A Dash of Insight

Interpreting Housing Indicators

Finding the right economic indicators is a challenge for investors.  Often the same data are presented in several different ways.  How does one make the right choice?

Today's data on home prices from S&P Case-Shiller provides a useful example.  As everyone knows, prices are down significantly from peak values and the annual data have a strong seasonal component.  There are three quite different approaches.

Month-over month changes.  The 20-city home price index for April fell by 0.6% from March.  This decline was reported by some media sources, but ignores the seasonality in the data.  When the seasonal effect is strong, it can be quite misleading.

Year ago changes.  Most solve the seasonality problem by comparing the prices in April, 2009, to those in April of 2008.  Sources using this approach cited a price decline of 18.1%.  This ran as a headline on some stories and as a subtitle on CNBC.

The problem with these year-over-year changes is that it is difficult to see improvement fast enough to be helpful for investment decisions.  Let us illustrate this with an unlikely and extreme example.  Suppose that the index went up 10% from April to May.  The year-over-year value would still be a decline of 9.2%.

To avoid this problem, those using the year-over-year method compare the annual change in one month to that of another.  The conclusion often reached is that prices are declining at a lower rate.  This is not correct.  In the example given, prices would be increasing, not declining at a lower rate.  It is not easy to get real insight from a string of year-over-year numbers.

Seasonally adjusted data.  S&P also puts out a seasonally adjusted version of the series.  This allows the user to focus on the month to month change, the real time movement of greatest interest, while removing the regular seasonal pattern.  Using this approach, prices declined by 0.9%, worse than suggested by the other two methods.

Conclusion

Using seasonally adjusted data is frequently the best solution for this sort of problem.  Many of our fellow data consumers are suspicious of any adjustments to raw data.  They are then forced to make their own seat of the pants guesstimates about how important the changes are.

Calculated Risk, a favorite and featured source, also focuses on the seasonally adjusted data.  You can check out the latest update to this series, comparing it to the bank stress test assumptions, in this article.

Problems with Housing Data

US equities responded favorably to morning news about pending home sales.  The data showed a third consecutive month of gains, actually up 6.7% over the prior month.  Some pundits favor the year-over-year comparison, which was up 3.2%.  It certainly seems like good news.

Commentators quickly pointed out some problems with the data ---- the sample size is small and sampling error is large.  Pending sales do not always translate into actual sales.  It is only one month.  Etc.

The Sad Truth about Housing Data

Housing is at the epicenter of the financial crisis.  Home values affect wealth, personal consumption, and the need for further write downs in "legacy" (formerly known as toxic) assets.  We would love to have good data about housing.

Forget it.  Nearly all of the housing series are flawed with significant discontinuities or conceptual problems.  No matter what the data report, there will be plenty of opportunity for pundits to dispute the results for the next year or so.

Here are some of the problems:

• Pent-up supply, and pent-up demand.  Most pundits claim that there are many homes ready to hit the market as soon as things improve a bit.  We believe that there are also many latent buyers, waiting for the right combination of loan availability and price.  Neither of these assertions has any hard data.
• Foreclosures.  The principal media and blog observations show the percentage increase in foreclosures.  This is an alarming increase from a small base.  Interpreting this series is guesswork.  There was a moratorium on foreclosures as the Obama proposals worked through the legislative process.  That gave a false sense that foreclosures were lower.  Since non-foreclosure sales are generally at higher prices, it made prices seem higher.  Now that the moratorium has ended, we are seeing the opposite -- more foreclosures and lower prices.  Those looking at the data series will be deceived by both effects.
• Tax credit effects.  New buyers have until the end of November to collect a tax credit of $8000.  It is reasonable to expect any first-time buyer considering a home purchase to act in the next few months.  This may draw forward demand, leading to a reduction in purchasers after the credit expires.
• Financing effects.  There is a sense that mortgage rates have bottomed, and moved higher.  This may stimulate some to act more quickly.  The increase in pending sales was quite dramatic in some regions -- over 30% in the Northeast.

Our Take

Like everyone, we watch housing data closely.  We also solicit anecdotal evidence from many sources.  We know of first-time buyers, using the credit, who put 5% down via FHA and got the seller to cover closing costs.  It is a great opportunity for qualified young buyers.  There is some Internet mythology that there are no 5% loans.  That is incorrect.

Our major conclusion?  Most of the pundits are too confident in their predictions.  We see so many who expect prices to move much lower, but there is little supporting data.

