Friday, August 24, 2007

On Students As Marketing Research Subjects

Being a double marketing major, there was a recent Wall Street Journal article which caught my attention. Two Fridays ago, the paper reported, in an article by Carl Bialik, on the pitfalls of too often using college students in marketing research studies.

I recall a marketing professor from my graduate days lamenting the amount of bad research and horrific consumer behavioral inferences based upon how college students evaluated stereo equipment. Back in my day, that seemed to be a favorite combination in which many marketing professors, no doubt on the tenure track, embedded their research concepts.

The Journal article details quite a few examples in which either products and concepts not really germane to college students are tested among them, or college students, as a group, are considered to be homogeneous. Neither of which makes for particularly valid conclusions.

A Professor Robert Peterson, marketing professor at University of Texas, Austin, found 63 examples in published research involving psychological relationships where students differed significantly from non-students.

Despite the Mr. Bialik's admonishment that the real fault lies with those who would apply such narrowly-based research results to non-students, I don't believe that's quite true. Studies using students for the sample, if they involve PhD work, are probably held out as offering real world conclusions. It's doubtful that so many student-based research projects would be done for nothing more than methodological validations.

No, I think the entire ethos of business school professors and graduate students using the available student population is an age-old, and recurring problem. Who knows how many products or services have had their basic concepts 'proven' this way?

It's an illuminating window onto a rather sordid and well-kept secret among the marketing department cognoscenti of academia.

Thursday, August 23, 2007

David Malpas On The Current Financial & Economic Outlook

A little over two weeks ago, which now seems like a year ago in these markets, David Malpass, chief economist of Bear Stearns, wrote a wonderful editorial in the Wall Street Journal concerning the distinction between credit markets and the 'real' economy.

Now, many economists and other pundits are declaring that we are on the edge of a recession, and that recent credit market problems have crippled, or are crippling, the 'real' economy.

To the contrary, Malpass wrote,

"Equity markets have recently lost over $2 trillion in the U.S. and even more globally -- many times the likely amount of mortgage and corporate debt losses in the foreseeable future. This is in part a correction from the sharp global equity run-up through mid-July. Current prices still signal growth ahead.

Another aspect of the market disruption is a dramatic stand-off between bond buyers and sellers: Buyers in both housing and debt markets are using the market discontinuity to claw prices and terms back to Earth. The slowdown talk weighing on equities also reflects the Wall Street view that debt, mortgage and takeover businesses have replaced General Motors as the economy's bellwether. According to the bears: As goes the credit market, so goes the economy.

Fortunately, Main Street is not that fickle. Housing and debt markets are not that big a part of the U.S. economy, or of job creation. It's more likely the economy is sturdy and will grow solidly in coming months, and perhaps years.

U.S. growth has endured other waves of equally loud pessimism -- over high gasoline prices, low (pre-revision) estimates of job growth, a supposedly negative personal savings rate (revised to positive on July 27 by the Commerce Department) and even the 2003 tax cut on labor and capital. Remember the argument that tax cuts would put the economy on a path toward fiscal collapse and recession? Now, the U.S. deficit is set to fall below $150 billion by Washington's September fiscal year-end, thanks to strong tax receipts."

Thus, Malpass calls our attention to some pretty badly mistaken prior economic calls by some of these so-called 'experts.' On the subject of using housing as a piggy-bank, Malpass wrote,

"The bearish view is that Americans live, breathe and spend their houses and mortgages. Yet the July 31 consumer confidence survey by the Conference Board jumped to 112, the highest in the six-year expansion. Data and theory show clearly that houses are not the be-all and end-all of the economy. Jobs matter more. For many, the value of future employment is much greater than their home equity. The low jobless claims and unemployment rate -- clear signs of a strong labor environment -- raise confidence and likely future wages. This outweighs changes in wealth, whether from declines in house prices or the stock market, especially for lower-income workers.

