The Federal Reserve released new data on the financial condition of the household sector of the United States. Like other sectors of the economy, the financial condition of this sector has deteriorated over the past year.
The value of household assets dropped about 15% falling from $77.3 trillion to around $65.7 trillion. Most of the decline came from the fall in housing values and in their stock market portfolios.
In terms of household holdings of stocks, the value of the stocks households owned, mutual funds that were held and funds in retirement plans, the loss was $8.5 trillion. That is, the value of stock holdings fell from $20.6 trillion to $12.1 trillion.
Although mortgage credit fell during the year, total household liabilities stayed roughly the same at about $14.2 trillion. This means that debt as a percentage of assets rose from around 18% to 22% during the year (or net worth as a percentage of assets dropped from 82% to 78%).
Mortgage credit at the end of 2008 was $10.5 trillion so that other household liabilities totaled around $3.7 trillion, with consumer credit making up $2.6 trillion of this latter number. Mortgage credit fell during the year, but not because the household sector was trying to get out of mortgage debt. The primary reason for the decline was foreclosures and the reduction in the willingness of financial institutions to lend.
What this means is that households took on increased leverage during the year, not because they wanted to in order to grow their balance sheets, but because of the decrease in the value of their assets and because of the need to borrow due to lower incomes. The increased leverage was a result of the collapse of the mortgage market, in particular, and the economy, in general. The increased leverage just happened—it was not planned.
In order to protect themselves in the face of these changes, households moved assets into cash and cash equivalent accounts. Banks deposits held by households were at about $7.7 trillion at year end.
This is important information for understanding the state of the economy and the contribution the household sector might make toward turning the economy around. The household sector was in free fall in 2008 and was reacting to events, not leading them.
Households took three major shocks last year: first was the decline in housing prices; the second was the rise in unemployment; and the third was the fall in the stock market. Not only was their cash flow significantly hurt, but the value of their assets fell precipitously. They borrowed in an effort to hold on and they became more liquid so as to be prepared for that “rainy day.”
The year 2009 does not look any better than 2008. Housing prices continue to plummet. The stock market has dropped since the first of the year. And, unemployment has ratcheted up. That is, one can assume that the direction observed in the balance sheets of American household in 2008 will continue to be followed this year. Even if the stock market were to stabilize or rise through the rest of the year consumer spending, I believe, will continue to be weak. Even if housing prices stabilize. Even with the implementation of the Obama stimulus plan.
According to the best information we have there are three further shocks looming on the horizon. The first two have to do with the mortgage market: over the next 18 a large amount of Alt-A and Options mortgages are supposed to re-price. Given the weakness in employment that is expected to continue and the lower household incomes, this event could be devastating. And, on top of that credit card delinquencies are rising and these are expected to grow given the financial condition of the household sector.
Consumers will continue to withdraw from the marketplace as they add debt where they can in order to maintain at least a part of their former living standards. Also, consumers will continue to try and become more liquid so that they can be prepared should they need to need cash to tide them over a rough time. Any improvement in the stock market will be met with households selling more stock so as to move the funds into more liquid assets, the rise in the market making it easier for them to get rid of stocks—even at a loss.
And where are the funds going to go that come to households from the Obama recovery plan? My guess is that a good portion of them will go into liquid assets, or into paying down debt. Households are scared right now. They are going to use whatever they have as conservatively as possible. This even goes for those that have some security in their employment condition.
The data that are coming out confirm the strength of the problem that the policy makers face. The United States has a tremendous debt overhang. This debt problem is going to have to be worked off. Economists talk about “the paradox of thrift”, the problem that consumers are not spending at this time and probably will not spend much in the near future, even though if everyone opened up their pocketbooks and spent, everyone would be better off.
