Moody's Negative Outlook on U.S. Local Government Debt

A few days ago, Moody's Investors Service announced that its outlook for the entire U.S. local government tax-backed and related ratings sector is negative. This is newsworthy not only for municipal bond investors but also for anyone following the U.S. recession. It marks the first time that Moody's issued an outlook on this entire sector, although it has issued ratings on the sector since 1914.

Moody's Investors Service is one of the leading issuers of credit ratings. Investors use these ratings to gauge the risks of investing in debt assets. So, one might conclude that the analysts at Moody's are remarkably pessimistic about the impact that recessionary economic conditions will have on the ability of local governments in the U.S. to meet their debt obligations. This means that the risk of defaults on these debts has risen.

However, Moody's hedged its announcement by mentioning that credit pressures will vary significantly across locales due to differences in economic conditions, property assessment methods, and authority to raise revenue. The varying economic conditions can largely be explained by localities' exposure to industries hit particularly hard by the recession. These include real estate development, auto manufacturing, financial services, tourism, gaming, and general manufacturing. Differences in property tax systems will play a major role. Moody's report shows evidence that about 72% of local government tax revenue comes from property taxes. The bursting of the housing market bubble will bring declines in property tax revenue for most local governments because of falling home values.

Several of these governments might have the authority to increase property, sales, or income tax rates to raise revenue. Whether the elected officials running these localities are willing to do this is an open question. Moody's points out that taxpayers are worried about their own financial conditions and are highly resistant to increases in local taxes. Raising taxes in this environment will be unusually difficult for locally elected officials.

Cutting spending during the economic crisis will not be an attractive option either. In part, this is because many of these governments may face service mandates that prevent them from reducing service-related expenditures. An example of a service mandate is that a state government may mandate that local governments provide health services for the poor. Moody's analysts also reported that the demand for improved government services will make it that much more difficult for these governments to sustain healthy finances. Local officials may find that it is more palatable to default on their bonds rather than raise taxes or cut spending.

The credit crunch is also having a direct impact on local government finance. Moody's report states that access to credit will be more expensive for these governments than it had been in recent years. Moody's negative outlook announcement surely caused investors to demand greater yields on the municipal bonds trading in the credit markets. The company also warned that some localities are in such dire straits that they may be completely shut out of the credit markets.

Yet, the situation ought to be tenable for numerous governments. For instance, some well-managed localities increased their reserves during the boom years and were prudent with the funds generated during the real estate bubble. A simple example from portfolio theory can help show why investors may still be willing to buy the bonds of a cross-section of municipalities.

Suppose that a bond investor purchases three one-year bonds with different expected returns and probabilities of default. For simplicity, we'll assume that the investor is risk-neutral and the bonds pay nothing in the event of default. Bond A has a 25% probability of default this year but pays a coupon of 15% if it avoids default. Bond B has a 50% probability of default this year but pays a coupon of 20% if it avoids default. Bond C has a 75% probability of default this year but pays a coupon of 30% if it avoids default. Let's also assume that all the bonds have a face value of $100 each.

What is the investor's expected payoff from investing in this portfolio? It is


(0.75 × $115) + (0.5 × $120) + (0.25 × $130) =

$86.25 + $60 + $32.50 = $178.75


So, on average, an investor would be willing to pay less than 60% of face value on these bonds to make a positive expected return.

This example was purposefully simple, but from it you can see the advantage of diversification and the problem of gauging risk. If the probabilities of default end up being higher than estimated, the investor might lose money but will only lose all his money in the rare case that all bond issuers default. Yet, if the probabilities of default are lower than estimated, the investor might earn a high rate of return.

Discussion Questions

1. How does the bond portfolio example relate to the impact that mortgage-backed securities had on financial institutions? What must have happened to their default rates for them to become known as "toxic assets"?

2. If you had a large sum of money that you had to use for investment purposes, would you put together a portfolio of U.S. local government debt? If yes, why? If not, explain what your preferred investment would be.

3. Besides an economic recovery, what changes, if any, do you think are needed for local governments to avoid defaults in the future? How feasible are your proposed changes?

Debit or Credit?

As an economist and beloved shopper, I shudder in disbelief at how many credit-card owners still purchase items with their debit card. Assuming that you have a debit card and a credit card that is not maxed out, I present the following economic argument for why you should choose to use your credit card over your debit card.

The classic rebuttal I get to this argument is, "People are not responsible; they simply charge things without keeping track until their bill comes in." But how sound an argument is this? When you use your debit card, you still need to maintain a positive balance in your checking account so you don't overdraw and incur any fees. It only takes a little more effort to keep track of credit card purchases if you get into a routine of noting expenditures. For example, you could do the following: Upon making a purchase, set aside the purchased amount into a separate interest-bearing checking or savings account (which is easy and quick to do thanks to online banking), or track purchases in a spreadsheet or program (also easy to do with programs such as Microsoft Excel or Microsoft Money).

