Doom’s collection of transcripts of AEI seminars now features a date-order list of our transcripts and the same list in the context of close to a hundred further events that throw light on some aspect of the subprime crisis, housing bubble or credit crunch while offering an audio and/or video record.  These all now have designation codes in case we want to create transcripts of some of them in future.

This made it necessary to change the designations on a couple of our existing transcripts.  So a lot of the links in the participants and questioners sections needed to be moved around and fixed.

The under-construction transcript VI.B has now been re-designated VI.C.

Of the nine completed Doom AEI subprime transcripts one, III.A, has been re-designated IV.C.

Doom regrets any inconvenience this may have caused to our readers.

The Board’s H.4.1 statistical release, "Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks," has been modified to include information related to TALF LLC, a limited liability company formed to purchase and manage any asset-backed securities that might be received by the Federal Reserve Bank of New York (FRBNY) in connection with the Term Asset-Backed Securities Loan Facility (TALF). This information will be presented in a new table 8, "Information on Principal Accounts of TALF LLC." … - For release² at 4:30 p.m. EDT November 19, 2009

Looks like the H.4.1 table itself is a bit newsworthy this week. If I’m reading the above correctly, they’re now providing a bit more transparency on some of their bailout numbers. Should be a long weekend for the number crunchers

After last week’s nothingburger the central banks really came alive. The Fed’s own MBS holdings surged $74.469 billion, and the cenbanks bought big in treasuries, and even added a fair hunk to their agencies holdings. This week’s Reuters report¹ was, as usual, based on the weekly update from the NY Fed’s H.4.1 table site.² Here is Doom’s updated CSV version³ of the agencies and treasuries foreign central bank holdings data set.

The treasuries buy rebounded to a big $12.557 billion.

The agencies number increased $4.616 billion, the biggest up move in a long time. Interestingly, the Agency Debt number has been pretty stable for the last 7 weeks. Are we entering another extended period where that figure barely moves?

This week the total US obligations number for the cenbanks blasted up $17.173 billion.

Twist’s ratios graphs went down on the bigger treasuries gain.

The Setser 52-week chart converged in both lines, but much more in the agencies.

________________________

Notes and References

[1]: "Foreign c.banks US debt holdings rise in week-Fed", by Chris Reese, Reuters, November 19, 2009.

[2]: "H.4.1 Factors Affecting Reserve Balances", Federal Reserve Statistical Release (weekly), Federal Reserve Bank of New York.

[3]: The updated data set as a Comma Separated Value (CSV) file is here.

PERKASIE, Pennsylvania (Reuters) - Carin Froehlich pegs her laundry to three clotheslines strung between trees outside her 18th-century farmhouse, knowing that her actions annoy local officials who have asked her to stop.

Froehlich is among the growing number of people across America fighting for the right to dry their laundry outside against a rising tide of housing associations who oppose the practice despite its energy-saving green appeal.

Although there are no formal laws in this southeast Pennsylvania town against drying laundry outside, a town official called Froehlich to ask her to stop drying clothes in the sun. And she received two anonymous notes from neighbors saying they did not want to see her underwear flapping about.

"They said it made the place look like trailer trash," she said, in her yard across the street from a row of neat, suburban houses. "They said they didn’t want to look at my ‘unmentionables.’

It’s a tougher economy out there these days, and people are looking to save money where they can:

Although exact numbers are difficult to come by, a Pew Research study found the number of Americans who deem the clothes dryer a necessity has dropped significantly since 2006 — from 83 percent to 67 percent. While that statistic doesn’t indicate how many people have switched to line-drying, anecdotal evidence suggests that for both economic and environmental reasons, more people are doing so.

HOAs however, are the natural enemies of clotheslines:

Florida, Utah, Maine, Vermont, Colorado, and Hawaii have passed laws restricting the rights of local authorities to stop residents using clotheslines. Another five states are considering similar measures, said Lee, 35, a former lawyer who quit to run the non-profit group.

His principal opponents are the housing associations such as condominiums and townhouse communities that are home to an estimated 60 million Americans, or about 20 percent of the population. About half of those organizations have ‘no hanging’ rules, Lee said, and enforce them with fines.

9.6% of American homeowners are behind on their mortgages and budgets are tight.  If it helps keep people in their homes, HOAs might consider that a clothesline in the backyard beats a foreclosure in the neighborhood.

Is there anything else out there that we ought to consider?  This is an open thread, so let us know what’s on your mind.

*********************************

Disclosure:  I have a clothesline in my backyard and use it all the time- much to the consternation of my neighbor. 

A ruling that Citigroup Inc. must resume lending to a stalled Syracuse, N.Y., mall project could push banks to revisit how they draft construction-loan agreements.

The New York State Supreme Court Appellate Division, in a split decision, upheld an lower court’s injunction requiring Citigroup to continue funding a $155 million construction loan on the Destiny USA Holdings project, even though the bank believes the project is a failure. Citi says the ruling is unprecedented in the state’s history. Now, New York lawyers are pondering how to write construction loans that would allow banks to stop funding what they believe are failing projects.

The ruling isn’t a total victory for Robert Congel, the developer behind Destiny. The court required the company to post a $15 million bond before Citi has to fund the rest of the money, roughly $29 million.
 

Why is this so significant?

This ruling definitely puts further strain on the market for construction financing.  Lenders are willing to take a bit of risk if the yield is right and it is clear that they have the option to back out of their commitment if the developer does not live up to his end of the deal.  But I can’t think of a single lender who would walk into a risky financing—no matter how high the yield is—if they cannot be certain on whether or not they have the right to back out when the developer fails to perform.  NY State Supreme Court’s decision in this case does nothing to provide that certainty.  Until lenders and their counsel can figure out a way to build that certainty back into their lending agreements, we can say goodbye to ground-up construction financing.

Commercial real estate lending might not be the only casualty of court rulings:

[R]ecent court decisions demonstrate how courts can override the words and intent of loan documents and lenders’ remedies notwithstanding the widespread concern about the fiscal health of our lending institutions and the need for them to recover to unfreeze the credit markets and permit economic growth to resume. The media regularly contains stories about home owners who have been able to avoid foreclosure and have their debt canceled because of administrative or technical errors by the lenders. One would think that the courts believe that the money people borrowed to buy homes magically appeared and did not come from other people’s savings, investments and retirement accounts. Has any court considered that, when they preclude a bank from foreclosing a mortgage, the home owner, who actually borrowed the money and is refusing to repay, is actually stealing the savings of their neighbors? So far, the courts seem to believe that they are playing the role of Robin Hood and ignoring creditors’ rights. This behavior is also causing lenders to think twice before making loans.

Can you say "unintended consequences"?

The coroner’s report left no doubt as to the cause of death: toxic loans.

That was the conclusion of a financial autopsy that federal officials performed on Haven Trust Bank, a small bank in Duluth, Ga., that collapsed last December.

In what sounds like an episode of “CSI: Wall Street,” dozens of government investigators — the coroners of the financial crisis — are conducting post-mortems on failed lenders across the nation. Their findings paint a striking portrait of management missteps and regulatory lapses.

At bank after bank, the examiners are discovering that state and federal regulators knew lenders were engaging in hazardous business practices but failed to act until it was too late. At Haven Trust, for instance, regulators raised alarms about lax lending standards, poor risk controls and a buildup of potentially dangerous loans to the boom-and-bust building industry. Despite the warnings — made as far back as 2002 — neither the bank’s management nor the regulators took action. Similar stories played out at small and midsize lenders from Maryland to California.

How’s this for understatement of the year?

“We all could have done a better job,” said Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation.

The New York Times indicated that one of the dangers now is that banks will be held to a too rigorous standard.  Not everyone agrees:

The Obama Administration is prepared to do anything, including dramatically lowering mortgage lending standards, to keep real estate prices inflated, as demonstrated by statements, reports and events in the month of October.

First came the Federal Housing Authority inspector general’s report on the FHA’s lender approval process, which found that FHA was missing or ignoring relevant information, failing to document loans, not preventing convicted financial criminals from participating in its lending program, and in most other ways failing to "ensure that lenders met all applicable requirements." The IG’s spot check revealed, for example, that just one out of 22 approved applications contained all the documentation needed to meet the FHA’s own standard for guaranteeing a loan.

So which way will the wind blow then?  Will banks be too strict, or too lenient?

My best guess is that private money will be strict.  The future of the housing market is still a big question mark, and lenders will want to be careful.  Profit will continue to be their main concern. Anything backed by the government is a different story.

More homes were produced during the boom than there were qualified buyers.  There are fewer qualified buyers today and a lot more vacant houses.  The government is more concerned with filling empty houses than it is with lending risk.  Moral hazard is out the window as different plans are rolled out to keep people- any people in homes.

The lending coroners are liable to be busy for some time to come.

Wall Street may not like it, but lower housing starts is good news for the housing market:

Privately-owned housing starts in October were at a seasonally adjusted annual rate of 529,000. This is 10.6 percent (±8.7%) below
the revised September estimate of 592,000 and is 30.7 percent (±8.3%) below the October 2008 rate of 763,000.

Single-family housing starts in October were at a rate of 476,000; this is 6.8 percent (±7.5%)* below the revised September figure of
511,000. The October rate for units in buildings with five units or more was 48,000.

Here’s how one analyst sees the situation: [Thanks L!]

Financial markets had expected starts to rise to 600,000 units. September’s housing starts were revised upwards to a 592,000 unit rate from the previously reported 590,000 units.

"The trickle-down effect of the housing number is going to be amazing," said Dan Cook, senior market analyst at IG Markets, Chicago. "It’s likely that more construction crews will get cut after this, and the supplier who supply those crews will be hurt as well. This is not good news at all."

I see it differently.  This is great news.  Throwing more inventory on a badly glutted market will never bring about stabilization.  Short term this will be painful for the industry.  Long term, this is what the market needs- a chance to sell what’s already out there.

Former Federal Reserve Chairman Alan Greenspan said it’s impossible to know that you are in a bubble when you are in one.  It isn’t impossible for most of us, but it sure seems to be tough for the Fed. Federal Reserve Vice Chairman Donald Kohn who seems to have the same problem:

Kohn said it’s wise to beware of "false positives" when assessing potential asset bubbles, such as with rising stock or commodity prices. A Fed action to correct a bubble might include hiking interest rates, which could harm a wider financial recovery, he said.

Why is it so difficult for the Federal Reserve to see when asset prices are out of whack with fundamentals? Or is it perhaps that admitting bubbles exist would require them to make unpopular choices in policy?

The pace at which people fell behind on their mortgages slowed during the summer for the third consecutive quarter, but the overall delinquency rate hit another record, a new report shows.

For the three months ended Sept. 30, 6.25 percent of U.S. mortgage loans were 60 or more days past due, according to credit reporting agency TransUnion.
That’s up 58 percent from 3.96 percent a year ago.

Being two months behind is considered a first step toward foreclosure, because it’s so hard to catch up with payments at that point.

CNBC quotes F.J. Guarrera, vice president of TransUnion’s financial services division who said:

Two things must get better before mortgage delinquency rates start reversing themselves, he said: home values and unemployment. "Until we see improvement in both of those areas, it’s possible that it will take longer for delinquency to improve," Guarrera said.

Guarrera said he doesn’t expect declines until the middle of 2010.

Guarrera is overly optimistic.  You don’t fix a mess like this in only six months.  Home prices are still out of whack and improving employment is not on the horizon.

Chris Low, chief economist of FTN financial recently said:

[A] stable housing market is essential to a stable banking system, and he believes “everything that can go wrong in the housing market already has.”

I would disagree. One of the things that housing can still suffer from is attrition.  Some problems get worse over time.

One of the factors that can wear over time for housing is employment.  There is no such thing as a "jobless recovery"

With the unemployment rate at 10.2%, the stock market might take some comfort in the thought that we are closer to the peak in the unemployment than the trough.  Unfortunately, we are likely a lot closer to the beginning of a long, jobless recovery than the end.

If 200,000 jobs could be added monthly to nonfarm payrolls starting in November (and that will not happen in November), we would recover all of the jobs lost so far in the Great Recession sometime around April 2013.

Unemployed people don’t buy houses.  Underemployed people don’t buy houses.  People who are worried about their jobs don’t buy houses. [Unless they are downsizing.]

I don’t agree with the politics of John Buell, a political economist, but I have to give him his point here: 

One need only look at a number of widely accepted measures of economic health. While nearly one of six American workers is unemployed or underemployed, almost a third of our productive facilities stand idle. While homelessness continues to grow, nearly one in seven rental properties stands vacant and foreclosure rates rise.

Put aside Economics 101 and ask a simple question. Isn’t there something wrong with an economy that fails to steer unemployed workers into the unused plants? And if some policy achieved this purpose, wouldn’t more workers earn enough to rent those vacant homes and apartments?

Americans often pride themselves on looking at facts on the ground. I find it hard to deny that as an economy we have already produced enough homes and factories that everyone could live comfortably.

Buell is right in that there is something wrong with the economy and there are enough houses out there.  Policies that encourage more home building aren’t going to stabilize housing or the economy.

When employment has recovered, housing will begin to recover.  Since there is an overabundance of houses, building more of them won’t help the economy stabilize.  As Buell’s data shows, we have an unbalanced economy that is directing resources in the wrong places.  Until the American economic machine produces what we need and quits overproducing what we don’t, there will be no stabilization.

Low is wrong.  A lot more can go wrong with housing.

1:36:34 … This crisis was caused by massive government subsidies to purchase homes by people who couldn’t really afford them. So what does Congress do? They pass an $8,000 tax credit for people who can’t really afford to buy a home to buy one. I mean, how stupid can you get? - John Makin

Doom Transcripts: Index & Guide

Housing Doom is pleased to present a complete unauthorized annotated transcript for the American Enterprise Institute’s October 22, 2009 event "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis".¹ The event site has a variety of resources including both an audio and a video of the proceedings. There is as yet no official transcript.

Table of Contents

[link navigation works best when full article displayed]

1. 0:00:00 - Alex Pollock intro (preview post)
2. 0:11:43 - Tom Zimmerman presentation (preview post)
3. 0:26:50 - Chris Whalen presentation (preview post)
4. 0:37:03 - Nouriel Roubini presentation (preview post)
5. 0:54:19 - John Makin presentation (preview post)
6. 1:08:20 - Desmond Lachman presentation (preview post)
7. 1:21:56 - Panel discussion (preview post)
   1. 1:22:08 - Roubini discussion
   2. 1:22:59 - Whalen discussion
   3. 1:23:57 - Lachman discussion
   4. 1:25:24 - Makin discussion
   5. 1:28:01 - Whalen question
      1. 1:28:18 - Makin response
      2. 1:29:19 - Pollock response
   6. 1:29:51 - Pollock (with Roubini) aside on Canada
8. 1:31:26 - Q&A (preview post)
   1. 1:32:00 - Bert Ely question
      1. 1:33:04 - Zimmerman (with Roubini) response
      2. 1:34:29 - Whalen response
   2. 1:34:58 - Brian Gardner question
      1. 1:35:43 - Makin response
      2. 1:36:59 - Whalen response
   3. 1:38:18 - Steve Votaw question
      1. 1:38:59 - Lachman response
      2. 1:40:38 - Roubini response
      3. 1:41:22 - Zimmerman response
      4. 1:41:49 - Pollock response
   4. 1:42:11 - Jack Phelps[ph] question
      1. 1:42:54 - Makin response
      2. 1:43:24 - Whalen response
   5. 1:44:40 - John Serrapere question
      1. 1:46:02 - Roubini response
   6. 1:46:27 - anonymous question
      1. 1:47:44 - Whalen (with Pollock) response
      2. 1:48:44 - Roubini response
      3. 1:49:52 - Makin response
   7. 1:50:42 - Barry Wood question
      1. 1:51:12 - Roubini response
      2. 1:54:36 - Whalen response
   8. 1:55:02 - Christine Eisner[ph] question
      1. 1:55:24 - Zimmerman response
   9. 1:57:22 - Dale Kinsella[ph] question
      1. 1:57:55 - Makin response
   10. 1:58:44 - Pollock brief wrap-up
9. 1:59:06 (end)
   • Notes and References

Alex Pollock: [0:00:00] Good afternoon ladies and gentlemen. [slide² 1]

When in the course of financial events we have a huge bubble and the inevitable succeeding huge bust, a decent respect for the the opinions of mankind requires that we try to learn something useful from the painful experience. That’s the point of these deflating bubble series of AEI conferences, which you all have so kindly supported with your participation. So welcome to Deflating Bubble Roman numeral VI, "The Lessons of the Bubble and Crisis."

This conference, like its predecessors, is co-sponsored by AEI and by the Professional Risk Managers International Association, represented by Chris Whalen, who is here on the panel with us; and Chris, thank-you for your great partnership.

We have for you today our usual excellent and insightful panel, whom I will introduce in just a moment. But first, I’d like to try a brief setting of the stage for the current act of the intense financial drama which the bubble created.

First of all, a picture of the bubble. [slide 2] This is the Case-Shiller National House Price Index going back to the origin of the series in 1987 with the 90 percent increase in house prices. I’ve added a trend-line to this chart, which is the trend through the beginning of the series through 2000. It’s about a 3.3 percent nominal average increase, which is pretty plausible for house prices.

So the point of this chart is not that corrections necessarily stop when they get to the trend, but when they get to the trend it means we’ve had a really large adjustment. And as you all know we did a little stabilization — that doesn’t mean that we can’t go on down further, but we have made it back to the trend line.

A second point, and Desmond’s … I think you’ll see in Desmond’s presentation I know you’ll see this chart again, but my point here is that the … well we all talk about the housing bubble, as we’re all now aware, we really had a double bubble: a housing price bubble and a commercial real estate price bubble; so this is the same Case-Shiller National Home Price Index, along side the Moody’s National Commercial Property Price Index. [slide 3]

When I had this chart made I was astonished at the practically identical shape of these property property price bubbles, the commercial bubble lagging about … for a long time about 6 quarters, the peak about 6 quarters, and now the fall … And if you look over to the far right hand end, the commercial price index has now dropped further. So we had a peak-to-trough — at least trough so far — in the house price index of about 32 percent fall. It’s now 40 percent as of the reports of the Moody’s index today. A peak to so-far for commercial property. And National Mortgage News had a nice article on this which they said this induces a strategy which might be described, they said, as "extend and pretend," but can also be described as "delay and pray." [no laughter]

Lest you think that the highly regulated commercial banking sector was not part of the bubble, I want you to just look at this chart. [slide 4] This is the percent of aggregate commercial bank loans of all banks which are real estate loans. Note that from the last time real estate really hurt the banks in the early 1990s this was flat for several years, and then follows a run-up. Now this is not the amount of loans, this is the percent of all loans which are real estate loans, both residential and commercial, of the entire commercial banking system. So of course the total loans is expanding, and the proportion which are real estate loans dramatically expanded, as you can see here, and on the commercial part, as Sheila Bair remarked recently, that bank exposure to commercial real estate loans stands at an historic high.

Well how about the little banks? There are, of the 7,000 American commercial banks, about 6,500 we think of as the smaller banks. That’s banks with assets of less than $1 billion. This is the proportion of the total loans [0:05:00] of all of these smaller banks which are real estate loans. [slide 5] And as you see, on a 16 year look, the line has headed straight north-east from over half to a really quite remarkable 3/4s of all loans of these banks.

And within the banking system it’s not only loans, it’s also in the securities portfolios. So if we look at the percentage of the securities owned by the aggregate commercial banking system, and in this chart [slide 6] I have added together mortgage-backed securities and the debt of Fannie Mae and Freddie Mac. So it’s got Fannie and Freddie debentures, which are real estate investments, in fact, and MBS. And here you see, indexed to 2000 equals 100, the really quite remarkable rise.

So not only in the loan portfolio, but also in the securities portfolios of the banking system we had this amazing concentration of real estate risk.

So finally, what I do here [slide 7] is to take, coming back to the real estate loans, index them to 2000 equals 100, and set them up against the double bubble in residential and then commercial property prices and get this really amazing relationship with the prices of the underlying assets dropping as aforementioned. And you see the tracking of the flow of bank credit, of course facilitated by a government intervention called "deposit insurance." The flow of bank credit into real estate risk and contributing to the bubble.

And this is in the intensely regulated commercial banks, so in addition to bringing us at least to part of the current phase of the deflating bubble, it suggests one proposed lesson, which is that if you think that regulation will save you, it won’t.

Now to introduce our panel, and today, for a change, we’re going in reverse alphabetical order. Which means that first, we will hear from Tom Zimmerman. And he told me he feels like decades of being last are now being partially corrected.

Tom is a Managing Director at UBS, where he’s been involved in managing the firm’s asset-backed and mortgage-backed securities research efforts for 11 years. This is after managing asset-backed and mortgage-backed securities research groups at Prudential Chemical Bank, and previously research at Salomon Brothers. And Tom’s research appears in numerous fixed income publications and industry reference works. He was a member of the UBS research team that consistently ranked first in the annual Institutional Investors’ survey. And finally, Tom knows more about the MBS market than anybody else we can think of.

Second will be Chris Whalen, the co-founder and Managing Director of Institutional Risk Analytics, and as previously mentioned my partner in setting up this series of conferences. Chris previously worked as an investment banker, research analyst and journalist covering a variety of industry sectors including technology and financial institutions.

In addition to editing the Institutional Risk Analyst newsletter, Chris contributes regularly to various financial publications, and he is the representative of the Professional Risk Managers International Association with us today, and a Regional Director of the Association’s Washington DC chapter.

Our third speaker will be Nouriel Roubini, who has become internationally well known for his accurately pessimistic forecasts over the last few years, some of which, if you’ve been here, you’ve heard at these very conferences, the "Deflating Bubble" series.

Nouriel’s a Professor of Economics at New York University’s Stern School of Business. He is co-founder and Chairman of Roubini Global Economics, an economic and geo-strategic information service which has been named as one of the best economics web sites by BusinessWeek, Forbes, the Wall Street Journal and The Economist.

Nouriel has served as a senior advisor to the President’s Council of Economic Advisors and the US Treasury, has published numerous policy papers and books, and is regularly cited in the media.

Next will be John Makin, who is a Visiting Scholar at AEI. He has been associated with AEI since 1984. That is time to observe numerous financial crises over 25 years, almost.

John is also a Principal [0:10:00] at Caxton Associates in New York. He’s been an advisor to numerous US government agencies, the Federal Reserve System, the Bank of Japan, as a member of the Council on Foreign Relations and the Ecomonic Club of New York and the author of numerous books and articles on financial, monetary and fiscal policy. John writes the insightful and incisive monthly Economic Outlook for AEI, which I recommend that you should all have on your regular reading list.

And our final panelist is my colleague Desmond Lachman, who joined AEI as a Resident Fellow in 2003, after serving as a Managing Director and Chief Emerging Market Economic Strategist for Salomon Smith Barney. He previously served as a Deputy Director in the International Monetary Fund’s Policy and Review Department working on IMF policies towards emerging markets. Desmond writes on economic policy, Fund arrangements, monetary reform, import restrictions, exchange rates, emerging market economies and the role of multi-national and multilateral institutions. And, of course, he writes on the bubble and the financial crisis. He and I, and John, were partners in the bearish camp at AEI going back to late 2006.

Each panelist will talk to us for from 12 to 15 minutes. After that we’ll give them a brief chance to respond to each others’ comments. Then we will open the floor for your questions, and we will adjourn promptly at 4 o’clock, unless you all run out of questions sooner. … So Tom, you have the floor.

Tom Zimmerman: Thanks a lot, Alex, it’s great to be here again. [slide³ 0] What’s amazing about coming down here every 6 months is that I’m usually viewed as one of the more bearish people in my shop, and also when I speak at conferences around the country I’m usually sort of sitting on the bearish side of these discussions. But I come down here, [laughs] and I’m not … it’s a … I feel like I’m a raving bull about what’s going to happen in the world when you listen to some of these people talk. So anyway, that hasn’t changed, in the last 6 sessions, so …

We had lunch together today, and it’s exactly the same.

I see some green shoots here and there, but I think that it’s not something the other panelists see some real major problems down the road.

What I thought I’d do today is just continue some of the things I’ve talked about before in terms of the housing market, mortgage market. And then at the end talk about some of the lessons that we’ve learned from this bubble which isn’t over with yet, but we’ve learned some lessons or at least some take-aways from it.

But just the first couple of slides to go through what’s happened to the housing market here in the United States, and as most of you know, there are some positive signs. [slide 1] The existing home sales, new home sales, have bounced back a little bit the last few months, granted from very, very, very low levels from new houses, that’s for sure.

One questionary note: you take a look at the existing home sales, which are by far more important that new home sales in the total scheme of things — [slide 2] California came out (which is the West, that orange line there) … The existing home sales bounced back pretty rapidly back in 2008. And now what happened is the rest of the country sort of caught up with it, but you see California and the West has sort of slowed down now, while the rest of the country’s started to take off a little bit.

And I think what this slide points out is that you do stimulate sales when you crash a market completely, and California’s housing market crashed first, and I think that’s where you see the existing home sales came back faster. The questionary note — this bit of a bounce we’ve gotten in the other parts of the country may be a reflection of that process as well. So we may end up with a little bounce, and then going sideways the next 2 years. So I wouldn’t read too much into this particular chart.

Inventories are down, [slide 3] certainly more so on the new home sales than on existing home sales, and we’ll talk more about this inventory situation which … This is the visible supply, which is your local realtor board has it on their sheets. There’s a shadow inventory, which is considerably larger than this, and we’ll talk about that later. So this is positive, but not as good as it might be.

This is definitely a positive chart. [slide 4] This Case-Shiller index of home prices, and if you saw the article by Robert Shiller last week, and he said he’s amazed at this chart. You’ve got the last 3 or 4 months in positive territory for these 20 MSAs [Metropolitan Statistical Areas]. Granted, there’s a very sharp seasonal pattern to the housing market. I’m guessing, I’ll bet that these numbers will be in the negative territory by fall and winter. But nonetheless, this is a pretty amazing chart compared to where we’ve been. So his analysis of it in that article said something to the effect that he’s amazed that people think the housing market could have done as well — is going to do, [0:15:00] meaning that he had his survey, and I forget the percentage but a large number of people who were buying homes felt that in the next year or so their houses would be worth a lot more. So we’re sort of back to that … a little bit of that psychology’s coming back into the marketplace. That surprises me, by the way.

And it’s not just one area, it’s right across the country. [slide 5] Because this is … only in Las Vegas was the last datapoint negative, so it’s not just a few parts of the country.

In terms of affordability, which is this chart. [slide 6] This is a combination of home prices, interest rates and income. But certainly what’s happened here is this decline in the overall prices around the country has had a significant impact, as has the Fed and the Treasury keeping a lid on mortgage rates, which is pretty instructive here. When that goes away, this won’t look quite so good.

And this chart, [slide 7] if you take a look at that right-hand chart, it shows — the right hand statistic — is the percentage of the securitized market which is made up by non-Agency securities. And historically the non-Agency, which was subprime, Alt-A, prime, Jumbo, etc. used to run 19 or 20 percent — jumped up like 50 percent during the bubble, and now it’s down to 2 percent. And that 2 percent is mainly just re-securitizations of old loans that were out there. That business doesn’t exist, basically.

The securitizations, which used to be upwards to half of our market in America doesn’t exist right now, so in terms of your view of where the housing market goes, it’s still very hard to get a loan. It’s very … still very difficult to take out a loan unless you have a super-high FICO score and a lot of money. So that’s one of the big negatives, which is still here. That hasn’t changed.

And one of the big questions facing the mortgage market is going to be, "How do you wean us off of a total US government product?" And that’s basically what we have — HFA, Freddie, Fannie, etc., that’s it. There’s very little private mortgages going on.

Of course, the foreclosure numbers are astronomical. [slide 8] We’ve all heard about this on the front page of the paper. But this chart is pretty instructive. What you see in the paper, you don’t go back and see the history. But this is really an outlier from the last 30 years here in terms of foreclosures. Very significant number.

And one of the problems — This is the biggest … 2 big problems facing the market as I see it.

Some of that positive data we looked at. It’s a very sharp seasonal pattern to the housing market, and once you go into the fall and winter months both prices and sales might not look so good. So I would be prepared for some pretty negative numbers. It’s already started, by the way. The last couple of weeks you saw some numbers coming out which reflected the … according to the new … to the home builders it reflects the fact that this $8,000 stimulus tax refund might be … well, it’s due to expire in November 30th, whether they renew it or not I don’t know, but if you notice in the paper the last couple of days, there have been a number of articles about … criticizing that program. I think … and it was an amazing number: it’s something like 1.2 million Americans have signed up for this $8,000 credit. That’s like every house that was sold. Like, everybody thinks that they can get this credit.