This situation is like a “Prisoner’s Dilemma” game. If everyone else increases their spending reducing their savings and, willingly, increasing their debt and I don’t follow their lead, then I will be a lot better off that all these other people. But, if everyone else believes as I do and doesn’t reduce their savings and doesn’t increase their debt, then I end up losing big to everyone else. So, as in the “Prisoner’s Dilemma” everyone defaults to the decision to save more where they can and to pay off their debt. The consequence of this will be that consumer spending will remain weak and much effort will be extended, where possible, to work themselves out of debt.
The overall problem is that there is too much debt outstanding. The policy makers are focusing upon stimulating the economy by increasing spending. If the debt overhang is truly too great, then the stimulus package will only have a small multiplier effect on the economy as households try and get their balance sheets back in some kind of order.
Such behavior will not have much affect on the economy, and it will also not have much affect on the stock market. Government policy makers must direct more attention to resolving this debt problem. It seems to me that this is what the financial markets are trying to tell them. As Citigroup and Bank of America claim they are showing some signs of profitability. As General Electric survives a reduction in its credit rating, meaning that GE Capital has more of a chance to re-structure itself. As General Motors indicates that it has reduced costs sufficiently to rescind the request for another $2 billion from the government in March. And, as other financial institutions seek to repay to TARP money they had received last fall, the stock market rebounds.
It is the debt problem that is the big concern of the financial markets. In my opinion, as long as the government policy makers put their primary focus on stimulating spending, the financial markets—and the economy—will continue to flounder. When they refocus on the more crucial problem they will find that the financial markets will be more supportive of what they are doing.
Showing posts with label Mortgage crisis. Show all posts
Showing posts with label Mortgage crisis. Show all posts
Thursday, March 12, 2009
Wednesday, January 28, 2009
Are Derivatives the Problem?
Bob Shiller, the Yale economist, has gotten a lot of press in recent days supporting the use of derivatives and arguing against the use of the efficient markets model in understanding financial (and non-financial) markets. I am supportive of what he is trying to say. In this post I present my reasoning for this support…you can go to Bob’s articles in the Wall Street Journal and elsewhere and his upcoming book (along with his many other books) to get his view.
First, human beings are innovators. They are problem solvers and are constantly pushing the edge trying to come up with something new that makes things better.
The problem we are dealing with here is risk. People, investors, don’t like risk. They are constantly trying to reduce risk in their lives…and they are willing to pay to reduce risk.
And, this is the essence of derivatives. Derivatives are risk reducing tools that can be used to hedge cash flows and thereby protect individuals from assuming more risk than they would like. People will pay for this…derivatives will get invented.
Answer me this…will a large number of people pay someone to invent a tool for increasing risk? The answer to this is no! People don’t pay people to build speculative instruments. The expected return to speculation is zero or less. Now how much will you pay for someone to create a tool that can provide you with an expected return of zero or less? Right…nothing!
People will pay innovators to build instruments that help to reduce risk because they are receiving value by being able to reduce the risk. Now this does not mean that people will not use these risk reducing instruments to speculate with. Hedging is providing a cash flow to offset the movements of all or part of another uncertain cash flow. Speculation means that you are taking an uncovered position…that is, you are working with only one of the cash flows.
So, like other innovations, derivatives have been created for a positive reason…but can be used in ways that increase risk. Like cars…or drugs…or nuclear energy plants. All these can be used in positive ways…but they can also be used in other ways as well.
Conclusion: derivatives will continue to be used, created, and, at times, misused. Financial innovation is with us and will continue with us. My experience supports the view that only a minimal amount of regulation will be effective to control the use of derivatives because part of innovation…is to get around the rules. That’s life!
My second point has to do with the efficient market hypothesis. People who support the efficient market hypothesis argue that market prices reflect all the information that is available to the market at a particular time. That is, market prices are correct. In essence, everyone in the market knows what information is available, what that information means, and how that information is translated into market prices…for all time. At least, there is a well informed group of arbitragers that know these things so that “on the margin” market prices can be made “right”.
In the world I live in, individuals have to deal with incomplete information…especially about the future. That is why uncertainty exists and why people have created probability theory as a way to deal with incomplete information and the resulting uncertainty. For prices to be “correct” and for markets to be “efficient” we need complete information which means no probability distributions for we will have certainty. I can’t believe that everyone in the market, given what information is available, knows what the price of every stock will be at every period of time in the future.
