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04/07/2008

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Jack

Hmmm, seemingly left out of the treatise on "risk" is the fact of CEO "compensation" having gone from 60 times working folk pay to over 500 times since 1980. This, while wages for those of median and lower incomes have been either flat or decreasing. The "risk" seems that of getting a LOT vs that of getting a major gob, with a finely sewn golden parachute for those who gambled the fate of there employees and lost, except for those a toke over the line who are now in jail.

As for "The housing boom of the past few years now appears to have been a serious bubble where pervasive optimism about housing price movements raised the rate of increase in housing prices far beyond sustainable levels. Sophisticated lenders as well as low-income borrowers underestimated the risks involved in the residential housing market, as they appeared to have assumed that housing prices would continue to rise for a number of years in excess of ten percent per year."


......... there will be a time when things slow down to look more closely at who did what and why during the housing run-up. We WILL find that it was far more often that the well-heeled took unnecessary and speculative risk in buying more McMansion than needed and speculating ala "Flip this House. At the lower end we'll find much more a picture of "what choice did I have???" as those good with numbers can clearly see such a high rate of home ownership with but a $45k median household income means most folks are chin deep in debt just to put a modest roof over the heads of their families. And what choice? a pile of rental receipts or take a shot with their own mortgage?

Jack

What role did the government play on the housing bubble?

For years the tax benefits home, and even multiple home ownership have been getting sweeter and sweeter. Especially so, FOR those with large tax liabilities.

First the tax deduct of mortgage interest means that a 9% mortgage post tax is under 6% net, and amount typically covered by inflation itself or at least by home appreciation. But, until recently to "cash in" a couple had to wait until 55 to take out their equity.

Today, they can play the game and take out equity purchased with 'free money' at any time.

The way I see it many were living with their "2nd income" being from the stock run-ups of the 90's, then what "saved us" and allowed the purchase of the most fuel hogging fleet of SUV's was that of pumping out home appreciation as the "2nd income".

Anyone see a third "savior" coming down the pike?

Diversity

Let's do some experimental economics the lazy way; just thinking about it.

We all expect ferry boats to rock a bit. It is a normal phenomenon, like variability in a company's rate of profit.

Next time you take the ferry, offer one energetic fellow passenger a dollar for every time the boat rocks more than 10 degrees, ten dollars for every time it rocks more than 20 degrees and a hundred dollars for every time it rocks more than 30 degrees. I think Professor Becker would agree with me that it would be wise to take a seasickness pill before boarding the ferry.

That schedule of reward, applied to company profit, looks to me a fair proxy for many present day executive reward plans. The expected result is some pretty big and uncomfortable lurches in the economy - the boat we are all in. I am a bit surprised that Professor Becker does not see that one thing that was being rewarded was not classical entrepreneurial risk taking, but rather decisions which would tend to make profits more variable.

Wes

If you have a problem that the wrong people are getting their heads chopped off, you don't need a different king or different incentives for the king. You need a different system (of laws and courts and juries).The problem with the subprime mess is not that financial corporations needed different CEOs (or that the CEOs needed different incentives) but that the CEOs shouldn't have been making those decisions at all. Rather than having one person (no matter how well compensated) making such decisions based on gut feelings, there should have been an entire system of specialists to accurately calculate the risks.There was enough information out there to know that the subprime loans that were being packaged up and traded around so freely were likely to go bad. The question is not what individual could have recognized this fact but, instead, what system could have recognized this fact.

Brn 2 Run

Jack makes some excellent points, but I am not sure what he would suggest as an alternative and I would suggest that he might be anchoring on high real estate prices in cities, like Chicago, versus other parts of the country where you can actually get a home for a reasonable price. As for the CEOs pay and guarantees, etc., I say start by getting rid of the lawyers. No offense to Judge Posner.

Jack

Born2, Ha! good question; and I remember chuckling over the run up in housing prices in So Cal of the early 70's. Cocktail parties were full of talk of buying as much house as the "creative financing" of the era could manage, "sheltering income" and finally flipping the house to your neighbor at the latest inflated price. The "profits" would then be spent on fine dining and an imported luxury car and thus was "wealth" to be created.

For now I'll leave fixing the current mess on the run to the bankers and pols who seem to be coming up with some real doozies! But, if starting with a clean sheet of paper, I've a lot of trust in the power of capitalism to most efficiently deploy the factors of production. But only if we "get it right" on the ground rules. This is no easy trick as are few absolutes and things keep changing too.

