A Short Break

Some sort of illness has overtaken your editor, rendering him unable to do much more than rise periodically from bed to watch an episode of Andy Griffith or Gunsmoke (the mountain man wrongly accused of murdering a family of three was thankfully just exonerated again earlier today).

Hopefully, the normal fare will resume here in the next few days.
That was no easy task getting that picture up - clearly it was worth it. Time for a nap.

Read more...

Irrational Exuberance, Ten Years On

In recalling the now famous speech given ten years ago on Tuesday, it's natural to wonder what the world would be like today if former Federal Reserve Chairman Alan Greenspan had taken a different course of action after wondering aloud whether all the fuss with the stock market wasn't just another bit of, well, irrational exuberance.

Through history, financial manias and bubbles have been common - tulips in Holland, the South Sea bubble, the Mississippi scheme, and the 1926 Florida real estate bubble, to name just a few.

While it's impossible to know what would have transpired had the monetary clamps been applied ten years ago, perhaps one of the best ways to assess what really did happen is to look up "economic bubble" at Wikipedia:
Quibble if you will about what constitutes a "bubble", but without question, there have been an ever-increasing number of events with "bubble-like" characteristics in recent years.

Surely, ten years ago at age 70, the Fed Chairman had been around long enough to know what might result from his neglect of (and then cheerleading for) the rise in equities.

You didn't have to look very hard to see the signs of exuberance at the time. The speech was made after two years of hefty gains in the S&P 500 - over 30 percent in 1995 and over 20 percent in 1996.

Wasn't that enough?

Following are a few excerpts from the now famous speech that began with a lengthy stroll through history. Like Ben Bernanke, the former Fed chairman has a great appreciation for the past as well as a deep understanding of money, prices, and the role of the Federal Reserve.

For, at root, money--serving as a store of value and medium of exchange--is the lubricant that enables a society to organize itself to achieve economic progress. The ability to store the fruits of one's labor for future consumption is necessary for the accumulation of capital, the spread of technological advances and, as a consequence, rising standards of living.

Clearly in this context, the general price level, that is, the average exchange rate for money against all goods and services, and how it changes over time, plays a profoundly important role in any society, because it influences the nature and scope of our economic and social relationships over time.

It is, thus, no wonder that we at the Federal Reserve, the nation's central bank, and ultimate guardian of the purchasing power of our money, are subject to unending scrutiny. Indeed, it would be folly were it otherwise.
...
After the Civil War, redemption of the paper greenbacks issued during the war brought an era of a gold-standard-induced deflation, which, while it may not have thwarted the impressive advance of industrialization, was seen by many as suppressing credit availability for the rural interests of the nation, which were still a majority. The general price level declined for more than two decades, which meant borrowers were paying off their loans in more expensive dollars than those they borrowed.
...
Even with a central bank, the gold standard was still the dominant constraint on the issuance of paper currency and the expansion of bank deposits. Accordingly, the Federal Reserve was to play a minor role in affecting the purchasing power of the currency for many years to come.

About five pages later we are back in the 1995 and the discussion turns to the difficulty in measuring prices and the rising price of assets.

I doubt the tasks will become any easier for the Federal Reserve as we move into the twenty-first century. The Congress willing, we will remain as the guardian of the purchasing power of the dollar. But one factor that will continue to complicate that task is the increasing difficulty of pinning down the notion of what constitutes a stable general price level.

When industrial product was the centerpiece of the economy during the first two-thirds of this century, our overall price indexes served us well. Pricing a pound of electrolytic copper presented few definitional problems. The price of a ton of cold rolled steel sheet, or a linear yard of cotton broad woven fabrics, could be reasonably compared over a period of years.

But as the century draws to a close, the simple notion of price has turned decidedly ambiguous. What is the price of a unit of software or a legal opinion? How does one evaluate the price change of a cataract operation over a ten-year period when the nature of the procedure and its impact on the patient changes so radically. Indeed, how will we measure inflation, and the associated financial and real implications, in the twenty-first century when our data--using current techniques--could become increasingly less adequate to trace price trends over time?

