Monthly Archives: November 2008

Do I really know something Steven Levitt doesn’t?

Steven Levitt writes:

Back in the old days, banks didn’t package and resell the mortgages they wrote. So when a homeowner got into trouble, they could go down and talk with the bank about working out some solution other than foreclosure. For instance, the bank could allow the borrower to pay back the loan over 30 years instead of 15 years, reducing the monthly payment.

Not really… Even in the old days (unless we’re talking really old days), the homeowner would not talk to the lender. Instead, they would talk to the servicer in charge of their loan (in the really old days, servicers were units of lender banks, but eventually, independent servicing companies sprang out all over the place). Here’s how Fannie Mae explains what servicers do and how they are compensated:

We do not perform the day-to-day servicing of the mortgage loans that are held in our mortgage portfolio or that back our Fannie Mae MBS… Typically, lenders who sell single-family mortgage loans to us initially service the mortgage loans they sell to us. There is an active market in which lenders sell servicing rights and obligations to other servicers.

Mortgage servicers typically collect and remit principal and interest payments, administer escrow accounts, monitor and report delinquencies, evaluate transfers of ownership interests, respond to requests for partial releases of security, and handle proceeds from casualty and condemnation losses. For problem loans, servicing includes negotiating workouts, engaging in loss mitigation and, if necessary, inspecting and preserving properties and processing foreclosures and bankruptcies. We have the right to remove servicing responsibilities from any servicer under criteria established in our contractual arrangements with servicers. We compensate servicers primarily by permitting them to retain a specified portion of each interest payment on a serviced mortgage loan, called a “servicing fee.” Servicers also generally retain prepayment premiums, assumption fees, late payment charges and other similar charges, to the extent they are collected from borrowers, as additional servicing compensation. We also compensate servicers for negotiating workouts on problem loans.

So from the borrower’s standpoint, not much has changed because of securitization; the borrower still deals mostly, of not exclusively, with the servicer.

I have four questions:

OK, let’s take them one at a time, keeping in mind that there are servicers…

1) With mortgage-backed securities, is it really the case that a given mortgage is stripped into multiple pieces held by different entities?

Not exactly. First, mortgages are assembled into a pool, which is structured as a separate legal entity with mortgages as its assets. Then, this pool can be stripped, with strips becoming the pool’s liabilities; the alternative is a simple pass-through structure. The company that puts the pool together (such as Fannie Mae) is the sole equity holder.

2) If mortgages really are stripped into pieces, how does foreclosure work? If many different firms hold a piece of the mortgage, who initiates foreclosure? Who pays the costs of foreclosure? It would seem to me that many of the same obstacles to working out a refinancing deal would be present for foreclosing as well.

Foreclosure works just as it used to before securitization. “Many firms holding pieces of the mortgage” are creditors and thus have no say in the foreclosure matters. The out-of-pocket costs of foreclosures are paid by the pool (meaning that in the end they accrue to the company that created the pool); the decision to initiate foreclosure is also made by the pool (meaning, essentially, by the company that has created the pool).

3) If mortgages are not stripped into pieces, are there firms out there trying to scoop up failing mortgages at rock-bottom prices and getting on the phone with the homeowners to try to negotiate deals to avoid foreclosure? If mortgages are not stripped into pieces, I don’t understand why it is so hard to value these mortgage-backed securities.

Where would those firms “trying to scoop up failing mortgages at rock-bottom prices” come from? By now, whoever wanted to invest in mortgages, already has more than they know what to do with; that’s why we have a credit crunch on hand… As to difficulties in valuation, they come not so much from stripping, but from uncertainties surrounding mortgages; the borrower can default (and the amount to be recovered from selling the foreclosed home is highly uncertain, as house prices change over time) or refinance. Neither of these eventualities is in control of the lender, so valuation ultimately depends on assumptions the lender makes about probabilities and timing of default and/or refinancing, as well as about the likely value of the home in the event of default.

4) If indeed mortgages are stripped into pieces, weren’t people worried about the complications that would result when these mortgages were divided into pieces?

Yes and no. Complications should be weighted against opportunities they afford. Mortgage securitization offered an easy and cost-effective way to invest in mortgages for mutual funds and insurance companies…

Are we in a liquidity trap yet?

