Felix Salmon

How much is Treasury’s housing guarantee worth?

Felix Salmon
Aug 18, 2010 15:17 UTC

Arnold Kling is incredulous when it comes to Pimco’s Bill Gross, who said yesterday that “without a government guarantee, mortgage rates would be hundreds — hundreds — of basis points higher, resulting in a moribund housing market for years.”

“The standard estimate in the literature is that Fannie and Freddie reduce mortgage rates by 25 basis points or less,” says Kling, and he’s correct: that is indeed the standard estimate. But the standard estimates were all calculated back in the day, when no one worried much, if at all, about mortgage default risk. Here’s Gross again:

It’s an $11 trillion secondary mortgage market. Agencies are about a half of it. The other half, or a good portion, were financed when people thought housing couldn’t go down in price. We know that’s not the case now. So to suggest there’s a large place for private financing in the future of American housing finance is unrealistic.

The 25bp figure dates back to the time when Frannie accounted for roughly half of all mortgages: back then the best estimate was that Frannie-conforming loans were about 25bp cheaper than private-label loans, all other things being equal. That 25bp wasn’t only a function of the government guarantee, so much as it was a function of the fact that Frannie’s capital requirements were much lower than banks’ capital requirements, and the fact that Frannie had huge economies of scale when it came to things like managing the risks associated with prepayment and negative convexity.

Now, however, everything has changed: Frannie accounts not for half of the market, but for essentially all of it. And while private money is happily pouring into corporate bonds and other credit instruments, it’s still shying away from mortgages, partly because no one really knows how to price them any more.

In order to price a mortgage, lenders and investors need to have an idea of what the borrower’s default risk is. And right now, they haven’t got a clue. We know that default risk is highly correlated to house prices, but we don’t know whether or when or by how much house prices might fall. We also know that default risk is a function of societal norms: historically, people paid their mortgage first, before other debts like credit cards, or other household expenses. That’s changing dramatically.

And beneath it all is the fact that the US housing default rate isn’t something that any lender can calculate: rather, it’s something controlled mainly by US government policy. The government has a huge range of ways in which it supports the housing market, and it can remove those supports at any time, sending defaults spiking. Alternatively, it can throw even more support at the housing market, as Gross would like to see:

Gross, speaking at a Treasury forum on the future of housing finance giants Fannie Mae and Freddie Mac, said a massive refinancing program to slash monthly mortgage payments could boost consumer spending by $50 billion to $60 billion and boost home prices by 5 to 10 percent.

“Policymakers should quickly re-engineer a refinancing opportunity for all mortgagees that are current on payments and are included in GSE-securitized mortgages,” said Gross, PIMCO’s co-founder and co-chief investment officer.

This is a crazy idea: the last thing we want is to send large checks to anybody lucky enough to have a conforming mortgage. Nor do we want house prices to rise even further away from the market-clearing level which we’d see were there no artificial government support. To the contrary, we want houses to become more affordable and to account for a much lower proportion of households’ budgets than they did during the housing boom.

But the point is that if it wanted to, the government could throw so much money at the housing market that defaults would no longer be much of a problem. And so the key analysis of anybody trying to price mortgages has to be primarily political rather than economic or financial.

Bond investors are by their nature very cautious folk, and they hate massive uncertainty about something as important as future housing default rates. So they simply avoid the housing market altogether, absent a government guarantee. That’s why Gross says that the guarantee is worth hundreds of basis points. I don’t know whether he’s right, but I’m sure the number is more than Kling seems to think.


Aren’t jumbo loans in effect priced by the market without a government backstop? Mr. Gross seems to be looking to sustain the high leverage that homebuyers have been able to obtain over the last ten years. I am sure that there would be a market for loans made with real underwriting standards to people with actual, you know, equity in their houses. That might mean that housing prices still have to decline in some areas but I think that a housing financing market that is totally reliant on government leaves us vulnerable to the same boom and bust cycle we went through as it will be in the politician’s interest to push loans out and mbs buyers have less incentive to police the value of loans going into those securities.