I just read an article today, that in the investigation they found out that there’s quite a few people under the age of 18 who signed up for it as well, so … [laughter] it’s a classic example of … I mean, it’s an amazing program, but they’re planning on renewing it, I think, as part of the … Keep America Going.

But in any event, part of the problem is that this chart [slide 9] is a roll rate chart which shows the … this is for non-Agency product, which we’ve followed pretty closely at our shop. And what it shows is the percentage of loans … this particular part of it shows the percentage of loans which are in this 90+ day delinquency bucket, which is really a bad, bad bucket. And as loans age from 30 to 60 to 90 and they roll into foreclosure, and they get liquidated, what’s happening is that the servicers, mainly for political reasons, are not pushing these people through. So what happens is, this roll rate, i.e. the percentage of loans that are in a 90-day bucket, which get rolled into foreclosure, has slowed down pretty dramatically. And you can see it in this data right here. It’s still going on, by the way.

So one of the problems is the build-up of delinquent loans in 90 days and foreclosure, etc. which don’t get pushed through and pushed out to the system.

That earlier chart, we saw the inventory of unsold homes. Those are the homes listed on MLS. That’s not all this stuff. This stuff is back there waiting to come out, and that’s one of the biggest problem’s we’re going to have to deal with.

He’re another example of that, [slide 10] just of the different servicers, and you can see that some people are doing more and better than others in terms of these 90-day buckets getting pretty big. But I won’t spend much time on this.

But here’s a broader picture of these 4 parts of this non-agency market. [slide 11] And what you’ll see is this … the blue line is REO, and it’s kind of coming down in some of these sectors. This orarge line is foreclosure, and the yellow line is 90+ day. [0:20:00]

That 90+ day and that foreclosure bucket you’ll see in all these sectors is still rising, even though the total may be going down. That amount of … the amount of loans that are in this 90+ foreclosure bucket is growing.

This is a big question mark for the market for the next year, I would say.

This [slide 12] is our best estimate of what can happen over the next few years in terms of tracking these delinquencies as they go through the pipeline. And the solid lines are stock figures, the dotted line is a flow figure. The solid lines are showing 60+ day delinquency on the top, will peak out somewhere towards the end of next year, the REO and foreclosure numbers a little later. And then this dotted line is what we estimate are the liquidations out of the foreclosure bucket going into … out of the REO bucket, and actually being liquidated.

And so you can see that this chart says that the bad stuff continues all the way up through the … almost the end of next year.

So the housing market has a lot of wood to chop to get through this cycle. We’re not over by any means in terms of the negative part of the housing market, even though you’ve seen some positive indicators in the past 3 or 4 months. We have a long ways to go in the housing market.

This is a chart which shows the number of people who are underwater. [slide 13] If you add all those to the right in the negative side, it comes up to about 30-some percent, so more than 30-some percent of Americans have homes which are underwater right now. Not a good sign.

And finally, [slide 14] this program that’s in effect right now which the government’s pushing, the HAMP program. This is like the 3rd or 4th go at this. As you know, the first three didn’t work very well. And this program has lots of detractors, if you talk to the servicers and what’s going on.

Part of it, and I’ll talk about it in a minute in terms of lessons learned in this cycle, it’s not a new lesson, but the government has a problem in dealing with problems like this where you can’t be sloppy about how you deal, because you get criticized for allowing … just like the problem I mentioned earlier, about this refund program. They’re getting 18-year-olds signing up for it. So they … for this modification program, to save the American housing market, the Treasury and the IRS created this nightmare of paperwork to be done. So basically, they have 2 parts of this program. A trial period for 3 months; after 3 months of making your lower reduced payment you go into a full modification. Well what’s happening is during this 3 month trial period, the people are not filling up all the documentation they require to go into a full modification, because of all the complex nature of this program that was established.

So here we have something announced back in March, launched in May, now they’re finally last month decided to streamline the documentation process, because it’s so complex no one could do it.

So this is a perfect example of things government doesn’t do very well.

So I don’t hold a lot of hope that this will really … this big program, although you’ve heard a lot about it, is going to have a really major impact on the foreclosure numbers that we looked at earlier.

And I’m going to jump through a couple of things here and go on to lessons of the bubble. [slide 18 ... 15-17 not used]

And just … how much time do I have? …

voice: … three minutes …

Tom Zimmerman: … three minutes … OK, lessons in 3 minutes.

This is … Alex and I have talked about this. You’ve got to have regulation, but it’s necessary but not sufficient. It’s people and politics that run this thing.

The rules and regulations are out there. It was a bubble, pure and simple. It’s not so pure and not so simple, but I mean it was a bubble. And I don’t care what regulatory environment you put together, you’re still going to have bubbles.

I think the bank regulatory effort to go toward a single regulatory body is probably a wrong thing to do. I like to have different people competing with the process; different ideas, different … I think we’re better off in this crisis having 3 or 4 different agencies who are able to deal with different parts of this problem. And if one didn’t do it, somebody else picked up the slack — and they did it outside their jurisdiction, but they did it anyway.

So I prefer to have several big players able to help solve these problems than just one person, one agency that might not get it right.

The government is great at some tasks, it’s terrible at others. I think the way they solved that bank liquidity problem, after all those efforts the Fed did to bring the banks back on-stream lending to each other was fantastic. I don’t think anybody can criticize that. But as I just said, that HAMP program is a disaster, and most of these big programs that they’ve launched in the housing market are disasters.

So government can do certain things well, certain thing they don’t do very well at.

The pendulum theory — it’s always there, this is not new. In terms of consumer finance, they stopped the subprime lending 2 years ago with that regulatory … it was done, it was dead. There was no subprime or Alt-A lending after they said, "fully indexed, fully amortized, that’s the way you qualify a loan." End of story, end of subprime, end of all that craziness. That was done two years ago. Now you’ve got Reg Z coming on-stream, you’ve got the new bank card regulatory thing.

Believe me, the consumer’s in good shape. We don’t need [0:25:00] a Consumer Finance Protection Agency. All you’re going to have is an enormous bureaucracy that doesn’t change things very much.

We’re just too far, too much, but that’s typical. Pendulum swings too far. And they’re talking about this pre-emption of Federal rules which I saw in the paper today that they’ve backed off a little bit on that. That would be a nightmare. Talk about your bankers here. Talk to any banker about this, trying to meet 50 different rules and regulations instead of one or two is crazy. I mean this would really cost a lot of money, if you had to had to deal with every State and locality in the country.

And finally, [slide 19] just a couple of obvious things about lessons, you know, [laughter] they’re hypocritical … during the crisis, everybody in this room was so glad when BofA bailed out Merrill Lynch for gossakes. You know, my grandmother has her account with Merrill Lynch. Who’s going to save her. I mean everybody was glad when these things happened, and when the Fed bailed out the whole system, and then, you know, 6 months later they’re killing the banks and the Federal Reserve? That’s ridiculous, you know.

There’s two different worlds. When a war is on, you just get it done, and then later on — don’t go back and criticize the generals for what they did, just do it.

Anyway, that’s just my own thing.

And then, the last thing. I’ve been into Wall Street for a number of years. I’ve seen a lot of these cycles like some other people up here. And when things are really, really going good, you know it’s not going to last. It’s the old seven fat years and seven lean years. So don’t be too happy the next time you’re in a really good part of the market, because it won’t last forever. Thank-you.

Alex Pollock: Thanks, Tom, very good data and very interesting observations. I’m sure you all remember the saying, I learned it as the definition of an auditor, but I think it applies to your hypocrisy point. Which is those who come to the battlefield after the battle is over and bayonet the wounded. [laughter] … Chris.

Chris Whalen: Thank-you Alex. Bayoneting the wounded is what regulators always do. In fact, that’s the only thing they do well. And they do it with great zeal.

I’m going to talk a little bit about the industry because we’re in the middle of earnings season, and I apologize for not preparing something, but I’ve been reading bank earnings statements, so I will share some of my impressions of that. And then I want to talk a little bit about not only lessons, but some of the enduring trends that I see that have not been affected by the extensive bailout that the government has put together for our largest financial institutions.

In general, when you look at the industry you have to recall the words of Mr. Feinberg, and I don’t mean the guy who was in the newspaper today, I mean my friend Bob Feinberg in the back of the room, who predicted several years ago in an interview we published that the GSE would become the business model of choice for the United States.

And so we now have at least 4 GSEs, maybe 5: obviously Fannie, Freddie, Citigroup and AIG; I think you would also probably want to include BankAmerica and Wells Fargo in that fine association; and depending on your mood you might put JP Morgan in as well, but I generally have JP 4th on my list of worry for the top 4, OK, so you’re wondering what my order is.

When you look at the big banks, the first thing that jumps out at you, of course, is their marvelous earnings results. And when you dig into their financial statements what you find is that their net interest margin tends to be a good 50, sometimes 60, percent higher than it is for smaller banks. This is the subsidy that everyone in this room is providing to the equity- and bond-holders of these institutions.

Another way of looking at it is if you look at the Revenue Run Rate for Citi for the analyst community next year, their estimate, it’s $10 billion lower than the current revenue run rate for Citi. What’s wrong with this picture?

Well, what it is telling you is the Street doesn’t think that in a normalized scenario that bank can generate as much revenue as it is generating today with the various subsidies from the Fed and Treasury.

The other real eye-opener, of course, with Citi, is that we’re almost up to my prediction of a year ago of 6 percent charge-offs. This is inclusive of loss-sharing. This is inclusive of various other subsidies. So the question you should be asking yourself when … that is when Citi …

Alex Pollock: … Chris, when you say inclusive, do you mean "net of," "on top of," loss sharing?

Chris Whalen: … I mean that this is the number modified by the loss-sharing. So in other words the actual loss rate is higher.

In all of your minds you should be thinking to youselves, "Gee, Chris told us a couple of years ago that Citi peaked around 3 1/4 percent charge-offs in the early ’90s, so if they’re reporting almost 6 today, and the actual economic losses inside the enterprise are higher than that, then that tells you that a lot of what Tom was just saying about the environment is absolutely right. And that these banks are going through a terrible, terrible period of loss. But we have [0:30:00] nicely disguised it.

Now you see this, of course, because the top performing financials over the last 6 months in terms of equity markets were the GSEs — Fannie, Freddie, Citi. They were followed by the Life Insurance underwriters, who are as opaque as companies get, and also performed about 150 percent over a 6 month period.

But then when you get down into the rest of the banking industry, what you see is a fairly gruesome picture. We do a preliminary index / snapshot right before the FDIC press conference where we look at the industry ex- large bank. And our stress index right now is a little over 5. The benchmark year is 1995, which is equal to 1. So what we’re talking about is this sleepy, pedestrian industry known as commercial banking has moved almost a half an order of magnitude in terms of stress in a period of just a couple of years. They were down at the average 1 rate back in 2007 — lower than that, actually.

This is not normal for banks, and as my aircraft engineer partner Dennis Santiago remarked after we got the second quarter data, "Gee, Chris, some of these banks are moving too much. They are not going to recover, because their indices are moving far too rapidly for a bank."

Now the thing that really worries me, though, because obviously "extend and pretend" is the operative policy at the moment with respect to the financials, is when you look outside of housing, and when you look outside of banks, and you look at things like … commerce.

We all remember commerce, right? Before financial services became the main engine of growth in the US economy? Well I just did an interview with my very dear friend Jerry Flum. Jerry runs a tiny little publicly traded company called Credit Risk Monitor. Have about $5 million in revenue this year.

They serve corporate treasurers, and corporate credit people. Every month they gather accounts payable and accounts receivable data from the Fortune 1,000. What this data shows you is that a financing market that used to be 4 times the size of the banking industry’s lending book is now just about gone. And when I say gone, I mean vendor financing has been withdrawn from the commercial channel.

What does this mean? This means cash on delivery. This means you’re not getting 30 days anymore from whoever, who’s selling you a couple boxes of widgets that you need for your business. They want to be paid up front.

So what this means is that for all manner of small, medium, even relatively large companies out there, there’s no longer any free working capital coming from the vendors that serve them.

Many businesses, if they’re well run, will actually have negative net working capital, right? They make somebody else finance the business. That’s not the case anymore.

So as Jerry said to me, and we’ll be running this interview either tomorrow or early next week, there’s no oil in the machine. That worries me a lot, because the banks can’t pick up the slack. This is the world of the CITs and some of the other private factors, but they’re only a small part of this market. When you talk about commerce, you talk about vendors who are willing to finance everything from CISCO routers to tubs of chemicals or whatever it is. They all give their buyers 30, 60, 90 days, whatever the practice is, whether it’s retail, what have you. And that market is gone.

So we can sit here and pretend as much as we like that the economy’s good because the Fed has liquified the financial system and they are providing ample credit. They’re even trying to pump up housing. But the thing I worry about with my banks is if we don’t get a bounce in unemployment, if we don’t get a recovery in the real economy, then we’re not going to see changes in credit loss experience for banks, even after next year. It’ll just keep on going.

And this is why I’ve been telling my at times cranky clients who say, "Chris, they were up 150 percent, you’re bearish." I say, "Yeah, I’m bearish for the simple reason that there are so many people betting on the long side of these instruments, whether they’re stocks or bonds." The change in pricing, the change in market sentiment that could occur will be very rapid. It won’t be a nice change in direction. This will be a sudden shift that is going to catch everybody as flat-footed as we were caught last year about this time.

So when I take a step back and I think of lessons I say, well, the chief lesson I am drawing from all this, and I’ve talked a little bit about this in a session I was involved with Vince Reinhart here about a week ago, is that, you know, our country is more and more being governed by a group of leaders who are far more interested in the opinions of the international community, and particularly our creditors, than they are in the views of our citizens and really in the interests of our economy here in the United States.

I think [0:35:00] you see this in many of the policy prescriptions that our colleagues are going to describe in terms of monetary policy.

And the question is, what’s the cost? Well the cost to us is inflation. I hear constantly from people, in part thanks to my friend John here in the front, talking about how, "Oh, Chris, deficits don’t matter, the Fed can just print money and it’ll be OK, we don’t have to worry about this, it’s all just inflation." Yeah, well it’s all just inflation, but you know what? If we continue along this path, most families in this country are not going to be making it in 20 years. And we are going to see this society collectivize.

Because we’ll have no choice. As Bob Feinberg predicted, the GSE will rule, and private corporations will not be able to compete in that environment. In fact it’s very hard for private banks to compete with the larger GSE banks today.

I smiled when I saw the results from my friends at Hudson City Savings this week, because they hit one out of the park again. Very profitable. But that’s a little bank that actually lends money to real people for real purposes in the New York area. How can they compete with an entity like Ally Bank, that has the Treasury underwriting them, that has terms on their deposits that are clearly unsafe and unsound, and yet this entity is allowed to continue, including with these obnoxious television ads.

I’m going to write a little piece about Ally Bank next week. I may just do the hat dance on them on a regular basis, because I just find it obnoxious that we could allow an insolvent institution like this to go around advertising the fact that they don’t have to follow the same deposit rules as solvent institutions.

So there are many lessons I could draw, I think most of them are moral, however. When we allow our government to stop paying attention to our wants and needs, this is what happens. And I look forward to your questions.

Alex Pollock: Thank-you, Chris. I’m reminded of Bob Feinberg’s Law, by your comments, which I state as: "Every group deserves its own GSE." [laughter] Nouriel.

Nouriel Roubini: OK. Tom spoke about housing and mortgages. What Chris spoke about — the banks. So I’ll try to speak about the economy and what’s going to happen to the economy looking ahead.

We’ve had the most severe recession and financial crisis since the Great Depression. Given the monetary and fiscal stimulus and the backstopping of the financial system now we’re close to the bottom, at least on a temporary basis.

And now the debate is, of course, on what’s going to happen — the shape of the recovery. Given what has happened in the markets I would say the markets are pricing now a V-shaped recovery with rapid return to potential growth, and that’s even what the macro forecasters’ consensus is.

There is a second view, which is the one I share, is that this recovery is going to be at best an anaemic, subpar, below trend, with growth well below trend for the next couple of years, much as in the US, but also in advanced economies. So more like a U-shaped recovery. That’s also the view of the IMF and the one of those folks at PIMCO who are talking about A New Normal.

But there is also a third view. The view that actually we might have kind of like a double-dip, a W-shaped kind of recession. And when I speak about that idea with with people like George Soros he says there’s going to be a double-dip, there’s going to be an inverted square root, meaning it will go up, we go down, and then we go back to an L essentially, because we’re going to run out of policy bullets if there’s a second dip.

So what’s going to be the outlook? V, U, W? I assign about 60 percent probability the U, about 25 or so to a W, and less than 20 to a V, I think that the chances of a rapid recovery of growth, are very, very slim.

Why? First observation is about the labor market. And unemployment rate is almost 10 percent. If you include in the unemployed discouraged workers and partial employed its already 17 percent. It’s true we’re not losing 700,000 jobs a month like in January, it’s only 260[,000]. But during the last recession, it was only 150[,000]. And the last recession was mild, with only 8 months. And we had job losses continuing after the recession was over in November 2001 all the way through August 2003 — job loss, and then jobless recovery.

This time around it’s going to be just the same, only worse. The ratio between applicants and vacancies is 6/1, the ratio of continuing to initial claims is as high as ever, the average duration of unemployment is as high as ever.

And the point is that the losses of labor income are not deriving only from the job losses; because, as you know, labor income is the product of … jobs TIMES hours TIMES average hourly wages.

And now as a way of sharing the pain, many firms are telling their workers, "let’s cut hours; let’s accept furloughs; and also let’s accept a lower average wages." The full time equivalent of the loss of hours in the United States is another 3 million full time jobs lost on top of the [0:40:00] 7.2 million that were lost formally. So the effects on labor income have been massive.

And with collapse in labor income, how are you going to have a recovery of consumption?

Second observation: This is not your typical kind of recession because inflation gets out of hand, the Fed puts a brake and then you go into a recession and then you take the brake away and you have a rapid recovery which is V-shaped. This, we agree, is it’s the kind of a recession driven by over-leverage and debt accumulation — a balance-sheet recession: debt accumulation of the housing sector, of the financial system, and also the factor of the corporate sector.

And while there is a lot of talk about deleveraging, when you look at the debt ratio of the private sector, they’re not rising any further, they have stabilized at a very high level and they’re barely falling. And instead, as a way of socializing the private losses, we have now had a massive releveraging of the public sector. We’ve huge budget deficits and debt accumulation.

Net US debt as a share of GDP is going to double from 40 to 80. Officially we’re estimating a cumulative $9 trillion deficit over the next decade.

Now, if you take this interpretation of the crisis as being a debt crisis, there are at least another 5 reasons, in my view, in addition the weakness of the labor market, why it’s going to be at best an anaemic recovery, and at worst, a double-dip.

First one: The US consumer — and it’s not just the US consumer, it’s also the consumer in all the countries that have large current account deficits and housing bubbles: is UK, is Ireland, is Iceland, is Spain, is the Baltic states, is Dubai, is Australia, New Zealand — so this consumer is shopped out, saving less, debt burdened.

And even when GDP growth is going to become positive, consumption growth has to be smaller than GDP growth as a way of rebuilding savings and reducing the leverage ratio. But since consumption is 70 percent of GDP, then if consumption grows less than GDP then GDP growth has to be very weak, unless other components of aggregate demand are growing much faster. And I’ll argue they’re not going to grow much faster.

So that’s the first and crucial point — the US consumer has never been squeezed so much, both in terms of his P&L [profit and loss] and balance sheet. Savings rates have gone now from zero to 4. IMF estimates have it go to 8 percent so it will be a significant further slowdown in consumption.

Second point: In the typical V-shaped recovery investment, capex [captial expenditure] spending grows much faster than GDP. That’s why you have a V-shaped recovery. But this time around I don’t think there’s going to be any robust growth in capex spending, leaving aside even housing that is in the doldrums. And the reason is very simple. Capacity utilization in the United States today is 70 percent. Capacity utilization in the Eurozone is 70 percent. Is the lowest we’ve had in decades in any recession. Capacity has to be at least 80 / 85 percent before you see any pickup in investment.

The point is, if a third of capacity is not utilized, why would anybody want to do more capex spending? There’s a glut of capacity and you’re not using a third of it. So why would you want to do capex? There is not going to be any significant recovery of capex spending.

Third point: The damage to the financial system and to credit growth. It’s not just the damage, of course, to the traditional banks. You know the big ones have been backstopped, but we have 100 of them that have been closed by the FDIC, and those that are on the critical list is another 479 so far. Most likely is going to increase.

So is not just the small banks, the medium sized banks, that are in trouble, but more crucially, most of the Shadow Banking System, the non-bank financial institutions, has been either destroyed or severely damaged. 350 non-bank mortgage lenders gone. SIVs and conduits gone. Securitization, as Tom was saying, died 2 years ago and there’s none of it in the private sector. Hedge funds had to deleverage. Private Equity funds are having problems with LBOs which should never have occurred. AIG; Fannie & Freddie; Citi; Bear Stearns; Lehman; finance companies — massive amount of distress in the Shadow Banking System.

The point being, today credit growth in the financial system is negative. And as Chris was pointing out, there is not even credit growth through the corporate system. But even if and when credit growth is going to become positive, credit growth is not going to be as robust as the go-go years, in which were the high growth of the economy because of a credit bubble and a credit boom.

And if you don’t erect any credit growth, how are you going to finance capex spending? How are you going to finance residential investment? How are you going to finance construction of new homes? How are you going to finance consumption of durable goods?

So we’ve low credit growth, we’re going to have a slower growth of the economy.

Fourth point about the fiscal stimulus: The fiscal stimulus in the US and other countries by the middle of next year becomes a fiscal drag. And if there is not any means for recovery of private demand, and I argue why there is not going to be a recovery of private demand, then you’ll have a problem with growth again slowing down sharply.

And if instead [0:45:00] we decide to increase that fiscal stimulus — again we have another fiscal package or a series of other ones and we keep on monetizing them — eventually that’s going to crowd out the recovery. Monetization of large fiscal deficit through a number of channels going to be crowding out the recovery.

Finally point about the U [-shaped recovery] from a global point of view. For the last decade the US and a bunch of deficit countries were the consumer of first and last resort; spending more than their income, running current account deficits. And on the other side you had China, Germany, Japan, emerging Asia, Latin America were producer of first and last resort; spending less than their income, running current account surpluses.

Now the over-spending countries have to retrench private domestic spending, because they have to save more and they have to deleverage, and that’s just happened, not just the US but in all those overspending countries.

But if they overspent, now they’ll spend less, and their trade deficits are shrinking, and therefore the surpluses of the surplus countries are also shrinking. Then unless the over-saving countries compensate for the reduction in spending of the over-spender by reducing their own savings rate and increasing their own domestic private spending, then globally, where you have a glut of capacity — and that glut of capacity is becoming bigger, because now China is doing another round of capital intensive[ph] over-capacity investment.

So you have a glut of capacity globally, and the recovery of global aggregate demand is going to be slower than otherwise. And therefore you’re going to have essentially an anaemic recovery of the global economy.

That’s the best scenario. That is a U. I see many reasons why we could have a double-dip. Why could we have a double dip?

First of all, the risk of a significant policy mistake of one sort or another. And the way I see the exit strategy problem is: damned if you do, damned if you don’t. What do I mean by that?

We know that fiscal deficits of this sort of $1 trillion per year are unsustainable. And monetization of them eventually[ph] is going to be a disaster.

Suppose you take this deficit seriously, and you decide to raise taxes or cut spending sooner rather than later and to mop up the liquidity sooner rather than later. Then you’re making a mistake. Because demand in the private sector has not recovered, taking away the policy stimulus is going to push you back into stag-deflation. Is the same mistake Japan made between ‘98 and 2000, when they introduced a consumption tax and then moved away from ZIRP too soon. Same mistake FDR made in ‘37 when he raised taxes and took the monetary stimulus. In both cases you had a double-dip recession or depression.

So if we take away the stimulus too soon, stag-deflation.

But let’s suppose we don’t take it away, because in the US, at least, the policymaker realize they don’t want to do that. If you talk in private or public to Bernanke, Geithner or Summers would say, "We shouldn’t exit too soon." Then you have a runaway fiscal deficits. These deficits imply that next year with unemployment at 10 percent, and it stays above $1 trillion. Then you might have a universal healthcare plan that might not be fully funded. Then you’re going to add a series of mini fiscal stimuluses. You will extend the unemployment benefit for those who’ve expired. You’re going to have to help him bail out State and local governments. You might extend Cash for Clunkers, you might extend the First-Time Homebuyer’s Tax Credit. You might have a tax credit for hiring workers. You might even have another round of shovel-ready labor-intensive infrastructure projects. You add it all up, is another $200/$300 billion.

And then at some point by the middle of next year the bond market vigilantes, who’ve been asleep at the wheel so far, they’re going to wake up and say, "Wait a moment. Politically you cannot raise taxes, and you cannot control spending. And therefore the path of least resistance becomes to keep on running the printing presses." And if you do that, you don’t need to tell a Zimbawist story of hyperinflation, it’s enough that expected inflation starting in 2012 goes up by, say, 200 basis points, and then 10-year treasuries go from 3 1/2 to 5 1/2, mortgage rates go to 7 1/2, other private rates go to 10 percent or above, and then you crowd out the recovery again.

So damned if you do, and damned if you don’t.

And the policy path that gets you to do the exit and do it right is a very narrow-edged, razor-edged and difficult. And the risk, especially in an election year, of making a policy mistake on one side or the other is significant.

Additional point about a double-dip. Oil prices now have gone from $30/bbl to $80/bbl and above at a time when demand is back to 2005 level, and the inventory is at an excess supply like never before. Why? It’s not fundamentals. Is a game. The wall of liquidity and the bubble chasing these assets. Last year, oil at $145/bbl kept the global economy in a global recession. It was not just Lehman and the fallout from it. When oil it came at $145/bbl was a negative in terms of trade, a real disposable income shock in the US, the Eurozone, Japan, China, India and every other oil importing country in the world.

Today we are already at $80/bbl. We’ve just a weak recovery of the global economy. [0:50:00] Now that the ETF and the option traders and the speculators are starting to crank up the stuff, oil’s soon enough going to be at $90/bbl, and then $100/bbl. And if it’s admitted, oil at $100/bbl early next year, it’s going to have the same effect on the global economy as oil at $145/bbl last year.

Why? When oil was at $145/bbl, most of the global economy was still growing. Today instead we have a global economy that’s collapsed. The worst recession in 60 years is barely on its knees trying to rise. And if oil goes to $100/bbl it’s going to be like a hammer hitting you in the head from the back, and push you back into another recession. And oil is going up not because of fundamentals but because of speculation and it’s becoming dangerous.

Third point. There are also geostrategic risks. I would not rule out that there is going to be a military confrontation between Israel and/or the United States and Iran on the question of nuclear proliferation. If that were to happen, of course, you’ll have just a threat even of a blockage of oil leading to oil prices doubling overnight, and another global stag-deflation. And that’s something that you have to worry about.

Final risk. The increasing asset prices we’ve seen since March for everything: global equities; in US, equities; EM [emerging market] asset classes; commodity; credit; everything around the world is driven by one factor.

You have one easy monetary policy around the world, almost everywhere — zero interest rates in most countries. But more importantly, is driven by the fact that in the United States, not only are you at zero interest rates, and expected to stay at zero, but the Fed, essentially, by buying $1.8 trillion of treasuries, MBSs, Agency Debt, is a major seller of volatility and is keeping the volatility of asset prices very low, both on the short end and the long end.

And therefore the bet that everybody’s doing is borrowing dollar at zero interest rates and buy any other asset in the world.

Now you’re not borrowing at zero interest rates, you’re borrowing at negative rates to the tune of 20 / 30 percent annualized. Why? Because with the dollar falling, you have a capital gain on essentially going short in dollars and long in other global assets.

So you’re borrowing at minus 30 percent, and everybody, the people think they’re geniuses because everybody’s up, any asset manager — is just anyone can do it. Borrow in dollars, buy any asset in the world. Could be in China, could be in India, could be in Brazil, could be in Russia; could be commodities, could be equities, could be credit, could be anything under the sun. It’s all going up, and not only is it going up, but they’re all perfectly correlated.

So you are in a situation that in terms of Value At Risk is the scariest one, because you have now correlation among all assets that are going back to 1.

And volatility is now down close to zero. So it looks like you are safe. But everybody’s doing the same bet, you have the Mother of All Carry Trades. You have the Mother of All Asset Bubbles. And the dollar cannot keep on falling down to zero. At some point the music is going to stop. Something’s going to reverse, and when the reversal occurs, like it happened to the yen in 2006, could have the dollar swinging back 30 percent overnight? Because you’ll have unraveling of the carry trades, and everybody was long in that stuff and leveraged. Is going to collapse the asset that they bought.

So we’ll have another crash that’s going to be bigger than the one we had last year.

