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

Watch my interview.

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.

Follow me on Twitter.

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.

Read the rest of this entry »

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.
Read the rest of this entry »

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.

Follow me on Twitter.

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

Professor Rick Larrick is following the cash for clunkers debate on his MPGIllusion.com blog.  Check out his recent posts to understand why replacing cars and making small MPG improvements aren’t always the greenest things to do.

Obama scorecard

President Obama means well and is doing a great job in many areas. However, I fear that we are perpetuating the same policies of the previous administration when it comes to the financial sector. It is simply not fair that each of the 19 big banks are bailed out. If you take risk, then there must be some consequence. Right now it is a blanket insurance policy that will lead to similar problems down the road.

See video.

Stress testing the banks

The so-called stress test is a sham. They delayed the release of the test because it is really hard to explain why so many of the banks (including the very largest ones) are offside when the adverse scenario is looking like an optimistic scenario. Note the adverse scenario has 8.9% unemployment in 2009. We could be there next week. It has 10.3% in 2010 and we could be there by the end of the summer. The whole idea of a stress test is to see what happens in a scenario that is worse that what we expect. The test fails on that dimension. It is misleading, increases uncertainty, and decreases confidence.

See video.

Professor Harvey interviews Len Blum of Westport Capital

See video.

Westport Capital conducted a stress test based on leaked information. They estimate a further impairment of $200 billion. I question why they would use the government rosey assumptions. I specifically ask for their assumptions on the prime mortgage impairment. It is rumored that the U.S. Treasury is using an assumption of 5% impairment which, in my opinion, is way too low given the surging unemployment.

Are we seeing the end of the recession

While the stock market is up and consumer confidence is up, it is hard to see any economic fundamentals that point to a trough. In particular, the surging unemployment will likely cause a second wave of mortgage defaults. We don’t see the defaults right now because people are drawing down their savings. We will see it soon.

See video.