Dollars and Jens
Friday, August 31, 2007
the no-profit condition
Before the Industrial Revolution all societies were caught in the same Malthusian Trap that imprisons Africa today. Living standards stagnated because any improvement caused births to exceed deaths. The resulting population growth, pressing on fixed land resources, inevitably pushed incomes back down to subsistence.


The African environment has always created high disease mortality. This was a blessing for Africa's living standards. Before the Industrial Revolution, Africa was rich, with material consumption probably double or triple that of China, Japan, or India, and as good as that of Europe. For example, when the British were looking for cheap labor in East Africa in the 1840s they had to turn to India for low-wage workers. Asian living standards were low because of high standards of personal and public hygiene in preindustrial China and Japan. This condemned Asia to subsistence on a minimal diet. Europeans in contrast were lucky to be a filthy people who bathed rarely and squatted happily above their own feces, stored in basement cesspits. Filth engendered wealth.
What I find particularly interesting about this argument is how familiar it looks. In equilibrium economics, one is always left to ask of any given industry, why do more companies not join the industry, or existing ones leave it (by going out of business, for example)? Sometimes there are government-enforced monopolies or social barriers, but in a clean, efficient, competitive equilibrium, the answer one generally looks for is that the marginal economic profit of a new firm, and the most tenuous firm that is in the industry, must be zero; if it were higher more firms would enter until it dropped, and if it were lower weak firms would go out of business until the remaining ones were able to get by.

The Malthusian trap looks similar; economic growth simply leads people to enter or leave until equilibrium is reestablished with life at just a high enough quality to sustain the population. The author argues that industrialization allowed us to escape the Malthusian trap — he seems, though I'm not clear on this, to mean because it produced economic growth at a rate faster than the population could keep up. Labor, today in industrialized countries, is the primary factor of production of most of our economic product, and we tend to think of new people bringing in labor in proportion to their numbers and not really changing the economic product per person. The birth rate, though, has gone down in industrialized societies; we have clearly not kept up with the amount of population growth the economy could have sustained; this at least suggests something else is getting in the way of the Malthusian trap. Perhaps he meant to include this in his argument — that industrialization leads to the cultural changes that prevent population growth from eating all our profit, as it were.

þ Mankiw

Thursday, August 30, 2007
commercial paper rates

and other related pretty pictures.

Happy 77th to Warren Buffett.

Tuesday, August 28, 2007
A month ago I wrote (in follow-up to a housing post),
I thought I'd mention, in re housing, that the first thing I'm waiting for is for the inventory-to-sales ratio to come down from its peak. (It's in the six to seven months range right now, depending on exactly what you're looking at and which month.) I don't see a reason for prices to firm up on a widespread basis until the backlog is behind us, and I don't see a reason for much increase in investment until the prices firm up. So if you're wondering whether we're past the bottom yet, keep your eye on how many months' sales are outstanding. If it's within noise of its peak, the answer is no. We might see that in this calendar year, but I wouldn't bet any of my favorite body parts on it.
Well, some of my numbers may have been out of date even when I wrote that.
Homeowners trying to sell last month faced the biggest glut of homes on the market in about 16 years, as declining sales and growing problems in the mortgage market helped push home prices down for the 12th straight month.


Not only did sales slip but the number of homes for sale jumped 5.1 percent, the group said, meaning there is now a 9.6-month supply of homes for sale, up from 9.1-months in the June reading. It was the biggest supply of homes by that measure since October 1991.
Also out today, prices in the second quarter were down from a year ago:
On Tuesday, Standard and Poor's said its nationwide S&P/Case-Shiller Home Price Index [was down] 3.2 percent in the second quarter [from] a year [earlier]. For the three months ended June 30, prices dropped 0.9 percent from the first quarter.

Major housing markets showed worse declines. The Case-Shiller index covering 20 top metro areas for the month of June fell 3.5 percent, and the 10-city index dropped 4.1 percent year-over-year.
In San Diego and DC, it was more like 7%.


Sunday, August 26, 2007
I like VMWare, which you may have heard issued shares to the public for the first time this month. We use their product at work, and if we didn't, I'm sure my occasional requests for a new machine would be greeted with derisive laughter. But as long as I indicate that a virtual machine is fine, I'm not even asked what I want it for. One "machine" I have — at most one other person ever uses it — is idle for weeks at a time, but the hardware isn't idle, it's running other machines.