For example were we strict and honest capitalists we'd not have the home mortgage interest deduction which benefits the wealthy and stable as compared to those less wealthy and whose careers keep them on the move such that renting would be wiser for them. The deductibility of interest skews that decision as "society" decided that home ownership was a societal good and it sold well to voters and bankers.

It's clear that what's happened, in the "big" housing markets is a combination of false signals. First that anyone making a few bucks "needs" a mortgage if only for the tax shelter. Obviously that factor alone adds froth to the game. And "the game" was fundamentally that of providing housing for 80 million "boomers" and their families which would create a strong market that would bid up prices w/o further incentives.

But more was added, easy financing, the ability to "refi" and pullout cash with no tax liability and the myth of money growing on houses became deeply rooted.

As Wes points out, even the bankers we'd expect to rely on risk analysts did not and instead used the false signal of ever rising home prices to justify selling their flaky portfolios.

And for the many hardworking, passive investors, what could be better than living in your best investment instead of worrying about a portfolio of risky stocks and low yielding bonds?

Well, who is to say? But there's been the run up and there'll be a trillion or more "lost" that had housing not been so heavily subsidized might have gone into medical research or investments in plant and equipment or been used to restore our weary infrastructure, or even to invest in emerging nations around the world.

The point being that when we decide to distort our "capitalism" with incentives we should think long and hard about the unintended outcomes. Then there IS adapting to change. I was in So Cal when there were still backyard incinerators and air was a "free good" and oil nearly so. So I don't blindly trust "the market" to be the answer either; man can identify some of the long term trends and should tweak his capitalism to avoid flying up some of the more obvious blind canyons.

Or so it seems to me.

n

In the instance of recent financial debacles, the tendency to get upset at CEOs may be somewhat misguided. It is a systemic problem and not specific to one person or position. You have an entire industry that is highly leveraged (refer to "31.6" at http://www.chicagogsb.edu/usmpf/docs/usmpf2008confdraft.pdf). How was this allowed to happen? Should it be allowed? Who got rich from the leverage and who was hurt? Would anyone in the 1940s think such leverage as a bright idea?


"Evidence suggesting that the risk taken by companies during the recent boom was not mainly due to a principal-agent problem between executives and stockholders is that the major private equity firms also experienced serious loses on their investments, especially on their housing investments. Private equity companies have much less of a principal-agent problem than do Citicorp, Bears Sterns and other publicly traded companies because private equity companies have a concentrated ownership. Also borrowers in the residential housing market have basically no principal-agent problems since they buy for themselves; yet many of them too took on excessive risk because of undo optimism about the housing market."

I think there is still a concern about a principal-agency problem. The leverage in brokers is high. Pretty much all the traditional majors - Bear, Goldman, Lehman, Morgan Stanley, Citigroup, others - have lots of leverage and have been caught in the recent stock-market sell-off in financials. Managers suck cash out of the company via switching firms, bonuses, and dividends -- resulting in high debt loads for the public to solve. On the other hand, it is probably possible to find private investment companies (hedge funds for lack of better word) that may have $0 or little leverage. Schwab does not look like it is over-leveraged. Also, many subprime borrowers did not have means or resources to assess risk and cannot be compared to banks or private equity funds.

n


http://www.ft.com/cms/s/0/7a0777c6-0679-11dd-802c-0000779fd2ac.html

Bankers act to head off tighter regulation
By Chris Giles, Ralph Atkins and James Wilson in Frankfurt

Published: April 9 2008 23:17 | Last updated: April 9 2008 23:17

Excerpt:
The world’s banking industry is so determined to avoid tighter regulation that a committee of leading bankers has produced a report laying bare their own failures and proposing action to restore confidence.

Ian

I think an important point which was quickly passed-by is the definition of "asset bubble". I fear the proposed definitions are vastly over-broad. An asset bubble can't any significant drop in the value of an asset class. If a market is working efficiently, the value of an asset class will change according to new information whether that information is due new "facts" or less obviously new "metrics". What I mean by new "metrics" would be any new mechanism for determining asset value which is more accurate than currently exists. Sometimes those new metrics may cause for significant valuation changes. Such changes should not be considered a bubble because they are exactly the changes that should occur in a working market. I think we need a stronger understanding of the definition of asset class bubble because the current definitions are vastly too broad and include the market re-assigning values efficiently. There needs to be a definition which excludes normal market movements.

