My Jaded Crystal Ball

Okay, this is wonky.  I’ve been avoiding writing about securitization for awhile because it can even get the best of people that know financial markets. You may remember that some one asked me where the next bubble lurked and I said commodities.  Now, that’s actually a dangerous place for a bubble because commodities are things you eat and things that make your house light up and your car run.  The housing bubble pretty much wiped out middle class wealth in the west.  What would a commodities bubble burst do in the right markets?  Well, think Mad Max or at least The Grapes of Wrath. Conversely, it could lead to a massive drop in key prices like that of oil.  Imagine that one!

Here’s some interesting finds from FT Alphaville on the securitization of commodities. It’s titled “The subpriming of commodities” for effect.

It’s always been common practice for commodity inventory to be financed by banks by being pledged as security for the loans in question.

The problem comes if such enterprises, instead of using the inventory for general business purposes, are encouraged to stockpile for the sole purpose of liquidity provision and the opportunity to punt on the underlying commodities themselves. It’s a process which arguably artificially pumps up demand for the underlying inventory.

Bundle all those loans together, meanwhile — ideally into a product that can be sold to buyside investors seeking exposure to  commodities — and suddenly you’ve got a direct source of funding for an ever-more speculative game.

When it comes to the larger players,  meanwhile, this arguably transcends ‘trade finance’ even further — especially if it involves the setting up of a large number of special purpose vehicles to accomplish the process.

Here, for example, are the thoughts of Brian Reynolds, chief market strategist at Rosenblatt Securities, regarding what’s going on:

A little more than a year ago we picked up on a trend that we termed the “sub-priming” of commodities. Wall Street has been increasingly been doing structured finance deals wrapped around commodities, and this has added a bid for them while also making them vulnerable to downdrafts.

We know that many equity investors think (or at least hoped) that, after the disastrous record of wrapping pipeline and telecom assets in the 1990’s and sub-prime housing in the last decade, financial market reforms such as Dodd-Frank would have eliminated structured finance as a macro driver. When Dodd-Frank was proposed it envisioned standardized derivatives being placed on exchanges and clearinghouse. We felt it would encourage more non-standardized, exotic, and opaque structures to be created, and in the two years since it was enacted that’s what seems to have happened.

Important trends indeed. Yet, as Reynolds also notes, they’re also very hard to quantify given they mostly occur off-balance sheet:

This process is virtually impossible to quantify. We know that’s a disappointment to equity investors who are used to dealing with voluminous information, but that’s the nature of structured finance. Many structured finance deals are private in nature. As such most people, even those in the credit markets, did not know the full extent of the structuring going on in the 1990’s or the last decade until those firms, which were trapped by “Special Purpose Vehicles” (SPVs), such as Enron, WorldCom and Citigroup, became forced sellers. But over the last year we’ve heard more and more anecdotal evidence of Wall Street increasingly structuring commodity deals, such as structured notes and swaps and even using commodities as collateral.

In Reynold’s opinion — even though he’s not a commodity expert per se — this activity significantly increases the risk of a sharp drop in oil in the coming year, especially since structured finance transactions usually come with caps and floors, which act as important support and resistance levels.

That’s an interesting analysis for oil or copper.  However, what happens if the commodities in question happen to be food?  The only place this used to happen significantly was the gold market.  Actually, it’s understandable for oil too.  But is Wall Street so hungry for  financial innovation that they’re willing to bet the world’s food supply on it?  Yes, of course.  They’ve already done it several times.  History teaches us that it drives the prices up to unreasonable and unsustainable levels that take all kinds of people down when prices collapse.

Here’s an interesting bit on a contango that happened in the wheat market that already led to a food price crisis in 2007-2008.  This one had the Goldman Sachs brand all over it.  Last year, a similar situation occurred with the Oil Market and the same player.

On Monday, April 11, Goldman Sachs told its clients to sell commodities, and the market reacted with a $4 tumble in the price of West Texas Intermediate (WTI) crude oil and sell offs in other commodities.

On Thursday, April 14, the leaders of the “BRICS” nations (Brazil, Russia, India, China and South Africa), meeting in Sanya, China, continued to press for a new world monetary system that has a much lower reliance on the dollar, and called for stronger regulation of commodity derivatives to dampen excessive volatility in food and energy prices.

We are in another commodity price run up, like that experienced in the 2005-2008 period.  Such commodity price frenzies have devastating consequences for the world’s poor who, in some instances, already spend half of their income on food.  Today, in the U.S. itself, the rise in the price of gasoline to more than $4 per gallon threatens an economy still struggling to free itself from the still lingering effects of the last bursting bubble.

It appears that the Western economic systems have become ever more volatile over the past decade.  That is, bubbles, followed by severe contractions, are appearing more often and with increased severity.  This is in stark contrast to the dampening of the business cycle we observed, and celebrated, in the 1980s and 1990s.  So, what changed?

In Harper’s last July, Fredrick Kaufman wrote an article entitled The Food Bubble, which explained the reasons for the run up in agricultural commodity prices just prior to the ’08 financial meltdown and worldwide recession.  The popular business media gave the article short shrift.  But, most of what Kaufman observed as the causes of the commodity price run up in the ’05-’08 period is now being repeated, a short three years later.

I’m finding all this interesting as I watch Jamie Dimon squirm on the big hedge loss reported by JP Morgan.  That’s the $2 billion mark to market loss that makes me thing we’re on the verge of 2007 redux.  Specifically, the market concentration is incredible because “the whale” created a huge problem for tons of hedge funds.  Also, the regulator appeared to be asleep at the switch.  You remember are old friends the Credit Default Swaps?

99 per cent of all CDS trades live in an information warehouse called DTCC, to which the regulators of the banks have access in however much detail they want!!! What kind of regulator doesn’t go and look at the that, when the mere public, aggregated info shows this?

Go check out the accompanying graph.

