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On June 19, 2009, a premiere economic consulting firm (not to be named) forecasted a job loss of 275,000 in June.

To me, this seemed odd. The May drop of "only" 345,000 jobs (unrevised) seemed like noisy data. There was no substantial change in Initial Claims for unemployment insurance. Initial claims were running more than 600,000. The ADP also remained at an elevated level. The May ADP number showed a job loss of 532,000. Why should a lower reading be repeated in June?

We are in the mode of seizing any piece of good news as evidence of the turning point. So what, if the May Non-Farm Payroll number was inconsistent with Initial Claims and the ADP? A green shoot is a green shoot.

Throughout June, nothing really changed on the employment front. People viewed it as good news that initial claims were running in the 610,000 range rather than the 640,000. We were going to see a much better number for June. As I said, as of June 19, the Non-Farm Payroll loss was pegged at 275,000.

But 610,000 Initial Claims, while better than 640,000, is still terrible news. The ADP on Wednesday completely deflated the unrealistic expectation of a substantial turnaround. The ADP came in at a job loss of 473,000. Economists quickly revised their expectations.

The job loss today of 467,000 was no surprise to me (and to readers of my blog). This is consistent with the forecast made by CFOs in the latest Duke-CFO survey. The CFO survey, conducted in May 2009, suggested that private sector jobs would be scaled back by a staggering 5.6% over the next 12 months. Given the addition of public sector jobs, I estimated the net job loss over the next 12 months to be 4 million (this assumes 2 million public sector jobs are created). We are 1/5th of the way there (May+June losses divided by 4 million).

Perspective

• We have lost 6.46 million jobs in this recession
• We have lost more jobs in this recession than double the sum of the previous two recessions!
• We are 400,000 job losses away from the worst job loss situation since WWII. Technically, the recession of 1948 is still worse. However, it is a weird recession with one amazingly bad month. The percentage loss of jobs in October 1949 would have caused a print of -2.5 million losses today (in a single month).
• This ain’t over yet.

The Main Systemic Risk Factor

My main worry is that policy makers and risk managers at financial institutions have greatly underestimated the impact of unemployment on prime mortgages. Given that housing prices are falling at a 19% annual rate and given that many people with prime mortgages are losing their jobs, it makes sense that more and more people will choose to default on their prime mortgages. The assumption of a 2-4% loss on prime mortgages in the Treasury’s adverse stress test scenario seems unrealistic to me.

Increased defaults on prime mortgages could easily cause a second credit crisis.

Remember when the sub-prime crisis started? People initially said it was no big deal because the size of the market was small. Well, it was a very big deal and, yes, the size of the market was small. The prime market is gigantic and a surge in defaults in that market could quickly wipe out the capital of our financial institutions.

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The following post was written by Kevin Schulman, M.D., Director of Duke’s Health Sector Management Program:

Imagine a country of 1.3 billion people with 100 cities of 1,000,000 or more, a per capita GDP of almost $6,000 (PPP) growing at almost double-digit rates, and an economy ranked in the world’s top 5 and you’ll have a pretty accurate image of China today. While the economic miracle has worked in most areas of the Chinese economy, healthcare has struggled in the transition from communism to capitalism.

The Chinese government has just outlined a new health reform plan. This plan includes the acknowledgement by the government of two new rights for the population: the right to basic medical services and the right to basic medical security. This effort includes an expansion of the basic health plan to rural populations (to 150 RMB per capita in 2011, approximately $22US), construction of 5,000 new grassroots hospitals, 3,000 new regional hospitals, training of 10,000 new doctors for rural areas, reform of public hospitals, and new rules for private hospitals in China. This is clearly a very ambitious agenda, the details of which will be released in 21 specific documents over the coming months. Reform will also address incentives in the public hospital system which currently spurs utilization of imaging, long lengths of stay, and prescription dispensing as a means of generating income.

