A simple solution to the housing market problem

Posted in Economics, Financial Markets, General Musings, Politics and Policy at 4:02 pm

Forced debt to equity conversions have been proposed as a solution to make insolvent banks solvent again.  The idea is that some portion of a bank’s outstanding debt is converted into equity in order to restore a positive net worth (assets – liabilities).  There’s no reason why this same approach could not be taken with private homeowners.

Let’s look at a simplified example:

Home purchaser takes out a $100k bank loan to buy a $100k house.
Assets = $100k, liabilities = $100k, net worth = $0.

House price drops to $80k.  Now:

Assets = $80k, liabilities = $100k, net worth = -$20.

Undertake the debt to equity conversion:

Loan reduced to house market value = $80k.
In exchange, bank gets $20k equity = ($20k/$80k) = 25% ownership stake in house.

The homeowner essentially gives up 25% of future increases in home value in order to not be underwater now.

At some point in the future, the house will be sold.  When that happens, one of the following scenarios will play out.

Scenario 1 – House sells for <$80k.  Bank gets fraction of its $80k loan back.  Bank gets nothing on its equity.  Homeowner gets nothing.

Scenario 2 – House sells for $80k.  Bank gets all of its $80k loan back.  Bank gets nothing on its equity.  Homeowner gets nothing.

Scenario 3 – House sells for >$80k.  Bank gets all of its $80k loan back.  Bank gets 25%*(Home price – $80k) on its equity.  Homeowner gets 75%*(Home price – $80k).

At a sale price of $160k, the bank recoups all of its initial loan ($80k modified loan + 25%*$80k = $100k).  The bank makes a net profit on any final sale price over $160k.

The homeowner will also receive an option to buy out the bank’s equity at any point in the future for 25% * (Market value – $80k) plus some pre-determined premium.

This program would be open to all homeowners, banks would have no say in the matter.  Obviously, homeowners who are not underwater would not have any reason to participate.

Is this solution perfect?  No.

Is it preferable to a taxpayer-funded mortgage forgiveness program whereby the government pays banks to forgive a portion of underwater loans?  Yes.

Is it preferable to doing nothing and having the debt overhang doom the economy to a decade or more of below-potential GDP and high unemployment?  Yes.

I’m well aware of the difficulties involved.  The loan writedowns would impair bank earnings for a period of time (though there would now be future upside).  The impact on mortgage services, MBS, CDOs, and the holders of MBS and CDOs would be messy.  There would be lawsuits.  Again, it must be measured against the alternatives and not some utopian fantasy world where all debts will be eventually paid in full and no losses have to be taken.

What I’ve laid out above is a simplified, stylistic version.  All sorts of modifications could be made to improve it.  The percentage of debt converted could be increased to provide additional monthly payment relief.  The equity structure could be modified to give the bank a bigger percentage claim on the first $20k in price appreciation.  Other terms of the loan could be modified.  The point here is just to lay out a set of guiding principles; the details can be hashed out later.


Barro on “Regular Economics vs Keynesian Economics”

Posted in Economics, General Musings at 8:47 am

Very odd statement:


Barro’s “regular economics” describes a world that is always operating at 100% capacity with zero unemployed labor or idle capital.  Thus, resource and technology constraints mean that there is a real tradeoff between government spending and private spending and between current consumption and investment spending.

“Keynesian economics” describes a world that is not operating at capacity, and therefore has unemployed labor and idle capital.  In such a world, it is possible to increase government spending and private spending simultaneously, or to increase consumption and investment simultaneously.  In fact, doing so moves the operation of the economy closer to its capacity.

Which world best describes our current state of affairs?


Fed Announcement

Posted in Economics, Financial Markets, Politics and Policy at 7:25 pm

The Fed announced at 2:15 that it would hold the Federal Funds rate near zero for 2 years.

More significant was what it did NOT announce:

  • It did not announce it would keep rolling over its bond portfolio for 2 years.
  • It did not announce it would change the composition of its bond portfolio to longer maturity bonds.
  • It did not announce it would cut the interest rate (0.25%) it pays on bank reserves.
  • It certainly did not announce QE3.

The immediate market reaction was predictably negative – market consensus was for more action by the Fed.

However, that reaction was short-lived, and the market soon took off like a rocket.  Very odd.


Greek exposure and derivatives exchanges

Posted in Economics, Financial Markets, Politics and Policy at 1:53 pm

There’s a considerable amount of debate regarding the exposure of US banks to Greek sovereign default via their CDS protection sales to European banks.  See:





Yet some policymakers and industry participants still aren’t convinced of the need to move CDS trading to exchanges and bring transparency to the market?  Seriously?  We really didn’t learn anything from the 2008-2009 crisis.