Anyway, I’m not going to get long winded and all financial economist on you, but sheesh, how many times does history have to repeat itself in markets before we get some one to do something useful?   I’m just reminded of all the little canaries that died on the way to the big 2007 blow up that people ignored.   How many canaries have to die this time out before we get another big one


Vegas Gambling vs Wall Street Gambling

One of the things that has always struck me about folks that treat the financial sector like any other business venture is the lack of understanding of what the finance sector really does.  There are several basic functions if you read the literature.  The banking industry originally evolved from goldsmiths that would safekeep gold for people.  This eliminated the need for every one to keep a small army with them at all times to stop robbers from stealing all their gold.  Goldsmiths eventually learned that a fairly sizable chunk of that gold never left their premises and found out they could lend some of it out for a return and not be caught short.  That eventually lead them from being gold babysitters to lenders.  Then, we eventually got around to trying to find some financial contracts that would help us if the worst happened by buying insurance.  From these sets of agreements, we now have exotic derivatives, financial innovations, credit default swaps, and a host of other banking services.  The basics things that the banking sector does is help you save or store up future purchasing power, borrow or lend purchasing power, and help move money around from place to place via the payment systems.  That would be check clearing and ATMs and things like that.  The Federal Reserve Bank was set up to handle that latter function but most of that function has been privatized since regional banks now clear checks and there are private clearing houses for Automated Payments.  The Fed’s role is now fairly small.  It still pushes cash from the US Mint/Treasury into the banking system and its FedWire system still handles a huge number of wire transfers between banks.  If banks won’t lend to each other via the Fed Funds market, it is also available to lend money at the discount window.  That used to be only available to member banks but it’s now open to a lot more institutions.

Bankers usually make money by charging fees on their services, interest rates on their loans, and then they make arbitrage profits if they invest.  For years, that last function wasn’t a big deal for bankers because laws stopped them from investing in anything very creative.  Laws have changed a lot over the last 10-20 years and even if commercial banks can’t make risky investments, they are likely to be part of a bank holding company that owns some subsidiary that can.  Allowing banks–who basically still have the role of “safekeeping”–to gamble has been a huge mistake.  Besides the lax laws, they have had a lot of cheap cash available because of Greenspan’s relatively lose monetary policy during the last years of his tenure and they’ve been able to reduce their risk by having deposit insurance which covers their deposits in case of default.  There has also been an increase in “financial innovations” and techniques which serve as pseudo insurance but generally come in the form of very hard-to-price assets so they can be risky. Many banks don’t use them just for hedging which is this risk management approach to their use.  A lot of banks just plan gamble.  We’ve definitely seen banks misjudge risk and rely heavily on what I would consider gambling activities.

So, I’ve worked back of the house at a casino and I’ve worked in banking and of course, I’m a financial economist so I’ve got a little knowledge and experience on all fronts.  The one thing that I will say about gambling in a casino is that a good time is had by all, every one understands it’s gambling, and the gambling industry hires a lot of people in the process that do fairly straightforward jobs.  They only get tips if the customers say so.  Bonuses for random wins are de rigueur in the finance sector.  Silly thing is that most financiers think they’ve actually earned those bonuses for doing some miracle.  There’s a few good reads to let you know exactly how misguided they are on their opinions of their skills.  The first is anything by Nassim Nicholas Taleb who is a practitioner of financial mathematics and a former Wall Street trader. His book “Fooled by Randomness” is just full of examples of the fallacies that drive Wall Street Bankers into thinking too highly of themselves and paying themselves based on gambling and randomly hitting the jackpot.   You can also read anything by Nobel Prize winner Daniel Kahneman.   Actually, you can watch them both talk about these things in a video at Edge in a program called Reflections on  a Crisis.

Kahneman explains why there are bubbles in the financial markets, even though everyone knows that they eventually burst. The researchers used the comparison with the weather: If there is little rain for three years, people begin to believe that this is the normal situation. If over the years stocks only increase, people can’t imagine a break in this trend.

Taleb speaks out sharply against the bankers. The people in control of taxpayer’s money are spending billions of dollars. “I want those responsible for the crisis gone today, today and not tomorrow,” he says, leaning forward vigorously. The risk models of banks are a plague, he says, the bankers are charlatans.

It is nonsense to think that we can assess risks and thus protect against a crash. Taleb has become famous with his theory of the black swan described in his eponymous bestsellers described. Black swans, which are events that are not previously seen–not even with the best model. “People will never be able to control a coincidence,” he says.

Okay, so that’s actually the background to something I want to point you to  on VOXEU called “What is the contribution of the financial sector?” by Andrew Haldane.  I think it’s a good thing to look at because we need to establish some basic knowledge and laws that separate the speculative activities from the banking activities that actually may provide value. (Although I still could argue that privatizing the payments system may prove risky and foolish some day, there are some things that banks do that are useful.)  This way we can see the damage done when so many politicians essentially empower the gambling aspects.  Another offshoot is our tax policy which favorably treats capital gains without any reference to the source of the profit.  People that run businesses that enhance economic welfare of every one are taxed at the same favorable rate as those that basically gamble resources away.  That’s a very bad incentive system.  Haldane points out the difference between managing risk of financial contracts and risk-taking that is basically gambling and how much of the Western nation’s financial sector has morphed more into a gambling sector than a financial services provider.

But crisis experience has challenged this narrative. High pre-crisis returns in the financial sector proved temporary. The return on tangible equity in UK banking fell from levels of 25%+ in 2006 to – 29% in 2008. Many financial institutions around the world found themselves calling on the authorities, in enormous size, to help manage their solvency and liquidity risk. That fall from grace, and the resulting ballooning of risk, sits uneasily with a pre-crisis story of a shift in the technological frontier of banks’ risk management.

In fact, high pre-crisis returns to banking had a much more mundane explanation. They reflected simply increased risk-taking across the sector. This was not an outward shift in the portfolio possibility set of finance. Instead, it was a traverse up the high-wire of risk and return. This hire-wire act involved, on the asset side, rapid credit expansion, often through the development of poorly understood financial instruments. On the liability side, this ballooning balance sheet was financed using risky leverage, often at short maturities.