Neither the economy nor job growth has been dependent on housing. Residential construction declined to 4% of GDP in the second quarter -- right on the 1990s average -- having boomed excessively in 2004 and 2005 and subtracted heavily from GDP in 2006. But strength in commercial construction more than offset the weakness in residential construction, allowing overall construction to add to GDP for the first time in a year.

Concerns about high inventories of unsold homes are exaggerated. At 537,000 per the Commerce Department, the June inventory equals 7.4 months of 2007's average sales. This is only a bit above the 6.7 months average inventory from 1980-1995. The leaner inventories in the 1996-2005 "sellers' market" resulted in part from the super-low interest and mortgage rates earlier this decade, and the 1997 cut in the capital-gains tax on houses.

Those overstating housing's impact on jobs often use dates spanning the 2001 recession, as in the widely quoted calculation that 37% of the net new jobs were in housing. That was true only between March 2001 and September 2005, because housing jobs grew in the recession while other jobs shrank. A fairer picture of the role of housing in the expansion is to start counting from any month after the recession. From the end of 2003 through present, jobs from residential construction plus real estate and mortgage brokers created only 3.6% of the net new jobs, 5.3% if all credit intermediation jobs are also included.

Nor has consumer spending been dependent on "cashing in" on the housing boom. The increase in mortgage equity withdrawals in 2004 and 2005 funded big net additions to household financial assets, while consumption growth remained steady. Mortgage equity withdrawals slumped throughout 2006, yet consumption growth was particularly fast in the fourth quarter of 2006 and the first quarter of 2007."

Thus, Malpass dispels the common notion among many in the business media that all Americans have done for the past decade is borrow against their rising home values to spend, spend, spend! Rather, Malpass notes they have invested, invested, invested! A housing value decline might cause some loss of demand for financial assets and, thus, some price declines, but not wholesale loss of consumer spending as a driver of the overall US economy.

On that theme, what about the egregious rises in sub-prime mortgage payments coming soon? Won't those rises in monthly mortgage payments be the final death blow to the US economy? Not so, wrote Malpass,

"In the long list of worries about consumption, the threat of mortgage-rate resets is providing the latest fixation. It shouldn't. Payments on some $500 billion of adjustable rate mortgages are scheduled to go up in 2007. If the mortgage rate is adjusted upward by an average two percentage points, that's $10 billion in added payments. To put this in perspective, wages for nonsupervisory workers increased by $296 billion over the last 12 months. The July 27 revision alone added $130 billion to the last year's total U.S. personal income, raising it to $11.5 trillion, reflecting the hard-to-track dynamism of the U.S. economy.

The constant warnings of a housing-related collapse in domestic consumption overstates the importance of housing in the economy, while understating the importance of jobs and economic growth, both of which have been solid. Of course, sellers of both houses and bonds would like more froth in their markets. But buyers, and likely the economy as a whole, will probably benefit over time from the wrenching return to more normal market conditions."

It is truly a pleasure to read a balanced, reasoned, informed opinion in a major news medium which contradicts the current hand-wringing that, thanks to a few sub-prime mortgages that were made, securitized, and sold as investments, our entire economy is about to be brought to its knees.

It's not. The sliver of the housing market that is sub-prime is but a piece of an otherwise dynamic and resilient US economy, still the envy of the world's other economies.

Wednesday, August 22, 2007

Brian Wesbury's Excellent Analysis of The Current Credit Market Situation in the WSJ

We're very fortunate to have a lucid, informed and competent economist of the stature of Brian Wesbury writing frequently in the Wall Street Journal.

On Monday, Mr. Wesbury wrote an inspired piece entitled "The Fed's Job."

In brief, he makes the point that, throughout our country's history, people have wrongly diagnosed economic problems as 'a lack of liquidity.' Now, Wesbury explains, the problem is leverage and uncertainty- but not liquidity.