China is clearly under-spending in the health sector. Currently, healthcare is around 4% of GDP of which only 50% is public spending. If China moves toward the levels of healthcare spending of Japan or the EU, there will be a huge increase in health spending in the Chinese market. Adopting Western IP laws will also force changes in the pharmaceutical industry – which currently is a generic market rather than a research-based product market – and possibly the medical supply market as well. Increases in spending could also drive demand for private health insurance within China. Read the rest of this entry »

For at least 50 years, television advertisements have been ordered randomly within commercial breaks. But given the spread of digital video recorders (DVR) that allow users to blip-blip past the ads in fast-forward, it’s time to change this business model to maximize ads’ effectiveness, according to a new study.

The research, by Kenneth C. Wilbur of Duke University’s Fuqua School of Business and David Kempe of the University of Southern California’s Viterbi School of Engineering, was presented by Wilbur on June 23 at the Advertising Research Foundation Audience Measurement 4.0 conference in New York City.

“Think of two very different ads: the iconic Coca-Cola polar bears commercial, and a commercial for ‘natural male enhancement,’” said Wilbur. “The Coke ad will keep the audience glued to its screen, but the other ad will annoy some viewers, causing them to fast-forward or switch the channel. If the Coke ad is placed first during the commercial break, it still delivers most of the audience to the second ad. But if the Coke ad is placed second, it gets a significantly smaller audience.”

To account for these types of ad sequencing issues, the researchers have developed the Audience Value Maximization model. This new algorithm shows how to optimally select, order, and price ads based on a mathematical formula that considers advertisers’ willingness to pay and viewers’ propensity to switch channels during commercial breaks.
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The following post was written by Kevin Schulman, M.D., Director of Duke’s Health Sector Management Program:

As Director of Fuqua’s HSM Program, I hereby nominate the physicians and hospital managers of McAllen, Texas, for a special joint Nobel Prize in Medicine and Economics for their brilliant experiment demonstrating, beyond a shadow of a doubt, that PHYSICIANS DO RESPOND TO ECONOMIC INCENTIVES. In recognition of this work, all physicians and hospitals in McAllen should receive a bonus payment equal to their 2009 Medicare billings, and then should be permanently excluded from the program (the public system responds to few incentives beyond those of special interests, but when you’re the subject of a must-read report at the White House, you’re out of luck).

So if you’re one of the few people who has yet to find time to read Atul Gawande’s piece in the New Yorker (and it is must-read material). Here are the major highlights:

For over 40 years, Jack Wennberg and his group at Dartmouth (now including Elliott Fisher and Jonathan Skinner) have shown there is significant variation in medical practice — more variation in “discretionary” services like imaging vs. essential services like appendectomy. This group has also created a database called the Dartmouth Atlas of Medical Practice, which reports variations in medical care according to hospital referral regions in the United States. From this database, a region that was identified as one of the highest utilizing sites was McAllen, Texas. Gawandi of the New Yorker visited to try to gain a better understanding the case and uncover reasons for the high utilization.

Less developed in Gawande’s article is the idea that the Medicare program has known about this practice for years. Annually $1 billion dollars is spent on a national program of Quality Improvement Organizations. These spends are allocated for the review of medical practices within the Medicare program. State Medicare medical directors, contracted health plan managers, and Office of the Inspector General at HHS are all involved in the review. All seemed powerless to take action in the case. (In terms of the public-private plan debate, it seems the private plans in the market had the same incentives and observed the same results in McAllen, so private plans aren’t the automatic fix to this practice pattern issue).

So what are the implications of this study? Read the rest of this entry »

The Duke-CFO Survey was released today and the news is grim.

One of the big challenges is to reconcile the growth in confidence against the hard data. Consumers as well as CFOs are more confident. However, our survey shows that this confidence is not influencing business plans. CFOs are playing a cautious, wait and see game, before pulling the trigger on new capital spending and employment growth.

Reconciling Hard vs. Soft Data

In examining the data, consider three factors:

1. Bottomming Out? CFO confidence graph shows that optimism is up but still lower than any other point historically (except the last quarter). It is like saying that housing sales increased by 10% - that is good but a 10% increase on a very low level doesn’t do much for economic growth.
2. Sustained vs. fleeting. I think people are grasping for some good news. There is talk of green shoots. However, there is very little fundamental data to support a recovery at this point. It is somewhat easy to feel a little more optimistic. It is a different matter to translate that into corporate plans. That is why I emphasize the idea of “sustained” optimism. Optimism will only translate into corporate action after CFOs are confident that the recent news is not fleeting. They will not change their corporate plans until there is evidence of a sustained recovery. Of course, there is a chicken and egg problem that results from this!
3. This crisis is different. I think CFOs are feeling more optimistic but given the gravity of the crisis - it is dangerous to extrapolate from previous recessions/recoveries. This is another reason to be cautious.