So that created the biggest asset and credit bubble of all through this US monetary policy. The countries on the other side, either they have to intervene now, to prevent their currency from appreciating (that’s unstabilizing intervention that feeds their bubble) or like Brazil they’re imposing capital controls, or to have to ease further to prevent their currency from appreciating, and it creates more of a monetary easing around the world.

So we’re creating the biggest bubble ever, and it’s going to come crashing. Because when the music is going to stop, it’s going to get ugly.

So, in conclusion, if we’re lucky we’re going to get the U, most likely it’s going to be a W, and when things going to occur, is going to be scary. Is going to be scary for the following reason …

Alex Pollock: On that note, we’re going to have to wrap up. But do we take as your main lesson that we’ve addressed one bubble by creating another one?

Nouriel Roubini: A bigger one. Yes.

Alex Pollock: Thank-you, Nouriel. John? … You have to get your mic up and over … [crosstalk]

John Makin: So I’m going to say that so far what we’ve heard is, it’s the lessons of the — having deflated and about to reflate bubble. And that’s a little different than the idea that the bubbles burst and it’s past us.

But, you know, I’ve taken the charge here quite literally — What are the lessons of the bubble? And I think we’ve heard that it may not be the only bubble that we’re getting, but I … The main lesson of the bubble in the US in a sentence is "You’ve got to be Too Big to Fail," because then you get bailed out.

Unfortunately, that [0:55:00] may be consistent with Nouriel’s suggestion that there may be another bubble coming. But, anyway, a few months ago I took a crack at these lessons and have refined it a little bit. It’s on the AEI website. I haven’t got a presentation here, but it’s basically, "What are the lessons of the bubble."

And I’m going to look back a little bit and then quickly look forward.

First, there are three lessons of the bubble that we’ve seen so far. The first is that disruption in the financial sector can have a devastating effect on the real economy. And we saw that last fall when; … Remember, it’s important to remeber that in August of 2008 the Fed minutes suggested that the big concern was that inflation could get out of hand. That was 6 weeks before Lehman collapsed, and we know what happened there. We had one of the sharpest economic contractions in … certainly in the post-War period.

But I think in a way we had, if you read the anecdotes or the discussions about what was going on in September or October of last year, we had a near-death experience. Anybody who was close to the crisis that we saw unfolding in September of 2008, and I was in the middle of it, saw that we could have had a systemic meltdown that would have resulted in an immediate and serious global depression.

So I think one of the lessons of the bubble is to remember that we got through that. Don’t be too critical of policymakers, they had to extemporize how to deal with a counterparty run on investment banks, which is a new phenomenon that we’ve seen in this cycle; a little different from what we were kind of expecting, which was a depositor run on commercial banks. A counterparty run on investment banks is, in a way, a little bit more toxic because it happens faster. With a very sophisticated marketplace it means that people hear that an investment bank is in trouble and won’t do business with them, [so they] withdraw their capital and the investment bank goes down. A counterparty run on investment banks, had the Fed and the Treasury not truncated it, would have eliminated not only Lehman but Goldman Sachs, Morgan Stanley and any other investment banks that might have been hanging around there.

That could have happened. We were very close to that.

So I think one of the … The sense of urgency that Chairman Bernanke and Hank Paulson felt was related to the viciousness of that activity. And again it’s still a risk out there, but I have to hand it to Bernanke and Paulson, extemporizing how to run … how to deal with a counterparty run on an investment banks in the space of a few days is quite a trick.

I wouldn’t want to try to do it again, but the first … again, the first lesson of the crisis is … be careful, this is a very, very dangerous business. And we all … It was tied, of course, to the bursting of the bubble, but when the rubber meets the road, you’re in that kind of a situation and we were lucky — skillful, but lucky.

Second lesson: The Fed was slow to move, but powerful when they did move. In that sense they would … If I had to criticize I would say to everybody on Wall Street, and a lot of people on this panel, the Bear Stearns crisis, it was totally clear that this counterparty run on inventment banks was an incipient, then an actual problem. The idea that keeping Bear nominally alive, on life support from JP Morgan, was going to solve the problem was ridiculous.

I can’t resist pointing out that it was in April of 2008, a month after the Bear Stearns crisis, that the famous Jim Cramer wrote a piece⁴ in New York Magazine suggesting that, "Isn’t it a wonderful time to get back into the markets? Everything’s fixed." It wasn’t fixed, and in effect we’d had a warning that, if we’d heeded it more promptly, we might not have had quite such a toxic experience in the fall.

So it was sort of like — Too bad we didn’t learn about Bear, we didn’t, but somehow we managed to pull it out anyway after Lehman, but we were lucky. So there again I look back and one of the things I carry away from the crisis is … I don’t want to go there again, because it’s a real problem.

The third lesson, of course, and people mentioned this, is don’t forget China. China’s now the most [1:00:00] dynamic and largest force in the global economy at the margin, that is in terms of growth rates. Their behavior has a tremendous impact on what’s happening in the world today.

And of course they have the wherewithall to respond far more forcefully and successfully to the fallout of the financial crisis than advanced industrial countries. Remember China didn’t really have a kind of financial system meltdown problem because they didn’t have a sophisticated financial system. They were plugged into it.

China was threatened by the massive real economic fallout from the financial collapse in the industrial world. They effected a massive fiscal stimulus to … probably triple the US stimulus, and then the followed up with very aggressive monetary stimulus. The latest data that we’ve seen suggests they may have overdone it, but one of the things we’re seeing is rapidly rising commodity prices are partly a result of China’s very aggressive expansion. Shouldn’t be taken as a signal that there’s global inflation coming down the road, but rather that the Chinese are stockpiling commodities.

China has a big wealth-storage problem, and so they tend to stockpile real assets in periods of crisis. Asian investors like to own gold, and that’s another price that’s going up.

So I like to keep China in mind as we look at this. And of course one of the immediate problems we have now is that China, having effected a massive fiscal stimulus, and a domestically oriented, or a domestically based monetary stimulus, … China, which is really using the Fed as its central bank as of the … Chinese currency is pegged to the dollar. Then in effect US monetary policy is Chinese monetary policy. They’ve had huge capital inflows which they have not successfully sterilized them so China may be heading …

China may be the first bubble experience that we see in this environment where they’ve got massive stimulus in place, rapidly rising property prices and rapidly rising stock markets. So that is something that makes me nervous, because the Chinese are going to have to manage that problem. If they don’t manage it well, and it’s a tough one to manage, we could have a problem coming out of China which, of course, is not where we’re looking for problems right now.

The other lesson of the financial crisis that I started out with a little bit facetiously with, but I actually, I think it’s … it’s indicative of a problem is it’s best to be too big to fail. That’s another way of saying that we have a huge moral hazard problem after the financial crisis.

I saw a play in London about the financial crisis called "The Power of Yes." And it was … it was essentially a pretty good play. It kind of leaves the audience wondering how did these guys who screwed up so badly end up not getting crushed in the crisis.

And that leads us to other questions. In order to save the system we had to step in and underwrite some activities by financial institutions in the US and elsewhere that were certainly related to the problem. And these institutions are now happily making loans again, and in many cases, or some cases making an awful lot of money, which is OK, but I don’t think we should have investment banks essentially able to boost leverage while simultaneously being underwritten by taxpayers. And the threat of counterparty runs on investment banks has made that the case in the US. I do not think that the Fed or the Treasury dares withdraw the support that they’re implicitly supplying to former US investment banks that are now bank holding companies by saying, "You know, we’re cutting these guys loose." Which in a perfect world, where we were back in some kind of equilibrium, they would do, because that would be a good way to induce them to cut leverage.

Now if this were a New York audience everyone would be jumping up and down and saying, "Well, you guys are so bearish, how come the stock market’s gone up by 56 percent, and how come commodities are rising blah-blah-blah …" And I think you have to address that question in terms [1:05:00] of understanding the aftermath of the crisis.

I mean the broad lesson is — when you fix a crisis of this magnitude that the financial sector responds a lot more rapidly than the real economy.

And what we’ve had is a strong bounce in the financial sector. In the US we have had I think ultimately a counterproductive cosmetic efforts to bump up the growth rates in the second half of this year — Cash for Clunkers and the subsidies for homeownership can do tremendous things to annualized quarterly numbers.

Now of course Tom pulled that little trick with his house prices. You’ll notice that his house price series was annualized monthly data, which does wonders for the clarity that comes out, but every … and Tom wouldn’t want to mislead you with that, but I can asure you that there are some people on Wall Street who love to use quarterly and monthly annualized data to say, "You know, the recession’s over, we’re all off to the races, I’ve got some stocks and bonds for you to buy, so please step up and buy them."

And the reason that these things have up in value is that, simply, if you’re in the business, people say, "Heh, these things are going up, and don’t be so fussy, go out and buy them." And so it’s a bubble. I mean, how does it develop some momentum of its own? Why do you want to own it? Because everybody else owns it. I share some of the concerns that Nouriel has about what is going to happen going forward.

I think almost by definition we’re … I mean I would say W, because I think in the US anyway we’ll still see a 3 1/2 percent growth number in the 3rd quarter, which will be reported next week,⁵ and maybe a 3 percent number in the 4th quarter …

Alex Pollock: … Also a quarterly number annualized …

John Makin: [laughs] … I should add that these are quarterly numbers annualized, and it’s again … the arithmetic is powerful if you get people to go out and buy cars at a 14 million unit rate in production. But you’ll notice if you watch the US data is the production side numbers tend to be stronger than the demand side numbers, which are all weak.

The problem is there’s a hangover. So in the first half of next year I think we’ll have downside surprises which I would call the W. And maybe at that time, as we’re starting to see audited earnings reports from the 4th quarter, the euphoria in the markets will evaporate.

But I would guess that you could continue to see that upside continue for a while with folks on CNBC waving their arms around, jumping up and down. But I’m guessing that by the end of the year and into next year people may want to be edging toward the exits.

So that’s the last of the last lesson I had is that financial markets can respond far more quickly to rescues than the real economy. And that the underlying probability that the real economy won’t respond implies substantial risk in the financial sector. I’ll stop there.

Alex Pollock: Thank-you, John. … Desmond.

Desmond Lachman: Alex, thank-you very much again for organizing this conference at a 6-monthly interval.

I think one’s got to go through life counting one’s blessings, and one of the blessings that I’ve realized that I’ve got to count on now is that my name isn’t Tom Zimmerman, and that I come at the end of the presentation.

Because much of what is said, I really agree with. So I can walk through a presentation. I’ve entitled it "A False Dawn for the Housing Market?" [slide⁶ 1]

In the interests of being optimistic I’ve put a question mark whereas I really meant putting an exclamation mark. [laughter]

Let me start just with the lessons that one can draw from this crisis, and I think that there are a whole bunch of lessons. We’re going to be writing books about this for many years to come, much like The Great Depression we’ll be looking through this crisis. And I very much agree with what both Nouriel and John have said, that one really needs to be paying attention to bubbles, that we’re just creating another bubble that is going to be bursting. But I think that there are just a whole bunch of other lessons to be learned.

What is really of concern to me is — What are we learning about this as a society? And I’d say that it seems to me that we’re not learning very much. I look at what occurred after The Great Depression. The Great Depression produced fundamental reforms in the financial system, whether it was the Glass-Steagall Act, whether it was the FDIC, whether it was the SEC, [1:10:00] there were really very basic changes.

What I see occurring this time around is we’ve got institutions that are even bigger to fail, we’ve got more moral hazard, we’re not really dealing with the derivative problems, we’re not really dealing with the incentive problems, we’re not dealing with a whole lot of this stuff that really caused the problem in the first place.

I don’t want to dwell on that too much. What I thought instead is, I would just deal with the one lesson that I think by now we should know is that housing and the economy are joined at the hip, [slide 2] and I think that their being joined at the hip leads me to very much agree with Tom that we’re not at the end of this housing bust. I think that we’ve got at least another 10 percent to go. And I think I’m more in the camp that we’re going to get a W. I just don’t see the basis for a V, but I’ll establish that going forward.

Many of the slides you’ve seen before, but just let me start with the idea that housing’s joined at the hip. You know I think that what’s really important is, what happens to house prices in the sense that it basically affects households’ wealth, [slide 3] it affects their access to credit, it increases losses at the central bank … at the banking system, the finacial system. So if we do get another 10 percent drop in house prices that’s not very good news.

Likewise, I don’t see how you can get stabilization in the housing market unless you get some kind of recovery. So I think that the two feed off one another.

Organizing the slides just a little bit differently from Tom is … I put them in terms of the good news [slide 4] where we’ve already seen this slide. [slide 5] Basically prices coming back more to trend levels, more in line with rents, more in line with income. That indicates to you that you’re probably nearing a bottom, that we’re a lot better than we were 6 months ago.

Mortage rates come down [slide 6] so what we’ve got is we’ve got affordability levels, [slide 7] this orange line, it’s scale is inverted. Affordability levels really at very strong levels historically. So all of that is rather supportive to the housing.

And then basically what you’ve just seen is you’ve seen residential investment collapse, [slide 8] so that what we’re doing is we’ve got 500,000 starts on the housing side where demographically there are 1.5 million units being formed, so you’re basically working off the inventory … you’re beginning to work off the inventory gradually.

That was the good news.

The bad news, as far as I see, [slide 9] is that you do have a substantial overhang of stock. You’ve got, like, a million units above the normal level that are vacant. [slide 10] So you’ve got stock overhanging a market. I don’t see how you can really get prices increasing in any meaningful way.

And then what Tom indicated, and I think that this chart [slide 11] really bears it out, is that you’ve got a real foreclosure crisis unwinding. So you’re going to be just having additional supply coming onto a glutted market, that that has to mean that prices reverse the little increases that we’ve seen to date.

This chart [slide 12] coming from the IMF just indicates how many more people are going to be underwater going forward, which just aggravates the foreclosure problem.

Something that Tom mentioned, this slide [slide 13] I thought you might be be interested in, just indicating that first-time homebuyers have really been the ones who’ve been accounting for the increased sales. So we’ve got a problem … if this $8,000 credit gets wound down. Then we’re going to see sales coming off again.

Tom didn’t mention, I don’t think, the problem with option-ARMs, [slide 14] you’ve got like $200 billion of option-ARMs resetting in 2010, which isn’t going to be much fun.

But I think that this is really the chart [slide 15] that bothers me is the state of the labor market. It’s not simply a question that you’ve got unemployment at 9.8 percent, but as Nouriel mentioned, if you include part-time workers, the number goes up to something like 16 3/4 percent, which just means that you’ve got a lot of job insecurity. That’s why you’re not seeing the affordability converting into sales.

And I think that the issue is, "Where do we go forward?"

The last few slides, but before we quite get there I think that this slide [slide 16] is of particular relevance. This comes [1:15:00] from the Atlanta Fed, which shows what is happening to part-time workers who aren’t in full-time employment in this cycle. That’s the dotted line at the top. And if you compare it to the 1981/82 cycle, which was the worst recession before then, you see them as running at something like double the rate  So what I’m suggesting is that the labor market slack this time around is a lot worse that 1981/82, which is very problematical going forward.

The reason I don’t think there can possibly be a V shaped recovery, and why I think that you’re running the risk of a double dip is that you’ve allowed the gaps in the labor market to really reach very high levels. [slide 17] And what that does is it puts real pressure on incomes that I think one’s really got to be worried that in the 2nd quarter of this year, at a time that you were getting tax cuts boosting incomes the only way in which incomes could rise after-tax-incomes was through these tax cuts, yet consumption fell by 1 percent. [slide 18] So what happens when we don’t have that kind of support and when we’ve still got downward pressure on wages through high unemployment levels?

This chart [slide 19] just indicates that you get quite a nice correlation between the gap in the labor market and what happens to the employment cost index. And what it is telling you is that the gap in the labor market is going to widen to something like 4 or 5 percentage points. At least that’s where we are right now. You would expect to see a sharp decceleration in the employment cost index. Where I come out on this is that if you don’t have income growth it’s very difficult to get consumption. And to make matters worse is you’ve got to look at the indebtedness position of the households.

Households today have debt that is something like 135 percent of their incomes. [slide 20] If we look at what happened in 1981/82 it was only 60 percent of the income, so I don’t think it’s unreasonable to suppose that we’re going to see the savings rate gradually move back towards its historic level of around about 8 percent.

If we get any increase in saving, and we don’t get any increase in income or we’ve got a decline in income this means that consumption has to decline. What Nouriel says I totally agree with. If you’ve got excess capacity, that it’s really very high, you’re not going to get investment. So I think that the probability that we get a double dip is pretty relevant …

Another chart [slide 21] just indicates what’s happening with mortgage equity withdrawal. It’s totally collapsed. Consumers are credit-constrained, so we have that problem as well. [slide 22]

The problem that I’m worried about in addition to consumption is that the charts that Alex had put up earlier, [slide 23] what’s going on in the commercial property market, that with Alex mentioning that this is all that the regional banks really do. If $500 billion in loans come due in … commercial property loans come due in 2010, we have a further collapse in commercial property market prices, I don’t see how regional banks can possibly survive. So what we’re going to get is we’re going to get further tightening in credit conditions.

My bottom line, as I say, [slide 24] I think that house prices fall by 10 percent. [slide 25] We have further decline in the economy and I’ve kept this presentation as optimistic as I can [laughter] by not talking about what’s going on in Europe, where I think that the real problems we’re going to see.

We’re first going to see the Baltic countries running into real difficulties that can only be a couple of months away that has an impact on the Swedish banking system. But the serious problem in Europe are Spain, Portugal, Greece, Ireland, you know, the those places. To me, having worked on Argentina for a long time, I think that that is the area to worry about.

So I’m not particularly worried about the United States, I’m worried about Europe.

Alex Pollock: Desmond, you did that so efficiently you have some time. Would you go back to your lessons slide and do some of the other lessons you had an interest in? Can you make it go backwards? … Give us a quick review here.

Desmond Lachman: [slide 2] One of the lessons that I would suggest that hasn’t been learned is that people haven’t really read Kindleberger’s "Manias, Panics and Crashes." That had they read that they would see that [1:20:00] this is really a repeating kind of cycle which Rogoff and Reinhart have brought out. That basically I think that the Fed hasn’t paid attention to asset price inflation in the past, that it’s really problematic. I don’t know how you can be dealing with it right now.

The other thing that I thought that we really should have learned from this cycle is that GSEs are not a very good idea. So to have the government running these banks, I think that that is rather problematical.

The house lending[ph] needing regulation, that that seems to me fairly obvious, but it’s something that I haven’t put up here is … The way I think of it is a lot of the problems are that you’ve got incentives that aren’t really … not in line with the public interest. So what I’m thinking is stuff like the rating agencies, stuff like the compensation practices from Wall Steet. All of that really needs a radical overhaul.

And what I’m seeing, what Treasury’s proposing and what is actually being passed to date really seems to be skirting at the edges, it doesn’t really seem to be changing the system in the way that I’d like to see.

I would just say that I very much agree with the speech [PDF] that Mervyn King made yesterday that basically, in effect, I think that bringing back Glass-Steagall would be a good idea. But unfortunately I think that the moment to have done that has passed. It would have been at the time when the banks were really in a rather weak position. That the fact that you didn’t do it in March of 2009, I’m not holding my breath for that to occur.

Alex Pollock: Thank-you, Desmond.  Having heard five really interesting presentations, let me give the panelists, if they want, a chance to add something, or react to the others.  Nouriel?

Nouriel Roubini: Just a comment on the last point that Desmond made. In this crisis, regulated banks got in trouble, but also a lot of non-regulated financial institutions — were broker/dealers like Bear and when bust. And so in some sense, suppose we go back to Glass-Steagall and not against it? What does it rule out? And then you’re going to have a bunch of broker/dealers or non-bank Shadow Banks that are going to become too big to fail. They’re going to do crazy things and eventually we’ll have to bail them out.

So do we need to really go back to Glass-Steagall? Or we need to break up every financial institution and make it so small that it can fail and who cares? And we don’t have to bail them out. What’s the appropriate policy choice on that? And I think that’s an open question for everybody else on the panel.

Alex Pollock: Other comments? Chris? … and then I’ll come to Desmond.

Chris Whalen: The most striking thing I heard from the other presentations was that chart of existing homes. [slide⁶ 13] We still have a third of the purchasers in the investor category. In ‘05/’06/’07 we had 40 percent of all home purchases in the US by investors. So that shouldn’t make you feel good.

I mean, homeownership used to be a form of forced savings, as Alex and I have discussed many times. And it’s still a speculative vehicle. So if you go back to the banks and look at the forebearance that’s currently keeping those loss numbers down, and you look at the emergence of yet a new acronym, TDRs, Troubled Debt Restructurings, which is essentially the banks’ way of saying, "Well, we won’t push you into foreclosure, we’ll live with you."

That, to me, is scary. Because if you don’t have a vigorous recovery next year, then transactions like Wells / Wachovia don’t work. They’re all premised on a bounce.

Alex Pollock: Desmond?

Desmond Lachman: My view is that I don’t think that there is a silver bullet on financial reform; that I think that Glass-Steagall by itself, you know, I don’t think really it solves the problem. That I think it helps, but I think that you’ve really got to do a lot more in terms of creating the right kind of incentives; changing the whole compensation scructure on Wall Street would be one way of doing it. Getting the rating agencies not to be paid by the issuers would be another thing; that you can just think of a whole multitude of real reforms that you need.

I think what bothers me now is you’ve just got far too many of the financial institutions have got the whole of the financial … firstly you’ve got far more concentration than we had before. The 10 top banks now are controlling more of the markets, we’ve got a lot less competition. So that breaking these banks up into smaller units, having some kind of competition, I think that that would really be [1:25:00] something that one wanted to go.

I’m also concerned that you’ve just got a huge moral hazard now, that all of these banks have got access to the Fed window, which they didn’t have before. So you really just, I think, encouraging moral hazard on a great scale.

You really need a total overhaul of the system. Otherwise I think all we’re going to do is we’re going to just repeat the boom / bust kind of cycle that we’ve lived through the last few years.

Alex Pollock: John …

John Makin: I think the comments that I’ve heard everyone make suggests to me a kind of framework that I’m imagining some thoughtful policymakers are contemplating. And that is: We look at the post-bubble situation and we look at the policy response, and they sort of … we had to save the too-big-to-fail institutions.

I think that leaves central banks especially with a very difficult choice. That is, either they reinflate the bubble, and Nouriel suggesting that we’re on the way to doing that, and I think there’s a good case to be made that that’s probably going on. Or they say, "All right, we’re going to get tough and we’re going to consign ourselves to a kind of global lost decade à la Japan where we’re going to do the right thing, we’re going to step up, we’re not … we’re going to kind of create a different attitude toward risk-taking." The problem with that is that it’s very difficult to implement, maybe politically imposible, and very risky.

So I think as … So what’s the outcome? Well, it’s sort of like — damned if you do, damned if you don’t — as Nouriel’s suggesting.

And so it may lead to hesitation — although one reminder: We have had two major burst bubbles in the past 80 years, and in both cases, in the case of the Fed in 1936/37, when we raised tripled reserve requirements, raised reserve requirements 3 times, and tightened fiscally; and then in Japan in August of 2000 when they abandonded the zero interest rate [ZIRP] policy … In both cases the central bank made a feint — that’s f-e-i-n-t — toward the sort of tough medicine and created such a crisis that they had to back off.

So I think that’s something I’m watching as I follow the discussions among central bankers, is that the risk of trying to exit this too aggressively while worrying about the need to not create another bubble. That’s a huge dilemma.

Alex Pollock: Tom? (let me just see) … Tom, anything? … Chris?

Chris Whalen: I want to ask John a question. In the past, reflation has lifted all boats. But the concern that I have and what I want to ask you, because you have studied this for a long time, is: What happens if the reflation doesn’t help the real economy? What happens if it’s only effective on those who have direct access to the monetary authorities?

John Makin: Well, I think that your … it’s a fair description of what’s happening now. The monetary base has been boosted tremendously by the Fed’s activities. The Feds have said, "OK, here’s a lot of cash" to the banks.

The money multiplier has collapsed, so that M2 aggregates, or most credit aggregates, are flat to falling. So in a way, the effort to stimulate the economy went through the usual channel at a … When you’re at zero interest rates you try to do quantitative easing if … and the Fed doesn’t like to call it that …

But so far those efforts have been a total failure. And not only that, but if you look at the behavior of money relative to nominal GDP, velocity has actually collapsed.

So we’ve already failed to affect quantitative easing and interest rates are at zero.

Alex Pollock: A case you might think of there, Chris, would be the reflation and runaway inflation of the late 1970s. We remember the history that it had an inflationary runaway in the early ’70s, a commodity / oil price boom. Interest rates to then unheard-of levels in the US, then a big recession and a big bust — ‘75/’76. And then the inflation, which created inflation, but also created stag-flation and ultimately the bust of the 1980s.

One other point I’d like to make on the question of Glass-Steagall, or of banks that are too big. [1:30:00] Here’s a counter-example.

Canada is now held up as an example of a financial system which has weathered the current bust quite well. And actually, the Canadian banks also weathered the 1930s much better than the Americans did.

Well what’s the structure of the Canadian financial system? It’s 5 big financial companies, big banks, who control the whole system.

So, you know, there’s nothing for safety and soundness like a comfortable oligopoly. We might think about that and … we’re planning, for those of you who are interested, a conference, coming up in a few months, contrasting the Canadian house finance and financial system with the American system. So there’s a little advert — little preview.

Let me come now to your questions …

Nouriel Roubini: Quick question …

Alex Pollock: Yeah, go ahead.

Nouriel Roubini: You know, they are oligopoly, but aren’t they highly regulated? Much more than our financial institutions, so …

Alex Pollock: They’re highly regulated and the oligopoly is more than the banks, it’s the club of the regulators, the central bank, the government and the banks. You know, the traditional in-group system, as I interpret it.

That gets you safety and soundness, but it may not get you a lot of vibrant innovation.

Let me come to our questions. We’re going to, we have microphones, a microphone in the back. Please remember how this works. Wait for the microphone, please tell us your name and your affiliation, and then ask your question. For those of you who may feel the urge to make an assertion in addition to your question, may I ask you to keep your assertion short and to the point, otherwise I’ll feel compelled to ask you to come to your question. … I have a hand way in the back, here. … Oh, it’s Bert [laughs] …

Bert Ely: I was hiding on you, Alex. Bert Ely, banking consultant. A suggestion and a question. In terms of describing the kind of recovery you have, let me offer another suggestion to you that I’ve been using. I call it a washboard recovery. Slow and very bumpy over the next few years.

My question relates to something that some of you have alluded to, Desmond particularly, but I think needs a little bit more attention. And that is as we look at the economy coming out of this recovery, to what extent can Congress help or hurt the recovery through its various regulatory reform activities. We have a lot of that percolating along right now — executive pay limits, the CFPA and who knows what else?

So I’d be interested in what the panel’s thoughts are as to the dangers, if you will, to the recovery from Congress’ initiatives and the Administration’s initiatives to try and prevent a repeat of this crisis.

Alex Pollock: [undecipherable] … would you take this?[ph] Well, you have the pendulum point, Tom, …

Tom Zimmerman: Yeah, I mean I think those are probably minor things. It’s not good, it’s certainly not going to help, but I don’t think that’s the, you know … Yeah, you shouldn’t be doing that right now, but I think those are probably minor things compared to some of the broader pictures, broader comments[ph] and issues we’re dealing with here.

I don’t think that will, in itself, stifle the … It’ll cost more for the average consumer for his credit card loan, for his credit card debt, for his car loans. And a sustantial number of Americans won’t be able to get a loan, that’s what will happen, because you will price people out of the market.

But yes, you will have a safer and sounder system to some extent, but you will pay for it.

Nouriel Roubini: Anything wrong with having lots of people not being able to borrow, since this is a crisis of overborrowing?

[laughter]

Tom Zimmerman: No … I don’t know … if you …

Nouriel Roubini: No. Seriously.

Tom Zimmerman: No, but if you … One of the reasons we have payday lending is because banks don’t lend to a lot of people now. I suppose payday lenders will get an exemption, just like we have a lot of exemptions out of the new Consumer Finance Act, we’ve got all sorts of [undecipherable] exemptions because Congressman [tape skip] wants it that way. But I don’t know where it ends, but … Yeah, you know even the Mafia lends money too. You know, we … Yeah, for a rate, right.

So, you know, if you restrict the functioning system, in a way there will be lending, it will take place, it’s just whether it takes place through the back door, or through the front door.

Alex Pollock: Just a quick comment then, and we’ll go onto another question.

Chris Whalen: You know, the "legislative reforms" quote-unquote on the Hill are not about helping anyone. They’re about building monuments. Both Shelby and Dodd want to build a monument to consumer protection. Meanwhile, we will not have meaningful reform in the one area that is crucial, which is Over the Counter [OTC] Derivatives. If you look at the latest turn of the legislation on the House side, it pretty much leaves the dealers alone. They might as well not even pass it, there will be no change.

