Portfolio.com: Odd Numbers

The Year in Research

Zubin Jelveh — Wed, 31 Dec 2008 14:13:31 GMT

Once again, here's a completely subjective rundown of the most noteworthy academic research that sprung forth from academia in 2008.

1) Subprime All the Time
What we learned, sort of learned, and should have learned about the financial crisis:

Bubble Psychology or Declining Standards?
Two papers took a relatively similar tact to arrive at very different answers about what started the current mess.

The first, by four Fed economists, found that the information available in 2005-06 should have allowed analysts to deduce the presence of the subprime ticking bomb. The reason that didn't happen, the researches argue, is that analysts just didn't think home prices would fall so rapidly. And why didn't they? Bubble psychology of course.

The second paper, from Uday Rajan, Amit Seru, and Vikrant Vig found that even if analysts' models knew exactly how badly home prices would perform in the future, they would have still failed to predict the subprime outcome. The real culprit, they argue, was lax standards induced by securitization. Their evidence:

We analyze data on securitized subprime loans issued in the period 1997-2006 and demonstrate that interest rates on new loans rely increasingly on hard information characteristics - interest rates become increasingly sensitive to a borrower's FICO score and loan-to-value (LTV) ratio and the distribution of interest rates shrinks over time.

The papers aren't as in much disagreement as it might seem. The Fed economists found that while most analysts were able to predict that a drop in home prices would have disastrous effects on mortgage-backed securities, there was one firm that failed to do so: Standard & Poor's. And the model used by the authors of the second paper was based off one created by ... Standard & Poor's.

Still, I don't know if that explains all of the difference between the two papers' results. It could be that, ultimately, analysts trusted S&P's model more than their own, or that a firm's MBS business didn't use their own analysts' models. Research by Efraim Benmelech and Jennifer Dlugosz of Harvard of 3,912 CDO tranches issued by different firms found that the tranches "all seem to conform to the same CDO model." That model being S&P's.

A Central Figure
I was a big fan of Yale and AIG's Gary Gorton highly informative paper arguing that declining lending standards couldn't account for the subprime blowup, but then I read this quote from him in December 2007 at an AIG investor meeting:

"We stopped writing [the CDO] business in late 2005 based on fundamental analysis and based on concerns that the model was not going to be able to handle declining underwriting standards."

Hard to Break Bad Habits
If bubble psychology was even partly responsible for our current woes, can we learn not to repeat the same mistakes? The results of a study of 100 German money managers isn't promising: Even when the managers were aware of the existence of behavioral biases, they didn't feel it applied to them.

The Credit Crunch Is Real
In the aftermath of Lehman's bankruptcy in September, some Minnesota Fed economists boldly claimed that the credit crunch was in large parts a myth.

But a survey of CFO's by Murillo Campello of the University of Illinois and John Graham and Campbell Harvey of Duke showed that 80 percent of firms with lower credit ratings had to cut back on R&D, employment, and capital spending because of the crunch.

Other work by Harvard's Victoria Ivashina and David Scharfstein found that new lending "declined substantially during the financial crisis across all types of loans."

Short-Sales Bans and Small-Scale Asset Repurchases Don't Work
In response to the Panic of 2008, the government pulled out most of the stops to calm markets including a short-sale ban and the infamous TARP I. New research shows that the first was useless while the second would only work if very large amounts of money were devoted.

The Aftermath for Wall Street
After a decades-long ascent, the financial sector is likely to contract for an extended period, suggests research by NYU's Thomas Philippon, who also shows, to no one's surprise, that bankers had become overpaid.

2) White Guilt
My favorite non-subprime paper this year came from Devin Pope of Wharton and Justin Sydnor of Case Western who found that on the peer-to-peer lending site Prosper.com, a listing with a picture of a black person was 25 to 35 percent less likely to get funded than a listing with a white person with similar a profile. But despite this, risk-adjusted returns on loans to blacks were lower than the average return for all loan, implying that lenders weren't discriminating enough.

3) Global Warming and Growth
Melissa Dell and Benjamin Olken of M.I.T. and Benjamin Jones of Northwestern show:

First, higher temperatures substantially reduce economic growth in poor countries. Second, higher temperatures appear to reduce growth rates, not just the level of output. Third, higher temperatures have wide-ranging effects, reducing agricultural and industrial output, investment, innovation, and political stability.