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Google’s email nastiness

Felix Salmon
Aug 18, 2010 12:41 UTC


Yesterday afternoon, I started wondering why my steady stream of emails seemed to have come to a halt. It didn’t take long to get the answer: emails to me were being bounced back to their senders as undeliverable, on the grounds that my Gmail account was over quota.

Naturally, I immediately paid Google the $5 they wanted to upgrade to 20 GB of storage from the free 7.5 GB. But the email is still bouncing, and Google says it could take up to 24 hours before they start letting it through again. When I log in to my Gmail account, 14 hours after I upgraded, I still get the warning message saying I’m out of space and can’t receive any emails. (Incidentally, the link to Google’s “tips on reducing your email storage” provides no such thing, it just pulls up a page telling me how much storage I have.)

There are two extremely annoying things, here, for an old-fashioned person like me who still relies to a large extent on email. I’ve been using email for 17 years now, and I’ve encountered my fair share of email problems along the way. But in every case, the email ended up sitting there on my mail server until the problem was resolved. When Google decides I have an email problem (that I haven’t paid them enough money), however, they don’t keep the mail on the server until the ransom is paid. Instead, they just declare “a permanent error” and bounce it back to the sender. That’s incredibly aggressive and rude, and means I will now never receive a large number of emails which might well have been very important.

More annoying still is the fact that Google never told me this was about to happen. I’ve never used their web interface: while I like the reliability and spam-filtering abilities of the Gmail service, I don’t like checking my email in a browser. So I don’t: instead I use Apple’s Mail applications on my computer, iPad, and iPhone. Had I logged in to the Gmail website, I would have seen a warning telling me that I was running out of quota. But not once did Google send me an automated email saying that I was about to run out of storage space.

When Chris Anderson says that the web is dead, he’s talking about new applications which are supplanting things we used to use the web for. What he doesn’t mention is that millions of people never made the switch to the web in the first place, at least when it comes to email. Google behaves as though everybody using Gmail uses the web interface, when a moment’s thought would show that to be false. And then it imposes a punishment on people who run out of quota or who delay too long in paying which seems out of all proportion to the crime.

In any case, if you’ve tried to reach me via email and the message has bounced, try resending your message — with any luck it’ll get through now. I just worked out that although the paying-for-more storage solution takes time to work, the deleting-spam-emails solution seems to work immediately. It would be nice if Google mentioned that somewhere.

Alternatively, send it to felix.salmon at reuters. I came close to running out of quota there, too, recently, but they became very insistent that I had to delete old emails long before they bounced anything. It wasn’t a pleasant experience, but it was nothing compared to Google’s nasty and passive-aggressive behavior.


A friend of ours had a similar problem. She hit the limit, and fortunately was using the Gmail web interface so she saw the message — but then couldn’t delete mails fast enough to free up space. Every day was another chunk of time finding messages to delete — only to be hit with another big email that zeroed it out again. She had no idea about imap and had to get help.

As a result of this, we built http://www.findbigmail.com as a free service to identify large emails. It adds labels for big, very big and ultra big messages so you know what to delete first. Hopefully this can help some other people too. (And if it does, a donation will help to keep it running!).

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Felix Salmon
Aug 18, 2010 07:36 UTC

“Above all, he avoids nudity”: Bernard Knox’s brilliant review of a 1977 production of Agamemnon — NYRB

The software Peter principle: a dying project which is too complex to be understood even by its own developers — Wikipedia

The long-awaited Gawker redesign finally gets unveiled, and I like it a lot — Gawker, All Things D

Cool electricity pylons — Gawker

I want to rent in Australia

Felix Salmon
Aug 17, 2010 23:16 UTC

Over recent decades, public companies have steadily paid out fewer and fewer dividends, with little if any complaining from shareholders. They often prefer it when the money is retained in the company or used for share buybacks, because that way they don’t need to pay taxes on their dividend income.

Someone should remind Australians that houses are not, in this respect, like stocks. It would be wonderful for landlords if they could simply capitalize their rental income, seeing it reflected in a higher value for their property rather than having to be paid out in taxable income. But of course that can’t happen: whether or not a house increases in value is entirely unrelated to the amount of rental income that a landlord manages to extract from it.

