Kevin Drum

How Far To Fall?

| Tue Mar. 24, 2009 6:09 PM EDT
Via Andrew Sullivan, Mike at No Empty Wallets wants to know why I think home prices have another 20% to fall.  It's nothing complicated.  The most widely accepted barometer of home prices is the Case-Shiller home price index, which canvasses housing prices in 20 cities.  Here's the raw data.

Case-Shiller was at 150 in December 2008.  The GDP price deflator stood at 123.  So the inflation-adjusted value of Case-Shiller was about 122.

In January 2000, when home prices were near their historical trend levels, Case-Shiller stood at 100.  The GDP deflator stood at 99.  So the inflation-adjusted value of Case-Shiller was about 101.

My arithmetic is pretty simple: getting from 122 back to 101 is about a 20% drop. (The chart on the right, from Calculated Risk, is a year old, but even so it gets the same point across for the graphically minded.  The orange line is the 20-city index.  It's fallen 20% in the past year, and looks to have another 20% to go before it reaches pre-bubble trend levels.)

Actually, it's worth noting that I'm being a little generous here, since in a recession values often overshoot on the way down.  Mike suggests that lower mortgage rates and the upcoming stimulus tax credit will prop up prices a bit compared to past levels, and that's possible.  But mortgage rates are only slightly lower today than in 2000, and the effect of the tax credit is hard to judge.  I'm just guessing like everyone else (and since I have a house I'm trying to sell I'd be delighted to end up wrong about this) but I'd keep my money on a further 20% drop.  We still have a fair bit of recession ahead of us.

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Afraid of Risk?

| Tue Mar. 24, 2009 2:53 PM EDT
Brad DeLong points to a defense of Tim Geithner's toxic waste plan from Christopher Carroll:

Unlike the critics, the Treasury has absorbed the main lesson from the past 30 years of academic finance research: asset price movements mainly reflect changes in investors’ collective attitude toward risk.

....The details [of the Geithner plan] flow from an overarching view that the markets for the “toxic assets” that are corroding banks’ balance sheets have shut down in part because in those markets the degree of risk aversion has become not just problematic but pathological. The different parts of the plan reflect different approaches to trying to coax private investors back into the market by reducing their perceived degree of risk to levels that even a skittish risk-shy hedge fund manager might find tempting.

I don't want to disagree with this, but I think it's worth looking at it from a slightly different perspective. Obviously risk aversion goes up and down with economic conditions, but one problem with our financial markets is that over the past 30 years they've largely convinced themselves that risk doesn't really exist anymore.  This is especially true on the fixed income side of things, where I think it's been years since the Wall Street crowd really, truly, thought there was any risk left in the market for anyone smart enough to read a yield spread.  You just needed to have the right models and the right hedging strategy.

At the very least, investors should have learned their lesson on this score in 1998, when Long Term Capital Management collapsed.  There were multiple reasons for LTCM's failure, but the biggest one was that they felt comfortable taking enormous leveraged positions because they were convinced that their models had essentially hedged all the risk away.  They hadn't, of course, and they crashed spectacularly.  But in the end the Fed oversaw a rescue, LTCM's investors lost some money, and then they dusted themselves off and convinced each other that this was a once-in-a-century event they didn't really have to worry about.  (The guys responsible for LCTM's implosion went back to Wall Street 12 months later to start a new fund.  They had no trouble raising capital.)

But this time it's different.  It's pretty obvious that all the credit derivatives in the world, no matter how cleverly they're constructed, don't genuinely hedge away risk.  It's still there, and all the guys who thought they'd discovered a magical way to insure high returns forever discovered that they were wrong.

So, yes: risk aversion is sky high right now.  But this is more than just the normal ebb and flow of animal spirits.  It's sophisticated investors rediscovering the idea that risk really exists at all, even for them.  That's a tough transition.  Tim Geithner's about to find out if Wall Street has made it yet.

