The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

A few quick thoughts on today’s Housing data:

1st, we must begin with the laugher NAR headline: June Existing-Home Sales Slip on Contract Cancellations, but Prices Stabilize; My advice to them is to switch to bottled water, as there is obviously some psychotropic polluting their tap water.

Second, the data remains soft:

• Total existing-home sales declined 8.8% below June 2010 sales.
• EHS are at annual rate of 4.77 million in June 2011 vs 5.23 million unit level in June 2010
• National median existing-home price for all housing types was $184,300 in June, up 0.8% from June 2010
• The median existing single-family home price was $184,600 in June, up 0.6% from a year ago.
• Distressed homes, foreclosures and short sales accounted for 30% of sales in June 2011
• Total housing inventory rose 3.3% to 3.77 million existing homes, a 9.5-month supply
• All-cash transactions accounted for 29% of sales in June 2011, up 5% from the 24% level in June 2010
• First-time buyers purchased 31% percent of homes in June, down from 43% percent in June 2010 when 1st time home buyers tax credit was expiring

Is anyone still seriously expecting a Housing recovery anytime soon?

Last, our favorite housing chart, courtesy of Calculated Risk:

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Existing Homes Sales, Non Seasonally Adjusted 2005-2011

click for ginormous chart

Source: Calculated Risk

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Source:
June Existing-Home Sales Slip on Contract Cancellations, but Prices Stabilize
National Association of Realtors, July 20, 2011
http://www.realtor.org/press_room/news_releases/2011/07/existing_slip

Kill the AMT
July 20, 2011
www.cumber.com

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The Gang of Six has proposed elimination of the Alternative Minimum Tax (AMT).  Only in a comprehensive approach, as presently discussed, can such a thing be accomplished.

We have written about this for years.  We were instrumental in getting bipartisan bills introduced in the House to repeal it (Thanks to Congressmen Andrews-D  & LoBiondo-R, both from New Jersey where the AMT is sucking folks dry.).  Their bill never advanced.  Why?  Because the answer always was: “Where are you going to get the revenue to make up for the loss of the money that comes in from the AMT?”

Now there is a chance.  There is momentum building to change things.

The AMT is an alternative system of taxation that is burdensome, discourages investment, and acts as a surreptitious trap.  About 4 million people pay it; it started out as a tax on only 200 people, all millionaires.  Over the years it has sneaked up on the rest of us.

The present AMT payers are not mostly million dollar incomes.    Those folks know how to avoid it.  The people who pay it now are mostly in the middle-income group.  If you do not believe me, ask your accountant.  And while you’re at it, ask him/her how much extra it costs you to have him/her run the tests every year to see if you have to pay it.  And ask the other 20 million Americans who are threatened by it, what they have to do to avoid it.  Note that all of this expense is additional cost because of the AMT.

And ask those who do not get their deductions for their state income taxes or the real estate taxes on their homes, how much they like this tax.  And while you are at it, compute what their real cost of property taxes is when they get no deduction.  Then you can figure out why housing languishes in recovery.

Anyway, now is the time for taxpayers and middle-income working folks and small business to weigh in very heavily against the AMT.  The telephone for the US Capitol switchboard is 202-221-3224.  Ask the operator to connect you to your congressional member.  Be patient when you call; it may ring for a while, but they will answer.  They just did for me.  They are very busy.  BTW, I always compliment the switchboard operator for their service to the United States and the polite way they handle such a massive volume of calls.

And, also BTW, while we are getting rid of the AMT, let’s kill the ethanol subsidy, too.

The moment for citizens to take back their country may have arrived.

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David R. Kotok, Chairman and Chief Investment Officer

Josh Brown on Daily Ticker:

Don’t Sweat the Debt Ceiling, Buy “Secular Growth” Like Apple, Josh Brown Says

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Is Murdoch’s NewsCorp a BP ?

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Steve Wynn’s Obama ‘Wet Blanket’ Rant Is ‘Nonsense’, Says Brown

Good morning class.

This past academic year, we have studied the many causes of the financial crisis. We’ve looked at how this stock market collapse compared to others, the impact of bank bailouts on competition, and of course, the Great Recession. There are lots of moving parts in this saga, and understanding them all is our goal.

Your final examination is in essay form. Answer each of the following 10 questions, using specific data and facts to buttress your arguments. Note you will be penalized for unsupported assumptions and unproven theories. Ideological arguments that lack a factual basis will also penalize you.

You have 3 hours (~15 minutes per question).

Good luck.