This is at variance with such biased commentators as financial entertainer Jim Cramer, self-interested Senator Chris Dodd (Democratic Presidential candidate and Senator from the home state of many hedge funds, Connecticut), and CNBC economist wannabe, Steve Liesman. All three of these observers have been shouting loudly for various 'liquidity' bromides, ranging from the Fed cutting the interest rate by one-quarter to one-half of a point, to allowing Fannie Mae and Freddie Mac to 'invest' in jumbo mortgages.

Thankfully, Wesbury explains why all of this is unnecessary, but, never the less, in the long tradition of populist blowhards crying for easy credit.

To wit, Wesbury wrote,

"Blaming monetary policy for economic and financial market turmoil is a time honored tradition. Maybe the most famous bashing was in 1896 when William Jennings Bryan, an original populist, ranted against hard money and for inflation: ". . . we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold."

Monetary policy makes an easy scapegoat because printing money (like drinking a cup of coffee) is an easy way to give an economy a temporary boost. But if what ails the economy or markets was not caused by tight money in the first place, a temporary boost will not help. It may cover up the symptoms temporarily, but in the end it does not solve the underlying issue (a lack of sleep).

In fact, easy money always leads to greater problems down the road -- either rising inflation, or a reduced sensitivity to risk, as markets come to expect rate cuts to bail them out.
Lately, modern-day William Jennings Bryans have been loudly calling on the Fed to cut interest rates and inject cash into the banking system. They believe more money would stop financial markets from seizing up any further.

This would make sense if money was already tight -- or to put it another way, if a lack of liquidity was the real issue. But trades are clearing, banks are well capitalized, commercial and industrial loans are growing, credit-worthy borrowers are getting mortgages, and the economy is still expanding.

...the current turmoil in the financial markets has nothing to do with a lack of liquidity. More importantly, there is little hope that any liquidity the Fed would inject into the banking system would actually get to the sectors of the market where only sporadic, fire-sale pricing of securities is taking place.

Some are arguing that a sharp decline in the three-month Treasury bill yield, to 3.85% from roughly 5% during the past few days, shows the need for a huge infusion of cash that would force the federal funds rate down. But the drop in T-bill yields is a reflection of three issues: a flight to quality, a guess that the Fed will lower rates at its next meeting and a very liquid market."

Well, if liquidity, per se, is not needed, then what precisely is going on currently in financial markets? Wesbury continues his article with this explanation,

"The real problem with the financial markets is that extreme leverage and extreme uncertainty have met in the subprime loan market. No one knows how many loans will go bad, who owns these mortgages and what leverage they have applied. We do know that subprime lending is just 9% of the $10.4 trillion dollar mortgage market, and delinquencies are running at about 18%. The Alt-A market is about 8% of all mortgages and about 5% of this debt is delinquent.

As an example, let's take a very low probability event and assume that losses triple from here. Let's assume that 54% of all subprime loans and 15% of all Alt-A loans actually move to foreclosure. Then, assume that lenders are able to recover 50% of the value of their loans. In this scenario, total losses in the subprime market would be 27%, while total losses in Alt-A would be 7.5%.

From this we can estimate a price for the securitized pools of these assets. Without doing any actual adjustment for yields, or for different tranches of this debt, the raw value of the underlying assets would be 73 cents on the dollar for subprime pools and 92.5 cents for the Alt-A pools. Getting a bid on this stuff should be easy, right? After all, the market prices risky assets every day.

But this is the rub. A hedge fund, or financial institution, that uses leverage of 4:1 or more, would be wiped out if it sold subprime bonds at those levels. A 27% loss on Main Street turns into a 100% loss on Wall Street very easily. But because hedge funds can slow down redemptions, at least for awhile, and because they are trying desperately not to implode, they hold back from the market. At the same time, those with cash smell blood in the water, patiently wait, and put low-ball bids on risky bonds. The result: No market clearing price in the leveraged, asset-backed marketplace."

