Crazy Prices?

Oil for January 2009 delivery is priced at $43.80. For January 2010 delivery, it is $56.21, or 28% higher. That 28% has to cover my cost of financing and storing oil for one year. Could that be? Short term interest rates are very very low -- if a bank would lend me money on a sure bet! How much could the cost of storage be? Hmmm....

And NOMINAL interest rates on US Treasury bills went negative. In the US Treasury's auction of bills, the yield was ZERO. People are willing to lend US Treasury money at no cost. Gosh, I hope the Treasury locks in as much money as they can at these "deal of the century rates." I am going to wait just a bit longer, then lock in as much long term mortgage money as I can at 4.5 to 5% (I hope).

The Cold Blast is Coming

We hit close to zero degrees Fahrenheit in Hanover the last two nights.

Southern California is due for some cold as well: "Rare 50 year Arctic Blast Sets Sights On Southern California."

And 2008 will go down as the coldest year of the decade at least.

And the US Congress has seen it wise to take money from a fund dedicated to helping Detroit produce environmentally friendly cars and use the money for keeping the Big Three out of Chapter 11 (or 7). I vote for "none of the above."

Selling to the Highest Bidder!

On a day that I covered auction theory in my class, it was heartening to see that Governor Blagojevich of Illinois was (allegedly) running an auction of his own. According to the New York Times Blagojevich took to heart at least the most basic auction lesson, that of selling to the highest bidder:

"CHICAGO — Gov. Rod R. Blagojevich of Illinois was arrested by federal authorities on Tuesday morning on corruption charges, including an allegation that he conspired to effectively sell President-elect Barack Obama’s seat in the United States Senate to the highest bidder."

It sounds like his wife added some nice quips on the wiretaps.

Sears Brings Back the Layaway

You know that credit has really dried up when stores like Sears are again offering layaway plans!

Ask your children if they know what layaway means.

Hilarious Motley Fool Column

This is a great spoof on the Paulson about-face, from the Motley Fool.

Just one quote pulled here, but read the whole thing because it is worth it:

"Paulson acknowledged that there had been criticism of the TARP's actual strategy, which quickly became one of injecting capital directly into banks, though without demanding control in the form of board representation, or cuts in dividends, or any of the other limitations used in successful bank bailout schemes in countries such as Finland and Sweden. But he said there was good reason for handing out money with no strings attached.

"America is not Finland, and it is not Sweden," Paulson explained. "I don't see any of you eating lutefisk or swatting your sweaty bodies with a birch switch."

The assembled journalists laughed, looked at one another, and admitted that America certainly isn't Finland or Sweden. "That is silly," said Barney Field of the New York Examiner/Picayune."

YouTube Institutes Google-Like Ad Auctions

YouTube is finding new ways to generate revenue off its site. The last time I visited, I was surprised at how "pure" the experience was, surprising for a company that was bought for billions.

The new revenue model uses auctions like Google's search-word mechanism. When a YouTube user types in a search phrase, sponsored links appear. As in Google, the highest placed link is from the advertiser who bid the most for that phrase. The second highest link bid the second highest amount, and so on. And I am assuming it is a "second-price" auction, with the amount that the high bidder wins being the second highest bid, and so on.

Now I wonder what they will do to make sure that there is no copyrighted material being illegally displayed by any of the advertisers. That will create a revenue link that I think would weaken Google's defense in its copyright infringement case with Viacom.

Bye, Bye TARP

Has Hank Paulson lost all or merely most of his credibility?

Quotes from his statement today:

"Over these past weeks we have continued to examine the relative benefits of purchasing illiquid mortgage-related assets. Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other potential uses of TARP resources, in helping to strengthen our financial system and support lending. But other strategies I will outline will help to alleviate the pressure of illiquid assets."

OK, so TARP is not going to work out as planned, in the form of buying the mortgage-backed securities that were at the heart of the initial problem. I am on record as saying that success of this program would be measured by how much MBS they had bought 3-4 weeks into the program. As the answer, up until the AIG purchase announced this week, was ZERO, we can assess the program as pretty much of a failure. But fine. Lots of people thought it was going to be hard to figure out ways to effectively buy those MBS.

But, Paulson and Treasury have been standing by TARP for the last few weeks. Saying they were still moving forward, just taking time to work out the plans. All of a sudden...Change of plans.

Come on, at least a little more explanation than saying it "is not the most effective way to use TARP funds..." would be nice. Congress signed a bill for $700 billion of expenditure on the basis of a plan that is now not going to be implemented, and that is all the explanation we get????

But Paulson and Treasury still have $700 billion -- no, wait, $700 b. less what they have spent becoming owners of some banks and AIG -- and that spare change is obviously burning a hole in their pocket. Plus Nancy Pelosi has her sights on Michigan and the auto industry, so she is putting some pressure on them as well (TARP obviously applies to all troubled assets, and if the auto industry does not have troubled assets, who does?).

So another quote by Paulson:

"Second, we are examining strategies to support consumer access to credit outside the banking system. To date, Fed, FDIC and Treasury programs have been targeted at our banking system, and the non-bank consumer finance sector continues to face difficult funding issues. Specifically, the asset-backed securitization market has played a critical role for many years in lowering the cost and increasing the availability of consumer finance. This market is currently in distress, costs of funding have skyrocketed and new issue activity has come to a halt. Today, the illiquidity in this sector is raising the cost and reducing the availability of car loans, student loans and credit cards. This is creating a heavy burden on the American people and reducing the number of jobs in our economy. With the Federal Reserve we are exploring the development of a potential liquidity facility for highly-rated AAA asset-backed securities."

Ah. Illiquidity in the credit card receivables market is beckoning for government intervention. Because, if consumers can't borrow, obviously they can't buy anything and the economy will tank.

