Steven Engelhardt

Roger Lowenstein has written a fascinating article for the New York Times Magazine entitled Triple-A Failure which explores the role of rating agencies in the credit crisis. It even explains the process rating of an actual mortgage-backed security:

The business of assigning a rating to a mortgage security is a complicated affair, and Moody’s recently was willing to walk me through an actual mortgage-backed security step by step. I was led down a carpeted hallway to a well-appointed conference room to meet with three specialists in mortgage-backed paper. Moody’s was fair-minded in choosing an example; the case they showed me, which they masked with the name “Subprime XYZ,” was a pool of 2,393 mortgages with a total face value of $430 million.

…

Moody’s did not have access to the individual loan files, much less did it communicate with the borrowers or try to verify the information they provided in their loan applications. “We aren’t loan officers,” Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody’s, told me. “Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?”

…

In the frenetic, deal-happy climate of 2006, the Moody’s analyst had only a single day to process the credit data from the bank.

…

Mortgage-backed securities like those in Subprime XYZ were not the terminus of the great mortgage machine. They were, in fact, building blocks for even more esoteric vehicles known as collateralized debt obligations, or C.D.O.’s.

We built a financial house of cards on ratings agencies’ models, and these models turned out to be disastrously wrong.

In the course of preparing for Level 1 of the CFA Exam, I learned a few interesting things about the Fed I did not previously know:

• The Fed does not directly control the Federal funds rate. Instead, the Fed publishes a target for the Federal funds rate and attempts to hit it by using open market operations.
• It is a relatively recent development for the Fed to target the Federal funds rate. Before this, the Fed would often target the money supply.
• The Federal Reserve Bank of New York has a special place above all other regional Federal Reserve Banks. The representative from the New York Fed is a permanent member of the Federal Open Market Committee (FOMC), and all open market operations are conducted by the New York Fed under direction from the FOMC.

Changes in relative prices lead consumers to change the items they buy. For example, if the price of beef rises and the price of chicken remains unchanged, people buy more chicken and less beef. Suppose they switch from beef to chicken on a scale that provides the same amount of protein and the same enjoyment as before and their expenditure is the same as before. The price of protein has not changed. But because it ignores the substitution of chicken for beef, the CPI says the price of protein has increased.

CFA Institute, comp. Economics: CFA Program Curriculum, Volume 2. Boston: Pearson Custom Publishing, 2008.

I hate this argument. It’s no different from saying:

Because the price of beef went up, I bought less beef, so the price of beef didn’t go up.

Furthermore, “provides … the same enjoyment as before” is impossible to measure and unlikely to ever be achieved. I like beef more than chicken; no amount of chicken will ever provide me the same enjoyment as a good ribeye.

James Fallows, a correspondent for the Atlantic, has written an article entitled “The $1.4 Trillion Question describing the tenuous economic relationship between China and the United States. Former Treasury Secretary Lawrence Summers has aptly described the relationship as the “balance of financial terror”.

The most shocking aspect of the relationship is the sheer size of China’s reserves — $1.4 trillion and counting. To provide perspective, $1.4 trillion is enough to purchase all of the following companies outright:

• Microsoft ($302.57 billion)
• AT&T ($226.89 billion)
• Proctor & Gamble ($201.52 billion)
• Wal-Mart ($196.36 billion)
• Bank of America ($185.06 billion)
• Google ($170.19 billion)
• Coca-Cola ($135.08 billion)

In 2007 alone, China added $461.9 billion to its reserves. This was nearly enough to buy Exxon-Mobil ($463.64 billion). Imagine China buying an Exxon-Mobile every year.

Other countries also have large supplies of foreign reserves (Japan, the United Arab Emirates, and Russia are the runners-up per Fallows). What they do with them will have profound effects on the American economy.

Looking at these policymakers’ reactions in their entirety leads to the conclusion that this Fed is willing to react to large falls in asset prices that it feels are unwarranted by fundamentals. This is a change that I applaud. I only hope that this new approach is not asymmetrical and that US central bankers will see the need to respond to large increases in equity, fixed-income, and housing prices when they inevitably come.

Cecchetti, Stephen. “Bernanke’s Fed shows that it can be nimble.” The Financial Times 24 January 2008.

I predict the Fed will take up a symmetric approach to monetary policy at the same time the BLS takes up a symmetric approach to quality adjustment¹ when calculating CPI. In short, never.

For example, how much has inflation increased due to tasteless tomatoes or how much modern air travel resembles steerage?

