Global Economics and Management

Loan Brokers and House Prices

On Friday my colleague Ed Leamer showed me a neat graph displaying the ratio of the number of people in the US employed as mortgage and nonmortgage loan brokers, divided by total nonfarm payrolls (jobs), over time since 1990 (that's when the US government started tracking the number of loan brokers). This ratio is a measure of how important the loan broker sector is in total employment. I just had a bit of fun with this data set, overlaying the Case-Shiller 10-city composite house price index. The result is as follows:

Does the share of loan brokers in total employment cause house prices? Do changes in house prices cause variation in the proportion of loan brokers? Does a third factor cause both variables to covary? I will let you spend your Sunday wrestling with these fascinating questions.

Data sources: Bureau of Labor Statistics, Standard and Poor's

Weekend Guest Blogging: Jack Brethauer

Many thanks to your classmate Jack Brethauer for the following, a very thoughtful and informative guest post [note: I am happy to post your thoughts as main posts in the GEM blog; just email me and we can talk]:

"This week I found a few items in the press that addressed several of the issues we discussed in class on Wednesday.  I'd post them directly to the blog but didn't see a natural fit in the recent postings. 

First, at one point there was a brief discussion on FAS 157 and its consequences during the crisis.  In the FT on Wednesday the headline article for the 'companies and markets' section was about FASB reversing requirements for banks to use mark-to-market for loans.  The article didn't get into specifics on what kinds of loans were affected but did mention that commercial and retail banks like BofA, Citi and Wells Fargo would benefit.  It also mentioned that the change moves US standards closer to those endorsed by IASB.  My understanding is that M2M is significant because of the erroding effect on a bank's balance sheet during a crisis, when asset prices are negatively impacted by illiquid or frozen markets and fire sales driving down prices.  The M2M requirement can then force otherwise healthy banks to write down their assets and put them in violation of capital requirements. 

(the article is here) 

The next couple of articles, both from the same issue of FT, focused on compensation issues in the financial sector.  Thematically, both deal with actions at Barclays' and Morgan Stanley to align bonuses with the long-term interests of the firm's stakeholders.  At MS, the CEO is deferring 60% of bonuses, to be paid in cash or stock over the next three years.  Barclays' is considering paying senior executives' bonuses with "contingent convertible bonds."  Although I am not familiar with this type of instrument, the article says it has characteristics of debt which incentivize management to both keep the "firm solvent but maximize payout on insolvency... the point where equity-incentivized executives are most dangerous to bondholders."  It points out some problems with the particular instrument in question, but nonetheless both articles highlight potential ways in which executive compensation can be structured to align the interest of management with both shareholders and debt holders and encourage long-term value maximization with appropriate attitudes towards risk. 

(articles here and here)

I thought to bring up these two articles in response to Carlo's "rant."  Both show ways to make managers more sensitive to risk through their pocketbooks and even make them give up compensation when those sensitivities aren't enough.  I personally don't care how much a banker makes in bonuses as long as he is being paid in proportion to the value he creates for me as a shareholder... in both the near and long term.  In fact, I'm really hoping one of our classmates can take me out on their yatch someday. 

And just for fun, in case Carlo (sorry to pick on you man) hasn't gone through the roof reading this yet, here's a clip from dealbook on the (un)likelihood of anyone being criminally prosecuted as a result of the crisis.

I know that we get FT on campus for free but I thought some of these might be worth noting for the class as those papers tend to disappear pretty quickly from the courtyard. "

Hedge Fund Performance

Should this make me reconsider my choice of a career?

Old GEM blog posts

By popular demand, here are links to some old GEM blog posts relevant for what we have been discussing in class lately:

The FED's discount window

Lehman and Repos

Debt accumulation and the crisis

Bernanke on the FED's balance sheet

Merle Hazard meets Giuseppe Verdi

And it's not a pretty picture:

 

The New Monetary Policy Toolkit

James Hamilton over at Econbrowser has a superb discussion of the new tools of monetary policy, which rose to prominence in the wake of the crisis. In a couple of weeks we will discuss the monetary response to the crisis. This blog post by Professor Hamilton will come in very handy to understand recent developments in monetary policymaking. Highly recommended.