A very useful product, and I'm sure the company has room for growth. Surely, they're worth a lot of money. But 28 times annual sales? Really?

Thursday, August 23, 2007
fed funds target considerations
The fed, by which I mean Bernanke, seems eager not to prop up financial markets, and only to target interest rate policy toward keeping the real economy in balance. This, however, argues more and more for a cut in interest rates.

The first point to note is that 5.25% has generally been regarded as slightly restrictive. The entire yield curve has spent most of the past 14 months below that rate, and this has been consistent with the FOMC statements implying greater concerns about inflation than about economic weakness. They raised it to that point to tap the brakes — and inflation has, slowly, been coming down.

In fact, the spread between the TIPS and the nominal treasury notes has tightened over time; at 5 years, it was 2.3% or 2.4% at the beginning of July, 2.2% at the end, and is now right around 2.0%. (Using the rule of thumb that CPI, to which TIPS are indexed, overstates inflation by about half a point, this implies that inflation over the next five years is expected to be right where various memebers of the FOMC have suggested they want it.) These expectations are built around expectations that the fed will cut rates in the next few months; this certainly seems to open room for the fed to cut rates if it wants to without sparking (potentially self-fulfilling) expectations of high inflation.

So why would it want to? The housing recession has, up to this point, been largely contained — there has been a lot of expectation that new wealth and solvency constraints on homeowners would reduce consumer spending, but that hasn't been seen yet. The newest data, though, may be showing some signs of weakness. The market turmoil does seem to have had at least some impact; a few financial firms in particular have announced layoffs; unfortunately the August employment situation report that comes out in early September will provide a snapshot of the weekend after the major liquidity injections took place, and it may be that the fed will meet before favored statistics are available to quantify the effects of recent turmoil. Even the July report, though, showed an uptick in the unemployment rate from 4.5% to what was reported at 4.6%, but in fact was 4.65% if you go another decimal point. (In point of fact, the margin of error is likely to be between 0.01% and 0.1%.) Claims of unemployment insurance have been inching upward for the past couple months. Somewhat vexingly (not to be wishing for disaster!) none of this is unambiguous; it simply suggests a weakness that is particularly easy to read into the data if you've been expecting it.

Monetary policy generally acts with a lag that is longer than is often appreciated. On one hand, it is because of this that it doesn't make a lot of sense for the Fed to get overeager to act before the next meeting; an interest rate cut a month earlier wouldn't help a lot versus one in September, and there will be more data on unemployment claims, consumer spending, inflation, and, of course, what path the financial markets take between now and then, not to mention a cornucopia of anecdotal information collected by the regional federal reserve banks. On the other hand, it suggests that actions be taken based on where the economy is headed, and it's easier at this point to see sources of future weakness than an excessive willingness to pay higher prices for goods.

(Incidentally, the actual average overnight fed funds rate topped out at 5.03% Monday, and has otherwise been below 5% every night for basically the past two weeks. It could well still be that the target will ultimately be drawn around the interest rate being hit without the rate being brought back up to the target first.)

Tuesday, August 21, 2007
more notes from the front
Yields on short-term treasuries rose today:
The three-month bill yield climbed 0.48 percentage point to 3.57 percent at 4:28 p.m., rising for the first day since Aug. 13. The increase is the biggest since Dec. 26, 2000. Yields fell 0.66 percentage point yesterday, the most since the stock market crash of October 1987 as money-market funds dumped asset-backed commercial paper for the shortest-maturity government debt.

The Treasury today sold $32 billion of four-week bills, the largest amount since at least July 2001. The bills were sold at a high discount rate of 4.75 percent. The one-month bill yield fell as low as 1.272 percent yesterday, and was about 2.6 percent before the auction. In a sign of weak demand, the government received $1.11 in bids for each $1 sold, the lowest since at least July 2001.
In fact, I was left with the impression the size of the auction — of which $18 billion was needed to roll maturing debt — was increased in light of recent demand for the issue. I wonder whether they should incorporate a reserve bid into the auctions, at least above a certain size.
The Federal Reserve Bank of New York cut the fee bond dealers pay to borrow its Treasuries, in a bid to ease a shortage in the market for loans backed by the securities.


The New York Fed cut its so-called minimum fee rate to a record low 0.5 percent from 1 percent, saying in a statement that the move is ``temporary.''