This is an important statement because not only did political institutions loosen laws or not put in place laws to stop this from happening, but when it happened, we all paid and they’ve ignored how costly this was to every one else.  Plus, they keep wanting us to sacrifice instead of the people that broke the economic growth machine. The basic narrative is that these folks gambled with others’ money and the government had to pay the house.  This is wrong in every sense of what is and isn’t moral.  Haldane argues that risk-taking is not a value-added activity for banks and backs it up with empirical evidence.

The financial system provides a number of services to the wider economy, including payment and transaction services to depositors and borrowers; intermediation services by transforming deposits into funding for households, companies or governments; and risk transfer and insurance services. In doing so, financial intermediaries take on risk. For example, when they finance long-term loans to companies using short-term deposits from households, banks assume liquidity risk. And when they extend mortgages to households, they take on credit risk.

But bearing risk is not, by itself, a productive activity. The act of investing capital in a risky asset is a fundamental feature of capital markets. For example, a retail investor that purchases bonds issued by a company is bearing risk, but not contributing so much as a cent to measured economic activity. Similarly, a household that decides to use all of its liquid deposits to purchase a house, instead of borrowing some money from the bank and keeping some of its deposits with the bank, is bearing liquidity risk.

Neither of these acts could be said to boost overall economic activity or productivity in the economy. They re-allocate risk in the system but do not fundamentally change its size or shape. For that reason, statisticians do not count these activities in capital markets as contributing to activity or welfare. Rightly so.

What is a demonstrably productive economic activity is the management of risk. Banks use labour and capital to screen borrowers, assess their creditworthiness and monitor them. And they spend resources to assess their vulnerability to liquidity shocks arising from the maturity mismatches on their balance sheets. Customers, in turn, remunerate banks for these productive services.

The current framework for measuring the contribution of financial intermediaries captures few of these subtleties. Crucially, it blurs the distinction between risk-bearing and risk management. Revenues that banks earn as compensation for risk-bearing – the spread between loan and deposit rates on their loan book – are accounted for as output by the banking sector. So bank balance-sheet expansion, as occurred ahead of the crisis, counts as increased value-added. But this confuses risk-bearing with risk management, especially when the risk itself may be mis-priced or mis-managed.

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Markets (e.g. Herds of PEOPLE) aren’t very Rational a Lot of the Time

The Confidence Fairy is coming for your Savings!!!

One of the primary reasons I didn’t do an investments specialization for my PHD in financial economics is the overwhelming and pervasive group think on Rational Expectations or what’s called the Efficient Market Hypothesis. I’ve never really bought into this.  I think it is more an occasional circumstance or specific market behavior at that point when everything is going just dandy which is why I am more the sunspot equilibrium type.   I never found compelling reasons for the efficient markets view to be considered an overarching framework for all circumstances.  That kind of unorthodox outlook doesn’t buy you much print space in finance journals which means no tenure for you cupcake!!  (Although for some reason I can get it passed reviewers when it’s couched in the term “bubble” which is so very sunspot.)

Economists have become a little more accepting of the warts and  faults inherent in the hypothesis–notice it is still a hypothesis and not a theory–but finance people still have a tendency to worship at its alter.  Economists started out as philosopher social scientists–which is also why the big money is in finance–so they’re a little more open to the idea that markets aren’t all that efficient all the time.  I linked to the Wikipedia explanation of the idea for you which is adequate for our purposes.  The deal is when you build rational expectations into an economics model or investment model this is what you assume.

To assume rational expectations is to assume that agents‘ expectations may be individually wrong, but are correct on average. In other words, although the future is not fully predictable, agents’ expectations are assumed not to be systematically biased and use all relevant information in forming expectations of economic variables.

This basically rules out wrong group think that won’t deny “relevant information”.  If that was the case in reality, there would be no holocaust deniers, evolution deniers, climate change deniers, or flat earthers of substantial numbers to influence the average.  Basically, we’d have to accept the “average” rationality of today’s Republican Party and given the existence, electability and popularity  of Rick Santorum, Michelle Bachmann, and Ron Paul, I’ll rest my case and reject that. We have a major political party that’s basically a cult of irrationality these days.

There are two really important real life phenomenon that make that assumption look really bad in finance research.  One is a little paradox called the Home Bias Puzzle where research has basically shown that most people will still buy investments from their own country despite the availability of better deals abroad. The second is momentum.  This is the pack animal behavior in the market where you see something hit the market and suddenly every one is moving that direction when it doesn’t make much sense on a fundamentals level.  This is when I sell all my stock holdings.  The little voice inside of me will go:  “wtf is this rally for?  The economy isn’t all that great!  I think I better get out of here before they realize they’re all on something!”  This is how I’ve managed to remove my “ass”ets and avoid the major crashes since way back in the 1980s.

Whenever you get a financial crises or financial bubbles, you tend to get the panicked cow phenomenon in that if one is spooked the rest chase wildly along.  They’ve even programed this behavior into their computers oddly enough. Oh, and btw, none of the strategies and no market guru like Cramer or Buffet or Jesus your neighborhood grocer could ever be right and beat the market consistently if the financial markets were truly rational and efficient.  That’s another story, just accept my word for it right now.

I took an Advanced Investments Seminar because I had to for my final elective having no other choice and was subjected the entire semester to the work of Eugene Fama whose big fat head will be in Denver with me next month.   Fama is considered the father of modern finance and efficient markets is his dogma. He’s one of the jerks that was drinking the two overly expensive bottles of wine with Paul Ryan that BB wrote about awhile back. The other jerk being his son in law John Cochrane whose asset pricing models always assume the same efficient markets hypothesis.  The two of them have dominated finance for decades now and in my mind it’s held the entire field back and caused much damage in the real world. I had to recreate the research in many of Fama’s seminal papers and the most noticeable lunacy to me was how his data sets back then always skipped the Great Depression Era. His data sets usually involved equity market indices like the Dow Jones average during periods that excluded financial panics.  That never struck me as honest, but then, I’m not one of the Finance gods–there really are no goddesses–and so I don’t really get a say.