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Final Examination

1. Following the dotcom implosion and 2000 market crash, the Federal Reserve lowered rates to 2% for 3 years, including a then unprecedented level of 1% for more than a year. Discuss the impact this had on various asset classes, including Real Estate, Fixed Income, Oil and Gold. What difference might a more traditional interest rate regime have made for these assets?

Bonus Question: Imagine you were FOMC Chair. Where would you have set rates in the 1990s? After the 2000 crash? Today?

2. The rating agencies — Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings — originally had business that were  funded by bond investors, who paid for the NRSRO’s research. This changed in the 1990s to a Syndicators & Underwriter purchased ratings model. How did this business model change impact a) the performance of ratings agencies; b) the underwriting quality of syndicators?

Bonus question: Does finance still require NRSROs to evaluate complex financial products? What alternatives could replace these entities?

3. The Commodity Futures Modernization Act of 2000 was an unusual piece of deregulatory legislation, creating a new world of uniquely self-regulated financial instruments — the derivative. What was the impact of this on risk management, leverage, and mortgage underwriting?

Bonus: What did a lack of reserve requirements for underwriting derivatives mean for AIG, Bear Stearns and Lehman Brothers?

4. More than 50% of subprime loans were made by nonbank mortgage underwriters not subject to comprehensive federal supervision; another 30% were made by thrifts also not subject to routine supervision or examinations. What did this do to the supply/demand curve in the housing and mortgage markets?

Bonus: What was the role of changing credit standards in prior bubbles and financial crises?

5. In 2004, the SEC issued the “Bear Stearns exemption” — replacing Net Capitalization Rule’s 12 to 1 leverage limit  to with essentially unlimited leverage for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. Given that none of these companies exist today in the same structure as prior to the rule change, discuss the impact of this rule change on these companies.

Bonus: Changing broad legislation for only 5 companies is very unusual. What does this say about regulatory capture, democracy and the impact of lobbying on American society?

6A. Mortgage underwriting standards changed rapidly in the 2000s .Many lenders stopped verifying income, payment history, and credit scores.

6B. Traditional loan metrics also changed: Loan to value (LTV) went from 80% (20% down payment) to 100% (No Money Down) to even 120% (Piggyback mortgages).

6C. The loans themselves changed: “Innovative” new mortgage products were developed and marketed in the 2000s: 2/28 ARMs, I/O s, Neg Ams

Q: Discuss the correlation this had on a) home prices; b) new inventory build; and c) foreclosures.

7.  Banks developed automated underwriting (AU) systems that emphasized speed rather than accuracy in order to process the greatest number of mortgage apps as quickly as possible. What was the impact of this on the RE market? How did this impact default ratios and foreclosures?

Bonus: Real estate agents and mortgage brokers were known to repeatedly use the same corrupt appraisers to facilitate loans approval. Did this correlate with AU? Discuss how and why.

8. Collateralized debt obligation (CDO/CMOs) managers who created trillions of dollars in mortgage backed securities and the institutional investors (pensions, insurance firms, banks, etc.) who purchased these appear to have failed to engage in effective due diligence prior to underwriting or purchasing of these products. Reconcile this in terms of the Efficient Market Hypothesis

Bonus: What does this mean for self regulation of the financial industry? Is it desirable? Even possible?

9. The Depression era Glass Steagall legislation was repealed in 1998. What impact did this have on the size of banking institutions? What did this do to the competitive landscape of financial services industry? Did this impact bank risk taking? Discuss.

10. Numerous states had anti-predatory lending laws which in 2005 were “Federally Pre-empted” by order of John Dugan, head of the Office of the Comptroller of the Currency (OCC). What impact did this have on states with anti-predatory lending laws default and foreclosure levels, pre- and post- pre-emption?

11. In 2006, more than 84% of subprime mortgages were issued by private lending institutions not covered by government regulations (McClatchy). Discuss what this means in terms of profit motive, government policy, and GSEs.

12. The Bank Bailouts “rescued” the system, but may have created additional issues int he future. Discuss the Moral Hazard of bailouts, what they mean in terms of competitive landscape and concentration of assets in the financial services industry.

Bonus: What impact might the Consumer Financial Protection Bureau on lending and future credit bubbles?