We continue to look for good indicators on housing, and welcome comments.  Our major observation relates to the calculation of "months of inventory."  This measure takes the known inventory and divides by the annualized rate of sales.

At this point, the rate of sales is so low that even modest increases will dramatically reduce the months of inventory.

Be Like Mike? Or Shane? Or RIck? -- Looking beyond the Obvious

Here at "A Dash" we like the comparisons between analyzing sports and analyzing markets.  There is much more data in sports, and the risk/reward calculations are similar.

When it comes to the NBA, we are zeroed in on the Michael Jordan era.  To celebrate a birthday party for a famed Chicago options trader, one of our friends sent invitations to a party -- dinner and Bulls tickets for a playoff game that night.  Attendance was excellent!

Can We Learn from the NBA?

Shrugging off the current Bulls record, we try to remain open to new information.  In particular, is there any relevance for investors?

Investment experts are weighing in on the Shane Battier article by Michael Lewis.  In a reprise of Moneyball, Lewis shows how Battier is more valuable than his obvious stats indicate.  Briefly put, he makes everyone on his team better -- and stars on the opposing team worse.

Dr. Brett Steenbarger shows his typical excellence in drawing performance parallels.  We noted this when we reviewed his book on trader performance, suggesting then that anyone in any field could learn from the lessons.  Brett describes how traders could "be like Shane."

At another of our featured sites, Adam Warner also highlights the Lewis article.  He emphasizes the +/- aspect of the analysis, with bows to the Moneyball aspect and a humorous look to hockey.

Shane Battier is no Michael Jordan, but they share the characteristic of improving the players around them.  It would be interesting to see similar data on the Jordan era.

Investment Implications?

Our own take is implicit in the Lewis analysis. Investors should look beyond the obvious comments and stats, seeking the undervalued and poorly-measured effects.

Today's celebration of Rick Santelli's revolt is a good example of the obvious.  The story was featured in many places, but Adam Warner's piece is a good recap.  While we almost always agree with Adam, we dissent on his endorsement of the Santelli revolt.

Here is why.

Popularity is Easy on CNBC

It is easy to speak on your home field -- Rick's supporters on the trading floor, for example.  The audience on CNBC shares his political bent.  So does the readership of most blogs or mainstream media articles.

Being like Rick is not being like Mike.  His popular viewpoint weakens the surrounding team, encouraging them to fight a war that has already ended.

Any of the many government programs is an easy target.  Those of us who feel secure in jobs and did not engage in reckless borrowing can criticize everyone else.  We can complain that government money is helping the foolish, the dishonest, and the deceitful.  Readers and viewers will cheer.

It does not matter.  The election is over.  Our mission has changed.  No matter what our preferences were last November, it is now a new problem.  Any government policy should be judged in two ways:

1. Is there a societal benefit?
2. What are the investment implications?

Let us be completely clear.  We are not stating what will work, although it is on our writing agenda.  We are simply arguing for keeping a clear head about the criteria.

Too many analysts are taking the role of the taxpayer as investor, asking whether the return on investment is justified.  This is silly.  None of us would hire the government to be our investment manager.

The real question is whether the entire package of government programs will address systemic problems.  As a government, we should act to assist groups for a societal purpose.

Conclusion

Instead of asking what each program does for us personally, we should ask whether the entire body of programs -- Fed lending, stimulus package, mortage rate reduction, housing help, and more -- can succeed in restoring a stronger economy, with normal and sensible lending.  Without such actions, our state and local governments will fail, our property tax rates will rise, our local services will decline, our investments will falter, our property values will sink, and eventually, all of our businesses will be threatened.

This question, like Shane Battier's stats, is not so obvious.  Understanding the less obvious effects may be the key to investment success in 2009.

Our current indicators are pretty bearish, reflective of the general sentiment.  Meanwhile, most pundits are confusing their political persuasion with a dispassionate analysis of policy impacts.  At "A Dash" we expect the multiple and massive government actions to be reflected--eventually-- in the upcoming economic data.  The market will respond, but it may be kicking and screaming all the way.

 

Economic LIteracy: Do You Meet the Test?

As we all plan our investments for 2009, no factor is more important than the economy.  It is a subject on which everyone has an opinion.  That is the natural state in the American democracy, dating back to the observations of Alexis de Tocqueville.  His famous work, Democracy in America, is still read by every student of political science.