Again, I don’t want to teach this stuff so I generally avoid classes where the textbooks ooze it. I  inherited the sincerity gene from my father which causes me to go apostate on my students which may help their critical thinking skills but won’t further the ass-kissing group think skills required in today’s finance jobs. Also, I’m late to academic life and spent the 80s doing hedging, forecasting interest rates, pricing financial assets and liabilities, and generally surrounded by rational senior management thoughts  like:  “Gee, we’ll get bigger if we do this merger and I’ll get a bonus!  Who cares if it drags our income and balance sheet into the depths of hell?” I can also give you examples from the 90s too.  Irrational market decisions ooze from marketing divisions and departments daily.

So, behavioral finance and economics looks at the herd mentality that was originally identified as “animal spirits” by J.M. Keynes during the time period and stock market behavior that Eugene Fama likes to systematically ignore.  Keynes didn’t have the luxury of skipping over the data of the Great Depression. The kind of apostate philosophy that drives me actually has a label and basically looks at decision making under risky and generally unpredictable situations.  In a lot of cases, people don’t make decisions in these circumstances rationally.   BB and I have been having some phone conversations about the topic because as a psychologist, she’s very interested in human behavior.  Human behavior very much causes people to do different things under times of risk.  Let’s face it, people and hence markets aren’t very rational a lot of the time when they’re panicked about losing their jobs, their businesses, their homes, and their savings. They’re a lot more efficient, rational decision makers when circumstances are not risky and unpredictable or when the biggest decision variables are messy and not well understood. Then, there’s the existence of powerful “deciders” who think their egos have a better understanding of alchemy than their necromancers and are on the look out for narratives to reinforce their beliefs.  Remember the word narrative because it plays a big role here in where I’m going and where Robert J. Shiller went.

So, this background chat brings me to the topic of this blog post which is a project syndicate article by Robert J. Shiller who is a very well respected economist and dabbles in behavioral economics. He is well known for the Case-Shiller index which measures activity in the housing market in some key markets. (BTW, Case is a big sunspot equilibrium sort as is Douglas Diamond who the Republicans ran out of the District earlier this year.)  I’ve taught out of his textbooks.  He teaches at Yale and co-authored a book with Nobel Prize winning George “market for lemons” Akerlof called “Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.”.  His voice is important in this day and age of people chasing confidence fairies and reacting to events here and in Europe rather irrationally which frequently happens during periods of great uncertainty and increased risk.

I’m consistently amazed at the success of the narrative that Republicans have managed to push into the national psyche that we’re over taxed and that our national debt is horrendous as its never been before and that our children and grand children will be crushed by it.  You even hear President Obama spew the stuff and he should know better given his ability to access any of the aforementioned economists by phone easily.  As I’ve said before with the use of data and nifty graphs,  the debt was far worse after World War 2, the tax rates far higher and none of us or the US economy was the worse for it.  Really, would you have rather they not borrowed money to fight World War 2 and lived with those results instead? We had nothing but debt when started out as a country and also after the Civil War.  As long as you have lots of really high quality assets and people and the power to tax and print money, it’s NO BIG DEAL! Greece does not have Bill Gates and Microsoft continually pumping out huge amounts of value. We have him and lots more like them!  People have been reacting to ideological nonsense and narratives.  We have a failure of governance and policy because of this. That’s hardly rational.  It’s also causing bad effects in our home prices, the value of our savings, and our ability get and keep jobs.

So, here’s Shiller writing on “The Great Debt Scare” about how this ideological nonsense has shaken consumer confidence in both Europe and the U.S. causing a “perverse dynamic” that has been discouraging consumption and investment which has brought about economic weakness.  What this basically shows is that the psychology of self-fulfilling prophecies is alive and well in financial markets. Rational Markets my swamp people ass!

We now have a daily index for the US, the Gallup Economic Confidence Index, so we can pinpoint changes in confidence over time. The Gallup Index dropped sharply between the first week of July and the first week of August – the period when US political leaders worried everyone that they would be unable to raise the federal government’s debt ceiling and prevent the US from defaulting on August 2. The story played out in the news media every day. August 2 came and went, with no default, but, three days later, a Friday, Standard & Poor’s lowered its rating on long-term US debt from AAA to AA+. The following Monday, the S&P 500 dropped almost 7%.

Apparently, the specter of government deadlock causing a humiliating default suddenly made the US resemble the European countries that really are teetering on the brink. Europe’s story became America’s story.

There is something—most likely hard wired–in people that creates highly irrational narratives ( we call them frames) to justify stuff that occurs even in the face of incredible evidence against the frame. It’s why there are so many evolution and climate change deniers. The narrative makes them feel better than the reality.  We all edit out the data coming from those periods of intense irrationality–like Fama did with the Great Depression–to justify our pet juicy rationalizations.  It’s like the post-trauma narrative you create to justify something you did when your lizard brain kicked in. Republican and so called conservative operatives seem to thrive on spinning lizard brain activity into parable like narratives to hone their advantage.

Changes in public confidence are built upon such narratives, because the human mind is very receptive to them, particularly human-interest stories. The story of a possible US default is resonant in precisely this way, implicating as it does America’s sense of pride, fragile world dominance, and political upheavals.

Indeed, this is arguably a more captivating story than was the most intense moment of the financial crisis, in 2008, when Lehman Brothers collapsed. The drop in the Gallup Economic Confidence Index was sharper in July 2011 than it was in 2008, although the index has not yet fallen to a lower level than it reached then.

So, what do these current confidence surveys tell us according to Shiller?

The timing and substance of these consumer-survey results suggest that our fundamental outlook about the economy, at the level of the average person, is closely bound up with stories of excessive borrowing, loss of governmental and personal responsibility, and a sense that matters are beyond control. That kind of loss of confidence may well last for years.

That said, the economic outlook can never be fully analyzed with conventional statistical models, for it may hinge on something that such models do not include: our finding some way to replace one narrative – currently a tale of out-of-control debt – with a more inspiring story.