Even so, reports Clancy Yates,

According to Tax Office figures, the proportion of taxpayers who own rental property has swelled from 6.5 per cent in 1989 to 13.5 per cent in 2009, two thirds of whom claim a loss on their investments.

Why this doubling in the number of Australian landlords, if they’re not making any money renting out these houses? The psychology is obvious: it doesn’t matter if I lose money on a cashflow basis, so long as I’m making money in terms of rising home equity. Of course, this is a classic bubble mentality, and is fundamentally unsustainable. I just hope that the banks have done a very solid job underwriting the mortgages on these rental properties.

(Via Kedrosky)


The losses are paper losses, due to depreciation deductions that are not available on non-rental property.

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Why banks find it so easy to borrow

Felix Salmon
Aug 17, 2010 22:49 UTC

John Lounsbury attended the most recent meeting between bloggers and Treasury officials, including Tim Geithner. He reports:

In one brief exchange an interesting thought emerged. The fact that bank stocks are trading at or below book value seems to be in conflict with the fact that banks are having little trouble in selling bonds. The thought was expressed that the bond market is looking at solvency and the stock market is looking at future profitability. Markets now are telling us that investors are not worried about insolvency but do have questions about profits in coming years.

I have thought about this after the meeting and wish I had asked the question if there is still some backstop mentality in the bond market – the government will not let these banks fail.

The first thing worth noting here is that from a policy perspective we want banks to have low spreads and low stock prices: both of them are an indication that they’re approaching low-risk, utility-like status. High spreads and high stock prices would imply a banking system full of gambling and risk.

It’s not really the case that a low stock price is “in conflict with” a low spread on a bank’s bonds. To the contrary, it’s an indication that the market believes that the government is, or will be, doing its job when it comes to bank regulation. High stock prices come from excess profitability, which in turn comes either from inappropriate risk taking, like the prop trading which is being outlawed by the Volcker Rule, or else from the kind of predatory fees which the Consumer Financial Protection Bureau exists to crack down on.

But yes, the market still believes that the government will bail out bank bondholders. As Tyler Cowen asked Geithner (or possibly one of the other Treasury officials):

“What I really want to know is how your incentives have been changed! What is to say that next time the decision will not be made to again bail out the bondholders?”

There’s an enormous amount of institutional pressure, within any government, to bail out bondholders who get themselves into trouble. It happened with AIG, it happened with Citigroup, and it will surely happen with California or any other large state approaching default as well. It didn’t happen with the automakers, and the squeals of pain from bondholders were very loud and astonishing to behold.

So the best way to avoid a future bailout of bondholders is to ensure that it never becomes necessary. Because if there’s another banking crisis, the pressure on the government to bail out bondholders will be just as strong as it was last time around.


Everybody is having an easy time borrowing right now because (looking at the past ten years) people have decided that stocks are for gambling fools while bonds are the only investment that makes any sense.

Of course the joke is on them, as this bubble too will burst. There is no investment that won’t suffer under SOME set of conditions, and that suffering is most likely to follow an extended bull run.

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Looking at Europe from Uruguay

Felix Salmon
Aug 17, 2010 20:53 UTC

I had the very good fortune to have lunch today with Carlos Steneri, the veteran Uruguayan debt manager and negotiator who is finally leaving public service after many decades to do some work in the private sector. I’ve known Carlos for the best part of a decade now, and have the greatest respect for him. He’s seen a lot over the course of his tenure working for Uruguay, and it’s worth listening to his highly-experienced take on today’s global situation, and how the likes of Greece and Italy can learn from Uruguay’s experiences.

Carlos reminded me that Uruguay had a Brady program — something which you wouldn’t necessarily expect, given that it was one of the very few Latin American countries not to default on its debts in the 1980s. The Brady scheme took defaulted sovereign bank loans and turned them, with some help from the US Treasury in the form of zero-coupon Treasury-bond collateral, into performing, liquid, tradable bonds — something which marked the beginning of the end of the Latin American “lost decade” as banks started being able to offload their formerly-bad debt at ever-higher prices.