So long as individuals make contractual arrangements for future payments valued in dollars, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money. No matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services. Hence, we must assume that embodied in all products is some unit of output and hence of price that is recognizable to producers and consumers and upon which they will base their decisions. Doubtless, we will develop new techniques of price measurement to unearth them as the years go on. It is crucial that we do, for inflation can destabilize an economy even if faulty price indexes fail to reveal it.

But where do we draw the line on what prices matter? Certainly prices of goods and services now being produced--our basic measure of inflation--matter. But what about futures prices or more importantly prices of claims on future goods and services, like equities, real estate, or other earning assets? Are stability of these prices essential to the stability of the economy?

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

It is clear from the last few paragraphs above that the Fed chairman was struggling with the whole idea of measuring prices and monitoring asset values. The Fed's take on collapsing asset bubbles is defined here as well - they "need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy".

Well, they probably should have been concerned - if not in 1996, then certainly a few years later.

At the time, the internet as we know it was being born and technology was changing at a pace set to accelerate in the years ahead. Pioneers like Mosaic with their nascent browser software would revolutionize the world of computers and communication and it's easy enough to look back and think that something could have been done to slow things down - at least a little bit.

So what if some start-ups couldn't be funded because money just wasn't available? Investors would have complained that money was too restrictive and that growth was being hampered - the absence of such complaints are characteristic of the recent era.

Monetary conditions in the last twenty years, and in particular in the last ten years since this speech, have been nothing other than easy. Money is now created, borrowed, invested, and lost with such casualness that most octogenarians, still mindful of harder times early in the last century, probably wince when they think about it.

Perhaps the former Fed chairman can be given a pass for his role in the late 1990s technology boom that went bust, but not so for what happened afterward - one look at the list of "economic bubble" above bodes ill for stability in the future.

Read more...

Couldn't Pick a Title for This One

Yesterday's WSJ report More Borrowers With Risky Loans Are Falling Behind($) was so chock-full of juicy quotes that it was impossible to pick a title for this post.

You see, sometimes when a blogger starts slacking off leading up to the year-end holidays, the easiest thing to do to fulfill the daily requirement for new material is to just find a good article, use the most titillating quote as the title, excerpt a few paragraphs and voila! - another blog post is done.

The story by Ruth Simon and James Hagerty was so full of zippy one-liners that it would have been unfair to all the others to pick just one. Here's a partial list of what was under consideration before arriving at the title you see above:

• "We are a bit surprised by how fast this has unraveled," says Thomas Zimmerman, head of asset-backed securities research at UBS
  
  
• KeyCorp was leaving the subprime market because "it no longer fits with our long-term strategic priorities"
  
  
• In retrospect, "the tightening process should have started a bit earlier," says James Konrath, Accredited's CEO
  
  
• In many cases these loans are "so bad right off the bat"

From this, snappy titles could have been easily extracted:

• Surprised By How Fast It Unraveled
  
• It No Longer Fits with their Long-Term Strategy
  
• Tightening Process Should Have Started Sooner
  
• So Bad Right Off the Bat

Indecisiveness such as this has never occurred here before. Of course developments such as those now unfolding in the mortgage lending industry have never occurred before either.

The story goes on at great length about the quandary faced by both lenders and borrowers now that the bloom has come off of the housing boom.

Americans who have stretched themselves financially to buy a home or refinance a mortgage have been falling behind on their loan payments at an unexpectedly rapid pace.

The surge in mortgage delinquencies in the past few months is squeezing lenders and unsettling investors world-wide in the $10 trillion U.S. mortgage market. The pain is most apparent in subprime mortgages, though there are signs it is spreading to other parts of the mortgage market.

Subprime mortgages are loans made to borrowers who are considered to be higher credit risks because of past payment problems, high debt relative to income or other factors. Lenders typically charge them higher interest rates -- as much as four percentage points more than more-credit-worthy borrowers pay -- one reason subprime mortgages are among the most profitable segments of the industry.

They also have been among the fastest-growing segments. Subprime mortgage originations climbed to $625 billion in 2005 from $120 billion in 2001, according to Inside Mortgage Finance, a trade publication. Like other types of mortgages, subprime home loans are often packaged into securities and sold to investors, helping lenders limit their risks.