"We are doing it to provide additional liquidity to the Treasury financing market,'' said Andrew Williams, a spokesman for the New York Fed. He said the rate was the lowest in the history of the program, which has existed in its current form since 1999. The New York Fed last lowered the fee rate on June 26, 2003, the day after policy makers cut their target overnight rate to a four-decade low of 1 percent.
In fact, I hadn't known it wasn't still 1.5%.

Incidentally, here's why I'm not buying the full-fledged flight-to-quality story:In blue is an ETF that follows the S&P 500. In red is an ETF that follows junk bonds. In a broad flight to quality, these should be staggering downward. (In the sort of flight-to-quality indicated by short term treasuries, they should be sprawled naked passed out on the floor.)

The commercial paper markets, as I understand it, are still a bit illiquid, but a number of companies have successfully placed bond issues in the past couple days. I expect there's some widespread credit concern, just as there was two and three weeks ago. The abject panic seems to be localized, though.

Monday, August 20, 2007
short-term treasury turmoil
At one point during the day, a dispatch from Bloomberg read
The yield on the three-month Treasury bill fell 1.23 percentage points today to 2.53 percent as of 12:26 p.m. in New York. It's the biggest drop since at least Oct. 20, 1987, when it fell 85 basis points on the day the stock market crashed.
Looks like the research boys were doing the best they could to keep up with the markets.

A later report indicated
The yield on the three-month Treasury bill fell about 1.21 percentage point to 2.55 percent as of 12:47 p.m. in New York. It's the biggest drop since at least 1983, when Bloomberg began tracking the data. The move eclipses that on Oct. 20, 1987, when the yield fell 85 basis points, or 0.85 percentage point, on the day the stock market crashed, and the decline of 39 basis points on Sept. 13, 2001, the day the Treasury market reopened after the attacks. The yield has fallen from 4.69 percent on Aug. 13.
It ultimately bounced about half-way back before the end of the day.

Most of the data, even commercial paper, seems to be mostly back to normal; it fact, were one prone to sanguinity, one could easily suppose that the aggregate data are consistent with the theory that the market is mostly where it was two weeks ago with the exception of a small but determinedly risk-averse group of market participants pouring into short-term treasuries; one can almost see injections of liquidity by the fed being routed rapidly through these people to short-term treasuries, leaving the rest of the financial world largely unaffected. (There are, I believe, some micro-data that don't gibe quite as glibly with this, but it may be a large part of the story.)

Update: Oh, I also wanted to mention that the 2 year swap spread has now climbed above 73bp. That fits into my narrative insofar as the two-year treasury yield is pulled by forces acting on short-term treasury bills; the two-year swaps are in line with the bulk of the financial markets, and the spread is just a function of the paranoid buying up two-year notes (or things that are being arbitraged against two-year notes).

Sunday, August 19, 2007
Fed action
Just to quibble, the discount rate isn't set by the FOMC; it's set by the board of governors alone. The rest of the FOMC is supposed to chime in on the open market operations policy, viz. the fed funds target. The actual "action" taken, though, was just by the board of governors.

It does look increasingly likely that a cut in the funds target itself is forthcoming, but I think if I were on the FOMC I'd be glad not to have a meeting until a month from now. What needs to be done can almost certainly wait a month, and much more will be known, particularly about financial conditions (as opposed to economic conditions), a month from now. Today's relief rally doesn't mean a whole lot, but if the markets — particularly the short-term paper markets — remain stable for the next week or two, normal principles that monetary policy is effective over periods of quarters and years rather than months come into force.

I'm going to quibble with the term "bail out" a bit, too. "Bail out", to me, suggests something more focussed and more dramatic than generally causing interest rates to ease slightly. I worry about long-term inefficiencies created by artificially preventing weak entities from going out of business. Creating a firebreak in the midst of a general credit crunch that threatens a lot of solvent but illiquid institutions, especially in the service of preventing general economic collapse, is fine with me. Few companies that deserved to go under will be spared by these actions.

Friday, August 17, 2007
The Fed Reacts
I'm more interested in my brother's take than in my own, but I'm here and he isn't.