When we have incomplete information markets cannot be efficient because we don’t know the exact models to forecast the future with and we don’t know the appropriate probability distributions that surround our forecasts. As a consequence, our risk management models, as well as our risk management controls, have been inadequate. As such, our hedges have contained more risk in them than we had anticipated and our speculative positions have provided way more risk that we had assumed. Thus, our financial structure has been out-of-line with where we thought we were and our financial system has been more fragile than we thought.
My third point concerns the incentives present in an economy. People will use the instruments that are available to them in ways that are consistent with the incentives that exist within the economy at a given time. For example, in the past, the price of a house may have appreciated over time but this was not the real value of the house. The real value of the house was the flow of services that people received over time…it was this which made the house a home. What people acquired was the flow of housing services…not the stock…not the house itself. This was because the house was not going to be sold…at least not for a long time into the future. In this sense the price of the house was only important at the time of purchase.
What changed? In recent years in too many cases the price of the house became more important than the flow of services. Why? Because in many cases, houses were “sold” every two or three years. People with teaser interest rates, or whatever, that reset every three years, “sold” their house to themselves because the game was to refinance the house using the inflated house price to get a better mortgage rate. Living in the home was not the essence of the deal…speculation on the house price was the focus…and this was seen explicitly in the many “speculative” deals that arose at this time. And this was the essence of the asset-based securities used to support these transactions.
Also, remind me sometime to tell you about my friend that ran a mutual fund who avoided moving into dot.com stocks until the year before the stock market bubble burst. He did not move into these securities until he saw that too much money was leaving his fund…going into funds showing better results because they had invested in dot.com stocks. And he made the front page of the Wall Street Journal when the bubble burst and his “late-in-the-day” bets…collapsed.
Finally, my last issue has to do with the government. Unfortunately, in many cases, government policies can dominate the economy; government policies can create the incentives that people respond to. And, although the government may not mean to, it can create incentives that are detrimental, at least over the longer run, to the health of the economy.
If you have read many of my posts, you know that I believe that the Bush43 tax cuts, the war on terror along with other events that inflated the spending of the government, and the Greenspan “low interest rate” policy set the scene for the bubble in the housing market, the exponential increase in credit over the past eight years, and the overwhelming increase in leverage. The incentives that were created during this time put more and more pressure on business executives to take speculative positions and finance these positions with more and more leverage.
Who was responsible for the behavior of these business executives? Like my friend that ran the mutual fund…even those that were relatively conservative in their business decisions…ultimately found themselves forced into positions where they had to take on more risk than they would like. Competitive pressures “forced” decision makers to respond to the current environment that existed in the market place. After-the-fact they seem to have been overly greedy. After-the-fact they appear to have been insensitive to the risk they were taking…careless even. And now, people and politicians have dumped on them for their mis-guided behavior. The politicians that created the environment many years ago…although they might have lost the election…walk away defending their legacy in other areas. This is one of the difficult things about economics…results often trail, by many, many years, those policies and programs that were their cause.
Yes, I agree with Shiller that derivatives are here to stay. And, I agree with Shiller that many new kinds of derivative securities will be invented in the future. I just wish that we could invent a derivative that would allow us to hedge against bad policy making in Washington, D. C.
First, human beings are innovators. They are problem solvers and are constantly pushing the edge trying to come up with something new that makes things better.
The problem we are dealing with here is risk. People, investors, don’t like risk. They are constantly trying to reduce risk in their lives…and they are willing to pay to reduce risk.
And, this is the essence of derivatives. Derivatives are risk reducing tools that can be used to hedge cash flows and thereby protect individuals from assuming more risk than they would like. People will pay for this…derivatives will get invented.
Answer me this…will a large number of people pay someone to invent a tool for increasing risk? The answer to this is no! People don’t pay people to build speculative instruments. The expected return to speculation is zero or less. Now how much will you pay for someone to create a tool that can provide you with an expected return of zero or less? Right…nothing!
