American Enterprise Institute

December 17, 2007

[Edited transcript from audio tapes]

1:45 p.m.	Registration
2:00	Introduction:	Peter J. Wallison, AEI
2:15	Presenter:	Charles W. Calomiris, AEI and Columbia University
	Discussants:	Kevin A. Hassett, AEI
		Desmond Lachman, AEI
		John Makin, AEI
		Vincent R. Reinhart, AEI
	Moderator:	Peter J. Wallison, AEI
4:00	Adjournment

Proceedings:

Peter Wallison:  Okay.  I think we are about to begin.  Everyone, please take his or her seat.  Thanks very much.  I want to welcome all of you to what I believe will be one of the more interesting AEI conferences in a while.

I’m Peter Wallison.  I’m a senior fellow here at the American Enterprise Institute, and I am absolutely thrilled to be on the same panel with some distinguished economists.  As I say to people, I’m not an economist; I just occasionally play one on television.  It seemed to me that there was really an opportunity here to show people a number of things about the quality of the economics analysis at AEI and the diversity.  And I think that is what you will see when this conference finishes.  So thanks very much for coming.

In trying to assess the meaning and long-term effects of the current turmoil in the financial markets, two questions seem to stand out.  The first is whether what is going on is just a financial market problem with no major adverse effect on the real economy.  Second is whether there is anything that could have been done to stop this train wreck from happening.

This conference will focus on the first of these questions:  Where this is all going, and what can or should be done about it.  The discussion today is particularly well-timed, I think, because the New York Times yesterday had a mini debate on the question of whether a recession was on the way; in fact, one of our panelists today participated in that indirectly.  And the president is also giving a speech today on exactly these questions.  So you will be hearing a lot of material here that will be coming out in the press tomorrow.

We will hear today from five distinguished AEI economists.  Charles Calomiris will deliver a paper that considers the economic evidence on whether current credit problems will lead to a recession.  Then, he will be followed by Kevin Hassett, Des Lachman, John Makin, and Vince Reinhart, who will respond to Charlie’s views with their own and, in many cases, quite different views.

Are we dealing with a problem, indeed, that is limited to the financial markets, or will it cause a recession in the real economy?  To be sure, the theory that a recession is inevitable or very likely is well-founded.  Housing prices are falling fast.  This will produce a huge loss of personal wealth, and that might cause people to reduce their consumption of goods and services and increase savings.  Enough of that, and a recession is certain.

In addition, losses at banks will cause a tightening of lending standards reducing the amount of credit available to consumers, and thus cutting back on their ability to spend.

Finally, problems in the asset-backed securities market will mean a rise in credit card rates and perhaps a tightening of credit there with the same negative result for the economy.

In any way, past history shows that recessions almost always follow close upon large-scale housing price declines, but the evidence of an impending recession is, in my view, ambiguous at this point.  Employers are still adding jobs; there was robust growth in the third quarter, which included the beginnings of a housing price collapse.  The stock market, while volatile, is well above where it was a year ago when the economy looked very rosy, and it is certainly not forecasting a recession. 

The old joke about the stock market, as you know, is that it predicted six of the last three recessions.  The point of the joke is that the stock market is always skittish and tends to overreact.  In the current case, however, despite the jitters, there is certainly a lot of buying when prices decline.

Asset-backed commercial paper, the securities which are in market disfavor at the moment and the principal source of bank and other losses, are not trading normally, but rates have come down substantially since their August highs.  Non-financial commercial paper is trading normally and well below its 52-week high.  Car loans are at 52-week lows, and home equity loans are only a few basis points above their 52-week loans.  If there were really a credit shortage that might cause a recession or a fear among lenders of an impending recession, one would expect to see pricing for car loans and home equity loans that reflect substantially greater risk.

Then, there is the question of what could have been done to prevent the current turmoil in the financial markets.  As tough as it is to determine where the credit crunch is leading, it is even tougher to look back and say with confidence that there was some action that could have been taken to prevent the collapse of risk-taking that occurred in early August of this year. 

In an article in the Wall Street Journal last week, Alan Greenspan made two points in arguing that he and the Fed were not responsible for the subprime debt problem.  First, he contended that the very low interest rates in 2003 were necessary to ward off deflation; second, that there was no way for central banks to deflate asset bubbles while they are under way.  “After more than a half-century observing numerous price bubbles evolve and deflate,” he wrote, “I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own.  There was clearly little the world’s central banks could do to temper this most recent surge in human euphoria, in some ways reminiscent of the Dutch tulip craze of the 17th century and the South Sea bubble of the 18th century.”  He might also have cited the dot-com bubble of the 20th century.

It is important to recognize that Greenspan is talking about the Fed’s monetary authority.  The Fed’s other role as a bank regulator is a lot more difficult to excuse.  Once again, regulation has failed but that does not mean that Congress will not try to impose more regulation; they certainly will.  Regulation is one of the very few government endeavors that gets more power the more it fails.

Despite its self-serving character, the Greenspan analysis strikes me as correct.  Asset bubbles are linked to human nature.  Our inbred tendency to believe that whatever is going on at a particular time will continue indefinitely even though we know this cannot really be true.  As Herbert Stein of AEI once said, “If things cannot continue, they will stop.”  But if we cannot stop bubbles from developing, are we doomed to endless cycles of boom and bust just when we thought we knew how to tame the business cycle through monetary and fiscal policy?  That seems excessively pessimistic but in a single decade we have witnessed two sectors of our economy blossom into bubbles, and then quickly deflate, wiping out substantial amounts of wealth.

Nevertheless, it is important to remember that both these bubbles were the result of major changes in investor outlook brought on by changes in technology.  The dot-com bubble was a creature of the sudden emergence of the Internet, which stimulated a lot of entrepreneurial imaginations.  The housing bubble, which occurred in almost all developed countries, was likely to have been brought on by an enormous growth of worldwide savings that resulted when hundreds of millions of people in Asia and Eastern Europe began to earn better than subsistence wages, and their earnings outstripped their ability or desire to consume, all that saving caused the hunt for yield and a decline in risk premiums.

Thus, the optimistic view would be that the dot-com and housing bubbles are one-off events.  Not only will they not be repeated for the same assets in the future, but we are not doomed to suffer asset bubble after asset bubble after all. 

But having said all that, what should we do now?  Most of the moves by the Fed and the other central banks have not appreciably changed the reluctance of the world’s major banks to lend to one another.  Credit markets still seem frozen.  Should we worry about this?  Will it lead to a major recession?  Can a major recession be prevented by the government or by central bank policy at this point?  What is that policy?  These are questions for our distinguished AEI panel of experts.

The way we will work this today is that I will introduce Charles Calomiris now.  He will present his paper, and then each of the panelists will have something to say about Charlie’s paper and, probably, knowing them, about their own views.  We will proceed now.  I will introduce them in order after Charlie speaks.

Charlie is a visiting scholar at AEI, and is the co-director of AEI’s program on financial market deregulation.  He is the Henry Kaufman Professor of Financial Institutions at Columbia Business School, and a research associate at the National Bureau of Economic Research.  At AEI, he has done a lot of work on banking regulation, corporate finance and monetary economics.  His most recent book is China’s Financial Transition at a Crossroads, which was published by the Columbia University Press in 2007.  Charlie?

Charles Calomiris:  Thank you, Peter.  It is a great privilege to be here today.  Thank you all for coming.  I also want to recognize and thank my colleagues for coming.  I think this is going to be a real treat for all of us.

The paper that I circulated in your packets is also accompanied by the slide presentation I’m going to do.  The paper was written and presented first at the FDIC’s annual research conference in mid-September.  It was a much more courageous paper to offer in mid-September than it is now, and I say that with some gratification. 

The slides that are in your packet are updated, but the story really has not changed.  There will be an updated version in the paper at some point, too. 

Let me start by just quickly going over what happened, why it happened, and then we will talk about what it might mean going forward.  The key collapse that you are all aware of is the collapse of the subprime credit market, meaning that subprime mortgages which had been originated in increasing volume started showing huge foreclosure rates and large losses associated with those foreclosures.  That translated into more than just problems in the subprime market because subprime mortgages had become a very important part of MBS; that means overall mortgage-backed securities issuances in securitizations.

But then, it gets a little bit more complicated because MBS was not the end of the story.  Subprime took on a larger fraction of total mortgage-backed securities.  Those mortgage-back securities were associated with the creation of new conduits called CDOs, collateralized debt obligations, which were backed by MBS and increasingly backed by subprime MBS.

That is not the end of the story.  CDOs were then used to create securities that were claims on other CDOs.  That is sometimes called CDO squared.

Then, some of the higher-rated paper debt that was issued back by the CDOs, the so-called super senior tranches of the CDOs or triple-A tranches of the CDOs, were then used to create additional conduits called leveraged super senior conduits or trades, which then created claims that were put into asset-backed commercial paper conduits or, also, SIVs, which are similar to asset-backed commercial paper conduits.  A sort of working capital warehousing facility that the banks setup for their various debt obligations that were coming out of all these conduits, but especially the LSS conduits that were not finding ready markets.

So there is a sort of aggression’s [sounds like] loss story here.  If the bank cannot sell the debt coming off of the CDO squared or the LSS, it houses it in its own asset-backed commercial paper or SIV conduit and then issues largely short-term paper against that, creating, of course, a large liquidity risk for itself if people decide that they do not know that those assets are very valuable.

