Sunday, December 21, 2008

The Week Before Christmas

There is still a very large disconnect between the actual data on the US economy and the off-the-cuff descriptions of the economy. We are not in a depression. 6.7 percent unemployment is not 25 percent unemployment. A one-half of one percent fall in GDP is not a thirty-three percent fall in GDP. Perhaps we will get there, but we are nowhere near there and we have a very, very long way to go before we even get 1/3 the way there.

With the economy slowing and the rhetoric (by politicians and by the financial media)out of control, it is not surprising that financial markets were panic-stricken in October and November. That seems to be abating. The surest measure, however, is the yield on the three month treasury bill. When the three month bill rate comes off the floor, look for better times ahead. The three month bill rate (inversely) measures the degree of panic in the financial system. There is still panic, but it is abating.

The Detroit auto industry is being kept afloat a while longer with more than $ 17 billion in taxpayer money (add that to the $ 25 billion provided at 2 percent just three months ago). It will take about $ 120 billion annually to keep the Detroit auto industry propped up. No amount of money will make it profitable or competitive. This seems like a heavy cost simply to provide a small number of autoworkers with a retirement package roughly four times as lucrative as that of the average taxpayer. A grand "reverse Robin Hood" experiment. Take from the middle class and give to those whose income is much higher (some of whom no longer work at all) and whose retirement benefits are four times as high. It must be nice to be "too big to fail."

The Comptroller of the Currency released a report earlier this week that showed that mortgages that had been altered to lower monthly payments (substantially lower in fact) were still heading into delinquency just a scant 60 days later. Those who advocate lower monthly payments are missing the point (and the problem). Mortgages don't go delinquent (or into foreclosure) because borrowers cannot afford the payments. Mortgages go delinquent or into foreclosure because the amount owed in mortgages (including home equity lines) exceed the price of the home -- we call this situation "negative equity." If there is positive equity (current home price exceeds cumulated mortgage loans), homes do not go into foreclosure (homeowners somehow find a way to meet the mortgage payments in this situation). Thus the foreclosure rate is a function of how big your existing mortgage is (not whether it is prime, subprime, or alt-a) and what the current (and future) price is of your home. The monthly payments just don't matter in the foreclosure decision contrary to widespread popular (and incorrect) belief. Look at the study done recently for the state of Massachusetts by the Federal Reserve Bank of Boston (available at their website). Thus, the only way to forestall foreclosure is to forgive principal (which creates other problems, like fairness...what about the guy who didn't take out a slew of home equity lines and therefore has positive, not negative, equity and lives next door...he would have been better off taking out those lines and receiving foregiveness too).

Note that volatility in the equity market has come down dramatically in the past two weeks. That is the first sign that the panic might be abating. The credit markets are still a mess, but they could "unfreeze" quickly if politicians would quit advocating quick fixes that abrogate existing contracts (like forcing lenders to forgive borrowers). These suggestions of simply tossing out financial contracts as if they don't matter,make it very unclear the value of various credit instruments that depend upon such contracts. If you want me to buy a mortgage backed security, don't suggest you plan to alter the terms of the mortgage after I buy it...not a good idea...might keep me from buying it.

The Madoff scandal is a sad one on many counts. It will certainly hurt the hedge fund industry because it raises the concern that the industry's due diligence is simply not what people say it is, which is true, by the way. The Madoff scandal reinforces the old adage: "If it is too good to be true, then it is probably not true." Many innocent and unsuspecting people were badly hurt by Madoff. We need to think hard about how to prevent future Madoffs, if that is possible...it may not be.

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