People will pay innovators to build instruments that help to reduce risk because they are receiving value by being able to reduce the risk. Now this does not mean that people will not use these risk reducing instruments to speculate with. Hedging is providing a cash flow to offset the movements of all or part of another uncertain cash flow. Speculation means that you are taking an uncovered position…that is, you are working with only one of the cash flows.
So, like other innovations, derivatives have been created for a positive reason…but can be used in ways that increase risk. Like cars…or drugs…or nuclear energy plants. All these can be used in positive ways…but they can also be used in other ways as well.
Conclusion: derivatives will continue to be used, created, and, at times, misused. Financial innovation is with us and will continue with us. My experience supports the view that only a minimal amount of regulation will be effective to control the use of derivatives because part of innovation…is to get around the rules. That’s life!
My second point has to do with the efficient market hypothesis. People who support the efficient market hypothesis argue that market prices reflect all the information that is available to the market at a particular time. That is, market prices are correct. In essence, everyone in the market knows what information is available, what that information means, and how that information is translated into market prices…for all time. At least, there is a well informed group of arbitragers that know these things so that “on the margin” market prices can be made “right”.
In the world I live in, individuals have to deal with incomplete information…especially about the future. That is why uncertainty exists and why people have created probability theory as a way to deal with incomplete information and the resulting uncertainty. For prices to be “correct” and for markets to be “efficient” we need complete information which means no probability distributions for we will have certainty. I can’t believe that everyone in the market, given what information is available, knows what the price of every stock will be at every period of time in the future.
When we have incomplete information markets cannot be efficient because we don’t know the exact models to forecast the future with and we don’t know the appropriate probability distributions that surround our forecasts. As a consequence, our risk management models, as well as our risk management controls, have been inadequate. As such, our hedges have contained more risk in them than we had anticipated and our speculative positions have provided way more risk that we had assumed. Thus, our financial structure has been out-of-line with where we thought we were and our financial system has been more fragile than we thought.
My third point concerns the incentives present in an economy. People will use the instruments that are available to them in ways that are consistent with the incentives that exist within the economy at a given time. For example, in the past, the price of a house may have appreciated over time but this was not the real value of the house. The real value of the house was the flow of services that people received over time…it was this which made the house a home. What people acquired was the flow of housing services…not the stock…not the house itself. This was because the house was not going to be sold…at least not for a long time into the future. In this sense the price of the house was only important at the time of purchase.
What changed? In recent years in too many cases the price of the house became more important than the flow of services. Why? Because in many cases, houses were “sold” every two or three years. People with teaser interest rates, or whatever, that reset every three years, “sold” their house to themselves because the game was to refinance the house using the inflated house price to get a better mortgage rate. Living in the home was not the essence of the deal…speculation on the house price was the focus…and this was seen explicitly in the many “speculative” deals that arose at this time. And this was the essence of the asset-based securities used to support these transactions.
Also, remind me sometime to tell you about my friend that ran a mutual fund who avoided moving into dot.com stocks until the year before the stock market bubble burst. He did not move into these securities until he saw that too much money was leaving his fund…going into funds showing better results because they had invested in dot.com stocks. And he made the front page of the Wall Street Journal when the bubble burst and his “late-in-the-day” bets…collapsed.
Finally, my last issue has to do with the government. Unfortunately, in many cases, government policies can dominate the economy; government policies can create the incentives that people respond to. And, although the government may not mean to, it can create incentives that are detrimental, at least over the longer run, to the health of the economy.
If you have read many of my posts, you know that I believe that the Bush43 tax cuts, the war on terror along with other events that inflated the spending of the government, and the Greenspan “low interest rate” policy set the scene for the bubble in the housing market, the exponential increase in credit over the past eight years, and the overwhelming increase in leverage. The incentives that were created during this time put more and more pressure on business executives to take speculative positions and finance these positions with more and more leverage.
