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    Mortgage Backed Securities (Insecurities)

    Jul 28 • Financial Markets, Money and Monetary Policy, Regulation • 402 Views

    NPR’s Planet Money has been looking for the people behind a mortgage backed security. The story, almost like a page turner mystery, began with a $1,000 purchase. With $1,000, Planet Money reporters purchased a tiny piece of a mortgage backed security composed of loans on 2,000 mortgages. Like most investors, they hoped to make some money. In this example, they would profit if the owners of the properties continued to pay the interest and principle due on their mortgages.

    A mortgage backed security begins its life when a mortgage broker or a bank or some group says, “We can lend you the money to buy your house.” From there, probably, the lender sells the loan to a second group who combines it with other loans and then sells it to someone else as a mortgage backed security.

    You can see the cash flow here. When loans are sold, the seller gets more money to make more loans and then sells them and gets more money to do it all over again. The money made is from the transactions. The incentive? More transactions.

    Their podcast was especially good because the mortgage backed security–essentially a computer printout–became human when Planet Money went to Florida to find the people with the mortgages. One couple, 82 years old with a dog named Muffin, had purchased their dream retirement home. However, when its value plunged and they had to choose between maintaining their lifestyle and paying their mortgage, they defaulted. A real estate speculator had purchased multiple properties for resale and then defaulted. A third group was being investigated by the FBI for fraud. And this was only the beginning. If the Planet Money reporters had continued, they would have found a different story behind each mortgage.

    The Planet Money story reminded me that so many people relate to a mortgage backed security. In addition to the individuals who initially borrowed the money, we have the mortgage sellers, the mortgage packagers, and the investors. We can look at government and Fannie Mae and Freddie Mac. We can investigate private businesses, families, investment banks, and hedge funds. And still there is more. The group is huge, it is diverse, and its spans the world. 

    The Economic Lesson

    Mortgage backed securities enabled a financial bubble to inflate because they funded house sales with more money than otherwise would have been available. More dollars chasing the same number of goods inflates prices. As with all bubbles, eventually prices cannot move any higher. At that moment, the bubble pops and prices descend. 

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    Consumer Financial Protection

    Jul 27 • Financial Markets, Households, Money and Monetary Policy, Regulation • 335 Views

    I have been curious about why the new Bureau of Consumer Financial Protection (BCFP), established by the Dodd-Frank financial reform bill, is an independent bureau within the Federal Reserve. While I have not discovered a satisfactory answer, I have learned several interesting facts.

    There already is a Consumer Advisory Council (CAC) housed within the Fed. According to its website, the council advises the Federal Reserve Board “on the exercise of its responsibilities under the Consumer Protection Act…” Noting that the CAC had not been effectual, several past and present members suggested that any new consumer protection agency reside elsewhere. Barney Frank, during March, said that a consumer protection council would be a second or third rate group if it were inside the Fed. 

    In addition, there already is another Bureau of Consumer Protection in the Federal Trade Commission. Its website says that, “The Bureau of Consumer Protection works to protect consumers against unfair, deceptive, or fraudulent practices in the marketplace.” Through its Financial Practices authority, the FTC “protects consumers from deceptive and unfair practices in the financial services industry.”


    The Economic Lesson

    A WSJ article noted general facts about the BCFP. Funded by the Federal Reserve, it will create and enforce rules about how financial products ranging from mortgages to credit card fees affect consumers. Its enforcement authority, though, extends only to such large financial institutions as banks with more than $10 billion of assets. Other federal regulators will keep an eye on smaller institutions. Nothing, however, was said about the hierarchy. Does the Fed Chairman have any power over the agency if they provide the funding? 

    The FDIC (1933) and the SEC (1934) emerged through the turmoil of the Great Depression. With 19th century panics in mind, the Federal Reserve (1913) was created specifically in response to the Panic of 1907.

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    A Chocolate Squeeze

    Jul 26 • Demand, Supply, and Markets, Financial Markets • 319 Views

    One person might have purchased enough cocoa to make 5 billion chocolate bars. And, he is not even in the candy making business. Instead, he is doing what financial speculators have tried to do for centuries. He is trying to corner a market.

    The man is Anthony Ward. His firm, Armajaro, does financial investing that includes commodities trading. One of those commodities is cocoa. Recently, he has purchased a lot of cocoa. 