So there is a cascading phenomenon here linked to the multiple generations of intermediation that are occurring starting with subprime.  If subprime goes bad, then all the way down the line we start having increasingly problematic views of the securities that are fundamentally based on subprime.

Of course, that creates problems for banks because they threw liquidity risk and also reputational risk because the banks themselves have come to the rescue of their conduits.  The banks are now at risk in hard-to-understand ways to a hard-to-understand extent.

Also, money market mutual funds that bought the commercial paper that was intermediated through this process are suffering some similar problems.  Some money markets, in general, seized up during this crisis, too.  So it was a crisis of subprime mortgages, of mortgage securitizations, of asset-backed commercial paper, and even of money market mutual funds.

The problem is illustrated -- we will get to some slides.  The problem of uncertainty about bank credit quality is illustrated by the rising spread between LIBOR, the London Interbank Offer Rate, the rate that large banks charge each other.  That rate has grown relative to other rates; most notably, as I’ll show you, the one-day LIBOR rate grew relative to the one-night Fed funds rate in an unprecedented way, and it still is at a level that is unprecedented -- that spread prior to August.

Associated with this collapse of subprime and the securitizations related to subprime has been a collapse of confidence in these securitizations going forward.  It is not just that securitizations that were in existence are having problems, but the whole securitization mechanism has fallen into disfavor, lack of confidence.  Why?  Well first, we learned that the models banks were using to judge the risk of these securitization entities were flawed.  They certainly did not take into account liquidity risks, and they did not take into account the default risks adequately.  We will talk about why that was so in just a minute.

Along with that, there is a concern that the ratings agencies and the banks not only were giving incorrect views, but views that on a forward-looking basis, we do not have confidence in; that is, I think, it is not just a lack of confidence in the models but a lack of confidence in the bankers and in the ratings agencies concerned about their incentives and about agency problems that have to do with the way brokers, banks and ratings agencies behaved, and whether there was a systematic bias due to poor incentives that made them underestimate risk.  So we have a problem not just with an existing portfolio or set of portfolios but, also, with a lack of confidence in this mechanism going forward.

If you had not heard of CDOs until last year, maybe that is not surprising because they were not nearly so important until 2005 and 2006.  So you can see just from this slide how much CDO issuance accelerated during the recent boom.  Asset-backed commercial paper which was that last generation of securitization in this process also grew rapidly during 2006 and 2007. 

You can also see, though, that the recent crisis led to a sharp contraction in asset-backed commercial paper; it has now flattened out.  But other commercial paper, including even finance commercial paper, has recovered and nonfinancial commercial paper really was not part of the crisis.  So it is a localized financial turmoil, not one that has spread to all markets even within the commercial paper market. 

Why did this happen?  Well, the first fact that I would like to put before you about this crisis is what happened in subprime foreclosures in the early 2000s.  By some measures - and I’ll show you one right now - the peak of the foreclosure rate problem in subprime mortgages happened in 2002, 2003. 

So a big puzzle is if this mechanism was showing so much weakness in terms of high foreclosure rates in 2002 and 2003, then why did issuance in subprime mortgages accelerate from 2003 to 2005 and from 2005 to 2006?  So in 2003, we had, I think, about $150 billion a year being issued in subprime mortgages but by 2005 we had three times that, and by 2006 we had over $600 billion.  In other words, after the foreclosure rates had peaked in 2002, 2003, we kept issuing and accelerated our issuance. 

Why did we do that?  A big part of the explanation was that home prices were rising dramatically in 2003 and 2004 -- 2002.  And that meant that the loss given default, that is, the actual total loss in the subprime portfolios, were fairly small.  So according to Moody’s, for example, subprime losses of foreclosed mortgages in 2003 were really only about six percent in those portfolios.

So even though they were very high foreclosure rates, the losses were low.  What, of course, the ratings agencies then did, instead of appropriately, in my view, saying, “We just ducked the bullet.  Now we know that subprime is very risky.”  They said the opposite; they said, “Now, we know that foreclosures are costless.”  So that is the kind of attitude that will lead us to think that we can now assume that foreclosure rates are not very important because losses are low.

   Now, what can we do?  Well, we can have no docs mortgages - liar mortgages, as they are also known - because we do not really care.  We know that home prices will bail us out through their constant appreciation.  That is the attitude that got you from $100 billion a year to $600 billion a year.  And when you talk about the problems in the ratings agency - and I’ll talk more about them in a minute - there is no simpler fact that is more indicative of those problems than the fact that we doubled and tripled our issuance of subprime mortgages in the light of huge increases in foreclosure rates.

Other contributing factors, of course, were the novelty of these products.  In a work that Joe Mason and I have done on securitization, more generally, we have shown that it is always a bumpy ride; there is always a learning curve in securitized products.  We tend to underestimate risks; then we learn and we adapt.  Unfortunately, while this was a normal learning process, it was an abnormal volume of issuance because of the problems I mentioned.

Also, Peter mentioned the high liquidity of the market in the early 2000s, the low yields, the hunger for yield, and also a lack of turmoil for the previous few years, which encouraged a search for high yields and an underestimation of risk.  You will see in a minute also some data showing how low the risk premium had gotten in the markets generally; in the bond market, in the emerging markets, debt instruments in all of them.

So this kind of story about mistakes that should have been foreseen but were not is very reminiscent of my late friend, Hyman Minsky.  And that is why, to honor him, I used his name in the title for this paper.  But the Minsky model, which is really a macroeconomic model, has to go a lot farther than just a moment of myopia and underestimated risk.  Also, to be a real Minsky moment you have to also deliver a recession.  The question is:  Is this financial turmoil going to lead to an economic crisis, a recession?

Before we get to that, I also wanted to show you the data underlining what I said to you before.  The blue line there is the inventory of existing foreclosures as a proportion of outstanding subprime mortgages.  So you can see very well how things ramped up in 2001 and 2003.  In fact, according to these data, we still have not gotten back to the peak in the foreclosure rates that period.  But the second measure, which is this brown measure, these are new foreclosures.  So by this measure, we have now exceeded where we were in 2003.  The point here to mention, which I think is really -- I want to emphasize is how forecastable the problem of subprime was as of 2004 and 2005.

Male Voice:  [Off-mike] Can you explain the discontinuity in that chart?

Charles Calomiris:  Well, during the earlier period we do not have the prime mortgages broken out from the subprime.  So here, we have prime only; here we have subprime; here we have the total.  I’m not going over in great detail the charts.  The paper does go through them.  These are the updated charts, too.  But given the time limitations - and Peter is a fierce chair - I want to make sure that I do not miss my story.

So the question of macroeconomic consequences has a few different parts to it.  One part of it is, are we going to have a severe credit crunch?  That means a severe contraction in the capacity on the supply side to create credit, both intermediated credit and direct credit.  So if firms, ultimately, that might be demanding credit cannot get a supply of credit because of some problem in the intermediation of credit - contraction of the supply capabilities of the financial system - we call that a credit crunch.

Of course, a credit crunch is happening; there is no question that there is a credit crunch.  The question is how severe.  I would argue, which we will come to in a minute, that when you look at credit crunches, you have to ask yourself a set of questions, not just whether banks are suffering losses, hits to their equity.  But you have to ask:  How big are the losses?  Are the losses indicative not just of an immediate loss but an ongoing loss, meaning low earnings or negative earnings going forward for some time?  Are the banks going to be able to retain sufficient equity to be able to add to their portfolios?  In this case, banks have to re-intermediate the lending that was done in the securitized instruments by bringing things on to their portfolio.  Many are doing that as we will see.

But do they have enough capacity in terms of their equity capital and other capital to be able to absorb those loans and grow?  And do they also have enough capacity - if necessary, confidence from the market - to be able to issue Tier 1 equity, which we will see is currently the binding constraint?  The Tier 1 leverage ratio is the binding constraint of importance in the banks from a regulatory standpoint.  Will they be able to raise Tier 1 equity to be able to support continuing growth so that they can do things on balance sheet that they used to do off balance sheet?  Any analysis of the credit crunch has to have all of those pieces and more. 

What about non-intermediated credit?  Is there enough financial slack that if some firms found that they were not able to turn to banks for credit, could they do offerings in the market directly?  That is, bond offerings or commercial paper offerings.

My main point, if you do not take anything else away from my presentation today, is those are the questions you have to ask yourself, not just if there have been large losses, not just if people have lost confidence in securitization.  But you have to ask yourself at each one of those margins whether supply is going to be constrained in a significant way.  I come to the conclusion that it will not be.  That supply will be able to continue growing along with demand.

We have also seen some unprecedented effects that make us worry not just about the existing capital of the banks, but about their ability to lend to each other coming from these elevated LIBOR spreads - that I’m going to point to - which are indicative of high adverse selection costs among the banks.  Fortunately, those spreads have been narrowing but that is something we have to keep an eye on as I’ll explain in a minute.

But beyond the credit crunch, there is another problem, which is if you think that the country was in a housing bubble and if you think that housing bubble just burst; then you think, maybe, housing prices are going to decline, that could make credit worse as consumers are losing equity in their home.  Also, the credit crunch itself could make the housing price contraction worse; they could feed on each other.

Furthermore, just a decline in wealth itself could have an effect on consumption through the wealth effect which the Federal Reserve has estimated as being about five percent; that is the elasticity of consumption with respect to a change in housing wealth.  I will argue that is not a very plausible elasticity estimate when I get a little farther down the road.  So those are the concerns that we can worry about.