When I got online this morning and saw the news, I thought it was the federal funds target that they had cut. Even though there had been talk of cutting the discount rate while leaving the federal funds rate alone, I still saw "FOMC cuts rate" and thought it was the federal funds rate. And a 50 bp cut in the federal funds rate struck me as excessive, but when I realized it was a 50 basis point cut in the discount rate, I was pleased. Especially since they also, according to CNBC, told banks that use of the discount window was encouraged. An immediate, steep cut in the federal funds target would have struck me as bailing out the financial markets, but they seem to be simply stepping up and emphasizing that there is a lender of last resort, and doing it in a more forceful way than they did last week. Financial institutions that take bad risks should be left hanging, to the extent that this can be done without greatly imperiling others. But financial institutions that can't borrow money just because everyone is panicking should be backed up.

The open market committee also released a statement indicating more bearishness than they previously had. Apparently, people are expecting roughly a 40 basis-point cut in the federal funds rate at the September meeting. I have no argument with that, but I hope they haven't committed themselves to anything before they see what results from today's action.

My fear for the economy in the next year is less of financial institutions going down than it is the subprime borrowers. While loan defaults aren't good for the people who own the loans, they don't indicate good times for the people paying them, either. And I think the blunt instruments available to the Federal Reserve will be less useful for dealing with that side of the mess (though I suppose a rate cut would help). OFHEO might have a role to play, though I haven't thought this all through.

market update
Asian markets are off 3%.

Why, yes, I should be going to bed.

capital gains taxes
I want to re-float an idea I mentioned in April, but with more numbers. (I like numbers.)

The idea, again, is that we make a tax that is savings-neutral by having you index the cost basis of long-term capital gains, but have you then pay regular income tax on it. This seems particularly satisfying to me in the case of an individual earning money from trading on a frequent basis; economically, it seems to me that the money you make in excess of the risk-free interest rate is the actual gain attributed to your labor, rather than a simple decision to defer spending. The decision as to whether to defer spending is not affected by taxes up to the point at which you simply earn the risk-free interest rate.

The best argument against this is that it would be complicated — though I raised an economic point in the April post, and have given no more thought to it since then; I still suspect it's invalid — but I don't imagine this adding an appreciable amount of complexity to the tax code. I imagine the 1040 instructions would be supplemented by a table like this:


When you report capital gains, you're already asked for the date of acquisition. If you buy a stock in 1997 for $100, it's not that hard to look up in the table that we're treating that as $140 in current dollars; if you sell it in 2007 for $200, add $60 to your Adjusted Gross Income.

To keep things this simple, your cost basis only accrues interest at midnight on January 1; this would create some preference for buying late in the year and selling early in the year, and I'm only giving credit for entire calendar years in which a position is maintained in part to reduce the value of exploiting that distortion, which I think is, on a practical basis, pretty small if you have to hold the position for a full calendar year in order to realize it. The chart starts in 1990 largely because that's the most recent time we went from a tax regime in which capital gains (as measured as though dollars in one year were the same as dollars in another) were treated the same as new income to one in which they were not; my sense of fairness wouldn't be too aggrieved if we simply said that any position established before 1990 is priced as though dollars before that point were constant, so that a position established for $100 in 1970 is treated as $195 in today's dollars; it would be more fair, probably, to extend the table back, though, and not too complicating either. So whatever.

Thursday, August 16, 2007
today in Finance
The three-month treasury bill, which has seen its yield drop significantly in the last week, gapped thirty some basis points lower early this morning, but returned to a mere 20 bp lower by the close, yielding, according to Bloomberg, 3.87%. The stock market closes later than the bond market, and stocks rallied hard after the bond market closed; I would guess yields on treasury bills will come back a bit more tomorrow morning — especially if someone starts a rumor that the U.S. Treasury has significant sub-prime mortgage exposure — but international markets are doing the sorts of things that make one reluctant to put any kind of conviction into guesses of that sort.

Indeed, it was only right before the stock rebound this afternoon that Reuters put out an item with the title, "Stocks may have more downside: technicians":
NEW YORK (Reuters) - The S&P 500's (.SPX: Quote, Profile, Research) drop on Thursday of more than 10 percent from its July 19 record finish is a decisive break that may induce more downside for U.S. equities and possibly stall the bull market's run from late 2002.

Market technicians consider a 10 percent decline from the highs in an index or a stock as a sign of a corrective pullback that can either be followed by a resumption of another leg-up or an even deeper decline.
Yeah, because technicians, you know, they're useful like that.

