bow-wow”) program described above, it should restrain the Lords of finance and compel them to prudently manage their regulated financial quasi-utilities.

If not, the Lords (who had no problem rewarding themselves with well-timed stock options in the high times of what is now seen as low finance) will face the warranted wrath of their taxpayer vassals. 

Finally, since the program is conditional upon future financial sector missteps, it preserves the spirit, if not the substance, of our hallowed free-enterprise system.

I believe that this program can work if given a chance. So could I. My email address is ibartman@inbox.com, and I would be at your service.

I used to work with numbers for a living. I am struggling to break the bonds of the recession and unemployment as I search for a new job, or at least my next idea. Till next time.

Last week, Professor Gary Gorton (of Yale and the NBER) took Fed officials on a whirlwind tour of US bank panics. He focused on two periods:

1. 1864 – 1913, in which newly established and lightly regulated commercial banks spread across the country, and suffered from frequent panics and failures; and
2. 1934 – 2007, the “Quiet Period” following the introduction of deposit insurance, in which few banks (distinct from special-purpose savings and loans) failed.

He did this because he believes that:

1. There are similarities between today’s problems and the failure-prone era that preceded the creation of the Federal Reserve;
2. Today’s crisis is a modern institutional banking panic that occurred within a relatively new Shadow Banking System; and
3. An understanding of what made the “Quiet Period” so quiet (with respect to bank failures) might help fix today’s crisis.

Let’s begin by taking a look at the historical incidence of US banking failures. A chart of bank failures looks something like this:

Figure 1: US Bank Failures, 1892 – 2008.

The banking panics that occurred prior to 1913, were “retail panics”, marked by crowds of small investors who swarmed into uninsured banks in an attempt to withdraw their money before the banks went bust. (The S&L failures “don’t count”, since they were largely confined to specialized institutions, rather than the banking system as a whole.)

These retail panics had the following characteristics:

Figure 2: Characteristics of Retail Banking Panics, 1863 – 1913.

Following the passage of the 1933 Glass-Steagall Act, which created the FDIC and provided for deposit insurance, the US banking system entered the Quiet Period:

• The period from 1934 … until the current crisis is somewhat special in that there were no systemic banking crises in the US. It is the “Quiet Period” in US banking. This Quiet Period led to the view that banking panics were a thing of the past.

G. Gorton, “Slapped In The Face By The Invisible Hand – Banking & The Panic of 2007”, 2009

To explain why the Quiet Period was so quiet, Professor Gorton suggests that it may have been the result of a careful balancing between the:

• “Stick” of bank regulations; and the
• “Carrot” of benefits granted by bank charters.

As summarized below, banks recognized the value of their charters and self -regulated, i.e. respected the rules, to preserve them.

Figure 3: Quiet Period Begins – Bank Charters Are Valuable.

The value of banking charters gradually eroded, as unregulated intermediaries (such as money funds and junk bonds in the late 20^th century) exploited loopholes in the banking regulations and began to successfully compete with the regulated banking institutions. Restrictions eventually drove capital and business out of the regulated banking system and promoted the rise of a “shadow banking system.”

 
Figure 4: Quiet Period Ends – Bank Charters Become Less Valuable, Promoting Rise of Shadow Banking System.

The Shadow Banking System replaced many of the banking functions – but not the federal backing of – the regulated banking system through the use of:

1. Derivative securities, such as credit default and interest rate swaps; and
2. Securitization, in which loans that had once been funded and held by banks were sold to investors in the capital market.

The following charts, of outstanding swaps and issuance of mortgage or asset backed related securities, suggest the rise of the tough-to-observe Shadow Banking System.

Source: G. Gorton, “Slapped In The Face By The Invisible Hand”, 2009.
Figure 5: Rise of Derivatives – A Proxy For The Shadow Banking System.

 
Data: G. Gorton, “Slapped In The Face By The Invisible Hand”, 2009
Figure 6: Issuance of Mortgage and Asset Related Securities – Another Proxy For The Shadow Banking System.