TARP is slipping rapidly from a program aimed at preventing systemic financial system failure as evidenced by the failure or near failure of major financial institutions to an almost Keynesian-like stimulation of the economy. Surely Paulson sees a difference between the failure of Lehman Bros., and the threat of runs on banks and near-banks like money market funds; versus "raising the cost and reducing the availability of car loans, student loans and credit cards." When the US financial system appeared to be on the brink of ceasing to function in most important ways, that was a time for major and innovative intervention, such as TARP and, maybe most important, the support by Treasury and the Fed of the commercial paper market (which money market funds rely on). But are we now just shifting to supporting credit cards and car loans so that we don't reduce the number of jobs in the economy?

Is anyone surprised that the market fell over 400 points today?

American Express Becomes a Bank

AMEX, issuer of my favorite credit card, has been approved by the Fed to become a bank holding company. AMEX follows Morgan Stanley and Goldman Sachs on this road -- supposedly the road to a lower cost and more stabele source of funding.

I have heard several people say that one of the causes of the current crisis was the repeal of the Glass Steagall Act that prohibited commercial and investment banking being done in the same firm.

So let's see: Bear Stearns, Merrill, and Lehman, the three firms that fell, were pure investment banks (no commercial bank status). Citigroup and JP Morgan (Chase) are firms that combined investment and commercial banking and did not fail.

And now we have two of the remaining investment banks taking advantage of an open window to becoming banks, and even AMEX doing the same. They seem to think that stability comes from combining both activities.

Hmmm.....

Where Does Obama Stand on Vouchers?

The Obama family is checking out private schools in Washington, DC for their children. Most of us who could afford to send our children to private schools would do the same. The Clintons did so. Probably the vast bulk of Congress' kids who live in the DC area go to private schools.

The problem is that many of those same politicians will not support voucher programs that would allow middle- and lower-income families to take advantage of the better private schools. If you want to empower people, what could be stronger than letting them decide where to send their kids to school (without having to pay twice that is, once in state and local taxes and once in tuition).

Where does Obama stand on this? At one point, he seemed to be more open than the typical Democrat. Later reports suggest that the Democratic NEA establishment has gotten to him. Too bad. This would be a great chance to show some real change.

Another Cause for Celebration

Massachusetts decriminalized marijuana possession! Finally some comon sense prevails. How about legalization, with a nice alcohol/tobacco type tax? Think of the revenues, and the stimulus to agriculture in states like California and Washington!

Congratulations Obama! (And the Dartmouth Reaction)

Well, it is indeed an historic moment. The passing of an administration that has been in charge for 8 years, a whole new agenda coming in, and of course the first African American President. One cannot help but be somewhat amazed and certainly excited.

I think for young people the election of Obama is really meaningful. Here is a story I heard this morning that really makes me reflect on the great side of this election.

At around 1230 am this morning, a Hanover resident heard a loud roar coming from town. He got on his bike (!) and rode in, to find several hundred Dartmouth students outside President Wright's house, celebrating. President Wright came out and gave an impromptu few words. The students went on to the Green, where they continued their joyous celebration by singing the national anthem.

That story should inspire anyone!

Obama has a great opportunity. He has great leadership capability, and he has a pretty strong mandate for change, winning more than 50% of the vote. With any luck at all, we are at the bottom of the financial crisis and while unemployment will be creeping up for some time to come, the economy should turn around well before the midpoint of Obama's first term. The US should be able to exit Iraq, with honor and leaving a country that has good economic and political prospects.

I only hope that he and his advisors take advantage of these events to make the country stronger, economically, socially and politically. I would love to see a major revision of the tax code, especially a fix to the AMT. I suspect someone should take a hard look at military expenditures and especially our intelligence services. How about some sense to the nation's drug laws? Energy policy could certainly be improved, but let's not do it by economic engineering, e.g., having folks in Washington decide which alternative energy sources should get subsidies.

Mortgage Servicer Proposal

There is no shortage of proposals by thoughtful people on how to get out of this financial/economic mess the world finds itself in. I do hope that we see the Treasury moving forward on its original plan to buy up a good chunk of the mortgage backed securities. I want to see the Treasury make some money in this market!

John Geanakoplos and Susan Koniak have an interesting oped in the New York Times today, addressing the role of the master servicer in mortgage pools.

I have been saying for some time that the incentives of the servicing organizations are key to how homeowners in default are treated. And that the terms of the mortgage trust that bought the mortgages, appointed the servicer, and sold the mortgage backed securities are the determining factors. The NYT piece argues, albeit with a lack of specificity, that the servicers are loath to renegotiate with homeowners in arrears as it will benefit some MBS owners and hurt others. I wish they had given some examples of how that would happen. If there had been only one class/tranche of MBS created, then the incentives of all would be aligned: renegotiation might make sense, say by lowering the interest rate in return for a higher likelihood of principal repayment. But with differing classes of security holders, conflicts will exist. The higher tranches won’t want to lower interest rates for a higher likelihood of repayment of principal, as they are first in line for both interest and principal. Also, there were triggering events in a lot of these pools that will benefit the higher tranches if they occur – so avoiding those events might not be in the higher tranches’ interests.

I am not sure I agree with the authors’ proposal for government-appointed trustees. No, wait, I am SURE I don’t like that proposal. What I could see working would be some legislation to change the terms of the mortgage pool contracts, or at least to give the servicers some indemnification from lawsuits.

A Republican Halloween?

I was afraid that the signs in my front yard would deter trick or treaters, but that doesn't seem to be the case -- all kinds of little munchkins showing up right now! I also wonder if the signs will make it through the night. Last election, I did have my Bush signs thrown in the bushes.

One little girl was dressed up as Palin, an amazing costume. Very cute.

Oil Demand Elasticity

Some data on oil price elasticity are starting to arrive.

