August 31, 2007
Report from Jackson Hole
Here are some brief impressions about this morning's papers at the Federal Reserve conference.
First up was "The Housing Finance Revolution" by George Washington University Professor Richard Green and Wharton Professor Susan Wachter. One of the interesting points made by this paper is that although there are important differences across countries in how mortgage finance has changed recently, there are some dominant trends that are unmistakably global. The 8% average annual growth in U.S. mortgage debt between 1992 and 2002 seems actually modest compared to many other countries:
Rising real estate prices and declining interest were also very much a global development, as indicated by these global averages from the paper:
Green and Wacther then asked whether the mortgage finance revolution would now be followed by a reign of terror, delving into the origins of current problems with subprime mortgages. The authors write:
The behavior of investors with respect to subprime mortgages is puzzling, to say the least. Mortgage originators had powerful incentives to originate loans, regardless of quality: every mortgage that was successfully originated and sold to an investor produced a fee for the originator. While companies that originated the loan, such as New Century, could give representations and warrantees to investors that loans met some minimum standard, they were not well enough capitalized to make good on any promises in the event of large-scale default. It is difficult to understand why this was not clear to investors ex ante.
The second puzzle is that investors and rating agencies appeared to believe that diversification per se could cause systemic risk to disappear. It is of course the case that as a security becomes more diversified, unsystematic risk will get smaller, but mortgages with ten percent default probabilities will continue to carry such probabilities, regardless of the securities in which they are packaged....
The third puzzle is investors' seeming lack of understanding about housing market risk.
I agree very much with Green and Wachter that these are the key questions to be asking, and will offer some further thoughts about them tomorrow.
The authors of the second and third papers of this morning's session, Yale Professor Robert Shiller and UCLA's Ed Leamer both struck fiercely iconoclastic tones. Shiller's basic answer to the Green-Wachter puzzles is as follows:
...a significant factor in this boom was a widespread perception that houses are a great investment, and the boom psychology that helped spread such thinking. In arguing this, I will make some reliance on the emerging field of behavioral economics. This field has appeared in the last two decades as a reaction against the strong prejudice in the academic profession against those who interpret price behavior as having a psychological component....
These principles of psychology include psychological framing, representativeness heuristic, social learning, collective consciousness, attention anomalies, gambling anomalies such as myopic loss aversion, emotional contagion, and sensation seeking.
One thing I have never understood is the source of Shiller's confidence that he is able to rise above these cognitive pitfalls in a way that market participants can not. Nor does his quantitative evidence help me to understand his position any more clearly. He notes for example a 1988 survey which found that the median new homebuyer in Los Angeles expected 11% price appreciation over the next 12 months, whereas the median buyer in Milwaukee expected only 5%. Since the OFHEO house price index shows a 13.9% appreciation for Los Angeles and a 6.2% appreciation for Milwaukee during 1989, it's hard for me to see how these survey results are supposed to convince us of people's lack of rationality. I also am unsure how Shiller's concept of real estate price bubbles in "superstar" cities is to be reconciled with the fact that the problems with mortgage defaults initially proved to be most serious in rustbelt areas where there had been very little real estate price inflation.
Leamer was likewise proud to flash his credentials as an iconoclastic outsider, declaring "the good news is that I am not a macro-economist". His evidence was mainly derived from nonparametric kernel regressions of a variable on a time trend to identify its "normal" contribution to output, and then accumulating deviations from "normal" to generate a "cumulative abnormal contribution" such as depicted in the diagram below:
This kernel regression basically defines the "normal" value for date t as a weighted average of observed values before and after date t, with an observation getting a smaller weight the farther it is removed in time from date t. It's thus just a two-sided moving average filter. I welcome Leamer's effort to throw in a creative alternative to the popular Hodrick-Prescott filter, though Leamer's method suffers from the same problem as the Hodrick-Prescott filter, in that it will introduce temporal patterns into a series such as a random walk that originally had none. I think there is a great advantage in trying to summarize the data using statements about the forecastability of the series. Two-sided filters such as Leamer's necessarily make these questions of forecastability more obscure.
Notwithstanding, I found another of Leamer's main themes to be an intriguing suggestion. He claims we should think of monetary policy as doing very little about the long-run growth rate (which he thinks will be within 3% of a 3% annual growth line regardless of policy), and that stimulating the housing market therefore just changes the timing. Specifically, Leamer believes we bought ourselves a boom in 2004-2006 at the expense of a recession in 2007-2008.
Tomorrow I get the chance to put in my own two cents.
