Category Economy

Richmond Residents Are The Ones Harmed By Eminent Domain

Danny Vinik Leave a comment

Richmond, California’s use of eminent domain continues to move forward. As regular readers know, the entire plan is a fraud intended to rip off investors so that Mortgage Resolution Partner (MRP), the firm supplying the capital to Richmond, can profit. Why Richmond agreed to take MRP up on it’s ridiculous plan has been unknown for a while now. Maybe they really don’t understand it. Maybe there is corruption involved. It’s unclear.

What is clear though is that the ultimate losers from this play will be Richmond residents. Investors are (rightfully) infuriated by Richmond’s decision to move forward with eminent domain and have filed a lawsuit attempting to block the plan. A judge threw out that suit, saying it was “premature,” but the legal battles are just beginning. Once the city does seize the mortgages, investors will file suit again. Hopefully a judge immediately sees through this highway robbery and isn’t fooled as well. This entire thing is an unnecessary and costly waste of time.

In the end though, investors will be okay here. MRP’s plan will fail. The losers will be Richmond residents, which Moody’s made clear last Friday. The credit rating agency named the plan “credit negative.” From the report:

The eminent domain program is credit negative for the city because it will likely lead banks to raise mortgage interest rates and reduce mortgage availability, which will in turn limit the growth of property values and related taxes

…

Lenders will factor in the additional risk by raising mortgage interest rates or decreasing their availability

None of this is surprising, but it’s still sad to hear.

If this plan was done properly, Richmond would offer up a fair value to investors. Some of those investors may disagree with Richmond’s valuation. There would be quibbling and the two sides could look to work out a fair deal. Some banks may be wary of the additional risk and factor it into higher rates, but the rise would be small. If investors are properly compensated, they won’t be too upset to offload defaulted, underwater mortgages. They may not even put up much of a fight. In the end, mortgage rates wouldn’t rise much, if at all. But MRP’s plan is such a ripoff that if it were to go through, banks would jack up rates. Luckily that won’t happen, but it shows what a mess this entire situation is. MRP’s plan is a fraud, Richmond fell for it and its residents pay the price.

The Unemployment Rate is Just One Indicator

Danny Vinik 1 Comment

One criticism of the Fed’s recent communication strategy has been that it relied too heavily on the unemployment rate as an indicator of the health of the labor market and communicated that reliance to the market. As I wrote earlier, the unemployment rate is falling, but the economy is barely improving. In his June prepared statement, Fed Chairman Ben Bernanke said:

And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains

The Fed projections at the time expected the unemployment rate to be at 7.2-7.3% in the fourth quarter of this year. In August, the unemployment rate fell to 7.3%, well ahead of the Fed’s projections. Except this was not the result of above-average economic growth. On the contrary, financial markets tightened and the August jobs report was disappointing.  The drop in the unemployment rate was not representative of the overall economy.

Bernanke had hinted that the unemployment rate would be around 7% when asset purchases fully ended, but it had not even begun tapering yet. That was one major reason that so many journalists and investors expected the taper last week. Yet, this is once again not the Fed’s fault. The central bank could have done better in a number of areas. The long silence from the Fed governors provided little guidance for investors and Bernanke should have emphasized more that the Fed uses many different pieces of economic data to judge the labor market, not just the unemployment rate. But fundamentally, this was the market misreading the Fed.

Investors took one economic indicator and assumed the Fed would base its monetary policy on it. Worse, they knew that the drop in the unemployment rate was not the result of improving economic growth. It should have been common sense that the Fed would not that into account. But it wasn’t. There’s no doubt the Fed and Bernanke could have been more clear, like NY Fed president BIll Dudley was today and Bernanke was in his press conference last week. There, the chairman emphasized that the Fed looks at other economic indicators as well:

Last time, I gave a 7 percent as an indicative number to give you some sense of, you know, where that might be. But as my first answer suggested, the unemployment rate is not necessarily a great measure in all circumstances of the–of the state of the labor market overall. For example, just last month, the decline in unemployment rate came about more than entirely because declining participation, not because of increased jobs. So, what we will be looking at is the overall labor market situation, including the unemployment rate, but including other factors as well. But in particular, there is not any magic number that we are shooting for. We’re looking for overall improvement in the labor market

Too many commentators overreacted to what Bernanke said in June. The 7% unemployment rate number was treated as a trigger, not a threshold, even as Bernanke emphasized that it was the opposite. The unemployment rate was treated as the pivotal economic indicator influencing Fed decision-making. If you take a step back and look at the economic growth the past three months, there were few reasons the Fed would taper and many it wouldn’t.  The most important thing is that the economy underperformed Fed expectations. Yet, it was conventional wisdom that the taper was coming. That doesn’t mean Bernanke couldn’t have been clearer in June, but it means it was a fundamental misreading by journalists and investors. The Fed’s over-reliance on one economic indicator doesn’t change that.

The Real Test for the Fed’s Policy of Forward Guidance

Danny Vinik Leave a comment

Stanley Fischer, the former head of the Bank of Israel, doesn’t think the Fed’s policy of forward guidance is beneficial for the economy. He believes it limits what the Fed can do in the future and confuses the market. Fischer is not necessarily wrong here. If the market does not believe that the Fed will adjust its policy to different labor market conditions, then forward guidance will continually cause shocks to the market as the central bank makes those adjustments. The Fed needs to credibly tell investors that it reacts to economic data. Last week’s non-taper put actions behind those words. Now, we’ll find out if the market has learned from it.

The markets are not listening to Ben Bernanke.

The market is not listening to Ben Bernanke.

The purpose of forward guidance is to give the market a clear understanding of the future path of monetary policy. As Fischer say though, the central bank itself doesn’t know what that path will be. This means that the Fed must condition its forward guidance on future economic data. If that data comes in as expected, the Fed will take the path it laid out. If it comes in above or below expectations, it will adjust its policy accordingly. When investors have a better understanding of future monetary policy, there are fewer shocks and swings in the market. Resources are allocated more efficiently between different asset classes and across different time horizons due to the predictable nature of policy. The market functions more smoothly. That is the rationale behind a rules-based monetary policy regime. Forward guidance is an attempt to implement a qualitative rules-based regime.

That’s exactly what Bernanke was trying to do in June, but the market overreacted and took it to mean that the Fed was set on tapering in September. That’s the problem with such a policy: if the market regularly overreacts to the Fed’s forward guidance, then it doesn’t work. When the market assumes that Fed policy is static and then the Fed adjusts its policy in light of the current economic conditions (as it said it would do), then wide swings in the market take place. This isn’t the Fed’s fault. It’s the market’s. The question is whether investors and journalists will realize that Fed policy is dynamic and forward guidance is only a guide. Mark Dow is skeptical, saying its human nature for the market to overreact and human nature doesn’t change. He may be right, but the upcoming months should test that theory.

If economic data continues to come in below expectations, the Fed will likely delay tapering yet again. Will the market realize that or will it once again blindly assume that the taper is coming? If the market does blindly assume that the Fed won’t adjust its policy, then the Fed must realize that forward guidance doesn’t work. Bernanke could not have made it more clear, both in his press conference and now by the action (or lack thereof) the Fed has taken, that the central bank is data-dependent. If the market has not learned by the next FOMC meeting, it’s never going to and the Fed must admit defeat. In that case, Stanley Fischer would be right: forward guidance just confuses the market. However, I’m not ready to make that determination quite yet. We should know soon enough.