    Cornering any market requires massive buying, so much buying that little remains for anyone else. The result is control of supply and price. Typically, when a commodities trader makes a purchase of corn, for example, the seller locks in that price. Meanwhile, because with corn the buyer is purchasing a crop that will be harvested in the future, he has the opportunity to take advantage of a price rise. The seller gets security and the buyer is the speculator. Trying to corner a market just involves buying more.

    In 1869, another financial speculator, Jay Gould, tried to corner the gold market. In the Gold Room, located near the Stock Exchange in NYC, traders bought and sold gold. When Gould’s agents (secretly working for him) started to buy and buy, the price of gold moved up. During subsequent months his men continued buying. Ultimately the U.S. government entered the market as a seller and foiled Gould’s plans.

    In the wonderful 1983 film Trading Places, Eddie Murphy and Dan Aykroyd foil a plot to corner the orange juice market.

    The Economic Lesson

    There are many buyers and many sellers in perfectly competitive markets. As a result, no one controls price or quantity. Because all producers are price takers, they have to abide by the price established through the intersection of demand and supply.

    Cornering a market involves taking control away from demand and supply. The demand curve is “hijacked” by an individual. As price goes up, other potential buyers are “squeezed” out of the market. The ultimate result, though, is control of the supply curve.   



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    Jul 25 • Businesses, Developing Economies, International Trade and Finance • 345 Views

    The Big Mac Index is out again. Not much has changed. Norway’s Big Macs are most expensive and Chinese Big Macs are cheap.

    What do Big Mac prices tell us? Starting with an average U.S. price of $3.73 (based on 4 cities), we can determine whether other currencies are over valued or undervalued in comparison to the dollar. So, when we see that a euro based Big Mac will cost $4.33, we know the euro is overvalued. Rather interestingly, a Brazilian Big Mac, at $4.91 is also more while Argentina’s Big Mac is very inexpensive at $1.78.

    I wondered, though, whether a low price would be inexpensive domestically and discovered that we can also look at the Big Mac Index from an average net wage perspective. In March, 2009, someone buying a Big Mac in Chicago, Tokyo, or Toronto would have needed 12 minutes of work time. By contrast, workers in Nairobi, Mexico City, and Jakarta worked longer than 2 hours. The global average, based on 73 cities, was just below 40 minutes.   

    The Economic Lesson

    As economists, the Big Mac Index takes us to purchasing power parity. A 2 page St. Louis Fed paper clearly and briefly connects the Big Mac Index to economics. Starting with a “one price” theory, they explain that price deviations can vary because of local productivity. If workers producing exports have higher wages, other workers benefit, and prices move up. Looking at supply and demand, Big Mac prices relate to the cost of local labor and the amount consumers are willing and able to spend. Does export activity relate to Brazil’s position on the list?


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    Institutionalized Trust

    Jul 24 • Economic History, Economic Thinkers, Macroeconomic Measurement, Thinking Economically • 320 Views

    The production path of a pair of Levi’s stonewashed 501 jeans could have started in a Mississippi Delta cotton farm, continued with a North Carolina fabric weaver, and included the Dominican Republic and Haiti for cutting, sewing, and finishing. Then, the jeans would have returned to the U.S. to one of countless retail outlets, to a consumer, and maybe even to a recycled life afterwards in some other country.

    Commenting on these “production paths” economist Tim Harford  says they ultimately lead to economic growth but only if the path is preserved by trust. The trust he refers to is primarily an institutionalized trust. We “trust” that money will have a certain value. We “trust” that a contract will be enforced. We “trust” transactions that involve Visa and American Express. We “trust” that we will receive a package that we order from Amazon.

    Correspondingly, in economies where corruption and bribery abound, economic development is constrained. Explaining why Haiti has made little progress rebuilding its main harbor, the Miami Herald points out that the project is “mired in cronyism, waste, scandal, and inertia. They could also have said that there was no institutional trust.   

    The Economic Lesson

    Secretary of the Treasury Alexander Hamilton realized that the sanctity of contracts was essential for U.S. economic development. As a result, when he had to decide who owned Revolutionary War bonds, the benevolent patriots who had sold the bonds at a discount or the ruthless speculators who bought them, he chose the speculators. Why? Government has to enforce a legal contract. A nation has to have “institutional trust.”

    Contemporary economists have researched the role of trust in the market system. You might want to look at “Adam Smith’s Essentials: On Trust, Faith, and Free Markets,” and “Trust and Growth“. 


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