Until the past year or so, delinquency rates were low by historical standards, thanks to low interest rates and rising home prices, which made it easy for borrowers to refinance or sell their homes if they ran into trouble. But as the housing market peaked and loan volume leveled off, some lenders responded by relaxing their lending standards. Now, the downside of that strategy is becoming more apparent.

Translation: What appeared to be a free lunch really wasn't. Despite early 21st century conventional wisdom, all of Western Civilization cannot become rich at the same time just by bidding up the price of each others' homes.

How did this all start anyway?

The subprime industry's current troubles can be traced back to 2003 and 2004, when defaults were unusually low. Investors who purchased these loans did well and were eager to buy more. That encouraged lenders to lower their standards, making loans to more people with low credit ratings. Lenders also grew less inclined to demand full documentation of income and assets and more willing to offer "piggyback" loans that allowed borrowers to finance 90% or 100% of the purchase price without being required to buy private mortgage insurance.

Many lenders kept introductory "teaser" rates low even after short-term interest rates began rising in June 2005, while increasing the amount the rate could rise on the first adjustment. That meant borrowers would face sharply higher costs when their monthly payments were reset.

Fraud has also increased. Some borrowers who took out no- or low-documentation loans were coached by loan officers or mortgage brokers to inflate their incomes and couldn't afford even their first mortgage payment, says Theresa Ortiz, a foreclosure manager with Neighborhood Housing Services of New York City, a nonprofit that works with homeowners in financial trouble.

Another report yesterday, this one on record foreclosures in the Denver area, provides a good indication of what may come next to a neighborhood near you.

But it's never been easier to qualify for a loan, so many people who would have been unable to buy a home previously can now buy one, he said.

Despite rising foreclosures, Barnes said there has been no move to tighten borrowing requirements because the federal government wants to encourage homeownership.

Previously hot markets such as the West Coast, Phoenix and Las Vegas now are softening. In those cities, unlike in Denver, many of the buyers were people speculating on rising home prices in order to flip properties quickly for a profit.

Said Barnes: "If the national lag in these 'bubble zones' is anything like the lag we saw after the technology crash," he predicts other cities will see an increase in the foreclosure rate similar to Denver's.

"I think (the metro area's record foreclosures) are very significant for the rest of the country," he said.

Maybe it should be a little harder to buy a house.

Read more...

Be Careful What You Wish For

With Alan Greenspan hanging around the football field like the star quarterback who graduated last year and with superstar transfer Hank Paulson joining the team to replace
fumble-prone John Snow at Treasury, does Ben Bernanke sometimes ask himself why he ever wanted the job of Fed Chairman so badly?

If he knew that energy prices would be so difficult or that many metal prices would double in his first year, would he still have taken the job?

Is this a case of "be careful what you wish for, because it may come true"?

Commodities and Dollars

First of all, it's a good thing that base metals and precious metals don't show up in any major price index. If they did, double and triple digit annual percent increases would look more than a little strange in this "low inflation" world.

Unfortunately other commodities do - like oil and gas.

The recent fall of the dollar has added to the problem of rising commodity prices. The ministers of the oil exporting countries meet next week and the declining value of the dollar is sure to be a hot topic of discussion.

When asked about possible production cuts, now expected to be in excess of one million barrels a day, OPEC President Edmund Daukoru of Nigeria said, "We cannot ignore the extremely soft dollar amongst other factors".

From their point of view it's easy to see why they would be concerned. If they sell oil to the U.S. in exchange for dollars and then go shopping in Europe, those same dollars buy much less than they did just last summer. They're getting killed on the exchange rate.

What's a prince to do? What's Ben Bernanke to do?

Gasoline and heating oil prices are about the easiest prices for consumers to gauge, and they weigh heavily on the "inflation expectations" measure that is all important according to the economic textbooks.

The New Guy

According to some, Hank Paulson single-handedly solved Ben Bernanke's inflation problem last summer by pulling the rug out from under energy prices. When the re-jiggering of his former employer's commodity index resulted in the dumping of $6 billion worth of gasoline futures onto the market, other energy prices quickly followed gasoline down.

If he wasn't responsible for helping to nudge sky-high prices down a very steep slope, he sure gets a lot of credit for it.