So after our lizard brain causes fight or flight, the Captain Picard part of our brain tells us to make our narratives so. What we are building into our psyche is not any kind of analysis based on rational views of historical data, economic theory, or for that matter, common sense.  What we are building into our psyche is a narrative that isn’t very rational and that’s impacting our behavior and the behavior of markets.  Now, if we could just stop the press from reinforcing all the irrational crap out and about these days maybe we could sit down, take a few deep breaths, and peel back the layers of skin on the onion of those destructive narratives.  Think about it. Yes, the Garden of Eden story is a great narrative, but what explains the carbon dating data on rocks, the dinosaur bones, and the vast existence of several varieties of protohumans’ remains better?  Dinosaurs and Neanderthals in the Garden of Eden with Adam and Eve (not Steve or Lilith) or the Big Bang THEORY and the THEORY of evolution?  What explains the financial crisis and the fallout better?  The narrative that it’s too much government debt, too high taxes, and too much  regulation that were all at much lower levels now than after the World War 2 economic boom or excessive speculation in the markets and exotic, difficult to price, unregulated derivatives, NINJA loans, government encouragement of monopoly and oligopoly power, and  fiscal policy known to suppress economic growth? Your choice.  Theory or comforting bed time tale.


Tuesday Late Afternoon Blues

Minxy’s out surfing samsara this afternoon.  I’m trying to muster up some good vibes today for her as she faces all the “it’s a short life” kind’ve stuff that goes on with the early passing of a friend. As for me, I seem to be entering my blue period. Maybe it’s because I just get cannot this friggin’ gravity model specified correctly and maybe it’s just my parameters that are tangled up and BLUE Okay, you won’t know what BLUE means for a regression estimator (Best Linear Unbiased Estimator  e.g. BLUE) unless you’re as steeped in econometrics as I am but it’s a good play on words.  REALLY. Chuckle sympathetically because I need it today.  I wish I could like football like normal people.  Instead, I follow the bloodsport of politics and its inherent nastiness these days and I have way too many degrees in the dismal science.  The results are bound to get to you one way or another.

So this little piece is about the U.S. and blue to match my mood.   I’m going to start out with some blue estimators of a different sort.

There was a bit of poll that showed a glimmer of true hope instead of the manufactured sort out today.  Recent entrant into the Massachusetts Senate Race, Elizabeth Warren, is polling ahead of glamor boy Republican Scott Brown who replaced the late Ted Kennedy.

Elizabeth Warren has had an incredibly successful launch to her Senate campaign and actually leads Scott Brown now by a 46-44 margin, erasing what was a 15 point deficit the last time we polled the state in early June.

Warren’s gone from 38% name recognition to 62% over the last three months and she’s made a good first impression on pretty much everyone who’s developed an opinion about her during that period of time.  What was a 21/17 favorability rating in June is now 40/22- in other words she’s increased the voters with a positive opinion of her by 19% while her negatives have risen only 5%.

The surprising movement toward Warren has a lot to do with her but it also has a lot to do with Scott Brown.  We now find a slight plurality of voters in the state disapproving of him- 45%, compared to only 44% approving.  We have seen a steady decline in Brown’s numbers over the last 9 months.  In early December his approval was a +24 spread at 53/29.  By June it had declined to a +12 spread at a 48/36.  And now it’s continued that fall to its current place.

Meanwhile, the mixed up mess of Republican presidential candidates is shaking up to a two white man race.  Gallup reports that Perry has a better chance than Romney of sealing the nomination at this point, but Romney has a better chance than Perry to beat Obama.  No surprises there.

Rick Perry leads Mitt Romney by 31% to 24% in a new USA Today/Gallup poll of Republican presidential nomination preferences. The two are well ahead of the rest of the GOP field, with Ron Paul the only other candidate in double figures.

Perry seems to have momentum, but that could be slowed in the coming weeks if Republicans start to perceive that Romney is more electable in the general election. The new poll finds the slight majority of Republicans, 53%, prefer to see their party nominate the person who has the best chance of beating Obama, even if that person does not agree with them on almost all of the issues they care about. Forty-three percent would prefer a candidate who does agree with them on almost all of the issues, even if that person does not have the best chance of winning in November 2012.

Romney currently edges out President Barack Obama by 49% to 47% in national registered-voter preferences for the November election, while Perry trails Obama by 45% to 50%. However, neither Romney nor Obama is ahead by a statistically significant margin.

It’s no wonder Perry wants out of Texas.  This poll should direct Perry into the Even Cowgirls get the Blues line.  Texans do not like Governor Goodhair if you believe PPP’s numbers.

The poll, released Tuesday, showed Perry with a negative approval in Texas: while 45 percent of the state’s voters approve of Perry’s job performance, 48 percent of Texas voters say they don’t approve.

Obama should have The Blues over this poll from Marist.  Will this lead to calls for a primary challenger on calls on him to pull an LBJ?

President Barack Obama faces a litany of bad news.  The president’s job approval rating, his favorability, and his rating on the economy have hit all-time lows.  To compound matters, three in four Americans still believe the nation is in a recession and the proportion who thinks the country is moving in the wrong direction is at its highest point in more than a decade.

According to this McClatchy-Marist Poll, the president’s approval rating is at 39% among registered voters nationally, an all-time low for Mr. Obama.  For the first time a majority — 52% — disapproves of the job he is doing in office, and 9% are unsure.

You’ve always known that Wall Street is only True Blue to profits and not the country right?  Grok this headline at Politico via the WSJ.  It looks like a lot of hedge funds were betting the US to lose its AAA standing with S&P.  The SEC is launching insider trading probes.  Can we please get some perp walks now, please?

Securities and Exchange Commission officials have sent subpoenas to financial firms in a probe of whether there was insider trading — betting on a market crash — before the United States’ long-term credit rating was cut by S&P last month, reports The Wall Street Journal.