Paul Krugman writes:

Key interest rates

Bernanke’s problem, and ours. This picture shows the target Fed funds rate, the usual tool of monetary policy; the 10-year Treasury rate; and two rates that actually matter to the private sector, the mortgage rate and the rate on Baa-rated corporate bonds. The Fed has had no success in reducing mortgage rates, and corporate borrowing costs have gone up, not down. Add in falling expectations of inflation, and in real terms monetary policy has gotten tighter, not easier.

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Economics of spam

As seen on Freakonomics:

Since last Wednesday, the torrent of junk e-mail coursing through the internet has been slowed dramatically, with 40 percent or more of it cut off at the source.

The source of all that spam? San Jose, California. That’s where a group of servers responsible for much of the world’s spam had been operating until they were severed from the internet last week.

The servers had controlled some of the world’s biggest botnets, the legions of hijacked personal computers that flood your inbox with ads for male-enhancement drugs.

The shutdown could be a major blow to spammers’ finances. Every day the botnets remain down means revenue lost. But how much revenue?

Nobody knows for sure, but a team of computer scientists at U.C. Berkeley with an ingenious plan recently reported the first-ever hard numbers on the economics of spam.

After taking over part of an existing botnet, the Berkeley team waged its own spam campaign, sending out almost 350 million pieces of junk e-mail over 26 days. By the end of their trial, they had netted a whopping 28 sales. That’s about one response for every 12.5 million e-mails sent, a conversion rate of less than 0.00001 percent.

They estimate the yearly revenue of the botnet they had infiltrated at around $3.5 million (their full paper is available here).

To put that in perspective, spam costs U.S. companies $33 billion a year in lost productivity, according to one estimate, and $100 billion worldwide.

That means it seems likely the spam industry generates far less wealth than it destroys.

But the parasitic scam will remain with us as long as one in every 12 million or so of us buys the product they’ve been spammed for.

So what are the characteristics of the 28 good souls who decide to click on through and make a purchase?

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A weird Firefox upload/download problem (solved)

This morning, my Firefox started acting up. It would freeze when I attempt to upload a file or use the right-click Save As… functionality. Upon a closer look, however, it turned out it wasn’t really freezing, but taking a very long pause; eventually, the File Upload or Save As… (as the case may be) dialog would be displayed.

It turns out that the reason for this behavior is that I recently downloaded to (or uploaded from) a location that is no longer accessible. In my case, it was a folder on a network share, but I would guess something like this could also happen with a removable storage device, such as an external hard drive or a Flash drive. So Firefox was essentially trying to access the location it accessed before, taking its time to repeatedly try it and eventually failing.

Now that I understood what the problem really was, fixing it was a matter of seconds. I typed about:config into the Firefox address bar, scrolled down to browser.download.lastDir configuration variable (highlighted in the picture below), and changed it from its old value (which was something like \\myServer\myFolder) to C:\temp, which was a name of a directory that exists on my system.

Firefox config window

Problem solved…

Meanwhile, in Mexico…

How Options Saved Mexico’s Budget
Nov-14-2008 | Source: Futures and Options Intelligence

The news that Mexico has locked in prices of at least $70 a barrel for 90% of next year’s oil exports has surprised many traders, and demonstrated the depth of the oil derivatives markets.

If reports are correct, Mexico has protected $37bn of revenue from oil sales, vital to its 2009 budget, at a cost of just $1.5bn. It is believed to have done so, far-sightedly, in late September and early October, while oil was falling from about $120 towards $90.

The government has already revised its budget, lowering its oil price target from $80 to $70.

With oil now dropping through $60, the country’s budget would have been devastated if it had not hedged so much of its production and if prices stay low. Oil revenues make up nearly 40% of public sector income.

By warding off this disaster, Mexico will likely have protected the public finances, its credit rating, its currency and its stockmarkets.

Moreover, Mexico used put options for the hedge, so that it will still be able to benefit if oil prices go high again, by choosing not to exercise its options.

News of the transaction appears to have broken in Reforma, a Mexican newspaper, on November 6.

The story was based on a footnote in the finance ministry’s quarterly report for the third quarter of 2008, saying that Ps15.5bn ($1.5bn) was spent from the country’s $10bn oil stabilisation fund on “financial investments, as part of the measures taken for risk management, and the payment of fees to the trustee and its auditors/advisors”.