Let me first talk briefly about the financial system.  This is not 1989, 1991 when we had a real credit crunch that contributed significantly to a recession.  Why?  First of all, the banking system right now is in pretty good shape.  Back in the 1989 to 1991 period, it was really a comedy of errors, almost.  We had the collapse of sovereign debt; we had the post-1986 commercial real estate collapse; we had the oil price collapse; we had the agricultural price collapse in the early to mid 1980s; the savings and loan disaster.  Everything that could go wrong, it seemed, went wrong from about 1980 to about 1988.  Banks were heavily undercapitalized.  Some people were saying that our money center banks were insolvent in 1990. 

That is not the case today.  In fact, I would say, basically, under reasonable worst-case scenario for Citibank, what these subprime losses will mean for Citibank is two quarters of zero profits followed by positive high profits again; that is, last quarter and this quarter, zero profits followed by positive profits without necessarily any impact on its equity position.  Furthermore, as you know, Citibank along with many other banks has already announced that it is going to be growing its equity through a preferred stock offering.

So we are seeing the banks re-intermediating substantially.  We are seeing that large losses are being recognized quickly, again, unlike the position in the late ‘80s and the early ‘90s.  We are seeing the banks much better diversified.  Furthermore, corporate balance sheets are in great shape, unlike 1990.  In 1990, we had just gone through a high leveraging period.  Thanks to the dividend tax cut a few years ago, we are in a situation where leverage in corporations are back to where it was prior to the build-up in the 1980s.  Huge liquidity, huge debt capacity in corporations means the corporations, if they needed to, can raise debt on their own.  There is a lot of debt capacity in corporate America.

Here is a graph that shows you how much we have seen growth in re-intermediation and the balance sheets of the banks so far.  Peter has already passed me a note, so I’m going to be going a little quickly here.  The point of this graph is to show you that money market rates have come down a lot as a result of Fed actions, and the jumbo and conforming mortgage rates, although they were up substantially as of July and August, have come back down quite a bit too.

A key problem has been because of adverse selection problems in the banking industry - that is, people not knowing each other’s condition perfectly - LIBOR spreads relative to other money market rates have gone way up.  So the Fed has had to cut the Fed funds rate by even more in order to bring LIBOR down to where it wanted LIBOR to be.  But the Fed is able to do that, I would say, fairly effectively.

This is the unusual spread.  This had never been greater than five basis points.  Prior to this current crisis it got up to 127 basis points, the spread between overnight LIBOR and Fed funds.  And that is because LIBOR is the large-bank-to-large-bank lending rate, and it still is at a very elevated point somewhere in the 20s and 30s right now, but much lower than it was in the heat of the crisis.  This gives you the data about corporate leverage that I mentioned before, indicating a lot of debt capacity in corporations.

What about housing prices?  Well, I will not be able to go into this in much detail; except to say, first of all, do not believe, or at least do not take at face value, the data that you are seeing in the headline news.  Median sales prices of homes are basically a meaningless indicator, I believe.  The Case-Shiller index is a very flawed indicator; we are going to probably have to talk more about that.

More generally, if you look at the MSA level of data instead of at the national level, what you see is huge diversity.  We did not have a national housing bubble.  Arizona had a housing bubble.  Some parts of California had a housing bubble.  Florida had a housing bubble.  Nevada, maybe, had a housing bubble.  Ohio and Michigan have had a housing decline for a long time; they did not have a bubble.  If you looked at most of the country, housing returns looked like the cardiogram of Iraq for the last 10, 15 years.

So you have to be very careful about these data.  There are few locations where we do see some problems but I would not say that characterizing the U.S. as a housing bubble is accurate at all.  Housing sales have been way down.  What is interesting, though, is housing sales have been down even in the really hot markets like Seattle and Austin.  So it is not so clear that housing sales means a good predictor of housing price decline; in fact, we know it does not.  So it is interesting what we are going to make -- I have another paper coming out on this topic and I will just say I think that we should not jump to that conclusion.

As Kevin Hassett pointed out - I stole one of these graphs from him - housing has already been in a recession for a year.  So on a forward-looking basis that is good news because it means that housing is not going to be contributing downward pressure probably going forward.  And the lack of buildup of inventories from new housing starts over the past year is going to provide some supply side support to prices going forward in housing.

This was also meant to indicate that the Case-Shiller Index is very much at odds with the OFHEO Index, which is produced by Fannie and Freddie, showing a much more stable housing price path.  We can talk about that in the discussion period, I’m sure.  Furthermore, part of what is driving Case-Shiller to those exaggerated numbers is that it does not have very good coverage in much of the country where housing prices have been fairly favorable.  If you have doubts about OFHEO, this shows that there is a very tight fit between OFHEO’s location-specific housing pricing changes and foreclosure experience over the past year.  I’m trying, Peter.  I’m almost there.

Then, furthermore, as David Malthus [phonetic] likes to point out, household wealth is doing great.  So I’m not going to give you all the good data on the economy; this is the graph that was stolen from one of Kevin’s recent papers about how we have already experienced significant declines in starts, which is going to help us, I think, in the recovery.

So before moving on to policy, recession risk to me seems minimal.  Credit crunch, I think, is going to happen, but it is not going to be very severe.  Some credit spreads remain elevated, but they were much too low before the turmoil.  So I think that is more realistic.  I would also point to this recent study by Zhi Gan [phonetic] that I think is a very interesting.  It is a paper on Hong Kong housing prices.  It is a microeconomic analysis of housing price elasticities in consumption that at least leads me to think -- I find this a much more plausible measure of elasticity than five percent.  Just to point to this to show you there has been a permanent elevation in the spreads of BAA out of time.

So here are my policy responses to whet your appetite.  M-LEC was a bad idea.  It is bad to encourage phony bookkeeping and postponement of recognition of losses.  Nobody fell for it; that is good.  The Foreclosure Relief program, I think, was also a bad idea; a better approach would be to stop subsidizing equity and use this current turmoil as a good way to have a whole new approach to supporting equity for low income people, which is to do matching down payments; when they are willing to put down payments up, we can match them.  That will build home ownership in a real sense rather than just home renters who on paper are called homeowners, which is what we have.  We have been heavily subsidizing leverage which has been a part of the problem.

We need bank regulatory reforms and reforms of GSEs in light of this, but we will just save that for further discussion. 

Sorry if I went over.

Peter Wallison:  Charlie, thanks very much.

Charles Calomiris:  Yeah.

Peter Wallison:  That was detail-filled and very, very useful.  We will ultimately extend this beyond four o’clock because a lot of you will have questions, and we will get as many of our experts here to stay if we can.  So do not worry about it.  Okay.

Kevin Hassett is our next speaker.  Kevin, as probably all of you know, is the director of economic policy studies here at AEI and a resident scholar.

Kevin Hassett:  Just let me go.  Everybody knows who I am.  We are running short of time.

Peter Wallison:  Okay.  Good idea.

Kevin Hassett:  Read the bio if you want to know more.  So if you read the writings of AEI folks, and you look at how we’re situated on the panel and note that we are moving from this side to that side, then you could think of me as the dawn before the storm, before the darkness.  What I’m doing with my presentation is thinking a little bit more carefully about how to think about Charlie’s question: Is now the Minsky moment?  For me, I decided to put a heavy emphasis on the second word, “now.”  Are we in the Minsky moment now?

The reason that I decided to do this is that I have been finishing up a book that will be out late spring with Jim Hamilton of the University of California at San Diego and Marcelle Chauvet of Cal Riverside, where we have been working with new models that were really innovated by Marcelle and Jim that help you think about the question, “Are we in a recession,” in a very precise way.  So what the model does is it -- Jim’s model, I originally just used GDP data.  And Marcelle has a whole series of different models that use monthly real-time indicators to try to figure out whether we are in a recession, given the data that we have in hand right now.

I think that as we move across the panel and think about whether we are in a Minsky moment, then thinking about whether the data we have in hand right now are suggestive that we are in or about to be in a recession is a very useful topic for gaining perspective.  I’m about to show some charts using what I think is the best model to date of this forum that Marcelle has generated that uses employment IP, personal income and manufacturing and trade sales.  This model, which, basically, filters through the data and tries to figure out whether we are in a recession or not, views recession as an unobservable state of the world, except that you get glimpses of it through different types of data that switches on and off.

This model has correctly called every postwar recession, never made a false call, and in some sense then you could think of it as being not a weather forecast but a rain gauge.  So did it rain?  Are we raining right now?  Are we in a recession right now?  There is actually not a reason to have to have to have an opinion about it anymore.  It is more or less knowable, given the real-time data and the success of these models.

So here is a chart; I hope it is not too hard to see.  The blue lines are really what I would like you to focus on, mostly because I do not want to talk about Bayesian smoothing in mixed company.  But the blue line is the probability of recession out of Marcelle’s best monthly model.  The gray shaded areas are postwar recessions and you can see that the model, more or less, in just about real-time has told us that we are in a recession as the recession started.  There are a few unfortunate blips but if you apply the rule that we decided that we are in a recession, if two months in a row this Markov switching - it’s called a model - tells us that the probability of a recession is greater than 0.5, then it called every recession correctly and never gave a false signal.