The wholesale, or institutional, banking panic of 2007 began with a home price decline that weakened the credit of privately issued securitizations that lacked any government backing or guarantee.

As summarized in the table below, the Shadow Banking Panic of 2007 shares many similarities with the numerous banking panics that plagued the late 19^th and early 20^th centuries – except that it is an institutional (or wholesale) panic among large investors, rather than an individual (or retail) panic among small depositors.

Figure 7: Characteristics of Shadow Banking Panic of 2007.

In order to close the loopholes that were exploited to produce the current crisis, and return to the calm of the Quiet Period, regulators should accept that the current crisis IS a (Shadow) banking panic of the Shadow Banking System.

They should then attempt to regulate the system with both carrots (benefits) and sticks (regulations). Professor Gorton suggests that these could include:

1. Government insurance for senior tranches of approved asset securitizations;
2. Government supervision and examination of securitizations, in place of that previously supplied by private rating agencies; and
3. Limit access to the securitization market by determining that any firm that enters the securitization market IS a bank, subject to government supervision.

I used to work with numbers for a living. These days, I labor in the shadow of the housing bust as I search for a new job, or at least my next idea. Till next time.

On April 27^th the Administration buzzed Manhattan with an F-16 and a Boeing 747. On May 5th, it cracked down on General Mills, the maker of Cheerios, an illegal drug found in many schools, playgrounds, and lunchboxes.

So you may have missed the May 12^th critique suggesting that inept government policies threaten to disrupt more than tall buildings or your breakfast morn.

As hard as it is to believe, the government is also screwing up monetary policy.

Speaking at a financial markets conference sponsored by the Atlanta Fed, economist and keynote speaker John Taylor of Stanford closely examined (in Systemic Risk and The Role of Government) the responsibility that the government had for provoking and continuing the current crisis.

Government As Enabler

Professor Taylor declared:

1. Today’s crisis was induced by the government:

• The primary culprit was the Federal Reserve, which maintained interest rates at unjustifiably low levels from 2002 – 2005;
• These low rates produced a housing boom and encouraged the wide use of adjustable rate mortgages; and
• Government sponsored enterprises – Fannie and Freddie – “fueled the flames of the housing boom” and promoted speculative risk taking through their government-induced purchases of higher risk loans.

2. Today’s crisis was prolonged by the government:

• The government “misdiagnosed” the situation as a liquidity problem, rather than one involving counterparty risk; and
• It responded by slashing rates too quickly, sharply depreciating the dollar. This caused oil prices to skyrocket, hammering the economy and the auto industry.

3. Unclear government policies worsened the situation even as the government rescued Bear Stearns and let Lehman fail:

• The government botched the roll out of TARP;
• A plan that had been designed to purchase distressed assets was confusingly transformed into one that acquired the equity of distressed institutions.

A Prospective Look At Systemic Risks

The government would like us to believe that the current problems could be solved through the creation of a Systemic Risk Regulator, with the power to review, regulate, and limit financial innovation.

But in looking forward at systemic risks, Professor Taylor believes that the government is the biggest source of future systemic risks. These risks are posed by:

1. Enormous federal deficits and growing debt:

• In ten years time, the Congressional Budget Office estimates that federal debt will equal 82% of GDP (twice the current percentage);
• Either a 60% tax increase or a decade of inflation (that is, 10% a year for 10 years) will be required to manage this burden.

2. Explosive transformation of the Fed’s balance sheet:

• Since September 2008, the Fed balance sheet has ballooned from $8 billion to $800 billion – will the Fed be able to dispose of these assets in a non-inflationary fashion?

3. Apparent miscalculation, by the Fed, of the degree to which it can provide non-inflationary liquidity:

• The Financial Times reports (see Days of Swine and Poses) that the Fed believes that current interest rates should be equivalent to negative 5%, using the Taylor Rule;
• Professor Taylor (it is his rule) says that “Fed’s calculation reported in the Financial Times has both the sign and the decimal point wrong” and that the correct rate is not – 5% (negative five percent) but +0.5% (positive one-half of one percent).
• The Fed does NOT have much time before it must remove liquidity and raise rates, if it is to prevent inflation.