The Press Release

The press release is found here. Here is an excerpt from the draft release:

For the second consecutive quarter, there has been an increase in optimism. In the latest survey, 54% of respondents are more optimistic about US economic prospects. However, these numbers need to be tempered because the overall level of optimism is still low.

"Our survey carries an important message: don’t put too much weight on the ‘soft’ data like consumer confidence, which has been overemphasized in the news. Recovery requires sustained confidence, and such confidence is forged by stronger economic fundamentals," said Campbell Harvey, founding director of the survey. "The economic fundamentals are still fundamentally troubling. There is no thaw yet in this winter of hardship."

One example of hard data is the surveyed companies’ employment plans. Employment is projected to decrease by 5.6% over the next 12 months. This is essentially unchanged from last quarter’s projection of a 5.7% reduction.

"Approximately 109 million people are employed in the private sector. A drop of 5.6% means the loss of 6.1 million jobs. Presumably, government programs will offset some of these losses, but even the most optimistic government forecasts would reduce the losses by only two million. We’re facing a staggering four million additional job losses," said Harvey.

Since the recession began, 5.7 million jobs have been lost and the unemployment rate is 8.9%. The Congressional Budget Office assumes an unemployment rate of 8.8% in 2009 and 9% in 2010. "CFOs know their companies’ employment plans. Slashing employment by 5.6% means unemployment in the 11-12% range. Our survey evidence renders the CBO projections completely unrealistic," said Harvey.

Full results of the survey.

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Here are my talking points for my Fox Business News interview.

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1. Why should all the bailout money be focused on financial institutions? It is seems a matter of fact but no one has really challenged the logic.
2. We must act now to prevent the second wave of the credit crisis. The first wave was partially caused by people with jobs buying houses well beyond their means. The second wave will be people with prime mortgages who have lost their jobs. They are paying out of savings right now (and that accounts for the lull) — but savings will run out.
3. Fed stress test had unrealistic 2-4% assumption for loan losses in prime mortgages.
4. Prime is by far the biggest market. Close to $9T. Hence, every percent mistake in the Fed assumption is worth $90B. So a small error in prime loan losses could make many financial institutions insolvent.
5. We can’t afford any more spending - hence, we should redirect some funds.
6. Will be moral hazard problem (people want to be bailed out that don’t need to be bailed out). But not a valid critique of mortgage loan restructuing. The current policy has an even more extreme moral hazard problem. Financial institutions faced with coin flips where “head I win., tails you lose” — you being the American tax payer.
7. Target: 1) responsible borrowers - those that put at least 25% down on their houses; 2) simple means test based on 2008 tax filing + investment portfolio information; 3) priority in the process to recently unemployed. Reckless borrowers should be foreclosed.
8. Restructuring should be handled by bank or service provider — not the government or the courts. Not much has happened because little capital has been directed to the individual mortgages.
9. Proactive action to head off second wave. All of this could have been done two years ago and muted the impact of the sub-prime problem.

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The revised and expanded edition of Dan Ariely’s Predictably Irrational is out now, featuring Dan’s thoughts of the current financial crisis from a behavioral economics perspective.  The new version also features correspondence between Dan and readers who wrote to him seeking advice on topics related to the book.

Dan also shared his views on the financial crisis, money, and morality on the PBS program NewsHour.  Watch the segment here.

An analysis of social networks and minute-by-minute customer transactions during a run on an Indian bank has found that bank runs can spread through a community like a contagion.

Duke University finance professor Manju Puri and co-author Rajkamal Iyer of the University of Amsterdam assembled a unique data set on the bank run and then employed epidemiological techniques to determine connections between bank depositors, using Google Earth to map the locations of their home addresses.