But Uruguay, too, took advantage of the program, swapping a large chunk of its bank debt into Brady bonds, in the process essentially paying 56 cents on the dollar to buy back its own debt. (Which was the market price at the time.) That did wonders for the country’s debt profile, without harming its reputation at all — a large part of its investment-grade credit rating in the following years was due to the fact that it had never defaulted.

The problems facing the PIGS are very different from those which faced Latin American economies in the 1980s. The debt/GDP ratios are much, much bigger, for starters. And none of them can do an Uruguay-style restructuring-while-current, for the good reason that none of them have performing debt trading at 50 cents on the dollar.

But Carlos reckons that some kind of European Brady plan makes sense — he calls it the Trichet plan. Germany would take the lead in providing the collateral, in the form of zero-coupon 30-year notes — and get money back for issuing them, as well, so it wouldn’t lose out. The PIGS would at the very least be able to term out a bunch of their short-term maturities, dealing with their liquidity problems. And the new instruments, with embedded partial German guarantees, would be more palatable to investors than plain-vanilla Greek debt, making it easier for banks to offload the paper into the secondary market. That’s important, because a large part of the sovereign-debt problem in Europe isn’t the sheer size of the debt so much as it is the leveraged nature of the banks which hold it. If the debt can be moved off bank balance sheets and into the hands of bond investors, the amount of systemic risk would fall dramatically.

This is neither a necessary nor a sufficient solution to the debt problem, of course, but it might be a helpful step in the right direction, and at the very least demonstrate a willingness to face up to the magnitude of the crisis facing Europe. Carlos was adamant that muddling through is simply not going to work — and the longer it seems that Europe is trying just that strategy, the more painful the eventual crunch is likely to be.

Meanwhile, small countries in general, and Uruguay in particular, seem to be in a much healthier spot, these days, than the Europeans they used to borrow from. Their domestic pension funds save far more each year than the government borrows, which means that there’s a healthy domestic savings rate and no need for Uruguay to tap any foreign investors at all. The tourist trade in and around Punta del Este is booming, especially as Brazil’s southern states continue to thrive. (Punta del Este is a lot closer to the southern states than Rio de Janeiro, and much safer, too: no need for bodyguards in Uruguay. Plus, it has casinos.) Uruguay is a highly-educated, highly-dollarized, highly-professional economy, which also happens to have a hugely valuable deep-water port in Montevideo. It’s not the offshore banking haven that it used to be, but that’s no bad thing. For institutional investors small enough that a Uruguayan investment is still capable of moving the needle, it has a much rosier outlook, I think, than the likes of Italy or Spain. Not least because all of its debt woes are now, finally, behind it.


The problem with Europe is exactly the sheer size of the debt. Eurozone debt is 3X the size of US debt relative to GDP. What makes it more of a ticking time bomb is the fact that the general shape of European banks is flat out catastrophic. This debt needs to be restructured. Trichet along with the ECB will play the ponzy extend and pretend game all the way to the bottom. This is the only end game for Europe. The EU Stress Tests were a complete joke. How in the world with all that we know about the PIGS, that EU institutions only need to raise some 3B? How is this? If US Stress Tests were a joke than the EU tests are quite comedic. Trichet is jumping for joy over the fact that the Sovereigns are able to sell bonds. Are they really? Most of the direct takedowns in the Spain auctions were BBVA and Santandor. These institutions buy these bonds then immediately REPO then with the ECB. It’s a total farce.

Restructuring of EU Sovereign Debt is 100% inevitable. When does it happen? Like all good ponzy schemes, it will end when there are no new buyers.

Its no different than Madoff and Stanford.

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Corporates won’t trade through Treasuries

Felix Salmon
Aug 17, 2010 15:14 UTC

A rather startling pronouncement pops up on Fortune.com today:

“I wouldn’t be surprised if someday JNJ trades at a spread below Treasurys,” says Jack Ablin, Chief Investment Officer, Harris Private Bank. In other words, Johnson and Johnson yields could dip below the so-called risk-free yield on government debt.

Ablin might not be surprised, but I would be absolutely astonished. (Remember that Ablin is talking about Johnson & Johnson’s bonds, here, not the dividend yield on its stock.)