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A rousing day in the markets to cap a tumultuous month! There will be some kind of assistance - not a bailout, honest - for delinquent mortgagees: Under Bush’s plan, the FHA during the fiscal year beginning Oct. 1 would help in 80,000 more refina... [Read More]
Tracked on August 31, 2007 09:15 PM
Another answer to the "puzzle" was the widespread reliance, by economists and practioners both, on econometric models.
The models significantly underestimated the range of potential defaults. The reasons are various, but principally they relied on a too-short data series; and they failed to take into account the impact of systemic leverage and the potential evaporation of liquidity.
Plenty of analysts thought that subprime defaults were correlated with job losses, which in turn were not in evidence. This alone was cause for most of the mistakes made by market and lending industry participants.
Posted by: David Pearson at August 31, 2007 12:33 PM
Green and Wachter: "...It is difficult to understand why this was not clear to investors ex ante.
The second puzzle is that investors and rating agencies appeared to believe that diversification per se could cause systemic risk to disappear. It is of course the case that as a security becomes more diversified, unsystematic risk will get smaller, but mortgages with ten percent default probabilities will continue to carry such probabilities, regardless of the securities in which they are packaged...."
It is not a puzzle at all. Throughout the ages, mankind has shown an endless capacity for irrational "exuberance", manias and stupidity. Religion is the perfect example of this.
As for your question about the source of Shiller's confidence, I would give out two possible sources-- one, I don't know if Shiller is atheist/agnostic, but it is self-evident that any agnostic/atheistic person is more rational than a believer. And given that believers are an overwhelming majority of the population, that confidence comes easily.
Second is history and experience. Shiller's confidence may be coming from his study of history (of bubbles and manias) and his own correct calls about market bubbles earlier.
Would you say Warren Buffett and George Soros should not have confidence in their understanding of market forces and widespread irrationality in the world?
Although I respect your focus on data, theoretical models based on overly generalized data (like the above chart) alone cannot explain markets.
Posted by: TedK at August 31, 2007 12:35 PM
Is it necessary to be able to "rise above a cognitive pitfall", before reasonably asserting that it exists? I'm not sure where this would take us, but possibly into a something of a vacuum. Proving that a result exists is sometimes easier than proving an algorithm or process that yields an actual value; I take a calculation of the price (or whatever) under a presumed set of rational conditions as perhaps the operational meaning of "rising above the pitfall".
Somehow, we do seem to be experiencing a serial bout of "irrational exuberance" that over the years keeps shifting from one sector to the next, leaving behind an ever-wider trail of expensive bailouts and moral hazards, even if no one seems to know - or in some cases even wants to know - how to put an end to it. It's already the 2008 election year, so the latest version of the scam appears to be that the taxpayer is going to buy millions of enormous houses and give them away practically for free to a horde of irresponsible borrowers. So I keep hearing a nagging little voice asking if we're going to end up like Zimbabwe, or the Weimar Republic.
Posted by: PaulS at August 31, 2007 01:09 PM
It is of course the case that as a security becomes more diversified, unsystematic risk will get smaller, but mortgages with ten percent default probabilities will continue to carry such probabilities, regardless of the securities in which they are packaged....
When you elucidate your thoughts, Prof., will you please make their position more clear? In my casual discussions with some who are not market professionals, it has become apparent that there is little understanding of the tranching of mortgage-backed securities.
Fortuitously, I used the same 10% default figure in an example published in my own blog and claimed that if I created a senior tranche representing 80% of the pool value and a junior tranche representing 20% of the pool value then the senior tranche should legitimately have a higher rating and be worth more.
While I am quite sure that Green and Wachter need no lessons from me on this point, the key concept is missing from your extract.
Posted by: James I. Hymas at August 31, 2007 03:00 PM
If memory serves, the 1st edition of Shiller's Irrational Exuberance came out in March 2000. The 2nd edition with expanded coverage of the housing market followed in 2005.
As soon I get word of a 3rd edition going to press, I'm going to fuckin' liquidate everything I own.
Posted by: Constantine at August 31, 2007 04:43 PM
Thanks very much professor, great update.
Regarding the two "puzzles" described by Green and Wachter, IMO there's a form of the principal-agent problem at work linking both together (at least regarding the subprime mortgages packaged into CMOs. If all of New Century's subprime mortgages had been sold directly to mortgage investors, it would have been clear "ex ante" that the representations and warrantees were of a pig-in-a-poke variety - but that's not how the game was rigged.