At issue are trades that were made by hedge funds and other firms shortly before the rating agency Standard & Poor’s downgraded U.S. debt from triple-A to double-A-plus on Aug. 5 and cited the dysfunctional political climate in Washington as one of the reasons.

The Dow Jones Industrial Average dropped 635 points, or 5.5 percent, on Aug. 8, the first day of trading after the downgrade. This was the sharpest one-day decline since the financial crisis in 2008, but it also made bets against the market very profitable.

Securities regulators are looking for firms that bet the stock market would drop — in particular, bearish trades that seem unusually large or were made by firms that typically do not make them.

An SEC spokesman declined to tell The Wall Street Journal which investment firms have received subpoenas.

My guess is it’s the usual vampire squid suspects and all the rest of the guys whose blue balls we pulled out of the bankruptcy fire with TARP and tax dollars. Bets any one?

So here’s the a nifty chart from Paul Krugman–with blue bars–that will make you scream until you’re blue in the face.  Look whose been winning the class war since 1979.  So the deal is not only is their share of income and assets way up, but their after tax income has gone way up too.

Changes in tax rates have strongly favored the very, very rich.

Now, they’re only a fairly small part of the huge growth in the after-tax inequality of income. But tax policy has very much leaned into that growing inequality, not against it — and anyone who says otherwise should not be trusted on this issue, or any other.

So, of course the moment we get a whiff of anything slightly Democratic coming from the President we experience blue dogs howling at the blue moon and the beltway press.

Centrist Democrats, a dwindling breed on Capitol Hill, were quickly faced with another rough choice once Obama went public with his plans: Reject their president or back what Republicans are already calling the largest tax increase in the nation’s history.

Florida Sen. Bill Nelson, who is up for reelection in 2012, has supported raising taxes on millionaires but was still weighing whether he’d support higher taxes on those who make more than $200,000 a year, said spokesman Dan McLaughlin.

Sen. Ben Nelson (D-Neb.), a key moderate who’s up for reelection next year, didn’t mince words: “There’s too much discussion about raising taxes right now, not enough focus on cutting spending.”

But Sen. Jon Tester (D-Mont.), who likely will face GOP Rep. Denny Rehberg in next year’s reelection bid, hedged a bit, saying he backs provisions in Obama’s plan that call for closing tax loopholes that benefit millionaires and corporations

“This plan isn’t the one I would have written, nor is it the one that will end up passing Congress,” Tester said. “But I welcome all ideas to the table so Congress can work together to create jobs, cut debt and cut spending.”

Blue blooded villager David Brooks admits to being an Obama sap and refers to Beltway Bob as “appreciative”.  I prefer the term deep-throating, but hey, there’s a glint of recognition, right? It’s a two for one villager idiot piece! Look! I’ve managed to use some blue language.

Yes, I’m a sap. I believed Obama when he said he wanted to move beyond the stale ideological debates that have paralyzed this country. I always believe that Obama is on the verge of breaking out of the conventional categories and embracing one of the many bipartisan reform packages that are floating around.

But remember, I’m a sap. The White House has clearly decided that in a town of intransigent Republicans and mean ideologues, it has to be mean and intransigent too. The president was stung by the liberal charge that he was outmaneuvered during the debt-ceiling fight. So the White House has moved away from the Reasonable Man approach or the centrist Clinton approach.

It has gone back, as an appreciative Ezra Klein of The Washington Post conceded, to politics as usual. The president is sounding like the Al Gore for President campaign, but without the earth tones. Tax increases for the rich! Protect entitlements! People versus the powerful! I was hoping the president would give a cynical nation something unconventional, but, as you know, I’m a sap.

Being a sap, I still believe that the president’s soul would like to do something about the country’s structural problems. I keep thinking he’s a few weeks away from proposing serious tax reform and entitlement reform. But each time he gets close, he rips the football away. He whispered about seriously reforming Medicare but then opted for changes that are worthy but small. He talks about fundamental tax reform, but I keep forgetting that he has promised never to raise taxes on people in the bottom 98 percent of the income scale.

I nearly had to stop reading the damned thing since I was about to pass out from putting my palm to my forehead just a few too many times.  Yes, it’s turning black and blue. How are we supposed to get grown up discussions about policy when the two largest newspapers in the country insist posting self serving drivel on a near daily basis.

Okay, here’s my last offering which really does show the best of the Red, White and Blue.  Today is the formal removal of DADT.  0penly Gay and lesbian members of our military no longer have to live double lives or be subject to dismissal.

With Tuesday’s repeal of the military’s “don’t ask, don’t tell” policy, gays and lesbians are now free to serve openly in the U.S. armed services.

The U.S. military has spent months preparing for the repeal, updating regulations and training to reflect the impending change, and the Pentagon has already begun accepting applications from openly gay men and women.

It’s events like this that give you a sense that in some way, it’s still

WE THE PEOPLE of the United States, in order to form a more perfect union, establish justice, insure domestic tranquility, provide for the common defense, promote the general welfare, and secure the blessings of liberty to ourselves and our posterity

I’m going to get some iced tea and head back to my trade and foreign direct investment research. But, here’s two of my favorites: Dylan’s Tangled up and Blue done by the Indigo Girls for you on this afternoon in New Orleans under a blue sky.

and every one of them words rang true

and glowed like a burning coal

pourin off every page

Like it was written in my soul from me to you

Tangled up and Blue

I lived with them on Montague Street

In a basement down the stairs

There was music in the cafes at night

And revolution in the air …


Still no answers for the Jobs Crisis

It’s difficult for me to watch the job market continue to dither knowing full well that nothing is being done about it.  Just in case you’ve missed the other headlines today, U.S. jobless claims “unexpectedly” jumped.  It wasn’t unexpected on my part.

Applications for jobless benefits jumped by 43,000 to 474,000 in the week ended April 30, the most since August, Labor Department figures showed today. A spring break holiday in New York, a new emergency benefits program in Oregon and auto shutdowns caused by the disaster in Japan were the main reasons for the surge, a Labor Department spokesman said as the data was released to the press.

