I just returned from NYC. The mood there is pretty bleak :-(

It looks like people are deserting the city in droves. Entire areas of finance and banking are gone and won't return for many years. I heard some very detailed estimates of the carrying cost of supporting a family in Manhattan (see Times analysis here):

An interesting new report on innovation competitiveness. (Click below to enlarge chart of summary statistics and rankings.) The US placed 6th overall. The countries ranked higher tend to be small (e.g., Sweden, Denmark), with the exception of South Korea. The report also gives "change scores" in each category -- essentially, the first derivative calculated over 1999-2005 -- that indicate who is gaining on whom.

The authors normalize most statistics to national GDP or population, which gives a more realistic picture of smaller countries than just looking at aggregate numbers. Some figures seem quite misleading. For example, Russia ranks number one with over 50% of the population completing tertiary education, whereas Germany ranks only 18 with 22%. But I suspect the level of training and human capital is much higher in Germany. Similarly, rankings of venture capital invested relative to GDP probably overstate the impact of government-backed funds in many smaller countries which lack a long history of venture investing. Some tables of interest in the report include corporate and government-funded R&D relative to GDP, GDP per capita and productivity per capita.

Anyone using a netbook? About 6 years ago I had a tiny Sony (SNE) Vaio with a 9 inch screen that I loved. Ultimately I couldn't stand XP anymore and switched to a Mac once OS X took off, but I always thought the form factor was great. At the time, only Japanese consumers would tolerate such a small screen and keyboard.

Now netbooks, which look just like my old Sony, are the hottest thing, accounting for about 10 percent of unit laptop sales. They can sell for under $300 and often run Linux distros like Ubuntu.

There is no way government stimulus can replace the trillions of dollars of debt driven demand that the U.S. and world economy have relied on for years. What's ahead? See here for some very good, but very gloomy, analysis. (Earlier related post here -- see Microsoft (MSFT) CEO Ballmer's comment.)

Let's hope we don't go the way of Japan:

Hmm... after tax, that's barely above the carrying cost for a family of 4 in Manhattan -- assuming the usual private schools and a typical banker's wife.

I understand the pay caps don't limit incentive stock option compensation. Perhaps that leaves some wiggle room, depending on what people think about the future value of bank shares (and modulo the inevitable nationalization we keep putting off). You certainly have to apply a deep discount relative to cash.

In no-arb, efficient market fairy tale land, investors are assumed to be able to value a company by simply looking at its balance sheet, researching its market and business model and projecting into the future. Sound difficult? Why, yes, it's almost impossible to do, and even after a lengthy research project executed by a team of brilliant analysts there is a huge remaining uncertainty.

So what happens in the real world? Well, we apes with limited cognitive power and limited information rely on simple heuristics -- rules of thumb -- to guess what will happen in the future. That is, we say "Rob Rubin seems like a smart, careful guy, and top management at Citi (C) must know what they are doing, and surely the market knows what it's doing, so, yeah, $40 a share seems ok with me..."

How much is consumer spending likely to fall as a consequence of stock and home price declines? If we assume a $10 trillion decline in housing and equity wealth, and a wealth effect of .04, we arrive at a decline in consumer spending of $400 billion. So, roughly 2-3 percent of GDP.

Even if we get the financial crisis fixed, we can expect a serious recession.

Consider the following proposition. You put up an amount of capital X for one year. There is a small probability p (e.g., p = .01) that you will lose the entire amount. With probability (1-p) you get the entire amount back. What interest rate (fee) should you charge to participate?

What I've just described is a catastrophe bond. A catastrophe bond allows an insurer to transfer the tail risk from a natural disaster (hurricane, earthquake, fire, etc.) to an investor who is paid appropriately. How can we decide the appropriate fee for taking on this risk? It's an example of the fundamental investor's choice problem. That is, what is the value of a gamble specified by a given probability distribution over a set of payoffs? (Which of two distributions do you prefer?) One would think that the answer depends on individual risk preferences or utility functions.

As I suspected, AIG's (AIG) CDS collateral obligations have eaten up the government's initial $85 billion loan commitment, which was recently boosted to $123 billion. AIG's CEO reported that they had sold over $400 billion in CDS contracts.

The WSJ piece below profiles Yale finance professor Gary Gorton, who helped Cassano's group (AIG Financial Products) build their risk models. They note that there is still a chance that the models are ok -- that in the long run losses on the securities they insured may not be large. The problem is that the CDS contracts require the insurer to post additional collateral if the market value of the security in question falls. Since all credit related products are oversold due to rampant fear, this forces collateral calls even on good securities (if there are any). I can imagine that triggers might depend on the value of various CDS indices, which have plummeted during the crisis.

At least for a while. Note the dip after the great depression -- is that where we are headed?

Via Calculated Risk, Case-Shiller indices (10 and 20 city composites) show that, adjusted for inflation, we have given back two thirds of the peak relative to 2000.

click to enlarge

Bill Moyers' Journal is usually pretty boring, but of late he's been quite good. Two weeks ago he interviewed George Soros, who said the following:

GEORGE SOROS: ...this belief that everybody pursuing his self-interests will maximize the common interests or will take care of the common interests is a false idea. It's a suitable idea for those who are rich, who are successful, who are powerful. It suits them to justify you know, enjoying the fruits without paying taxes.

Question: Were bankers and risk managers and investors who got us into this credit crisis plain stupid? Or were they just responding to incentives up and down the line?

