Not Again

"Double, double toil and trouble; Fire burn, and caldron bubble."

That's from Macbeth, or as recent history would call it, Freddie Mac. Today's "surprising" Case-Shiller data made me queasy. What's not immediately available is data for the ARM load over the last couple of years. The reports have pointed to the fact that C-S is for 20 largest metros, which were hardest hit by the subprime/ARM bubble; the reports, oft quoting those with skin in the game, say that those metros overshot house price on the crash, so this rebound isn't out of bounds. So to speak.

Since figures don't lie, but liars figure; I figure there's some lying going on. Off on a snipe hunt. After all, employment (by most measures) isn't any better, nor is median income (falling, by latest data). So, how's this all happening?

I did find this report from the New York Fed (hi, Tim) from December, 2012.

We conclude that the growth in the market value of originated mortgages remains something of a puzzle.

Dare I say it, "Oops!"

While at each point in time TBA contracts with different coupons trade, the current coupon is a hypothetical security that is trading at par and is meant to be representative of the yield on newly issued securities.

That sentence, in its entire meaning, requires reading the paper up to that point. You can do that. Even if you don't, note this: it's much the same mess as LIBOR was; a measure of market activity which never appears in the market. Can you say, foobar?

It doesn't copy all that well, so have a look at figure 5 on page 12. Mortgagers have never had it so good!

And now, some pages later, after discussing the arithmetic of costs, we get:

The discussion in the previous subsection appears to indicate that the higher OPUCs on regular agency- securitized loans are not likely to be driven exclusively, or even mostly, by increases in costs. As a result, the rise in OPUCs could reflect an increase in profits.

Ta Da!!

Now it gets interesting. The Great Recession was fueled, indirectly one may say, by lenders exploiting the weakest of the flock, with subprime and ARM (or both). So, what do we have now?

Thus, the evidence strongly suggests that originators make larger profits on HARP [Home Affordable Refinance Program] loans than on regular loans, by being able to exploit their pricing power.

In other words, just as QEx has been a moolah spigot to Wall Street, HARP has been music to the ears of lenders. Not so much for those having/getting mortgages. Ain't America such a country! So, we find that lenders are eager to lend.

Now, is there data on ARMs? Not that I've found, so far.

[That was all yesterday. I didn't get around to posting, so here's more carrots for the stew, from today's news.]

Thus, a riff on central bankers:

Because governments are not taking steps to revive economies, like increasing spending or cutting taxes, the traditional concern of central bankers that economic growth will cause too much inflation has been supplanted by the fear that growth is not fast enough to prevent deflation, or falling prices.

Ya think?

What we need to return to, if the Right Wingnuts allow, is to economy that looks like Wimpy, not like Schwarzenegger. Most of the weight right there in the middle.

The lackluster results have provided cover for the European Central Bank, which has remained the most cautious of the major central banks. It is sticking to the more traditional formula of cutting interest rates -- a string Japan ineffectually pushed for more than a decade -- in the hopes that it will encourage banks to lend more money to businesses.

That didn't work for Japan, and it's one country that can (and now is, more later) use the fiscal lever. There's that string metaphor again. I can't claim originality, but I've beaten that poor thing to death.

And what does Mr. King [the departing governor of the Bank of England] have to show for his monetary exertions -- beyond record stock market highs and bottom-scraping yields for British corporate bonds? An anemic recovery. Growth this year is expected to be 0.5 percent, according to the monetary fund, while Japan's gross domestic product grew at an annualized rate of 3.5 percent in the first quarter and the United States' is expected to grow a little more than 2 percent.

So, two decades, that's 20 years, of history and the Bank of England's leader still doesn't get it.

As to Japan:

[T]he country is coupling its central bank action with fiscal stimulus, which means that the new money created by the bank is put to use. Calls for austerity have largely fallen on deaf ears.

Yes, the Keynesians have been berating Japan for all those two decades. Will it work? Could be. But...