Alex Pollock: I have a question back here …

Brian Gardener Brian Gardner with [1:35:00] Keefe, Bruyette & Woods. Kind of staying on the theme of legislation that’s up on the Hill. It’s interesting to … after every member of the Committee has been recognized over the last couple of days, after they say think-you Mr. Chairman, the next statement is, "We can never let this happen again." In 1913, you know, and it was "We can never let this happen again." When we set up the banking and regulatory system in the ’30s, "We can never let this happen again." When we did FedICIA and FIRREA, "we can never let this happen again."

And this seems to be playing out.

One thing that has not been touched on today, and I’d like your collective opinions on this, is, "Where should we be going on … more on the regulatory side, with bank capital standards?"

Alex Pollock: Somebody want to take up bank capital? John?

John Makin Well the answer to the comment is, "We can, and we will." [laughs] I think the lesson of all these iterations is that there’s no magic regulatory bullet. And the notion that somehow there is, is probably what fosters the problem. And again the Congress is not very good at designing legislation that fosters better performance in the financial system, and there’s no reason why you would expect them to be. They’re ignorant of what goes on in the financial markets and, let’s face it, they’re driven by (*gasp*) political motives.

Why else would you — again, to go back to a comment that Nouriel said … This crisis was caused by massive government subsidies to purchase homes by people who couldn’t really afford them. So what does Congress do? They pass an $8,000 tax credit for people who can’t really afford to buy a home to buy one. I mean, how stupid can you get?

So we can’t let this happen and we won’t? Nonsense: we can and we will.

Alex Pollock: Chris …

Chris Whalen: To pick up on John’s comment, the Congress doesn’t have a problem at the moment. They don’t see a crisis, because as long as the Treasury can borrow and fund their activities without their having to go back to the electorate and raise taxes they have no problem. The only time the Congress in the United States will have a problem is if the Treasury market has a failed auction. That’s when they start to have a real political problem, but at the moment, they have no problems.

And that’s why we see this ridiculous Kabuki on Capitol Hill. It has nothing to do with the actual problems of the country, it has to do with those members of the political class remaining entrenched. And as long as they can sell bonds, they’re going to stay right where they are.

So the policy moves that they take really have nothing to do with our collective wants and needs, really. I don’t think the Congress is at all representative anymore, even though John’s characterization is completely right.

You know, it took 30 years for the Congress to study market structure problems between the 1880s and the beginning of the Roaring ’20s. That’s how many crises we had to go through before we finally got Glass-Steagall; people forget that.

Alex Pollock: I have a question right here when … well OK, we’re going to move forward, to the right-hand side here.

Steve Votaw:OK [undecipherable] was my microphone. Steven Votaw with Deloitte consulting. I have actually two questions, and I think in light of what we’ve all talked about in terms of this bubble, like the housing bubble and the concentration of all banks in housing, I’m not convinced that the too-big-to-fail would really work. I mean wouldn’t … if we had a lot of smaller banks, wouldn’t they all just fail at the same time?

And then the second part of the question is — Desmond, you have only 10 percent down on home prices? But it seems like that backlog of foreclosures is pretty huge. Why only 10 percent down?

Alex Pollock: Both those questions are for you, Desmond.

Desmond Lachman: Just remind me of the first one …

Alex Pollock: If you had a whole lot of small banks, instead of a few big ones, wouldn’t they all just fail.

Desmond Lachman: … Do you know, if you had a lot of small banks, all doing exactly the same kind of thing, all being being subjected to exactly the same kind of shock, I would agree with you. But that’s hopefully not what you’re going to get in a very competitive system where you’ve got a lot of small banks doing different things.

So you could allow banks to fail, and that that would send very good signals. You know, you would get rid of moral hazard; you wouldn’t just have these banks able to borrow indefinitely knowing that the borrowers are going to be bailed out.

10 percent … I certainly think that prices could overshoot and I’d want to see what happens. If what I’m thinking is going to occur, we do get a double dip. Then I think you certainly could go way below.

I think that’s a point that Marty Feldstein [1:40:00] keeps making is that in the same way as you overshot equilibrium you can undershoot on the way down. There’s nothing magic about it. I think that there’s a dynamic process.

What would concern me is if you get yourself into a loop with lower prices causing more people to be underwater, creating greater incentives for people not to want to pay their mortgages you know we’ve really got a problem.

Alex Pollock: Nouriel?

:Nouriel Roubini Yeah, but in …

Alex Pollock: We’ll get Nouriel quickly and Tom, and then we’ll come to the next question.

:Nouriel Roubini Yeah, on the issue of many smaller banks I actually agree with the view that you can have systemic risk even if you have thousands of smaller banks. I mean one example was, you know, the S&L crisis — 1,400 of them went bust, none of them was a Lehman or a Bear (systemically important), meaning if there are conditions that create a bubble, whether it’s easy money, poor regulation / supervision, subsidization by the government of housing or whatever, you’re going to create a bubble, and then everybody’s going to behave the same way, it’s going to go bust, and then you have a systemic banking crisis.

So certainly too-big-to-fail is a problem, but unless we go to the core of the reasons why everything [undecipherable] bubble in the United States that goes bust, and then we have a severe economic / financial crisis is going to happen over again if we had lots of small banks.

Alex Pollock: Tom …

Tom Zimmerman: Yeah, I was going to say pretty much the same thing only from subprime perspective. We had a bunch of small subprime lenders and they were all doing the same thing. And because the regulators didn’t come down and say, "You can’t make these kind of really idiot loans." If you were in subprime lending and you didn’t do it, you were out of business.

So it’s the old, "You have to …", the bad loan drives the good loans out, clearly. And if you’re a … if you get by of those bad loans, people love it and they’ll go for it, and that’s why you need regulation.

Alex Pollock: There’s a famous saying of John Maynard Keynes that the market can stay irrational longer than you can stay solvent. That’s on the downside. On the upside, which is what Tom just described, there’s a parallel saying, "The market can stay irrational longer than you can stay employed." And therefore, you participate. I have a question right here. Go ahead.

Jack Phelps[ph]: Yes, Jack Phelps[ph], FHFA. I think along the lines of dealing with systemic risk, TBTF, I think Chris touched on, one of the necessary reforms is moving OTC derivatives to a clearing house. I think that’s a necessity. I think the other part that we hear zero discussion of … I think Alex maybe had a thoughtful piece⁷ in the American Banker a week or two [ago] on this, is perhaps separating payments from commercial / merchant investment banking, and let’s treat the payments system as a utility, let’s protect it, not let it be affiliated in that kind of structure.

And if me move to that, then we can have these large firms fail, we can protect that. So I think that’s a necessary reform. Perhaps somebody can comment on that.

John Makin: Yeah, I would just say that I agree with the need to have banks that are focused on transaction services. But investment banks remember, that are large and subject to counterparty runs like we saw last September, can bring the system down. So there is a size issue there.

And so I think we have to be aware of that as well.

[crosstalk]

Alex Pollock: … OK Chris …

Chris Whalen: Remember Bear and Lehman were clients of banks, as John was saying. So having them not directly plugged into the clearing systems doesn’t help you. But what I do think we have to move towards, and you’ve heard it kind of discussed in the regulatory community, is — make debt of these holding companies convertable. And I mean all of it. You could do it in 10 percent increments.

Because then, you’ve got the resolution baked in, and we can stop talking about winding down these large institutions. That’s not what we need. We need to fund them, and [tape-skip] do stupid things, the bondholders have to know that they’re going to convert.

Alex Pollock: … just say what that means — what do you mean, "convert"?

Chris Whalen: Well now, [undecipherable] if you had Citi last year. Before the government put equity in, instead the bondholders would have been told, à la GM, "you’re converting into equity." You drop the interest expense of the entity immediately, and the next day you charge off … You know, Citi holdings, to give you an example, has about $300 billion in assets, half of which are covered by loss sharing agreements. If instead we had charged that off and used the new funds from the bondholders to recapitalize the entity, we’d be done. You’d never have to write a check again, if you’re the public perspective.

Alex Pollock: You’ve been waiting here up in the front … Then I’m going to come to the back here next.

John Serrapere Yeah, it’s John Serrapere from Arrow Insights and from Pittsburgh. One of the things I wanted to comment about is I want to thank you for putting on these presentations. I’ve made 5 of 6. It feels like I’ve made 12 of 9. [laughter] But it’s been a most rewarding in terms of my research. I just want to thank everybody.

But the question I had is — When the G20 was going on in Pittsburgh [1:45:00] I was able to get in some private forums (pre- the G20, of course) and one of the things I’ve learned that I didn’t know is that, one, it’s the G23, and another one is that … because there’s three members that really are always there.

But I learned that there’s a piece in NAFTA in 1999, drafted by Geithner, that actually prevents financial regulation for global financial intermediaries. So if we passed a law here and the banks are involved in other countries, it can’t be enforced in terms of the free trade. And Geithner actually drafted this when he worked for the Administration.

Now it’s a clause that’s reviewed, and it’s apparently being reviewed and it’s going to be added to the new Doha round? And it would revert, make impossible for you to reverse anything that was drafted after 1999 on a global basis. And I was unaware of this, but I was wondering if anyone in the room understands its impact on financial regulation.

Alex Pollock: Any comments?

Nouriel Roubini: I mean, the only point that I’d make is that whatever you have to do, you have to do at the global level, otherwise there would be jurisdictional arbitrage. And so whatever agreements are made about reforming the system of financial[ph] regulation, we cannot do more than others or vice versa … otherwise it would be a game of jurisdictional arbitrage.

Alex Pollock: Thank-you. Can I have a question way in the back here?

anonymous questioner: Why should we, and pardon me, maybe this is naive, but speaking to the international matter here, because I think we’re looking at a macro solution, but …

First, why should we be worried about jurisdictional arbitrage if we decide that our macro solution would be, first, keeping our Constitution? So Article 1, Section 8 compliant trade would be demurring on keeping G20 agreements. So what do you say to us where we decide that, you know, we’ve got to clean up our house here?

Because we’re not going to have enough people who can pay their mortgages and buy cars and things like that, you know, once you’ve offshored their production into one of the former colonies of our allies, which is in effect complying with … US’ compliance with the G20 agreements is collapsing our economy and offshoring our productions.

So Free Trade’s been [crosstalk] … but that’s my question, you know. I mean. what are you say that [crosstalk] where our macro solution’s are something we need to do?

Alex Pollock: … What are we … how are we to answer this naive question? Why do … as you said, why do we care about this international jurisdictional issue?

Chris Whalen: Well I think at some point we’re going to have a government in power that’s going to make a choice between the American people and our creditors, who are predominantly foreign. And I think that choice will involve letting the dollar depreciate. I don’t think we’ll ever actually repudiate our debts, as long as we can print more dollars. But I think that’s the fundamental political issue that faces our entire society …

To what extent are we going to go along with this wishful thinking about a global economy when we still have entities that are national?

And look at banking. Look at Basel II. There is no global framework here. There is no global accounting system. There is not even a global definition of default, for chrissake. So how can we pretend that this is a global regime for capital adequacy?

Alex Pollock: One minute in the penalty box for the profanity, but just do you …

Chris Whalen: … my name is Chris …

[laughter]

Alex Pollock: … do you favor a global accounting system, Chris?

Chris Whalen: It’s not possible.

Alex Pollock: Nouriel …

Nouriel Roubini: I mean, if what we’re going to do is to essentially devalue the real value of our public debt and avoid debt deflation through inflation and debasing our currency (it’s an option), at that point, I think that the creditors of the United States are going to pull the plug.

Because if we’re going to the route of high inflation then China, the Gulf States, Brazil, Mexico, Russia, Japan, you name it, they’re not going to go and sit back and take the capital levy of hundreds of billions of dollars on their own dollar assets. And they’re going to run away.

Last time around we did it in the ’70s we were a net creditor country and a net lender. We were running current account surpluses. This time around we are the biggest net debtor in the world, to the tune of $3.5 trillion and we’re still borrowing on net half a trillion a year because we have a large current account deficit.

So you can try and impose that capital levy, then you have a sudden stop of capital and the dollar collapses, and then you have a spike in interest rates and you have disorderly stagflation again.

So it’s too easy to say we’re going to screw our creditors, because those creditors are not going to bend over and say, "I’ll take it." They’re going to run away, and it’s going to be nasty at that point.

[laughter]

Alex Pollock: John …

John Makin: Well I want to add, we’re all kind of in this … in the same dilemma.

Comment: that is … [1:50:00]

The maturity of US Federal Debt is very short, something on the order of 2 years, so the option of … It’s really not going to work very well if we try to zap our creditors.

And secondly, I don’t think that the Fed is in a mood to do this. I know everybody’s very sceptical, but I don’t think the Fed will play along. And that will cause some difficulties with the Fed’s independence, but this Fed will go down fighting to avoid the sort of simple-minded "inflate our way out of this" story.

Alex Pollock: Question right here please.

Barry Wood: Barry Wood, free-lance economics correspondent.

In terms of what Nouriel was saying about the dollar carry trade, what’s the solution to this. Can market deal with it?

There’s resistance in Brazil, that tax you mentioned. There’s resistance in Europe to seeing the dollar more than to $1.50 [== 1 euro]. What can be done as a corollary to force the renminbi in China to come up and not go down with the dollar?

Nouriel Roubini: Well I think that, you know, the trouble is that the Fed keeps on having zero rates and expects to keep them at zero. And the Fed reduces volatility by buying long rates, then the game everybody’s going to play is a carry trade. And that’s what’s happening right now and other countries are in trouble because either they intervene, like the Asians are doing, because their currencies are appreciating too fast. And if you intervene is unstabilizing intervention and therefore you increase your base money and credit growth becomes worse. Or you decide to cut interest rates, and that’s the same thing, because you try to avoid your currency from appreciating by following the US monetary policy. Or you try to do what Brazil does.

But they are all variants of the same, that imply that everybody around the world has to import our monetary policy, and therefore our easy money becomes a global easy money, and that particular bubble continues. And that’s the scary part of it. It’s really the scariest thing that’s happening right now.

People say the economy’s recovering, these asset prices are going up because of that. The reality is that money not only is free, but if you borrow in the US is a negative interest rate. And everybody’s playing exactly the same game. And people are not realizing that it’s the most dangerous game we’re playing right now.

Of course the trouble the Fed is facing is that it has two objectives. One is to stabilize growth and avoid deflation, and the other one to avoid financial instability.

But they’re using one instrument, the Fed Funds Rate, to achieve stability of growth and avoid deflation. But they’re creating exactly like 2003-2006, financial instability. Because at that time we kept the Fed Funds Rate too low for too long, and you normalize it too slow, too little. And we created the asset bubble, the mortgage bubble, the housing bubble.

This time around, is occurring on a global scale. It’s not just the US. What’s happening right now with this carry trade, is creating a global asset bubble that we haven’t seen in decades. And is going to go bust.

Alex Pollock: Nouriel, given all that, what’s your forecast for the price of gold?

Nouriel Roubini: Actually, you know, on gold, in my view, gold goes very high under two scenarios. One in which you have inflation, and the other one in which you have again, Armageddon, in which you cannot even backstop the financial system.

For the time being I see a glut of capacity globally, demand weak, weak recovery, and there’s deflation and firms cannot sell their goods and they’re slashing prices.

And on the labor side, slack in labor market — unemployment at 10 percent. So for the time being, I see just deflation around the world, and that cannot be good for gold.

Too, gold could sharply spike if we’re going to go back into, again, another double-dip in which we cannot anymore backstop the financial system. Because you’ve got governments that are going to be essentially having banks too-big-to-fail and too-big-too-be-saved. If you get into that world in which really we cannot backstop the financial system because they government is insolvent, that’s the time to buy guns, ammunition, canned food, [laughter] gold bars and run to your log cabin in the mountain.

That was the world after Lehman, and that was the world of February / March. That’s when gold went above $1,000 again, right?

So gold usually goes up when you have inflation, expectation like the first half of last year, or when we have catastrophe and Armaggedon. Those two theories, for now, have been reduced. The one of the inflation because you have this slack in goods and labor market, and the other one because we’ve decided to backstop the financial system.

If we have a double dip, that’s a different story. But in that case, before we get inflation then we get a near-Depression and stagnation.

Alex Pollock: Chris, quick comment and then a question coming here.

Chris Whalen Well you know it’s interesting, if you look at the UK real estate market right now, it’s going up, even though the economy there is flat. And I think what you’re seeing, to John’s earlier points, is that holders of paper money are starting to look for solid assets to buy.

So I think even in this country you’re going to see selective spikes upward in prices for really prime real estate, but only when it’s been marked down. [1:55:00]

Christine Eisner[ph]: Christine Eisner[ph] with KW Commercial. My question is regarding the re-evaluation of real estate mortgage investment conduits, or Re-remics.

How effective or ineffective do you think this this tool is in relation to the banks’ reserve requirements, and possibly the real estate industry.

Alex Pollock: Tom, you maybe want to take that one?

Tom Zimmerman: Would you say that again?

Christine Eisner[ph]: It’s the Re-remics. Re-evaluation of real estate mortgage investment conduits, regarding a bank’s reserve requirements? In other words, …

Tom Zimmerman: Is this the changed rule about the tax code you’re referring to? About the fact that for some commercial real estate CMBS you …

Christine Eisner[ph]: They’re re-evaluating the package of investment portfolio loans and they’re taking the good loans and they’re re-evaluating them upwards and taking the bad ones and …

Tom Zimmerman: Oh! Oh that. Oh, no. That’s not going to be a big problem. That’s … That’s just a matter of re-securitization. They’re taking a pool of securities — several pools of securities. Taking some of the … taking those loans and repackaging them and now selling off part of that as a triple-A again.

So it’s a little bit like they did before, only this time the rating agencies and the criteria for these Re-remics are so much stricter that investors will buy those triple-As without much concern.

Now we can say when they did that 4 years ago and got screwed, but under this current regime of the rating agencies, what they require for those Re-remics and the kind of collateral going into them, anyone that’s frugal is going to want to buy that stuff, because it’s just rock solid.

That’s a little bit like, if you can buy a mortgage loan created today, it would be great, because, you know, you’ve got 20 percent down and high LTVs and all that. So if you have the wherewithal to buy certain assets right now, even beyond this thing we’ve been talking about here, …

What happens, when banks go through a crisis like they did in 1990/’91 or like we’re just going through now, lending criteria, what few loans they make, are rock solid. So it’s a little bit like when they re-securitize these mortgage loans right now, this is the best of the best. So I don’t view this as a problem.

Alex Pollock: Alright, time for one more question. We’ll come to the back here.

Dale Kinsella[ph] Hi. Dale Kinsella[ph] with SSA. I was wondering if you guys could comment on there being a correlation between the economic downturn and the high unemployment and stagnant and falling wages. Is this … is there really not a big correlation, and this is more due to competition than labor markets from like China, for instance. And there being a lot more competition in the labor market in the United States.

Alex Pollock: … John? …

Dale Kinsella[ph] … 20 years ago an Ivy League law degree meant a lot more than it does today, for instance.

Alex Pollock: John?

John Makin: You know, look. I think when the economy … The primary pressure on employment is simply that there’s massive excess capacity and for most businesses labor is 70 percent of their cost base, so, you know, what we’ve seen … certainly over the past 6 months is, anybody who’s reporting better earnings is saying, "Well, we contained a lot of … cut a lot of costs." And the way to cut costs is to lay people off, and so that’s what we’re seeing.

The … So that scale effect is far more dominant than the substitution effect, which would be the operation of alternate production facilities abroad. It has some effect, but it’s being overwhelmed by a simple surge in excess capacity that forces people to cut a lot of costs as rapidly as they can.

Alex Pollock: With that, we’ve come to the end of our conference. We thank you all for being here. We look forward to seeing you all for Deflating Bubble Roman Numeral VII in March 2010, and let’s thank our panel for great presentations. [applause] … [1:59:06]

Notes and References

[1]: "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis", AEI event homepage, October 22, 2009.

[2]: "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis" (PDF slide deck), by Alex Pollock, AEI, October 22, 2009.

1. Title
2. The Housing Buuble: Case-Shiller National Home Price Index Values — 1987-2009
3. The Real Estate Double Bubble: Commercial and Residential Property Price Indices
4. Real Estate Loans as a % of Total Loans — All Commercial Banks
5. Real Estate Loans as a % of Total Loans — Commercial Banks with Assets Less Than $1 Billion
6. Mortgage-Backed Securities Holdings Index — All Commercial Banks
7. Bank Credit and the Double Bubble
8. Title (end)

[3]: "The Deflating Bubble, Part VI: The Lessons of The Bubble and Crisis" (PDF slide deck), by Thomas Zimmerman, UBS, October 22, 2009.

0. Title
1. Existing and New Home Sales Appear to Have Bottomed
2. But Sales in the West Raise a Question
3. Inventory of Existing and New Homes Has Dropped
4. Home Price Indices Have Turned Positive
5. Case Shiller 20 MSA Indices Gained 1.6% MoM in July
6. Affordability Has Reached an Historic High
7. But Non-agency MBS Market is Almost Non-existent
8. Foreclosures at Record Level
9. Monthly 90-day to Foreclosure Roll Rate Still Falling
10. Delinquency Buckets By Subprime Servicers
11. Loans in Delinquency Buckets by Product Types – Total Non-agency
12. Expect 5 MM Defaults In 4 Years Plus 2 MM in Delinquency
13. Distribution of Homeowner Equity
14. Government Programs Have Had Little Impact So Far
15. Debt Burden Still Elevated
16. In Spite of Fundamentals, Toxic Assets Have Rallied
17. 1-4 Family Mortgages Outstanding
18. Lessons of the Bubble and Crisis
19. Lessons of the Bubble and Crisis – (cont’d)

[4]: "The Bear Stearns Bull: With the collapse of the country’s fifth-largest bank, the market hit bottom. The bear (small b) has finally been tamed.", by James J. Cramer, New York Magazine, March 21, 2008.

[5]: "U.S. GDP rises 3.5% as stimulus kicks in: Gains in consumer spending, inventories, housing drive growth", by Rex Nutting, MarketWatch, October 29, 2009.

WASHINGTON (MarketWatch) - The U.S. economy expanded at a 3.5% annual pace in the third quarter, as massive government stimulus helped drag the economy out of the longest and deepest recession since the 1930s, the Commerce Department estimated Thursday.

[6]: "A False Dawn for the US Housing Market?" (PDF slide deck), by Desmond Lachman, AEI, October 22, 2009.

1. Title
2. Lessons from the Housing Bust
3. Housing and the economy are joined at the hip
4. The Good News
5. S&P/Case-Shiller Home Price Indices
6. Mortgage Rates to Remain Focus of FOMC
7. Affordability at Recent Highs
8. U.S. Residential Investment
9. The Bad News
10. Housing Vacancies
11. Foreclosure crisis looms over U.S. recovery
12. Homeowners with negative equity (millions)
13. Home Purchase Market by Homebuyer Type
14. Monthly Mortgage Rate Resets
15. Unemployment and Under-employment as per cent
16. Part-Time for Economic Reasons
17. A fragile economic recovery
18. Personal income, % change, month ago
19. Change in growth rate, in percentage points
20. Household Debt to Personal Income Ratio US (Quarterly) as of March 20009
21. Mortgage Equity Extraction (Net Mortgage Equity Withdrawal, Trailing 12 Months) as of December 31, 2008
22. Bank Loans Fall Further: Bank loans and leases, over 13 weeks, $ chg, SAAR [seasonally adjusted annual rate]
23. The Real Estate Double Bubble: Commercial and Residential Property Price Indices
24. The Bottom line
25. HPD [house price depreciation] forecasts have clustered

[7]: "Deposit Insurance a Persistent Problem", by Alex J. Pollock, American Banker / AEI, October 7, 2009.

On one hand, there is the fervent political desire to make deposits riskless for the public, so that depositors do not need to know anything about or care about the soundness of their bank. But their deposits fund businesses that are inherently very risky, highly leveraged and cyclically subject to much greater losses than anyone imagined possible.

1:27:42 No, might go wrong. - Allan Meltzer

Doom Transcripts: Index & Guide

Almost 19 months later, Doomers may enjoy putting some of these opinions up against what actually took place.

Housing Doom is pleased to present a complete unauthorized annotated transcript for the American Enterprise Institute’s April 28, 2008 event "What Lies Beyond the Credit Crunch? Part II".¹ The event site has a variety of resources including a summary and both an audio and a video of the proceedings. There is an official transcript, but the link to it does not seem to be currently working.

Table of Contents

[link navigation works best when full article displayed]

1. 0:00:00 - Peter Wallison Intro
2. 0:07:43 - Charles Calomiris presentation
3. 0:24:33 - Kevin Hassett presentation
4. 0:36:53 - (interruption for computer problems)
5. 0:39:20 - Desmond Lachman presentation
6. 0:55:22 - John Makin presentation
7. 1:15:02 - Allan Metzer presentation
8. 1:36:04 - Vincent Reinhart presentation
9. 1:55:20 - Panel discussion
   1. 1:55:36 - Calomiris discussion
   2. 2:00:18 - Hassett discussion
   3. 2:01:55 - Lachman discussion
   4. 2:03:41 - Makin discussion
   5. 2:06:49 - Meltzer discussion
   6. 2:10:30 - Reinhart discussion
10. 2:12:34 - Q&A
    1. 2:12:59 - Jeff Wrase question
       1. 2:13:28 - Makin response
       2. 2:13:39 - Wallison digression
          • 2:14:33 - Calomiris response
          • 2:15:47 - Lachman response
       3. 2:16:26 - Lachman response
       4. 2:17:06 - Makin (with Wallison) response
    2. 2:18:34 - Bert Ely question
       1. 2:19:21 - Calomiris response
    3. 2:20:38 - Pieter Bottelier question
       1. 2:21:11 - Meltzer response
       2. 2:23:52 - Makin response
    4. 2:25:00 - Steve Entin question
       1. 2:26:05 - Meltzer reply
       2. 2:27:39 - Lachman reply
    5. 2:28:18 Wallison brief wrap-up
11. 2:28:54 (end)
    • Notes and References

Peter Wallison: [0:00:00] OK, I think we’ll get started. Everyone take his or her seat. I want to welcome you all on a pretty raining and nasty day. I’m delighted that all of you came out. This should be one of the more interesting conferences of the year, and I can understand why you’re all here.

This is the 2nd conference on exactly the same subject. The last time these esteemed AEI economists got together to discuss the future of the credit crunch and the US economy was in December of 2007. At that conference there was sharp disagreement at to whether the US, as a result of that housing meltdown, the credit crunch and other factors was headed for a deep recession, a shallow recession, or merely a slowdown for a quarter or two.

The data presented at that conference showed a serious breakdown in trading in the credit markets, and major losses in housing values. These factors would suggest a serious recession. But at that point there was no clear evidence of a recession, during the 4th quarter of 2007, at least. The Dow, which opened at 13,339 that morning, was down from its high of 14,000, but certainly was not signaling a serious recession.

All the participants in the December conference thought that their predictions would be proved correct when several months of additional data was available, so we scheduled this conference to see [laughs] whether in fact their positions have changed, and whether things have become any clearer to our AEI economists.

From the perspective of a non-economist, I must say things still look pretty cloudy. The Dow Jones is about 500 points lower than it was in December, but it has risen recently. It’s up again marginally today, when I last looked. Friday’s Wall Street Journal noted this with the headline: "Dow Rises 85.73 points, as Some Investors Shed Fear."² Since much of the buying was of financial stocks, banks and brokers, the fear that investors shed was probably that the credit crunch would deepen.

If in fact the credit markets are returning to normal, it would take … that would be one reason for taking a deep recession off the table. In this connection, it is useful to note that the 3-month Libor is 40 percent down from it’s 52-week high.

This first chart shows [Figure³ 1] that the spread of mortgage-backed securities over the 10-year treasury has declined substantially since the Fed’s moves in conjunction with bailout of Bear Stearns in March, but it is still 50 percent higher than it was last April, and 10 percent higher than it was at the time of our December meeting. And the very high Jumbo mortgage rates haven’t come down at all since December.

Nevertheless, it does look as though we are beginning to deal with the credit market fallout from the subprime meltdown.

Attached is table 2. [Figure 2] It’s a very interesting chart that shows recapitalization that has been going on among the banks. This indicates, it seems to me, that we are not headed for what we have, or what various people have called, a Japan Problem. What you see there is that the banks, in the last few months since January, have recapitalized by raising about $212 billion in new money, against about $308 billion in written down losses.

Recapitalizations will enable banks to begin lending faster, without concern that their loans will further reduce their regulatory capital. Sustained bank lending will shorten and reduce the severity of any recession.

In you materials is an article⁴ that I wrote a couple of months ago arguing that the real question of the subprime meltdown was whether the taxpayers or the shareholders would bear the loses. At the moment it looks very much as though it is the shareholders, and that’s the way it should be.