Another common response I hear is, "Some people keep a high balance on their credit card." When you use a debit card, the money is automatically withdrawn from your account. So the existing balance on your credit card is irrelevant when deciding whether to purchase the next item with either debit or credit since using your debit card would imply you have the cash on hand to buy it.

Even under the assumption that there is some cost to tracking expenses, there are still three significant reasons why you should use your credit card over your debit card.

1. The time cost of money
2. Typically credit cards offer better rewards programs
3. Build credit

Everyone knows that a dollar today is not worth the same as a dollar tomorrow. If you can forgo spending a dollar until a later time, then that dollar can earn interest until you actually spend it. In economics and finance, we analyze problems such as this using the concepts of present value (PV) and future value (FV). That is, the future value (FV) of a dollar today (PV) is

FV = PV x (1 + r),

where r is the interest rate over the time period in question. Since your debit card requires you to pay for the good today while the credit card allows you to pay for the good in the future at the same nominal price, economically you are better off letting the payment value collect interest until the balance is due and then paying off the balance.

Although debit cards are beginning to offer more competitive rewards programs, credit card companies typically still offer more diverse and appealing options such as cash back, miles, and points programs.

Last, the use of debit cards does not contribute to your credit rating. The responsible use of a credit card is a significant way that you as a consumer can build credit and improve your credit rating.

Discussion Questions

1. Why are some consumers unable to qualify for a credit card? Is their inability to qualify a good signal of their financial well-being?

2. How do rewards programs affect the bottom line of a credit card company? How can they afford to offer such incentives?

3. What kind of rewards would induce you to pay for something immediately rather than in the future by using your debit card over your credit card?

4. One argument for the use of debit cards is the option to receive cash back with your purchase if your bank's ATM is not near by. How does this affect your choice to use you a debit or credit card?

The Federal Reserve's Expanding Toolkit

On October 8 and 9, major central banks in Europe, the Americas, and Asia took the exceptional step of reducing interest rates in concert to stave off a global economic slowdown during the ongoing financial crisis.

The financial crisis is rooted in the faltering U.S. housing market. Many banks and financial institutions hold assets (such as mortgage-backed securities) that are tied to home loans. As house prices fall and more Americans have trouble paying their mortgages, these assets lose value, and financial institutions find their holdings are worth far less than expected. Such losses hamper the ability of financial institutions to borrow and lend. At the moment, financial institutions are very reluctant to lend to one another for fear of further exposing themselves to mortgage-related losses.

To combat this crisis of confidence, the Fed is dramatically expanding its role as the lender of last resort in the U.S. financial system. In addition to the coordinated rate cut, the Fed's new policy measures include direct loans to insurers and businesses, as well as an unusual level of cooperation with the U.S. Treasury Department. National Public Radio's Laura Conway catalogues the Fed's expanding monetary policy toolkit here.

Discussion Questions

1. Historically, the Fed's status as lender of last resort extended only to commercial banks. How has the scope of the Fed's lending changed as a result of the crisis?

2. Why don't central banks coordinate monetary policy more often?

3. If effective, how will the Treasury's $700 billion rescue package help the Fed's efforts to restore confidence among banks and financial institutions?

4. What constraints do central banks face in responding to the financial crisis?

Financial Market Risks and Negative Nominal T-bill Rates

On September 17, in the immediate aftermath of the Lehman Brothers bankruptcy, the AIG bailout, and the mortgage crisis, negative nominal Treasury bill rates briefly appeared for the first time since January 1940. As Madlen Read points out, a negative nominal Treasury bill rate implies that “investors were willing to take a small loss on the security.”

At first glance, such behavior on the part of seasoned investors seems odd. Why pay more for a security than the amount the US Federal government guarantees to pay you in the future¹? One possibility would be that the general price level could fall so that the smaller future payment would represent more purchasing power than the current price of the security. That is, if the price level falls enough, the $1000 payment one receives in several months could buy more than, say the $1000.05 price of the bill could buy today. There is some evidence for this: the US Bureau of Labor Statistics reports that in 2008, on a monthly basis, the percentage change in the CPI was 1.1% in June, 0.8% in July, and –0.1% in August. However, if that is the case, one would still get more purchasing power by holding the $1000.05 in cash through the period of falling prices than by receiving only $1000 in the future. Yet, where can such cash be stored safely?

A more likely explanation is that growing fears of systemic risk have discouraged investors from holding any but the safest financial assets. One example of systemic risk comes from the Reserve Primary Fund, the oldest U.S. money-market fund, which lost two-thirds of its asset value due to its investment in Lehman Brothers’s debt. Wary investors fear that similar losses could threaten other financial institutions. Since US Treasuries are generally considered to be the safest investment possible, there was apparently a rush to invest in these securities. Therefore, an increase in demand for T-bills was likely accompanied by a reduced willingness to sell such securities. The latter represents a decline in the supply of T-bills. Both sides of the market then acted in unison to push up the price of T-bills to such an extent that their sales prices briefly exceeded their maturity values. The maturity value, represented on the graph below by the M=1000 line, is the amount, typically $1000, that the bill specifies will be paid to the owner at maturity.