Falling prices can freeze economic activity as buyers wait for still-lower prices, a cycle that is hard to reverse. Japan, the only major economy to fall into such a pattern in modern times, has struggled to escape for almost two decades.

The problem with deflation is usually couched in these terms. But the dynamics is what really makes the difference. With wages preceding prices down the rabbit hole, and employment uncertainty increasing, it's less that consumers hold out for better prices (which never seem to overwhelm falling wages), but that they still can't afford the goods because their real wage is yet lower.

One of the maxims of economics is that price reductions raise all boats, to invert two metaphors. The issue here is that it's true only for those that can afford the lower price. If the price of a new Ferrari goes from $500,000 to $450,000, that's a neat reduction, but irrelevant to 99.44% of consumers.

As wealth and income concentrate, deflation and depression have to follow. That's the only way the arithmetic can work. Have a nice day.

Losing At the Casino

For some time, but until now unfollowed, I've harbored the notion that MCMC (Markov Chain Monte Carlo) modeling might be suspect in The Great Recession. Turns out, I'm not the only one.

Skinny Tails

Monte Carlo simulation is a convenient statistical tool by which an analyst can make inferences over the probability of rare events. Basically, the method takes a model with its estimated parameters and simulates possible sample paths under some distributional assumptions on the errors. The technique is particularly useful for understanding the tail risk of distributions. The method has been widely adopted by banks, investors, and financial advisors. And, because the models failed so horribly in the current downturn, the method is now under attack.

Ya think????

Felix Solomon's take

So the lesson here, I think, is mostly that stock-market tails are fat. But there is a sub-lesson, too, which is that Monte Carlo simulations can be very dangerous, if they're implemented by people who don't know what they're doing. Including the quants at Moody's.

A 2007 critique (who knew anyone refused the Flavour Aid?)

The amount of derivatives in play is in the hundreds of trillions of dollars all bet on Monte Carlo Simulation. Wow!
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It sure seems like a hell of a lot is riding on the Monte Carlo Simulation of CDOs as well as the parameters and assumption that feed into the model. If and when a Credit Event occurs that rifles through multiple CDO tranches, the guarantors will be about as well capitalized to handle the guarantees as is Madame Merriweather's Mudhut Malaysia. Do I smell a government bailout coming up?

Ya think???

Practical magic?

The downside of Monte Carlo is that it is more trusted than historical data. This misplaced trust is rooted in the idea that if a person has no historical data, then the Monte Carlo forecast can be anything that is believed plausible. For example, the phrase: "Contingency was determined by running Monte Carlo" is equivalent to "PI was determined by using Monte Carlo." Monte Carlo could render reasonable results for each value. They both will not be precise answers because Monte Carlo is an approximation, and the results for both could be completely wrong.

The issue with such methods is that they view human actions as Brownian motion (really!). While reasonable for physical processes, not so much for finance, where the rules are made up by humans and can be changed at a whim. That's why we got our Great Recession: humans changed the rules faster than the data streams could reveal the changes. The analysts made their decisions under the assumptions that Tomorrow will look pretty much like Today, which in its turn looks pretty much like Yesterday; and, as with physical processes, that the platform was stable during measurement. The fact that median house price had come unstuck from median income wasn't relevant to the modellers or their models; to look in that direction wasn't in the self-interest of those engaged in the game. Alas, if you look at the data through a toilet paper tube, you'll not see that hyena licking his chops for dinner. You're dinner.

And, as past is prologue, comes reports that brokerage houses are luring retail investors into options trading. There's nothing more fun than playing with nitroglycerine whilst bungee jumping.

At Ameritrade, which has been the most aggressive, derivatives trades accounted for about 40 percent of all customer trades last year -- more than double what it was just five years ago. A vast majority of those trades were in options.