Gasoline demand in the US has fallen relative to year-earlier numbers for 26 consecutive weeks, with demand last week being 6.4% below the same week last year.

According to the EIA, and as reported by Forbes, US petroleum product demand fell in the last four-week period by 8.5% relative to the same four-week period last year.

Not sure what percent change in price to use to calculate a rough elasticity. If we use a 100% change in price, which is excessive, we get an elasticity of -.085 which is not too bad. I have always thought that an elasticity of -.20 was reasonable for a period of 2-3 years. I expect we are to see more "demand destruction" even though prices have come way down -- and many of these changes will be irreversible.

Some people might say that we are not observing price elasticity but income elasticity -- as the economy slows, oil demand drops. To some extent this is true -- to the extent that the slowing economy is due to non-oil factors. But we should expect some of the demand reductions to show up as GDP decreases. That is, some economic activity is no longer undertaken at high oil prices, and that shows up as a reduction in GDP. The decline in demand for oil should be attributed in that case to price increases, not to income falling.

Simply Incredible Price Volatility

Oil was at $147 per barrel in July of this summer. On Friday, about three months later, it was at $64.

The Canadian dollar, one year ago, bought more than one US dollar. On Friday, the US dollar bought 1.28 loonies.

This is incredible volatility, and to be honest, is quite hard to explain on the basis of fundamentals.

I was predicting for a long time that oil prices were too high, and that the economic forces of demand cutbacks and supply increases would bring us back from the skyhigh levels we were seeing. But the price went much higher than I would have anticipated, and it took a long time for the price to peak and start falling. Then once it started falling, it just has not stopped.

Either the price significantly overshot in the last year or it is now seriously undershooting -- or, very possibly, both.

Could it be that investment flows from hedge funds and general investors caused this incredible volatility? Or is it just that given the uncertainties in the world at this time, value is so hard to pin down? It is still true that oil demand and supply are both very inelastic, so in a sense you can have prices move a lot and not be too far away from equilibrium in regard to quantity.

Whatever the reasons, it is hard to make investments in alternative energy, or in oil production, given the volatility. As with the credit crisis, financial market turmoil has real effects.

That Great Cooling Sound

Listen carefully, and you will hear the sound of the mainstream media reporting on record cold temperatures and Alaskan glaciers growing for the first time in 200 years.

Hmmm......

On second thought, maybe you won't hear anything at all.

No, the recent data do not fall into line with accepted wisdom, so don't expect to hear about it.

Moral Hazard

With McCain and Obama fighting to come up with the best plan for giving homeowners relief, especially in the form of forbearance on defaults, I wonder why anyone rational would keep up their mortgage payements?

Equity Stakes vs. Buying Bad Assets

There are a lot of policy options being considered, but the two big alternatives are buying equity stakes in banks vs. the original idea of buying bad assets from the banks, predominantly mortgage-backed securities.

Judging from the huge increase in stock prices today, it seems that the market prefers the equity injection (if there was any news today, it was about that -- and the Morgan Stanley deal).

I understand the basic rationale there, that with the normal 10 to 1 leverage of banks, an injection of $100 of equity can support $1000 of new loans.

But will that additional equity be used for new lending, or will it go to just shore up cash on the balance sheet and/or pay off some existing debt? Given the risk aversion of banks right now, who is to say that they won't just buy more Treasury bills with the new cash?

I still like the buying of mortgage assets for four main reasons:

1. It goes to the heart of the original problem, which is uncertain value of banks' assets, and that has caused interbank lending to fall off.
2. It directly removes risk from the banks' balance sheets and thereby stands a good chance of increasing lending.
3. If done by auctions, it will establish prices for all assets in the same class, creating a spillover benefit that helps us sort out good banks from bad banks, even for banks that do not sell any assets.
4. And it still gets cash onto banks' balance sheets, that can be used for new loans.

Of course, these two options are only mutually exclusive in that the Treasury only has $700 billion to play with. Perhaps they will do some of both.

The Fundamentals of Value

The Dow is off about 33% in one year, with 20% of that coming in the last couple weeks.

I've been looking around for evidence that we have lost a third of our labor force, but that doesn't seem to have happened (in fact, labor supply has now increased tremendously, as some of our most productive workers decide they can't retire quite yet). And I looked to see if a hurricane or some kind of natural disaster destroyed a third of our capital base. Nope, nothing like that either. Not even a bad Supreme Court decision that would impact our still-strong legal regime of markets and private property.

Folks tell me that stock valuations are down because of fear that corporate earnings will be low.

Anyone who has done a discounted cash flow valuation of a company should be deeply disturbed by what is going on. In a typical valuation, with say 5 years of explicitly forecasted cash flows and then a perpetuity at the end, upwards of 75% of the total value will derive from the perpetuity value. Said differently, the first five years of cash flow make up only 1/4 of the total value of the company.

As an example: Suppose we have a very simple company that produces $10 of cash per year forever, and that the appropriate discount rate is 10%. The value of the company is then $100. Note this is a weird company, with no growth at all -- more like a bond than a company. Suppose a nasty recession next year is forecast to take the first year of cash flow away entirely. Wow -- the value of the company falls to $91. An even nastier recession is forecast, with no cash flows for two whole years -- and value falls to $83.

And bear in mind that in our real world, we are not looking at losing even one year of earnings, just lower earnings.

Folks also say that capital constraints will prevent companies from taking advantage of growth opportunities. That might be true for the short run. But are these growth opportunities going to disappear entirely? Doubtful. They will wait for capital constraints to release.

There have to be some real good deals out there right now. For instance, you could buy GM for about $3 billion. That's right, you can own all of General Motors for the low price of 3 billion dollars. One of the two largest auto manufacturers in the world, with a franchise in Europe that is to die for, and a great stake in Asia as well. And not exactly chopped liver in the US, especially if you get off the two coasts and get into the good old heartland, where folks still like to drive Chevys.