And if there's just not enough pain in your life, somebody singing under the name of "Merle Hazard" has inflicted a song on the world "very loosely inspired by [a song by Tammy Wynette]". I disclaim any consequences from the misuse of that information.

Options Expensing
He didn't get the acquittal last week he was seeking, but the backdating defense mounted by former Brocade CEO Greg Reyes at least served the purposes of clarity. His team settled on an argument that using so-called "lookbacks" to create in-the-money options had been a routine, open procedure at Brocade, innocently aimed at winning and keeping valued employees (a story that seems to square with the facts).
So starts Holman Jenkins's column (link for subscribers) in yesterday's Journal.

A few paragraphs later:
If "in the money" options were a useful tool, then why not just issue "in the money" options and take the expense and rely on the markets to see through it?

Here we reach a question without which a historical verdict on backdating, if not a legal one, isn't complete. And a related question: Given the immateriality of options expensing, why did so many tech companies fight tooth and nail to oppose it for so long?

Yes, expensing would have meant tiresomely highlighting for analysts and investors the purely notional non-cash nature of the charge. But guess what? That's exactly what thousands of companies now do as matter of routine since expensing became mandatory, and the markets have digested the change without a hiccup.
Exactly right, so far, and that's actually the point I wanted to highlight.

It seems likely that, during the bubble and its aftermath, tech companies, their investors and analysts were in consensual alignment on the undesirability of introducing confusion into quarterly reports by expensing some options and not others. But there's also the fact that the then-raging battle over whether options should be expensed was driven partly by a motive to demonize options rather than by the pros and cons of accounting logic.
Is that how he remembers it? He gives a single weak example, which I won't copy here. But it seemed to me that people I discussed the issue with, not to mention Warren Buffett, acknowledged that sometimes options are a fine expense to incur, especially for start-up companies with financing issues. But that doesn't mean that something of value given to an employee in partial exchange for his services isn't an expense.

Wednesday, August 15, 2007
a couple quick notes
Ima go to bed soon, but thought I'd observe a couple factiods: first, the spread between the two-year spread and the two-year treasury yield has hit 65 bp, and seems to just keep climbing. Second, while the Fed hasn't lowered its stated target, the actual overnight rate was 4.68% last weekend, 4.81% Monday night, and 4.54% last night. I don't know how much of this is a lack of fine control and erring on the side of liquidity and how much is a covert sense that they want to lower the interest rate on overnight borrowing for a while, but don't want to subject the market to an announcement that they're raising the target back to 5.25% when they think that's the thing to do.

Tuesday, August 14, 2007
An exchange for non-public stock
An electronic platform is being launched for the efficient trade of shares in unregistered securities.
Any private firm can list on Nasdaq's new platform, which is called the Portal Market, and raise money by selling stock to an elite group of shareholders. These companies would remain private and not have to make public their financial statements or submit to federal regulation, such as the Sarbanes-Oxley corporate accountability law.

the Greenspan put
There has been a fair amount of talk lately about fed responses to market downturns; indeed, there has been some criticism of a "fed put" or "Greenspan put" whereby the fed stands ready to bail out investors, and thereby creates a moral hazard. (Though it has some cheerleaders. Incidentally, it's entirely acceptable to me that the intricacies of United States monetary policy are decoupled from the whims of Jim Cramer's pharmacist. If you don't know what I'm talking about, never mind.) I'm not sure whether the fed really tries to bail out markets or not, but the main purpose of this post is to insist on the distinction between that concept and the fed's inclusion of the effect of financial downturns on the real economy into its considerations when formulating monetary policy.

While the fed sets a target for — and keeps a pretty good handle on — the interest rate at which big, safe banks lend each other money overnight, the actual ease and expense with which companies making investments (or consumers making purchases) borrow money are determined in the markets. When bond markets and stock markets tumble, that has an impact on the economy; a fed funds target that might have been neutral before, if maintained, will be contractionary when the neutral rate decreases. The fed's job is to maintain the stability of the value of the dollar, and it can't simply ignore major factors that influence how that is to be done; as long as it's targetting an interest rate, it is absolutely affected by financial markets.

Does that — the fact that, in the event of a market downturn, the fed will cut rates — encourage risk-taking in advance? Probably, but not in excess. The optimal amount of risk to take is not the answer to "what would be the optimal amount of risk to take if the Fed kept its head in the sand when the markets dropped?" In an efficient world, in fact, the amount of risk taken optimizes "the optimal amount of risk to take if the Fed responds in exactly the right way to maintain the stability of the currency." If that, in fact, is all the fed is doing, then responding to it is correct; imagining that short-term interest rates are pre-ordained is, in fact, likely to lead to excess caution.