4) Counterintuitive Claims

China Helps America's Poor - That was the claim of a controversial paper from University of Chicago economists Christian Broda and John Romalis.

What Resource Curse? - It turns out that being resource rich probably doesn't mean that a country is doomed to totalitarianism, say Stanford's Stephen Haber and Victor Menaldo.

5) If Women Ruled the World
Two papers gave us a glimpse of what that might be like. The first, by Uri Gneezy and John A. List of the University of Chicago and Kenneth Leonard of Columbia, found that in the matrilineal Khasi culture of India, women were more competitive than men, and just as competitive as men from a very male-dominated society. (Other work this year showed that women can become more competitive under affirmative action.)

The second paper, by M. Marit Rehavi of Berkeley, looked for a link between the percentage of women in a state's legislative body and budgetary priorities. Surprisingly, expenditures on health was the only category that increased as the relative power of women grew.

6) Trading on the News
Two different studies showed that algorithmic trading strategies relying on the text of news stories and analyst reports can be profitable.

7) Forensic Economics
More researchers turned to data to uncover potential wrongdoing. NYU's David Yermack found uncanny timing of stock gifts by CEOs to their own family foundations. Meanwhile, M.I.T.'s Mozaffar Khan and Hai Lu of the University of Toronto showed some compelling evidence of significant front-running on Wall Street. (Front running is when brokers execute trades for their own account, or tip-off favored clients like hedge funds, before filling customers' orders.)

8) Core Inflation or Not?
A Philly Fed researcher says headline inflation is a better predictor of future inflation. A DC Fed economist disagrees.

9) Did Fast Food Cause the Obesity Epidemic?
Michael Anderson and David Matsa, economists at UC Berkeley and Northwestern, examined this question and came to the surprising conclusion that, no, there is no correlation between eating out and weight gain.

But another recent study says Anderson and Matsa's finding isn't quite right. Janet Currie of Columbia University and Stefano DellaVigna, Enrico Moretti, and Vikram Pathania of Berkeley focus solely on fast food as opposed to all restaurants, and conclude that "among 9th grade children, the opening of "a new fast food restaurant within a tenth of a mile of a school is associated with a 11 percent increase in the obesity rate in that school. There is no discernible effect at .25 miles and at .5 miles."

10) Odds and Ends
Three more studies worth mentioning:

Wal-Mart didn't cause the obesity epidemic either.

Why does New York City have such relatively few married women with jobs?

Priests, just like CEOs, respond to pay incentives.

And that's it. I know, a lot to digest -- but you have all of 2009 to get through it!

Mind Your Value Judgements

Zubin Jelveh — Sat, 20 Dec 2008 00:52:12 GMT

In the leadup to government bailouts this year, a number of commentators said that if the U.S. did succumb to some sort of systemic crisis, it would have shown that despite its wealth, it's no better than a banana-republic. But this view is now being challenged by Ken Rogoff and Carmen Reinhart. In a new NBER paper examining crises in 66 advanced and emerging countries since 1800, they find that

not only is the frequency and duration of banking crises similar across developed countries and middle-income countries, so too are quantitative measures of both the run-up and the fall-out. Notably, the duration of real housing price declines following financial crises in both groups are often four years or more, while the magnitudes of the crash are comparable. One striking finding is the huge surge in debt most countries experience in the wake of a financial crisis, with real central government debt typically increasing by about 86 percent on average (in real terms) during the three years following the crisis.

There is one big difference between developing- and advanced-country financial meltdowns, though, which is that the former are typically government default-related while advanced economies have been experiencing "serial" banking crises since the the early 1970's with the end of the Bretton-Woods system.

Rogoff and Reinhart also argue that trying to put a dollar value on the cost of bailouts is "misguided and incomplete" because "the fiscal consequences of banking crises reach far beyond the more immediate bailout costs." Government revenues are severely hit for two to three years after a crisis, and again it doesn't much matter if the country is developing or advanced. In the following chart the blue bars show the average percentage change in tax revenues for advanced economies three years before and after a crisis first develops. The red bar shows the average for the five worst cases -- click here for larger image:

The real loser in crises, however is government debt levels. During the average meltdown, government obligations grew by an immense 83 percent three years after the financial shock. (If that happens in the U.S., by 2010 our national debt would be close to $19 trillion.)