4. Finally, and most importantly, today’s “capricious” and “intrusive” government interventions disrupt:

• private employee compensation arrangements;
• contractual obligations to debtholders; and
• corporate governance.

They threaten to destroy the US rule of law - “the most important ingredient to the success of our economy since America’s founding.”

Rather than creating a new systemic risk regulator, Professor Taylor urges the government to get its own house in order, and rein in the risks that the government itself poses to the future soundness of our economy.

After that, we can turn our attention to the real problems that darken our skies and mornings – a) low flying planes, and b) those evil, toasted, whole grain circles of oat.

I used to work with numbers for a living. Guess I’ll have to switch to Corn Flakes as I begin my search each morning for a new job, or at least my next idea. Till next time.

Two widely respected investment firms – Research Affiliates and Deutsche Bank – recently reviewed the relative performance of diverse asset classes over decades (Research Affiliates) and months (Deutsche Bank).

Each provides justification – even in tough times like these – that portfolio diversification rules!

The Long View – 40 Years

“Why bother with bonds?” asks Robert Arnott, the Chairman of Research Affiliates.

Writing in this month’s Journal of Indexes (Bonds: Why Bother, May – Jun 2009), Arnott reviews more than 40 years of market history.

He provides investors, betrayed by the unfulfilled “promise” of equity-burdened portfolios, with six answers:

1. Over the past 40 years, Treasury bond returns exceeded stock returns.
2. This is not a fluke – the equity risk premium (the excess return obtained by holding stocks, rather than bonds) is not reliable. Equity investors must frequently suffer through long periods of disappointment, occasionally interrupted by “some wonderful gains.”
3. The only thing that goes up in a market crash is correlation between asset classes.
4. Bonds have been an effective way to reduce portfolio risk.
5. 2008 returns on 14 out of 16 broad asset categories were negative. In a year when the S&P 500 dropped 38%, broad US bond market indexes (such as the BarCap Aggregate Bond Index and the Merrill Lynch 1-3 Year Government/Credit Index) rose by 5%. See Figure 1, below, for the details.
6. Long-term investors can improve their portfolio returns by broadening their horizons to include stocks and bonds that don’t resemble conventional indexes, such as the S&P 500 or the BarCap Aggregate. Note: These include high yield corporate credits. Let’s turn to those – now.

 
Figure 1: Aftermath of Crash (Full year 2008 Returns at right, highlighting by author); from R. Arnott, Bonds: Why Bother?, Journal of Indexes, May-Jun 2009.

The Short View – Since July 2007

For a short-term tilling of similar terrain, plow through the asset class review of Credit vs Equity, Which Has Outperformed? (Deutsche Bank, Jim Reid and Nick Burns, 11 May 2009.)

While news has been dominated by the equity market resurgence, the Deutsche Bank team provides answers to the following question:

• Which asset class has out-performed: bonds, credit or equities?

The answer – naturally – depends upon the date that you choose to begin your analysis.

Reid and Burns assess the performance of bonds, credit, and equities over more than a half dozen different time horizons with different starting dates.

They focus upon intervals beginning with the final week of each of the following months:

• July 2007;
• September 2008; or
• December 2008

and share a common ending date of the first week of May, 2009.

Following a detailed review, Deutsche Bank concludes:

• High yield corporate credit has clearly outperformed equities (although not Government bonds) since the beginning of the crisis and also since the end of 2008Q3.

• Year-to-date 2009, high yield credit has outperformed all other credit and equity sectors.