With high energy prices and inflation being increasingly synonymous, the Treasury Department now has the appearance of being the real inflation fighter in Washington.

And the talks with China about the work to be done regarding trade relations and currency adjustment - Ben Bernanke going along now seems like an afterthought. Back when it was Snow at Treasury and Greenspan at the Fed, no one really took the meetings seriously unless the Fed Chairman was in tow.

Add to this the stark difference in appearance between the two - Teddy Bear vs. serial killer (yes, here's that picture again) and the job of the Fed Chairman in 2006 probably has a much different feel than it did in 2005.

The Old Guy

Then there's retired Fed Chief and current Chatty Cathy Alan Greenspan who is now given equal billing when some of the financial media talk about Fed policy. In this Bloomberg report they are treated as co-equals - as if The Maestro is still conducting monetary policy through weekly speeches that are well attended by the media.

Treasury bond investors are so bullish even Federal Reserve Chairman Ben S. Bernanke and Alan Greenspan can't stop the biggest rally in four years.

They may as well have just said "Chairmen".

Of course it doesn't help when the entire bond market thinks that you've got it wrong.

"The bond market is effectively saying the Federal Reserve is in denial and there's going to be more pain to the economy,'' said Michael Cheah, who manages about $2 billion in bonds at AIG SunAmerica Asset Management in Jersey City, New Jersey.
...
Interest rate futures suggest traders are now almost unanimous in their expectation that the central bank will reduce its target rate to 5 percent by March. The odds reached about 100 percent on Dec. 1 after the Institute for Supply Management's factory index showed manufacturing in the U.S. contracted for the first time in more than three years.

Bernanke, Greenspan
...
"In the case of inflation, the risks to the forecast seem primarily to the upside,'' Bernanke said. "Whether further policy action against inflation will be required depends on the incoming data and in particular how these data affect the FOMC's medium-term forecasts.''

Greenspan said in a Nov. 28 speech in New York that a drop in global inflation pressures has "flattened the long-term interest rate structure across the world.'' He also said "you'll see the 10-year note going back to civilized territory'' as a decline in labor costs slows.

Who's in charge there at the Fed anyway? You can almost see the 2007 headlines already as a hesitant Ben Bernanke continues to talk tough about inflation while economic reports continue to show distress and the retired Fed Chairman is out promoting his new book.

Don't be surprised to see the headline, "Greenspan urges rate cuts".

Maybe Ben Bernanke is having second thoughts - if not he should.

If, after almost a year as Fed Chief, he now better understands the mess that he has inherited - next time he'll probably be more careful about what he wishes for.

Read more...

Disappearing, Falling ... Whatever

Some people just can't get enough of the continuing story of the falling dollar - present company is of course included in that relatively small group.

And why not?

It's all become quite a spectacle, generating lots of snappy headlines and smart graphics, though many must be disappointed with the title of the lead story in the current issue of The Economist - The Falling Dollar($).

THE dollar's tumble this week was attended by predictable shrieks from the markets; but as it fell to a 20-month low of $1.32 against the euro, the only real surprise was that it had not slipped sooner. Indeed, there are good reasons to expect its slide to continue, dragging it below the record low of $1.36 against the euro that it hit in December 2004.
...
The recent decline was triggered by nasty news about the American economy. New figures this week suggested that the housing market's troubles are having a wider impact on the economy. Consumer confidence and durable-goods orders both fell more sharply than expected. In contrast, German business confidence has risen to a 15-year high. There are also mounting concerns that central banks in China and elsewhere, which have been piling up dollars assiduously for years, may start selling.

The snappy cover art makes up for the less than snappy headline.
The story further inside is similarly title-challenged, but for this one at least, no subscription is required - Rebalancing act.

WELL before it happened, it looked obvious. America's economy is slowing; the Federal Reserve last raised interest rates five months ago; and the country has a vast current-account deficit. Europe's economies have been springing mostly happy surprises: the European Central Bank is almost sure to increase rates on December 7th and will probably carry on doing so next year. Asia looks strong as well, and Japan's central bank has been wondering when it will be safe to raise interest rates again. Sooner or later, the dollar had to fall.