While a complicated work should not be summarized in a sentence, the Wikipedia article includes a good warning:

Democracy in America predicted the violence of party spirit and the judgment of the wise subordinated to the prejudices of the ignorant.

The 21st Century

Democratic opinion has advanced into the 21st century.  Modern scholars are impressed with how well de Tocqueville's work has held up, but there are some changes.  With the help of the Internet, everyone is able to offer an opinion about anything and everything.  Millions of readers are consumers of these opinions.

Readers motives vary.  Many simply want to confirm existing beliefs.  That is easy.  Those seeking information and analysis face a challenge:  How does one identify an expert?

In particular, how can an investor form intelligent opinions about the economy.  At a minimum, one needs basic economic literacy.

A Few Elements of Economic Literacy

Bob McTeer's blog, once again, provides some valuable information for us all.  In his article, Economic Literacy:  A Few Basics, he cites ten principles that anyone should know before drawing conclusions.  They are all great points, but let us pick a favorite, as follows:

Decisions are made at the margin-a little more of this means a little less of that. You maximize profit when the marginal revenue from the last unit produced just matches the marginal cost of producing it. Fixed costs don't count. Once you've bought the tickets, their cost is irrelevant the next day when you're deciding whether to go to the game.

Anyone who thinks an economic question is some black and white causal relationship does not understand this fundamental point.  Pundits who do not understand marginal analysis say things like the following:

• There is no "pent-up" demand for housing.  This is wrong because housing demand is a continuous function, more demanded at any lower price, more offered at a higher price.  The question of whether demand (or supply) curves will shift is a microeconomic problem that might be affected by public policy decisions.
• Stimulus packages do not work.  This is wrong because any stimulus creates new demand at the margin.  Professionals can debate the magnitude, but the broad-brush, X or Y conclusions are inaccurate.
• Retail is dead.  This is over-stated because the level of sales is a continuous function.  Reductions are in percentages.
• And many more similar examples of business and consumer spending and employment, all continuous functions.

Here is another good principle from McTeer:

The fallacy of job counting. We will always have more work to do than workers to do it. Therefore, let's not count jobs; let's make jobs count. Workers are scarce and will go where their return is highest. Politicians focus on creating jobs for their own sake. If they focus on real needs, the workers will come. The false idea that there is too little work to employ all willing workers leads to things like France's 35-hour work week.

Many pundits focus on this count of jobs.  In fact, jobs are created all of the time.  Even in bad times the US economy creates over 2 million new jobs each month.  In bad times of course, even more jobs are lost.  It is not a question of whether jobs are created, but rather how many, and how quickly.  The net job change is the result.

These are just examples.  Readers can test themselves -- and they should - by checking out the entire article.

Conclusion

There are two important conclusions for investors.

1. It is important to realize what you know, and more important to realize what you do not know.  Many investors are making decisions -- right now-- based upon their personal conclusions about the economy.  They fail to realize that they are consumers of the economic conclusions of others.  They are just reading the newspaper or a pundit.
2. It is important to choose sources who understand these principles, not just "pop econ" journalists who throw around some economic terminology.

Our Take

Many of the popular pundits and journalists would come to a standstill if asked to do the following practical open-end essay test:

Take a legal pad and start writing what you really know about economics.

It would be interesting to see how many would stall out at page one.  The pop econ approach does not extend very far, but it resonates with readers whose knowledge is at exactly the same level.

The current Internet democracy, an echo of de Tocqueville, does not serve the investor.  Pundits have media appearances that consist of barely-challenged sound bites.  Journalists assume the role of the expert rather than that of wise communicator.  Readers must figure it out for themselves.  To do so, one must have economic literacy.

A wise investor knows his happy zone, a concept we borrowed from the Splendid Splinter.  The investor must also know when a pundit is swinging at an outside pitch.

How Equity Investors Should follow Credit Markets

The credit crunch was the proximate cause of six weeks of stock market stress, beginning with the Lehman non-bailout.  At the very minimum, this will cause an economic vacuum for a month or two.  The question is if and when policies will have a significant effect.