What a sale that is! KKR could write a check for $3 billion without even checking to make sure they have that much in their checkbook.

Sure, GM has some liabilities, and they have a lot of debt outstanding. But just think of the option value on that equity.

Two Paradoxes: Interbank Lending, Commercial Paper

The talk is that the interbank lending market has frozen. Rates for overnight borrowing are around 5.4%, much higher than the Federal Reserve's discount rate, which is at 1.75%. Paradox: why would anyone borrow in the private market rather than from the Fed?

Second paradox is commercial paper, another market that is supposedly freezing up. Volume is down signficantly, true, you can see that in Federal Reserve data. But rates are not very high, say 3% for 3 month paper. Those data seem more consistent with a drop in supply of commercial paper rather than a drop in demand to hold. If demand to hold paper were low, then volume would go down but rates would go up.

There is a theory to reconcile these paradoxes, I think. And it reinforces the general idea that incomplete and asymmetric information is driving a lot of the patterns in all the markets.

Let me use loosely, as we sometimes do in our models, the idea of "good" banks and "bad" banks.

In the interbank market, the good banks -- those who know they are solvent -- will borrow from the Fed. The bad banks don't want to undergo the examination that I believe they will get from the Fed if they show up at the discount window. So they go to the interbank market and get charged an appropriate risk adjusted rate. And there is not much lending going on in that market, with credit being rationed on the basis of knowing that a counterparty is of decent risk.

A similar idea explains the commercial paper market -- essentially a credit rationing story. Only the best credit risks can sell their commercial paper. And they get a reasonable rate charged -- around 3%. The worse risks just cannot sell any paper at all. So the rate we see in this market is low, but that is because we are seeing only the best risks using the market.

So the Fed is stepping in to both markets, trying to get reserves to even the bad banks, and letting the marginal borrowers still access the commercial paper market.

Now Jean-Claude Trichet Speaks Out

Jean-Claude Trichet, head of the European Central Bank, has urged financial market participants to "collect themselves."

The scary thing is that he may have a point.

Gary Becker Speaks Out

Professor Gary Becker of Chicago has an excellent column in the WSJ today.

Here is one particularly good section:

"The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have limited understanding of the aggregate risks created by the system. That is, insufficient appreciation of how the whole incredibly complex financial system operates when exposed to various types of stress. In light of such limitations, it is difficult to propose long-term reforms. Still, a few reforms seem reasonably likely to reduce the probability of future financial crises."

I think this does hit one nail on the head -- that participants did not know how the system as a whole would behave when under stress.

The best analogy is that of soldiers marching over a bridge. The longstanding rule is to break cadence, or there is a risk that the frequency of the march will hit the natural frequency of the bridge and cause a positively reinforcing, amplifying force that can cause the bridge to collapse. In differential equations courses, this film of the Tacoma Narrows collapse is often used to illustrate the concept.

In the mortgage backed securities markets, participants were in some sense walking in step and did not realize it. One place where I really see this is in the complexity of all the MBS, which given the point we are in now, really exacerbates the problems of valuation. A little less tranching and fewer bells, whistles and triggers on these securities would be really nice right about now.

The "How To" Questions of Reverse Auctions

The Treasury plan is to buy mortgage backed securities (MBS), instead of purely whole loans (the mortgages themselves). They have the authority to buy the underlying mortgages, but I am not sure there is $750 billion of those available. Most of the mortgages went into pools, on which the MBS are defined over. And then some of the MBS went into secondary pools, on which collateralized debt obligations (CDOs) were created. What a mess.

So how will Treasury buy the MBS? It is easy to just say, well, by reverse auction. Current owners of the MBS submit offers to sell (price and quantity specified). The government accumulates the bids, from lowest price to highest price, and keeps track of cumulative volume offered. When that dollar volume hits what the government has agreed to buy in that auction, the price associated with the last accepted offer (or first not accepted offer)becomes the price that all offers are paid. That would be a nondiscriminatory auction. An alternative would be a discriminatory auction, whereby all accepted offers get the price they offered their MBS at. For several reasons I won't elaborate on here, I think the nondiscriminatory auction is the way to go.

But this begs the question of: what is being offered? Not all MBS are the same! If we were buying, say, shares of GM from different holders, there would be no problem, one share of GM being equivalent to another.

So the big issue is how to define the characteristics of MBS that will be accepted in any given auction. There is even the simple matter of different coupon rates, so that you cannot even say that $100 of face value is the same across different MBS even if credit issues are equivalent. But credit issues are the real big one.

I still think that the way to go will be to define ranges of credit characteristics that will enable a MBS to qualify for an auction. Prime candidates for the qualifying characteristics: Date of mortgage issuance, original rating of MBS, degree of subordination in pool (ie what tranche), prepayment history of pool, current default rates, etc. Just the kinds of things that the rating agencies would use to give a rating -- hey, maybe that will be some more work for our friends the rating agencies!

My colleague Bob Aliber has a neat idea, which I think has some merit. He suggests having sellers put all their MBS into a new pool, and define new securities with equal claims to the cash flows from that pool. Then the sellers offer these new securities to the government.

Note that this is essentially creating new CDOs out of the MBS. Neat. Put all the MBS into a pool, and define just one class of collateralized mortgage obligation on that pool. This is in fact essentially what CDOs did, and you can now see why maybe they made original sense -- to pool a bunch of disparate risks together. (Of course, the original CDOs then created multiple tranches on those secondary pools, which in Aliber's plan would not happen.) What this plan also may help to solve is the risk of getting just the absolute worst "lemons" from the sellers. If they have to pool everything together, they can't cherry pick and keep the best.