Note: While the Deutsche Bank team used broad worldwide indices accessible to institutional investors, my analysis (below) includes charts of my own construction. These charts reflect performance of asset classes similar to that referenced by Deutsche Bank. They are based on total return data (from Yahoo!) for representative mutual funds, as follows:

• GNMA Mortgages: Vanguard GNMA (VFIIX)
• High Yield Corporate: T Rowe Price High Yield (PRHYX)
• S&P 500: Vanguard Index 500 (VFINX)

My commentaries, while broadly consistent with Deutsche Bank’s views, reflect the performance of the US mutual fund proxies that I have chosen as “stand-ins” for the Deutsche Bank asset classes.

Since July 2007

• The asset class that has been the best since the start of the crisis has been Government-backed bonds. Equities have delivered the worst performance. Although high yield credit significantly under-performed other credit sectors, it still managed to outperform equities.

Figure 2: Relative Asset Class Returns Since 07-30-2007

Since September 2008

• Government backed bonds still produced healthy returns, and equity markets generally delivered the worst market performance. High yield corporates managed to recoup virtually all of their losses by the beginning of May.

Figure 3: Relative Asset Class Returns Since 09-29-2008

Since January 2009

The dismal performance of equity markets over the past 40 years has reinforced the importance of bonds in a diversified portfolio. Investors looking to diversify their portfolio and enhance their returns, even in troubled times, should also consider investing in “unconventional” asset classes such as corporate credit.

I used to work with numbers for a living. Pigs, pandas, and mules – oh my! – could my next job be in Kansas as I continue my  search for a new job, or at least my next idea? Till next time.

 
                                        
If Chairman Bernanke’s best efforts have greened (i.e., to make or become green) the shoots of economic recovery, what would cause him to cede his current position, stand up, and leave?

It would be unusual for a successful sitting Fed Chair to leave after one term (about as rare as a standing panda). But let’s take a look at history and “determine” what would be needed to make Chairman Bernanke a one-term Chairman of the Board.

To do this, I will:

1. Briefly review the terms of modern-era Fed Chairmen;
2. Invoke a well-known metric to benchmark their performance;
3. Develop a model that relates their length-of-service to this benchmark; and
4. Calculate the performance level required to make Chairman Bernanke a one-termer.

Historical Review of Fed Chairmen

Since the Fed’s 1913 inception, there have been eight Chairmen of the Board of Governors, a position established in 1934.

• Note: Prior to 1934, the top Fed post was called the Chairman of the Board of Directors of the Federal Reserve System, Fed Directors served shorter terms, and they were not as powerful as the current Fed elite.

Figure 1, below, lists the terms of the modern-era Fed Chairs’.

Figure 1: Chairmen of the Fed’s Board of Governors

If you look closely at the figure, you’ll see that I’ve italicized two names – Ben Bernanke and Thomas McCabe:

1. I’ve highlighted Chairman Bernanke because he is the current Chairman, and his first term ends in January of 2010. Assuming that he is re-appointed, his complete term of service could run much longer than the currently scheduled 4 years.
2. I’ve highlighted Chairman McCabe because (as we will see below); McCabe is the “exception that proves the rule.”

Performance Benchmark

To measure the Fed heads’ performance, recall the Misery Index of economist Arthur Okun. The “Misery Index” is simply the sum of the:

• Unemployment Rate; and
• Inflation Rate.

Okun’s index suggests that both higher unemployment rates and inflation create economic and social costs. A combination of rising inflation and more people out of work implies deteriorating economic performance, and a rise in “misery.”

Below are charts of the Misery Index and it’s constituents.

Figure 2: Inflation and Unemployment, 1948 – 2009

 
Figure 3: Misery, 1948 – 2009

As Figure 3 indicates, since 1948 (when my data begin) the worst time, in terms of Okun’s Misery, ran from the mid-1970’s until the mid-1980’s. While unemployment has risen in the last year, it has been offset in “Misery Index terms” by low (reported!) inflation rates.

Modeling The Length of Service of Fed Chairman

To “model” the length of service for prior Fed Chairman, all that we need to do is plot their a) length of service against b) the average misery level that prevailed during their term.

I’ve done this below in Figure 4.