Thus, Mr. Wesbury comes to the logical and sensible conclusion that what we are witnessing is not a shortage of liquidity, but the realization on the part of a lot of supposedly-smart hedge fund managers and other institutional investors, that they weren't so smart in their headlong use of sub-prime mortgage-based instruments without understanding the underlying risks to those mortgages. It's no different than any other case of sophisticated and/or institutional investors making poor investment choices- they lose money. In the cases of many of the hedge funds, some of whom call Senator Dodd's state home, they have used leveraged money, and are, quite likely, now insolvent.

So we have populists crying for the relief of wealthy hedge fund investors and managers, at the same time that they also cry for relief for the sub-prime mortgage borrowers! At least it's equal-opportunity financial forgiveness. However, it's unnecessary.

In his conclusion, Mr. Wesbury goes on to state,

"There is a lesson here. Populism is in the air these days, and the threat from tax hikes, trade protectionism and more government involvement in the economy, is rising. This reduces the desire to take risk. Congress is working on a legislative response to current mortgage market woes as well. And as with the savings and loan industry (forcing S&Ls to sell junk bonds at fire-sale prices), and Sarbanes-Oxley, the legislative response almost always compounds the problems.

The interaction of an uncertain regulatory and tax environment with a highly leveraged, illiquid market for risky mortgage debt creates conditions that look just like an economy-wide liquidity crisis. But it's not. A few rate cuts will not help.

What William Jennings Bryan was really complaining about in 1896 was falling commodity prices, especially falling farm prices. What he and the other populists ignored was that these prices were falling because of productivity, not tight money. His "Cross of Gold" speech was a clear stepping stone to the creation of the Fed in 1913. Since then, inflation has been much higher than it would have been under the gold standard. But all that inflation never did save the family farm.
Similarly, even very easy money today can't put off the day of reckoning for subprime mortgage holders who bought homes with no money down and thought interest rates would stay low forever. It can't help overly leveraged investors who thought they were getting risk-free 20% annual returns. Providing enough liquidity to allow markets to function, while keeping consumer prices as stable as possible, is the best the Fed can do. It should be all we really ask."

Amen, Mr. Wesbury. Ben Bernanke is wisely providing 'liquidity' to banks, in order that they may accept and offer, for repos, paper of dubious quality, in order to assure that credit markets continue to function, and do not impeded the normal course of our non-financial economic sectors. Truly, that's all for which we should ask from the Fed. Beyond that, borrowers and investors must accept the consequences of their own financial decisions.

Tuesday, August 21, 2007

How New Exotic Investment Products Misled Retail Investors

Last Tuesday's Wall Street Journal carried an article detailing the many exotic financial investment opportunity's available to the average retail investor in today's market environment.

Between ETFs covering many asset classes, mutual funds implying "market neutral" performance, and vehicles allowing relatively easy entry into foreign currency, foreign market funds, and commodities investment/trading, today's retail investor can enter the realm of complex financial instruments, electronically, totally unaided.

According to the Journal story, this is bringing the sort of results you'd expect- margin calls, losses and bewildered retail investors.

What seems to be happening is that uneducated retail investors are entering financial markets which are largely dominated by sophisticated institutional traders and investors. In such environments, it's almost a given that any sort of turbulence, as we have been experiencing of late, will leave the retail investors holding the losses. Typically being late to market gains, and late exiting declining positions.

Then there is the damage done by implying to retail investors that they, too, can construct effective asset hedges. The same non-performing hedged positions which have caused so much financial loss among leveraged institutional investors and traders is, of course, also causing losses among less-leveraged retail investors.

This brings to mind the opposing forces of financial innovation and regulatory vetting of individuals and institutions as qualified to invest in various instruments.

Basically, it's another version of the old liberal versus conservative viewpoints,

'Should we protect people from themselves?'

Liberals would tend to say "yes," while conservatives would tend to say "no."

I'm not sure we can ever really protect retail investors from foolish behavior. Going back to the go-go equity markets of the 1960s, or the Bonneville Power Authority bond defaults of the 1980s, it doesn't take much in the way of financial opportunities to allow average retail investors to lose their money via bad management.