So then the question is what is going on right now?  This is using all the data through October.  If you look down at the bottom, the blue line at the very end - that is through October - you can see that while we have had a lot of stress in the economy and a lot of reason to be concerned, given the factors that Charlie talked about - and Des has some even more disturbing things to show you - the still underlying data have been pretty darn surprisingly strong, and the probability of recession -- this is just looking at what it looks at right at the end of the sample, looking at the last recession and where we are -- the probability of recession right now according to this model is only 0.16.

We have a little bit of the data that we would need to do November but you got to decide what assumptions you want to make and so on to get it to spit out a probability.  When we played with it last week, we did not like the judgmental factor enough to want to put in the New York Times the November probability.  So the October one is a pretty hard number of 16 percent but the November probability is looking like it might even be a little lower than October.

So what it means is that the best kind of mechanical method that we have for deciding whether we are in a recession right now, given the data, suggests that if a recession is going to begin, it is going to have to begin in December or later.  Okay?

So then the question is; is that going to happen?  I guess everybody could have a lot of opinions about that, and probably we will up here.  I find, sadly, both arguments extremely compelling; either it is going to be a real problem or it is not.  The happy scenario is one where you say, “Well, the fraction of housing in overall GDP is less than four percent now.”  So you can get an F in housing and still get an A, and it is going to work out.  But then on the other hand, you can say, “Yeah, but housing is a huge fraction of wealth.  If that is going down because prices are declining, then that is going to cause financial distress and consumption is going to go down a lot and so on.”

I could see both happening but I’m somewhat, I guess, soothed by the thought that a heck of a lot of bad stuff has already happened, right?  So there are all these losses that we did not know about that are out there; there is the huge decline in housing that has already happened.  So I think that as we move across the panel and decide how anxious we want to be about the first quarter, which is really where the recession has got to start if it is going to, then, really, I think what you have to do if you want to be convinced that we are going to have a recession is you have to convince yourself that the worst is not behind us in terms of just the straight financial market and housing data.  That there is going to be turmoil, credit crunch, unlike any crunch you have seen so far if you want to move us from where we are in the recession.

I guess we will wait and see if they can convince us of that.  But I find the notion that we would have gone through all the stresses that we did and then still avoided up to the last minute that we can actually calculate a recession.  Incredibly implausible in the sense of last summer if we told you what was going to happen, then would we not be in recession according to the best indicator we would have, then I think no one would have said, “Yeah, we would have avoided a recession.”

So I guess that mystery is the one promising thought that I leave you with as I now hand you off to Des.

Peter Wallison:  Well, Des will give the counterargument, I’m sure.  Des Lachman is a resident fellow and came to AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney.  I will not go on with the rest of it.  You can read it in your material.  Des?

Desmond Lachman:  Peter, thank you very much for inviting me and thank you very much for organizing a seminar on something that I think is going to be important, not just at the moment; I think that this is going to be with us for a while, and I really do hope that you follow this up with another session in six months’ time to see whether or not we were going to be in a recession or not.

I really enjoyed the presentation of Charles, and if I could really believe it I think I would sleep a lot more easily at night.  But sadly, I cannot really go along with his conclusions.  I think that a lot of what he said, I would agree with but I think that it is more the omissions that bother me.  That what he seems to be saying is that we did not have much of a bubble; that there is not too much of a credit crunch; that the problems are just in the subprime area, and that we are certainly not going to have a recession.

I would take a rather different view and I think that it is grounded in the data that I’ll be showing you shortly.  I’ll be saying that what we are witnessing right now is the bursting of probably the largest bubble that this country has had, certainly, on the housing side and, probably, as well, in the credit market side.  So I think that what we are dealing with in the financial markets is not a liquidity issue, but it is more a solvency issue.

Charles mentioned the complexities that are involved, and I think that what is a key point is that we have a transparency problem as well.  So even if the losses -- you only wanted to estimate the losses at $200 to $400 billion, though, and say that is not very large in relation to banks’ capital.  The issue is we do not know where those losses reside or, more importantly, the banks do not know where those losses reside.  So what this is causing is the market to freeze up.  I would say that the bad lending practices were endemic, that subprime was really just symptomatic.  So we are really going to have losses that are on a very much larger scale.

Just to answer very briefly Peter’s questions before proceeding, I think that a recession is almost a certainty in the sense that what is occurring is that this credit crunch is not occurring in isolation; it is occurring at the same time that the housing market is bursting; it is deflating.  And a minor detail is we have oil at $90 a barrel, which is sapping consumer demand.  So I think that if we do not get a proper response from the Fed, this not only could be a recession but it could be of a nasty sort.

The second question that Peter asked, seemed to intimate, was that bubbles are inevitable.  I do not believe that.  When I go through my slides, I would make the point that the Fed certainly helped to throw a lot of fuel to the bubble, both in terms of lower interest rates and regulatory negligence that caused subprime to take off.  What I wanted to do just on the slides, which I’ll walk through very quickly, are just to establish the fact that maybe we did have a bubble; maybe, there was too much borrowing going on.  I want to also talk about where house prices are likely to be going forward, and then look at some of the aspects of the credit crunch.

The chart that I think says it all, at least as far as I’m concerned, is the Robert Shiller chart looking at house prices over the last 100 years.  What we see in this chart, if you just focus on the period after the Second World War, is that you see in a typical housing boom-bust after the Second World War is we would have like a 20-percent oscillation, meaning that in real terms - this chart was adjusted for inflation - we might get house prices going up by 20 percent followed by a similar bust.

Move on to 2000 to 2006 - we have an increase of a mere 80 percent in real terms.  So something extraordinary is going on, and I would think that the prologue might be telling you what is going to happen with the sequel.  Looked at in a different way, if you look at house prices, if you wanted to scale them in relation to income, which I think is rather relevant, we see that house prices typically would be around about 3.2 times an average household’s income. 

We go to 2006; we see that the figure is around about 4.5.  That means that either incomes have to increase very much or the more likely scenario is house prices have to come down.  So over the course of the cycle, it looks like house prices are overvalued anywhere between 20 and 30 percent.  I’m not suggesting that this is going to occur in a hurry, but I am suggesting that what we could very well see as house prices declining by 5 to 10 percent over the next few years.

 The next chart just reinforces the point that I was saying that we did not get the house bubble; it did not just come out of the air.  It was not a question of demographics or some fundamental change, but it was rather in response to the Federal Reserve reducing interest rates after the NASDAQ bubble burst to something like 1 percent, and then holding those interest rates for too long at a low rate, and then taking its sweet time in withdrawing the stimulus to house buying.  As if that was not bad enough, what the Federal Reserve allowed was the subprime lending to take off. 

So what we had as originators who were just printing stuff that is going to -- as Charles has well indicated on Wall Street, these were known as liar loans or indenture [sounds like] loans, meaning there was no income, no jobs, no assets.  So these are really very bad loans.  I would have thought that the Fed’s responsibility should have been to see that toxic waste was not being distributed -- was not bad enough that it was being distributed in the United States financial system; it was being distributed in the global financial system.  And I think that we are now reaping -- that is probably the wrong metaphor but the chickens have come home to roost. 

If there was any doubt that lending standards were declining over the period, just take a look at this chart.  This chart is telling you what is occurring to subprime lending by vintage.  What are the delinquency rates?  And the line at the far left is basically the 2006 vintage.  What that is showing is that the delinquencies are running at twice the rate, given the period that is elapsing. 

So that after 18 months of having 2006 vintage subprime loans, we have got delinquencies that are around 15, 16 percent.  This is long before the interest rates reset so we have got real trouble, and I’m suggesting that this kind of lending practice was not confined to the mortgage industry, but was the story with credit cards, with auto loans, with home equity lines, the rest. 

I should mention as well on the subprime lending, what was occurring is that, traditionally, you had loan-to-value ratios of about 80 percent; subprime, they were doing loan-to-value ratios of about 96 percent.  And on top of that, there were second mortgages, there were piggyback loans.  So you were lending way above the house so when house prices begin to come down, we are going to have negative equity in a big way; we are going to have defaults in a big way, and that is really what is going to make this credit crunch a lot worse.  This is not something that is going to be solved in a short while.  It is not something that the Fed, through doing what it is doing right now through liquidity injections is going to solve a solvency problem.

 I do not mean to add on the gloom on the housing side but I cannot resist showing you the chart on the amount of speculation that was taking place in the housing market.  This is a chart from the National Association of Realtors, which showed that at least, in 2005, as much as 27 percent of the homes being bought were for speculative purposes.  They were not primary residences; they were not vacation homes.  They were speculations.  So there is a lot of speculative activity in this market that will have to unwind, which is going to keep this market suppressed for a while. 

Now, what is occurring at the same time as we are creating a housing bubble is we are loading up on borrowing by the private sector.  So what we have seen is -- do you see this top line?  It’s showing you that between 1990 and 2000, it is really relatively stable; slight increase in household indebtedness. 

But now what we have got is we have got indebtedness going up by 40 percent.  We are looking at ratios of something like 140 percent to GDP in household debt, which is a real problem.  The balance sheet does not look too bad if you are taking on this debt and your house prices are increasing in value and the stock market is booming; you know you can withstand it. 

The question is what happens when those bubbles burst and you are stuck with it?  I think that that is where you are going to get a big impact on consumption. 

Let me move -- this chart, one really cannot see the lines.  They did not come out but it basically just shows that savings has collapsed and that the amounts that households are spending of their income to service their debt has gone up fairly abruptly.