 
Figure 4: Fed Tenure and Misery, 1948 – 2009

As noted above, Chairman McCabe is a special case that I shall exclude, and we’ll get back to him in a moment. Leaving McCabe aside, the “expected” relationship prevails:

• Fed Chairmen associated with lower economic misery had longer terms of service than Chairmen plagued by miserable economic conditions.

Chairmen Martin and Greenspan each served almost 19 years with low misery levels: 6.8 for Chairman Martin and 8.6 for Chairman Greenspan.

Chairman Miller (appointed by President Jimmy Carter) established the peak for the Misery Index – his average misery index of 15.1 easily “explains” his short Fed tenure of just 1.4 years.

Chairman Bernanke’s misery level, since the beginning of his 2006 term (inspect Figures 1 and 3) is 8.3. If Chairman Bernanke maintains this average misery level throughout his tenure, one might expect that he would serve more than 18 years, as long as either Martin or Greenspan.

In order for Chairman Bernanke to be a “one-termer” with a 4-year term, however, the “model” and Figure 4 suggest that Bernanke’s misery would have to average about 14.75 – and he’s nowhere near that – yet.

Stress-Testing The Chairman

Federal financial journalism guidelines require that I make a passing deferential reference to the government’s “stress test”, or as it is properly called – the Supervisory Capital Assessment Program (“SCAP”).

So I shall.

As described in the SCAP Design and Implementation document of 24 Apr 2009, the adverse stress test (see Table 1, page 6) posits that unemployment will average 10.3% in 2010.

While the SCAP document does not mention inflation (think about that), let’s assume that future inflation will equal 3.3%, the average level that prevailed in 2006 – 2008 (the first 3 years of Chairman Bernanke’s term).

An assumed unemployment rate of 10.3 and inflation rate of 3.3 produce a Misery Index of 13.6.

• Question: How long would a Fed Chairman serve if the Misery Index averaged 13.6 during his term?
• Answer: About 8 years, equivalent to either Chairman Arthur Burns or Paul Volcker.

On a steady-state basis, the stress test metrics are roughly consistent with the suggestion that Chairman Bernanke will be reappointed as Chairman in 2010 – but that’s it. If the adverse stress test conditions are realized, he will be replaced in 2014.

Chairman Thomas McCabe, 1948 – 1951

Finally, a few words about that “standing panda” of a Fed Chairman, Thomas McCabe. McCabe was an extraordinarily principled Fed Chair who stood up to the Treasury Secretary during wartime, forcing the Treasury to back down from inflationary policies. This integrity came at a cost – McCabe’s position.

As described by the Richmond Fed, after the US economy slipped into the 1949 recession, the Federal Open Market Committee determined that loose credit and low interest rates were needed to revive the economy. This policy “pleased the Treasury, [since it] resulted in cheaper debt financing.”

But the economic rationale for expanding credit -and lowering rates- faded as the economy revived with the 1950 onset of the Korean War. The mix of “economic expansion, artificially low interest rates, and new …debt financing” to finance the war would have generated serious inflation.

In response, the Fed raised rates, infuriating the Treasury:

• Conflict between the FOMC and the administration ensued… Thomas McCabe … [and other Fed officials] pressed for a relaxation of the interest rate peg [that kept rates low].
• They argued that the inflationary pressure generated by the [low rate] peg would undermine war financing by creating inflation. After months of intense sparring in the public eye, the Treasury backed down and settled its argument with the Fed.
• However, the chairmanship of Thomas McCabe was a casualty of the conflict [between the Treasury and Fed, and the Treasury Secretary]… told [President] Truman that he could not work with McCabe… McCabe resigned in March.

Biography, Thomas Bayard McCabe, Federal Reserve Bank of Richmond

This is why McCabe is a “special case”, and why I excluded his 1948 – 1951 term from my model.

His term was short because he was effective, not because he was weak. Viewed broadly, his term should be considered to be a part of that of the legendary William McChesney Martin, who followed him as Fed Chair and served successfully for almost 19 years.