The paper is the latest in a growing list of crises retrospectives, which already includes Rogoff and Reinhart's contribution from last year.Related Links
Charts of the Day: How Does the Subprime Bust Compare to Past Crises?
Worst Is Yet to Come
Rogoff, Wolfowitz, and Blue Ribbons

S.E.C. Short-Sale Ban: Pretty Much Useless

Zubin Jelveh — Fri, 19 Dec 2008 20:45:12 GMT

That's the conclusion from the preliminary results of a new paper by Ekkehart Boehmer of Texas A&M, Charles Jones of Columbia, and Cornell's Xiaoyan Zhang. They studied the impact of the short-sale ban which lasted between mid-September to early October and found that

the start of the shorting ban is associated with a sharp increase in share prices for affected stocks, consistent with most models of shorting constraints. Shorting activity drops by about 85%. Stocks subject to the ban suffered a severe degradation in market quality, as measured by spreads, price impacts, and intraday volatility.

The following chart shows the daily price changes for banned and non-banned stocks, click here for larger:

Advice from Japan: Don't Forget TARP 1

Zubin Jelveh — Fri, 19 Dec 2008 19:31:29 GMT

Delivered via Janet Yellen, who just came back from a trip to East Asia:

analysts universally concluded that the government needs to help banks get toxic assets off their balance sheets. Otherwise, banks will remain focused on the potential for further deterioration of these loans at the expense of looking forward and making new loans. Thus, new capital will be hoarded to protect against potential new losses. Equally important is price discovery. In Japan, the government took severe haircuts in purchasing assets from banks (in 2000). This policy reduced uncertainty by establishing a floor price for future asset sales. Everyone we met with urged the U.S. to move forward with an asset disposition program, as originally envisioned for the Troubled Asset Relief Program (TARP).

Chart of the Day: Money Market Stress Easing

Zubin Jelveh — Fri, 19 Dec 2008 01:57:42 GMT

The Libor-OIS spread is getting within striking distance of its pre-Lehman levels:

The big moves down in October were related to the bank recapitlization plan and the announcement of the Fed's programs to buy assets from the non-financial sector. It's harder to pin-down the exact reasons for the current southward trend. But it's worth noting that it coincided with the first junk-bond sale in six weeks.

Stanford's John Taylor has some more to say about the behavior of the Libor-OIS spread post-Lehman and argues that its collapse wasn't the primary cause of the heightened crisis. Highlights here.

House Price Bubble Deflated?

Zubin Jelveh — Thu, 18 Dec 2008 22:57:07 GMT

Interesting set of charts from a presentation by Columbia's real estate guru Chris Mayer showing house prices relative to 50-year trends:

It looks like there is a bit of mean-reversion going on here, but two factors make Mayer think that there could be an overshoot: Excess housing supply and the high spread between 10-year Treasuries and 30-year mortgage rates --2.52% now versus 1.6% historical.

As Mayer and Hubbard said in their WSJ op-ed yesterday, the solution they like is the one proposed by the Treasury: lower mortgage rates to spur demand. But not everyone thinks that's a good idea. (Mayer and Hubbard's paper.)

Where Were the Whistleblowers?

Zubin Jelveh — Wed, 17 Dec 2008 04:03:32 GMT

Mark Gimein points to

"a legal precedent set in the Bayou case that should scare the heck out of anyone who once invested with Madoff but who managed to get out safely in the last few years: Any investors who managed to take out profits from a fund like Bayou before the fraud was revealed had to give the money back."

That means an investor who somehow became aware of the Madoff fraud had an incentive not to snitch, thinks Gimein:

The consequence of this is that any longtime Madoff investors who'd gotten suspicious could very well have seen that publicizing their suspicions and outing Madoff's scam would not have saved their money, but actually exposed them to greater losses.

But I don't think this is the whole story (or even much of it) behind why nobody -- or nobody who could get the SEC's attention -- tried to reveal the fraud. Madoff was under suspicion since at least 1999 while the Bayou decision only came down this year. Where were the disincentives in the pre-Bayou-ruling era to keep investors tight-lipped?

More importantly, the Madoff fraud will hopefully mean that regulators take a serious look at extending Sarbanes-Oxley's whistleblower protections to also cover private companies, or private financial firms at the least. These protections have been found to increase reporting of fraud both in the lab and in the real world.