Quote of the Day - 3.24.09

| Tue Mar. 24, 2009 2:00 PM EDT
From Marc Ambinder, explaining why he thinks Obama is moving more cautiously than his critics would like:

What's kept the administration from being as bold as its critics want is not a lack of imagination, or a lack of contact with the outside world, or an overreliance on the banks....It's a combination of the knowledge that Obama cannot do big things unless he remains a majority president, that he could make a hash of them if Congress perceives that the administration is pushing too close to the boundary of what's acceptable, and that the administration has accepted that it cannot allow Congress to be a partner in leading the American people towards a solution.  The stimulus package debate in February was dispositive; the administration lost confidence in Congress's maturity fairly quickly.

It's not clear how much of this is just Ambinder's own judgment and how much is informed by his reporting, but presumably he wouldn't say this if he didn't have good reason to believe it.  And that's pretty interesting: Obama no longer trusts Congress.  It's also a wee bit frightening, no?

(Ambinder also has a list of questions he thinks need to be answered before any kind of nationalization plan is possible.  I don't quite understand some of them — why would there be a run on a nationalized bank? — but they're worth taking a look at.)

The Price of Health

| Tue Mar. 24, 2009 1:45 PM EDT
Ezra Klein has a friend who got airlifted to a small town in Germany after an accident in Sierra Leone.  Now he's stuck:

My friend does not speak German. He does not know anyone in Germany. He wants to come home and receive his care in the states. He wants a doctor he can communicate with and nurses who can understand his requests and friends who can speak to him and calls that aren't subject to international fees. But his insurance is refusing the request. Medical treatment, they're arguing, is simply too expensive in America.

....My friend's insurers are not lying to him. They are not making a capricious decision. They simply have no wish to pay American prices when care can be obtained at German rates. And so my friend and his family must now focus their days and nights worrying over what to do, and how much to spend. As for the rest of us in America, we pay these prices anyway, and never realize how terribly we're being ripped off.

Just keep telling yourself: best healthcare in the world, baby, best healthcare in the world.  Say it often enough and you might even believe it eventually.

The Swedish Model

| Tue Mar. 24, 2009 1:08 PM EDT
The interview of the day is Benjamin Sarlin's short chat with Bo Lundgren, the finance minister who oversaw Sweden's temporary bank nationalizations in the early 90s:

"There are similarities [to Sweden's case]," Lundgren said. "There are three things any plan must do — the first is to maintain liquidity, that's taken care of by the Fed. The second thing is to restore confidence, and that hasn’t been done so far and obviously the first proposal to buy toxic assets wasn't enough. And then you need capital injections so banks can keep lending at the levels needed for the economy as a whole."

However, Lundgren said that Obama was correct in observing that a similar nationalization scheme might be more difficult given America's size and preeminent role in world finance compared to Sweden.

"With Japan and Sweden, the crises we had, even if it was a very long process with Japan, they were crises that we had on our own," Lundgren said. "The rest of the world economy managed to be not perfectly good but still reasonably good. This time it's worse; it's a kind of financial tsunami."

I suppose you could equally make the case that the worldwide nature of this crisis makes dramatic action like bank nationalization more necessary than it was in Sweden's case.  Still, Lundgren is almost certainly right that it would be a lot more difficult.  Nationalizing a $2 trillion institution that's a commercial bank, an investment bank, a hedge fund, an insurance company, a brokerage, and owner of a portfolio of other banks around the world is a lot trickier than nationalizing a midsize regional bank in the era before the explosion of credit derivatives.

In fact, here's an assignment desk job for someone with the background to know the details: What would it take to nationalize an outfit like Citigroup?  What are the likely legal, financial, diplomatic, and operational issues that would have to be resolved?  It would be a real public service if someone with a credible background in this stuff could lay out the details in a way that's understandable for all the rest of us.

Toxic Waste for All

| Tue Mar. 24, 2009 12:09 PM EDT
Will ordinary citizens be able to invest their hard-earned shekels in Tim Geithner's sweetheart deal to buy up toxic waste legacy assets from distressed banks?  Here's a quick followup:

Two of the country's biggest money managers — Newport Beach-based Pacific Investment Management Co., known as Pimco, and New York-based BlackRock Inc. — say they may launch funds that would allow individuals to have a stake in some of the bad assets to be purchased from banks.