Even before last week, claims had drifted up, raising concern the improvement in the labor market has stalled. Employers added 185,000 workers to payrolls in April, fewer than in the prior month, and the unemployment rate held at 8.8 percent, economists project a Labor Department report to show tomorrow.

“We’re seeing so many distortions in the claims numbers week to week that it’s hard to say, but I’m willing to be patient and wait and see,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. “Other reports show an improvement in the labor market. It’s going to take a while to dig out of the hole we have in relation to the jobs the economy lost during the recession.”

Yes, it is a hole, and there’s very little being done to fill it.  There are quite a few factors that contribute to the current appalling job market.  The Fifth Fed District’s Macroblog looks at the contribution of offshoring.  Offshoring basically means that part of a production process is moved to an overseas location.  That can mean anything from a call center to manufacturing of a good.  You can see that the impacted industries include both service and manufacturing sectors.  The nifty table up there in the left hand corner will give you an idea of the impact of offshoring by industry.  The numbers are tabulated from data during the years of 1999 – 2008.  The changes and content of the ‘other’ category is further elucidated in the macroblog piece. It includes another table that you may review too.

Sixty-nine percent of the foreign employment growth by U.S. multinationals from 1999 to 2008 was in the “other industries” category, and 87 percent of that growth was in three types of industries: retail trade; administration, support, and waste management; and accommodation of food services. Some fraction of these jobs, no doubt, reflect “offshoring” in the usual sense. But it is also true that these are types of industries that are more likely than many others to represent production for local (or domestic) demand as opposed to production for export to the United States.

This is a bit interesting.  There are two main types of Foreign Direct Investment that involve ‘offshoring’.  One is called vertical and the other is horizontal.  Horizontal FDI means that one segment of the process is moved to another country but the final good or service still goes to the consumer in the company’s home country.  The last analysis from macroblog implies that a substantial part of that offshoring is actually Vertical FDI.  This means that the company is moving itself over to the country to take advantage of end consumers in the other country.

This finding isn’t surprising if you consider the number of countries that are experiencing booms in the number of middle class citizens.  There are more middle class Chinese than there are US citizens, as an example.  There is also the fact that the middle class in the US has been losing income and purchasing power for nearly 30 years.  It only figures that these companies would look for greener pastures elsewhere.  Why expand here when your customer base is unlikely to be expanding and unable to afford your products in any meaningful way?

Macroblog points out that this is unlikely to explain all the doldrums in the US job market, but it does provide one factor and and interesting one at that.  I would say that this analysis basically says that US businesses are much more bullish on foreign markets than they are on their own. (Capital flows for investment suggest this too.) This should give all of us pause.

Interestingly enough, another FED President also suggested that the economy and the US job markets weren’t as stable as they could be and suggested more stimulus.   Three Fed Presidents rotate in and out of the Open Market Committee–that’s the monetary policy decision body–and each district is a world unto itself in many ways.  Fed Boston is not in the current rotation.

Federal Reserve Bank of Boston President Eric Rosengren yesterday said record stimulus is necessary to spur the “anemic” economy and that raising interest rates to combat increasing food and fuel prices would impede growth.

“With significant slack in labor markets, stable inflation expectations, and core inflation well below our longer run target, there is currently no reason to slow the economy down with tighter monetary policy,” Rosengren said during a speech in Boston.

Not surprisingly, equity markets seemed to be caught a bit off guard with this news.  Right now, I think the market seems to be in one of those periods where it’s not paying much attention to fundamentals. Bloomberg.com notes that Futures Fell on the news. Some times Wall Street thinks as long as their churning out fees and capital gains, all is right with the world.  This is definitely not the case. It does explain why their economists tend to get caught off guard though.  Hello?  Real World anyone?

Stock-index futures dropped after the report. The contract on the Standard & Poor’s 500 Index maturing in June fell 0.6 percent to 1,334.8 at 8:58 a.m. in New York. Treasury securities rose, sending the yield on the benchmark 10-year note down to 3.18 percent from 3.22 percent late yesterday.

Dean Baker from CEPR is pretty pessimistic about the entire thing.

Weekly unemployment claims jumped to 474,000 last week, an increase of 43,000 from the level reported the previous week. This is seriously bad news about the state of the labor market. It seems that the numbers were inflated by unusual factors, most importantly the addition of 25,000 spring break related layoffs in New York to the rolls due to a changing vacation pattern, however even after adjusting for such factors, claims would still be above 400,000 for the fourth consecutive week.

This puts weekly claims well above the 380,000 level that we had been seeing in February and March. This suggests that job growth is slowing from an already weak level. This is news that should be reported prominently.

Unfortunately, the lackadaisical job market is off the front pages. Much of the political focus on the economy remains honed in on the federal debt.  Again, this is the silly because one of the best ways of increasing tax revenues and closing the debt is for people to be employed.  It’s an uphill battle to expect the deficit to close with this unacceptable level of unemployment.  I still can’t figure out where they’ve placed their heads back their in Washington, D.C.   Oh, well, look over there … it’s a dead Osama Bin Laden and we’ve not got any pictures yet!


FCIC Report is very Illuminating

The Financial Crisis Inquiry Commission (FCIC) is a congressional sponsored study into the reasons for the Financial Crisis. They were authorized by the President in May 2009. They have issued their final report and are disbanding. Google FCIC and you will find their information is being maintained by Stanford University. The published report is available on the website and at booksellers (ISBN 978-1-61039-041-5). It is more than 500 pages long. I have personally purchased about 15 books on the Financial Crisis over the last two years. (I know I should get a life). Each book discusses a separate segment of the crisis. This report is the most comprehensive book to date and is very readable by a person interested in the subject.

The commission was chaired by Phil Angelidies and former congressman Bill Thomas. There are eight additional commissioners appointed by the Democratic and Republican party. They had a staff of 60 people. They held hearings in Washington and locations in states hardest hit by the Real Estate bubble.