My thinking has been that Treasury will buy the MBS using pooling techniques of some kind, and then will pool all the MBS and create new securities, ie, CDOs, on that new pool and sell off those claims.

We shall see. It does look like Paulson is moving fast. Given the market turmoil today, that would be good.

Whew, What a Day

Nice quote in this story on CNBC:

"We'd actually like to see a little more panic," said Matt Cheslock, a senior specialist at Cohen Specialists.

The Government's Significant Role in the Causes

I wish we had more people in the media documenting the negative role of government interventions in the housing and mortgage industry and in particular the supportive role that government actors played in creating this whole mess. Right now, populist opinion is heavily weighing against the greed and predation of private enterprise and thinking that government regulation will be our saving grace. Please let's not let that pendulum swing too far.

Tom Sowell had a nice piece today, "Do Facts Matter?" where he points out the role of Fannie and Freddie in buying subprime and Alt-A mortgages, and the strong lobbying by various politicians for easy credit.

Fannie and Freddie did indeed buy hundreds of billions of MBS created from subprime and alt-A trusts. Without the easy money from these government-sponsored entities, with their clear US taxpayer guarantee and subsidy, the housing market would definitely have been less heated. I won't lay all the blame on their doorstep, but they share in it heavily, and this should make rational people remember that while markets are not perfect neither are political regulatory mechanisms. We still await that legendary benevolent dictator -- and it appears that Paulson will not have his chance at the job!

Some of the Pork

Besides the tax break for children's arrows, here is another good one:

"Representative Mike Thompson, Democrat of California, said he switched his vote to support the bill in order to help the economy. He would not say whether the insertion of a measure to give tax breaks for auto racing tracks, which he had previously tried to get passed, played a role in his decision. One such race track is in Thompson's district. The addition of such sweeteners was criticized by some who said the bailout bill was being loaded with wasteful earmarks."

Full article, which is not focused just on the pork, is from the Boston Globe.

Deep Disappointment

On the part of Democrats, that is. Palin not only did not fall on her face, but she did a fine job. Do I wish she had more at-hand knowledge of policy issues -- of course. But she has certain qualities that are very important. Anyone who can get up on that stage against Senator Biden and hold her own the way she did -- well, I give her credit for having some real sisu (look it up, Finnish word that has no clear translation to English, but very roughly it means I WILL GET THE JOB DONE.)

David Brooks of the NYT has a very fair evaluation.

The Behemoth Bailout Bill

I wonder if the function

y = f(t)

where y = dollar amount of non-credit market tax breaks and subsidies
and t = days that Congress has to write the emergency stabilization bill (aka as the bailout)

converges to a positive number or if it goes to infinity. I suspect the latter.

A good story on the "children's bow and arrow" tax break is here. CNBC almost makes it sound like it is a reasonable thing to include in the bill.

My question: If the arrow tax is such a bad thing, why not get it taken care of in a bill that is at least somewhat related to taxes?

Why can't our elected congresspeople have the courage to put this bill to a straightforward up or down vote? Can it really be that these pork barrel items are needed to get support? Someone is opposed to the bill in principle but will vote for it if a business in their area gets some kind of break? Please give me a break.

And, where is dear John McCain, he of principled opposition to earmarks and government waste? How can he ever again rail against earmarks if he is not willing to take a stand right now?

A Mortgage Backed Mystery

As I review some of the terms of mortgage backed securities, I am really struck by the complexity that the designers of these securities created. Too clever by half, I am afraid.

A $1 billion pool of mortgages went into a trust, and out came 20 tranches of different securiies. The top few were called A level, as they got first dibs on any payments. Then the middle 15 or so were "mezzanine" and they got second dibs on payments, but of course in order of M1, M2, M3.....

Then at the very bottom were the equity and unrated tranches who were last to be paid and first to incur losses.

But this was not the only complexity. There was a lock out period which meant that principal payments went only to the A tranches initially. There was something called overcollateralization, meaning that the face value of the MBS sold was less than the principal value of the mortgages. Overcollateralization was enhanced by capturing excess spread, the difference between the average interest rate on the mortgages vs. the average rate paid on the MBS. Then there were triggers that would be evaluated a couple years into the pool performance that would determine if this over-collateralization would be released to benefit the equity or the higher rated tranches.

Plus there was an interest rate swap on the whole pool, converting a fixed payment by the mortgage trust to a LIBOR payment from the swap counterparty.

Very complicated.

There is simply no way that anyone can value such a complex scheme. No way. You've got default risk, prepayment risk, 20 different tranches, the triggering events, ....

But here is the real mystery. Why all this complexity? If you look at how Fannie Mae creates MBS, they throw everything into a pool and create just one class of MBS pass-through security out of it. Of course, it is easy for them, because they guarantee the payments, so everything is highly rated.

Therein lies the secret to what was going on. The creators of the subprime MBS were optimizing the tradeoff between the A rated MBS versus the lower-rated tranches. They were facing prices of MBS that were higher for high rated securities than for lower rated ones. And the relationship between price and rating was nonlinear, in that as rating went up, price went up by even more. This is what made it feasible to essentially put more risk on the lower class MBS, and less risk on the higher rated ones. If the relationship between price and rating was linear, then you cannot benefit from trading risk between the classes.

I can imagine that the underwriters would go to the rating agency and show them the deal, and the raters would say something like: "No, to get AAA you have to give the top tranches more security." Thereby came all the bells and whistles: reduce the size of the AAA tranche, increase the overcollateralization, create some trigger events that would benefit the AAA.

As I put this issue to one of my finance colleagues, he brought up what we call the Modigliani-Miller Theorem: that the value of the firm cannot be increased by moving claims to that fixed value between the debt and equity holders.