 Let me turn to the outlook for house prices, and I think that that is a key that Charles is not talking about; that is, if house prices decline, what you are doing -- this is really a big market; the mortgage market is something like $10 trillion; the housing market is something like $20 trillion.  What you are doing is if house prices decline, you are eroding the collateral of the banks. 

So the key issue is how much are house prices going to decline?  If you think that house prices are not going to decline, if you think that they are going to increase, you do not need to worry. 

But if on the other hand you look at some of the indicators that tell you that house prices have to decline -- I showed you one chart that suggests that the equilibrium price is really probably something like 20, 30 percent out of whack.  But look at the -- what is already occurring is house prices are really occurring by most measures.  I know Charles is not going to like the Shiller measure, but if he wants to look at the OFHEO measure, that is already declining at the national level at the last quarter. 

But look at the situation that we are in; we are in a situation of clear oversupply.  Vacancy rates, which is a very good indication of how much excess supply there is -- we normally were at something like 1.5 percent; that has gone up to something like 2.7 percent.  It is a historic high; it is telling you that there are too many houses on the market.  Or if you just want to look at unsold inventories of houses when we should really be at something like 2.5, 3 million houses, we are stuck with 5 million houses, which is something like a year’s supply.  So it is going to take a long time to work off. 

The issue gets worse when you ask yourself what is going to happen to demand going forward.  Well, the one thing that has occurred is that the subprime lenders, many of those have gone out of business.  I should mention subprime lending and Alta-A lending was 40 percent of financing to the mortgage market.  Well, the fact that we do not have that financing anymore means we have knocked off one leg giving support to the house market. 

The other is what is happening with adjustable rate mortgages.  This is measured from the beginning of the year and you see that we are now going in to the peak period.  And what I would emphasize is that we are not just talking about subprime mortgages resetting; we are talking about prime mortgages resetting; we are talking about Alta-A; we are talking about the whole ka-bang.  And that is bound to create problems going forward.

 Being in academics, I’m not quite sure what exactly a Minsky Moment is.  But when I look at the chart like this, I think that maybe there is a Minsky Moment right here just in terms of what are the mortgage [indiscernible] conditions like.  This comes from the Federal Reserve’s quarterly survey of lending intentions and you see we are off the chart; basically, nobody really wants to be doing any kind of mortgage lending, given what the trouble is.  So that is another reason that we will have lower demand and the speculative supply. 

Being an institution like this one believe in markets and the only market that one has got in forward contracts on houses is the Shiller market.  If you look at the second column, people are betting that house prices between 2007 and 2009 are going to be declining in double-digit rates in most cities in the United States, which would be consistent with my view that we are going to be seeing house price declines the next two years of 5 to 10 percent, which is really going to be problematic for the credit markets.

 Let me turn now quickly just to say a few words about the credit crunch because I think it is important that the estimates on subprime losses are $200 to $400 billion.  But I do not know why they are not talking about other losses on mortgage loans.  The other mortgage loans, the Alta-A loans are bad.  What we are hearing from Fannie Mae and Freddie Mac are that conventional kinds of loans have got problems, so one would really have to add to those loans. 

But I would think that the real problems are going to be in at the credit cards, the auto loans, the home equity lines.  So that the 200 to 400, I think, that that is probably half the problem.  We are more likely to be coming up with a $600, $700 billion figure; and now, you are talking about real money that is something like 5 percent of United States GDP, which I do not think is a small matter. 

What is important is that the banks at this point of the game have only recognized something like $60 billion of those losses.  So looking forward, we really have to expect a lot of surprises and it would really surprise me if we do not get one or two dead bodies floating around here.  That could be problematic. 

Something that I have not mentioned, but this is also symptomatic of what is going on, is what is going on with leverage loans and junk bonds; those have actually exploded to something like $1 trillion.  And what we see - Charles mentioned - that there is a compression of spreads, which is a nice way of saying that there is mispricing of risk that what the markets are doing in their wisdom is that they are pricing these loans that the implied rate of default is very much below the historic rate of default. 

And what I’m suggesting is the fact that we have had the mother of all housing booms and credit bubbles that are busting is that the downturn is unlikely to be an average downturn; it is likely to be worse than a normal downturn.  So it means that the losses that we are going pile up on these are going to be just really compounding the problem.

 I do not think I have been gloomy enough so far so let me just mention the credit derivatives, which is just a slight problem is that now we have got -- you just see the explosion of credit derivatives, which is now something like $45 trillion dollars.  So there might be a slight problem of counter party risk if we get one or two institutions failing.  So this whole thing is, not to put a fine point on it, a royal mess.  And I really think that the Fed was just totally asleep while this was occurring, not that they are responding to it in a better way.

 Finally, I will just say that I think that there is a major credit crunch, and in two minutes I’m going to go through the slides.  Charles has really just mentioned that, essentially, what we have got is -- this is showing you that, globally, we have got a credit crunch.  This is not confined to the United States so anybody who thinks that there is decoupling and that somehow, the rest of the world is going to make the softer -- I think should just be taking a look at these charts.  This is just showing you that we peaked in August; we are back there to where we were before despite tens of billions of dollars being pumped into this by different central banks; it does not seem to be doing too much good.  And this chart is just comparing the LTCM crisis with what we have got now is that you see on the LTCM crisis -- that was the 1998 credit crunch that quickly solved itself in a matter of a few weeks.  Whereas this is now going on for something like three months and I suspect it is going to get worse.

 The last chart -- I would not minimize this problem of the asset-backed commercial paper.  What has occurred is that that market has collapsed.  I would liken that to run on the banks that what we have got is we have got the structured investment vehicles, which were being funded by this; it is something like $400 billion out of that. 

The Paulsen plan has failed miserably.  Last week, Citibank and HSBC had to take on an aggregate of close to $100 billion of debt back on to the books.  So I think that, going forward, the lending is not going to be there. 

Finally, I’ll just say that I think Marty Feldstein is right.  The risks that we face are that of running a severe downturn and that we are ready to require right now is aggressive action and not having the Fed look in the rear view mirror at inflation.

 Peter Wallison:  Thank you very much, Des.  Well, if you are puzzled now, we will give you some more information.  John Makin is a visiting scholar at AEI; he is also a principal at Caxton Associates.  He served as an adviser to numerous U.S. government agencies, the Federal Reserve, and the Bank of Japan.  John?

John Makin:  Say no more.  Well, I’m looking out at the audience and I am thinking I have a big job to do because in the space of -- I’m not going to succeed but I feel a heavy responsibility because here people come to get an idea where we are going and one person says, “Hey, no problem,” and another person says, “The sky is falling.”  So I’m going to start and go from the specific to the general.

 In 1929, Joe Kennedy decided it was time to sell his stocks when a newsboy started giving him stock tips.  Now, in 2007, November, it is time to worry about the economy when I read to you an e-mail that I received at one o’clock today.  A Ferrari F430 F1 Coupe with only 3,700 miles available is for sale below list.  I do not -- I see we do not have many car fans in the audience.  This is a car that is sought after by every collector and four or five months ago was totally unavailable.  The Ferrari salesman would laugh in your face if you try to put in an order.  And now, it is yours for a mere 235k.  What does this tell us? 

Well, it tells us that there is distress outside the subprime sector, but I will have to be more convincing than that, I guess.  We just do not have enough car fans out there.  You guys got to wake up.  Think condos.  [Cross-talking] that is it.  That is it.  Right, right. 

I’m a little bit, I guess, nonplused by the discussion because it seems to me to be a very straightforward business cycle picture and a very straightforward move into what will probably be a recession.  And I’m not sure recession is a crisis; we have them all the time.  So I’m not sure that talking about a recession is talking about the end of the world. 

But I confess that my thinking on this issue jelled at the Fed’s Jackson Hole conference where I heard papers say that a housing recession is a necessary but not a sufficient condition for recession; that was Ed Lemur’s [phonetic] paper.  And a very good paper by John Muellbauer from Oxford suggested that it is not really the wealth effects that are associated with real estate and housing problems that cause severe economic slowdowns; it is the credit issues.  And I tend to agree with that.

 But let me just give you my chronology of thoughts about this.  We did have a bubble, I think, to suggest and I’m very unsympathetic with Chairman Greenspan [inaudible] you cannot identify a bubble because we do have -- the best measures we have of house prices are the Shiller measures.  Maybe, they are not perfect but they are a lot better than the OFHEO measures, which are conforming loans only.  And if that was not a bubble, I do not know what was.  And the Fed was, perhaps, not as attentive as they might have been but that is water over the dam.

 In my role as an economist who is subject to constant humiliation in the New York financial markets, I listen to a lot of people who really make it their business to look at these sectors from the bottom-up.  And by the summer of 2006, you could talk to any good mortgage department at any good investment bank - Lehman Brothers, Goldman, or others - and they could tell you that there is real trouble on the way. 

The way the trouble started was very specifically this.  In 2005, the Miami condo market was so hot that people would take out three undocumented loans, finance the condo, purchase 100 percent, and flip the condo before they even had to take possession.  So this activity was going on and this was an activity that was viable after the Fed had begun to raise interest rates.  Remember, the Fed raised interest rates by 400 basis points from 1 percent -- 425 basis points from one to five and a quarter percent over the two years between June of 2004 and June of 2006.  And that began to cut in 2006 and here is what happened:  The Miami condo market collapsed because the flippers could not flip anymore. 