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Economics 301, Professor Ritholtz
Causes and Elements, Financial Crises and Depressions
Office hours Tu-Thu 3-5

Council of Economic Advisors’ Annual Reports 2005-2007: No Crisis Here
By William K. Black
July 2011

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I decided to look at what President Bush’s Council of Economic Advisors (CEA) were saying in their annual reports for 2005-2007 about the massive real estate bubble, epidemic of accounting control fraud and mortgage fraud, the resultant rapidly developing financial crisis, and the great increase in economic inequality. Here’s what I found on these topics.
CEA Annual Report for 2005

N. Gregory Mankiw chaired the CEA.

Home ownership reached a record 69%. Home prices were surging. No discussion of the developing bubble. The CEA was enthused by the housing sector.

No mention of subprime or nonprime loans (or any variants, e.g., stated income).
There was no discussion of financial institutions’ risk.

There was no mention of Fannie or Freddie.

No mention of the FBI’s September 2004 warning that there was an “epidemic” of mortgage fraud or the FBI’s prediction that the fraud would cause a financial “crisis” if it were not stopped. No mention of mortgage fraud.

The report contained an extensive discussion of Internet frauds.

No use of the term “inequality,” but discussion of some of the factors increasing inequality. It does not discuss the perverse incentives arising from executive compensation tied to short-term reported firm income.

CEA Annual Report for 2006
No CEA chair listed because no replacement was in place after Bernanke’s resignation when he was appointed as the Fed’s Chair.

“During the past five years, home prices have risen at an annual rate of 9.2 percent.” The report argues that this was driven by increased demand and lower financing costs. It does not use the word “bubble,” but it argues that there is no bubble.

No mention of subprime or nonprime loans (or variants).

Chapter 9 of the report is devoted to financial institutions. The CEA argues that the U.S. has a “comparative advantage” in financial services. It premises its analysis of financial institutions on information asymmetries. It has a glaring false tone at the start of this discussion when it asks: “why do [banks] ask for so much information before making a loan….? By early 2006, of course, the striking change was how little information banks verified.

The CEA explains the concepts of adverse selection, moral hazard. The explanation is critically flawed in that it ignores fraud despite the fact that adverse selection and moral hazard are exceptionally criminogenic. Again, the CEA ignores the FBI’s warnings of the growing mortgage fraud epidemic and ignores the risk of accounting control fraud by financial institutions and their agents. It notes that banks can take steps that are known to minimize adverse selection and moral hazard, but ignores the vital fact that the officers that controlled the nonprime lenders typically refused to take such steps (even though any honest businessman would do so) and that nonprime lending was vast and growing rapidly.

The CEA’s discussion of these topics is bizarre – it fails to recognize or address the implications of the fact that nonprime lenders are acting in a manner directly contrary to the economy theory the CEA argues explains why financial intermediaries exist. Under the CEA’s theories, the actions of the nonprime lenders are rational only for accounting control frauds. In conjunction with the FBI’s 2004 warnings that the growing fraud epidemic would cause a financial crisis this should have caused the CEA to issue a stark warning. Instead, the discussion is triumphal. The CEA even sees the tremendous increase in GDP devoted to the financial sector as desirable – proof that the U.S. has a “comparative advantage” in finance over the rest of the world. The CEA then claims that this advantage leads to exceptional U.S. growth and stability, helping to produce the “Great Moderation.” Deregulation and the rise of financial derivatives explain our comparative advantage in finance, the Great Moderation, and our superior economic growth. This self-congratulatory dementia achieves self-parody when the CEA lauds “cash-out-mortgage refinancing” for purportedly having “moderate[d] economic fluctuations.” The CEA’s discussion of “safety and soundness” regulation is overwhelmingly a highly generalized description of Basel I and II.

Chapter 9 discusses the need to combat identity fraud as one of its prime (and rare) examples of desirable forms of consumer protection, but it primarily emphasizes the dangers of consumer protection regulation and attacks the (repealed) Glass-Steagall Act.

Chapter 9 discusses Fannie and Freddie and their systemic risk. More precisely, it assumes that the systemic risk arises from prepayment risk – not credit risk. Accordingly, it explains that the administration wants Fannie and Freddie to expand their securitization of lower credit quality home loans (“for a wider range of mortgages”) while decreasing the number of home loans Fannie and Freddie hold in portfolio so that they can reduce their prepayment risk.
The report uses the term “inequality” and ascribes the growing inequality overwhelmingly to the distribution of skills. It does not discuss the perverse incentives arising from executive compensation tied to short-term reported firm income.
CEA Annual Report for 2007

Edward P. Lazear, CEA Chair.
The report does not mention the word “bubble” and continues to argue that the price increases in housing are due to rising demand for housing and lower financing costs. The CEA claims that the growth in home prices during the decade was “modest” in most metropolitan areas. The growth in most metropolitan areas was materially faster than GDP and population growth. The report admits that all housing indices fell sharply in 2006, but stresses that unemployment is falling and claims that the fall in housing may increase growth in other sectors by reducing “crowding out” effects in private investment. The report does not mention mortgage fraud or accounting control fraud by lenders and their agents. It mentions fraud in two contexts. First, it states that it is possible that regulation could reduce fraud with respect to disaster insurance. Second, it notes that fraudulent papers can make it difficult for employers to avoid hiring undocumented immigrants.

