August 2009 – Donald Marron

The Fannie and Freddie Anomaly

Can anyone explain the stock prices of Fannie Mae and Freddie Mac, the two government-sponsored enterprises that are supporting our mortgage market?

On Friday, Fannie’s common stock closed at $2.04 per share, up 250% since the start of August. That values the company–to be precise, the privately-owned common shares in the company–at more than $2 billion.

Freddie Mac’s common shares closed at $2.40 per share, up almost 300% since the start of August. That values Freddie’s privately-owned common shares at more than $1.5 billion.

Collectively, then, the common stock of these two wards of the state totals almost $4 billion.

This seems a trifle high, however, since most observers think their common stock is worthless (see, for example, this AP story).

I think those observers are right.

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Positive, Normative, and … ?

Am I the only one who feels unfulfilled by the standard distinction between positive and normative economics?

I am gearing up to return to the classroom next week, to teach microeconomics to incoming masters students at the Georgetown Public Policy Institute. Anyone who’s experienced the first day of micro class knows what’s coming. After introducing myself and talking about the wonders of economics (which is, indeed, fun, useful, and enlightening), I will launch into the great positive vs. normative distinction.

In brief:

Positive is the science side of economics: understanding and predicting the behavior of individuals, firms, markets, economies, etc. In short, the part of economics in which we try to be physicists (or, sometimes, biologists).

Normative is the side of economics where we make value judgments, identifying policies as good or bad. In short, the part of economics in which we try to be philosopher-kings.

Both styles of economics are important, particularly in a public policy program. And drawing a careful distinction is vital, not least because of the many people in Washington (both economists and non-economists) who try to dress up their value judgments as science.

I have one problem with this distinction, however: it overlooks a great deal of what economists actually do.

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The Rubber Room

Over in the New Yorker, Steven Brill discusses “the battle over New York City’s worst teachers“:

These fifteen teachers, along with about six hundred others in six larger Rubber Rooms in the city’s five boroughs, have been accused of misconduct, such as hitting or molesting a student, or, in some cases, of incompetence, in a system that rarely calls anyone incompetent.

The teachers have been in the Rubber Room for an average of about three years, doing the same thing every day—which is pretty much nothing at all. Watched over by two private security guards and two city Department of Education supervisors, they punch a time clock for the same hours that they would have kept at school—typically, eight-fifteen to three-fifteen. Like all teachers, they have the summer off. The city’s contract with their union, the United Federation of Teachers, requires that charges against them be heard by an arbitrator, and until the charges are resolved—the process is often endless—they will continue to draw their salaries and accrue pensions and other benefits.

“You can never appreciate how irrational the system is until you’ve lived with it,” says Joel Klein, the city’s schools chancellor, who was appointed by Mayor Michael Bloomberg seven years ago.

Neither the Mayor nor the chancellor is popular in the Rubber Room. “Before Bloomberg and Klein took over, there was no such thing as incompetence,” Brandi Scheiner, standing just under the Manhattan Rubber Room’s “Handle with Care” poster, said recently. Scheiner, who is fifty-six, talks with a raspy Queens accent. Suspended with pay from her job as an elementary-school teacher, she earns more than a hundred thousand dollars a year, and she is, she said, “entitled to every penny of it.” She has been in the Rubber Room for two years.

Brill paints a picture of a stunningly costly and, frankly, stupid system for handling teachers who are accused of misconduct or incompetence.

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Craigslist’s Business Model

The magazine Wired regularly publishes some of the most interesting articles about economics and the modern world. Last month, for example, they had a great article about the antitrust threats looming over Google. The month before, it covered the economics of Somali pirates, which I never found time to write about. And the month before that, it discussed how Google, not eBay, is really the master of auctions.

This month, Wired provides an in-depth look at craigslist.

For those who don’t already know, craigslist is the place to post classified ads on the web. According to Wired, it is the world’s “most popular dating site,” “the most popular job-search site,” and “the nation’s largest apartment-hunting site.” Not to mention the myriad other things you can buy, sell, trade, give, receive, etc. on the site.

How did craigslist achieve this dominance? The article doesn’t provide a crisp answer, but it does offer some gems about how the company operates. You should read the article for the full effect, but here is a sample:

On innovation:

Think of any Web feature that has become popular in the past 10 years: Chances are craigslist has considered it and rejected it. If you try to build a third-party application designed to make craigslist work better, the management will almost certainly throw up technical roadblocks to shut you down.

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OMB’s 2009 Deficit Estimate Is Likely Too High

As expected, the new budget projections from the Office of Management and Budget show an estimated deficit of $1.58 trillion in the current year (which ends on September 30).

In their coverage of the dueling budget releases, many members of the media are noting that this estimate is almost identical to the $1.59 trillion estimate released by the Congressional Budget Office. Thus, it may appear that OMB and CBO reached similar conclusions about this year’s deficit.

That is not correct.

OMB and CBO use different accounting for a growing part of the budget — the federal take-over of Fannie Mae and Freddie Mac. If you adjust for those accounting differences, an apples-to-apples comparison shows that OMB’s projection of a $1.58 trillion deficit should be compared to a CBO estimate of $1.41 trillion. (For details, see the table on p. 2 and the box on pp. 8-9 of CBO’s report.)

In other words, using identical accounting, CBO is projecting a deficit that is almost $200 billion less than projected by OMB.