And what happens when you cannot flip a condo and you do not make the first payment on the mortgages?  The mortgage goes back to the mortgage broker, a thought that I find very appealing.  These mortgage brokers are the folks who just make loans and flip the paper back to somebody else through the channel that Charlie so carefully described and confidently described.  And so this began the unwinding of the process that the mortgage brokers that had mortgages put back to them folded.  And you may have recalled at the end of 2006, there were sage and dour faces saying, “Well, we have a big problem in the subprime sector in the Miami condo sector, but it is going to be contained.” 

Simultaneously, in the fall of 2006, Bear Stearns was starting up its second hedge fund dedicated to speculating on mortgage securities; this is the fall of 2006.  By April of 2006 that hedge fund was severely under water.  And for one instant in June of -- I’m sorry, 2007.  And for one instant, in June of 2007 Bear decided to try to have an auction of the some of the CDOs that had been accumulated or had accumulated claims on mortgages.  The bids were so bad that the auction was terminated very quickly.  The rest of the story for Bear Stearns is well known; it did not go well. 

And what everyone decided at that point was that the CDO market and the other derivative securities market was to be the “do not ask, do not tell” market:  I do not want to know what it is worth either as a borrower or a lender because it is worth a lot less than the hundred cents on the dollar at which the banks are valuing it, that is, that the banks were valuing it before some of them fired their CEOs.  And so we had a big problem that was unwinding.  And why was it unwinding?  Well, what is new about this?

 The Fed, withdrawing extreme liquidity, which is what the Fed was doing from 2004 to 2006 in a market where you have had extreme elasticity in the credit market is just the same as tightening.  The effect was somewhat delayed by the extreme elasticity of the credit markets and the compression of risk spreads that Charlie has described.  And what the problem is that when that game ended, that is, when people started having to price risk more accurately, credit conditions actually tightened a lot.  By August of last summer, you may all recall, the Fed nonchalantly suggested on August 7th that the risks were balanced; 10 days later they were out saying, “We got to do something with the discount window,” and so on and so forth. 

And since then we have oscillated back and forth into risk taking and risk avoiding behavior as the Fed has struggled with a very difficult problem - a very tricky credit market meltdown with an ambiguous path for the real economy.  And it comes under the heading of something that we all started out with:  How do financial markets affect the real economy?  It is very complex, very difficult to follow. 

But what we have seen is that when -- and the Fed has been trying to deal with the financial problems by being innovative in terms of liquidity provision.  I am going to let Vincent talk about the Taft [phonetic] effort, but that is essentially an effort to distribute funds more broadly into the banking system, not just through the dealer network while being skeptical of the idea that there could be a recession.  And skepticism about the idea there could be a recession has been reflected in a hundred-basis point reduction in the Fed funds rate over the past several meetings in two doses of 25 and one dose of 50. 

The problem, I think -- so we have thrown a number of things at the credit problems and at the economy slowdown without really much effect.  I mean, you cannot look just at the stock market to diagnose what the outlook -- or what is happening at the economy; you have to look at the sectors of the stock market. 

And be my guest, just look at the financial stocks.  Look at the stock of Citibank.  Look at the stock of Lehman, even Goldman.  But look at the banks and investment banks.  And the market is telling you that people are very concerned about the future value of those stocks.  So I assume that Charlie is a heavy buyer of Citi at 30 - today’s price - because even Abu Dhabi is behind on this one; it is down 12 percent since they bought it and Citi borrowed the money at 11 percent.  I guess, what I’m saying is that if you are in the financial markets and looking at what is going on, it is pretty scary. 

And going to Kevin’s point about are we in a recession, I mean, every time a number comes out, there are three consultants that run a little model and say, “Okay, the fourth quarter growth rate is 0.1 percent.  Last week, it was -0.1 percent.”  This is all the little models that calculate, have their little assumptions.  “This week it is +0.8 percent because we had one strong retail sales number for November, which is preliminary and probably will be revised down.” 

And is there going to be a recession?  Probably, there is.  It is really not the issue.  The issue is:  Is economic activity going to slow rapidly enough to re-exacerbate the problems in the credit markets and the housing market? 

And I think that there is a substantial risk that that is going to happen.  Des has documented a lot of the underlying problems there.  I think there are many ways in which you can calculate where you expect the price of housing to go.  Lots of people have known it.  I would say the modal expectation for the decline in house prices over two or three years is 15 percent.  The housing stock in the U.S. is worth $23 trillion; that is a $3.5 trillion hole.  And what makes me nervous about that is that the equity capital of banks, investment banks, and other financial institutions in the U.S. is a trillion. 

Now, they do not have all of that facing them and maybe the number is only 10 percent down.  I do not know.  But I’m concerned about the equity capital of the financial intermediaries in the U.S. being severely compromised, and concerned about the ability to continue to create credit in a way that could lead us to a recession.

 So actually, I had come -- so I think -- short answer:  I think we are going to have a recession.  The markets are really pricing and yields on two-year notes are 3 percent.  The Fed funds’ rate is 4.25.  Guess what?  The market thinks that the Fed has got a lot of cutting to do.  Again, I will leave it to you all to go on to your Bloomberg’s or to stare at your Barons and look at the prices of financial sector stocks.  The best stock out there these days is Coca-Cola; that is understandable because people drink Coke.  In fact, when things go badly they drink more Coke.

 I want to just close because I have 1.5 minutes left.  Where do I think we are going to have to go with this?  And this is where it is going to get a little bit messy.  First of all, in order to bring about the transparency in the marketplace that we need because a lot of the problems that people have pointed to about banks do not want to lend to each other; there are signs of a lot of uncertainty -- we need transparency.  The way you get transparency is you auction the assets on bank balance sheets.  You have an open auction market.  Right now, everybody is moving heaven and earth to avoid pricing those assets and so we have to eventually get to a point where there is an auction.  And that will reveal a big hole in bank balance sheets. 

So the second step is that as we did with the SNL crisis, we will with this crisis, which I think is a pretty big one.  You folks should get ready to write checks totaling probably something on the order of $500 billion to fill the hole in the financial system.

 Thirdly, the Fed needs to move aggressively enough to steepen the U-curves [sounds like] as they did the last time we had a big crisis like this.  So the banks can essentially do the easy thing of borrowing short and lending long and make good flow profits. 

And, lastly, I think that we are probably going to have to have two or three years of 3 percent inflation instead of 2 percent.  The target now is something on the order of 1.5 to 2.  Believe me; I say this with knowledge of the things that would be put in jeopardy by that suggestion.  I can assure you the Fed will not take that suggestion until -- and if they absolutely have to because the great moderation has been responsible for more rapid productivity growth, a big increase in people’s welfare.  But I guess, suggesting that that is a possibility is to suggest that I take this problem pretty seriously.  I will stop there.

 Peter Wallison:  Thank you, John.  [Audio skip] to Vince Reinhart.  This one actually is going to be very interesting to me.  I have been at AEI now for eight years.  And in that period Charlie and Kevin are almost always optimistic about the direction of things and Des and John are almost always pessimistic.  [Audio skip]

 John Malkin: That is not true.

 Peter Wallision:  Yeah, right.  But I do not know where Vince Reinhart is.  Vince is a resident scholar, former director of the Federal Reserve’s Division of Monetary Affairs.  And he spent more than two decades working on domestic and international aspects of U.S. monetary policy.  Vincent?

 Vincent Reinhart:  [Audio glitch] and my complete bio is in the folder and I’m proud to say that I have never been laughed at in the face by a Ferrari dealer.  I want to thank Peter for this invitation but more than anything I want to thank him for the ordering.  I get to be the reasonable guy.

In my presentation, I'm going to make some initial observations on Charlie Calomiris’ paper.  I’m going to talk about the macroeconomics of the meltdown in mortgages, then talk a little bit about the financial market consequence.  And then, taking Peter’s injunction at the beginning - where is this all going - I’m going to make some homework assignments. 

But first, let’s start with a map of the world to situate the other people sitting up at this panel.  I think Charlie would be to the right of that line suggesting that probabilities are that we will have a modest sub par economic extension.  We have the reassurance of Kevin that right now we are to the right of the line.  I would also note that those probabilities move very quickly so that past performance is no guarantee of future behavior.  Des and John are pretty obviously to the left of that line.  In fact, the page is not big enough to go far enough left to where -- in terms of potential macroeconomic outcomes. 

This sort of framework is useful because what we mostly hear are story telling, a narrative; people talk about their modal forecast.  But policy actually has to be built on the entire map of potential outcomes, and what is staying the Federal Reserve’s hand with regard to responding to the aggregate demand shock associated with the reduction in home prices is concerned about what potentially is to the right of that map, that is, the prospects for inflation, which are serious enough. 

The Federal Reserve officials, when you look, say, at their long run forecast, which have potential output only growing in the neighborhood at 2.5 percent, and a natural rate of unemployment about 4.75 percent.  That is, right now, we have no resource slack and even some modest loan will not create much more.

Now, is this a Minsky Moment?  I said I would give you my initial reactions and so I’m actually going to talk about page 1, line 1 of the Calomiris paper.  We are talking about is there an interaction between balance sheets and asset prices which affect credit availability and then, therefore, affect economic activity and that compounds its own effect by then feeding back on to balance sheet behavior.  Now, it could be called a Minsky Moment; I could have also called it a Fisherian Fissure because if you look at Irving Fisher’s Debt-Deflation paper, he says over indebtedness means simply that debts are out of line, are too big relatively to other economic factors.  And sort of like Peter’s introduction, it may be started by many factors of which the most common appears to be new opportunities to invest. 

