Markus Brunnermeier's presentation and the Negative Feedback Loop

Much has been written lately about the unintended consequences of investing through financial intermediaries.  Of course the intent is for the intermediaries to coordinate the transfer of capital from less productive to more productive uses. This gives the owner of less productive capital an opportunity for a higher return when their capital is used for more productive purposes. Capital is provided to those who can employ more than have, giving them an opportunity for a greater return.  The intermediaries charge a fee for the service of coordinating the parties involved and their transactions.  Everyone is happy because everyone makes money.  Sometimes.

For the last couple of years, the media has been highlighting a laundry list of things that can cause an investment to go bad. From price shocks to fraud and lack of due diligence to intention misrepresentation, the list goes on and on.  Markus Brunnermeier gave a lecture based on his paper, “A Macro-Model with a Financial Sector” that he is writing with Yuliy Sannikov. In the lecture he mentioned several reasons why investments may not work out as planned and he showed how he was modeling them.   He illustrated the benefits of “inside money”.  Examples would be an intermediary putting its own money at risk give incentive for monitoring the investment which helps lower the investors’ risk, or an entrepreneur having money at risk in the investment as an incentive to increased effort.

It was difficult for Dr. Brunnermeier to cover all his material in 90 minutes so I surely could not do all of his work justice here. Instead I’ll just mention the part that stuck out for me the most, the negative feedback loop.  Normally negative shocks are modeled as causing a lower payout for the investment and this behavior is described as linear.  Dr. Brunnermeier noted that these model work near the steady state but they do not hold below the steady state so a new model is required.  The reason is that when shocks are large enough leveraged intermediaries not only reduce payouts but they must also sell assets at fire sale prices.  These fire sales cause asset prices to fall leading to a feedback loop where lower asset prices reduce intermediaries’ net worth causing them to sell assets to raise funds to meet leverage requirements.  So much for buy low and sell high.

RE: Government Spending from The Imperfect Economist

I admit that when I first read your post, I thought there was probably something amiss with the data interpretation so I jumped over to FRED graph at the St. Louis Fed website(one of my favorite places to play around) to see for myself.  I pulled up a graph of GDP, current expenditures, and currents receipts.  While the relationship wasn’t perfect, it is easy to see that expenditures track nicely with GDP, although a little less nicely the last year or so.  What was also easy to see was how erratic the receipts series is by comparison.  Without deep investigation it surely seem like the cause budget deficit has a lot more to do with a drop in receipts than an increase in expenditures.  I’m a little embarrassed at my previous misconceptions, but I’ll just keep those to myself.  Thanks for the insight.

Missing Signs of the Recovery

According to Steven Gjerstad and Vernon L. Smith,  authors of the paper “Household exhttp://www.blogger.com/post-create.g?blogID=6970246168829061655penditure  and economic cycles, 1920 – 2010”, “In the Great Depression and in every recession since, recovery of residential construction has preceded recovery in every other sector, and its recovery has been far larger in percentage terms than the recovery in any other major sector.” (WSJ Why We're in for a Long, Hard Economic Slog)

The problem is that the recovery in residential construction seems quite a way off.  The number of existing houses being sold is still declining and is now at the lowest point since the National Association of Realtors started tracking the sales in 1999.  Sales of new homes are declining even faster resulting in a problematic gap in the level of sales.   (Graph from calculatedriskblog.com)

When demand for housing declines, the price of existing houses also declines until a buyer is found or the price drops below what the seller is willing to accept.  The minimum a seller is willing to accept can be determined by a myriad of factors and can continue to drop well below what recently may have been considered the fair value.  With new housing, there is more of a price floor.  If prices drop below the level at which a builder can make a profit, finished houses may be sold at a loss but more houses will not be built until prices recover.  The increasing gap between the number of existing and new home sales is an indication that prices are falling below the floor at which new homes will be built.

So when will prices rise enough to encourage builders to start building again?  When demand starts to catch up to supply and right now there is a whole lot of supply.  According to the National Association of Realtors, in July there were 3.98 million homes for sale, representing a 12.5 month supply. Additionally “As of March, banks had an inventory of about 1.1 million foreclosed homes, up 20% from a year earlier, according to estimates from LPS Applied Analytics” was reported in the Wall Street Journal. Another 7.8 million homeowners are either in the process of foreclosure or are delinquent on their mortgage.  Real estate date provider CoreLogic estimates that 11 million homeowners are underwater on their mortgage.  It is difficult to say how many of these houses will end up on the market and eventually sold but it looks like it is going to be quite some time before excess existing inventory is reduced enough to encourage a significant increase in the new home consrtuction that is supposed to lead the economic recovery.