The issue, as I saw it, was whether the banks would recapitalize, [0:05:00] diluting their shareholders, or hold back in the hope that the government would pick up the losses.

The bank recapitalizations, which are probably forced by regulatory jawboning, seems to be answering that question. Nevertheless, there are indications that some banks will not be able to recapitalize, and will fail. That will produce a market shock that could send the market reeling again, because things are really quite fragile.

At the same time, the votes last week in the House Finacial Services Committee significantly narrowed the number of subprime, or other, borrowers who are likely to be eligible for bailouts. What this means, I think, is that the decline in home prices will be sharper, but will end sooner. You can take your choice about whether this is good or bad. The important thing, in my view, is that the losses are recognized by the financial institutions and appropriate actions are taken, and that appears to be happening.

Finally, a few weeks ago, the Business Roundtable published a summary … [Figure 3] of the views of the CEO members at the Round Table about the future. And the best summary of this summary is: "A slightly better economy in their veiw, in the months to come." As you can see, that 1st sector at the top on the left, "How do you expect your company sales to change in the next 6 months?" 70 percent of them believe there will be an increase in sales.

So overall, there is a modest improvement, but the key issues –

• How far will home prices fall? and,
• Whether there will be failures among the banks, and
• Other intermediaries,

– these are still major unknowns.

And this is just right for commentary by our economists.

We’ll go in alphabetical order, as it turns out, which is probably the best way to get these people to talk anyway, given what there positions are likely to be.

And so we’ll start with Charles Calomiris. …

I’m not going to introduce them at any length, because I think all of you know them, either by watching television or reading the stuff that they write, so I’ll just say a sentence or two about what they’re doing now.

Charlie is a Visiting Scholar at AEI, and he’s Codirector of AEI’s Program on Financial Market Deregulation. He’s the Henry Kaufman Professor of Financial Institutions at Columbia Business School, and a Research Associate at the National Bureau of Economic Research. … Charlie.

Charles Calomiris: Thanks, Peter. Welcome everybody. It’s a pleasure to be here.

What I’ve done for the presentation today is used exactly the same slides⁵ that I used before, except I updated the data. And I didn’t change — I don’t think I changed 10 words in the slides. And I guess what that’s meant to indicate is that I think that probably I was right before. [laughter]

Although, I want to emphasize that I agree with Peter. I learned a saying as a young man, "Today’s peacock, tomorrow’s feather duster." [laughter]

And so I don’t want to be too effusive in my self-praise, except to say that I do think it was forecastable — of course there’s uncertainty in the economy, but I do think that there were elements of this turmoil from the very beginning that gave us reason for optimism and that set it apart from the experience in 1989-92, and of course very far apart from the 1930s.

I’m not going to discuss it, I’ve already discussed it. I’ll highlight a few of those issues, because I’ve only got 15 minutes.

What I want to do though is say that I very much underline my view last time was explicitly the forecast that banks would be raising capital. And not just that the regulators would try to get them to. Remember regulators don’t actually regulate capital. They regulate capital ratios.

Regulators really pretty much can’t make banks raise capital. What they can do is make banks either raise capital or shrink assets. And when banks are faced with severe problems of asymmetric information in markets, that make it very difficult to raise capital, they choose to shrink. That’s what happened in the ’30s, that’s what happened in ‘89-’92.

What I was forecasting — which I think has turned out to be true — is that despite much of the confusion in the markets, that the banks were in sufficiently good position, and that there would be sufficient ability to resolve that confusion, that they would be able to significantly access capital markets. That was the real prediction, the real uncertainty, the biggest uncertainty [0:10:00] in my mind, and as you saw from Peter’s slide, all of that capital was raised since December.

So that’s the sense in which there really has been a significant piece of news. And that’s what is very gratifying for me, since I stuck my neck out and predicted it would happen.

I’m not going to review this slide, except to point you toward it. This was exactly the same slide I used last time, except I added a line here, which I think was missing before.

Just to explain how we got to where we are — I’m going to skip over that [Figure 1] — remind you of how abrupt the financial innovations of the last 5 years had been in terms of CDO issuance, mortgage-backed securities making use of subprime, and I spent a lot of time talking last time about how inappropriate the risk measurement was, and how it had been inappropriate ex ante, and many of us had confused it, (… I’m sorry, confused it, …) had criticized it and saw it, particularly the ratings agencies confusing use of triple-B or double-A or single-A to mean completely different things when they were looking at structured products and at normal corporate securities as one of the key contributing problems. And also the way the rating agencies had failed to do appropriate stress testing of subprime.

One of the things we pointed out last time was that the crisis has been very localized. It hasn’t affected everyone. Even financial commercial paper issuers have been — that is, the ones who aren’t directly related to subprime — were not really very hard hit by it. And non-financial commercial paper issuers weren’t affected at all. But we had about half a trillion dollars of runoff, in the first stage of the crisis, coming from subprime-related problems and working capital manangement by the large banks in the form of SIVs or Asset Backed Commercial Paper conduits, that had to run off a lot of commercial paper. That was the first part, and I think I correctly forecast last time that we wouldn’t have a return of that, and we haven’t. That was a one-time shot.

Why this happened? One of the things I want to emphasize for those of you who weren’t here last time is: part of the problem here was that the financial system learned the wrong lesson in 2001 and 2002. Actually, it may surprise you that — just look at this graph. [Figure 7] You can’t see it very well, but the top line here shows you that the peak foreclosure experience in the subprime mortgage market was in 2001 / 2002. We still haven’t gotten back up there. And that’s going to be a surprise if you haven’t heard that before.

Of course it was a much smaller market, but it experienced very high foreclosure rates. But since the housing market was booming, the Loss Given Default in subprime in that experience was only 6 percent. That’s how you got liar mortgages, no-docs mortgages; from a perception that it didn’t matter what peoples’ creditworthiness was, because "housing prices can’t fall." Sounds a lot like Japan in the 1980s, right? "Real estate prices never go down." That was the mentality then in Japan, and it was very much the mentality here about subprime. And that was built into the rating agencies’ assumptions, and in some instances it was known to be wrong.

The other thing built into them was grade inflation. It was very self-conscious. A triple-B CDO, as of 2005, triple-B debt coming off of a CDO, as of 2005, had a 5-year default probability of 20 percent. A triple-B CDO corporate bond had a 5-year default rate of 2 percent. Obviously triple-B did not have a meaning that was common to all securities.

From last time again, what are the likely macroeconomic consequences? I stressed two different likely transmission mechanisms of adverse consequences –

1. credit supply contraction,
2. the other, housing price decline.

And I argued, and remain with those arguments, that the credit supply wouldn’t be severe because banks would be able to raise capital, that they had continuing profit sources, they were much better diversified, and that the losses would not undermine their ability to grow, and that they would be bringing capital from outside and growing their loan portfolios rapidly.

And of course, in fact, the last 4 months have been among the fastest growth periods in US bank lending in post-War history, as I’ll show you in just a minute.

What about housing prices? I argued that the Case-Shiller index is a flawed index, that the median home sales index is a flawed index, and that in fact, there are reasons from a macro perspective to prefer the OFHEO index, which gives us a much brighter picture. [Figures 3,4,5] And I talked a little bit about some of the problems in the construction of some of these indices. I still believe that, and I also believe that the wealth effects are over-estimated by most macroeconomists when they think about the effects of housing price decline, and that they’re probably more like half the size that most people estimate.

That led me to the conclusion that this would not be 1989-’91, and that the … for both of those reasons, and one additional reason, and this is something again that needs to be emphasized. The Bush 2003 dividend tax cuts had an affect that was exactly what they intended, [0:15:00] which was to reduce leverage, excessive leverage that was there to try to take advantage … tax advantages of debt.

And leverage, corporate leverage has fallen since 2003 like a rock. [Figure 15] This is very important to bear in mind as we go forward. What it means is that debt positions of US corporations are back to where they were prior to the 1980s, giving huge debt capacity to those corporations, and we’re seeing a lot of debt being raised right now, and that again takes the pressure off of the banking system for large corporate borrowers. That’s another very important fact to bear in mind.

These are pictures of the growth of bank lending, [Figure 18] whether you looked at the large weekly reporting commercial banks, or the overall banking system, and you can see huge growth. And that has been made possible by that continuing growth in profits, and also outside capital raising.

This gives you the Jumbo and the conventional mortgage rates. [Figure 10] The key point here I would make is, yes it’s true that the Jumbo rate has edged up, but let me take you down to Latin America when a financial crisis causes interest rates to go up a little bit more. What’s really been happening here, of course, is — that bottom line shows — the Fed has been targeting this mortgage rate effectively and just reducing interest rates as need be to keep that mortgage rate from going off into the sky. That’s one way to look at this graph.

So money-market rates have come way down. We’re currently at, I think, too low a Fed Funds Rate at 2 1/4 percent.

I’ll skip this in the interest of time, but the point here is how interesting some of the new patterns in money-market spreads have been in this crisis. Maybe during Question & Answer we can come back to that.

What’s the meaning of some of these very unusual spread movements that we’ve seen? [Figures 11,12] Some of these unusual movements have persisted, they’re the part of this crisis that has surprised me, that they haven’t corrected themselves more, particularly the overnight Libor relative to overnight Fed Funds, which I will point to in just a minute.

How accommodative is monetary policy right now? When you look at real Fed Funds rate we’re at a position that we’ve only seen about 5 times in the post-World War Two period in terms of the real Fed Funds Rate, and in my view, actually, that is … it’s even worse, because my expectations of inflation are higher than the market consensus. So I think we’re in an extremely accommodative position in monetary policy.

My view is that the Fed has done the right thing on the Discount Window consistently, and I praise them for it. I think they’ve overdone it on the Fed Funds Rate, and that, by the way, I noticed, was the theme that came out of today’s Wall Street Journal lead editorial.

This is the graph [Figure 13] of the spread between the overnight Libor and Feds Funds, reflecting the fact that large banks, in lending to each other, still are not lending at very low rates. That reflects a combination of counterparty risk perceptions among the large borrowers, because the Libor market is a big bank to big bank market, as well as just a general hoarding going on by large banks still, to get back to their equilibrium liquidity positions.

So we’re still seeing a stubborn persistence of high Libor rates that makes us think that we’re really not done with the money market part of the adjustment, the liquidity part of the adjustment of this.

Credit spreads, which is the bottom graph here, have risen. That’s good news, they were way too low, they’re back to about normal. I’ll predict that that triple-B spread will fall to below 3 percent, let’s say within 6 months, but shouldn’t fall much more than that.

The good news is the stock market has kept itself fairly high, …

Credit spreads … You can sort of see the turmoil as happening in 3 waves. [Figure 14] And I have two spreads here, one of them is the credit default cost, as indicated by the CDS spread, Credit Default Swap costs, and you can see the 3 waves there. We’re now in a position that is much lower than it has been during any of the 3 waves.

The orange graph, though, is Fannie & Freddie’s spreads over Treasury, [Figure missing?] and you can see those have actually gone up recently. And the reason for that is that we’ve expanded … Fannie and Freddie’s roles since this point, and expanded their riskiness. So this is a concern. It’s not a concern about the crisis so much as it’s a concern about how long term policy toward Fannie and Freddie has now given us a new long term risk, because we’ve given up on capital regulation and portfolio restrictions that we shouldn’t have given up on.

This is the point I was making about how much post-2003 corporate leverage has fallen like a rock, and those of you who are thinking it’s a good idea to repeal the Bush tax cuts, take a good close look at this graph, and think how much worse off we would be if we hadn’t gotten all of that excess debt capacity since 2003.

How much time do I have, Peter?

Peter Wallison: … [undecipherable] …

Charles Calomiris: … OK … Housing prices, I’ll just be very brief and say I think the last 2 months [0:20:00] have given us a brighter picture of housing prices in the data, but it doesn’t surprise me. I think that I’d like to talk a lot more about housing prices. I have another paper which I’d like to present here, actually, at some point maybe in a month, on the relationship between foreclosures and housing prices going forward. And I’ll stay with the prediction I made last time, which was, according to the OFHEO combined resale and refinance index that peak to trough we won’t see a nationwide decline in excess of 10 percent, and I’ll stay with my 5 to 10 percent range.

Nothing like the very irresponsible and really almost crazy statements by some economists. None of them are on this panel, by the way. And I mean that sincerely. By people like Nouriel Roubini or a Bob Schiller who .. Bob Schiller I think said housing prices might fall by 50 percent in the US. Just ridiculous. And nothing like that … and actually, last time, even though we were differing … we differed in our interpretation, many of us, I thought, I think John and I specifically said we thought about a 10 percent decline was about what we would expect. Maybe John will revise that view, but that’s still my view. …

Case-Shiller is a very untrustworthy index, regionally it’s not constructed in a way that gives us the kind of indications that we want for the whole economy, or for the segment of the population that’s most subject to wealth effects coming from house price declines, so I won’t say any more about it except just to say that I’m not a big fan of that index.

There is real concern about the connection between foreclosures and house price declines, and that’s what my next paper is all about. There is going to be a continuing pressure on house prices to decline because of foreclosures. But there’s a good news story too. Which is that housing starts have been in decline for a very long time prior to this crisis. And so the pipeline has … is not … has not been increasing for over a year. What we’re going to see is that by September we will be back to a more-or-less equilibrium in terms of inventory, and I think that this is the reason for that. So the good news is that the housing price slump — I’m sorry — that the housing slump in housing starts long predated the crisis. And that’s helping us a lot looking forward, and what we’re going to end up with with housing prices.

So, severe recession risk is minimal for all the reasons I’ve said before, and I think that this is so far been true.

I’ve already talked about the Fed policy …

Foreclosure relief — I’ve said before I think and I’ll stay with it — I think we should be doing more. I think it’s a waste of money. We’ve spent $160 billion on this completely useless fiscal relief package, it’s all politics. We should have spent $20 billion on encouraging efficient foreclosure avoidance. We could have done it, we still may do it, and I’ll leave that for the Questions & Answers.

Bank regulatory response — of course I wish I’d spent all of my time on this topic, because it is one of my favorites. I think it’s taught us how bad the Basel II standards really are, and it’s taught us a lot of other things. We need to increase capital substantially, phased in over time, for US banks, I think, among other things.

Reforming the GSEs — this is one of the tragic aspects of this crisis, is how far we’ve gone from the right direction on that policy.

Inflation is really worrying me here. You can see … I’m a fan of the Discount Window, I’m not a fan of the Fed Funds Rate reduction. Look at commodity price acceleration, industrial commodity prices have been booming. Look at the spread between the Fed 10-year TIPS and nominal Treasury showing you inflation expectations are rising substantially, and if you look at … it’s not just the US that’s experiencing this, especially countries that have tied themselves to a dollar exchange rate, but more generally all the world is seeing much higher inflation, so for this sample of countries: Panama, Saudi Arabia, Hong Kong and China, inflation now approaching more than 8 percent.

So I think that we do have some corrective policies to do, and I hope the Fed doesn’t keep expanding the mistake, which I would put at about 75 basis points too much expansion so far. Thanks.

Peter Wallison: Very good, Charlie. Thank-you. Now Kevin. Let me first say a few words about Kevin, everyone knows him, of course, but he’s the Director of Economic Policy Studies here, and a Resident Scholar at AEI. He’s also a weekly columnist for Bloomberg, and for Kevin and everybody else, there’s quite a lot of biographical material in your kits. … Kevin.

Kevin Hassett: Thanks a lot, Peter. If we go back through the WayBack machine to the last conference, then my humble contribution was to discuss an article I’d just written in the New York Times, which is the … it was the real-time output of a book that’s now in editing here at AEI that I’ve been writing with Jim Hamilton [0:25:00] at the University of California San Diego, and Marcelle Chauvet at Cal Riverside.

And what we’ve been doing is developing, especially Marcelle going all the way back to her dissertation, was working on this area, was developing real-time models that help you call when you’re in a recession or not. And the basic idea is that the National Bureau of Economic Research [NBER] is the official arbitrator of whether we’re in a recession, and they very often tell you you’re in a recession, on average I guess it’s about 7 to 11 months after the recession begins, and since a recession lasts, on average, about 11 months, then you can sometimes find out you’re in a recession after the recession’s over.

And when we were meeting … late last fall or early in the winter, I guess, I forget whether … which side of the Solstice it was, but it seemed to me at the time that everyone had made up their mind that we were in a recession. And this model that Marcelle and I drew upon in our New York Times piece is a very effective model of a recession, that takes the data and then reproduces calls that the National Bureau of Economic Research would make, although many months later. In fact the model had called every recession correctly, reasonably precisely, down to the month, in post-War history without ever giving a false signal.

And the message as of last December, but then we were talking about hard data through October, as I recall at that point, was that there was no recession as of October, and I had about half the data for November, and I said it doesn’t look like November either, and so the conclusion of my talk was that I’m not nearly as able as my colleagues who do it for a living to think about what the future might hold, but I’m pretty good at forecasting the past in this case, and that I was reasonably comfortable saying that we didn’t … weren’t in recession at the time, and if a recession was going to begin, then it would have to be in December, and that was the punch line.

Well, subsequently we’ve had, … some time has passed, and we’ve drifted down the river, and we’ve had a few more months of data. I now have complete data for December and January, or we do, Marcelle ran the numbers last week, and either it’s absolutely not a recession in December, absolutely not a recession unless we kind of change the definition, in January.

In February, the data took a marked turn for the worse, and we’re at that point now that’s most frustrating for econometricians, the point that’s most, I guess, annoying to be at, which is that the model says that the probability of a recession for February is about .5, OK?

So the last time I talked, how have things changed? The last time I talked said, "Well I don’t know if we’re going to have one next year or not." I think that some of the things that the folks over here to the left of me, are going to say are pretty disturbing, and may give you pause, but on the other hand Charlie was kind of pumping me up, and I wasn’t sure, but I was really sure that we weren’t in a recession yet.

And so I’ve changed quite a bit, because I’ve gone from being really sure we weren’t in a recession yet to now suspecting that when I end up having my complete data for February that it will show that a recession began in February, but the 2nd New York Times piece hasn’t been written yet, because … we don’t have enough, … February’s not a complete story, and it’s right at a point that’s frustrating. And so if it finishes February at .5 then we’ll have to wait for March to see.

And so, again, though, note that this is a remarkably different place to be than it seems like the popular culture has taken us too, wherein if we call a recession the same sort of thing that happened before when we called it a recession, then it’s not obvious that we’re in one yet, despite all of the awful things that have happened. And that’s, to me actually, pretty remarkable.

Now looking forward, I think that we have to think about what it … where we’re going to go from here. I think that are a number of new factors, as the tax policy person that one needs to point out as we think about, let’s assume that the model does end up convincing us that the recession starts in February, so then that means that, well, if it’s typical, then it’ll probably last through to about the end of the year, so we’ll have a bad year.

It’ll be the … a really opportune time for the next President to arrive, because if you arrive right at the trough, then every growth comparison of you to anyone else will always be favorable, but … so we’re looking at something like it could run towards the end of the year, and then the question is, what is policy done to make it so that it will be shorter or longer? And in that regard, I’ll leave the discussion of monetary policy to people who are [0:30:00] far more able than me to discuss that, but it looks like there’s been a heck of a lot of stimulus since our last meeting.

And if we’re basically riding about flat last year, not quite in recession, and riding about flat, as near as we can tell, right now, I asked some economist friends of mine who do this for a living what 1st quarter GDP was — the highest one I got was about 1.3, and the lowest was about 0, and so 1st quarter GDP, it could end up negative, but it’s a little bit positive, it’s not really negative, which is one of those things you’re looking for for a recession. So we’re running about flat, and then we’ve thrown all this stimulus in.

And so what’s the risk going forward? Well it could be that finally the bad things we’ve been fearing really happen, or it could be that inflation gets really out of control, and certainly commodity markets are fearing the latter.

What has policy done outside of monetary policy? Well the stimulus package is going to have, probably, a small effect. If we use back-of-the-envelope approaches to think about how much … [crosstalk] … No we have to do the add for Windows, isn’t that part of … [laughs] … [crosstalk] …

So the stimulus package is probably worth maybe 1/2 a percent of GDP the 2nd half of the year. And that’s if you’re optimistic about people consuming from a temporary tax cut. The literature on that, I think, is mixed. People inaccurately have cited a paper⁶ by Jonathan Parker which looked at the last tax cut and found that people consumed it, and then concluded that the stimulus would be large. … The comparison is weak, because the last time we did this we gave people a permanent tax cut, and so even Milton Friedman would concede that they would consume a lot of it, because … at least permanent as long as the Byrd Rule applies, or you get your 10 years of Bush tax cuts.

But this time it’s really explicitly temporary. So you might expect to see a very, very small effect. Though the last policy thing that I think we have to start thinking about, in terms of what’s going to happen in this recession, if we do kick in in February, is that there are a heck of a lot of policy variables on the table, both for the next President, and also, I guess, to be discussed during the campaign. And those policy variables, I guess there are 2 main ones –

1. One is the deficit; and,
2. the other is the marginal tax rates.

If you crank the numbers for Senator Obama, assuming he’s the nominee, I guess nobody really knows for sure, then the marginal, the top marginal tax rate on labor income from Mr. Obama is, after you account for interactions of things, about 52 percent. Goes from the current rate to about 52 percent. He gets that high rate on labor income because he removes the cap on the payroll tax.

The top marginal tax rate on non-labor income for wealthy people is about 10 points below that, so it’s a lot higher than where we are, but not nearly the big marginal tax hike, up to 52. That difference however, is exacerbated, like the gap between where we are and where we might be under Mr. Obama, is exacerbated by the fact that he’s going to argue for an increase in the capital gains tax rate, and it seems a repeal of the dividend tax cut, although I find the positions at times murky on these things.

But if the dividend tax were to go up to, back up to, say, a top rate of 42 percent or something, then we’d be talking about the kind of change that would have really a pretty dramatic effect, I believe, on equity markets. I think if we go back and look at the dividend tax cut before, then you could sort of back out that maybe be about a 7 or 8 percent celebration occurred in equity markets because of the dividend tax reduction. In this case where we might be more than reversing it, and with a 50 percent probability, if you think that it’s a coin-flip election. And so that means that as we head into the fall, there is a significant amount of tax policy uncertainty that you might really begin to see in financial markets.

Now the last time around, I had a paper in the American Economic Review with Alan Auerbach where we looked at the behavior of futures markets in response to … options markets in response to Presidential futures, [laughs] and teased out that there are really big and significant effects of tax policy on equity markets around the election, and that basically with higher taxes being more likely when Kerry’s future was very [0:35:00] positively traded.

And so what that means is that as we think about how we get through this recession, the policy thing that I want to add is that we’re about to enter a fall where there are going to be some pretty big policy stakes, potentially, that might really move markets around as markets change their priors about how Mr. Obama’s doing.

I guess I have to have a full revelation, I’m not speaking in any way for a campaign at the moment, but I do advise, informally, Mr. McCain from time to time, but I think that this policy uncertainty has the potential to be really big in financial markets, and not just that, but another one, another area where you might see it would be in municipal bond markets, because if marginal tax rates are going up a lot, then that has a big impact on the relative price of muni bonds, and it’s something else to look for.

… What did you do, Charles? …

Charles Calomiris: … I didn’t do anything.

Kevin Hassett: … I told you not to touch that computer, did I not?

[laughter]

And so then, to summarize, I think that last time I was sure that we weren’t in a recession, and yet. This time it’s close. And I guess if you’re a betting person you might argue that getting all the way up to 50 means that with a little bit of more data revision we’ll be over the top, and it will look like February would be the start of the recession. I think that policy, on the one hard might make … might give us a half a percent or so from a not-so-bad level over the rest of the year, but that uncertainty about future policy, which would be a much larger scale might have an effect in the opposite direction.

And so, for me the way I am feeling right now is it’s a little bit worse than the flatness that we’re been riding, and maybe lasting a little bit longer than we might have thought.

Peter Wallison: Thank-you very much, Kevin. We’re having a little bit of difficulty with the computers, so you all should have in your packages Des’ slides. Des, I think you’re going to be talking from slides? Is that right?

[start 2 1/2 minute technical interruption]

Desmond Lachman: … until Charlie was here … [laughter]

Peter Wallison: Well, we still have your slides, so … oh, is it back? Is it coming back?

In any event, let me talk about Des a moment while we’re waiting for something to happen. Des joined AEI as a Resident Fellow after serving as the Managing Director and Chief Emerging Market Economist … Economic Strategist, at Salomon Smith Barney. He was previously the Deputy Director in the International Monetary Fund’s Policy and Review Department, and was active in the staff formulation of IMF policies toward emerging markets. Now you’ve got an emerging … set of slides, so go ahead.

Desmond Lachman: … try to start … [dead air] … [cross talk] … I was quite prepared for this. I’ve worked in New York for a while at Salomon Brothers, and the first thing that I was told at Salomon Brothers was you didn’t have to worry about anybody stabbing you in the back, at Salomon Brothers they’d stab you right up the front.

So that’s how I’m feeling right now.

Thanks …

[end 2 1/2 minute technical interruption]

Desmond Lachman:Thank-you very much, Peter, and thank-you very much for arranging this seminar.  And as I said at the last seminar, I hope that you do this in 6 month’s time, but I hope that we don’t have reconstructionist versions of what we said at the time.

My recollection is that I was very clear that we were headed for recession, that there would be a lot of problems in the financial system, and my recollection is also that I didn’t get much support at this table for those views.

So let me be quite clear about what I’m thinking right now. I think that [0:40:00] I take quite a different view from the previous speakers, in that I think that the outlook is not very bright, to use a euphemism.

I think that what we’ve got here is a recession that is going to be very much longer than the normal recession, and that what we’re going to get is we’re going to get a recurrence of problems in credit markets. This time around, what’s going to be occurring is that the weakness in the economy is going to be feeding back into the credit markets.

Just to begin [slide⁷ 1] with my slide presentation, I thought it would be useful just to take stock of how things have changed since we were here in December, and in particular to take note of a couple of people who seem to be coming around to my point of view.

Let me start with Alan Greenspan, [slide 2] who’s perhaps the architect of the mess we’re in, who’s now describing the situation as "the most wrenching credit crisis in the post-War years." Wanting to outdo him we’ve got Paul Volcker describing the present crisis as the Mother of All Crises.

Ben Bernanke has recently acknowledged that output in the 1st half of 2008 could have contracted in the United States, but more importantly, what he has done is he’s led the Fed to adopt measures that they haven’t resorted to since the Great Depression.

Just to round this out, we’ve got Marty Feldstein, who has some influence on the National Bureau of Economic Research, [NBER] who dates these recessions and will tell us how long it is, who’s talking about this being very likely to be a severe recession.

And then finally there’s the minor issue of the data. We’ve lost 230,000 jobs in the 1st quarter of the year, and consumer sentiment now is at its lowest level in the past 25 years.

What I did in December was (the reason that I had a pessimistic view of the outlook) was that I thought that there was a confluence of 3 factors [slide 3] that were impacting the economy.

When I asked myself, "Where we are going now?" I asked myself, "Are those 3 factors still in play? Have some of those factors perhaps got worse?" and my answer is, "Indeed those 3 factors are in play and a number of them have certainly got worse."

What I’m referring to, of course, is the housing bust. I just refer you to a chart [slide 4] which shows that house prices now, in real terms, have probably fallen by something like 14 / 15 percent the past year, and that when we look at the rate at which they’re falling now, [slide 5] (this is from the much maligned Case-Shiller index) that the last quarter we’ve got house prices now falling at 20 percent. So in terms of the housing market, I would suggest that not only have we got a bad situation, which I’m wanting to talk about a little bit more, but it’s accelerating. The pace, if you like, the 2nd derivative is positive, which is problematic.

We’re seeing that also, just in terms of Mortgage Equity Withdrawal, [slide 6] which was a big support of consumption. That is now just evaporating.

So that is the first part of the crisis that bothers me. The second is the credit crunch, and some of the slides that have been shown before would suggest that despite the Fed cutting interest rates by 300 basis points, borrowing rates are, for the most part, above where they were in August last year. So I’m not sure how stimulative the monetary policy … I’m not sure why one would look at the Federal Funds Rate, adjusted for inflation, when what we’re getting is we’re getting the long end of the curve not coming down so much, and spreads widening, so that the borrowing rates are at … high.

In addition what we’re getting is we’re getting contraction of balance sheets. And once again I wouldn’t look at the banking sec– simply at the banking sector, I’d be looking at the whole financial system. Banks today only intermediate something like 30 percent of overall credit, as opposed to something like 50 percent 15 years ago.

The third shock that I would suggest has got a lot worse than when we were here last time is international oil prices. My recollection is in December they were at $85/bbl. Today that’s round about $120 dollers / barrel. So when I take those 3 shocks together and see [0:45:00] that they’re still in play, still … some of them getting worse, I’m not sure that I see what the case is for thinking that this is going to be a short, shallow recession.