The application of that concept to MBS is simply that this trading of risk between the different tranches could not have created any value. What one tranche gained, another lost.

So why was it done, and to such an extent? Good question, and we are living with the complex consequences.

I think it was essentially taking advantage of errors in ratings and errors by the capital markets in pricing securities rated by the agencies.

The Senate Bailout Monstrosity

We have gone from a nice clean three page bill that was short on oversight to a 450 page monstrosity.

Do we need any more evidence on why Congress deserves its abysmally low approval rating -- 18% according to RealClearPolitics?

A bunch of tax provisions and special benefits to buy votes have made their way in. From the article cited in the above link:

"And tucked away in the tax provisions is a landmark health care provision demanding that insurance companies provide coverage for mental health treatment—such as hospitalization—on parity with physical illnesses.

Really a bill onto itself, the mental health parity measure has been a bipartisan priority for top lawmakers in both chambers but has stalled because of disagreements again over how to pay for its estimated $3.8 billion five-year cost. In the current climate, that seems to be no longer a stumbling block, and if the Treasury plan becomes law, it will also."

Right. Nice work, guys. A true hat trick: many can say they voted against the original bill but then voted for a better one, and they can brag to certain special groups that they got their bacon as well.

The Impossibility of Insuring Against Systematic Risks

One similarity of today's crisis with 1987 is the (failed) role of insurance. In 1987, portfolio insurance was a relatively new idea and many investors had implemented such insurance plans, either through simple things like stop-loss orders or more dynamic portfolio strategies based on options. I think it is pretty well accepted that not only did many portfolio insurance schemes not work -- because prices changed discontinously -- but also that they contributed to the very large (approx. 20% in one day) price declines.

Today we have insurance in the form of credit default swaps, which I do like to think of just as insurance. Once again, many of these insurance policies have not been effective and, because they can lead to forced selling of assets, may also be contributing to positive feedback cycles in the markets.

I recall some of my graduate econ coursework with the late Prof. Jack Hirshleifer, who used to emphasize things like the impossibility of insuring against "social," i.e., wide-scale risks. In 1987 and today, there do seem to be insurance policies taken out that would not be payable in certain states of the world.

Principle vs. Pragmatism

Well, if that is the market's expectation of what will happen without a bailout plan, it is bad but not that bad.

This is a tough call, one that balances principle vs. pragmatism. I do not like this level of intervention in markets, in particular to the extent that it alleviates the costs to investors and managers who made bad decisions in the past. I think that the incentive impact of any kind of workout/restructuring/"bailout" will linger for a long time and will adversely affect future economic behavior and decisions. On the other hand, I do see a legitimate role for Federal financial authorities to help stabilize, in a liquidity sense, our credit markets. That is not intervention like deciding which form of alternative energy should get funded; it is simply playing a role of nudging markets back to an equilibrium path when they are veering towards a series of essentially bank runs.

I do understand the anger of people and their willingness to accept a fair degree of pain, if it means that we will see clearer financial impacts of all those earlier decisions and given the risk of large taxpayer outlays that could enrich further those who already benefitted.

Interesting times, for sure.

Reverse Auction Questions

The design of any reverse auction to be used by Treasury is not at all clear. One big issue is how to define the range of mortgage-backed securities (MBS) to be included in any auction (I am assuming that they will be buying MBS). The complexity of the MBS market is rather overwhelming: In a typical $1 billion mortgage pool, there would be upwards of 15 different tranches of MBS created, from the top A level securities through mezzanine to even lower priority class securities. Suppose there was $2 trillion of subprime and alt-A mortgages securitized in this way. That would mean 2,000 different pools/trusts created and about 30,000 different classes of MBS securities!!

So obviously you cannot just run an auction where you say, submit offers to sell any MBS. You have to define the class of MBS you will buy more narrowly. Of course, if you go too narrow -- for example, just the M-2 class from the GSAMP Trust 2006-NC2 pool -- you may end up with too few holders and therefore too few potential sellers.

I suspect the Treasury will have to define acceptable securities for any auction by things like original offer date, original degree of credit subordination, current and/or original rating, plus all kinds of characteristics on the underlying mortgage pool. I think one can define classes narrowly enough so that the MBS are similar enough to think that one price can be efficiently put on all of them, while defining the class broadly enough so that the auction has effective competition.

Once the Treasury buys the MBS, what do they do with them? Like a used car dealer, I suspect they will want to "fix them up" so they can be sold at a higher price. What might that mean? Lots of things, including possibly re-pooling the MBS, creating what were called collateralized mortgage obligations. Put all the MBS from an auction into a new pool, and define new securities with claims to that pool of cash flows. I would love to see some simplification there: don't define many new classes, keep it simple and just create one or a couple different CDO tranches.

Then they have to structure an auction to re-sell the new securities. That will be the easy part.

Connection Between the Two Most Messed-Up Industries

I would have to give the housing industry, especially the financing side of it, and health, again the financing side of it, as the two most problematic industries in the country.

Is there possibly a common factor leading to problems in each industry?

Well, one candidate would be tax deductibility. Mortgage payments, and real estate taxes, are deductible from Federal income taxes, and provision of health care benefits by employers are not considered taxable income.

Such deductibility raises demand for these products/services by about 25% and causes distortions in how they are paid for (encouraging borrowing and encouraging payment by employers).

Using this as a predictor of future industries that will have problems, I guess I would have to point to two: one, retirement pensions, and two, education. As for pensions, contributions up to certain limits are deductible, and as for education, we have the relatively new 529 Plan industry, with 529 Plan investment earnings being tax free.

RIM vs. Apple

It appears that the iPhone might indeed be taking a large bite out of RIM's Blackberry-flavored apple. See this story.

Many of my Bridge students valued RIM last summer as part of the Business Bridge curriculum. I wonder if you want to go back and change some assumptions?