We can solve for the negative nominal rate mathematically using the following formula:


where M is the bill’s maturity value, PB is the bill’s price, and r is its annualized rate of return on the bill when it is held to maturity.

To illustrate the negative rate phenomenon, suppose that for a $1000 maturity value, the market trades a 3-month T-bill at a price of $1000.05. The nominal rate of return, r, is therefore –.02%.

Negative nominal rates were described here in the context of the Japanese market by Daniel L. Thornton in the January 1999 issue of "Monetary Trends." In the article, Thornton states that “investors are willing to accept a negative nominal return on a risk-free asset because holding it is cheaper and less risky than transporting and storing cash.” So it seems that for one day at least, investors were willing to lock in a nominal loss on a safe asset rather than risk leaving cash in financial institutions.

Discussion Questions
1. The Lehman Brothers bankruptcy, the AIG bailout, and the mortgage crisis have apparently shaken investor confidence in financial institutions. Do you think their fears are justified? Do you believe that these financial events have had an impact on your life? If yes, how, and if not, then why not?

2. How might forecasts of a falling general price level in the near future help to explain investors' willingness to accept negative nominal T-bill rates?

3. The dramatic shifting of funds into the safety of Treasuries implies that funds left other sectors. With many financial sites available, you can find information the returns on various financial assets online. Which investment sectors had the largest declines on Sept. 17, 2008? Which investment sectors had the largest gains on that day? How would you explain the results that you found?
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¹ Recall that T-bills have zero coupons which means that they make no payment until the maturity date.

Speculating about the Nobel

Next week, we can expect the winner to be announced for this year's Nobel Prize in Economics. (Last year, the Aplia Econ Blog posted an article about the previous winner, Edmund S. Phelps.) This weekend will see lots of speculation over who will take the prize. Proving there's a market for everything, Intrade posted its odds on this year's prospective Nobel laureates, and allows speculators to bet on who they think will win (thanks to Greg Mankiw for finding this site). The early favorite on Intrade (though trading has been extremely light) is the University of Chicago's Eugene Fama. Truth be told, Professor Fama is my favorite for this year's Nobel (at least, my favorite non-Aplian!).

It's a challenging matter determining how to judge academics relative to each other, especially when they may publish in significantly different fields. The number of citations an academic receives is probably the gold standard for measuring performance in academia. An author receives a citation when a later author recognizes the original author's work as contributing to the later author's own research. This site seeks to objectively measure economists' citations, but applies a weighting scheme to control for individually authored papers relative to co-authored papers and for the time elapsed since papers were cited. Eugene Fama also resides at the top of this list (though a lot of us at Aplia think number 21 on the list deserves a good look too).

Professor Fama has made major contributions to the finance field with his work on market efficiency and asset pricing. He is regarded by many as the father of the efficient market hypothesis. In the early 1990s, he published a series of papers with Kenneth French in which they challenged the Capital Asset Pricing Model's assertion that a stock's market beta is the primary determinant of variations in stock returns. They argued that the market and its participants are too complex to be encapsulated by a single factor. In an article entitled "The Cross-Section of Expected Stock Returns," they developed a three-factor model that tried to explain stock returns using two observed anomalies. They incorporated the fact that small companies tend to outperform big companies, while value stocks (with higher book/market ratios) tend to outperform growth stocks (with lower book/market ratios). Since the paper's publication, Fama-French's three-factor model has become a fundamental evaluation tool in the portfolio management industry.

Discussion Questions

1. Why is an economist's number of citations a relevant measure for his or her impact on the field?

2. The citation list weights recent citations more heavily than older ones. Why might this distinction be relevant when judging an academic?

3. Are markets efficient?

4. There have been a few times in stock-market history when crashes (huge stock-price declines) occurred, such as the stock-market crashes of 1929 and 1987 and the burst of the Internet bubble. What would an analyst who believes in market efficiency say to explain these events?

The Dollar Is Sinking, but What Does That Mean to Me?

Last week, the U.S. dollar continued its downward spiral against most major currencies, including an all-time low against the euro. The previous week, the U.S. dollar had begun trading at parity with the Canadian dollar—something unfathomable 10 or 20 years ago. An earlier Aplia Econ Blog post discussed the role of monetary policy and the effect of the Fed's rate cut on exchange rates.

The graph below illustrates how the U.S. dollar has performed relative to four major currencies (the euro, British pound, Canadian dollar, and Japanese yen) over the last decade relative to their January 1, 2000 values. But what effect do declining exchange rates really have on us?