So it is a Minsky Moment; it is also a Fisherian Fissure.  We could have called it a Cane’s [phonetic] Crackup, a Hicksian [phonetic] Hiccup, or a Friedman -- well, never mind.  The problem I have actually talking about a Minsky Moment in the blog world that talks about that work is really accusatory about mainstream macroeconomics; the sort of view that you have to go outside the mainstream to understand what is going on right now.  And I think Charlie’s paper is a good example that you can apply what is standard in the mainstream, including various selection mechanisms, some information problems, the financial accelerator to explain what is going on. 

What is true is all these are very hard to quantify and that may, in fact, pose a particular problem for policy makers whose temptation are to work with models that do not have many of these mechanisms built in and cannot tell you the basis point consequences of an unavailability of credit. 

Now, let’s talk a little bit about the macroeconomics of this.  Basically, the U.S. household made a bad bet.  For about a decade, activity in housing continued to move up; that demand for housing was well-supported, initially, by strong growth and disposable income, low real mortgage rates, and favorable demographics.  We had an inflow of immigration about 10 years earlier and the population is getting older.  So that supported both starter homes and second homes. 

In this case, demand created its own supply and that, as you see in the right panel, resources shifted to satisfy the elevated demand for housing.  Employment in construction and finance increased about 2 percentage points over that decade.  The industry swelled in size to accommodate -- even that, though, was not enough to keep house prices from going up.  This is the same chart Des showed with a different price deflator but that really does not matter.  And the blue dotted line tries to explain those real house prices in terms of GDP, real mortgage rates, and inflation. 

Now, you can look at that a couple different ways.  The late great Fischer Black would say that any market price that is no more than a factor of two, then fundamentals is probably efficient [sounds like]; he was a big believer in noise.  I think one might say that there is a bubbled element to that but in any case what it did reflect is a limitation on how far the housing market could run.  Affordability got harder; the growth of disposable income slowed; the Federal Reserve raised interest rates.  And for a while in 2005 and 2006, the mortgage industry tried to keep itself going by easing terms and standards so that we have the elevated defaults in the 2006 cohort that Des showed you.

Now, there is a couple of ways of thinking about that but, basically, we have an imbalance and there is a stock flow imbalance.  The amount of houses built were exceeded fundamentals for a couple of years and it is going to take a couple years of slowing residential construction to work off that imbalance and that would associated with the clients in home prices even more than we have seen.

Well, if you look at the household balance sheet from the great resource the Federal Reserve provides the flow of funds accounts you will see that real estate is about $23 trillion on a household balance sheet.  So a 10 percent decline on house prices means something on the order of about $2.25-trillion reduction in household wealth. 

Now, some households will look at the decline in their major asset and walk away from their major liability, their mortgages; hence, we get the elevated mortgage defaults in the neighborhood, possibly, of $200 to $400 billion.  John Reed, the former chairman of Citigroup, gave some useful advice about workout situations.  He said any time you go into a workout situation, double your initial estimate; so $200 to $400 billion is no doubt a moving number.  But the transmission is, basically, there was a shock on Main Street, reduction in house prices.  And that is being transmitted to Wall Street by what it does to their mortgage book.                           

Let’s make the transition to a little discussion of what that means for financial markets.  When you think about the mortgage collateral that is important for much of finance today, there is both a lower mean - that is the economic loss associated with default - and a higher variance.  We are just not sure how big that loss ultimately will be.  So that poses a riddle wrapped in a mystery inside an enigma.  The riddle is, what are securities backed by mortgage collateral worth?  We just do not know.  There is an economic loss associated with mortgage defaults.  The mystery is who holds those securities?  And then the enigma is how will market participants react knowing that many of them hold securities that are difficult to price. 

Now, a thing to appreciate is that higher uncertainty has deadweight cost here and that applies both to individual securities - securities that have mortgages as collateral - and the institutions that hold those securities because we are not sure about their balance sheet.  So what I’m talking about applies both to things like the price of mortgage-related securities, here represented by the ABX index.  But also the ability of entities holding those securities to borrow, and that is on the right panel, the money market risk spreads that both Charlie and Des showed you. 

Basically what is going on is increased uncertainty leads to various forms of selection.  That is a selection in the form of the instruments you get that are offered on market tend to be the worst ones, the ones that probably have the poorer prospects.  Similarly, the financial institutions that want to borrow in the money market you worry that they may be the ones with the more impaired credit positions.  There is also a par-value constraint; when uncertainty increases, as a debt holder you do not put [sounds like] better than 100 in return. 

And that is also true when you think about the high tranches and mortgage-backed securities.  If the mortgage portfolio performs a little bit better you do not get any more money; it goes to the entities in the lower tranches.  So uncertainty tends to - because the upside is truncated - lower the expected return on a given portfolio.  But an uncertainty also for a given amount of risk aversion increases risk premium and, probably, we are in an environment where risk aversion itself is increased. 

So you put those three together:  Lower means because of the economic loss associated with mortgage defaults; selection mechanisms that means what is shown is even worse than that; elevated uncertainty that raises risk premia, and more risk aversion, which further raises risk premia -- we are in a situation that the market loss can be a multiple of the economic loss. 

So Des mentioned that we can add up right now about $60 billion worth of announcements of financial institutions recognizing losses on their balance sheet.  They are not recognizing the loss given default; they are recognizing the decline in market value of their portfolio.  The economic cost, the $200 billion to $400 billion, is probably reflected in even greater market loss.  So it is a big hole. 

Now, my homework assignment for those who care about markets, for macro theorists and for monetary policy makers, I came to AEI in part because I do believe in markets and it has been a bad couple of months for that.  When you think about every link in the chain between borrower and investor there have been multiple incentive problems.  Why?  Borrowers who probably have little access to alternative forms of wealth creation decided to make levered bets on the American home.  Mortgage brokers were receiving fees based on the volume of lending activity rather than how the loan works out. 

Depository institutions bought those loans from mortgage brokers without appropriate due diligence.  Servicers were willing to say that they would service the loan, again, probably without appropriate due diligence.  Underwriters put a lot of them together, and using complicated models, asserted the whole was greater than the sum of the parts.  And rating agencies, again, compensated for the act of rating, gave underwriters a pass.  And then finally, investors did not do their appropriate due diligence.  But other than that, the mortgage market works. 

So I believe in markets; I do not believe in people.  And what we are seeing here is people are responding to poorly- designed incentives.  And when we think about regulation going forward we have to really think about the very hard job of arranging a framework that gets incentives right.  And that will not be done quickly. 

About macro theory, I think we are learning that some relative prices serve multiple roles.  They both direct the flow of resources; that is, a home price is in part what it takes to take resources and build a house but it also has an inner [sounds like] temporal dimension; it is an asset.  It matters to the allocation of the stock of assets over time.  And the home price is like other relative prices; it serves multiple roles like equity prices and exchange rates. 

And what we are probably seeing is financial innovation lowered the transactions cost associated with using a home as collateral.  It allowed households to use that resource to better smooth their consumption over time.  That served a useful role but it also meant that home prices now have a bigger asset dimension to them than earlier, and we have to understand what consequences that has. 

And finally, about monetary policy, how do you deal with something that is difficult to quantify?  Credit availability, consumer confidence, the willingness of firms to continue to invest are all at risk in the current macro economic environment.  But that is something that is difficult to put into a simple macro model.  And so monetary policy now is much more about risk management in the face of considerable uncertainty as to the model itself.  Then there are also some issues about implementation.  Today we have an auction of reserves and the Federal Reserve is learning by doing how the distribution of reserves matter for the functioning of markets. 

Now, in case you did not notice, the Federal Reserve had a constitutional convention in the last couple of months to amend the monetary articles of confederation.  For 130 years, central banking has viewed the discount window as having an emergency role in the conduct of policy, that is, the Central Bank should be the lender of last resort.  What the Federal Reserve is doing with its auction -- the term auction facility is changing the discount window to have a role in the distribution of reserves that has credit consequences, that has consequences for the role of the Central Bank going forward. 

They are probably doing the right thing but nobody else was invited to that discussion.  And I think it is incumbent on policy makers going forward to explain why they did it and what consequence that will have going forward and how it potentially changes the role of the Central Bank.  But before Peter gives me a note, I think I will stop there.

 Peter Wallison:  [Audio glitch] I think I would like to give Charlie and Kevin an opportunity to respond to what we have heard from Des, John.  Okay, take your lapel [sounds like].

 Male Voice:  [Inaudible]

 Peter Wallison:  Okay, [audio glitch] Kevin.  And you can respond and then any one else who wants to respond to their response.  And then we will go questions.  So if you have questions, note them down.

 Charles Calomiris:  Thanks Peter.  I thought the discussion was at a very high level.  I guess I would say I did not think that there was a lot of news in the discussion, that is, I think we are all aware of the facts that each other is talking about.  I think what is interesting to ask is - or at least most of them - why do we disagree?  And so I want to just in two minutes try to tie together different things to try to explain why in my mind I think we disagree. 