No mention of subprime or nonprime loans (or variants).

The report does not mention Fannie or Freddie.

The report uses the term “inequality” and ascribes the growing inequality overwhelmingly to the distribution of skills. It does not discuss the perverse incentives arising from executive compensation tied to short-term reported firm income.

Conclusion

During the key period 2005-2007 when the epidemic of mortgage fraud driven by the accounting control frauds hyper-inflated the bubble and set the stage for the Great Recession the President’s Council of Economic Advisors were oblivious to the developing fraud epidemics, bubble, and the grave financial crisis they made inevitable absent urgent intervention by the regulators and prosecutors. President Bush’s economists in this era were blind to the factors that were making the financial environment so criminogenic (e.g., deregulation, desupervision, and de facto decriminalization plus grotesquely perverse executive and professional compensation). They typically did not make any relevant policy advice and when they did it was the worst possible advice warning of the grave dangers of regulations designed to reduce adverse selection. They were so blind that they did not even find it worthy of reporting that there were over a million “liar’s” loans being made annually.

The only CEA report that even attempted to address financial regulation discussed a theoclassical fantasy world that bore increasingly little relationship to the reality of nonprime mortgage lending. The tragedy is that “adverse selection” and lemon’s markets are superb building blocks for analyzing the frauds that drove the crisis and for understanding why only liars make a business out of making liar’s loans in the mortgage context. The CEA did not warn of any credit risk at Fannie and Freddie. Indeed, it urged them to make more loans to weaker credit risks as long as they securitized the loans. Securitization would not have reduced Fannie and Freddie’s credit risk.

As I’ve said in the past, there are stocks, bonds, commodities and Apple Inc. Apple has become its own asset class and an incredibly impressive one at that. What happens with Apple is not a new economic indicator for the broad economy but more an undeniable endorsement of an amazing product and brand. With this said, it certainly has created a feel good about the general market following through on yesterday’s IBM helped rally. Underlying the strength though is another rally in the debt of Italy, Spain, Ireland, Portugal and even Greece. With respect to the US debt ceiling, the US Treasury market has for months sent the message that it’s going up, whether on Aug 2nd or days after. The only question is what strings are attached with it. Ahead of the Existing Home Sales figure where we’ll see how the market responded to the spring selling season and ahead of that the MBA said refi’s rose 23.1% bouncing off a 10 week low, finally responding to low mortgage rates. Purchases though were flat and are down 4 of the past 5 weeks. II: Bulls 46.2 v 44.1 Bears 21.5 v 22.6, Bulls at 2 month highs, Bears at 6 week lows.

Here is what’s on my Instapaper for today’s reading:

• Wynn Conference Call Tidbits: Q2 2011 (Kid Dynamite’s World)
• Soros’s Quantum at 75% Cash Leads Hedge Funds Reducing Risk (BusinessWeek)
• Goldman Bets Less and Takes Hit (WSJ) see also Goldman’s Safer Positions Eat Deeply Into Its Profit (Dealbook)
• Understaffed SEC/CFTC Atlas Shrugged. Will Regulators? (WSJ)
• The Debt Limit and National Security (Economix)
• “The easiest ways to differentiate an economist from anyone else in society” (Andrew Gelman)
• China to Dive for Buried Treasures (WSJ)
• Phone hacking crisis shows News Corp is no ordinary news company (Guardian) see also The Raging Septuagenarian (NY Mag)
• The Untold Story of How My Dad Helped Invent the First Mac (Fast Co Design)
• No New Social Network Launched Today (Borowitz Report)

What are you reading?

We’re still reeling from Apple’s stunning and historic earnings release after the market close.   The company beat expectations by over 34 percent, posting $7.79 per share and up an unbelievable 121.9 percent y/y and 21.7 percent q/q.  Revenues grew 81.5 percent y/y and 15.5 percent q/q.  The company now sits on over $76 BN of cash and long-term securities, which equates to around $83 per share.  We read somewhere that Apple could almost purchase RIMM with just the increase in its cash position this quarter.