Answer: Both. For many people, it was rational to participate in the mortgage bubble even if they thought it might (would) end in tears. On the other hand, even smart people can be taken in by bubble logic if everyone around them is convinced. For example, here is a 2006 discussion from Brad DeLong's blog of a column by Paul Krugman, making the case that most of the country was not experiencing a bubble, and that zoning was the main culprit for coastal price increases (hence prices were sustainable). If you were a CDO modeler in 2006 and believed that argument, you might not have even considered that your model assumptions were way too optimistic -- even with people like Robert Shiller (and me) shouting that we were in the midst of a gigantic bubble.

How do CDS contracts get settled after a credit event? We've had several recently, which means upcoming auctions (see also here). Fannie Mae (FNM) and Freddie Mac (FRE) auctions were October 6 (yesterday), Lehman is October 10, and Washington Mutual is scheduled for October 23.

Since Treasury is guaranteeing the GSE debt, October 6 was probably not as much of a problem as the Lehman auction will be in a few days. Many firms are scrambling for or hoarding cash because they don't know what they are on the hook for. At the auction, one first has to determine the value of the bonds before deciding the value of each CDS contract. That means first an auction of Lehman debt, presumably worth only a fraction of its face value (but exactly how much?), and then a settlement of contracts. If most of the contracts are offsetting they can be canceled then and there, but the suspicion is that many CDS counterparties (perhaps, especially, hedge funds?) were writing naked contracts, which means they would have to come up with the money on the spot. For detailed discussion see here. Related post at naked capitalism.

Charlie Rose interview

Skeptics will claim he is talking his own book, with the recent GS and GE investments. But I think he knows what he is talking about. Buffet says that if he could take a 1 percent stake in the bailout (investing $7 billion), he would. He thinks the bailout will make money investing in distressed mortgage securities at current market prices.

As I mentioned in my previous post on the mortgage bailout, it seems clear that Bernanke and Paulson both think that mortgage backed securities are undervalued at current market prices (my "scenario 1" in the previous post). Bernanke refers to the difference between "hold to maturity" and "fire sale" prices in his congressional testimony.

Many commentators are trying to wrap their heads around this difference. To understand, it helps to have seen the collapse of a financial bubble firsthand. If you haven't (as, I suspect is the case with most academic economists), you are likely to cling to the idea that the market price of an asset is a good forecast of its actual value. However, this is completely wrong in the wake of a collapse. (And, certainly, the predictive power of the market price cannot hold at all times -- it is likely to be most wrong at the peak and in the aftermath of a bubble.)

As we all know, the devil is always in the details. The proposed legislation will put $700B in the hands of Treasury to buy distressed assets in an attempt to unfreeze credit markets. This gives the current and future Treasury Secretary incredible financial and discretionary power. Let's put aside issues of corruption and abuse of power and assume a benevolent, public spirited, intelligent person in charge. I make this assumption not because it is realistic, but in order to proceed to the question: How, exactly, will this work?

First, let's differentiate between CDOs and CMOs (Collateralized Debt / Mortgage Obligations), which are securities that entitle the holder to future cash flows from bundles or tranches of mortgages, and CDS (Credit Default Swaps) which are derivative contracts which allow two parties to bet on defaults. CDS can be used for pure speculation, or to spread out the risk associated with CDOs. I will discuss CDOs and CDS separately below, although it should be obvious that both markets are interconnected and, at this time, highly problematic.

If this article by John Cassidy in the New York Review of Books is any guide, Obama's grasp of economics may be orders of magnitude deeper than that of John McCain. A long exposure to the market-obsessed Chicago School has probably made him at least familiar with the arguments favoring market outcomes over government intervention. The remainder of the article is mainly about behavioral economics, rather than Obama, but well worth reading.

...Should Obama win the nomination, political considerations may well force upon him a more interventionist position, but his first inclination is to seek a path between big government and laissez-faire, a trait that reflects his age—he was born in 1961—and the intellectual milieu he emerged from. Before entering the Illinois state Senate, he spent ten years teaching constitutional law at the University of Chicago, where respect for the free market is a cherished tradition. His senior economic adviser, Austan Goolsbee, is a former colleague of his at Chicago and an expert on the economics of high-tech industries. Goolsbee is not a member of the "Chicago School" of Milton Friedman and Gary Becker, but he is not well known as a critic of American capitalism either. As recently as March 2007, he published an article in The New York Times pointing out the virtues of subprime mortgages. "The three decades from 1970 to 2000 witnessed an incredible flowering of new types of home loans," Goolsbee wrote. "These innovations mainly served to give people power to make their own decisions about housing, and they ended up being quite sensible with their newfound access to capital."

This NYTimes illustration of the various components of the CPI (inflation index) is one of the most impressive web graphics I've seen in a while. I suggest you click on the chart to look at the interactive original -- it allows you to zoom in and see the contribution from individual components (gasoline, computers, college tuition, eyeglasses, etc.) to the overall index. Blue regions represent deflation (reduction in prices); reddish regions are strong inflation (the big red blob is gasoline).

I believe the outlines of the bust are becoming as visible as the bubble itself was to any astute observer a few years ago. But, it has yet to hit bottom! If I had to guess, I'd say we are going to give back most of the integral over the curve from 1997 to 2007 or so, net of overall inflation during that period (say 20-30%). In other words, extend the blue trend line beyond the early nineties, and integrate your favorite curve minus this trend line from 1997-2007 to get the overvaluation. (Note the graph is of year over year price changes in nominal dollars, not absolute price.)

click to enlarge