One thing that Vince pointed to was the demographic changes that have happened in the U.S., especially in the last decade, which, of course, in some recent research as well as research within the Fed from what I understand, supported the notion that the housing price increases were not a bubble, at least for much of the United States.  So I just want to point out there is a large literature; a paper for example by Himelburg [phonetic] and Meyer [phonetic] suggesting exactly it is the demographics that help explain the facts.  I find that literature convincing; apparently Des does not. 

Another thing that I think is an interesting sort of tying together is this question of what price index do you believe?  So John Makin said Case-Shiller is believable because OHFEO only covers conforming.  Well, the interesting thing, though, is if you actually look at the data, as I have, and as I discussed in the paper, whether you are using conforming or not does not create bias in your estimates of what is going on; that is, OHFEO is not giving you a different answer from Case-Shiller having anything to do with conforming, which you can see in the cross section by looking at where conforming is more less important. 

It turns out that bias is not informative; that is not relevant.  What is very relevant, though, is the regional bias of coverage where Case-Shiller is far inferior.  So I have a much longer paper on this but that is again sort of one of the bases for this disagreement, what number do you believe? 

I also want to point out that Des said he thought that over the next couple of years housing prices nationwide would decline by five to ten percent.  My estimate which I gave at a presentation where Vince and I were [inaudible] Goldman Sachs was about five percent; I’m not saying a zero decline.  Of course, real price decline will be greater than that probably because inflation will continue up.  So there is going to be a significant real price decline in housing; I never said otherwise.  But that does not mean that it is going to be sudden or dramatic or cause a recession.  So from that standpoint apparent disagreement maybe is not actual disagreement, at least on that one fact. 

John cited the Miami example.  Well, of course, Miami was a housing bubble; so was Phoenix; so were some other places.  But I would have you look at each of the 300 MSAs in the United States and you will see that in about 280 of them, you will not be able to convince yourself that it is even possible that there was a housing bubble.  So, yes, you can find examples but that that example does not mean that it is the relevant fact for the whole economy. 

What about credit derivatives, scary stuff?  Well, not necessarily.  Maybe credit derivatives are part of the diversification that makes us think that the impact of this shock is going to be spread very broadly.  In fact, we have some data that nobody put up - which I wish now I had brought with me - which is we do know a fair amount about who bought CDO tranches, and actually hedge funds bought a huge number of them.  So actually the distribution of likely loss coming from the let’s say $350 or so billion loss here is going to be spread very widely.  There is no plausible way to argue that commercial banks are going to be holding the majority or I would say even more than about a quarter to a third of those losses. 

Do I agree with Des that the Alt-A loans are going to be a problem, too?  Yes, I said so in my paper.  So what do we really disagree about then?  I’m not sure.  I think that what we maybe disagree about is the way I posed the question:  Is the financial system going to be able to re-intermediate and grow equity so that it can absorb the increased lending?  I think the answer is “Yes.”  We have already seen a huge amount of equity offerings and we are going to see more. 

Furthermore, what about corporate balance sheets?  Corporations are going to be able to continue to borrow.  Consumption is very unpredictable as I pointed out in my paper, although so far with employment staying strong and wages staying strong, consumption has not collapsed yet.  So I do not think that any of us really knows whether consumption is going to collapse; I do not claim to, certainly.  And so I do not think that the nature of our disagreement is based on some sort of different set of facts.  I’m not sure exactly what it is based on.

 Peter Wallison:  Thanks, Charlie.  Kevin, you want to say something?

 Kevin Hassett:  [Inaudible]

 Peter Wallison:  Des?

 Desmond Lachman:  I think that there certainly have to be differences because we arrived at very different conclusions.  I think Charlie is saying that this is going to be a breeze and I am saying that there are risks of a real slump.  The reason that I’m saying that is that I’m thinking that what we see in credit markets is not occurring in isolation; it is occurring with another asset price bubble deflating and with oil prices being very high. 

Charles, I think, is thinking that the fact that we are spreading risk is a great idea and that really reduces the risk to the outlook.  Whereas what actually turns out is that the spreading of that risk, the spreading of those subprime mortgages across the system has really increased problems of transparency and increased problems that you could get a particular institution declining. 

I do not take that much comfort from the fact that not all of this is going to fall on the banks.  If the banks’ clients are in deep trouble, the banks are going to be in trouble as well.  A lot of the intermediation has been occurring outside of the banks; that is the way in which we got this levered up.  I think that what we are in the process now is in the process of this declining.  We see this most clearly with structured investment vehicles coming back to the banks’ balance sheet with all of that activity not coming out.  So I think that there are pretty fundamental differences in terms of diagnosis and it is very important in terms of what is the prescription. 

I will just finish by just saying that when I think the way in which the Fed should be looking at it, it should be from the point of view of risk management.  I agree that there is uncertainty, that there is a risk on the side; if they are too easy you have got a slight problem of inflation.  But if they are too tight you have got the very strong danger of going down the Japanese route.  And I think that what a prudent policy maker would be doing would be looking at what are the costs of the policy mistake is making.  And that is why I think that you should be erring on the side of ease rather on the side of tightness.

 Peter Wallison:  John?

 John Makin:  I’m not sure it is productive to continue our discussion of Case-Shiller versus OHFEO.  In your opinion OHFEO is a better measure and in my opinion Case-Shiller is.  We will see.

 Charles Calomiris:  I’m sure we will see; that is the problem [cross-talking] measuring different things.

 John Makin:  Well, I guess if I look at what is happening in the marketplace after the Case-Shiller number comes out, there are some people who believe it, but we will see.  As I say, if you believe your story you should be buying Citicorp stock today. 

Consumption - where is consumption going?  Consumption is slowing rapidly; typically, in a housing-driven recession consumption slows and then investment slows.  We have had a slow-down in consumption spending with the bump up from the November data.  I’m very close to it - November borrowed from December.  We are probably going to see consumption below one percent in the fourth quarter. 

Employment growth is not so good.  Over the past nine cycles, the year over year growth rate of employment entering a recession is two percent; today it is one percent.  So I do not take great consolation from the employment data.  But here again, I think what we have is an unusual cycle, a turning point and a wide difference of opinion.  And sorry, you will just have to deal with it.

 Peter Wallison:  Okay, it is time for your questions.  Please identify yourself.  Wait a minute.  David.  We have a microphone.

 David Wessel:  I’m David Wessel from the Wall Street Journal.  Given all that you have said, given the risks, what is the optimal mix of monetary and fiscal policy in a time like this?

 Peter Wallison:  It sounds like you, Vince.

 Vince Reinhart:  For an ideal policy maker one would expect then that this is an aggregate demand shock, one that may be unfolding quickly enough that you do not want to rely exclusively on monetary policy, which may take some time to affect the spending.  Hence, there would be some scope for fiscal stimulus - if we had an ideal policy maker.  We do not, and I’m kind of hesitant to put fiscal policy into the mix because by the time it would actually unfold, it may be too late. 

And if anything the odds we will have some fiscal policy impetus, anyway, coming out of legislative initiatives to ease the homeowners’ plight is pretty high.  The fact that Alan Greenspan was willing to concede that there is some scope for fiscal policy must tell you a couple of things.  One is I suspect that he is extremely concerned about the alternative, and the alternative political impulse which would be to interfere with contracts.  And his distaste for that is sufficiently high; he is willing to talk about fiscal policy.

 Charles Calomiris:  I would like to broaden the policy mix.  First note in monetary policy, if you looked at the average response to 1970, 1987 and 1998 by the Fed -- I’m not saying that they are identical to the current situation, but the response was basically one full percentage point decline in Fed funds across those three episodes; that is more or less what we have done.  I think you could argue just from the relative severity of the current shock, and I think we all agree.  I hope we would all agree that the current shock is a more severe shock, that there is room for additional loosening, particularly, given the increased spread between LIBOR and Fed funds. 

So we are not disagreeing I think.  At least, I’m not arguing that the Fed needs to tighten up.  At the same time I’m very mindful of the inflation risks.  I think what I would praise John Makin for is being upfront and saying he is willing to take that risk.  What I do not hear a lot of other economists who share his position - being willing to do - is make that balanced statement.  But I think the bigger policy to ask yourself about is foreclosure relief policy.  And what really worries me is that we are going to make things worse by moving more in the direction of encouraging leveraging. 

What we need to do is develop a housing policy that rewards homeownership, meaning equity in a home, and we need to stop subsidizing leverage.  We have FHA re-financings that allow you to first do your FHA mortgage with 97 percent of debt.  And then if there is an increase of equity in your home, you can take out all but five percent.  We need to think about ways to get around that and this is a good opportunity.  So I think spending some fiscal policy budget on down payment matching is a much better way to go.

 Peter Wallison:  Kevin?

 Kevin Hassett:  There is actually already a fiscal policy thing going on that is worth noting, which is that if the marginal tax rate goes up then you have a benefit if you delay deduction into the year where it is higher.  And it is a well-known effect in public finance, but the basic idea is that people might be pushing closing cost and all that kind of stuff into the higher marginal tax rate year.  In other words you should delay housing transactions until the Democrats increase the taxes or that the Bush tax cuts expire.  That effect probably is totally inconsequential now, but it might start to be very significant if come November it is looking like the tax cuts are really going to expire. 

The other thing I would mention about fiscal policy is that it seems almost certain that, given the climate and the divergence of opinions, we are going to have a fiscal policy debate next year in an election year and even have some proposals.  The thing