I would add that what we’ve had is we’ve had stock prices declining, we’ve had debt prices declining, which is a further drain on wealth; and, a point I’ll come back to, which I think is rather important is that we’re now getting very clear signs that the commercial real estate [CMBS] market, which was booming last year, is now entering into a bust. So there are very many reasons, I think, to be concerned.

Let me just go through the housing market rather quickly. [slide 7] The reason why I’m concerned, and the reason that I’m doing this, is twofold. I’m suggesting that if we don’t get stabilization in the housing market, that could be very important for consumption, which after all is 70 percent of aggregate demand. And the reason it could be important for consumption is that housing is the largest asset — largest component of wealth — in private portfolios. And secondly it makes it difficult for people to borrow against their homes, which is the the way in which they were financing their consumption.

The second reason, I think, that one wants to focus on the housing market, is that the bigger the bust that can get in the housing market, if it’s true, as I would suggest, that housing prices are probably going to decline another 20 percent before this is all over, what we get is we get an amplification of the losses that we’re going to be getting in the financial system. Those losses [unintelligible] are already estimated fairly widely at something like $1 trillion, of which only something like $250 billion has been recognized by the financial system, so I’m not sure that I see that we’re at the end of the tunnel.

Let me now just run through quickly the part of my reasoning why we’re going to get housing prices declining by 20 percent. This chart [slide 8] is just showing you, using the OFHEO index, how much we’ve got away from equilibrium during the boom, that you can see that there’s a trend line that that looks it looks like it’s something like 30 / 40 percent above what the trend is. If I do this in relation, if I scale it as I correctly should in relation to income … If I look at a house to income ratio, I come to the same conclusion, that that ratio rose from something like 3.2 to 4.5. So that alone would tell you that coming back to equilibrium would require a rather big change.

But I’d rather focus on — what are the facts on the ground? If I look at the housing market, inventories of unsold homes are now something like a million units above what is a normal level of inventories, [slide 9] or if you want to look at it in terms of rato to sales, [slide 10] we’ve got the ratio to sales, housing inventories to sales, at something like 10 / 11 months supply, which is the largest that it’s been the last 30 years.

So we’ve got a situation where we’ve got excess supply on the market, and what I would suggest is — that is only going to get worse, for at least 3 reasons.

First is, just in terms of the financing of the house market, if you look at what occurred in 2001 … 2006. [slide 11] In 2006 something like 40 percent of the financing was coming from subprime lending and Alt-A lending. You fast forward to the 4th quarter of 2007, what we’ve got is 90 percent of the lending is coming from the GSEs, and that the amount of lending has contracted from a rate, an annual rate of $3 trillion in 2006 to $1.8 trillion in the 4th quarter of 2007. So the financing side is going to make less demand for houses. You see it also if you just look at the lending condition index, [slide 12] the survey that the Fed does, that really is just going through the roof, that is back in January. I’d expect the next quarter to be even worse than this. So we’re going to get less demand.

We’re going to get, also, the question of resets. [slide 13] That might not be as serious as it was when I was talking in December, because we’ve had some interest rates coming down, but nonetheless, it’s going to come into play on the reset.

What I’m really concerned about is the story on the foreclosures. [slide 14] Foreclosure procedures that have already been initiated in 2007 are literally going off the chart. What we’re getting is we’re getting something like double the rate. We’re now running, instead of 900,000 units a year, which was the story in 2006, we are now [0:50:00] at something like 1.8 million units in 2007, and there’s a lag of something like 12 months, 18 months before those houses hit. So we’ve got a real problem on the foreclosures side. Foreclosures are going to come onto a saturated market.

Another way of looking at it, which I find rather scary, is that the equity in people’s homes has now dropped. [slide 15] The average household has only got 47 percent equity in his home. It’s the lowest it’s been in the post-War period, and the chart [slide 16] that I’ve constructed is that if house prices fall by 10 precent in 2008, this histogram just shows that you’re going to have a third of households having negative equity in their homes, and this great land of ours with non-recourse loans, people have got every incentive to walk away from their houses.

So I’m not sure that we stop foreclosure problems even if we have the Frank-Dodd bill in place.

If you don’t want to take my word for it, just take a look at the forward market in the Cass-Shiller Index. [slide 17] We’re just looking around — major cities in the US, something like Los Angeles, over 30 percent decline the next 2 years in house prices. Just eyeballing that, it doesn’t seem to me unreasonable to expect house prices to fall this year by something like 10 to 15 percent, and probably fall by a similar amount next year.

As I mentioned, I’m not only concerned about the housing sector, I’m concerned about the non-residential construction sector. [slide 18] What you’ve got in 2007 was that as housing was busting, you were getting a boom in commercial real estate. All of the indications are telling you that that has turned. The last 3 months have been pretty negative for commercial real estate, and looking forward, when you see what’s happening with lending conditions on the commercial real estate, [slide 19] the expectation is that that’s going to be busting further, which I think just compounds the story on the credit crunch.

Let me just briefly say a word or two about the credit crunch, [slide 20] that as I’ve mentioned, my read of the credit crunch is, because of the credit crunch, we’ve had spreads widening. This has been going on since August last year. Borrowing rates are no different than they were August of last year, so we’ve really got a situation that I would not describe as accomodative.

And the 2nd point that I would make is that balance sheets are being shrunk, not simply on the banking side, but outside of the banks. We’re really getting a process of deleveraging occurring, that my expectation is that that continues.

I just thought I’d put up one or two more slides. This slide [slide 21] just suggests that … the line in black [red?] is the way in which credit conditions have tightened as measured by the Federal Reserve survey for the banks. And what it does is it just pushes it forward by 4 to 6 quarters, which is the lag. One doesn’t expect, as credit conditions tighten in the banks, one doesn’t expect bank credit to fall immediately, because what happens is people either draw their lines, or else if they can’t be borrowing, if they can’t be placing their bonds in the market with a high degree of securitization, they go to the banks. But what occurs 4 to 6 quarters later is what we’re going to be getting, is we are going to be getting, at least in my view, a contraction of credit.

Some of these other charts [slides 22,23,24] have been [unintelligable] just in terms of interest rates, not being very different than before. This is the chart that I just think just needs some attention paid to. [slide 25] It’s really just looking at the amount of intermediation through banks and through the securities markets, and what you see, the last 25 years, is that basically, the action is really in the security markets rather than in the banks, [slide 26] so that if you’ve got problems … if you’ve got shrinking of balance sheets on Wall Street, I think you’ve got a problem for the economy.

So where I am is that the recession is going to be longer, deeper than before. I think that it’s not too early to be thinking of additional stimulus measures, [slide 27] and I think that we might have to resort to the non-orthodox kind of measures that are being talked about to put a floor under the housing market if we’re not going to get a really deep recession.

Peter Wallison: Thanks. Does anyone wonder why he says all that with a smile? [laughter] [0:55:00] The sedatives are in the back, incidentally, if you’re …

Our next presenter is our colleague John Makin. John is a Visiting Scholar at AEI, he’s also a Principal at Caxton Associates. He’s been an advisor to numerous US goverment agencies, the Federal Reserve system and the Bank of Japan. John?

John Makin Thank-you, Peter. Well the … I don’t have slides, because Desmond’s are so good I don’t really need to go through them again.

But the title of the Outlook that’s in the package that you have is called "Denial, Hope and Panic," and we certainly have heard some denial up here today, not from Desmond but from my colleague Charles Calomiris, who — I often wonder, Charles, what planet you’re living on, but let me try to make that case.

Peter Wallison: We don’t get personal here, do we? [laughs]

John Makin: Oh, sorry. Well your numbers, I don’t know where they came from, because I have data from the bank credit analysts on capital infusions, and they are somewhat below yours, but anyway …

Look, … I’m concerned here because we have an audience in front of us that’s probably trying to figure out where the economy’s going, and when they get through listening to this panel, I expect they’ll probably be very confused, because they’re hearing very different interpretations of what are supposed to be a set of facts.

So what I’m going to try to do is suggest a very basic theme that economists have looked at over at least a century, and that is — two centuries really — that you have a big … you have two things going on, you have the financial sector and you have the real economy.

And in this particular episode that the United States is in, you have a crisis in the financial sector that’s being driven by a rapid drop in housing prices, and you’re having a crisis in the financial sector because it is chock full of securities that were written conditional on the assumption that house prices don’t go down. And the value of those securities is very difficult to ascertain, and they have a huge bearing on the financial wellbeing of many of the institutions that we’re looking at — the commercial banks and the investment banks.

The reason that I am a little bit surprised to hear the idea that everything really is OK and we never had a problem, or bad things might happen — bad things did happen in March, and let me tell you that if the Fed had not stepped in (I’m trying to kind of go through this is The Outlook) if the Fed had not stepped in on Sunday, March 16th to … and I don’t know how to put this, did they rescue Bear Stearns? No, they rescued the investment banks.

That day Fed essentially stepped in in order to stop a run on the investement banks from their counterparties. The counterparties to investment banks are analogous to the depositors in commercial banks, and I know that most institutions in the financial sector on Sunday March 16th were sitting around their conference tables watching the screens, waiting to see what the Fed was going to do. And if the Fed had elected to do nothing, Bear Stearns would have failed, and a list of investment banks that I will not name would also have failed.

And so the Fed really had no choice but to take the extraordinary measure, really, to do two things:

1. they opened the discount window to investment banks, which is almost unprecedented;
2. and secondly, they took $30 billion of toxic crap from Bear Stearns’ balance sheet onto their balance sheet,

 and then turned it over to Black Rock to manage for them, and of course the head of fixed income at Black Rock is none other that Peter Fisher, the former manager of the desk at the New York Fed.

And I suppose … I mean my own nervousness about financial markets is probably driven somewhat by my intimate involvement in this, and the days I spent in early March moving funds out of Citibank and into Treasury bills, [1:00:00] while Treasury bill yields reached as low as 60 basis points.

So if nothing was really happening in the credit sector, I wonder why there was such a run into absolutely safe assets, that the yield on Treasury bills went to 60 basis points.

If everyone was sitting around saying, "heh, it’s going to be fine, no problem," there would not have been a virtual panic run out of banks and into Treasury bills.

Now, but part of what happened on March 16th is very important. The Fed took away the downside. That is the Fed took away the incipient run and collapse of the investment banking system by opening the discount window to those institutions. And I think the analogy is, when someone’s beating you over the head with a two-by-four, which is you have an incipient collapse of the investment banking system, when they stop beating you over the head you feel better.

So one of the things that happened was that the Fed, … I would argue the Fed never should have been putting itself in the position they were in on March 16th, and had they not been so casual about how bad the ecomony was, and had they not been so slow too move on remedying those problems, had they not been so complacent, they wouldn’t have been in that position. But given that they were, they had no choice but to try to stop a run on the investment banking system, and they succeeded.

And so when you say, well, people are now raising capital, they are. Lehman Brothers and other investment banks are raising capital because the Fed has essentially put the safety net under these otherwise aggressive institutions so that they can raise capital. In effect they’re diluting common shareholders by doing so, but they are raising capital. I would point out, however — and this is in the bank credit analyst last week — that Level 3 capital, which is basically the junk bin that banks and investment banks use to put assets that they choose not to value into — is still running about $568 billion out of $1 trillion of total equity capital in the banking system.

And equity 3 capital is basically stuff that they don’t want to value, and so it suggests to me that some of the incipient risks that Desmond’s talking about are still there.

SO I think one of the reasons — and I’m trying to account for my own different view here — one of the (how shall I say?) metrics for being concerned about the financial system and the economy is probably how close you are too it. And maybe I’m too close, but in my view, we were too close to where I didn’t want to go, which was to watch Bear and a bunch of other investment banks go under.

By the way, the rules were pretty well followed with Bear. The rule is, let the shareholders go, and protect the depositors. The depositors in this case were the counterparties who were protected. Most counterparties had already abandoned Bear, and were preparing to abandon all the other investment banks and the Fed essentially came in and said, "Don’t worry, you’ll be OK." That was a very important step.

The shareholders at Bear probably were treated a little too well, and I think maybe JP Morgan had a little too much leverage at the time, because they were well aware of the need, literally, for an announcement to be made by whatever it was, 7PM on that evening, 7:45 give or take, I think it was. I was too busy sweating to watch the clock, but there it was.

So we had a near-meltdown in the credit sector, which was averted by aggressive Fed action, and that took the … some of the wide tails off of some of these financial markets that … and some of the instruments have improved considerably. In other words, if you’re not having to price credit derivatives, swaps, for the possible, possible meltdown of the financial system, you can be a good deal more aggressive in buying those things. And we have seen a nice comeback in the credit markets.

So my shorthand is, and I think it may help to bridge some of the gaps here, not all, and we’re not going to agree on everything is that … Credit … We had a credit near-panic averted. That’s good. Now we have the real economy, which is slowing rapidly, and I kind of agree that the numbers starting in February [1:05:00] would … if you look at all of the numbers, and I’m very plodding. I look at the number and I say, "Ooo, what happened in the last 6 sessions? and how does consumer confidence look, and how does employment look?" It’s probably what your computer does very systematically. How does … how does housing look? How do all these things look? And everything looks like we went into a recession in the 1st quarter, and whether …

By the way, I … First quarter growth was 0.6, which is not exactly a rip-roaring economy, and so probably your model was starting to wonder, and we’ll get a report on the 1st quarter numbers probably, what is it? on Thursday, and we’re probably going to see a number around 0 to .5, a headline, but the domestic final sales, which is really the demand growth part, I think the important, arguably the important part of the number because, … it’s probably going to be negative. And the difference will be we’ll probably have an inventory accumulation, and the inventory accumulation in an environment where growth is slowing, is not a good sign going forward, it’s a sign that momentum is being lost.

So one of the things that concerns me as I talk to people about the economic outlook is, "Yes I know it feels good that we’re not going to have a collapse of the 5 major investment banks, I’m really happy about that, and you should be too." However that doesn’t mean that the real economy is going to do wonders, and this month I tried to look at that in kind of a long run sense, and the deleveraging — we’re going to see deleveraging in the financial sector, and we have begun to see that. Many of those who thought that they had home equity lines of credit with the major banks have discovered that they don’t, because the boss at the bank says, "We don’t want any more exposure to households, so if they haven’t used their home equity line, cancel it." And if they have used it, we’re stuck, because home equity lines are second liens, and banks find that people walk away from those lines and say, "Come and get me, but you’ll have to foreclose on my mortgage first," which may have something to do with the rise in foreclosure rates we’re having.

The housing sector — again I hate to argue about numbers, but the Case-Shiller futures index is a market. People buy and sell those contracts, it’s not the biggest and best market in the world, but it is numbers people are willing to bet on. And house prices are falling, and they’re falling at an accelerating rate. OFHEO, again, we had this discussion in December, we’ll have it again. OFHEO is conforming mortgages only. It excludes the most vulnerable part of the housing market.

Be that as it may, real estate markets everywhere are weakening rapidly, and not only that, but the rates don’t … rates which haven’t come down much don’t fully tell the story. I invite you to go to your bank and ask for a loan, be it a regular loan or a Jumbo loan, and see how much the down payment requirement is, relative to what it was a year ago. It will be substantally larger — 20 to 30 percent.

So you have rates at the same level with higher down payments, and so credit conditions are more difficult for prospective homebuyers, and will probably continue to get more difficult, because banks are deleveraging. They don’t want exposure to households, because they’re trying to deleverage while they raise capital, and they have been in effect asked by the authorities, various authorities, to do so.

So, what about the longer run? Well I went back and looked at the Fed’s data on household wealth, and … because I’m trying to get a sense of how much do households have to delever. And what I discovered was that … in the 1990s, from 1990 to 2000, household real net worth, which is kind of the bottom line of the flow-of-funds data, rose at an annual rate, compounded at an annual rate of over 5.4 percent. So households, at the same time, the household saving rate, which excludes those … the mirror image of this, was … the household savings rate went from about 8 percent to 2 percent.

So households were developing the notion, at least the way the broad numbers looked that, "I don’t need to save out of measured income, I simply will [1:10:00] be able to save by virtue of wealth accumulation."

In the current decade, wealth accumulation, that is household real net worth, has compounded at about a 2.3 percent annual rate through 2000 … 2000 to 2007. But as we look at household balance sheets now, we see that equity prices are down — no too much, maybe 10 or 11 percent from the highs, but they’re not going up any more. And house prices are down, and we can argue about how much, but house prices are certainly down from their highs, and the availability of credit that has been tied to the rise in house prices has sharply curtailed.

So probably, as households face sharply higher energy prices, deleveraging by the financial sector, their own need to deleverage (the data on State tax collections show that reak incomes are dropping, have to be dropping unless people are avoiding taxes), we’re going to have a sharp slowdown in consumption, which is already started, it’s in the data. Beyond that we’ve also seen investment spending start to slow. One of the things that we suggested back in December was that that would be what you would expect to see as we get closer to a recession, and that’s what we’ve seen.

So again, it seems to me it’s playing out exactly as we … the big wrinkle was the crisis in March, which none of us actually envisioned. We did not envision a …

voice: … you and I did … I’ll remind you of that …

John Makin: … OK, well I didn’t envision something quite that intense, but we had it, we got through it, it’s a good thing the Fed performed their job.

But now I think the problem is we have this underlying deleveraging in the finacial sector and the household sector that’s going to slow consumption growth, and probably pretty rapidly. We throw in a little bit of a curveball here because, as everyone’s mentioned, Treasury will be sending out checks with a total up to about $100 billion over the next several months, and it’s very hard to figure out how much are people going to spend. I do know that if you annualize the increase in energy costs over the past month, it’s $60 billion, simply because gasoline and other energy prices have gone up so rapidly. That maybe will go away, it may not. But it’s not a plus for households’ disposible income.

So where do I come down on this? On the financial crisis, the financial sector is better than it was six weeks ago, and we dodged a very serious bullet, and that feels good, and it’s given financial markets a nice lift. By the way, this is the 13th 5 percent bounce in the stock market that we’ve seen since last summer, as I checked, Alan Ableson pointed it out over the weekend, and sure enough, we’ve had [undecipherable] … And actually I’m surprised that it’s not a little bit better, given that, again, they’ve stopped hitting us over the head with this 2-by-4 called an incipient credit crisis.

But the underlying picture in the real economy, which is tied to a persistent and accelerating drop in home values, which is the major balance sheet item of most households, continues. And I suspect, again I suspect that if we gather again in 6 months we will say, "Gee, consumption slipped quite rapidly, investment slipped rapidly, and the 2nd quarter growth rate was … somewhere around zero, because we got a boost from the stimulus checks." But when the stimulus checks go away, the 2nd half of the year actually could be more difficult.

So it’s not as dramatic as the onset of a credit crisis, but it’s kind of a steady grind down, which I think probably adds up to a fairly lengthy recession. I’ll stop there.

Peter Wallison: Thank-you very much, John. There isn’t actually any pattern to these presentations, except alphabetical order. So you think it’s been arranged in some way, it hasn’t been.

OK, our next speaker is someone who was not here for the one in December, for our meeting in December, so he’s an entirely new participant, and that’s our esteemed colleague Allan Meltzer. Allan is the Visiting Scholar at AEI, and he’s also the Allan H. Melter [laughs] University Professor of Political Ecomony at Carnegie Mellon University. He was a member of the President’s Economic Policy Advisory Board during the Reagan Administation, and he has been an Acting Member of the President’s Council of Ecomonic Advisors and a consultant to the Treasury and the Fed.

I should mention that he received the first annual Irving Kristol Award, and delivered the Irving Kristol Lecture at AEI’s Annual Dinner in February 2003. And Volume 2 of his History of the Federal Reserve is forthcoming from the University of Chicago. [1:15:00] Allan.

Allan Meltzer: Thank-you. Having watched recessions over something like a 50 year career, I must say that one of the things that stikes me most about this one is the enormous exaggeration that characterize the comments that were being made.

People were talking about … people as smart as Larry Summers were talking about depression and how we were on the verge of depression. And the media was just full of talk about how the 6 percent — at the time 6 percent default rate on housing was the worst since the Great Depression. Well in the Great Depression it was 50 percent, and if you can’t see the difference between 6 percent and 50 percent, you have to be as blind as many of the people who write the newspapers.

Another example is the hand wringing over the decline in house prices. House prices have to fall. The problem won’t end until house prices fall. We have to see house prices fall. A quick fall will be hard, but it will also get it over somewhat faster.

Sure, they may overshoot, but what will signal, for me and many other people, the end of this problem, the housing problem, the beginning of the end of the housing problem, will be when the expectation in the market of a housing price stabilizes. When they know what the housing price, or think they know what the housing price is going to be, they will be able to value the securities in their portfolio, they’ll be able to raise more capital. People will have more confidence in what their assets are.

If you look at the market now you see that people — banks are willing to lend to each other, money market people are willing to lend to each other, for one night or two nights. They’re not willing to lend for 30 days, because they don’t know what kind of junk is in the portfolio of other people. And that junk is characterized by the fact that we don’t know what the value of the underlying assets are, and we can’t know that until the expected housing price settles.

So that has to happen, and that will be a signal of the fact that we’re approaching the end of this financial crisis.

I share the view that this slowdown, it’s not yet a recession, it may be a recession, but it’s not yet a recession, that the slowdown in the economy will be prolonged, not so much because of the housing price problem, although that certainly contributes, but more important for consumers is the fact that gasoline and energy prices are way up, and they are really pressing on individual family budgets.

I mean, take a person at the median income of around $40,000 / year. Every week, when he fills up his SUV to go to work, and he needs to fill the SUV [laughs] to get to work, he spends $80, approximately, for gasoline. That’s a big slug out of his weekly income, monthly income, annual income. It only amounts to maybe an additional $500 or $600 a year, but that’s a big bite in costs, and food costs add to that problem.

So the reason I think that that’s affecting more people than housing, the gas and energy prices are affecting more people, is because … I don’t inhabit Wall Street, and so I don’t … I can see what I think is playing from the data. That is, that this crisis which is very localized. The worst of it is in southern California, southern Nevada, Arizona, southern Florida and, for very different reasons, in the area around Detroit.

The rest of the country, housing prices may be falling, but most of the people who own those houses are not going to move, and many of them are not going to default. They know that housing prices can go up, or they believe that prices can go up or down, and they’ve lived through the uncertainty that that creates.

Now a friend of mine, who is the Chairman / CEO of a very large bank says to me, "I should read the number on foreclosures with a certain amount of skepticism. Why?" he said, "because my customers default on their loans, they give back the house, they don’t pay their mortgage, they go across the street, and buy the exact same house at a lower price." So the defaults are going to be overstated for that reason.

How important that is, he can’t tell me. He tells me it’s important for his bank, whether it’s universally important or not [1:20:00] we’ll find out eventually.

Second, let me talk about, so … I think that they’re a great deal of exaggeration about the disaster in the housing market. I believe that people on Wall Street saw a disaster because their positions in mortgages were underwater, and so what they saw was something they have, if they have anything on Wall Street, they have hubris, and they believe, "If things are bad for me, then they’ve got to be bad for everybody." But that isn’t true. They were talking their position.

I agree with those who say that the Fed, one of the Fed’s responsibilities is to act as lender of last resort. I have believed for, maybe forever, that the Fed is the lender of last resort to the financial system, not to the banking system, not to the member banks. And I have nothing … I have mostly praise for what they did in their lender-of-last-resort role. They said, "We have an obligation to protect the payment settlement system. We can’t allow the settlement system to fail. What we did for Bear Stearns was essentially what the Congress instructed us to do for banks when it passed FedICIA." It said, "Get rid of the management, wipe out the stock holders, and keep the institution running, because we don’t want a to eliminate what economists call ‘network externalities.’ " The fact that people were trading with each other and depend on each other to trade, that they get hurt when one of their trading partners goes down. Sure they can find somebody else, but there’s going to be a bad period while they search around. So keep them operating, wipe out the equity and wipe out and eliminate the management. And basically that’s what the Fed did.

Now in order to do that under the gun of waiting for the Japanese market, or wanting to get it done before the Japanese market was open, they said, [laughs] "We’ve got to have a deal by 7:45 on Sunday evening." That’s the same as telling a shrewd operator like Jamie Dimon, "You name the terms," and he did.

That … maybe there was no other way to do it. In any case, that’s what they did. So I have nothing to criticize about the bulk of their policy of maintaining the payment and settlement system. It’s been, for the most part, successful. The biggest problem that seems to remain shows up in the rate on the London Interbank Borrowing Rate, the Libor rate. No one, as far as I know, knows quite why that rate doesn’t come down. My own conjecture is that it has much more to do with Europe than it does with the United States. That is, that is has to do with the fact, rumors, that the Landesbanken, the German Landesbanken, or at least some of them, are deeply troubled by the bad loans that they haven’t yet announced in their portfolios, and that this affects the London … the European credit markets more than the United States. There may be other reasons, I don’t think anyone knows for sure. But the Fed’s policy seems to me to have worked reasonably well.

I disagree with my colleague Desmond on many things, but especially on the fact that he uses nominal rates to point out that they haven’t brought them down. But the inflation rate is now the expected inflation rate looking forward is about 4.8 percent for the year ahead, and I’m going to say a few things about that.

The part of the Fed policy that I don’t like is the inflationary policy which has led to a severe devaluation of the dollar, to an increase in desire for protection, to bring back a lot of the problems that we have had, and make them worse.

In you folder you’ll see 2 pieces of paper that sent to you from the web site of the Federal Reserve Bank of St Louis. One shows the extraordinary, and it is extraordinary, growth of M2. It has really taken off since the Fed began its severe easing in January. You can see that if you look in your packet. The other is a statement which … If you look at, [1:25:00] from the same source, if you look at bank credit, all banks, large banks, C&I loans (Commercial and Industrial loans) you’ll see that there’s hardly a break in the rate of increase.

In spite of all the talk that you hear over and over again on radio and TV about the credit crunch and how you can’t borrow and no one can borrow, just look at what’s happening and you’ll see that people are borrowing. And that while there’s been a slight decline in the last couple of weeks, that the rate of growth of loans and leases and bank credit, and especially all banks, banks outside of New York, that’s now …

Why do we get this news? Well because New York plays an important role in the financial system, and the Fed, in its history … throughout its history, has always been very sensitive to the attitudes and feelings of the New York bankers. They are an important part of the economy, not quite as important as they think, but important.

Second, I would add to the discussion of the possible recession the fact that if we you look at the unemployment rate, it’s risen, and it will probably rise more, but it’s still below the long-term average of the post-War period. So people are working, not in New York perhaps, but they’re working. And a measure which is more contemporaneous than the unemployment rate, which is a lagging indicator, is … how long it takes a person, on the average, who loses his job to find another job. Currently, the median for that is 8 weeks, a year ago it was 10 1/2 weeks. So it’s improved. Now it will get worse, but …

How I would describe the situation is, as I said, I think that there is a real problem for households and consumers because of the increase in gas and energy prices and food. There’s the possibility of all sorts of shocks that could happen. The German Landesbanken may fail, the Bundesbank may not bail them out, very unlikely, but possible. There are all sorts of things that could go wrong.

If you want to look for a list of things that can go wrong, talk to Desmond. [laughter]

John Makin: … have gone wrong …

Allan Meltzer: No, might go wrong.

The Fed’s policy, what I dislike about the Fed’s policy is it strikes me as a return to the mistakes of the 1970s. In the 1970s the members of the Open Market Committee [FOMC] were not stupid, they knew that they were producing inflation. What they told themselves and each other over and over and over again was, "We will stop the inflation before it gets bigger, or before it gets worse." And then the time came, and they did it, and the unemployment rate ticked up, and that was the end of the anti-inflation policy.

So fine tuning, stop-and-go policies failed. And they’re going to fail again. That’s my biggest concern, and we have seen, in the Euro market, M3 growth, which is what the Euro central bank watches, is up 12 percent. You can look at the chart of M2 growth for the United States and you’ll see that it has really ballooned. And as I said, the expected rate of inflation one year ahead is now 4.8 percent. That’s getting up there.

The Fed, when you listen to Bernanke, others from the Fed, Don Kohn, talk about the problem of inflation. They say, essentially, without using the words, say, "we’re relying on the Phillips Curve." That’s a weak reed on which to lean. It failed them. Athanasios Orphanides wrote a number of very good papers pointing out how that policy failed in the 1970s. It failed because, he said, pointed out, because we don’t know what the expected rate of growth is going to be. We can only guess at that, and we usually, often guess wrong. And it moves around more than the Phillips Curve, which assumes it’s constant, would like us to believe.

We see, in forward looking markets, traded good prices up, [1:30:00] depreciation of the dollar up, lots of signs that the market is anticipating continued inflation and at a higher rate. The Fed thinks, and says, that when the economy slows, inflation rate will come down. Maybe. That’s a weak bet on the Phillips curve, or strong bet on the weak Phillips Curve.