LittleBoss

I don't think the recent housing bubble was caused by distortions in executive compensation. Perhaps finding the optimal level of risk that a firm should take can be nudged by executive compensation plans, but the key for the market is that the firm offers to investors transparency in their operations. In this most recent case, it would appear, neither the CEO's or the market accurately priced the risks of some financial instruments. Simply, the CEO's did not fully understand or correctly price the risks they were taking.

In a previous time in history most mortgage lending was local. The lender had an interest in protecting the community they served from bubbles. I.E. As a community based lender, you are interested in the portfolio of loans in your community because you are interested in how the failure of new loans in the community can affect the portfolio of loans that you already hold in that community. The new innovations in subprime lending created some increased efficiencies but also removed prudent standards that had been normal for lenders.

The subprime segment of the market may have been under served and restrictions on the speculative market were relaxed. Th desire to serve the subprime market could have been induced by federal regulations. The speculative market driven by a false since of security about new financial instruments.

I just don't see executive compensation being a driving force (one could argue that such highly compensated people should be more aware of the true risks they are taking but I would argue that they thought they were being prudent). They may have tried to game the system on the low end and distorted or hid the risks in the speculative end

n

You wonder how people (mgrs and directors) sleep at night when they tell people the dividend is going to be there, right up until the point when the dividend is not there and people may have funds intended for retirement income invested in the stock. Do you think the mgrs and directors intentionally misled people on the dividend? Do you think the mgrs and directors did not know better? Did they lack resources to know better? Was it something else?


International Herald Tribune
Robert Rubin, the new chairman at Citigroup, hits the ground running
By Eric Dash Published: November 7, 2007

Excerpt:
NEW YORK: Until Sunday, Robert Rubin collected $17 million a year as Wall Street's ultimate hands-off executive. On Monday, he had to roll up his sleeves.

Rubin, who was named Citigroup's chairman after the departure of Charles Prince 3rd, has moved quickly to deal with the turmoil that has engulfed the banking giant. He has expressed a commitment to Citigroup's dividend and its existing strategy and is taking on a raft of problems, starting with the subprime mortgage mess.

http://seekingalpha.com/article/57134-citigroup-s-pandit-off-to-an-encouraging-start
Todd Sullivan
Dec 13, 2007


Excerpt:

Well, at least the position is filled, Pandit is a good man and Rubin is out. Citi (C) finally named Vikram Pandit as chief executive officer, ending the bank's month-long scramble to find a new leader after former CEO Charles Prince stepped down in November. Citigroup then named Sir Win Bischoff, currently the acting CEO as chairman, replacing Robert Rubin who stepped into the job when Prince, who also served as chairman, resigned.

If nothing else, finally having the CEO and Chairman position separate is a very good thing. Now Citi has a European Chairman and and Indian CEO, both of whom has extensive international experience.

This is going to be the key for Citi as it continues it's push into international markets. Vikrim does have the Prince comparison going for him. Other than being an abject failure, Pandit just has to prove to be competent to be an upgrade at CEO. Who know, he may even end up being great..... wait and see

Vikram Takes Charge
New CEO Vikram Pandit promptly Tuesday pledged to carry out "an objective and dispassionate" review of all Citigroup's businesses. Translation? Time to break this sucker up.

Pandit commented on the success Citigroup's wealth-management arm, which includes the Smith Barney retail brokerage and the private bank, and its overseas credit-card operations as "growth businesses." He continued saying he will immediately begin reviewing the bank's operations. "They are different businesses, and they need different strategies."

When pressed for an answer concerning a breakup, Pandit said he "would not rule out anything". This is a direct contradiction to recent statements by Robert Rubin, Sandy Weill and former CEO Chuck Prince who said that they believed in the "financial supermarket" concept.

Pandit's lack of anything coming close to supporting the concept can only be construed as an admission of change in direction.

Regarding the dividend, he said the board was very clear that the dividend was "where it was" and that they would make any decisions regarding it. What is more interesting is what he did not say. During each interview he gave, when it came to the various business units, he was consistent in his refrain of "all options are on the table".

When it came to the dividend question, he simply said that the boards have decided this. Not once did he say "we would review it" or that "any option is on the table". When it came to the dividend, its fate was decided already. Good....

Citi shareholders have to at least be encouraged that as we start out it does not seem like it will be business as usual at Citi. Who know what took so long to decide on Pandit, maybe it took Pandit that long to get the Citi board to give him the carte blanch he wants as it pertains to reshaping Citi, time will tell..


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