At the consumer level, it's fairly simple—a weaker dollar means our purchasing power is weaker when buying foreign goods. Effectively, imported goods become more expensive, since the U.S. dollar can buy fewer euros, for example. However, there is another side to this story, because it also means that U.S. goods are cheaper to foreign consumers. This is one of those things that sounds bad, but depending on who you are, can actually be quite good. If you are a U.S. firm, a weaker dollar can be beneficial because it enables foreign consumers to buy more of your products.

In fact, a weaker U.S. dollar is beneficial to U.S. multinationals in a more fundamental way. When a firm sells abroad, it generally sells its goods at a price denominated in the currency of the foreign country it is dealing in. Ultimately, the U.S. firm's shareholders care about dollar-denominated revenues and profits. A declining U.S. dollar means that a firm's euro-, pound-, or yen-denominated revenues can be exchanged for more U.S. dollars than they could have been when the U.S. dollar was stronger. Hence, a U.S. multinational that transacts in several currencies benefits when the dollar declines because its foreign revenues are worth more on a U.S. dollar basis, and vice versa. For example, in the mid- to late 1990s, many U.S. multinationals selling in Asia experienced phenomenal sales growth, yet their profits grew only modestly. During this period, the Asian currencies weakened, decreasing the worth of these firms' revenues in U.S. dollars. Hence, record-breaking unit sales translated into only modest profits in terms of U.S. dollars.

Discussion Questions

1. Who has a greater interest in a strong U.S. dollar—U.S. consumers or U.S. producers?

2. What sort of tax implications may exist for U.S. multinationals as a result of fluctuating exchange rates, especially a weaker U.S. dollar?

3. If a firm owes €100,000 to a German supplier due in 30 days (an account payable), does it prefer that the U.S. dollar strengthen or weaken relative to the euro?

4. Suppose a different firm is owed ₤88,000 from a UK customer due in 45 days (an account receivable). The spot exchange rate is $2.01/₤. How much (in U.S. dollars) would the firm receive if it were paid today? Discuss the gain or loss implications for the firm if the money isn't received for 45 days and the exchange rate moves to either $2.10/₤ or $1.90/₤ during that time.

Financial Contagion in Credit Markets

The ongoing U.S. subprime credit crisis has received significant attention from the domestic media and even here on the Aplia Econ Blog. However, recent developments suggest that this credit crisis might be spreading to the rest of the world. Around the globe, a credit crunch is being felt in subprime markets, as well as in safer prime mortgages and leveraged lending. The World Bank defines financial contagion as "the cross-country transmission of shocks or... general cross-country spillover effects," but notes that the term is generally used to describe the spread of financial crises. Distress in one country's financial system can be "contagious" and spread to other countries whose interests are tied to the "sick" country.

When a financial crisis begins to take hold, the old saying goes that "cash is king," leading investors to sell off securities and flock from risky positions. The result is depressed stock prices, lower Treasury yields, and higher default spreads. Default, or credit, spreads are the additional premium investors require to hold a security based upon its default risk. According to the article, many carriers of the crisis "bug" are credit hedge funds that face rising leverage due to falling collateral values, illiquid markets, and tighter lending policies from brokers. Leverage exists when investors finance their investments with borrowed funds (debt).

The effect of financial contagion is stronger the more institutions and investors in different countries have vested interests in each other's financial markets. These interests may be direct equity or fixed-income investments, or they may be complex financial arrangements (which may or may not be collateralized), such as interest or exchange-rate swaps, or arbitrage portfolios designed to profit from market imprecision.

A famous illustration of the effects of financial contagion is the case of Long-Term Capital Management (LTCM), a hedge fund founded by bond guru John Meriwether whose board of directors included Nobel laureates Myron Scholes and Robert Merton. LTCM's fixed-income arbitrage strategies provided investors with astonishing returns over its first few years, until a series of unfortunate events in 1997 and 1998 crippled the fund. The collapse of the Thailand property market spread throughout east Asia, causing panic and massive selling as market volatility soared to record heights. LTCM believed it was properly hedged to weather the storm—as long as the Asian crisis was an isolated event. Unfortunately, it wasn't: in August 1998, Russia unexpectedly refused to honor its international debt, causing investors to flock toward liquidity in the U.S. Treasury market. The real effect of these crises was to cause investors to take cover from losses and to cause markets to behave in unprecedented ways.

Discussion Questions

1. Interest rates are supposed to reflect an investment's risk. Why is it, then, that in a financial crisis (like the current subprime fiasco), Treasury yields actually go down?

2. What might be a larger concern regarding contagion if it extends beyond financial markets?

3. Why does a financial crisis that causes depressed stock prices and asset values also cause investors' and institutions' leverage to increase?