That's not to say the fed should try to bail out investors. If the fed is thinking, "a 25bp cut would restore neutrality, but would still leave investors with big losses, while cutting rates 50bp would be a bit inflationary but would soften the blow to investors," their job is to cut rates 25 bp. A bigger cut, aside from creating the aforementioned moral hazard, sows the seeds of the next cycle of excess. The best thing for the fed to do is to provide a stable currency; if they can keep an even keel while everything else shifts around above deck the economy has a much better chance of reequilibrating in a healthy way than if they keep confusing price signals.

As I noted two weeks ago, this is Bill Poole's take on it as well. This makes it easier for me to sleep well at night.

news links
Oh, boy, where to begin?

Well, we ought to note how the credit crunch has hit the commercial paper market, particularly recently in Canada, though it kind of started in Germany:
Germany's state-owned KfW Group and banking associations this month agreed to cover as much as 3.5 billion euros ($4.8 billion) of potential losses at IKB Deutsche Industriebank AG, after the bank's Rhineland Funding faced difficulty in rolling over commercial paper.
(It comes back to American subprime mortgages there. The German national bank is subsidizing American homeownership!) Some borrowers prudently wrote in options to extend their loans, and they're finding it optimal to exercise those now. And if you avoided lending in the money markets, thinking you could chase yield with "short-term bond funds", well, you know what chasing yields has resulted in recently.

Monday, August 13, 2007
the market today
After the Fed's operation on Aug. 10, the funds traded close to zero percent, pushing the weighted average to 4.68 percent, according to the central bank.

The London interbank offered rate on the dollar fell to 5.77 percent from Aug. 10, when it was 5.96 percent, the highest since January 2001, the British Bankers Association said.
It was basically a return toward normalcy today; three month bills moved to a yield 14 bps higher than they had been, closer to the fed funds target and the rest of the curve.

The fed reports that the effective fed funds rate for last Thursday was 5.41%. One of the more jarring figures from that table is the four-week treasury yields for the last three days of the week:

4.94 4.60 4.28
Um, yeah. But what most surprise me are the daily closing yields for BBB corporate bonds for the week:

6.61 6.60 6.71 6.70 6.69
Complete equanimity. Go figure.

Saturday, August 11, 2007
the recent financial turmoil for dummies
A good blog post on how the federal funds market works and recent events provides this:

Friday, August 10, 2007
short-term interest rates
The fed funds rate opened at 6% today, a good 75 basis points above the fed's target, so the fed started pumping in liquidity, and reminded folks that that's what they'd do.
The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets.

The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.
There is, in fact, no there there — the announcement is that the fed still exists, and is doing fed-like things in exactly the way that was to be presumed — but it helps sometimes to remind the markets that the monetary system continues unabated.

There's talk of the fed cutting the target before the next FOMC meeting, and I'm rather not sure that would be wise:
Until the past few days, most monetary policy makers were emphasizing their concerns about mounting inflation pressures rather than problems emanating from the troubles of the U.S. subprime-mortgage market. But that may be changing. "This is a disinflationary event," said economist Richard Berner of Morgan Stanley. "If it continues, inflation risks are mitigated. That gives the Fed and other central banks latitude to step up the timetable for moving rates back to neutral or below neutral if necessary."
Well, maybe. Certainly when the two-year yield drops as quickly and as far as it has, it suggests the neutral interest rate is lower than it might have been before. If the fed is trucking money into the system to keep rates at 5.25%, though, it's not obvious to me what added benefit committing themselves to truck in even more money is likely to have.

More intriguing — and I've seen this mentioned a few different places, but all places our reader(s) might not see — is the idea that the fed might cut the rate demanded at the discount window, which currently stands at 6.25%. In ordinary market conditions, a bank willing to borrow at 100bp above the funds target is giving a hint that it must be in trouble, or other banks would be lending to it. At this point that may not be the case, and providing an easy way for banks to assure themselves that, regardless of what the fed funds market looks like, they can borrow directly from the fed at a premium of only 50 or even 25 bp might be a good idea for a few days, while we wait to see what happens next.