The biggest problem with a plan like this, though, would be if the smaller average size of private financial firms made it less likely that an employee to would whistleblow. But even a lower propensity is better than no propensity at all.

It's Just a Recession

Zubin Jelveh — Sun, 14 Dec 2008 03:20:28 GMT

In this week's Off the Charts column, NYT's Floyd Norris describes how the young and old are having a very different experience so far in this one-year-old recession:

There are now more jobs than there were a year ago for every group over 55 years of age -- and fewer jobs for every group under 55.

What accounts for this?

The difference reflects the fact many more older people want jobs. The labor force -- defined as those who have jobs or are looking for them -- has grown rapidly among those who have reached the ages at which many traditionally retire. Now, with their 401(k) plan assets down sharply in value and their homes also worth less than they had been, many people are putting off retirement or seeking to return to work.

But I think Norris is reading a little too deeply into the numbers. Another way to examine these trends is to look at the employment-population ratio, which is particularly important given that whole Graying of America thing.

The following chart plots the change in the E-P ratio between November '07 and '08 for the same age groups Norris uses in his chart. A positive reading means that job growth is outpacing population growth while a negative number means that employment is falling behind.

This tells pretty much the same story as Norris: younger workers are suffering while older ones are staying above water. The only difference is that the 55 to 64 age group is down, not up.

But let's see what happened in recessions past. The following chart also throws in year-over-year E-P ratio changes for November '90 and '01. (And I will admit that I'm sticking with Novembers out of laziness.)

The patterns look pretty similar, so the next logical question: Does this only happen during recessions?

This chart also adds y-o-y changes for '87, '98, and '05 -- all of which were expansion years and happened three years before a downturns:

So, it looks like the discrepancy in how different age groups are being affected by the current recession is likely more a function of what part of the business cycle we're passing through than anything unique to our era.

Comparing American and European Unemployment Insurance

Zubin Jelveh — Sat, 13 Dec 2008 00:46:55 GMT

With the economy in tatters and the Democrats in control of the presidency and Congress come January, it would seem like the perfect time for an expansion of various social insurance schemes -- a New Deal II.

But no doubt there are some on the right who think we shouldn't go too far towards becoming a social democracy, so one way to measure our leftward movement is by comparing our programs with those of Western Europe, where social Darwinism holds less appeal.

And a new IZA study provides one such metric. Stéphane Pallage of the University of Quebec at Montreal and Lyle Scruggs and Christian Zimmermann of the University of Connecticut compare the generosity of unemployment insurance in Ohio and France. (The researchers picked those two regions because average wages and the percentage of the labor force in manufacturing were similar.)

Using data from 2005, they find that after controlling for differences like eligibility criteria and duration of bene¿ts, France's unemployment insurance system replaced about 50 percent of an unemployed person's income while Ohio's replaced only 15 percent. The researchers conclude that France's scheme is roughly three times more generous than Ohio's.

But over the last year as job losses have mounted, Congress and the president have responded by extending unemployment by 20 weeks so that the newly jobless can collect for 10 months. While this surely reduces the gap between Europe and the U.S., the narrowing is offset somewhat by the fact that unemployment duration is also on the way up here. (The amount of time a person is unemployed in the U.S. has always peaked after a recession is already over.) So we still have a long way to go on this measure before we resemble Europe.

Over at NYT's Economix, Harvard-bound economist Raj Chetty has a good suggestion for what the next administration should do about unemployment insurance:

Increase federal unemployment insurance benefits (a key feature that should be introduced is allowing unemployed individuals to be eligible for benefits even if they move to a different state -- they now lose eligibility if they do so. This prevents workers laid off in Michigan from moving to find a job.

Back to Normal?

Zubin Jelveh — Thu, 11 Dec 2008 21:33:46 GMT

The Fed released the Q3 Flow of Funds report this afternoon, and the news was not altogether surprising:

Dec. 11 (Bloomberg) -- U.S. household wealth fell in the third quarter by the most on record as property values and stock prices tumbled, highlighting the tattered state of consumer finances even before the most recent slump in lending.

Household net worth fell by $2.81 trillion:

And net worth as a percentage of disposable income is doing a little bit of mean reversion -- again:

Some more chartage from Rebecca Wilder