And on Green-Wachter's representation of the second puzzle, I'd take exception to their claim that "investors and rating agencies appeared to believe that diversification per se could cause systemic risk to disappear". It's hard to know exactly what investors in different complicated tranches of CDOs and CMOs thought they were doing because I don't think they knew what they were buying; however, what evidence is their that the economically-conflicted rating agencies truly believed that diversification per se could cause systematic risk to disappear - I don't think they really much cared - because they were even more incented to misrepresent CDO/CMO ratings than New Century was to misrepresent their underwriting standards - after all, New Century is quite dead and even Countrywide is staggering, but S&P's and Moody's are performing relatively robustly (and William Lerach is RETIRED, even!).
The fact that the buyers highly complex CDO/CMO securities were naive, overly reliant on credit "ratings" and far far removed from the initial origination of the securities they were investing in explains a lot, IMO. Fools and their money are soon parted, I think, and I hope someday that the ratings agencies and their security underwriting partners on Wall Street have to pay for their scurrilous behaviour.
Posted by: Anarchus at August 31, 2007 05:04 PM
I just completed designing a circuit block. Its as carefully crafted as a Swiss watch. I love my creation and can't stop marvelling at it. oh where were we, yes, there is no such thing as a bubble.
Posted by: EMH at August 31, 2007 05:08 PM
JDH, your comment that "annual growth in U.S. mortgage debt between 1992 and 2002 seems actually modest compared to many other countries" doesn't look at any segmentation of the countries. The listed high growth countries are relatively recent entrants to the EU, and with their new free trade and more business investment, I would expect higher GDP growth rates and higher mortgage growth rates as their citizens prosper. The listed mature economies have much lower growth rates. The US rate of 8% looks to be 33 to 100% higher than similar European mature economies. No doubt, other segmentation could yield other insights, but I don't think "modest mortgage growth" is one of them.
Shiller's concept of real estate price bubbles in "superstar" cities seems very similar to the behavior of marginal producers in micro-economics. They are often the last to get going (capital starved), the first to have financial problems in rough economics (low margins and margin for error), and the most likely to go insolvent (capital and unemployment problems). Most trends of consequence start on the US coasts and move to the marginal actors in the rust belt. When problems occur, the negative trend flows the other way. This is not the first time.
Lastly, the Leamer chart looks nice, but is it verifiable, and does it have any predictive use?
Posted by: Mike Laird at August 31, 2007 07:01 PM
Great comment, Mike Laird.
I was very susprised with the list: where is UK?
Here, in Spain (as in Portugal and Greece) one big part of the housing bubble comes from german and british reterees looking for sunny wheater + a lot of inmigration from South America and Africa + 117 billion euros of funds from euroland + interest rates going from 17% to 2% between 1990 and 2002. All togheter, you have a good picture.
But, where is UK?
I recently read that in 2007 the debt of british borrowers will be bigger than GDP of the country.
Posted by: jla at September 1, 2007 06:58 AM
Hey, TedK, it looks like the Bible-beaters, on average, sat out the silly housing bubble:
States with higher rates of church attendance had lower rates of growth in the OFHEO index.
Lots of us churchgoers demand data on everything, except the one thing that we take on faith alone.
Posted by: jg at September 1, 2007 07:51 PM
I am sorry if my comments offended you. My thinking is that "the one thing [believers] take on faith alone" means only that a particular area of the brain that checks for reality is wired differently in believers.
That is how one can come to terms with the fact that many highly accomplished people (obviously other areas of the brain handle other kinds of intelligence) are taking that one thing on faith alone.
However, if you consider two people with similar accomplishments and intelligence, one a believer and the other a non-believer, I would think the latter would be more rational.
I don't think the lower rate of housing price appreciation in the states with high church attendance can by explained by the values of 'faith.' A lot of things like historical pattern of migration and settlement, continuing immigration, 'desirability'--cultural scenes, arts, educational opportunities, higher salaries, etc., contribute to the fact that coastal areas have historically seen faster growth and been more expensive. That hasn't changed. What happens during a bubble is that people blow these factors out of proportion. While blowing out has naturally been more pronounced in coastal areas, the same reasons contribute to prices not falling too fast in these areas.
Thus the same factors explain your observation about church-attendance vs. price growth as well as Professor Hamilton's observation that "mortgage defaults initially proved to be most serious in rustbelt areas where there had been very little real estate price inflation."
Posted by: TedK at September 2, 2007 10:56 AM
I do not think it serves any purpose to question whether PRof. Shiller could raise above the cognitive pitfalls that he identifies with home buyers. This would take us all into an endless loop. Those who are in the field of analysing cognitive deficiencies can, forever, be subject to this charge.
The question is whether expectations can become self-fulfilling. In financial markets, there is ample evidence that it can and it does.
Second, even in macro-economics, expectations are accorded importance. Otherwise, why would or should central bankers worry about expectations of higher inflation becoming entrenched.
Posted by: Anantha Nageswaran at September 6, 2007 07:15 PM