4. The effect of leverage can be quite staggering, as seen in the case of LTCM, whose ratio of assets to liquid capital reached 30 to 1 in the middle of its meltdown. Suppose you run a hedge fund that leverages a $20 million equity investment into $100 million of managed assets. If poor market conditions cause your fund's managed assets to decline in value by 5%, the new value of managed assets becomes $95 million. But what is the percentage decline in value of your fund's equity position?

5. Drawing from the previous example, imagine now that your fund is even more leveraged, and the $100 million in assets is supported by only a $10 million equity position. Now what is the percentage decline in your fund's equity position due to a 5% decline in the fund's managed assets?

A Failure of Markets?

As everyone learns halfway through their first principles of economics course, sometimes markets "fail." Many economists argue, however, that the so-called failure of markets is just the reverse: it's the fact that there aren't enough active markets to reach an efficient outcome.

But can there be too many markets? Consider the latest problem with the housing market. In the good old days, when you took out a loan to buy a house, you had to convince the lender that you were creditworthy. After all, if you defaulted on your loan, they would be the one holding the bag. So they had a strong incentive to make sure that you could make your monthly payments.

This isn't the way loans work anymore, thanks to a financial innovation called mortgage-backed securities. What happens is this: when a homebuyer takes out a loan from a bank, the bank bundles that loan with many other loans to create a kind of mutual fund—except that instead of containing stock from hundreds of companies, this fund includes the debts (mortgages) of thousands of homeowners. The idea is simple: as with any mutual fund, even if a single homeowner defaults, it has a negligible effect on the value of the overall fund. The fund's price should reflect the overall risk of all the homeowners rather than the particular risk of any one homeowner.

This notion illustrates the concept of diversification—the fact that although one borrower may have considerable risk, much of that risk is unique, or diversifiable. A well-diversified portfolio of mortgages is only subject to systematic, or non-diversifiable, risk, and its value should reflect that. In other words, with a new kind of security and a market for it, the capitalist system becomes more efficient, because it spreads borrowers' risk across a wide class of investors rather than concentrating it on single lenders (banks, in this case).

So what's wrong with this picture? Think back to the initial lender. They know that they're not making a long-term loan—all they're doing is making a loan that they're then going to sell in this new market. Once they've sold the loan, their exposure to the loan's risk is over. Therefore, they have little incentive to see whether a homeowner can actually afford the payments, because they no longer bear responsibility for the credit decision. Quite the reverse, in fact: they have an incentive to sell the mortgage even if the homeowner cannot afford the payments—for example, by setting a low teaser rate that starts out fixed, but then balloons into a drastically higher variable rate. This has been one root cause of the various scandals about predatory lending practices that have been in the news in the last few months.

In the meantime, those looking to buy a home with no money down might take some advice from Saturday Night Live:



Discussion Questions

1. The crisis in the financial markets has caused some people to lose their jobs and made it harder to apply for a home loan, causing home sales to decline, both of which are very upsetting to Jim Cramer. Indeed, whenever a bubble bursts, lots of people get hurt, or at least find themselves considerably worse off than they were in the artificially inflated world of the bubble. Suppose you were a policymaker overseeing a market in which people were prospering in a way that was unsustainable. What would you do?

2. Cramer practically begged the Federal Reserve to intervene, which it did by lowering the discount rate (though not, presumably, because Jim Cramer asked it to). Does this get at the root cause of the problem? If not, what would?

3. How should society decide who gets to own a home and who does not? What would be the ideal set of institutions that could help achieve the optimal solution to such a problem? Could mortgage-backed securities play an important role in your solution?

Inflation, Taxes, and Saving

What's so bad about inflation? Economists typically break the discussion of inflation costs into two categories: the costs of low, predictable inflation and the costs of high, unpredictable inflation.

Economies with high, unpredictable inflation tend to experience slower growth rates. With unpredictable inflation, borrowers and lenders cannot be sure what the real interest rate will turn out to be over the course of a loan. This uncertainty makes people less likely to lend their money (for example, by buying bonds), which in turn leads to less investment and a slower rate of long-term economic growth.

If the inflation rate is low and stable, it imposes fewer economic costs. As prices rise, one dollar will purchase fewer and fewer goods and services over time. This slow erosion of purchasing power encourages people to invest their savings in interest-bearing accounts, keep more of their money in the bank and less in currency, and generally spend more time managing their assets than they would in the absence of inflation; but savings rates are pretty much unaffected… right?

Not quite. Even if inflation is relatively tame, it can still have some major consequences on savings rates because of the way investment gains are taxed. In a recent Slate column, Henry Blodget argues that the design of the tax system in the United States discourages saving—in part because portions of the tax code do not attempt to correct for distortions caused by inflation. Read Blodget's article to find out more about the tax treatment of savings and the tax distortions from inflation.

Discussion Questions

1. According to Blodget, what non–tax-related factors explain the negative U.S. personal savings rate in 2005 and 2006?

2. Suppose you purchase a $1,000 T-bill that offers a 4% nominal rate of return. The inflation rate is 3% per year and you're in the 15% tax bracket.