The growth has been a big help for the online brokers at a time when stock trading has fallen. The commission on the average options trade is more than twice that on the average stock trade, according to TD Ameritrade's former treasurer, Michael Chochon.
...
[H]e saw investors taking up options trading and "blowing up" on an almost daily basis. He said Ameritrade carefully tracked the risks its customers were taking but did not warn them until they were close to losing it all, if then.

If that sounds a bit like the Banksters grinding ever more, and expensive, fees from common depositors to make up for the loss of all those wonderful profits on subprime and such, well "yes I said yes I will Yes" (that's from a famous dirty book, btw).

A Cellars Market

Traditionally, finance quants bleat that government bonds "drive out" private (physical?) investment, and are therefore, ipso facto, bad. Bad for everyone, not just the coupon clipping class. The traditionalists miss the point, of course. As one of my econ professors pointed out: you get lucky, make a lot of money, and spend the rest of your life (as will your spawn) living off the market rate of interest. And that means, generally, Treasuries. In a time of Quantitative Easing, what are the finance quants up to?

The traditionalists have put themselves between a rock and a hard place. They want two opposites to be true at one and the same time; just adjusted to your particular circumstance. The rock: high risk-free Treasury rates drive out productive private investment in innovation, but increase un-earned income for the 1%. The hard place: cratered risk-free Treasury rates drive down the opportunity cost of productive private investment in innovation, but reduce un-earned income for the 1% (who are presumed to avoid the "risk" of equities). The reality: due to the enormous slack in the US (and global, it turns out) economy, QEx is having no obvious effect in driving out private investment. Most of that QEx moolah is going into fiduciary maneuvers, not plant and equipment. Refinancing of corporate debt is doing a Casey Jones. Even The Wall Street Journal admits it.

Private equity, in particular, has been eager to refinance the massive amounts of debt it accumulated during the leveraged-buyout boom, in addition to raising funds to pay special dividends to private equity sponsors this year. So far this year, $120 billion in leveraged loans have been issued, 62% of which have been used for refinancing. That compares with $158 billion in all of 2010, when 32% were used for refinancing.

And Citi agrees (who'd a thunk it?)

So far, so good; this part of the transmission mechanism seems to be working well enough. But this burst of issuance does not seem to reflect a confident corporate sector borrowing heavily to fund expansionary capex. Rather, CEOs seem to have used this money to refinance old debts.

So, we have corporate (risk taking?) CEOs on a sugar high, shuffling off expensive debt from years ago. What a way to re-pay the economy. But, as written here before, when physical investment is hampered by payback periods extending beyond product life cycles, what else is a CEO supposed to do? Give money away to lie-abouts? (Not that the CEOs do all that much heavy lifting; they could be visionary, seeking out productive and profitable physical investment. But Noooooo!!) This is just the circumstance where Keynes, et al, call for governments to proactively invest in physical assets; when the chicken shit corner office types run for cover. And from the collapse they created.

(If you want a full autopsy, then this paper will help. Lots of data and some algebra, and a good deal of historical argument; what the authors call "event-study methodology".)

But there is an effect. Let's say you're a pension fund, and by law/regulation/preference, you've mostly held bonds. You've gotten 7%, say, on average. Now, bond prices have risen, and returns have fallen. What to do? Well, you dive into equities. Pension funds have been in equities for some time, it's nothing new. But with the cratering of Treasuries, and the knock-on effect to corporates, coupon clipping isn't as easy and profitable as it used to be. You could sell off those bonds, at a profit, but that's a one-time gain. You're now chock-a-block in moolah.

Well, now you know why the stock market has risen. Here's the unintended (one hopes, anyway) consequence: an annual 10% capital gain means that only a Ponzi stock market can do that. Oops. Once again: returns to physical investment drive all other interest rates, whether measurable in a conventional data sense or not. Financial engineering for profit is a zero-sum game. Real productivity increase comes from technological progress, and can be sustained only if generally distributed. Hoarding by the few leads to failure of the mass of population. In due time, even the few can't afford progress, since the number of buyers is insufficient to amortize the necessary capital. In time, even the 1% need Obamacare.