A Greek Debtor’s Prison

Posted in Economics, Financial Markets, Politics and Policy at 8:42 am

Some key stats:

  • Debt-To-GDP of around 150%
  • Budget Deficit >10% of GDP
  • Current account deficit >10% of GDP.
  • GDP growth for Q1 2011 -5.5%
  • 15.9% unemployment rate
  • 2-Yr hitting a high of 30% and the 10-Yr hitting a high of 18%

With average interest rates around 20%, and around a 150% Debt to GDP ratio, Greece needs a primary surplus (government budget net of interest) of 30% to service that debt.  Yet tax revenues are falling at an alarming clip because of the decline in GDP.

What Greece needs, in order:

1. Economic growth
2. Lower interest rates

Austerity programs (lower spending, higher taxes) lead to lower economic growth in the short to medium term, with very little impact on interest rates over that time period.

The bailouts increased the debt to GDP ratio, and any softening effect they had on market interest rates was highly temporary.

Unfortunately for Greece, an absence of bailout funding means an almost immediate default on existing debt.  I agree that this would be a highly destabilizing event for the entire Eurozone if not the world, BUT – the architects of the bailout have no credible explanation for how Greece is to sustain its debt service over the next 2-5 years apart from simply ASSUMING that austerity will somehow magically lead to both balanced budgets and robust economic growth, which is NONSENSE.

Meanwhile, EU/ECB/IMF leaders’ primary concern is how to get Greece’s creditors to rollover short term maturing debt in a manner that does not trigger a “credit event”.  The fact that they are talking in CDS terms speaks volumes.  This is silliness.

The Greek Parliament ought to outright REJECT the asuterity measures that European banks are attempting to impose on them.  Tell the EU/ECB/IMF that they want to honor their debts but that the only way to do so is through economic growth, and ask for a plan that will increase economic growth to a level that makes current debt service sustainable.  Make it clear that the only other option to the “growth plan” is immediate default, French and German banks be damned.

The more Greece tries to balance its budget by cutting spending and increasing taxes, the more the budget deficit will actually widen as the economy slows and tax receipts decline.  Austerity is not the solution, it is a big part of the problem.  Likewise, exchanging existing government debt for new government debt, while interest rates continue to rise, only makes future debt service more difficult.  Stop the madness.

There’s a reason why we abolished debtor’s prisons a long time ago.  They effectively make it impossible for the debtor to ever repay his debts, and thus are to the detriment of both debtor and creditor.  Yet, what the European authorities have done is essentially put Greece into a debtor’s prison named Austerity.  They should release Greece if they are to have any hopes of being paid anything back.



Posted in Economics, General Musings at 10:22 am

WTI oil futures are trading at over $106 today.  This poses significant risks to the economy.  The fact that a number of “experts” in the media are going out of their way to tell us that it does not pose a threat should drive the point home.

In “Crude Realities”, Jeremy Siegel tells us not to worry:

“The U.S. consumes about 19 million barrels of oil a day and produces about 9 million b/d, meaning we import about 10 million b/d. Each $10 rise in the price of a barrel of oil increases our import bill by about $100 million a day or about $36 billion a year. In our $15 trillion economy, this increase costs us about 2 tenths of one percent of GDP. If crude rises $20 barrel, as it has from the beginning of the year, this increase will shave about 4 tenths of one percent from GDP. This is hardly debilitating to an economy that is expected to grow between 3% to 4% this year. If the price increase is much larger, say to $200 a barrel, this is more serious and could shave two percentage points from our projected growth. That outcome is likely only if there is a major disruption to the flow of Saudi Arabian oil.”


Seriously?  A couple of tenths of a percent off GDP?  Has he never heard of the effect of expectations?  Has he never heard of the concept of a consumption multiplier?  The accelerator effect on investment?

This is the same sort of simple-minded analysis (multiply the percentage of production costs attributed to oil by the price increase and subtract the result from GDP) that led him to declare a few years back that the subprime mortgage problem was “contained” (because subprime was just a small percentage of all mortgages and only a small percentage of subprimes were in default).  You’d think he’d have learned his lesson.  Apparently not.

The Economist does a little better in declaring that oil prices are “more of a threat than investors seem to think.”  Nevertheless, even they go on to underestimate the problem:

“Dearer oil still implies a transfer from oil consumers to oil producers, and since the latter tend to save more it spells a drop in global demand. A rule of thumb is that a 10% increase in the price of oil will cut a quarter of a percentage point off global growth. With the world economy currently growing at 4.5%, that suggests the oil price would need to leap, probably above its 2008 peak of almost $150 a barrel, to fell the recovery. But even a smaller increase would sap growth and raise inflation.”


There seems to be this idea that while the oil price spike of 2008 contributed to the economic downturn, we need not really worry unless the July 2008 peak of $147.50 is breached.

Let’s not forget that the peak number quoted was a one day event, even though the price spike was not.

To put things in context:

  • We entered 2008 with oil a little over $95/bbl and exited 2008 with oil just under $45/bbl.
  • Oil was only over $100/bbl from late February through late September.
  • Oil was only over $120/bbl from mid May through early August.
  • Oil was only over $140/bbl for a few days spread out over 3 weeks in late June and early July.