It was then picked up by a team of UBS analysts in Mexico City, including strategist Tomás Lajous, who wrote a detailed and apparently well informed report on the deal the same day.

On November 11 the Financial Times reported the story, adding that Barclays Capital and Goldman Sachs had arranged the hedge.

Those banks have declined to comment, as has the Mexican Treasury. Deutsche Bank and Morgan Stanley are said to have participated in Mexico’s oil hedging programme in the past, but this could not be confirmed – nor is it clear why they were not involved this time.

Lajous believes the transaction was arranged privately in the over-the-counter market. The banks would then have hedged their own exposure in the open market.

Lajous estimates Mexico hedged about 90% of its annual production, expected to be 533m barrels, or 1.46m barrels per day (bpd).

He calculated the cost at $1.5bn, based on the Treasury report and the fact that in the past, Mexico has usually spent about $500m to hedge 20%-30% of its production.

That would mean the country bought put options for 480m barrels, which Lajous believes were at strike prices of $70-$100.

Based on options at $70 for a barrel of Mexican crude oil mix, equivalent to $82 for West Texas Intermediate, the hedge will be profitable for Mexico if WTI oil trades next year at any level below $80. In other words, the higher revenues Mexico obtains by selling through the options rather than in the open market will exceed the $1.5bn option cost.

Between $80 and $85 for WTI, the option cost will exceed any gain – above $85, the revenue from selling oil at higher prices again pays for the option cost and leaves a profit.

But this analysis clouds the real virtue of the hedge, which Lajous calculates is to lock in a maximum revenue shortfall, compared to budget, of $3bn, including the option cost, even if WTI oil falls to $40.

That cost is 7% of budgeted oil revenues. Without the hedge, at $40 a barrel for WTI, Mexico would lose 59% of its budgeted oil revenue.

Yet if oil goes back to $100 or $120, Mexico will still make $10bn-$20bn of extra revenue, and only give up $1.5bn of this.

The urgency of hedging is even more clear when one recognises that Mexico’s oil production – the sixth largest in the world – is falling steeply. In 2006 the country pumped 1.6m bpd. This dropped to 1.4m last year and is projected by some to fall to 0.9m in the coming years.

“A few years ago Mexico had more leverage to impact the market. But with demand rising and production on the low, after 2010 Mexico may no longer be an exporter of oil,” said Adam Sieminski, chief energy economist at Deutsche Bank. “It is no surprise that the Mexican government wants to see how much revenue it can get by selling oil, even just for forecasting purposes. It makes sense to do this.”

Food for thought

That Mexico was able to execute such a beneficial hedge on such a large scale may change the way other producers operate, and make market participants reconsider some of their assumptions.

If Goldman Sachs and Barclays Capital were indeed hedging their options during the last week of August and first half of September, that would coincide with a period of steeply falling oil prices.

Lajous analyses the six month out WTI future, which slid from about $118 to $91 in that time, before rebounding to nearly $110.

He argues this pattern of trading “supports the view that the hedge took place (and confirms oil market trading comments from the time, which suggested that a LatAm producer was involved in transactions that put pressure on the futures curve)”.

Raymond Carbone, president of Paramount Options in New York, told FOi: “There were clear signals that an oil producer was hedging over the summer. The December 2009 contract experienced a surge in volumes.”

Carbone believes Mexico’s hedging could have added some downward pressure to oil prices as the banks involved would have been pushed to sell the commodity in the derivatives markets to manage their risk.

But there is strong reason to believe that the mid-September bounce in the crude oil price was caused partly by US oil refiners being caught with an oil shortfall in the wake of Hurricanes Gustav and Ike (see the link below to Futures and Options Intelligence’s story on September 30).

And after the bounce, oil resumed its steady downward course until it sank below $70 in late October.

So there would seem to be little evidence that Mexico’s trading affected prices substantially.

The average daily trade in Nymex’s Light Sweet Crude Oil future was 504,000 contracts in August and 550,000 in September, representing about 500m barrels of oil a day for all delivery dates.

The corresponding option trades about one fifth as much: 111,000 in August and 146,000 in September, or roughly 100m barrels a day.

If the hedging was spread out over three weeks, it would therefore have constituted about 30% of daily trading in the WTI options markets, or 6% of the futures market – perhaps enough to move a placid market, but not one in which sentiment was being whipped by contrasting forces of economic gloom and hurricane damage.