We are well aware of the issues involving the extent of the recession and the impact on earnings.  Following progress involves tracking credit markets.  To this end, we follow some key sources:

• JCK at Alea.  There is a daily update (often skeptical and challenging) on the various Fed moves and the impact on various indicators.  Today's report is typical.  There are also great articles on subjects like light trading in the ABX, used to mark securities and possibly subjectd to manipulation via the CDS market.  This is a daily must read for us.
• Calculated Risk.  CR is now doing a daily update on credit markets.  This is another must read for equity investors looking at credit markets.  There is much, much more, but the credit stuff is especially valuable.
• Tony Crescenzi at RealMoney.  (Full disclosure -- we write there, but we paid for the site before joining.)  Tony's daily blog is very valuable on all things economic.  Some of it gets reported elsewhere, but it is worth reading right away.
• Abnormal Returns.  This is a consistent source of new ideas from academic papers and "new" bloggers.  The author reads nearly everything and consistently points to new ideas, including credit issues.

There are plenty of other great blogs on our featured list, but today's focus is the credit markets.  Anyone wanting to look for signals of a potential turn in equities should be paying attention.

Election Day Rally

When two events happen at the same time, there is a strong psychological basis for connecting them.

Today is such a day.  The widely-expected end of the election and Obama victory is somehow getting linked to the stock market.  We discuss this, and future investment opportunities, at our sister site, ElectionStocks.com.  Please check it out for a more detailed analysis.  This will be the source for future stock-specific recommendations as we analylze the emerging Obama plan.

The key issues are still ahead of us.  Our read is that Obama is constrained by the economic environment.  We are very interested in his first decisions.  These will include the following:

• How to handle the funds approved for the "rescue plan."  Our hope is that there will be continuing attention to establishing accurate pricing for distressed assets, not just investments in private companies.
• The approach to fiscal stimulus.  There is widespread agreement on the need.  The implementation is open to debate.  Will something emerge from a lame-duck Congress, or will Democrats wait for the new term to get a package they like.  The trade off is delay versus a plan they really want.
• The attitude toward taxation.  An Obama administration is expected to increase taxes in a way that will affect capital gains and, perhaps, dividends.  We will be watching closely to see how Obama, as a President-Elect, views these issues.  Our forecast (based on better insight than most) is that many proposed tax increases will be deferred, perhaps for two years until the expiration of the Bush tax cuts.

Investment Notes

Somewhat to our suprise, the TCA-ETF model has already indicated some sector buy signals and more are imminent.  The climate is more positive, perhaps validating the signal from our Gong model.

While the Democrats sing Happy Days are Here Again, we have no such illusions.  There are continuing issues.  We will closely monitor the plans for dealing with the acknowledged housing and credit problems.

Important Considerations and Our Agenda

Here at "A Dash" we like to keep things objective and impersonal.  For reasons that will be apparent, I would like to depart from that mode for today's article.  My objective is to provide the most immediate help both for investors and for traders.  I also hope to stimulate discussion.

My focus group often says that I sound too professorial.  That comes with sticking to what I know about and trying to educate readers.  A few of those commenting think that I place too much value on credentials.  Same answer.  Credentials frequently encompass knowledge.  Beware of thinking that shorthand methods are good answers.  And someone on Seeking Alpha even suggested that I was "long-winded."  Indeed!  (TM OldProf)

Let us just say that I like to explain fully.  Good writing is terse.  One way to start is by getting the ideas down and then editing.  For the moment, I am just trying to explain things.  This article is a typical example.

An Explanatory Anecdote

Here is a little story.  Many years ago I was a young aspiring student, trying to pass something called "prelims" so that I could begin my doctoral dissertation.  The prelims involved an oral examination covering everything you had learned in all of your courses.  It was an awesome task.  The courses we took typically involved several books and many articles in each of thirteen weeks for each of four courses.  Every year.  You were also fighting against time.  If you delayed too long, those teaching the courses (and therefore the topics of the prelims) would change.  There were many students who had a continuing need to audit the classes of the new professors so that they could pass prelims.  They often postponed their prelims, year after year.

I violated the norm.  I made a list of everything that I needed to read and know before taking my exams.  I scheduled the exams.  Each day I crossed something off of the list as I read it, and I also added any new topics that required review.  I took the exams on schedule without regard to the list.

Here is the question from this story:  At what point in my study did the list reach its apex?

Since I was reading and crossing off, an initial guess might be Day One.  The astute readership of "A Dash" is undoubtedly way ahead of the story.

The list was the longest on the day I took the examination!

The key takeaway is that the more you learn, the more you realize how much you do not know.

To be an authority, you should stick to what you really know about.  Look for your pitch.