Fiscal Failures

Over at commentarymagazine.com, my former Stanford colleagues John Cogan and John Taylor (of "Taylor rule" fame) discuss the fiscal response to the crisis. They argue it was a complete failure. It is obviously difficult to know what would have happened in the absence of a certain policy (we don't observe the counterfactual), but they raise two basic points:

1) The stimulus in part took the form of temporary payments to households: temporary tax breaks, and temporary transfers. We know very well from economic theory that temporary income shocks do not raise consumption. Only changes in permanent income change consumption. People save rather than consume temporary income windfalls, as they seek to smooth consumption over the life cycle.

2) Perhaps more importantly, the major stimulus programs passed in 2008 and 2009 did not result in increases in purchases of goods and services. For instance, payments to states and local governments went to reducing their debt burdens (or avoiding increasing them) rather than increases in government purchases. Thus, there was very little effective stimulus. As for households, these payments went to saving (paying down the debt) rather than consumption.

I will note that this diagnostic is related to Ricardian equivalence: as the government was building up debt, households and states were offsetting this by saving more. There is a subtle difference between the Cogan/Taylor argument and Ricardian equivalence, however: under Ricardian equivalence, permanent increases in government spending reduce private consumption one for one. Under the Cogan/Taylor argument, temporary increases in government spending leave consumption unchanged, and result in increased savings.

Cogan and Taylor's argument is not that the multiplier of public spending is small. Their argument is that the multiplicand was small - there was little in those stimulus programs that was directed at purchases of goods and services. Under Ricardian equivalence, the multiplier is zero.

Carlo's Rant

In a couple of emails to me, your classmate Carlo Maerna rants on the financial crisis. With his permission, I reproduce his emails below. This is a fantastic opportunity for thoughtful (and civil!) debate. Debate on in the comments section!

"Am I the only one who thinks that “Wall Street” knew perfectly the risk associated with subprime mortgages but kept playing the game because as long as the bubble was growing, they could put some real money in their pocket (and then buying a Ferrari, a Yacht, a house in Antigua all by paying cash) while as soon as the bubble burst, somebody else (i.e. Paulson & Bernanke & the taxpayers) would have to clean the room?

How Geanakopoulos, who I presume is very smart, could say “It was nearly impossible to foresee the devastating consequences…blah blah”? It is SO obvious!

Of course they knew what was going on, but as long as they saw the big bucks going into their pockets, who cared?

They knew what they were doing was perfectly legal, and somebody else would have paid for that…the Community would have paid for their Cristal bottles at the clubs, for their yachts bought with outstanding end-year bonuses, for their 1^st class trips to Caribbean and so on… so who cares?

I was even more stupid than today in 2001, when I got a free pass for the 24-hours fitness in Westwood… I went there, enjoyed the facility and planned to leave after 2 good hours while a young salesman tried to sell me a yearly pass for $300...

“Dude, I am sorry, I am leaving to Milan tomorrow, my exchange program at UCLA is over, I have no idea on if and when I will come back”

“Whatever! You just sign here, and you can start your one-year pass whenever you want, even if you come back in one year!”

“Are you kidding me?”

“No, as long as you sign here, I will get my bonus, and you don’t even need to come here or actually pay for your pass…I just need your signature”

I understood the system was rotten in 2001, and Geanakopoulos says “it was nearly impossible to foresee the devastating consequence” ????

“Head: I win, Tail: you lose” right? So let’s keep flipping the coin… I like this game!

Did any of these “Wall Street” dudes ever had to give back their bonuses? So, why stopping the bubble from growing?

I am so upset that in this ton of readings there is NOBODY who tells the truth, which is the most elementary agency problem ever seen."

"It’s like a Wall Street Masonry: as long as it grows, we’ll reap obscene bonuses, but once it will burst, the taxpayers will clean the dirt…

Who cares if it bursts? We can retire at 40 and live the rest of our lives in Antigua!

And the first one who says I am a socialist / communist will be killed immediately.

Carlo"

The Collapse of Bear Stearns

Via your classmate Kuldip Ambastha, here is a Vanity Fair article from back in 2008 describing the collapse of Bear Stearns. This week in class we will go through a timeline of the financial crisis in the US (next week will be the international aspects), so this is timely. 

CDOs explained

Via your classmate Shaun Murphy, a nice video primer on CDOs, from NPR's Marketplace (the same metaphor of the bottle of champagne appears in the readings you had for class on structured finance):