....Bill Gross, co-chief investment officer at Pimco, said his firm was looking into the idea of creating mutual funds that would tap into the program. BlackRock is doing the same, said Curtis Arledge, co-head of fixed income at the firm.

The story goes on to suggest that the funds may be closed-end with a minimum buy-in of $25,000.  If that's how it turns out, it wouldn't exactly allow Joe Sixpack to get in on this deal.  Still, it's a step in the right direction.  It'll be interesting to see if Treasury encourages other retail funds get in on this action.

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Yet Another Scandal

| Tue Mar. 24, 2009 11:25 AM EDT
ABC News reports on the sordid past of Obama's Chief Information Officer, Vivek Kundra:

When Kundra was 21 years old, records show, he was caught stealing four shirts from a J.C. Penney store.

...."Thirteen years ago, Vivek committed a youthful indiscretion. He performed community service, and we are satisfied that he fully resolved the matter."

What's going on here? The new administration has a lot of work to do, but it keeps being sideswiped by issues in its appointees' pasts. Police records provided to ABC News show that those shirts from Penney's were worth less than $140. Kundra was fined $100 plus $55 in court costs, and ordered to do 80 hours of community service. He reportedly told the White House about the incident while he was being vetted for his current job.

I thank God daily that we have a vigorous and enterprising free press to look into these critical matters.  It's a source of inspiration to us all.

Another Mile Down the Road

| Tue Mar. 24, 2009 1:54 AM EDT
Yesterday I wrote that one problem with nationalizing big financial corporations is that the government probably doesn't have the legal authority to do it even if it wants to. They can seize banks, but they can't necessarily seize all the other components of big financial institutions. The Washington Post reports that the White House is about to ask Congress to change that:

The Obama administration is considering asking Congress to give the Treasury secretary unprecedented powers to initiate the seizure of non-bank financial companies, such as large insurers, investment firms and hedge funds, whose collapse would damage the broader economy, according to an administration document

....Besides seizing a company outright, the document states, the Treasury Secretary could use a range of tools to prevent its collapse, such as guaranteeing losses, buying assets or taking a partial ownership stake. Such authority also would allow the government to break contracts, such as the agreements to pay $165 million in bonuses to employees of AIG's most troubled unit.

The Treasury secretary could act only after consulting with the president and getting a recommendation from two-thirds of the Federal Reserve Board, according to the plan.

If, several weeks ago, you had charged a task force with figuring out how to successfully nationalize a big bank, what do you think they'd say you had to do? Three things, at least: (1) you have to figure out a widely acceptable way to value the toxic assets on bank balance sheets, (2) you have to set up a fair and consistent test for evaluating bank solvency based on those values, and (3) you need to make sure you have the legal authority to take over a huge, multinational financial conglomerate in an orderly way.  Is it just a coincidence that these are precisely the things Tim Geithner has set in motion over the past month?  I wonder.

Letting the Little Guy Invest

| Tue Mar. 24, 2009 1:10 AM EDT
One of the persistent criticisms of the Geithner plan is that it's a sweetheart deal for investors.  The government puts up most of the money, downside risk is limited thanks to the non-recourse funding, and there are probably lots of ways the auctions can be gamed.  Matt Yglesias points to a comment at The Baseline Scenario that suggests a way to deal with this:

If Geithner’s taxpayer subsidized toxic public/private plan goes forward, I think it would be fair if the federal government allow non-institutional investors to participate via a no-fee investment vehicle.  I think if Americans had the option of investing in this program (without having to pay the egregious fees to the investment advisors/PE shops), it would be much easier to swallow since they would at least get the same deal the sharks are getting.

Like James Kwak, I think this is a brilliant idea, and one that Treasury should not merely allow, but actively encourage.  At least one of the fund managers chosen to participate in the program should be one that agrees to allow investment by retail customers.  In the end, Geithner's plan may or may not turn out to be a sweetheart deal, but surely us little guys should have the same chance to find out as the well-heeled crowd.


| Mon Mar. 23, 2009 10:43 PM EDT
I thought that "Going Galt" was pretty much as stupid as conservatives could possibly get, but I was wrong. This has it beat.  Jeebus.