When you think of the oil price spike of 2008, don’t think of $147 oil.  Think of oil trading between $100-$125 for six months or so.  We’re already in the early stages of the 2011 repeat.

WTI Spot prices from:


FCIC Report

Posted in General Musings at 5:10 pm

I picked up a copy at the local B&N last night.  Stay tuned.  There has been quite a bit of commentary on it over the last week or so, but I’d prefer to actually read the whole thing before commenting.


Threats For 2011

Posted in Economics, Financial Markets, Politics and Policy at 9:55 pm

A number of bloggers are making their annual predictions on what’s in store for the economy in the coming year.  Since I consider trying to forecast GDP, unemployment, and other macro measures a year out to be a fool’s errand, I will instead focus on what I consider to be the biggest threats to the US economy in 2011.

  1. Oil Prices. Crude is now over $91/bbl.  That represents a 35% increase over where it stood early this past Summer.  Rising oil prices act as a brake on economic growth.  $100/bbl is an important psychological milestone, and if it goes much above that, we will certainly see an impact on auto sales, airline profits, and transportation industry profits, along with a general falloff in demand as disposable income is reduced.
  2. Real Estate Prices. Housing prices started falling again in July after appearing to stabilize.  It appears that the temporary stabilization was largely a result of the homebuyer tax credit, and its expiration means housing is resuming its slide.  This will mean more negative equity, more foreclosures, and more economic pain for almost everyone.
  3. Stimulus Wind Down. The growth rate of ARRA spending has already peaked.  Many programs are winding down.  There will almost certainly be many (misguided) calls for further austerity.  State budgets are being cut back to the point where basic services like snow removal (as the recent Northeast blizzard demonstrated) are becoming a challenge.  The 2% payroll tax cut and unemployment extension will provide some respite, but these are temporary measures.
  4. The European Debt Situation.  The crisis that is continually contained, until it isn’t.  It’s likely that we’ll continue to see flare ups followed by new emergency measures that bring about temporary calm repeated almost ad infinitum.  My fear is that, for whatever reason, there will eventually be a “European Lehman” that fails and the European authorities will be unwilling or unable to implement a rescue in time.
  5. Policy Paralysis. Politically, there isn’t going to be any further fiscal stimulus.  Conventional monetary policy is at its limit.  Unconventional monetary policy will face widespread opposition from both the left and the right.  We are thus vulnerable to any significant shocks that occur, whatever they may be.

Never forget the old boxing saying that it’s always the punch you didn’t see that knocks you out.


The Irish Bailout

Posted in Economics, Financial Markets, Politics and Policy at 7:11 pm

More or less what was expected.  €85 billion at 5.8% interest.  €10 billion in immediate cash to re-capitalize the banks, another €25 billion line of credit for the banks, and €50 billion to meet state budgetary needs.  Oddly, the Irish government must contribute €17.5 billion, mostly from the state pension system.

Most interestingly, a vague “permanent resolution mechanism” for restructuring debt was announced that will go into effect sometime in 2013, and that “may” require bondholders to take losses at that point.  That’s their long term solution to the contagion problem?  Wow.


Wait, what? Belgium?

Posted in Economics, Financial Markets, Politics and Policy at 10:58 pm

It seems that a number of blogs have picked up on Belgium as a likely candidate for the next domino to fall – either immediately before or immediately after Portugal.

Let’s look at the facts here:

  • Belgium’s budget deficit is under 5% of GDP, below the Eurozone average
  • Belgium has a savings rate of 11.5%
  • Belgium is currently running a current account surplus, and has been for some time
  • Belgian GDP is growing around 2% per year
  • Belgian 10 yr bonds are trading at roughly 1% above German Bunds, a mere fraction of the spreads at which other Eurozone countries’ bonds are trading

So what is the case for a Belgian default?

It seems to be:

  • Belgian national debt is around 100% of GDP, third overall in the Eurozone, behind Greece and Italy
  • Belgium has failed to form a new government for the past 6 months, with a split between parties representing the Dutch and French speaking areas
  • Concerns over Belgian banks, which in reality are no shakier than those of other Eurpoean countries not consider to be on the domino list, certainly far less shaky than those of Ireland

National debt as a % of GDP is not an indicator of short term instability.  It’s only real relevance is with regard to debt service levels, and given Belgium’s current account surplus, savings rate, and GDP growth, this is a non-issue in the short to medium term.  The danger represented by lack of a government is completely overblown, and if there were a crisis, I’m fairly confident they’d pull together a government in short order.  The banks, again, really are in no more of a fragile state than those in the rest of Europe.

If, in fact, a “crisis” does develop in Belgium, I think it warrants stepping back and re-examining what’s really happening in Europe and whether the current approach to rectifying the problem is appropriate.