Between now and year-end, don’t be bamboozled by suggestions (from the Treasury, as in 1950…?) that Chairman Bernanke will leave.

If Chairman Bernanke produces green shoots, and then leaves, it would be as rare as a standing panda.

I used to work with numbers for a living. I’ve had about as much of this stress test pandering as I can bear as I  search for a new job, or at least my next idea. Till next time.

 

 
Author’s composition.

Two questions.

1. Can you drive using just your rear view mirror?
2. Can you figure out where home sales are going by looking backwards?

I thought that the answers to both questions would be:

• Not well, or not for long; or
• No, not really.

But maybe I’m wrong.

Last week, I observed (see Drawn and Quartered – Home Sales and Foreclosures) that seasonal factors plague monthly home sales – winter home sales are typically much lower than summers’.

As a result, everyone discusses home sales on a seasonally-adjusted-and-annualized basis. But foreclosure figures are not (yet!) annualized when announced. This understates the magnitude and impact of foreclosures. Foreclosures should be annualized, just like home sales, to put each on an equivalent basis

This week, John Burns suggests (see his Sales Headlines Are Misleading) that the seasonal adjustment process used to produce the home sales headline figures is not very robust, and may obscure more than it reveals. This is due to the variable impact of weather, holiday calendars, and the like.

To see the big picture, Burns suggest a simple fix for housing seasonals – use a 12 month rolling sum (not! average) of new and existing sales. Consider the following two charts, inspired by Burns’ analysis.

Figure 1: New Home Sales, Rolling Sum and Seasonally Adjusted & Annualized

 
Figure 2: Existing Sales, Rolling Sum and Seasonally Adjusted & Annualized

The blue line in each of the above charts demonstrates the spiky irregularity of the “seasonally adjusted and annualized” home sales, and the red line is the “rolling sum” of the past 12 months of sales.

While the jittery “false positives” in the “seasonally adjusted” figures (see the blue spikes in Mar 2007) might briefly make news, Burns suggests that they should be ignored. Focus instead, on the meanderings of the rolling sum. These red lines will “signal” the bottom by flattening. Only then can we roll forward, and think about a recovery.

One last thing before I make my exit.

IF you are comfortable with the above methodology, then you might want to rethink the irrational exuberance that accompanied yesterday’s release, by the NAR, of their Pending Home Sales Index. As reported by Yahoo/Reuters on 4 May:

• WASHINGTON (Reuters) – Pending sales of previously owned homes rose for a second straight month in March … according to reports on Monday that suggested moderation in the long housing slump.

• The reports boosted U.S. stocks [DJIA up 214 points] and lent support to the view that the recession, now in its 17th month, was close to finding a bottom…

• The National Association of Realtors said its Pending Home Sales Index, based on contracts signed in March, rose 3.2 percent as first-time buyers waded into the market to take advantage of favorable prices and mortgage rates…

Below is a chart of the Pending Home Sales Index (“PHSI”), which has been produced by the NAR for only the last four years or so:

 
Figure 3: Pending Home Sales Index: SA, Rolling Average & NSA

This chart is similar to the prior two. The seasonally adjusted PHSI is in blue, and the rolling average of the non-seasonally adjusted pending sales is in red. I’ve added the “raw” non-seasonally adjusted pending home sales figure in green.

Given the variability of the pending home sales index (in either the raw or adjusted versions), relief at the rise in the seasonally adjusted (blue) PHSI seems a touch overblown.

If we were to apply Burns’ suggestion to focus on the red 12-month rolling figure (rather than seasonally-adjusted noise), it’s clear that there’s nothing really “new” in the 12 month, backwardly looking, version of the PHSI. Maybe the market should slow down a bit or pull over. There might be some sharp turns ahead.

• Note: Thanks to SoldAtTheTop, the proprietor of PaperEconomy, for the pending sales data. Don’t miss his take on yesterday’s pending sales release.

I used to work with numbers for a living. Time to rev up the engine and get back to the search for a new job, or at least my next idea. Till next time.