The first chapter summarizes their findings and they are quite illuminating on the many facets of the Financial Crisis. They dispel many myths and examples are provided below. One can definitely say we had less government in the Finance world. The evolved system was unsustainable. The end result was the crash of September 2008.
Conclusions of FCIC
1-The Financial Crisis was avoidable

Despite the “once in a 100 years” admonitions of regulators and politicians, this crisis was avoidable. The document does a thorough job, point by point highlighting and disputing the many actions in the last 20 years.

2-Failures in Financial Regulation and Supervision proved devastating to Financial markets

Greenspan was authorized to stop the writing of toxic mortgages despite the rising evidence that they were massive and detrimental. In 2004, the Federal Reserve could have denied loosening of capital reserves from 12/1 to 30/1. In other words, they would need $1 dollars in the bank for every $30 dollars of assets. This is considered very high leverage.  In 2000 the government declined to regulate Credit Default Swaps (Derivatives). Repeal of Glass-Steagle allowed mixing banks and Insurance companies. Citi bank was acquired by Travelers Insurance immediately. Under the regulation of the Federal Reserve Bank of NY (Tim Geithner) Citi was one of the first banks to get into trouble and require a massive government bailout.

3-Dramatic failures of corporate governance and risk management at important financial institutions, key cause of the crisis.

Many banks (not all) acted recklessly took on too much risk with too little capital to address the crisis, being very dependent on short term funding which evaporated as the crisis evolved. They were not able to raise capital to address demand claim of customer. In short they were not able respond to a run on the bank. This is called a liquidity event. Recall that Investment banks were lightly regulated and did not have access to the FED window for emergency loans. They relied on unproven software to evaluate their risks. In short they loaded up on Real Estate securities which turned toxic and they could not absorb the losses. This was done despite the fact that they knew the underwriting of the real estate loans was poor. Goldman Sachs recognized this and curtailed purchasing of bad loans and they survived.  The financial community was not able to police itself, requiring a massive government bailout. Risk people identified the problem and were ignored.

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A Self-Examined Academic Life

Macroeconomists seemingly have adopted monastic practices of self-flagellation to explain why the tribe completely misjudged the housing bubble .  Their collective crystal balls didn’t predict an ensuing financial crisis either.  A blog entry by Finance Professor Raghu Rajan at University of Chicago has further stimulated the conversation today.  He’s written a book called Fault Lines and made remarks from the book at its official blog site. I found it at Memeorandum along with a few choice links.

I’ve written about  fresh water and salt water economics before.  Some of today’s discussion clearly involves philosophical fault lines.  Rajan is from the panultimate fresh water university and all finance academics eventually drown in the Efficient Markets Hypothesis (EMH) literature. I’ve been pretty outspoken about how much damage I think the EMH has done to economics and especially my field, financial economics.  However, it’s hard to get published in finance journals taking a contrarian view.  This is one explanation he examines, then dismisses which is why I’ve taken a good look at his argument.

I have not read his book, but judging from the video and this blog entry, Rajan spends some time on the role of EMH and EMH true believers in the crisis.   I can provide you with my own anecdotes on this.  I can also tell you I tried to avoid some seminars because I don’t want to read any more Eugene Fama who is Rajan’s colleague.  I frankly think EMH blinders or misunderstanding were a good deal–but not all–of the problem.

I was researching the subprime markets directly after Katrina and was told by my finance professors that I was following an unpublishable and boring line of research. (They used the term ‘unsexy’.)  I saw hints of problems in subprime markets as early as late 2005 in the work I did with the sensitivity of stock prices of finance companies heavily invested in subprime loans to some key macroeconomic variables. I was told that line of research was unlikely to help my marketability and ability to get tenure upon graduation.  They yawned when I presented the paper.  I turned it in for my third econometrics seminar and switched to something else.

Finance journals editors do love them some EMH so anything on market anomalies is likely to get a jaundiced set of editor eyes.   But, Rajan brings up some important points and the resulting discussion is worth viewing here.   Here’s Rajan talking directly to the EMH and why he thinks it may not be a big deal.

Perhaps the reason was ideology: we were too wedded to the idea that markets are efficient, market participants are rational, and high prices are justified by economic fundamentals. But some of this criticism of “market fundamentalism” reflects a misunderstanding. The dominant “efficient markets theory” says only that markets reflect what is publicly known, and that it is hard to make money off markets consistently – something verified by the hit that most investor portfolios took in the crisis. The theory does not say that markets cannot plummet if the news is bad, or if investors become risk-averse.

Critics argue that the fundamentals were deteriorating in plain sight, and that the market (and economists) simply ignored it. But hindsight distorts analysis. We cannot point to a lonely Cassandra like Robert Shiller of Yale University, who regularly argued that house prices were unsustainable, as proof that the truth was ignored. There are always naysayers, and they are often wrong. There were many more economists who believed that house prices, though high, were unlikely to fall across the board.

Rajan points out that this probably isn’t the sole or primary explanation even though it is one that gets a lot of ink these days.  I too think some of the problem is a misunderstanding of the various forms of EMH . So, the major philosophical debate happening in finance circles isn’t central to Rajan’s explanation. There is no conspiracy of EMH apologists to force misunderstanding of market rationality, so alright, I’ll give him that one.

Economist Tyler Cowen at Marginal Revolution likes the alternative succinct explanation Rajan provides.  (You should read the comments to that thread.)

Raghu Rajan nails it:

I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.

Rajan also dismisses  another  circle of conspirators by stating this.  It’s also probably why one of those so-called progressives jumped on the dismissal earlier today.  This conspiracy meme crosses circles of folks that are more into political economy than economics itself.  This group argues the hypothesis that the “system” bribed economists to stay quiet.  I’ve gotten into it more than a few people of the Matt Stoller mindset and various Rand hanger-ons about  this improbable case.  One of the biggest memes is that the FED actively influences economists not to publish things against their interests. (Usually, this comes from Austrian School folks who can’t get published any where mainstream because they want to completely operate outside of the scientific method and ignore data.)  Matt Yglesias is one of these people making a living off this canard and he jumped to the bait immediately. His reasoning  speaks more about him than about economists.

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