Our Agenda

Since we are behind in a race with the market, we are going to do something a bit different.  Listed below are a number of propositions.  These are all conclusions we have reached based upon evidence we find convincing.  We hope and expect to write on each topic, so this is a preview, almost a data dump of thoughts in an effort to be timely with help.

Individual Investor Advice

We are getting plenty of calls and questions.  Here are the topics:

• Market reaction reflects plenty of unusual features, mainly "forced selling."  We will try to talk more about how to recognize this.  Meanwhile, Warren Buffett said (something like) if you don't know jewelry, know your jeweler.
• Most individual investors cannot figure this out for themselves and will make big mistakes if they try.
• The average investor should be cautious about making any big decisions.  There is no rush.
• My intelligent investors want to understand how this could have happened.  We have some articles planned.

Public Policy

There are plenty of opinions about what caused our problems and what solutions are best.  Most important for investors is the market implication.  Here are some topics:

• The original TARP plan was focused on what Bernanke called the "root cause."  That would be housing.  Counter-party risk forced the government to address immediate symptoms rather than the cause.
• A key question is the actual value of mortgage securities on the books of every financial institution.  Current methods of valuation range from a few cents on the dollar to the actual performing value of the loans.  Accounting rules favor the former, forcing financial institutions to shrink balance sheets at WARP speed.  A wise accounting expert recently wrote us that there would have been no problem if FAS 157 had been in place for ten or fifteen years before this crisis.  As we have said, it is a good idea, poorly implemented.
• The Treasury will create a working market for illiquid assets.  Nearly everyone thinks that this means that taxpayers will lose.  Wrong!  The test for this plan will be what we call "Win-Win-Win."  This means that the financial firms will no longer be stuck with a foolish and unrealistic price.  The taxpayer, qua taxpayer,  will enjoy the purchase of an asset that will probably appreciate.  The taxpayer, qua citizen, will benefit because a normal trading market in these securities will be established, creating a fair market value.  This means that the taxpayer will not lose in employment, government benefits, local services, and home values.  For a preview, read the insightful article from David Altig, one of our featured sources.
• The government actions will eventually restore normal credit markets for business and for home loans.  Most of those commenting on the housing market begin with a pre-conceived notion of the "correct" level of home prices.  The government plan will restore mortgage lending and facilitate actual price discovery.  No one knows for sure what this will be.

Pundit Pontification

For the moment, let us just say that many pundits are pontificating well outside of their happy zone.  In the shaded area of the Ted Williams picture, he explains that a good hitter becomes a 230 hitter if he swings at pitches even two inches outside of the strike zone.  The strike zone is increased by 37%.  We have too many pundits offering conclusions about things where they know nothing at all.  Their comments are what the average investor or trader reads every day.  This will be a theme for several articles, but the daily example is the insistence on "explaining" the stock market moves by some piece of news that would normally have a marginal effect.

Bonus Prediction

This is something you have not seen anywhere else.  In a few weeks, you will see it everywhere.  There is general consensus that the credit default swap market is flawed, unregulated, and possibly manipulated.

No one seems to have noticed that the ABX, the Market Index used to shrink the financial balance sheets and drive ratings downgrades, consists of only twenty securities -- all credit default swaps.

Connect the dots....

Do you think that these CDS's might have been manipulated by those seeking short sale profits on financial firms?  At some point we will see that the "marks" used by accountants were not only illiquid securities, but possibly manipulated securities.  If there is ever an SEC investigation, we will see some "perp walks."

You heard it here first.

If this is correct, we will see -- at some point -- a review of assets, an expansion of assets.  It requires a method that correctly prices mortgage securities, not the ABX.

Whom Should We Trust?

There is an argument making the rounds.  The first incarnation was in opposition to the Paulson Plan.  It has morphed into a question about whether the plan  -- and other measures -- will work.

At "A Dash" we did not take an advocacy position on the bailout -- er --rescue plan.  We have opinions about public policy, but that is not our job here.  We tried, both here and in the series of RealMoney articles, to inform investors about the progress and prospects of the legislation.  The market had already rendered a verdict on the need for some action.

We now have an interesting situation where those who were the biggest opponents of the plan are asserting that it will not work.  That probably is consistent logic.  The challenge for investors is to figure out whether the Plan will get to the key causes of the problems.  This is yet another agenda topic.

Meanwhile....

Whom Should We Trust?

There is a specious argument making the rounds.  It goes something like this:

Why should we trust the same people who got us into this to lead us out?