I use my iPhone more than any other device I have owned. Why? Easy to use, it works, zero marginal cost, and it is cool. Not a bad mix of qualities.

McCain's Wrench?

McCain seems to be calling for a delay in the Presidential campaign to allow him (and Obama) to join the deliberations over the proposed finance plan.

Interesting.

I give him the benefit of the doubt on sincerity. There certainly is an intellectually defensible position in saying that there needs to be a little due diligence put into this plan (after all, one can argue that if the Wall Street crowd had done more due diligence on mortgages, we would not be where we are today).

The markets are gyrating a bit today, but I am not sure we are hanging by a thread that would break if we took a few more days.

If McCain doesn't show up for the debate Friday night, will Obama debate himself?

Profits from Government Plan?

I have said that in principle the government should make a profit from serving as market maker of last resort: buying mortgage backed securities low and selling them high. With auctions being used at both ends, they might be able to pull it off; auctions are after all very good at setting prices.

Turns out I am in good company. Here is Warren Buffett saying the same thing:

"While "no one likes to write" a $700 billion check, Buffett thinks the government could make a profit when it eventually sells the now-toxic debt it would be acquiring in a bailout. "They could make money on this," he predicts, if it's handled properly."

Of course, trusting the government to handle this properly is taking a big bet...

Tuck School Event on Crisis

At Tuck today, we had a "News Hour" on the credit crisis. Besides myself, the speakers were Associate Dean Matt Slaughter, Professor Syd Finkelstein, and Professor Phil Stocken.

The video is here.

Good session, I think -- we managed to make some points in a short time.

Insolvent or Illiquid?

Suppose I run a bank with $X of assets, $95 of liabilities and $5 of equity. My assets are of long maturity, but my debt is short term.

Someone asks me the value of my assets. I check the market, and the current offer is $80.

If I can provide more information on my assets, and/or wait until more buyers show up, I think I can get a higher offer.

Am I insolvent, or is this a liquidity problem?

This is rather key to the government's plan. If the institutions are insolvent, this plan will cost the taxpayers. If the underlying problem is illiquidity, the cost will be minimal or negative.

This line of reasoning also suggests the similarity between the classic old commercial banking problem of lending long and borrowing short to the problem that investment banks face today. We never had a problem, I think, of having the Fed stand ready to help out commercial banks that were illiquid -- if their short term depositors demanded money, and they could not sell their long term assets at immediate prices to cover deposits, then the Fed would step in.

We just never imagined that the illiiquidity problems would be so systematic and that commercial banks had pushed this problem on to someone else.

Beware the Oil Price Data

From what I can tell, the massive increase in oil prices today -- around $25 -- is not really an increase in a meaningful price. The price increase was for the contract that was expiring, I assume the September or October contract. The next-in-line contract is not trading nearly as high.

It appears that some folks had very large short positions in that contract and had to buy to cover their shorts.

Some reporters are being careful to report the difference in price between the monthly contracts, others are not.

That by itself though is somewhat strange. Short squeezes do not happen often in large, liquid markets.

Sanity is indeed taking a vacation in some parts.

Of Credit Crises, Adverse Selection, and Reverse Auctions

One concept is absolutely critical to understanding the origins of the mortgage crisis, the current seizing up of markets and credit crisis, and to certain problems that the government will have with its plan to buy and resell mortgage-based securities: asymmetric information and adverse selection.

The classic examples are for used-cars and insurance. Suppose I offer a fixed offer price at which I will buy all used cars put on the market. Due to adverse selection, I will only find sellers who think their cars are worth less than my offer -- the "lemons.". If gains from trade are not great enough, then the average value of the cars I buy could be less than my offer. To at least break even, I would have to lower my offer price, but that will mean that more of the better cars drop out of the market, leaving me with even worse of a pool...In the worst cases, markets can cease to exist under these conditions.

The way I put the example should make clear the connection to the original financing of mortgages, the problems in lending to banks who have lots of mortgages on their books, and especially, the problem that the government will have in buying mortgage backed securities.

If the government offers to buy all AAA rated mortgage backed securities, to take an example, who will participate in that market? If the government sets a fixed price, the adverse selection will be severe. If they do a "reverse auction," there will still be a problem: The institutions offering their securities at the lowest price will be the ones who win the auction, and their securities will be the worst of the lemons. The good ones will stay out -- classic lemons market (for those not familiar with the "lemons" terminology, a lemon refers to a low quality item like a bad used car).

Auctions do not necessarily perform well when information is very poor, and that is the case we are in.

All this said, the lesson from adverse selection is that there are tremendous gains to trade that are going unexploited. If some entity (the government, for eg.) can solve the lemons problem, mutually beneficial exchange can explode, and the entity solving the problem can take a spread from each trade and make a mint. This would be the best case scenario for the government's plan -- in which case the cost of the plan will not be $700 billion but will be negative.

The classic way to solve lemons/adverse selection problems is pooling. You cannot let individuals decide whether to enter the market or not. Pooling works great for insurance, as in employer-based pools for health insurance. I suspect it will be critical for the government's plan to have some kind of forced pooling.

Tax the Underwriters

I have not been able to see the details of any proposal on the Resolution Trust Corporation idea being discussed as a grand plan for fixing the credit crisis.

I think we should consider a tax on all underwriters of mortgage backed securities to help finance any plan. A significant tax, based on historical underwritings, also based on the risk of the mortgages written.

Not just for incentive reasons, but because otherwise capitalism will get a blackeye from which it may never recover. The banks have to step forward and take some responsibility.

I am out in the heartland (Michigan) and seeing what people think. There is a fair amount of disgust, as much for the homeowners who stretched for mortgages they could not repay as for the banks who were writing and selling bad paper. If the plan does not make those people who are commonly, even if mistakenly, viewed as the perpetrators, I think we will have large political/populist problems.