Following the failure of a larger, neighboring bank, the customers of a bank that was fundamentally sound were withdrawing funds out of fear that they might not be able to access them in the future.

“Using these tools, we were able to track the ‘transmission’ of running from one customer to another, just as you would see with the spread of a disease,” said Puri, the J.B. Fuqua Professor of Finance at Duke’s Fuqua School of Business. “We found that an individual customer’s decision to run or not was highly correlated with whether or not their neighbors had already run from the bank. We found clusters of customers running who all lived in the same building or on the same street. If one person ran, many did, but in other places no one ran at all.”
See video.

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Entrepreneurs in high-technology industries often have significant prior industry experience. A new Duke University study published in the Strategic Management Journal reveals that this experience is critical to entrepreneurs’ success. Surprisingly, however, it is mainly the non-technical knowledge that founders gain from their experiences with prior firms that affects increased achievement at their new firms,rather than direct technical spillovers from the former parent to a new venture.

Aaron K. Chatterji, assistant professor of strategy at Duke’s Fuqua School of Business used financial and patenting data sources to assess the impact of industry experience on entrepreneurial performance and innovation in medical device start-ups.
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Most of the reporting on the stress test focused on the number of banks passing the test and the doable amount of capital the failing banks needed to raise. The tough question was not asked: if the stress test wasn’t really that stressful, why did a majority of the banks fail?

The Good News

1. This is a move towards being more transparent. This is a good start.
2. I was very concerned about the assumptions of the stress test. The news that leaked out before the release suggested the loss impairment assumptions were far from realistic. However, it turns out that all of the loss assumptions are for only a two year horizon. This is an important point. For instance, suppose you think that the total impairment over a four year horizon is 8%. You read in the WSJ that the government is using 4%. You think that is way too low. However, it is not as low if the horizon is only two years.
3. The fact this is in the news is serves an educational function. People are getting a forced lesson in risk management. Whether they like it or not, this learning should decrease the chance of a systemic episode in the future. More people know the right questions to ask.

The Bad News

1. As I have said before, the economic assumptions are problematic. The adverse scenario has 8.9% unemployment in 2009 (average). Today we learned that the unemployment rate rose to 8.9% in April. The adverse scenario has a rate of 10.3% in 2010. It is likely we will reach that rate by the end of the summer of 2009.
2. The two year horizon essentially assumes that good times return by 2011. That is not obvious to me. We have not seen unemployment like this since 1948 and I project that we will blow by 1948 (adjusting for the size of the workforce) by the end of the summer. Employment lags the business cycle. This means there will be loan losses in 2011 and 2012. So rather than $599.2, given the assumptions on loss rates but simply extending out to 2012, a more realistic number is $1 trillion.
3. I think the assumption on Prime mortgage losses is particularly problematic. The more adverse scenario assumes Prime losses of 3-4%. First lien mortgage category includes three components: Prime, Alt-A, and Subprime. Putting all these together the adverse scenario only assumes an 8.8% loss over two years. This includes 9.5-13% losses on Alt-A and 21-28% losses on Subprime. I focus on the Prime assumption because the market is so big. In the overall economy (not the 19 banks), we are talking about $6 trillion. So, for every extra 1.5% in losses we drop $100 billion in value.
4. What about the other 8,000 banks? The two-year losses for the 19 are projected to be $599.2 billion in the stress test. These 19 have 2/3s of the assets and half of the loans.
5. I reject the idea that nobody should fail. When anyone takes on risk, you reflect on the upside and the downside. You temper amount of risk you take because of the downside. But if you are always bailed out, there is no downside and you will (continue to) take excessive risk. In addition, it creates a double standard: financial institutions are bailed out but other industries or individuals are not (yes, there are some exceptions like the autos). There is also another double standard based on size: if you are big you are bailed out but if you are small you are allowed to fail. The only word to describe this is "unfair" This bailout mentality did not happen with the Savings and Loan Crisis in the early 1980s.

Resources

The Fed white paper on the stress test results is worth a read.

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See below my monthly employment graph that standardizes the job losses (based on the sized of the labor force) across different recessions.