It is one of those arguments that convinces the masses, but has little weight.  Let us see why.

Inappropriate Grouping

The popular argument suggests that we should not trust Wall Street, the Fed, the Treasury, or anyone else in government.  They all did something wrong.

Consider this example.  (We strongly suggest that readers use common sense in known situations to think about how they interpret market information).

You have a plumbing problem.  You call in a plumber who makes a major error.  The valve he installs makes the situation worse.  What should you do?

Would you call in a non-plumber?  An auto mechanic?  Your neighbor?  A surgeon?

Of course not.  You would try to find a better plumber.  So why do market participants think that all economists, all government official, and all corporate CEO's are complete bozos?

It is simplistic thinking.  The problems of many now in power -- both in government and companies -- were inherited.  The challenge is one of finding good economists, good government leadership, and good CEO's.  Where else should one turn for expertise?

Inappropriate Second-Guessing

The popular argument suggests that prior attempts at incremental solutions were wrong.  Let us consider this.

Suppose that you are diagnosed with cancer.  Your oncologist, before recommending major surgery that will have a permanent effect, recommends a chemo or radiation approach.  If it works, terrific.  If not, a stronger treatment will be needed.  A different oncologist might have recommended immediate surgery.

Let us further suppose that the incremental treatment does not work.  Would you dump your doctor?  Would you look to someone outside of oncology to take the next step?

In real life, experts often recommend an incremental solution.  When it works, it does not get any publicity.  Only when it fails do we second-guess the original plan.

This describes many of the moves made so far by the Fed.

What Now?

Figuring out what is wrong is easier than determining what is right.  Two conclusions stand out:

1. The general dismissal of government efforts is overstated, since people are using a brush that is too broad.
2. The winning investors will be those that can evaluate the specific features of the plan, determining whether it can get to the root causes.

We will have more to say on these prospects as specific proposals develop.

The Paulson Plan: Investor Implications

We have been writing a series of articles for RealMoney on the Paulson plan and Congressional reactions.  The editors have graciously moved some of these to the public site so that we might reach a wider audience in a timely fashion.

Mark-to-Market Accounting

One article reviews the emerging recognition of FAS 157 as a contributing source of credit problems.  This will be a familiar theme for regular readers of "A Dash."

Please note that we say "contributing source."  One of our favorite readers suggested that we are "talking down" to the unsophisticated.  It is a peril of trying to explain something that goes against the grain for most.  It is much easier and more popular to inflame opinion by playing to people's existing biases.

All of the critics of FAS 157 want to achieve accurate measures of assets.  We have stated this many times.  Despite our careful explanations, those taking the other side of this debate say something like, "accounting rules do not cause credit problems."

Well of course not. And none of the many critics allege this.  Those writing on this topic embrace a more complex causal model, where several factors contribute to a problem.  Check out this article for more insight.  Any reader or investor is free to choose a simplistic bivariate model and stick to it.  We merely suggest that there are many factors, and FAS 157 is an important element.

Briefly put, anyone is free to choose his/her own level of sophistication and invest accordingly.

Since the article appeared, there has been another round of strong voices on this issue.  Too bad that they were not so vocal back when it would have made a difference, at the time we were first pointing this out.  We shall try to catch up with the recent strong comments, including today's Bernanke testimony, in a future article.

The Oversight Issue

In a second article we argue that Congress is loath to relinquish its traditional oversight role.  We wrote the article before today's hearings, and the result was not a surprise for our readers.  Our expectation is that the final legislation will have some broad authorization for a plan, but limited initial appropriations.

Congress wants to maintain some control, and appropriations are the only realistic method of doing this.

How to Invest?

Will the market accept a plan with an initial limitation?  Paulson says "no."  The Democrats will try hard to satisfy the need for market reassurance while retaining ultimate control.  No one can predict the reaction with certainty.

While we are trying to share the main conclusions with our readers, we encourage those interested to read the entire articles on TheStreet.com site.

The Investment World and Public Policy

Public policy is determined by elected governmental officials and appointees who are responsible to them.  This is the nature of accountability and representative government.

As citizens we are all free to criticize and vote for our favorite choices.  One person, one vote.

At "A Dash" we are disturbed by recent commentary that suggests that trading in financial markets should dictate public policy decisions.  No one elected the financial managers nor the pundits.  Their interests are not necessarily aligned with the overall economy, the housing market, nor (especially) the GSE's --- Fannie and Freddie.