(By the way, the stock market was up for the week. Did you notice that?)

The Volatility Index
     Kent: Professor, without knowing precisely
what the danger is, would you say it's time for our viewers
to crack each other's heads open and feast on the goo inside?
Professor: Mmm, yes I would, Kent.
-- "Homer the Vigilante"

Thursday, August 09, 2007
Another quiet day on Wall Street
The European Central Bank, in an unprecedented response to a sudden demand for cash from banks roiled by the subprime mortgage collapse in the U.S., loaned 94.8 billion euros ($130 billion) to assuage a credit crunch.

The overnight rates banks charge each other to lend in dollars soared to the highest in six years within hours of the biggest French bank halting withdrawals from funds linked to U.S. subprime mortgages. The London interbank offered rate rose to 5.86 percent today from 5.35 percent and in euros jumped to 4.31 percent from 4.11 percent.


The ECB said today it provided the largest amount ever in a single so-called ``fine-tuning'' operation, exceeding the 69.3 billion euros given on Sept. 12, 2001, the day after the terror attacks on New York.
In the US Treasury markets, the yield on the two year note dropped 25 basis points.

Tuesday, August 07, 2007
high-risk consumer lending
The Economist writes "In Praise of Usury":
Is the South African government right to think that credit has gone too far? Rather than relying on theology or theory to answer this question, a recent working paper offers some rare evidence. Dean Karlan, a Yale economist who is co-director of the Financial Access Initiative, and Jonathan Zinman, of Dartmouth College, studied a profit-seeking lender that served some of South Africa's poorer neighbourhoods. Suspecting that its credit standards were too strict, the lender was willing to experiment with a looser provision of credit. It asked its loan officers in Cape Town, Port Elizabeth and Durban to reconsider 325 out of 787 applicants who had narrowly missed out on approval for a loan. The lucky 325 were chosen at random—nothing distinguished them from the remaining 462, except the luck of the draw. This allowed the researchers to establish a causal link between the loan and changes in the lives of the applicants.

Most of the new customers took a four-month loan at an annual interest rate of about 200%: a 1,000-rand loan, for example, would be repaid in four monthly instalments of 367.50 rand. For the bank, the study proved the wisdom of stretching its lending limits. The new clients were profitable, if not as profitable as the borrowers already on their books. The authors reckon the bank made a gain of at least 201 rand per loan.

Did these profits come at the expense of the poor? On the contrary. Despite the demanding terms on offer, those reconsidered for a loan seemed to prosper. Six to twelve months later, they were less likely to go hungry, and their chances of being in poverty fell by 19%. Not coincidentally, they were also more likely to have kept their jobs, perhaps because the credit helped them to overcome emergencies that might otherwise have forced them to abandon their posts. About a fifth of them, for example, spent their loan on transport, such as buying or repairing a car that they might have needed to get to work.

jumbo mortgages
My brother mentioned a piece of news over the weekend by which I believe he meant that Wells Fargo raised its basic jumbo mortgage rate by a dramatic amount last week.
Wells Fargo, one of the nation's biggest mortgage lenders, raised the interest rates on it 30-year, fixed-rate, non-conforming (AKA jumbo) loan to 8 percent last week, up from 6.875 percent. Other lenders followed suit and more are likely to join them.


Jumbos are loans of more than $417,000, the limit observed by Freddie Mac and Fannie Mae, the government sponsored enterprises (GSEs) that buy loans in the secondary markets. Freddie and Fannie don't buy loans above that cap.
Incidentally, if I needed to borrow $500,000, could I break that into a $400,000, conforming first mortgage and a $100,000 second mortgage?
[J]umbo borrowers are paying a point and a half more than those who receive a conforming loan. That's way up from the traditional premium spread of about a half to three/quarters of a point.
That big a spread would make the split worth doing even if you have to pay 11% on the second mortgage.
Even borrowers with shakier credit scores than many jumbo loan applicants can qualify for a prime loan at about 6.75 percent, only 0.25 or 0.30 percent above what more qualified borrowers get, according to Keith Gumbinger, of HSH Associates, a mortgage information publisher.

But jumbo borrowers are paying a point and a half more than those who receive a conforming loan. That's way up from the traditional premium spread of about a half to three/quarters of a point.

Why should jumbos, whose borrowers often boast high incomes and assets, cost more than conforming loans? It's because Wall Street has stopped buying the loans.