Who was responsible for the behavior of these business executives? Like my friend that ran the mutual fund…even those that were relatively conservative in their business decisions…ultimately found themselves forced into positions where they had to take on more risk than they would like. Competitive pressures “forced” decision makers to respond to the current environment that existed in the market place. After-the-fact they seem to have been overly greedy. After-the-fact they appear to have been insensitive to the risk they were taking…careless even. And now, people and politicians have dumped on them for their mis-guided behavior. The politicians that created the environment many years ago…although they might have lost the election…walk away defending their legacy in other areas. This is one of the difficult things about economics…results often trail, by many, many years, those policies and programs that were their cause.
Yes, I agree with Shiller that derivatives are here to stay. And, I agree with Shiller that many new kinds of derivative securities will be invented in the future. I just wish that we could invent a derivative that would allow us to hedge against bad policy making in Washington, D. C.
Sunday, September 21, 2008
Thoughts on "The Plan"
Well, “The Plan” is becoming a reality. What exactly it is and whether or not it will be successful is still a mystery. That is not the issue at this point in time.
To me the important thing is the philosophy behind “The Plan”. Up to now the policy makers have been shooting at a moving target…and the target that they have been going for is usually behind where the market and the institutions are. Thus, the policy makers have always been behind the curve…and things keep getting worse.
Now a new effort is being made. I think that we can clearly see the hand of Fed Chairman Ben Bernanke behind this move. I think that Bernanke finally won the day with the AIG effort. Bernanke, the student of the Great Depression, finally convinced everyone that the only way to really stop the down draft that was going on was to get out in front of it…not keep shooting behind it.
That is, the action had to be big enough to overwhelm the debt deflation going on.
This is the lesson from the Great Depression. One cannot let the debt deflation continue to cumulate. One must get out ahead of it.
This doesn’t mean that such actions may not cause problems in the future…inflation, moral hazard, or whatever. None of these are the problem now. If such problems are present in the future then the future will just have to deal with them. First…we have to reach the future without a major collapse.
The concern now is that debt deflation will get out-of-hand and the problem will only grow with time. That is why the policy makers believe that it is necessary to create a big enough plan to get ahead of the cumulating debt deflation and do more than is necessary to stop the downward cycle.
Will it be big enough? Will it succeed? Who knows? This is decision making under uncertainty and we are way beyond graduate school!
The policymakers believe that this package will be enough. But, they don’t know that either. My sense is that they just believe that the package needs to be big enough to really have a chance to work.
If “The Plan” works will this be the end of the effort?
No, the effort will still be in its early stages. The financial system and its regulatory framework will have to be revamped. What this administration is doing is attempting to buy time by stopping the downward spiral of financial markets and financial institutions. It is not proposing a solution about how the system will move forward. That will be up to the next administration.
Nothing the Paulson/Bernanke team has done suggests how the financial system and its regulation should be re-structured. The Fannie Mae/Freddie Mac bailout did not do it. Nothing that has taken place since that action has done it. This will be the job of the next administration.
And, Congress should remember this and not try and make all sorts of additions to “The Plan”.
In terms of the next administration, I believe that the two presidential candidates need to put their new programs and plans, like universal health care, on the back burner. I don’t believe that they will have much of a chance to put any of their promises or polices into place for three or four years. They are going to have to create the brave new world and get things back into order before anything else can be put into place. Thus, the candidates need to put their campaign promises into their back pocket for another time. I don’t think that it really helps the situation to talk much about them.
The presidential candidates need to see what the current administration puts into place and then needs to try and build on this to construct a plan to get financial institutions and markets back on their feet, to revamp the regulatory system, and to devise an economic policy that is both realistic and builds confidence, nationally and internationally. This is what the candidates are going to have to sell…first to the people of the United States and then to the Congress of the United States and then to the rest of the world.
The Paulson/Bernanke plan has to have a chance to work. It is not going to help right now to have the candidates confuse the issue with second guessing and petty attacks. This is going to be a fine line to walk, but the nation needs to pull together right now to stop the downward spiral.