What astounds me, though, now, is how a retail investor can so nearly replicate, albeit at higher costs, the sorts of financial investment and trading strategies which many sophisticated institutional traders and investors also employ. It's a frightening realization.

Damned If You Lend, Damned If You Don't.....

Yesterday, in this post, I provided a clear example, thanks to the Wall Street Journal's excellent article from last week, of how inappropriate financial behaviors on the part of everyone from borrowers to investors have helped to create the current, sub-prime mortgage-based credit market turmoil.

One point which I had planned, but neglected to add, was that, had the mortgage banking industry failed to provide something like sub-prime, piggyback mortgage loans, they almost surely would have been excoriated by some parties for denying 'affordable' housing finance to the less-economically well-off.

As if sensing my omission, today's Wall Street Journal carries a front page piece detailing Illinois' new steps to mitigate the assumption of undue financial risk and obligations, in the form of risky mortgages, by the economically less well-off in that state.

Sure enough, within the first few paragraphs of the article, regarding an earlier attempt at the same task, we read,

"Instead of winning plaudits, the pilot program quickly became mired in charges that it would make it harder for minorities to buy homes."

So, there you have it. At the same time that some are criticizing lenders and mortgage brokers for rapaciously victimizing the poor or less financially-educated who want to buy homes, attempts to minimize the recurrence of such inappropriate lending are already being branded as racist and discriminatory.

Damned if they lend to the poor, and damned if they don't.....the financial sector has become today's whipping boy for some who want the current credit turmoil magically vaporized, yet not by returning to older, tested home lending standards which resulted in higher-quality mortgages which could be more confidently securitized.

Monday, August 20, 2007

The Sub-Prime Mortgage Chain: Borrower to Investor

Last week's Wall Street Journal carried a detailed example of how sub-prime mortgages originate. I found the story both shocking and heartbreaking. Mostly, though, I found it emblematic of a culture of greed, at every step of the home loan process, from borrowers to investors.

For the full impact of the story, I've reprinted large sections of it below,

The price was a major stretch at $567,000. But the couple, who had sold a home a few years earlier to move to a better area, was tired of renting. Mr. and Mrs. Montes convened a meeting with their two teenage daughters around the kitchen table to hash out the implications. "We agreed we wanted to be homeowners again," says Mr. Montes, "even if it meant the end of vacations and not eating out as often."

Like many people who jumped into the rising housing market in recent years, they had little money for a down payment and chose a loan that would hold their monthly payments down for the first two years, then "reset" to a much higher level. Mr. and Mrs. Montes say their mortgage broker assured them they would be able to refinance in a couple of years to keep their payments affordable.

With a December "reset" on their loan looming, however, the refinancing option now looks impossible. A friend who works as a loan officer called with some bad news this week: Similar homes in their area have been selling for $535,000 to $565,000 recently. That means the Monteses' loan balance may exceed the value of their home.

And with thousands of mortgage banks and brokers threatened with extinction, lenders that embraced all kinds of risky loans two years ago are enforcing increasingly strict standards. They are refusing even to consider extending new credit to people like the Monteses who lack any equity in their homes.

They live in a solid neighborhood and are both employed and in good health. "My wife and I make pretty good money," says Mr. Montes. Mrs. Montes works as a school secretary. Together, they earned nearly $90,000 last year.

But they already pay about $38,400 a year on their home loans, even before taxes and insurance. In December, when their primary loan "resets" to a higher rate, that cost will rise to about $50,000 a year, Mr. Montes says.

When the Monteses decided to buy the bungalow in 2005, they had only a so-so credit record and little savings. So they settled for a "subprime" loan, with costlier terms than those available in the prime market.

The Monteses' primary loan is the type that became the dominant subprime mortgage during the housing boom of the first half of this decade -- and now has become a symbol of misguided lending, swept away by regulatory fiat and investors' flight from mortgages deemed too risky. These loans are known in the trade as 2/28 mortgages. The interest rate is fixed at a relatively low rate for the first two years (5.45% in the Monteses' case), then floats at a predetermined margin above an interest-rate index for the next 28 years. In many cases, that "reset" of the interest rate after two years leads to a monthly payment increase of 30% or more.