The lesson that I draw from reading and writing the history of the Fed is that most of the time, the Fed is not independent. Really isn’t independent. It’s whipped around by the Congress, and that’s what’s happening now, and Mr. Bernanke is not standing up to the Congress, not … at least negotiating with them, but in a sense giving in to them. They also are very much under the gun from Wall Street. People who hold bonds and mortgages are underwater, they’d like to see interest rates lower, in the hope that those bond prices and their losses will get smaller. And, although I don’t know this for certain, I would be surprised if Mr. Bernanke’s telephone doesn’t ring with phone calls from the Administration as well.

So I sympathize with him. I mean he’s under pressure all the time. He’s yielded to that pressure and he’s gone back to doing, to making the mistakes that got us into trouble in the ’70s. I hope I’m wrong, we’ll see what happens. At least we begin to see that expectations in the market that were, a few weeks ago were called for a 1 1/2 percent Federal Funds Rate by June have now come back up. So the Fed may stop cutting, but I don’t want to see them stop cutting. I believe the policy that they have to pursue is one which says, "We cannot run the economy from quarter to quarter. Our influence — we know for a long time that what monetary policy does, it does over a period of uncertain length, but at least 9 months or more on average."

So we should run the monetary policy as if that were a fact. As if what we can influence is the average at which the economy moves. The Fed’s best policy was the policy … the best policy over its history was the period from 1985 to about 2004. It essentially followed, not deliberately, but it followed in effect John Taylor’s Rule. And that policy worked very well on average. It kept down unemployment, it kept down inflation. It deviated from that policy now, and it ought to get back to it. It ought to pursue a policy which aims at the middle course.

I want to close with one last comment, which is — why did we get into this mess? and what do we have to do to prevent future messes of this kind? I believe that there are two reasons, which very few people talk about, but which need to be discussed more. One is the bad regulation, which Charlie Calomiris mentioned, Basel. The Basel agreement said to banks, "If you hold more risky assets, you’d better hold more reserves." So you’ve got what is the usual thing. Lawyers make the rules, the market figures out how to circumvent them.

The incentives were all wrong. The incentives were, take it off the balance sheet and put it in these strange instruments that we invented. And then we don’t have to hold more reserves, and we didn’t. That was a silly, foolish policy. Regulation, if there is to be regulation, has to worry about, what are the incentives that are being created? It isn’t easy, but if you’re going to have regulation, you’d better worry about it. What are regulators going to do when they see the regulation?

Second and last, the incentives in the market are geared to making short-term profits. You have to ask yourself, why do the MBAs, my former students, students from all the best business schools in the world, why were they buying and selling pieces of paper that they had to know were worth not much? The answer is, because if they didn’t do it, in most firms they lost their jobs, and if they did do it, they got big bonuses. That’s not a very good system, that’s how we got the dot com problem, [1:35:00] and that’s how we got the housing problem.

So what we need to do is to change those incentives, and an easy way to do it would be to average them over 5 years … average their returns over 5 years. Do something other than what we’re now doing.

If we don’t do that, we’re dealing with a market in which people borrow short and lend long. So it’s always going to be subject to some kinds of ups and downs. They’re unavoidable, but we can make them much less … more more avoidable if we change the incentives, both the regulatory incentives and the incentives of the participants.

Peter Wallison: Thank-you very much, Allan. OK, our last speaker is Vince Reinhart. He’s the newest member of this team. He’s a Resident Scholar at AEI and a former Director of the Federal Reserve Board’s Division of Monetary Affairs, and he’s spent more than two decades working on domestic and international aspects of US monetary policy. … Vincent.

Vincent Reinhart: Thank-you Peter. [speaker was obviously using a slide deck, but this was apparently not uploaded to the event site] Those thanks, of course, are tinged with regret [laughter] that you couldn’t see past the tyrrany of the alphabet, and so I have to speak 6th, after so many disparate views were expressed. And actually, it reminded me of something F. Scott Fitzgerald wrote, which was, "the test of a first rate mind is an ability to hold opposing ideas at the same time while retaining the ability to function." Perhaps it could also be said about a panel, although I would note it was in a book called "The Crack-Up."

I’m going to talk about 3 things in terms of what lies beyond the credit crunch. The current state of the US economy, that is the current conjuncture, the outlooks for the US economy, and then I’m going to argue is that there are really two distinct possibilities, and then the financial world after March 14th. I date the changing not at 7:45 on the 16th, but 8:15 on the 14th.

First, in terms of the the current conjuncture, the ongoing house price … housing correction is posing 3 drags on US economic activity. First, there’s the direct inventory correction as builders cope with excess stocks. And I would point out like Des, they’re chasing a moving target in that they are cutting back production even as sales fell ever faster, and we see the inventory / sales ratio rise.

The good news is, that sector is getting arithmetically smaller and smaller, so the contribution to the drag should lessen over time. But in addition, reductions in house prices are reducing wealth, slowing the growth of consumption. There you have the 2 favored house price indices on the right of our panelists; either the OFHEO index, the solid line, that Charlie prefers, or the thin line of the Case-Shiller. But the main point being that house … households, of about $23 trillion worth of housing wealth on their balance sheets are feeling less wealthy, and will have less wherewithall to support consumption.

You might argue that’s not a bad thing, given the saving rate being so low. That adjustment needed to happen. The question is, that it happens in too narrow a window, you’ll slow total aggregate demand.

And then third, a deterioration of the balance sheets of large complex financial institutions has made credit more expensive and difficult to get. The last panel is the net stardards on C&I lending, which moved up sharply; but nowhere nearly as sharply as the right panel, which is net standards on mortgage loans, that just took off in the last survey in January. And I look forward to seeing what the results of the survey are next week because presumably there’s one in the field.

The obvious question is, is this a recession? It’s not an an obvious answer for, I think, the reasons Kevin talked about. What I’ve plotted there is my favorite contemporaneous indicator of recession, and that’s the contribution to the unemployment rate of short to intermediate spells of joblessness, that is, the unemployment rate for people who have been unemployed under 26 weeks.

What you note about that indicator is, it moves very asymmetrically between recessions and expansions. In recessions, the yellow area, it goes up about 3 tenths of a percentage point a month. In expansions it mostly moves sideways, actually it declines on average by a tenth ever 6 months.

We have had [1:40:00] a weak job market, we’ve had a string of declines in employment, but that indicator, as most indicators of the labor market, haven’t moved sharply in the manner that we would normally associate with recessions.

Hence you get the ambiguous conclusion that we’re either in or about to enter a recession, or we’re probably in the third month of … third quarter of real GDP growth averaging something like a half percent.

In either case, it feels pretty badly, and I think in some sense it’s a consequence of the Great Moderation and the economic growth. If you look in the upper left panel, that plots real GDP growth since 1930, and quite clearly, from 19… around 1983 onwards, something happened, and that is, the growth or real magnitudes (and nominal magnitudes as well) became much less volatile. Ecomonists called that the Great Moderation.

What has accompanied it is what I would call the Great Whining, in which public sensitivity to a slowing economy has increased. In some sense the total amount of news is about unchanged, you just need a bigger response to each basis point of slowing associated with the moderation in economic activity. And one place you can see that is if you look at … go to Google Labs and look at Google Trends. That just looks at the number of hits, and number of newspaper articles in the bottom panel, using the word "recession." What’s striking is you can actually extract it from Google, is they do that for longer periods of news articles alone. And you see that the increase in references to the word "recession" this year is about … made up about 2/3rds of the increase in 2000 / 2001, and even more now than was the case in 1990 and 1991. I think that all that’s supposed to mean is you should filter what we hear, commensurate with the reduced volatility in macro aggregates.

Now what I’d like to do next is so … in terms of the current conjuncture you get your choice. We’re either in the 3rd quarter of growth averaging something like 1/2 percent, or after the fact, a few of those numbers will be revised down, and we will be technically in a recession. Going forward, I’d like now to talk about the economic outlooks, and that’s actually not a typo. Much of financial market behavior depends on expectations. Markets with an important role for expectations have really interesting theoretical properties, like you observe herd behavior where people follow the first movers, they have the possibility of self-fulfilling prophecies where just the thought of something going wrong makes that … makes something go wrong.

You also have the possibility of multiple equilibriums. That chart on the right is something out of a Brookings paper I wrote with Brian Sack, and it gives this little example of … consider a market where Agent A’s participation in market trading depends on the participation of Agent B. And similarly Agent B’s participation in market activity depends on the participation of … expected participation of A.

What you get in that particular case are two outcomes … potential outcomes. A high trade equilibrium and a low trade equilibrium. If everybody goes to the restaurant with long lines, one could imagine if not enough people show up, you crash. A lot of people show up, you’ll succeed with the long lines.

Same thing in market participation. If a lot … if it’s expected a lot of people will participate in market activity, then you’ll participate in market activity and get a high trade outcome. If, however, you fear that not much of your competitors will participate in market activity, you wind up with a low trade outcome.

I’m talking about that because financial markets do pose right now a quite distinct set of risks. We’re seeing, back when macroeconomics were fun, we’d … people would talk about fallacies of composition, that is, individual behaviors don’t necessarily aggregate up to good behavior at the macro level.

What we’re seeing now is the paradox of deleveraging. It is in the individual interest of every large complex financial institution to shrink their balance sheet so it’s … so that they have balance sheet ratios [1:45:00] more commensurate with the lower capital they have after they’ve realized the losses on their mortgage portfolio. And it is in each one’s interest to do so, but if everybody does it at once, you wind up, potentially, in the low trade equilibrium where there is no market clearing, because everybody’s trying to sell at once.

So I take that to mean, in the high trade outcome, the large complex financial institutions come to grips with that problem by getting more capital. That would allow financial markets to improve, financial conditions would improve, allowing the substantial easing of monetary policy, that is, the reduction in short rates in the upper right panel, to show through and support economic activity. At the same time, there’ll be additional impetus associated with the 5th … the tax rebates and, not inconsequential, the dollar depreciation, which has encouraged net exports, as you see the dollar depreciation in the middle panel, and the net contribution of real net exports of goods and services in the right panel.

So in the high trade outcome, it works because firms get more … trading firms get more capital, that supports better market functioning, and the considerable policy ease by the Federal Reserve will show through.

[crosstalk -- Peter replenishing Vince's water glass]

Let me go on record as saying, "The glass is one third full."

In that high trade outcome, in fact, the Federal Reserve’s problem will be to remove excess accomodation as quickly as possible. You see in the upper right panel, the solid line, core PC inflation is in the neighborhood here of 3 1/2 percent and, rather … the total PC inflation is in the neighborhood of 3 1/2 percent, and the core PC inflation, the dashed line, is hovering at 2 percent. And we know from the central tendency forecast published in the minutes [of the FMOC] both in October and March, that the committee’s implicit inflation goal is an outcome for that index somewhat less than 2 percent.

So if they want to satisfy their own internal goal, they’ve got a problem with inflation, and it is a problem with inflation that could be more serious given, as you see in the bottom 2 panels, the considerable increases in commodity and oil prices.

So in the high trade outcome, the Federal Reserve is going to have to show that its policy of … in this new post-gradualist world, is symmetric. That is, it’s got to be willing to tighten policy as quickly as it eased policy.

That might not be as hard as you think, because if in fact, in that high trade outcome, financial markets improve; that is, spreads narrow, t would be a natural thing to remove the policy accomodation put in place because of the unusual circumstances in markets, once those unusual circumstances lift. And they’d be able to show that they learned the lesson of 1998 and 1999; they learned the lession of 2004.

So in that high trade outcome, what we’re witnessing is a price discovery process. The people who have capital are holding out for a better price. Some have already moved, some more will move, and we’ll get a recapitalization in the banking system. …

But there’s a low trade outcome too. You can align your balance sheet ratios to what is desired either by getting more capital, or, with your depleted capital, shirk your asset … the asset side of your balance sheet sufficiently.

So the alternative in the low trade outcome is that capital doesn’t come in from the private sector. Large complex financial institutions have to shrink their balance sheets in order to bring them in better alignment with their depleted capital. Financial conditions do not improve. Now they don’t get worse, because the Federal Reserve has established a floor on market functioning with the primary dealer credit facility. If no primary dealer is allowed to fail, then there’s no reason to have runs on primary dealers, and market functioning doesn’t get worse.

But in that environment, there is no financial stimulus to show through the economy, because spreads are still high. And you have to worry about other parts of spending, including [1:50:00] non-residential construction, and the willingness of households to continue to spend in an environment in which there’s obvious turmoil.

And so the economy moves sideways or weakens if in the end the way large complex financial institutions deal with their balance sheet problems is by continuing to shrink their balance sheets.

Now we’ve talked about the primary dealer credit facility as establishing a floor on market functioning. I’ve got to consider, just a little bit, the world after March 14th, and I would agree with the other panelists that the Federal Reserve is to be commended for using both the size and its composition of its balance sheet to affect the economy. It’s the size of the balance sheet that determines the Federal Funds Rate, which has been eased aggressively to offset weakness.

It’s the composition of the balance sheet that influences market functioning. Essentially the Federal Reserve has been swapping with the private sector for illiquid assets, their mortgage related securities, for which there is no effective market, in return for either reserves, through long term RPs[ph] or the term auction facility, or for Treasury securities, through the Term Securities Lending Facility.

And that is, in an imaginative way, to use, to expose the Federal Reserve’s balance sheet to credit risk, to stem the deterioration in market functioning, to buy time until that capital comes. And recognize, however, your central bank doesn’t provide capital, your central bank provides temporary credit, and they’re buying time for that capital to come.

I would argue that the decision to lend to Bear Stearns, and extending lending to all primary dealers through the primary credit dealer, primary dealer credit facility really was the worst policy mistake in a generation. And I think it will be comparable and longer … with longer term consequences to the Great Contraction and the Great Inflation. And part of the reason we don’t see this is we tend to jump over the range of possibilities. And that is, if you give me the choice between Bear Stearns failing setting off a cascading multiple failures of other financial institutions, or the Federal Reserve providing them funds, I can understand the argument for the Federal Reserve providing funds.

The problem with that is the excluded middle — the possibilities that we don’t really … that we haven’t talked about. Like, would it be possible to have a tougher line with JP Morgan? Were there other suitors that could have been pursued? Was it possible to lift out the troublesome part of Bear Stears’ portfolio? Would it have been possible to do an on-the-spot term securities lending facility? All those things, short of lending to the dealer, could have been possible, but weren’t obviously pursued, and we’re going to live with the consequences.

What are those consequences? I think it eliminated forever the possibility that the Federal Reserve could serve as an honest broker. What’s that mean? Well, think back into September 1998, when 17 large firms were brought together in the Director’s Room of the Federal Reserve Bank of New York, and told, "You’ve got a problem, find the capital to solve it."

I think after March 14th, the … the reasonable question any one of those people in the room would now ask is, "and how much will you contribute to that solution?" And I think that’s changed what we think of our central bank.

It’s also tilted the political playing field toward direct mortgage relief. Why? Well, most households either own their home outright, or [are] meeting their mortgage payments, or [are] renting. And when asked the question, "Do you want to help the people down the block who got overextended?" As really a statement of fairness, say "No." However, if you reframe the question and say, "Now that the government has helped an investment bank, do you also think it’s appropriate to help the household down the street," and I think the answer is much clearly, more likely going to be "Yes." Because a question of fairness … unfairness among households has been translated into a question of unfairness between households and investment banks.

I think it also legitimized increased supervision and regulation [1:55:00] of a much wider portion of financial activity, and so the irony here is that concern about a prior mistake, the Great Contraction, may usher in a period of re-regulation that’s going to change the way the financial systems work for a very long time.

Peter Wallison Thank-you very much, Vince. OK, this is an opportunity for people on the panel who have disagreed, if that can be imagined, with others on the panel to have their say. … We can go down the line? And why don’t we start with Charlie?

Charles Calomiris: I know there are a lot of us, so I’ll try to be quick.

What I want to do is try to recast our discussion a little bit. Instead of nitpicking, because obviously there are a lot of data that we could all argue about, …

When I gave my presentation in December, and actually in September at the FDIC it was the same one, more or less, and now, the point that I was making was that we do have a benchmark of comparison to talk about. And that benchmark of comparison is — the 1989-92 capital crunch and credit crunch and recession, which Ben Bernanke made his reputation on, by the way. And my point was, things are different now in a lot of ways, and most of the ways in which things are different are better, and that if you’re looking, as many people of the time then, and still are now, if you’re looking at that experience, from the standpoint of the way the banking system is likely to affect the real economy, that we should think that it’s not going to be nearly so bad.

And so all along I’ve been saying –

• Is there going to be a contraction in credit? Yes.
• Are credit terms worse and likely to get worse? Yes.
• Will housing prices fall? Yes.
• Will there be a recession? Possibly, but if so a fairly shallow one, and not a very long one.

So I’ve not been arguing that we will necessarily avoid a recession, but rather that if we have one it’s going to look more like 2001 in terms of its cost relative to potential GDP than 1989-92.

So I want to be clear, that’s my benchmark of analysis. And if you look at all the things that were going wrong during that cyclical experience, whether you’re looking at the stock market, or whether you’re looking at credit conditions generally — not just in terms of percentage of people who believed it’s getting tighter — I find that a ridiculous statistic. If things are tighter, we all know they’re getting tighter. But how much, how bad?

Or if you look at the amount of capital being raised. Peter put up over $200 billion. By what I’ve got here from the FT [Financial Times of London], John questioned the number, it’s about $180 billion. By any measure, the 1989-92 was effectively zero.

This is very different from 1989-92 already, by everything we can look at. Now does that mean that we’re going to get out without a recession? Maybe not. But that’s not really the point, and so people are dancing a little on this, in my opinion, right now — economists. And I want to be clear, I’m not dancing. What I said is what I’m still saying, and I think that’s the metric that needs to be used here.

So I don’t really disagree, and I thought last time John and I agreed that by OFHEO’s measure we might find a 5 or 10 percent decline. I still think that’s true. Case-Shiller’s a different measure. You can trade futures on it, it’s a well defined measure, I don’t think it’s as useful for us in thinking about the macro economy.

I would also say, at the last meeting, right after it, actually, John and I talked about Bear Stearns. And we both believed, and this was in December, that Bear Stearns was likely to go. Do you remember that? And why? Because Bear Stearns had a uniquely high asset-side exposure to the subprime crisis, and it’s gearing was higher — that is, its leverage ratio — was higher than any other investment bank. And when Bear Stearns went, on the day that it went I was asked, and I publicly said, no other invest- … Now that the Fed has come in with liquidity, no other investment banks will go, because none of them has that exposure.

Lehman Brothers was much better diversified and was less geared, and nobody else was even close to their exposure. There really was a difference between Bear Stearns and the other investment banks.

So I just want to emphasize, the Fed’s response was predictable, and I predicted it, and I think it should have happened. It’s not like things have happened between December and now. That’s why my story hasn’t changed, because I thought it was going to be a severe crisis, in some respects, it still has been, but is this going to be 1989-92? That’s the question people at the Fed were asking me, and the people at the FDIC were asking me in September, and I said, "No." And I still say no. And everything that we’ve learned between then and now still says no. That’s the metric. Not say, "Do I think we’re going to have a recession? Is it going to be a little flat for 2 or 3 quarters?" That’s really kind of … you can waffle. And I … Frankly I think Des and John are waffling.

Of course [2:00:00] there’s going to be some weakness in the economy, but the real question is — put down your stake and say: cumulative GDP decline’s going to be worse than it was in ‘89-92.

Basically I say, "Put up or shut up."

Peter Wallison: Well … Kevin …

Kevin Hassett: Gosh. I have two questions for my colleagues. The first is that … I saw a little bit of dancing around — I saw a little bit of sleight of hand in the charts that I’d like to address, which is that on one hand, the folks who wanted to … who want to argue that it’s going to be really bad will show that prices have declined in they’ll show the Case-Shiller index and say, "Oh, look, it went down a lot." And so there’s a lot of trouble coming. But then when we look ahead, then we got a chart that said, "Oh, the prices haven’t gone down nearly enough." And that was the OFHEO index, which is the one that hasn’t gone down.

And so the OFHEO / Case-Shiller — there’s been a very complex argument going up here between these guys on this thing. And I’d just like to know — if we looked at the Case-Shiller index, and the decline that we had, then has that gone closer to trend, or I guess it hasn’t been around that long, so maybe we can’t tell. Is the gap between the Case-Shiller index and the trend about the same as OFHEO. That’s my question for Des.

My question for Vincent is that he had very strong language about catastophic policy errors, the worst … But after you said that, I didn’t really follow what was so catastroph– like we’re going to have to have more regulations, I guess that … right? … we’re really, you know, wearing your AEI badge proudly to make that … But you didn’t really say, you know, what’s … I didn’t see the catastrophe. And I’d like you to flesh it out a little bit for me.

And I’d like Allan to just weigh in on the historical judgment that it really is one of the biggest policy blunders that we’ve had.

Peter Wallison: Des …

Desmond Lachman: I’ve been accused of many things in my life, but waffling I don’t think is one of them. But that’s always a first, so I’d be rather clear that I think that we’re going to get several quarters of negative growth going forward, and cumulatively we’re going to see GDP, I think that the IMF forecast is pretty accurate in that we’ll see GDP declining by something like 3/4s of a point before this is all over, and we’ll get a really modest recovery.

I’m just … would agree with Vince that if one could solve the capital problem of the banks, I think that I wouldn’t be that concerned. My concern is that this might be a moving target, that as we get the economy slowing, what we’re going to get is we’re going to get larger losses, we’re going to get greater need for capital. So I’m not sure that this is that easy a task. And I don’t think that one can really look to the sovereign wealth funds to solve that.

Just with Vince, I’ve really got a question. I cannot understand his saying that the consequences of the Fed’s decision are really awful, and I would share that view. But I’m not sure that I understand what their alternative was, particularly with the size of the credit to swap … credit default swap market, that derivative market, is now something like $62 trillion, and what I’ve been reading is that Bear Stearns had enormous exposure to that market, and that really underlay the reason why they had to do that, otherwise they’ve just got counterparty risk running right through the system.

So I’m really not sure what the alternative was for the Fed.

Peter Wallison: John

John Makin: Yes. You know, you can read what I think every month in the Economic Outlook. I’m afraid Charlie hasn’t been doing his homework, but the rest of you can read it. On September 8, 2007, I wrote an Op-Ed in the Wall Street Journal that said, "Well, we’ll have a recession starting early in 2008." And since then I have tried to follow along with that and suggest where we might be going. And so far so good as far as that goes.

And it … As I recall, in our December meeting, there was a pretty strong conviction among many on the panel that there wasn’t going to be a recession. But it’s not … it’s not productive to go back and look at these things. I suppose, yes …

I think the Bear episode is an interesting one, and I do remember my conversation with Charlie. I would point out that there’s one thing that we didn’t anticipate, and that is that the Bear problems would spread to other investment banks, and that were Bear allowed to go under, and it would have been perhaps the right thing to do, other investment banks [2:05:00] would have been next, because counterparties with the investment banks would have had very little choice other than to withdraw their lines and those investment banks would have been compromised and would have gone under as well.

So it got a lot worse a lot faster than I anticipated, and than most of us anticipated.

My last comment is a question to Vincent, which I … I think the Fed got into a position that they ought not to have been in. That is, where they had no choice but to do what they did. And part of the reason they got there was the Fed’s staff consistently, consistently failed to foresee a recession or near-recession, and they have since played rapid catch-up.

And the FOMC consistently mischaracterized the economy. And they were complacent. Having been complacent, they got behind the curve, and they got to a position where, had they not taken extraordinary action, we would have had a financial meltdown.

My question to Vincent is this: Maybe one of the Fed’s options would have been to expand its balance sheet, rather than rearrange its balance sheet as part and parcel of some of the activities that it undertook on that day. Does that strike you as a good idea? Because that was the point that I was trying to make in the Wall Street Journal 2 weeks ago, where I basically said, "If we don’t contemplate an expansion of the Fed’s balance sheet, the housing disaster will be so bad that we will get … we’ll essentially nationalize the mortgage market. And that’s not a good thing.

Peter Wallison: I think we’d agree. Allan, do you have any comments you’d want to make?

Allan Meltzer: Couple of quick comments. Thank-you Vincent [for the mic] …

It’s not quite true that the Fed had no choice. It had a choice, it could follow what Bagehot advised them to do long ago. That is, let Bear Stearns go, promise to lend to the market, and if there’s a big run on the CDOs, buy what you have to. Lend at a penalty rate. That was Bagehot’s advice. I think it’s still … it might have worked under those circumstances.

In any case, what the Fed did was in my book not necessarily the best thing they could do, but it was a good thing to do.

People talk about the wealth effect. One the first papers I ever heard as a graduate student was Milton Friedman talking about the permanent income theory. How much of the wealth loss is permanent, how much of it is temporary? That’s a big question. To people who see the value of their houses go down, do they assume that they’re going to stay down, or do they assume that they never should have risen as much? And therefore they’re not going to allow their long term behavior to be affected.

On the same score, I think that (I’m on the side of the permanent income view by the way) On the same score, I think the Fed is making a mistake by talking about the core rate of inflation. The core rate of inflation is a good idea, normally, because it separates our transitory movements from permanent movements. But to me, the oil price increase, the food price increase, look like permanent movements. And therefore, the core is not going to be … it’s going to be misleading to them. And it is misleading them, because they think that the Phillips Curve is going to affect the core and prevent the inflation [undecipherable] …

Finally, policy blunders. Oh, gee! I have a 1,300 page manuscript full of policy blunders. [laughter] I mean, you’d be amazed …

voice: … forthcoming …

Allan Meltzer: Forthcoming. You’d be amazed at the number of blunders there are.

Where does this one stack up? Well, depends on how draconian the regulation’s going to be, and how adept the market will be at circumventing it. My bet will be on the market.

I would like to see a very much less regulation that we’re going to get, but some, some would says[ph], which I’ve talked about before, which ties the compensation of the market participants to something like their long-term performance, rather than their quarterly performance, because that seems to me to be an invitation to problems of this kind.

You have to remember that underlying all of this is the fact that all these financial institutions borrow short and lend long, so when something goes wrong, there’s always the possibility of a big problem.

And finally, I don’t try to forecast, and I don’t think, having studied forecasts that other people make, looked at how the Fed reports its forecasts, their forecasts, which have been [2:10:00] very good during the period of the Great Moderation, still made an average error of about 40 percent. That’s not something you want to rely on a lot. As I’ve said before, try to aim for an average policy. We did very well with that in 1985-2003, we would be well advised to get back to it, and to teach people in Congress and the marketplace that that’s what we’re doing.

Peter Wallison: Vincent.

Vincent Reinhart: I do agree that there is certainly the opportunity for well designed financial regulation to curb the multiple incentive problems that have shown up in the mortgage market, from the mortgage brokers who were compensated by volume as opposed to performance of loans to the rating agencies who were paid by the underwriters to the underwriters who were paid by volume and could shop for ratings to the final investors who were often … were sometimes in these collateralized securities who were taking advantage of regulatory arbitrage, or the special status and accounting rules given by … the stamp of approval from S&P and Moody’s.

I mean there’s certainly lots of scope for that. I’m not predicting whether there’s a recession or where inflation will be next year. What I am going to predict is — when that reregulation comes, it will not be the well designed, appropriately scaled to the problem. I believe that the great moderation owed importantly to deregulation and the marketization of more and more economic activity associated with advances in financial markets and financial engineering.

And so I worry that if the capital doesn’t come to the financial sector, that we have an extended period in which the economy is weak and moving sideways, that we will have a new President and a new Congress who will take the opportunity to reregulate and we will step back from those gains. And I think if we do this in 18 months, which we probably … 3 more times … [laughter] and that happens, then I think that we would move that up … move that policy action, the actions of March 14th, up in the list of your all time blunders.

[crosstalk]

Peter Wallison: OK, I think we want to get some time for questions from the floor, so let’s see a show of hands … people who are interested. Karen, we’re going to ask people to identify themselves, and then ask a question, not make a statement, because we don’t have a lot of time. Karen …

Jeff Wrase: I’m Jeff Wrase with the Joint Economic Committee. Jim Hamilton has this conjecture that the Fed, by keeping the real funds rate essentially negative right now, is adding pressure on things like the world food prices, commodity prices, because people aren’t storing wealth in these financial vehicles, they’re putting it in real things like commodities and wealth. Do you think that channel’s operating?

Peter Wallison: John.

John Makin: Yes. [laughter]

Peter Wallison: Anyone else? Anyone else want to respond to that?

voice: Anyone not think that’s the case?