Just one other point on the activities of this last week: it was necessary to get the President out in front of the cameras and speak about the financial chaos to the world. For too long in the current financial meltdown the President’s absence has been noticeable. Now, the whole world has seen the President speak out. Unfortunately for him, the puppet strings were quite obvious and one could see Hank Paulson’s lips move as the President attempted to mouth the words that were being spoken. One only has to wonder how much of his administration was conducted in this way only with someone named Dick Chaney controlling the strings and mouthing the words.
To me the important thing is the philosophy behind “The Plan”. Up to now the policy makers have been shooting at a moving target…and the target that they have been going for is usually behind where the market and the institutions are. Thus, the policy makers have always been behind the curve…and things keep getting worse.
Now a new effort is being made. I think that we can clearly see the hand of Fed Chairman Ben Bernanke behind this move. I think that Bernanke finally won the day with the AIG effort. Bernanke, the student of the Great Depression, finally convinced everyone that the only way to really stop the down draft that was going on was to get out in front of it…not keep shooting behind it.
That is, the action had to be big enough to overwhelm the debt deflation going on.
This is the lesson from the Great Depression. One cannot let the debt deflation continue to cumulate. One must get out ahead of it.
This doesn’t mean that such actions may not cause problems in the future…inflation, moral hazard, or whatever. None of these are the problem now. If such problems are present in the future then the future will just have to deal with them. First…we have to reach the future without a major collapse.
The concern now is that debt deflation will get out-of-hand and the problem will only grow with time. That is why the policy makers believe that it is necessary to create a big enough plan to get ahead of the cumulating debt deflation and do more than is necessary to stop the downward cycle.
Will it be big enough? Will it succeed? Who knows? This is decision making under uncertainty and we are way beyond graduate school!
The policymakers believe that this package will be enough. But, they don’t know that either. My sense is that they just believe that the package needs to be big enough to really have a chance to work.
If “The Plan” works will this be the end of the effort?
No, the effort will still be in its early stages. The financial system and its regulatory framework will have to be revamped. What this administration is doing is attempting to buy time by stopping the downward spiral of financial markets and financial institutions. It is not proposing a solution about how the system will move forward. That will be up to the next administration.
Nothing the Paulson/Bernanke team has done suggests how the financial system and its regulation should be re-structured. The Fannie Mae/Freddie Mac bailout did not do it. Nothing that has taken place since that action has done it. This will be the job of the next administration.
And, Congress should remember this and not try and make all sorts of additions to “The Plan”.
In terms of the next administration, I believe that the two presidential candidates need to put their new programs and plans, like universal health care, on the back burner. I don’t believe that they will have much of a chance to put any of their promises or polices into place for three or four years. They are going to have to create the brave new world and get things back into order before anything else can be put into place. Thus, the candidates need to put their campaign promises into their back pocket for another time. I don’t think that it really helps the situation to talk much about them.
The presidential candidates need to see what the current administration puts into place and then needs to try and build on this to construct a plan to get financial institutions and markets back on their feet, to revamp the regulatory system, and to devise an economic policy that is both realistic and builds confidence, nationally and internationally. This is what the candidates are going to have to sell…first to the people of the United States and then to the Congress of the United States and then to the rest of the world.
The Paulson/Bernanke plan has to have a chance to work. It is not going to help right now to have the candidates confuse the issue with second guessing and petty attacks. This is going to be a fine line to walk, but the nation needs to pull together right now to stop the downward spiral.
Just one other point on the activities of this last week: it was necessary to get the President out in front of the cameras and speak about the financial chaos to the world. For too long in the current financial meltdown the President’s absence has been noticeable. Now, the whole world has seen the President speak out. Unfortunately for him, the puppet strings were quite obvious and one could see Hank Paulson’s lips move as the President attempted to mouth the words that were being spoken. One only has to wonder how much of his administration was conducted in this way only with someone named Dick Chaney controlling the strings and mouthing the words.
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