Here’s how it works:

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More Stimulus Spending Than Originally Projected

Lots of budget news this morning, with the release of the newest projections from the Office of Management and Budget and the Congressional Budget Office.

One headline is that spending on the stimulus will be higher than expected. As reported by Lori Montgomery at the Washington Post (ht EconomistMom):

The $787 billion economic stimulus package President Obama signed earlier this year is likely to cost “tens of billions of dollars” more than expected, helping to drive projections for next year’s budget deficit to $1.5 trillion, White House budget director Peter Orszag told reporters.

With unemployment climbing, costs for a variety of stimulus programs are running higher than anticipated, Orszag said, including expanded unemployment benefits, food stamps and energy grants. In an interview embargoed for release Tuesday morning, Orszag said he could not estimate the overall cost of the package, but he called Republican estimates of $900 billion “slightly high.”

The $900 billion estimate that Peter mentions is reported in this letter from former CBO Director Doug Holtz-Eakin to Republican House Leader John Boehner.

The CBO also addresses this issue in its report (box on pp. 10-11). The box discusses lots of pesky nuances about budget accounting and the timing of payments. Perhaps the most interesting observation, consistent with the OMB quote above, is that:

The higher-than-expected unemployment rate has led CBO to raise its estimates of spending in 2009 for ARRA [i.e., stimulus] provisions that affect unemployment compensation (by $7 billion) and Medicaid (by $1 billion).

In other words, the weaker economy has added $8 billion to stimulus spending in fiscal 2009 alone with, presumably, more to come in fiscal 2010.

These developments further complicate the challenging task of tracking the stimulus.

President Obama Makes A Great Decision

David Wessel of the Wall Street Journal reports that President Obama will re-appoint Ben Bernanke as Chairman of the Federal Reserve.

Excellent decision.

P.S. Don’t let this good news distract you from the much-less-good economic news on Tuesday: CBO and OMB are releasing new budget projections that will show trillions upon trillions of coming deficits.

$9 Trillion in Deficits for 2010 – 2019

If you have bad news to report in our nation’s capital, Friday afternoon in August is a good time.

So what did we learn this afternoon? Well, according to various news services (e.g., Bloomberg and Reuters) the Obama administration is projecting that budget deficits will total about $9 trillion from 2010 – 2019. That figure was released by an unnamed official (the usual practice) in advance of the release of new administration forecasts next Tuesday

That projected ten-year deficit is up about $2 trillion from the administration’s previous forecast, reportedly because of weaker economic assumptions. The new figure is in line with earlier estimates by the Congressional Budget Office, which will release new estimates on Tuesday as well.

As I discussed a few days ago, the administration estimates that the budget deficit this year will total about $1.58 trillion; that figure is not included in the $9 trillion figure, which covers the next ten years.

The Disconnect Between Oil and Natural Gas Prices

Yesterday marked a new record in the divergence between oil and natural gas prices.

As noted in a small item in the Wall Street Journal, the ratio of oil prices ($ per barrel) to natural gas prices ($ per million BTU) hit a record 24.5 at yesterday’s close. As you can see from the following chart, that’s far out of line with historical norms:

Ratio of Oil to NG (August 21 2009)

A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would tend to to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline makes oil more valuable. As a result, oil has usually traded between 6 and 12 times the price of natural gas.

That’s changed in recent months. Natural gas prices have fallen to $3.00 per MMBtu, weighed down by new supply and weak demand. Oil prices, however, have stubbornly increased to more than $70 per barrel. That’s down sharply from the $100+ prices of last year, but up sharply from the $40 – $50 range earlier this year.

Where do prices go from here?

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How to Manage $3 Trillion

Shawn Tully at Fortune has a fun article recounting the rapid rise of Blackrock, which will soon be the largest asset manager in the world.

He contrasts the firm’s fixed-income investment strategy with other firms (e.g., Pimco) as follows:

BlackRock does not invest by forecasting which way interest rates are headed. Instead BlackRock wonkishly focuses on the other factors that drive bond values: prepayments and default risk. As a result, BlackRock was better equipped to analyze the complex mortgage securities that came to dominate the fixed-income markets and that caused so much havoc last year.

BlackRock’s approach works like this: Say mortgage bonds are selling at a big discount because rates recently rose. BlackRock’s models are expert at judging if those bonds are “rich” or “cheap” based on its technology for predicting prepayment trends and defaults. If the model predicts, for example, that prepayments will be higher than most investors expect, BlackRock can garner extra returns because homeowners will pay off their loans at full value, and the fund can reinvest the proceeds at higher rates.

The firm’s analytical modeling gets so granular that BlackRock found that people living near IBM offices prepay frequently because IBM executives are often dispatched to new cities.

I find that IBM tidbit very telling. It’s a great example of the information-processing that can, in principle, allow investors to earn super-normal returns (alpha, in the lingo). And if enough investors do it, market prices could approach the efficiency that finance theory often predicts. On the other hand, the need to get that “granular” suggests just how difficult it is for normal investors to value these kinds of securities. (Of course, experience has shown that many investors in mortgage-backed securities made much more basic errors — like trusting the ratings granted by the credit rating agencies — but that’s a topic for another day.)

P.S. For those too young to remember, the old joke is that IBM stands for “I’ve Been Moved.”