I have no problem with quality adjustment in theory, but intellectual honesty demands both symmetry and, for proper comparison, a recalculation of past CPI numbers with quality adjustment taken into account. However, given the impracticality of the latter, any comparison of post-quality adjustment to pre-quality adjustment CPI figures should be performed with a giant asterisk.

And don’t get me started on intra-category substitution. Inflation should compare the price of beef to the price of beef, not the price of beef to the price of today’s cheapest meat.

From the Congressional Budget Office, a graph of actual and projected federal spending:

Note that the vast majority of the growth of projected spending in Medicare and Medicaid is due to projected increases in health care costs.

The graph really says it all.

I was on the train today and somebody asked me whether I thought the Fed would raise rates. I said with confidence “they will keep rates the same.”

How am I so sure? Simple. Every now and again I look at the Cleveland Fed’s Fed Funds Rate Predictions page. The Cleveland Fed uses the price of options on federal fund futures to calculate and graph implied probabilities of future Fed Funds rates. Here’s April 23’s prediction of the probability of the outcome of May’s Federal Reserve Board meeting:

From this graph one can see that the markets predict a 95% chance that the Federal Funds Rate will remain at 5.25% after May’s meeting. Therefore, outside of a major surprise, it is highly likely that the Fed will keep rates the same next month.

Numerous other prediction markets exist. For example, the Iowa Electronic Markets predict an approximate 60% probability that a Democrat will win the 2008 presidential election. TradeSports predicts the New York Yankees will win the 2007 World Series. And HedgeStreet allows one to see market-based predictions of upcoming economic events. Wikipedia has a list of markets in their Prediction market page.

Naturally these prediction markets are flawed — they may be illiquid, participants may not have quality information, etc. But, like all markets, they offer the ability for self-correction. If you have strong reason to believe the market is wrong, you can participate in the market and, assuming you are right, help correct its prediction. You just might make a fair amount of money in the process.

The Commerce Department said yesterday that the nation’s economy grew at a seasonally adjusted annualized rate of 2.2% in the third quarter, up from its initial estimate of 1.6%.

The upward revision, which reflected a stronger-than-expected buildup in business inventories and slower-than-expected import growth, cheered investors, helping send the Dow Jones Industrial Average up 90.28 points to 12226.73.

Gerena-Morales, Rafael. Housing Slump Likely to Take Toll on 4th-Quarter Growth. The Wall Street Journal 2006 Nov 30: A2.

These are not the types of revisions I would expect to result in a market rally. Rising inventories seem to portend reduced future production and slowing import growth may indicate reduced consumption, both potential signals of a slowing economy.

While parts 1, 2, and 3 of this series are a start, there is still a lot left to understand about the Federal budget. To start:

• How do the numbers look adjusted for inflation? As a percentage of GDP?
• What was the actual source of new revenues? New spending?
• If the unified budget deficit was $247.7 billion and the on-budget budget deficit was $434.0 billion, why did the total national debt increase by $574.2 billion from 9/30/2005 to 9/29/2006? Where did the extra intragovernmental debt holdings come from?
• How are the revenue and spending numbers likely to change in the future? How will we deal with these changes?

While many people focus on the revenue half of government in that they incessantly clamour for lower taxes, to spend is to tax, as Milton Friedman taught us. Therefore we should look at how the Federal government’s outlays have changed over time. Here is a breakdown of outlays from 2005 and 2006 by major agency:

As a reminder, all numbers are from the U.S. Treasury Preliminary Statement of Budget Results for Fiscal Year 2006. Figures are not adjusted for inflation.

I don’t understand why “undistributed offsetting receipts” are counted as negative outlays and not receipts. Regardless, the three largest increases in outlays in percentage terms were from Homeland Security, the Office of Federal Student Aid, and the Corps of Engineers, respectively. The three largest increases in outlays in dollar terms were from Interest on the public debt, Medicare, and Homeland Security, respectively.

The Department of Defense, Medicare, Medicaid, Social Security, and the Interest on the public debt comprise over 75% of all Federal spending. However, Social Security is currently running a surplus. If you were to eliminate Social Security along with its associated, dedicated taxes, you would make the Federal deficit quite a bit worse in the short term.

Given current trends, future obligations, and political realities, I am highly pessimistic about the ability to address the Federal deficit from the spending side. The supermajority of future improvement will likely have to come from the revenue side. This means, of course, higher taxes. However, the longer we wait, the more likely it is that Interest on the public debt will continue grow far faster than the rest of the budget, which will make future tax increases or spending cuts even more painful.