The dividing line is clearly stated in this article by Zac Bissonnette at Blogging Stocks.  He contrasts the opinions of two people whom we admire, Barney Frank and Warren Buffett.  Here is the analysis:

In an interview with Money, Frank was asked about Fannie Mae and Freddie Mac:
I believe Fannie and Freddie are better off than the market thinks. Over the long term the market is a very rational distributor of resources, but in the short term it can fall prey to hysteria. Sometimes you need to deal with that.

Part of the problem is rumormongering by short-sellers. Our hope is that just by making U.S. financial support available, we'll quiet the fears and eliminate any need for that support.

After a favorable mention of Buffett's viewpoint, he concludes as follows:

It's unfortunate that Congressman Frank has fallen into the trap of name-calling, questioning the motives of the handful of savvy investors who were prescient enough to foresee trouble at Fannie and Freddie. We're in an era of financial McCarthyism, where anyone who raises questions about companies is a "rumormonger" or a "short seller." That's dangerous for the market in the long run because it squelches dissent and contributes to speculative bubbles.

Some Facts

We are planning a series of articles in the interaction between financial markets and public policy decisions.  At this point we have some observations on the current issue, but it is a work in progress.  Comments are welcome.

Having said this, we urge discussants to consider a few facts:

• Many government officials, especially Barney Frank and Hank Paulson are extremely intelligent and able -- whether one agrees with them or not.
• Government officials have a different set of considerations and must be accountable to  the electorate.
• Government often creates agencies that are quasi-public, in an effort to use free markets to improve performance.  These include, with widely varying degrees of success, the TVA, the U.S. Postal Service, Amtrak, the GSE's and many others.  Local governments embark on similar initiatives, outsourcing tasks from trash collection to operating tollways.
• The blend of public purpose and private enterprise responsiveness creates a tension for the managers of these enterprises -- being profitable without sacrificing public purposes.
• Investors in these enterprises -- whether stockholders or bondholders -- have done so with the assumption that they are partnering with the government.  Breaking this trust undermines future government efforts for such partnerships.  It is similar to the moral hazard argument.  Do we, as a society, wish to discourage future partnerships?
• Wall Street pundits should be more careful in concluding that those in government are less intelligent or less able than they are themselves.  They might consider that other smart people may draw different conclusions from the same set of facts.

Some Inferences

With these facts in mind there are certain conclusions that stand out.  These conclusions are observations about likely behavior, not opinion about what should be done.

• Government actors wish to preserve and enhance existing institutions.  They see these as the best likely solution to public problems -- especially in housing.  Crushing existing partners, whether they be shareholders or bondholders, is not their idea of a solution.
• The Bush Administration does not want the nationalization of the mortgage market as part of its legacy.
• McCain does not want a perceived government takeover of Fannie and Freddie as an election issue.
• Democrats want to be seen as doing something positive for housing, which means expanding Fannie and Freddie capabilities.
• Everyone in government would prefer a solution that did not require a government takeover of GSE's.
• Wall Street pundits have -- just recently -- started judging GSE's according to private bank rules -- capital ratios, FAS 157, and the like.  To government types, this is like changing the rules of football scoring in the middle of the game -- field goals count for 2 and touchdowns for 9.
• The pervasive Street commentary has served to reduce financing options.  There is a drumbeat of opinion that more capital is needed, even when official rules say that it is not.  The relentless selling of FNM and FRE has restricted the ability to raise new capital in private markets.
• The Street consensus is that common stock in GSE's must go to zero and management must be fired.  This is inconsistent with the public purpose perceived by government leaders.
• Dissident leakers in government have aided in the Street perspective.

Investment Implications

What has happened is that Wall Street, unelected and unaccountable, has voted on the nature of Treasury policy regarding Fannie and Freddie.  The actual government officials do not agree.  News accounts show that Freddie is exploring options with widely differing effects on current shareholders.

Will Wall Street opinion force the final decision?  We doubt it, but no one can know.  We suspect that the specific solution recommended by Jim Cramer and others will not gain acceptance.  If Cramer is right, the market is in for tough sledding for the next few months.

The alternative viewpoint is that Paulson will find a way to infuse lending and enhance the GSE's as players in mortgage markets.  It is a challenge.  If he succeeds, he will win high marks from economic historians.

Those studying public policy will ask questions about the role of markets in shaping public policy.  There are other recent examples for this interesting topic.

[No position in FNM or FRE.]