Peter Wallison: … apparently not. Let me ask a question, because, … No one asked this question, or talked about it, but it seems fairly clear to me that there’s something that’s a real disconnect going on here. When we had the recession in 1998 to 2001, or the 2001 recession, I guess, is what I’m talking about, the market fell from [about] 11,500 (this is the Dow) to about 7,500. And it fell pretty quickly, as I recall. Why is it that right now, with this terrible things happening in the credit markets (and we have to agree they’re terrible, they’re unprecedentedly terrible), yet the stock market has not fallen substantially, and if it is falling, it is falling very, very slowly. In other words, investors don’t seem to be particularly worried about this unprecedented credit problem.

What’s the reason for this?

Charles Calomiris: I want to answer that, because you could have said in December, because the stock market made the same mistake in the 1989-92 period. That is, it didn’t adjust right away, it took its time. And that would have been a correct thing to say in December. I don’t think you can say that anymore. That is, the market has a pretty persistent consensus view that’s much more optimistic than some of the view’s we’re hearing on this panel.

And that’s also, … And I think [2:15:00] it’s optimism grounded in fact. This has already been a different experience.

So I think, … And the consensus forecasts, … Actually my views on the economy are not … I just sort of think the consensus forecast makes sense, which is … which I think is underlying the stock market price, that flat growth, which is pretty much what I expected and said, … I think it’s unlikely, still think it’s less likely than: yes, for us to end up in a recession, as I define it, which is 2 consecutive quarters of negative growth.

Now of course recessions get redefined, but that’s how I define it. I don’t think we’re going to have one of those, but if we do, it’s not going to be very severe.

So I think the market is saying that’s what it thinks.

Peter Wallison: Des?

Desmond Lachman: I can partially agree with Charlie, but I think that the market’s doing a lot more; is what the market is doing is it’s anticipating that your’re going to have a very sharp V-shaped kind of recovery, and you see that in the analysts’ estimates of what corporate earnings are going to be doing in the second half of the year. They’ve got corporate earnings really recovering remarkably in the end[ph] of the year.

So if you don’t get … If my view of the recovery is right, that you get a prolonged recession, there’s going to be a [laughs] reappraisal of those equity prices.

Just to go back to that question before, I think that was an important question that there hasn’t been discussed on this panel, and that is a risk is that the Federal Reserve reducing the interests rates is really reducing the interest rate differential in favor of the dollar, and what you’ve had is the last 5 years you’ve had movement out of dollars, and that looks like, since August, it looks like that that is a serious problem, and that could get worse, which has obvious implications for the way in which financial markets might behave.

Peter Wallison: Anyone else have any comment on the stock market?

John Makin: … You started by commenting about what happened in 2001. That was an investment led recession that investment dropped very sharply at the end of 1999, and then the stock market collapsed in the first quarter of 2000 because there was obviously excess capacity in the Tech sector. And then the recesion followed. This is just a different situation where it’s probably going to be a consumer led recession. The stock market is 11 percent off its highs. It’s discounting a mild recession and if we have a mild recession it’s priced right, if we have another leg down it will go down another 20 percent.

Peter Wallison: That could be right, John, but that’s why I put up that survey of the CEOs from the Business Roundtable. Because maybe they’re not, maybe they don’t represent the entire economy, but they don’t think there’s going to be a consumer led recession. They see sales going up. So what’s going on here?

John Makin: The consensus among CEOs at the Business Roundtable has zero predictive power [laughter]

Peter Wallison: Well same is true of economists at AEI [laughs]

voice: … not this one …

Peter Wallison: OK, let’s see, right here? Where’s Karen? … Oh, there’s Bert. OK, Bert? A question, Bert.

Bert Ely: Quick question. Bert Ely, banking consultant. This question is directed primarily to Charlie. Others might want to pitch in. There’s been a number of references to overleveraging and the need for banks to raise their capital standards. Charlie, can you tell us a little bit more about how high you think bank capital standards should go, particularly in light of how you were quoted⁸ in a Peter Coy article in BusinessWeek a week or so ago?

I thought I read something about a 20 percent capital ratio? (Which struck me as a little high) And if that’s where you think it ought to go, what effect do you think that that will have on the incentives within the marketplace to securitize even more bank assets than has been the case in the past.

Charles Calomiris: It’s hard to answer that quickly, but let me try.

The costs … The social costs of high regulatory capital ratios are pretty much zero if the regulatory capital ratio can be met over a sufficiently long period of time. Because it gives the banks the ability to raise capital when it’s very inexpensive to do it, and there are lots of reasons for that.

So my first point, which was underlined in last week’s BusinessWeek article, was that if you raised capital in gradual way, if you phase in the increase, it has virtually no social cost. And so, yes, I was arguing for a 20 percent [2:20:00] phase-in.

The other advantage of doing that is that … then during recessions you could do what Charles Goodhart suggested, which is you can allow the minimum capital ratio to come down.

So my point is, if you phased in a 20 percent — 8 percent is a magic number that came from politics in the Basel committee. If you go back and look at historical bank ratios with the kinds of risk that our banking system probably has, I think 20 percent is a reasonable number to phase in, but then to allow during recessions for it to come down to a number like 15. That’s a very rough number.

Pieter Bottelier: Pieter Bottelier at Johns Hopkins SAIS. None of the panelists explicitly spoke about possible connections between the financial crisis and the external imbalances of this country and global current account imbalances. Professor Meltzer identified two good causes of the current financial crisis. Is there one that is even deeper than that, namely current account balances? Can a sustained recover be achieved without very substantial reductions in US external deficits?

Allan Meltzer: My answer to the question would be: Yes, we can achieve a recovery. You can speculate all day on the demise of the dollar, but you’ve got to think about what takes its place. And the answer to that question isn’t very obvious. I mean, there are people who say, "Well the future currency’s going to be the Chinese yuan." Bet against it. There’s no financial market there, there’s no regulation there. I mean, the banks are undercapitalized, I mean that’s just a crazy idea.

The euro? I think the big question for the euro is going to be whether it can hold together if in fact it falls, … if in fact they have a recession in Europe. Will the euro hold together? I don’t see that as a currency. They don’t have a lender of last resort function to speak of. I mean they depend on each individual country to take care of its own, they don’t have a harmonized policy about that. That would be … And they don’t have a capital market like ours.

It’s true that they like to boast about the fact that … how many bonds they sell, and they do sell a lot of bonds. But that’s it. The capital markets don’t go beyond bonds. The US capital market, with all its problems, is deeper and more resilient, and you don’t want to pick a currency where that isn’t true.

No it is true that we do everything to discourage the dollar as a long run problem. I mean, reading more Federal Reserve minutes than any human being ought to ever be required to read, [laughter] I can say you can probably count on the fingers of one hand, and cut off a couple of fingers, about the number of times that they actually worried about the dollar.

Employment is the thing, most of the time. Employment, and then, in the 1980s, Volcker brought inflation. And throughout, unemployment. But it’s unemployment, and its unemployment now that the Fed worries about. And why is it unemployment that they worry about? Because that’s what Congress worries about. And Congress leans on them very hard.

So my answer is, I think there are lots of reasons why you’d want to give up the dollar, why people want to give up the dollar, but give it up for what?

Peter Wallison: John? … and then Des, did you want to … comment on this?

John Makin: With the US current account deficit, it is endogenous. That is, it’s determined by the desire to store wealth in the United States. And if that desire goes down, the current account deficit will go down, and to some extent it has gone down.

But I would turn it around and say, "How could the world economy grow if the US saves 6 percent more?" which is what it would take to get rid of the current account deficit.

The world economy would collapse, because US net spending is very important to support the global economy.

So I … I don’t quite understand — I mean, I know Larry Summers harps on this all the time — I don’t quite understand how a reduction in the US current account deficit has anything to do with a recovery.

Steve Entin: [2:25:00] I’m Steve Entin with the Institute for Research in Economics and Taxation. I was in the Reagan Treasury. Let me ask: Are we making a fundamental mistake in the allocation of the roles of the fisc [fiscal] versus the monetary authorities? It seems to me that we’ve been relying on the Fed to promote growth and to worry about unemployment, but as expectations catch up with inflation, and as inflation raises tax rates on capital, we tend to slump into stagnation or recession.

Meanwhile, the fisc doesn’t want to cut the taxes permanently, and least of all on capital formation, because of its class warfare arguments. So we keep hitting investment over the head with a 2-by-4. And I’m just wondering, if this crisis, which was met with great glee in the Capital, because it gave them an excuse to do something and break the budget and thrash around the way they have. It’s just going to lead to more inflation, and a worse economic outlook.

Peter Wallison: This is one for you Allan, I think.

Allan Meltzer: Nothing is certain in this world, but we’re certainly headed in that direction. The Fed believes, I think, that they’re going to stop it before it really gets underway.

I don’t believe that will happen, but who knows? You only know you pay your money and you take your choice. Markets, you can bet on the markets. Markets have the expected inflation rate at close to 5 percent a year from now. That seems to me to be a reasonable forecast, but subject to change.

I mean, if they don’t cut interest rates at this next meeting, if they raise interest rates as soon as they think they can, then I think [unintelligible] that will change.

The fiscal policy? The Fed fiscal policy has really been supportive of growth during most of the post-War period. Why is that? Well, there’s something called voters. They evidently like what they get. As the Vice President said to Paul O’Neill, Ronald Reagan showed deficits don’t matter.

We forgot to add, as long as the Chinese are willing to buy them.

Peter Wallison: Des.

Desmond Lachman: Yeah, I think that an important point in this discussion is whether it’s appropriate for the Federal Reserve to do the bailout of the housing market. You know, that it strikes me as odd that by taking on $400 billion of mortgage related securities of dubious worth, that that is the appropriate way for a decision to be made as to whether or not to bail out … you know, whether taxpayers’ money should be put at risk through a decision of the Federal Reserve rather than through the US Congress.

Peter Wallison: Well, we’ve … Yes? Vince?

Well we’ve reached 4:30, and I’m sure you’ve all now understood perfectly well what is going to be happening in the economy in the future. But we’ll come back again in September and we’ll ask our esteemed group here to explain their positions more fully, and I hope all of you will come back, because this has been very interesting and I think you’ll find it even more interesting then. Thank-you very much for coming. I want to thank the panel for a wonderful set of presentations. [applause] [2:28:54]

Notes and References

[1]: "What Lies Beyond the Credit Crunch? Part II", AEI event homepage, April 28, 2008.

[2]: "Stocks Finish Higher: Good earnings news from Ford, a drop in jobless claims, a rally in the U.S. dollar, and lower oil prices helped boost the major indexes", by Ben Steverman, BusinessWeek, April 24, 2008.

"The [stock] market is ready to move higher," says Chris Johnson of Johnson Research Group. "A lot of the bad news out there is priced into stocks."

On Thursday, the Dow Jones industrial average closed up 85.73 points, or 0.67%, to 12,848.95. The broader S&P 500 added 8.89 points, or 0.64%, to 1,388.82. The tech-heavy Nasdaq composite index rose 23.71 points, or 0.99%, to 2,428.92.

[3]: "What Lies Beyond the Credit Crunch? Part II" (PDF — with Figures), by Peter Wallison, April 28, 2009.

Figures

1. Progress In Narrowing The Spread, Which Is The Target Of Fed Liquidity Moves, Has Slowed: 30Yr Conventional MBS rate and its spread over 10Yr Treasury
2. Worldwide Bank Asset Writedowns, Credit Losses, and Capital Raised
3. Summary of the views of Business Roundtable’s CEO members about the year ahead

[4]: "Capital Ideas: Lawmakers should turn their attention to persuading banks and other financial intermediaries to raise more capital." (PDF), by Peter J. Wallison, The American, March 19, 2008.

[5]: "Not (Yet) a ‘Minsky Moment’ " (PDF — with Tables and Figures), by Charles W. Calomiris, AEI, Revised: from October 5, 2007.

Tables

1. Mortgage Originations by Product and by Originator
2. Absorption Capacity of Three Largest U.S. Banks, June 30, 2007

Figures

1. Annual Cash CDO Issuance
2. U.S. Home Price Appreciation
3. OFHEO HPI: Disaggregated by Case-Shiller Coverage
4. Annual Home Price Appreciation (OFHEO & Case-Shiller) vs. Share of Homes Valued Above $500,000
5. State-Level Annual Home Price Appreciation (OFHEO) vs. State-Level Changes in Foreclosure Inventory Rates
6. Foreclosure and Delinquency Rates
7. Foreclosure and Delinquency Rates (cont.)
8. Residential Investment by Household Sector Relative to GDP
9. Commercial Paper Outstanding
10. Commercial Paper Rates, LIBOR, and Mortgage Rates
11. Commercial Paper Rates vs. Federal Funds Rate
12. LIBOR, Treasury Bill, and Fed Funds Rates
13. Overnight Libor-Fed Funds Spread
14. S&P 500 vs. 10-Year Treasury Yields vs. Spread Between Moody’s Seasoned Baa Corporate Bonds and 10-Year Treasury Yields
15. Corporate Leverage
16. Real Household Net Worth Per Capita
17. Household Leverage
18. Commercial and Industrial Loans

[6]: "Household Expenditure and the Income Tax Rebates of 2001" (PDF), by David S. Johnson, Jonathan A. Parker and Nicholas S. Souleles, Princeton U, August 2004.

[7]: "What Lies Beyond the Credit Crunch? Part II" (PDF slide deck), by Desmond Lachman, AEI, April 28, 2008.

1. Title
2. The U.S. Economic Outlook Has Darkened
3. A Confluence of Negative Shocks Still Impact the U.S. Economy
4. US real house prices
5. Home Prices
6. Mortgage Equity Withdrawal
7. The Housing Bust Has a Long Way to Go
8. Real Home Price Index
9. A Large Inventory Overhang Remains with the Housing Market
10. Unsold Housing Inventories (in months’ supply)
11. Subprime and Alt-A Shares Quadrupled Between 2001 and 2006, then Fell in 2007
12. Ever Mor Stringent Mortgage Lending Conditions
13. Adjustable Rate Morgage Reset Schedule
14. Number of Foreclosures Started
15. United States: Equity Share of Residential Real Estate Values
16. Falling Prices Leave Homeowners with Negative House Equity
17. House price Declines Implied by Case-Shiller Future Contracts
18. Residential and non-residential construction spending
19. Measures of Demand for Commerical Real Estate Loans
20. The Credit Crunch Shows No Sign of Letting Up
21. U.S. Bank Credit and Lending Conditions
22. Speculative-grade bonds
23. Jumbo Mortgage Spread
24. CDX North America Inv Grade 5y
25. Share of Intermediation through Banks and Securities Markets
26. Face Value of Credit Default Swaps Outstanding
27. Policy Response Needs Strengthening

[8] : "How New Global Banking Rules Could Deepen the U.S. Crisis", Peter Coy, BusinessWeek, April 17, 2008.

… In an interview with BusinessWeek, Charles Calomiris, a finance professor at the Columbia University Graduate School of Business, put forward the idea of giving the banks a decade to sell more shares in stages and gradually raise their total capital to perhaps 20% or even 25% of risk-adjusted assets, up from the current Basel standard of 8%.

"….and then the great housing bust ended in 2010 and they all lived happily ever after…." - Lawrence Yun, chief economist, National Association of Realtors

O.K. Yun may not have said it exactly like that, but this looks pretty darn close. [Thanks L!]

Home sales will increase 15 percent to about 5.7 million units and REALTOR® income will be up 20 percent in 2010, NAR Chief Economist Lawrence Yun told a packed room of REALTORS® today in a residential economic update at the 2009 NAR Conference & Expo.

Yun credited the home buyer tax credit with unleashing sales on the lower-end of the housing market this year, bringing up to 400,000 first-time buyers into the market who wouldn’t have bought otherwise. That influx tightened inventories of starter homes, shored up prices, and helped reduce households’ fear over continuing price drops.

This virtuous cycle will continue now that the federal government has extended the credit to mid-2010 and expanded it to make a smaller credit available to repeat buyers and to households with higher incomes. “The key is stabilizing prices and preserving household wealth,” he says.

Yun predicts the supply of homes to stabilize at the historic norm of six to seven months. Homes above $500,000 will remain elevated in the near-term, but that weakness will be offset by a hefty drop in starter-home inventories, which are running at about a five months supply.

The tightening inventory at all price points will help improve market performance by bringing supply into better balance with demand, but the added sales, particularly on the higher end, will also increase the number and quality of the market comparables used by appraisers to assign valuations. Once appraisals improve, foreclosures will ease, blunting their drag on the market and making it less likely that Fannie Mae, Freddie Mac, and even FHA will need help from the taxpayer.

What a happy, feel-good story.  It’s enough to bring tears to your eyes. I may need a tissue….

Dr. Jay Butler of ASU’s Realty Studies has released his monthly report on the Phoenix housing market.  He says he see’s "signs of recovery" in the market, but then goes on to say the market is "still bottoming out".  Here’s what Butler said about sales:

In October, foreclosures on 3,815 homes accounted for 38 percent of the total market, according to Butler. This is an increase from September’s 32 percent, but a drop from the 46 percent of a year ago. That’s not the whole story, however. Approximately 45 percent of traditional transactions — 6,140 sales — involved properties that had been in foreclosure. That means foreclosure-related activity was 66 percent of the market in October — about level with September.

While sales have returned to the levels of the boom years, the market is being driven by speculation and foreclosures.  October sales undoubtedly received a bump from the concern of buyers that the $8,000 credit would not continue.  Speculators, however, are having a hard time finding renters for these properties–the rental market is glutted.  The Phoenix economy continues to be poor and is unlikely to sustain it’s former rate of immigration.  What we are basically seeing is the activity of vultures picking over the carcass–this is not healthy activity.

Median Price

The median price in the Phoenix market held steady at $140,000 in October, 20 percent less than the $175,000 of a year ago. The median price for foreclosed properties, however, rose from $136,800 in September to $153, 450 in October compared to $159,775 a year ago.

The median price is off of its lows:

Year-over-year depreciation seems to have moderated as well:

So is this the "bottom"? Are we seeing "recovery"?  Here’s what Butler has to say:

Recovery is a matter of definition. The ordinary homeowner expects recovery to bring his home value back to the level of purchase, but whether or not that will happen is an open question, Butler said. Another definition relates to market structure. Butler said that typically, foreclosures account for 3 to 5 percent of the market, a fraction of the current level.

. . .

"The current economic recovery is limited, with the possibility of higher rates and a continuing weak job market," Butler writes. "Further, the housing tax credit — which has been extended to April 2010 — could be dissipating the pent-up demand and weakening its influence in the coming few years. And, foreclosures will eliminate many households from obtaining home financing to buy another home."

Investors are making the market right now, Butler commented. Lured by low prices, they are buying homes to flip or to rent out. A lot of people are troubled by the fact that the market is still being driven by investors rather than buyers who intend to live in the homes. One perception is that the growth in rental houses will negatively impact the already weak apartment market.

All told, Butler thinks the market is still bottoming out rather than recovering.

My take is that this is a plateau, not a "bottoming".  This data is basically watching only the lower end of the market, as sales above the conforming limit are basically dead.  In September, about a quarter of listings were for homes over $400K.  As Butler pointed out, there were 18 homes in foreclosure this month priced at over a million dollars. This is a sign of things to come. We have not yet begun to see a bottoming in this segment of the market.  With upper-end housing going into foreclosure at an increasing rate, lower-end housing will have no chance to appreciate. 

I disagree that "recovery is a matter of definition".  When you think about it, housing is a consumer product. As long as consumers are in financial straights and concerned about the future, they are not going to be investing in housing.  Until Phoenix consumers have recovered, housing won’t recover–no matter what the numbers say.

Suddenly here’s another week where there’s just about no movement in foreign central bank holdings. The Fed’s own MBS holdings ticked up $1.179 billion, and the cenbanks’ total went down just a tad more than that. There’s a lot of volatility in the Treasury Debt weekly figure that’s coming out of somewhere, but I have no idea from where. This week’s Reuters report¹ was, as usual, based on the weekly update from the NY Fed’s H.4.1 table site.² Here is Doom’s updated CSV version³ of the agencies and treasuries foreign central bank holdings data set.

The treasuries buy collapsed again to a mild $1.748 billion selloff.

The agencies number increased $0.509 billion. There have been several sub billion dollar moves lately.

The net change of US obligations was actually a slight dip of $1.239 billion, but it’s going to take more than one week of negative growth before that treasuries bottle-rocket would begin to show a course change.

Needless to say, twist’s ratios graphs were flat (mild uptick).

The Setser 52-week chart converged in both lines (big treasuries buy vs agencies dump a year ago).

________________________

Notes and References

[1]: "Foreign Cenbanks U.S. Debt Holdings Slip in Week - Fed", by Ellen Freilich, Reuters / ABC News, November 12, 2009.

[2]: "H.4.1 Factors Affecting Reserve Balances", Federal Reserve Statistical Release (weekly), Federal Reserve Bank of New York.

[3]: The updated data set as a Comma Separated Value (CSV) file is here.

WASHINGTON (Reuters) – Not sure what to give Uncle Sam this Christmas? How about a nice, fat check to help whittle away at the $7.6 trillion national debt?

The U.S. Treasury Department accepts gifts, payable to the Bureau of the Public Debt. Just mail them to the attention of Department G, Post Office Box 2188, Parkersburg, West Virginia, 26106-2188. Make a note in the memo section that it is a gift to reduce the debt held by the public.

Yes, really.

It’s all on the Treasury’s website, at the end of the list of frequently asked questions.

What their FAQs don’t explain is why you’d write them a check when the money would be gone before the ink could even dry on the paper.  Or why, when it’s "Here a bailout, there a bailout, everywhere a bailout, bailout", we seem to be donating whether we want to or not.

Have anything to say about this story- or on anything else today?  You can’t be off-topic, this is an open thread.  Let us know what’s on your mind.

Oops.  It looks like one couple’s home loan was modified right out from under them:

PHOENIX — Despite being up-to-date on their modified mortgage payments, a Valley couple found Chase foreclosing on their home.

"You work so hard. Put a lot of money down on your house. You pay your taxes. You pay your mortgage, and it’s all stolen from you,” said Jeff Zerner, the homeowner.

He and his wife, Yanthy, found out about the foreclosure when the new owner posted a notice on their door Nov. 4.

“I get this notice that says you have five days to vacate the property,” he said. “So I called the number (on the notice) and I say, ‘Who are you?’ and they say, ‘We’re the legal owners of this house. It went up for foreclosure."

Just days before, the Zerners thought their home was safe. They had finished their trial modification with Chase and were led to believe they would qualify for a permanent modification.

“We paid Chase several hundred dollars, which they accepted in good faith,” said Zerner. "I feel extremely ripped off.”

Chase officials admit they made an error by selling the house.

How did this happen?

Loan modifications and foreclosures are parallel processes. In the Zerners case, the sides failed to communicate with each other to halt the foreclosure until it was too late.

It doesn’t sound like the bank has a lot of confidence in the ability of their borrowers to go on to permanent modification. Homeowners in a loan modification process might want to keep an eye out for a Notice of Trustee Sale, just in case. 

Liz and Jerry Dawson expect their three Valley rental homes to be vacant at times, but they were unprepared to be hit by vandals, something that is becoming more common for empty rentals.

The Ash Fork couple were even more surprised when their insurance company refused to pay the damage claim because their north Phoenix home had been vacant for more than 60 days.

"You just feel betrayed," Jerry Dawson said of the insurance company’s
 denial of their claim.

Liz Dawson said she hopes that other landlords realize their insurance risk if their properties have been vacant.

Accidental landlords- longtime home sellers who gave up and decided to rent out the property instead, aren’t always aware of insurance rules for rentals. It can be a bit of a shock to find out how much more it is than a typical homeowner’s policy.  Policies for vacant properties are even worse.

Jim Gontjes, Foremost Insurance Co. regional product manager, said policies typically limit coverage for properties that are vacant for 30 or 60 days. Some companies will continue coverage with a permitted-vacancy clause, but that requires what can be a substantial increase in the premium, he said.

"Work with your agent so they’re aware of the situation . . . and can find other options for coverage," Gontjes said.

This year, his company, based in Grand Rapids, Mich., has written coverage for more than 2,100 vacant properties in Arizona through September. That is an increase of 161 percent from a year ago, Gontjes said.

Increased premiums, increased risk of vandalism, lower rents and a smaller chance of keeping the property occupied.  It’s a tough time to be a landlord- especially if you don’t read your insurance policy.
 

Good news that more than 650,000 borrowers have been put into trial mods, no news that we have no idea how successful those mods are now five months after the program really got cooking.

It’s coming, that’s what the folks at Treasury say. 

I have a strong suspicion that if the program were meeting with any success at all, the data would have been a lot more forthcoming.

That doesn’t seem to be the only omission either.  A class action lawsuit was dismissed in Minneapolis yesterday by a group of homeowners fighting foreclosure after their loan mods were rejected.  The homeowners claim that they weren’t given proper notice,  nor were they informed that they had the right to appeal.

The judge ruled that loan modifications were not an entitlement nor were there "due process" qualifications. The attorney for the homeowners said that the Treasury was making changes however:

Treasury now requires that loan servicing companies collect data on denials, provide written notices of denials within 10 days, halt foreclosures when homeowners challenge denials and provide homeowners with some of the data that went into servicer’s decisions.

So the Treasury not only doesn’t know [or isn't saying] the performance rate of loans in the trial period, it didn’t even bother to ask lenders how many borrowers were being rejected?  How could anyone adequately assess the value of the program without knowing the percentage of successful modifications or the percentage of applicants that were even allowed into the program? Additionally you would think that a breakdown as to WHY borrowers were being rejected would be useful- especially if this data could be compared between lending institutions.

There is a scene in movie The Sound of Music where the Nazis discover the Von Trapp family attempting to escape in the middle of the night.  The officer tells Captain Von Trapp, So Captain- we have not asked you where you are going, and you have not asked us why we are here.  Captain Von Trapp responds Apparently we are both suffering from an appalling lack of curiosity.

The Treasury seems to be suffering from the same thing– an appalling lack of curiosity. Either that, or an appalling unwillingness to share what they know.

I can’t help but wonder if Extreme Makeover isn’t a miniature example of subprime lending.  EM is helping people get into homes they couldn’t possibly afford.  These people either can’t handle the associated bills, or are allowed to borrow more than they can possibly repay against the home.

Euclid, a tutor to King Ptolemy, once said,"There is no royal road to geometry" when Ptolemy requested that Euclid make the subject easier.  We might want to consider that there is no royal road to homeownership either. 

Unlike some claims, homeownership does not cause prosperity.  Homes–even those that are owned free and clear–are demanding responsibilities. They are not money makers.  Renting is often the better deal.

Let us consider the poor beneficiaries/victims of EM receiving a home beyond their means when considering policies that advocate easy lending. The road too often leads to foreclosure

It’s been nearly three and a half years since I put up Doom’s first, rather uninspiring post. [In my defense, it was only a test.]  We were joining the ranks of a number of "bubble bloggers". 

Bubble bloggers were for the most part, regular folks who saw an insane real estate market and said, "It’s going to crash, and someone should say something".  Some, like HousingPanic, Ben Jones and Patrick had inspired a national audience, others were smaller and more local. There was a lot of comradery in those days.  We’d check each others posts, and add each other to the blogroll.  We had fun taking potshots at the likes of Lereah and Mozillo and watched the data in our local markets.

This morning I read Chuck Ponzi’s Top 10 signs you’ve been following the housing bubble too long.  Chuck, we’re you writing about me?

10. You kinda miss the days when everyone was still on blogspot.  Uh… except for that Ritholtz guy.

9.  Everything looks like a bubble now.  Even bubbles.

8.  Oompa Loompas and “The Tan Man” evoke feelings of intense disgust.

7. You know who Tanta and the Mortgage Pig are and you miss them.

6.  You KNOW Neil has got popcorn.

5. The inflation vs. deflation argument was sooo 2007.

4.  You wonder if Schiller has a time machine.

3. You know the rental multiplier for your neighborhood.

2. You think the Flying Monkey Warriors vs. Greg Swann battle was epic and you totally know who won.

1.  Hoodoodanode?

I can add another to Chuck’s list- you realize that nearly half your blogroll has disappeared.  Bloggers have logged off, cease to post, or have sold their name to RE interests or online casinos.

I told John that sadly, I think it’s time to do some housekeeping.  These are the names that I’m about to purge from the list.  If anyone has any suggestions as to who should or shouldn’t be on our roll- please speak up and let us know: [Links are still live on the left sidebar if you want to check these out.] We are also open to adding goodies if you know of any out there.

Blown Mortgage
Bakersfield Blog
Bubbletracking
Bull not Bull
Hawaii Blog
House Bubble
Housing Fear
HousingPanic
Lawrence Yun watch
Marin real estate
NAR Wisdom
OC Fliptrack
Real Estate Realist
San Diego Predatory Lending
Southern Florida

As for John and myself, I don’t think of us as "bubble bloggers" these days.  Housing bubble is nearly an outdated term now.  Real estate and economic commentators?  Nah, that sounds like talking heads from CNBC.  I guess we’re just bloggers- and for some amazing reason we’re still here.