And so it has. Against the euro, the dollar had been dropping, little by little, for more than a month before it broke through $1.30 on November 24th, going on to hit a 20-month low (see chart). Against the pound, on November 28th the greenback was at its weakest for two years. It slipped against the yen too, though it later made up the ground. Against the yuan—politically the most sensitive exchange rate these days—it continued a stately decline.

It seems that the markets are fixated on relative growth rates. When America's housing boom made its economy boom, the dollar was strong. Now that the bloom has come off the boom, the 'ol greenback just doesn't have the same appeal.

For more on the nation's economic ills, The Economist again relies on its new favorite American economist Nouriel Roubini with the obligatory counter point from the anti-Roubini in Washington, Fed chairman Ben Bernanke.

Pessimists argue that recession is just around the corner: Nouriel Roubini, of Roubini Global Economics, predicts a recession by the middle of 2007. That is still a minority view, but financial markets clearly expect things to get at least bad enough for the Fed to start cutting interest rates soon. The prices of federal-funds futures suggest that investors think short-term interest rates are likely to decline within a few months.

One person who does not sound gloomy is Ben Bernanke, chairman of the Fed. This week, in his first speech on the economic outlook since July, Mr Bernanke painted a much brighter picture. Yes, the economy was slowing, but this “deceleration” was “roughly along the lines envisioned” by the Fed in July. Mr Bernanke said output growth could be “modestly below” its trend rate in the very short term, but made clear that he expected the economy to be growing at its sustainable rate within a year. Far from hinting at lower interest rates, he noted that inflation was still “uncomfortably high”: “whether further policy action against inflation will be required”, he added, would “depend on incoming data”.

Surprisingly, Fed funds futures are now predicting an equal chance of 5.25, 5.00, and 4.75 percent short-term interest rates after the March FOMC meeting. This all changed rather dramatically in just the last few days - a half point cut by March is now as likely as a continuation of the pause.

Apparently the bond market isn't as sanguine as the anti-Roubini.

But, this is not just an American story. When pundits in the U.S. were deriding mainland Europe for their sluggish growth a few years back, maybe the stewards of the "old Europe" economies were just thinking a little longer term.

Those chirpy Europeans

There are two sides to any exchange rate: Europe's prospects matter as well as America's. In 2006 the euro area looks likely to grow at its fastest pace for six years. That its GDP growth is modest by American standards, largely because of its slower population growth, is not the point: what matters is that this year it has surprised the soothsayers time and again. That has lifted its currency, and not just against the dollar. A euro now buys more yen than at any time since the single currency was created.

To most Americans, what the dollar can be exchanged for overseas matters little - only about ten percent of the U.S. population has passports and most of those people never leave the country. As for import prices, recent studies have shown that only a very small amount of exchange rate movements are passed through via manufactured products.

Oil however is another matter. A steep decline in the dollar means that oil prices for Americans will go up, all else being equal - this reality may become more significant after next week's OPEC meeting where the subject of prices is sure to come up.

Read more...

Then and Now

What a difference a year makes for the nation's real estate markets. Last year at this time, you would have heard talk about high prices and rising inventory. Some wondered whether the landing would be "soft".

Today the tone is completely different.

In this article in today's LA Times, readers learn that the seller can't just set the price at ten percent above the last comparable sale.

SAVVY sellers take note: It's all about pricing, pricing, pricing. Not last year's. Last month's.

That's the word from sellers and agents across Southern California facing the realities of this fall's buyer's market.

"Pricing is critical," said Sean McLin, a Los Angeles-based ZipRealty Inc. agent. "Buyers start their search from there."

It's not easy being a seller today, what with homes on the market seemingly everywhere. Should owners underprice or stick with neighborhood comparables? How long should their homes be on the market before they consider lowering the price? What else can they do? Migraine, anyone?
...
Know when to lower the price. If a house sits on the market more than six weeks without much buyer interest, it's time for a few changes. Spruce it up. Stage it. Add nice furniture and remove the clutter — and lower the price.

Part of the problem for sellers is that they're competing with builders who now advertise and sell homes like they were selling automobiles.

ooo

Two weeks of cartoons from The Economist:

Read more...