Not An Ouroboros

What happens to an economy when the payback period of real, physical investment no longer meets the product life cycles that investment is built to support? That is, when payback is longer than life cycle? Who invests in such a circumstance?

The rational answer: monopolists who can, at least, command sufficient market share to amortize; at best, keep out competition to restore life cycle length. Who wins? Not the consumer, who ends up paying monopoly prices.

To review: the payback period is an estimate of an inverse (not *the* inverse, since there are other factors) of rate of return, or interest rate. So, if payback period increases for an industry or sector or entire economy, the implied rate of return (surrogated by interest rate) declines.

There are reports/studies of late that the payback period in "high tech" is increasing, while life cycles are decreasing. The end result is lack of motivation to invest; plant and equipment, that is.

This would explain, to some degree, why monetary policy of Bernanke/ECB doesn't seem to have much impact on employment or growth. If corporations see no a) no increase in demand and b) little chance of recouping investment, they'll sit on the cash. Which is what they're doing. That and massive amounts of re-financing of old debt.

Crab Apples

Much bytes have been devoted here to Apple's woes of late. And to whether, or not, these woes have any macro implications. Evidence is mounting that there are.

About a year ago, some opined that prepaids are cheaper, but:

Prepaid phone plans, where you pay the full price for a cellphone and then pay lower monthly rates without a contract, seem to offer what most budget-conscious people want. So why haven't they really caught on?

So, today we find that the tide has turned.

NPD said 32% of smartphone units moved in the quarter were prepaid, up from 21% in Q1 of last year.

Thousands of dollars a year to make phone calls? Of course not. These smartphones do much more, but that more can, generously, be characterized as self-distraction. Do people addicted to Angry Birds have a life beyond their particular version of self-abuse? Apple's (and what passes for tech these days) problem is that it has, with purpose, steered away from productive tech to entertainment. Toys. Mattel knows how to do that on a continuing basis. Apple hasn't shown that it can create a new toy from scratch. Google Glass may be worthless as a productive widget, or even as an entertaining toy, but it was created from scratch. Steve never did that.

Dee Feat is in Dee Flation, Part 27

Well, here we go again. The import/export prices are out, again. And, again, DEflation is the rule of the day. We're going Japanese. All you folks that been stuffing your moolah in the mattress, you win for the rest of us losing.

Let's Meet at Six Corners

My hometown, Springfield, MA was the subject of a good news/bad news piece on "60 Minutes" last Sunday. The bad news: it's a city with assault rifle toting drug dealers. The good news: a counter-insurgency program appears to be working. Social Darwinism meets police with a clue. One of the better known areas of the city was/is Six Corners, home (in my youth) of the "Six Corners Cafe". Six Corners is named for the fact that three streets intersect, with no traffic island (roundabout, in Brit speak). Well, the last couple of days have revealed a three-way confluence of quant/econ issues.

First, Texas remains antediluvian, happy in its brand of social Darwinism in the wake of exploding fertilizer.

Texas has always prided itself on its free-market posture. It is the only state that does not require companies to contribute to workers' compensation coverage. It boasts the largest city in the country, Houston, with no zoning laws. It does not have a state fire code, and it prohibits smaller counties from having such codes. Some Texas counties even cite the lack of local fire codes as a reason for companies to move there.

Next, reports that Germany recovers much better than the US or the rest of EU (follow the link for the text).

The euro zone's troubles have helped Germany's export-oriented economy. The weak euro has made Germany's exports more competitive against those of countries with which it competes, most notably the United States and Japan. Since the end of 2007, the euro is down about 10 percent against the dollar and about 20 percent against the yen.
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Were the euro zone to break up, there is little question that the value of a new German mark would rise sharply, while the currencies of many other members of the zone would fall relative both to the mark and other international currencies. That would depress German exports.

Finally, a Wall Street Fat Cat argues that more social Darwinism is the key to EU recovery.