U.S. lenders originated about $600 billion of subprime home loans in 2006, or 20% of all home mortgages, according to Inside Mortgage Finance, a trade publication. About 56% of those subprime loans were 2/28 mortgages, says Keith Ernst, senior policy counsel at the Center for Responsible Lending, a nonprofit research and lobbying group in Durham, N.C.

The Montes family got their loan through a mortgage broker in Rancho Cucamonga. Using what was then a common formula, the broker offered to arrange for two loans, one to cover about 80% of the home price and the other, a so-called piggyback loan, for the rest. For the first two years, their total monthly mortgage payments are about $3,200. The loans are initially interest-only.

Mr. Montes recalls feeling edgy about whether he would be able to afford the higher costs -- about $900 more per month -- due to take effect after two years. But he says the broker assured him he could refinance before those costs kicked in.

Mrs. Montes says she was apprehensive about the broker's assurances. "But I blame that on that I don't understand the lingo they were talking," she says. "It's a scary experience.... All I could see was all these numbers flash before me.... I said, 'Mario, I hope you don't get into something that is going to hurt us.'"

The Monteses received a letter informing them their property taxes had been reassessed based on the $567,000 sale price instead of its previous $389,000 value. That raised their taxes to $6,000 from $2,900 a year and would have increased their monthly payments (including the mortgages and taxes) to $3,931.

Mr. Montes says the family may try to sell the house, but that would be tricky in today's weak market. Or they could try to trim other expenses and keep meeting the higher monthly home payments that are due to take effect in December.

There is very little wiggle room. Mr. and Mrs. Montes also have two car loans, with payments totaling about $700 a month, and are borrowing more money to help put their elder daughter through college.

Those are the basic facts.

To me, it was shocking that the Monteses didn't even plan on affording the added cost of their original mortgage after the reset point, being advised by their mortgage broker that they would refinance before then. Not to mention that the wife of the couple confessed to not even understanding the loan document which she would be signing. Yet, this is the most expensive purchase most people will ever make.

Their income was insufficient to make the original mortgage payments even as low as 30% of that base. The article notes that fully 20% of all mortgages in 2006 are now this type, which is surprising to me.

The last time I applied for a mortgage, I kept my total mortgage-related (PITI) payments to 25% of my income, took an ARM with a repricing cap of 2.5 percentage points of interest each five years, and planned on affording it.

What I saw in this article is an example of people who should have waited until they actually had the money for a reasonable down payment, and then should have been more sanguine about their prospects of affording the mortgage they chose. Additionally, they seem gullible, in that they simply believed a mortgage broker's promise that they could refinance the mortgage. Perhaps they should have planned on affording the one for which they applied?

The broker, of course, hardly did anyone a favor by putting the Monteses into a barely-affordable mortgage. The institution which lent the money for the house didn't seem to have done a very careful job stress testing the Montes' ability to afford the mortgage.

Then the loan was likely bundled up into a security. I don't know what the 'seasoning' period is nowadays, but years ago, lenders typically had to hold their mortgage loans for a year, if I'm not mistaken, before other investors would buy them in CMOs.

This story displays a shocking tale of greed and overreaching on everyone's part, including the Monteses. They should never have expected, in their financial position, with other loans to service, to be paying as much as 42% of their income for housing, before taxes and insurance.

It's no wonder that this is the last year of the housing expansion. With loans like these, to borrowers like these, it was clearly time for mortgage merry-go-round to stop. I can't honestly express any sympathy for investors who purchased instruments backed by loans like those of the Montes.'

This was a total lending, underwriting and investing system failure. But it's not a banking failure, per se. Those who bought these loans, packaged as whatever, deserve the losses they take, just as if they had made unwise equity or currency investments.