• What is the before-tax nominal return on your T-bill in the first year?
• As Blodget notes, the U.S. government treats the return on your T-bill as income and assesses a 15% tax on the nominal return from your T-bill. How much tax would you pay on your nominal return from the T-bill?
• By how much does inflation erode the purchasing power of your nominal return?
• What is the after-tax, inflation-adjusted return on your T-bill in the first year?

3. What are the differences between taxes on gains from stocks and taxes on gains from holding T-bills? Suppose you purchase a share of stock that immediately doubles in value. What tax event will you trigger in the event that you sell the share of stock at its new, higher price?

4. How does low, predictable inflation distort savings decisions when the government taxes the nominal gains on savings vehicles such as stocks and bonds?

5. What are Blodget's suggestions for making the tax system less hostile to saving? How does he suggest taxing the capital gains from the sale of stocks? How would he treat the interest earned on T-bills? Can you think of other changes to the tax system that would encourage rather than discourage saving?

Subprime Primer

Subprime mortgage lenders make home loans to "subprime" borrowers—people who don't have the income, wealth, or credit history to qualify for the traditional lending terms offered to prime borrowers. The recent housing slump pushed multiple subprime lenders into bankruptcy as a rising number of subprime borrowers failed to make their mortgage payments. As subprime lenders go belly-up and subprime borrowers fall on hard times, lawmakers have been quick to find signs of fraud and abuse, and quicker to propose new regulations for the subprime market. Events in the subprime market offer a glimpse of several issues behind the housing market correction in the United States. A recent New Yorker column by James Surowiecki explains the subprime fiasco.

Surowiecki suggests that focusing solely on "predatory lending" practices does not suffice to explain the trouble in subprime markets. He notes that lawmakers cannot consider instances of lender fraud and abuse without also considering the "overambition and overconfidence of borrowers." For example, borrowers who expected sharp increases in home prices used the easy credit offered by subprime lenders to make speculative purchases—buying a home with the intention of selling quickly and for a substantial profit. Other borrowers were enticed by low introductory interest rates and placed too much confidence in the ability of their future selves to pay the mortgage when the low rates expired and higher, adjustable interest rates kicked in.

University of Chicago economist Austan Goolsbee calls for restraint in the regulatory backlash against subprime lending in his New York Times column. Goolsbee focuses on a research paper by three economists: Kristopher Gerardi and Paul Willen from the Federal Reserve Bank of Boston and Harvey Rosen of Princeton. The paper suggests that innovations in the market for home loans, including subprime lending, offer more upside than down. According to the authors, a government crackdown on subprime lending could reduce homeownership opportunities among young people, minorities, and people without a lot of money for a down payment.

Discussion Questions

1. What's a "liar" loan? How did borrowers use such loans to make speculative gambles in the housing market?

2. What's a 2/28 loan? In what ways do consumers tend to "overvalue present gains at the expense of future costs," as Surowiecki suggests? (Think about decisions on whether to consume today or save for the future, or whether to study for an exam or attend a party.)

3. According to Surowiecki, what percentage of subprime borrowers were living in their homes and making monthly mortgage payments at the time the article was written? What does this suggest about the wisdom of an outright ban on "exotic" subprime lending products like the 2/28's?

4. In what way do subprime loans (such as 2/28's) benefit currently low-income households that expect to earn much higher income in the future? How do subprime rates reflect the fact that the expectation of higher future income is not a guarantee of higher future income?

5. What factors traditionally cause homeowners to foreclose? Do recent numbers suggest that subprime lending is the leading cause of foreclosures in the United States?

6. According to Goolsbee, what is the link between the expansion of subprime lending and the growth of homeownership among African-American and Hispanic households?

7. According to both Goolsbee and Surowiecki, the vast majority of subprime borrowers are making their mortgage payments on time. As higher, adjustable rates kick in on home loans with low introductory rates, how might the rates of delinquency (missed payments) and default (failure to pay the loan entirely) change? Suppose the housing market correction continues and home prices continue to fall. How will this affect the bets of speculative borrowers in the subprime market?

8. How would a continued housing slump affect economy-wide consumption and investment expenditures? (Recall that part of investment is residential investment—purchases of new homes and apartment buildings.)

Why Does Bernanke's Small Talk Move Markets?

Consider the Bartiromo Affair: At a media dinner party, Federal Reserve Chairman, Ben Bernanke tells CNBC reporter Maria Bartiromo that Wall Street types underestimate his inflation-fighting credentials and expresses his willingness to continue raising the Fed's interest rate target in order to check inflation. Ms. Bartiromo finds the comments newsworthy, reports the chairman's sentiments on her CNBC program, and sets off a sharp decline in stock prices just before the market closed on Monday, May 1. Keep in mind that stock prices move up and down all of the time for lots of different--often inexplicable--reasons. Ms. Bartiromo's TV show may or may not explain the movements at the end of the day on May 1. Generally, however, changes in interest rates (or expected changes) send stock prices in the opposite direction--that is, interest rates and stock prices are negatively related. Why?