In the world of emerging markets, occasionally you’ll find corporates which trade “through the sovereign”. Generally, those companies are multinationals with strong and predictable dollar-denominated income streams, and the comparison is with dollar-denominated bonds issued by their home country.

It’s another thing entirely, however, for a company to trade at a lower yield than its home country can borrow in its own currency. And when it comes to the US dollars and Treasury bonds in particular, I’ll quite happily go out on a limb and say it’s simply not going to happen.

For one thing, if there’s a sell-off in Treasury bonds, that’s most likely going to be a result of worries about inflation — which eats away at Johnson & Johnson’s coupons just as much as it eats away at the US government’s. The only way for JNJ to trade through Treasuries would be if somehow there were worries that the US government was simply not going to pay some of its bonded obligations — while at the same time there were no worries at all about JNJ making its coupon payments. I can’t see it.

What’s more, Treasuries come with a substantial liquidity premium attached: to a first approximation, you can buy or sell them in any quantity, at any time, without moving the price. That’s very valuable — and it doesn’t apply to JNJ bonds. It’s also why Treasuries trade at lower yields than other securities without any credit risk, like World Bank bonds — which are guaranteed not only by the US but also by all the other World Bank shareholders.

So I’ll happily give Mr Ablin generous odds that JNJ bonds will never trade through Treasuries. Alternatively, I’ll buy some kind of financial instrument which pays off if JNJ never trades through Treasuries. The only problem is that no one would be willing to sell me such a thing.

Update: In the comments, tyler7 brings up a notorious Bloomberg article from March, which I dealt with at the time. People are always on the lookout for this kind of thing, but it never bears a thorough double-check.


130-30, the multinationals already borrow in a variety of currencies. I think they are called “Samurai bonds” when they tap the Japanese market (denominated in yen). Euro bond issues are also pretty common.

And yes, the yields in Japan are very low, as the currency is perceived to be free of inflation risk.

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Why the housing bulls never made much sense

Felix Salmon
Aug 17, 2010 14:28 UTC

Kristopher Gerardi, Christopher Foote, and Paul Willen, of various regional Federal Reserve banks, have a paper which looks at economic research on whether or not there was a housing bubble, and which concludes that “we do not currently have the ability to prevent a bubble from forming or the ability to identify a bubble in real time”. Yes, they admit, some smart and prescient economists did say, with complete accuracy, that there was a bubble. But! Other economists weren’t convinced! So, never mind, there’s nothing we can do.

Tracy Alloway has already dealt with the part of the paper which looks at the housing bears, but for me the part looking at the housing bulls is far more interesting. The paper says that “there were reasonable arguments on both sides” — so what were these reasonable arguments saying that there wasn’t a housing bubble? It turns out that they’re pretty laughable.

The main argument of the housing bulls is also one of the silliest:

If housing was so obviously overvalued, as the pessimists suggested, then investors stood to make huge profits by betting against housing. By doing so, investors would have ensured that house prices would have fallen immediately.

This doesn’t even pass the laugh test. For one thing, there’s an enormous difference between being able to identify a bubble, on the one hand, and being able to profit by betting on it bursting, on the other. Look at stock-market bubbles, which are easy to short: unless you know when they’re going to burst, it’s very hard to make money and very easy to lose money by betting against them. And of course no one knows when any bubble will burst.

But applying this argument to housing bubble makes even less sense, because it’s almost impossible to bet against housing. You might be able to short proxies for the housing market, like real-estate investment trusts or homebuilding stocks. But you can’t short houses themselves. And the handful of people who did manage to make money by shorting the housing market only managed to do so after Wall Street spent a huge amount of time, effort, and money creating credit default swaps on collateralized debt obligations comprising a large number of thin slices of private-label subprime mortgages. Such things didn’t even exist for most of the housing bubble, and even after they were invented they were available only to a very small number of dedicated housing bears.

The paper also quotes what it calls “perhaps the most widely cited evidence against a housing bubble” — a 2005 paper by Himmelberg, Mayer, and Sinai — as saying that “expectations of outsized capital gains appear to play, at best, a very small role in single-family house prices”. That argument is echoed in another paper, by John Quigley, who “claimed that high transactions costs in housing markets would tend to decrease the amount of speculation”.