However, stealth must have been an important part of the trade’s success. If the market had seen the two banks coming with $37bn of hedging to do for Mexico, it could not have got such good pricing.

“They have to be careful how they do this,” said Michael Wittner, global head of oil research at Société Générale. “They don’t want to sell too much or there will be too much downward pressure – they will end up shooting themselves in the foot.”

Mexico is said to be among the oil producing countries that is fairly transparent about its hedging strategy, while others are more secretive.

It will be a high priority for oil strategists to discover in the coming months how successful other nations and large oil companies have been at protecting themselves from what is already a savage fall in the oil price.

Paul Krugman on the New Deal

Paul Krugman writes:

 Everybody’s talking new New Deal these days — and, predictably, the FDR-haters are out in force, with all the usual claims about FDR having actually made the Great Depression worse. (To the right, way back when, FDR was “That Man.” Now Obama is “that one.” Interesting.)

Eric Rauchway is all over this. Basically, the anti-FDR argument on the data is based on (a) considering people employed by the WPA “unemployed” (even though they were getting paid, and building public works that are in use to this day) plus (b) always focusing on 1938 — the year in which the economy suffered a serious setback from the progress of the previous four years.

Let me offer two pictures, beyond what Eric provides, to clarify things.

First, here’s real GDP (in logs) from 1929 to 1941, plus the trend. (That’s to bypass the employment nonsense). You can see that the economy made up a lot of the output gap before the 1938 setback, but by no means all.

Potential vs. actual GDP

Now, you might say that the incomplete recovery shows that “pump-priming”, Keynesian fiscal policy doesn’t work. Except that the New Deal didn’t pursue Keynesian policies. Properly measured, that is, by using the cyclically adjusted deficit, fiscal policy was only modestly expansionary, at least compared with the depth of the slump. Here’s the Cary Brown estimates, from Brad DeLong:

Deficit as a share of potential GDP

Net stimulus of around 3 percent of GDP — not much, when you’ve got a 42 percent output gap. FDR might have been more of a Keynesian if Keynesian economics had existed — The General Theory wasn’t published until 1936. Note in particular that in 1937-38 FDR was persuaded to do the “responsible” thing and cut back — and that’s what led to the bad year in 1938, which to the WSJ crowd defines the New Deal.

Implications for Obama: be inspired by FDR, but don’t imitate him slavishly. In particular, your economic policy should be bolder, not more cautious.

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Sean Masaki Flynn explains author’s compensation

Sean Masaki Flynn, author of Economics For Dummies, answers a reader’s question on Freakonomics:

Q: Roughly what does one make for writing a Dummies book, and is it a more lucrative endeavor (in terms of dollars per hour) than the textbook route?

A: Author royalties are very paltry — both for textbooks and for other books. A typical royalty rate would be 6 percent or so of what the publisher can sell the book for at wholesale. That amount is typically half of the cover price. So if you see a hardcover selling for $30, the publisher probably got $15 at wholesale. So then 6 percent of that $15 would be only 90 cents. Then your literary agent will take 15 percent of that. So you are left with just 77 cents per copy.

And a book is considered a good seller if it sells 5,000 copies. Most sell far fewer. So basically, there is no money in publishing unless you can sell a lot of books.

Sadly, I am not J.K. Rowling.

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Include_HTML plugin: not-so-neat tricks

A question hoisted from comments:

I really want to use this plugin, seems perfect for me, but it doesnt seem to allow forms to work on the pages that are included. Is this possible? These are forms that would normally post to themselves.

There are options here, none of which is particularly elegant. Include_HTML was written to access content (including content from remote sites), not functionality…

One option is to include an iframe, show the form in that iframe and set the form’s target attribute to that same iframe. So when the form posts, only the iframe is updated. A slight variation of this approach is to write the included page as an AJAX client, so that it posts and updates without refreshing the whole WordPress page. This, by the way, is the approach used by the Contact Form plugin by Takayuki Miyoshi, which you can observe in action on the Contact page of this site.

Another way is to simply POST to the true location of the form and at the end of processing redirect back to the POSTing page (whose URL should be available as $_SERVER['HTTP_REFERER']).

But the most radical solution is simply to rewrite the plugin, requiring it to include() code rather than accessing content via file_get_contents().