The Fed influences a variety of interest rates in the economy by targeting changes in the federal funds rate. Interest rates have a direct effect on stock values, because investors have required returns they demand for holding financial assets, like stocks. Suppose an investor thinks she can earn a 5% return on her money by purchasing financial assets. Holding risk aside, she will only buy a stock if she expects it to provide a 5% return, but if the Fed raises interest rates, investors will require higher returns for holding stocks.

We can perform a crude stock valuation by assuming a stock will pay a constant dividend forever (a perpetuity) and investors’ returns are derived solely from dividends. Under this assumption, the price, or present value, of a stock simplifies to:

Present Value of Stock = Dividends per Share / Interest Rate

Suppose IBM's stock earns $1 per share. At an interest rate of 5%, the present value of IBM's stock is $1 / 0.05 = $20. If tightened monetary policy raises the interest rate to 6%, our crude valuation model predicts the stock’s value falls to $1 / 0.06 = $16.67. If dividends per share remain constant, an increase in the interest rate reduces stock values.

1. According to this valuation model, what happens to stock prices (present value) when the Fed targets lower interest rates?

2. Peoples' expectations about interest rates or dividends per share change stock values as well. Excessively tight monetary policy (higher interest rates) can lead to an economic recession. What happens to corporate profits during recession? If people expect that tight monetary policy will lead to recession, what will happen to stock values?

3. How did Ms Bartiromo's report about the Fed chair's dinner party comments affect peoples' interest rate expectations? How will a change in interest rate expectations affect required returns and stock valuations?

4. The Federal Reserve is one of the only central banks without an explicit inflation target. As a result, there is still considerable guesswork involved in determining the Fed's tolerance for inflation--that's one reason the Fed chairman's offhand comments receive so much attention. Uncertainty about the inflation target makes it more difficult to anticipate monetary policy. In the absence of clear monetary policy goals, small bits of information that change expectations can disrupt financial markets.

Ben Bernanke is an advocate of explicit inflation targeting--publicly announcing an inflation target and committing the central bank to its achievement. Would an explicit inflation target take some of the mystery out of monetary policy? How would explicit inflation targets change the likelihood of another Bartiromo Affair? How might an explicit inflation target inhibit the Fed's use of monetary policy during an economic crisis?

Nell Henderson offers a more detailed account of the Bartiromo Affair in the Washington Post.

Vikas Bajaj discusses the links between Fed policies and changes in both American and foreign financial markets in a New York Times article.

The idea for the post comes from Paul Romer's Econ 510 community discussion forum. Thanks also to Chris Buzzard for shoring up the finance.

Saving Early

Countless surveys and reports show that a majority of Americans, regardless of age, are woefully financially illiterate. The U.S. personal savings rate has been steadily declining over the past decade, even turning negative in 2005. According to many pundits, the problem is that youngsters are not learning financial responsibility and the importance of saving for the future. These bad habits follow them as they get older.

To fight this trend, some schools are promoting financial literacy at a young age and even starting savings banks. At Sunrise Valley Elementary School in Fairfax, Va, students operate the Sunrise Valley Savings Bank, a school branch of a local bank. There is no minimum balance and student deposits earn 5% annual interest.

Elsewhere, educators and financial institutions have sprung into action, teaching kids about basic money management skills. Indirectly, students will be learning about the power of the time value of money. The TVM is a central topic in finance and revolves around the concept that a certain amount of money received today is worth more than the same amount received sometime in the future. A variety of factors including inflation and the choice to consume or save play a role in this.

The basic TVM equation solved for future value: FV = PV (1 + r)ⁿ, where PV is the present value of the amount, r is the interest rate, and n is how long the amount is invested. The story mentions how a ten-year-old student, Nate, is depositing a $5 bill. If Nate continues to earn 5% on his savings until he retires at age 65, that $5 deposit will be worth $73.18, doubling nearly four times. If Nate continues his practice of saving $2 a week until he retires, he would have $30,414 when he retires. This is a slightly more complicated calculation, because there is a periodic payment being made, but trust me it’s right!

1. Near the end of the article, 11-year-old student William says he wants to buy a new skateboard. What is his opportunity cost of saving for a new skateboard?

2. The Sunrise Valley Savings Bank pays its members 5% interest, but it is reasonable to assume students will get higher returns for their money in the future. How much will Nate’s $5 deposit be worth in 55 years if he earns 6% interest? 8%? 10%?