This is also a silly argument, and it seemed silly at the time: you don’t need speculators to have a housing bubble, and indeed many of us were pretty clear that a large chunk of the housing bubble was not speculative.

On the other hand, it’s downright idiotic to look at rampant house-price appreciation and use it as evidence that there isn’t a housing bubble. But yes, even that argument was trotted out, as part of the thesis that houses weren’t overpriced if you look at the total cost of housing. Get a load of this:


The argument here is that the cost of housing is low, so there isn’t a bubble: houses are priced in line with fundamentals. But a key part of those “fundamentals” is the rate at which house prices are rising! In other words, the faster that house prices are rising, the cheaper houses look. Crazy.

Similarly, other housing bulls looked at “hedonic indices” and the size of homes, concluding that “a significant portion of the house price appreciation measured using the median price and repeat-sales indices was attributable to quality increases” — and therefore that there wasn’t a bubble. But the fact is that if a million-dollar house is unaffordable, it makes no difference how big it is, or how high its quality is. (And I haven’t found anybody saying that the quality of housing stock rose during the bubble in any respect other than sheer square footage.) If house prices are at unsustainable levels, then they will drop, regardless of how many square feet they’re based on.

So my conclusion, after reading the arguments of the housing bulls, is that they were mostly bunk. And there’s even a hint of that in one of the footnotes to the paper, which says that “economists at policy institutions may have shied away from making pessimistic predictions for fear of spooking the markets”. It seems to me that if there wasn’t a bubble, no one was likely to be worried about spooking healthy rising markets.

The bigger conclusion, of course, is that it’s silly to look to economists to forecast anything at all. Not because they don’t have the tools, but just because it’s always possible to find an economist who’ll believe just about anything. Housing bubbles are normally pretty obvious at the time: there’s one right now in Vancouver, for instance. You can see them in the rise of dozens of huge new glass-clad condo buildings; you can see them in massive price increases; you can see them when mortgage payments are significantly larger than the amount of money you could get renting out the place; and you can see them whenever people start making more money from selling their homes than they do from actually working. The only people who can’t see them, it seems, are economists, realtors, and bankers on Wall Street.


You make some interesting points but the year ahead expected capital variable or factor is not a crazy concept, rather it is the stuff of bubbles and quite rational behaviour. Purchasers expecting substantial price appreciation believe that the current price is cheap relative to their expectations. This is not crazy even though their expectation may prove to be irrational.

You state that Vancouver is currently in a housing bubble but I respectfully differ. Prices are currently declining following a sizable rebound from their recession low of Jan-2009. Your evidence of high-rise condo construction is insufficent to reach such a conclusion. Rents for newly constructed buildings are almost always lower than mortgage payments – no surprise here — otherwise builders/developers would build market rental buildings for their own account and that is not happening in Vancouver.

Yes, when taxi drivers talk about how much money they have made in the housing market it probably is a bubble but that is not what I hear from cabbies these days.

The housing market is well researched and documented as an inefficient market for a number of reasons and to expect otherwise is irrational.

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Felix Salmon
Aug 17, 2010 05:03 UTC

Steve Schwarzman FTL, by Godwin’s law — Newsweek

A few photos of stuff the same distance from the World Trade Center as the “Ground Zero Mosque” — Daryll Lang

A patent on patent-trolling — USPTO

Peruvian manufacturing +21.61% yoy — WSJ

Economics of Contempt on Basel III liquidity requirements. Wonky yet accessible, and excellent — EoC

The unseemly squabbling between HP and Mark Hurd degenerates even further — WSJ, NYT. See also Nocera’s excellent column.

“99% of all automobile trips in the United States end in a free parking space” — NYT


Tyler Cowen ought to consider Weehawken, NJ where all on street parking spaces are assigned to residents. You must have a sticker in your car window. The supermarket has free parking for shoppers.

Weehawken is about ten minutes from Time Square by bus.

Cornell’s campus has no free parking during the day on weekdays.

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