Conforming mortgages, or loans below $417,000, carry much lower risk, because Freddie Mac and Fannie Mae guarantee a market for them. In a tighter credit market, lenders are charging more for jumbos because of the extra risk of not being able to sell them to the investment community.
If that's purely liquidity premium, it seems like an awful lot of liquidity premium:
A buyer with a budget of $4,000 a month may be able to afford a $600,000 mortgage at 6.875 percent, but with jumbos up to 8 percent, a buyer with the same budget can only afford a $545,000 mortgage.
I won't get into why the math I'm about to do isn't quite on point, but if an investor can take on an illiquid asset that is likely to rise 10% as soon as liquidity conditions return to normal — and one on which most of the risk can be hedged or diversified — that seems awfully attractive; I'd think if you held onto this for 2 to 3 years, you'd beat LIBOR by 3% per year at low risk, and I'm sure there are ways of leveraging that up.

Or maybe, at the moment, there aren't:
As far as non-conforming loans are concerned, "We are seeing essentially a frozen market," said Jay Brinkman, the Mortgage Bankers Association vice president for research and economics. "When lenders can't get a bid even on the AAA loans, it's a market that has ceased to function."
I still think there's a bit of baby starting to go the way of the bathwater in this market.

global trade
An Indian company is putting a call center in Ohio.
Multinational corporations, of course, have been hanging shingles in the U.S. for years. According to the Organization for International Investment, firms headquartered abroad employ 5.1 million Americans in their U.S. offices. But while these jobs have typically been in manufacturing (think German carmakers' factories in the South), the mix is changing, and more companies are finding that hiring Americans offers distinct advantages. Some companies feel hearing a fellow American makes callers feel more comfortable. Other foreign firms think Americans bring a more entrepreneurial attitude to their work. In Expedia's case, its call-center workers need a firm grasp on U.S. geography.
Of those three reasons at the end of the paragraph, two apply primarily to serving American consumers, so ultimately don't really count as exports, but the "entrepreneurial attitude" is something at which the American workforce is second to perhaps no developed nation and few undeveloped nations, and our human capital is quite attractive in other reasons. We shouldn't be so insecure as to think we have nothing to offer the world.

trade-offs and mixed messages
This series of pages on managing mortgage debt is moderately interesting in and of itself, but I find it more interesting for something else: It consists of "four good ideas and four bad ideas" — which are, in fact, the same four ideas.

Depending on other circumstances, but also individual characteristics — from discipline to risk preferences — what can be a good idea for some people at some times can be a bad idea for other people or at other times.

Wednesday, August 01, 2007
Bill Poole on fed response to market turmoil
The Fed won't try to affect the stock market per se, but will defend the stability of the dollar if a stock market collapse looks to threaten that. So says Bill Poole, anyway. This is what I would want the behavior to be.

Incidentally, this is the policy I think the Fed should have toward just about everything -- including, for example, the dollar's exchange rate.

"the crack"
Futures traders refer to the price difference between the distillates of oil and the price of the oil itself as "the crack" -- it essentially represents the economic value of the "hydrocracking" done by oil refiners. Sometimes traders will bet on changes in this spread; if they think the value of refining will go down, they can buy 3 futures on oil for delivery one month and sell 2 on gasoline and 1 on heating oil for the following month. If they think refining will become more valuable, they can bet the other way.

That's your background for this:
If you're like most American motorists, you've noticed two things lately: Oil prices are at record highs, yet gasoline prices have dropped.

Over the last two months, U.S. crude has gained nearly 25 percent, and is now just pennies away from its all-time high. Yet gasoline futures have lost 7 percent over the same time. Retail gasoline prices have fallen even further, declining 11 percent from the all-time high set in May.
I'm pretty sure it was less than two months ago that I was reading articles about the opposite situation, when the price of the distillates of a barrel of oil were selling for $30 more than the oil, where $10 is a more historically typical level. There was, in fact, an article on trying hard to explain why there wasn't a bigger move to build more refinery capacity, what with it being so profitable and all; they did note that there was no guarantee it would stay at those levels. I looked at the futures at that time, and noticed at the time that December futures for distillates were $13 more than November futures for oil; just six months out, market participants were expecting a reversion to pretty much historical levels. Taking a quick look at futures now, the September oil / October distillates spread is down to $8 a barrel.

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