3. To see the importantce of teaching youths to save early, access this savings calculator. If a 10-year-old student saved $1 every day and deposited $365 at the end of each year from now until retirement (at age 65), how much would he/she have at retirement in 55 years? (Hint: Starting amount = $0; Years = 55; $365 additional contributions made annually; and a 10% rate of return compounded annually)

4. Use trial-and-error with the savings calculator to see what annual contributions another student would have to make if he/she didn’t start saving until the age of 55 (ten years from retirement) and wanted the same ending amount. (Hint: Change Years to 10 and try different values for additional contributions until you have about the same ending amount.)

Banking on Gas Prices

Consumers across the nation continue to struggle with skyrocketing oil and gas prices, but some have found an answer with the First Fuel Bank. Drivers can buy gas at an agreed upon price, even though they will not consume those gallons immediately. In effect, they have deposited gallons in the fuel bank, which can be “withdrawn” as they see fit.

This arrangement sounds like an open-ended forward contract on gas. A forward contract is a two-party agreement to exchange an asset at an agreed upon price at a specific date in the future. However, in this case there is no specified date and an option component allows the consumer to “exercise” this forward incrementally as they wish.

Suppose Brooke, a customer, buys 300 gallons at $3.00 a gallon today. Brooke now has the option to buy gas at $3.00 a gallon at any point in the future. If the current market price dips below $3.00, Brooke will simply buy gas at the current, or “spot,” price and leave her gas bank balance alone. Having this choice makes it sound like holding an option, but Brooke has already paid for the gas and exchange will occur at some future date. This fact makes it more of a forward than an option.

1. The article says there are no additional service fees for the transaction (a $1 lifetime membership fee aside). What incentive do retailers have for selling future gas at today’s prices?

2. If gas prices six months from now hit $3.50, how much does Brooke profit by filling her 15 gallon gas tank and using her “gas account”?

3. Suppose gas prices fall below $3.00 for a couple of years and then rise back to $3.20 in three years. When Brooke taps into her “gas account” to fill up her tank, how much does she profit? Are there additional costs at play here?

4. Retailers are committing themselves to supply gas at potentially very low prices in the future. Is there a default risk on their part?

5. If the current price exceeds your locked-in price, do you always want to use your account, or are there cases where you would go ahead and pay the current price?

Topics: Finance, Gas prices, Forward contracts, Incentives

Driving Green

Suppose you're in the market for a new car. With the average gasoline price hovering around $3.00 per gallon, buying a hybrid vehicle might seem like the best way to go. Sure, the price of a Toyota Prius or Honda Civic Hybrid might cost more than their gas-guzzling counterparts, but the gas savings and tax credits offset the "green premium." Right?

Think again. Reuters reports that, despite sharply increasing gasoline prices, many hybrid vehicles are staying on car lots a lot longer than expected. And Kiplinger shows that, even in the course of five years, buying a hybrid vehicle might actually be more expensive than buying the gas-guzzling equivalent.

Suppose you want to buy a hybrid and you're going to give it to your son or daughter after five years. You should purchase a hybrid vehicle if and only if the benefits outweigh the costs. The benefits of a hybrid over a non-hybrid include an end-of-year $2,000 tax credit and gas savings accrued over the five years. The hybrid’s costs include an extra $5,000 up-front at the dealership.

We will assume gas sells for about $3.00 per gallon for the next five years, and that you will drive about 12,000 miles per year. If your traditional, non-hybrid car gets 25 miles per gallon and the hybrid will get 20 more miles per gallon, is it worth it to purchase a hybrid?

The cash flows from purchasing the hybrid vehicle rather than the gas-guzzling equivalent are shown below:



At first glance, the hybrid saves you $200 over five years, but that is deceptive because it does not account for the time value of money. If you could earn a 10% annual return investing in a high performing stock index fund, the tax credit and gas savings are worth less than what they appear. In order to calculate the hybrid’s net benefit, we must consider the time value of money, which says $1 today is worth more than $1 tomorrow, because $1 today can be immediately invested to earn a return.

The following shows the present values of the cash flows from purchasing a hybrid vehicle rather than a non-hybrid.



Net Benefit = -$756

Under these assumptions, you are better off buying a traditional car than you are buying a hybrid.

1. What if you drove 16,000 miles per year; is it worth it to buy the hybrid vehicle?

2. Driving a traditional gas-powered car imposes a negative externality (pollution) on the community. How do externalities affect your decision making?

3. Currently, there are only a few hybrid vehicles available in the market. If automakers such as Honda, Toyota, Ford, General Motors, Volkswagen, and Daimler-Chrysler realize that there are unexploited profits to be made in the hybrid vehicle market, how would this affect the premium you pay for a hybrid? If the "green premium" decreases, how would this affect the net benefit of buying a hybrid?

CLICK HERE FOR THE HYBRID CALCULATOR (EXCEL)

Topics: Finance, Externalities, Time value of money, Invisible hand, Cost benefit analysis