Take autos. The European automobiles industry resembles that of the United States, circa 2009: too many factories employing too many workers, able to make more cars than the market can absorb. And, doing it too inefficiently. A Fiat autoworker in Poland produces three times as many cars as a Fiat employee in Italy and is paid one-third as much.

This is an intellectual Large Hadron Collider: three (seemingly) separate avenues of stupidity running head on at Six Corners.

Let's start with the Fat Cat's argument. By cheapening Italian labour, Germany will have a smaller market for its goods in Italy. And by reducing wages in a significant sector of the EU economy, there isn't any hope that this will, ceteris paribus, increase demand for automobiles. This is the classic deflationary spiral, writ specific. Recovery requires that income be distributed to those who don't currently have the means to pay for goods. Sending lots of moolah to those who've no need does nothing, except bid up stock prices, which is what we have here in the US.

So, what's Texas got to do with it? Just Germany exploits a common currency among disparate nations, Texas exploits a common currency among disparate states. Without the support of the dollar (and excessive in-flows of Federal dollars, fur sure), Texas wouldn't be able to freely arbitrage against higher wage states. The problem is that this gag can only work for awhile. Germany has been exploiting its weaker cousins, just as Texas does to its citizens here.

Germany, it seems, is beginning to figure out that it can't have its cake and eat it too: it depends on exports, both to other EU countries and the US. Export based economies tend toward draconian monetary policy, for other countries of course, since exchange rates impact profits ex-nation.

In the end, Germany and Texas are utterly dependent on other states (upper case and lower case). Texas, in particular, exports poverty, but can only get away with this because it's in the dollar and gets a substantial amount from DC. Or, in Romney-speak the 47%. One of the measures commonly used is the ratio of taxes to DC by expenditures from DC. The more accurate measure is per capita DC flows. Texas wins, in a sense, because it can exploit a common currency and Federal dollars. Fat cats do well, but the average Texan, not so much.

Water, Water Nowhere...

As chronicled in earlier musings, the downside to the various exotic (that is to say, more than lifting it out of the ground) hydrocarbon extraction regimes is water. You need a bunch of it. In case anyone's not noticed, a report today (I couldn't get through to Quartz, for the original) crunches some numbers.

In Texas, which is suffering through a long-running drought that has devastated cattle ranchers and farmers, 51% of wells are in high or extremely high water-stressed locations. Tarrant County, Texas, alone consumed 10% of all water used in fracking in the state, according to the report.

In sum: you can drink or you can burn. Soon enough, you can't do both. The "Peak Oil" deniers always talk about other hydrocarbon deposits: shale oil, tar sands, and fracked gas. Fact is: you need a bunch of water to turn it into marketable fuel.

During the study period, drillers nationwide used 68.5 billion gallons of water -- equivalent to the amount 2.5 million people would consume in a year. But Ceres researchers said that number most likely underestimates water use by fracking because disclosures to the FracFocus database are voluntary.

The reason the "Peak Oil" conclusion was reached in the first place is simple. The net energy put into the world's economy is maximized when the only energy cost of the hydrocarbon is lifting it out of the ground. Saudi Arabia had such a resource, Gharwar, but even it has had to use water injection for some years. With secondary and tertiary resources, one may, and I stress may, be spending more joules than one eventually gets. And running out of water, which humans kind of need more.

They ain't no such thing as a free lunch.

Shilling For Shiller, Part the Third

Sorry for the delay; I missed my Saturday Times. Here's Shiller's third part. It's largely, surprise, a re-hash of much of what I've been scribbling about: housing isn't an investment, as that word is generally connoted. The vig comes from the mortgagee's real income, not from productivity fecundity of said building.

Forecasting is indeed risky, because of factors like construction productivity, inflation, and the growth and bursting of speculative bubbles in both home prices and long-term interest rates. The outlook is so ambiguous that there is no single answer to the question of housing's potential as a long-term investment.

It ain't no investment. Full stop.