Banks' Balance Sheets and Naivety

I got on a plane to Motor City at 4 pm Thursday and the market was up 380 points. I wonder where it will close…(UPDATE: Obviously lots has happened since then!)

There are many, many lessons from this ongoing financial crisis. We professors of the dismal science, especially those of us who dabble in financial economics, will have plenty to talk about for years to come. Adverse selection, a concept that has to be part of any explanation, will have to be resurrected in many an MBA curriculum.

There is a fair amount of talk about the greed and stupidity of Wall Street managers. I think we should be a little careful in doling out blame as a result of what might be more of a perfect storm, a truly once-in-a-hundred years type event. Does some behavior of the past few years at this point look really stupid? Yes. Will it always be possible to find evidence of stupid behavior after a crisis? Yes.

One specific point that I have been thinking about is this: how could the principals in investment banking have thought that putting $30 of risky assets on top of $1 of equity be a reasonable idea?

We should hesitate just a bit, right? These are smart people, with great educatons, who even if they did not have huge ownership stakes (most of them did) it was pretty clear that their income depended on their firm surviving. That is, incentives were aligned and ability was certainly there. (There might be some issue around overpowered equity incentives, creating incentives to swing for all or nothing, but I would have to be convinced on this one.)

So leaving aside the question of how they got to a balance sheet of $25 billion of equity and $750 billion of risky assets, let’s just think for a minute of how you get out of the situation (these are roughly the Lehman numbers).

The $750 billion of assets is yielding a cash profit stream based on a spread, say borrowing at 5% and lending at 5.005% (yes, a very thin spread, but on a huge asset base). That yields $3.75 billion of spread, which along with some fee income etc., and a capitalization factor of 6.67 yields a market value of equity of the $25 billion.

Now all of a sudden those assets paying 5.005% lose two percent of their value. The two percent loss of value is $15 billion, so over half of your market value of equity is gone, and your leverage has increased even more.

So, why don’t the managers work out of this situation? Well, suppose they sell half of the assets remaining. But that leaves only about $368 billion of assets, with the cash flow stream from that spread now only $1.84 billion, which with the same capitalization factor of 6.67 yields an equity value of $12.3 billion. Selling any of the remaining assets takes away more equity value, which is going to be hard to swallow.

What I am saying is that once you suffer the loss in asset value, to deleverage by selling assets can be quite painful, as it gets rid of assets that are contributing cash flow, and , with lack of information from outsiders, market value as well. Holding on to the assets, while they continue to pay cash, is going to be real tempting.

And of course, getting more equity to deleverage is also difficult, as the new equity providers will see the new economics of the situation – that the old spread of .005 is no longer around. New equity will demand onerous terms, making old equity quite upset.

Do we see why we might try to hold on and see if times will get better?

I am trying to come up with a good metaphor. Maybe: it’s like asking a man dying of gangrene that has gone from his toe up his leg and is now attacking his whole body – why didn’t you cut that little toe off when it turned black?

Rescue AIG?

I have been looking a bit into the AIG situation. From their 2007 annual report, one can read about what their financial products group did:

AIG Financial Products Corp. (AIGFP) is at the forefront of
AIG’s global capital market activities. It acts as a principal in nearly
all of its transactions... AIGFP focuses on a variety of over-the-counter derivative and structured finance transactions...
A key attribute that differentiates AIGFP from its peers is its
ability to commit significant amounts of its own capital—depending
on the opportunity arising from a particular investment—at different
levels of a company’s debt and equity capital structure.
The firm is also a major investor in a wide array of debt and
equity securities.

As a result of the severe disruption in the U.S. residential mortgage
and credit markets that accelerated during the fourth quarter of 2007,
AIGFP recognized unrealized market valuation losses of more than
$11 billion on its credit default swap portfolio written principally on
the super senior tranches of multisector collateralized debt obligations."

I read this as follows. We have a profitable full line traditional insurance company that generates lots of cash, but returns have not been extraordinary. In search of extraordinary returns, we set up a financial services group to write insurance (credit swaps) on all kinds of debt securities. Counterparties bought our insurance, not understanding that in the event of a systemic crisis, we would either renege on our insurance or not be able to pay. In the meantime, we booked a lot of revenue and profit from selling this insurance.

Now that the systemic crisis has occurred, we are asking the Federal government to bail us out, and thereby, all of our customers as well.

I fail to see the compelling argument here. Let those who unwisely bought the insurance go without it; we do not want to save them from their mistake -- too little of caveat emptor remains in our economy as it is. Send the holding company into bankruptcy, with losses taken by equity and by all the claimants on the financial services insurance. Separate the traditional AIG insurance business from the rest and let it continue -- no problems there.

The long term interests of a free market economy would seem to prevail in this case, unless someone can convince me that the collapse of AIG would cause not just a further decline in equity markets but a true banking crisis. Otherwise, I have to think that we can get over this.

Lehman vs. Bear?

Hank Paulson, the Treasury, and the Fed helped Bear Stearns shareholders get $10 per share.

They are letting Lehman hang by itself.

What's the difference between Investment Bank A (Lehman) and investment Bank B (Bear Stearns)?

1. Bear had the good luck to go first. One is an exception, two becomes moral hazard.

2. Bear was more intricately entwined with the rest of the financial system through complicated swaps and other guarantees.

3. The markets had ample time to get ready for Lehman's demise.

I suspect my order of the above is about right.

If I were in Manhattan today, I would have gone to Lehman and stood on the sidewalk and just watched. I was at the Berlin Wall in 1989 -- that was a much, much bigger event, but history is being made today.

My favorite question now is: How does it make sense to have $700 billion of assets supported by about $20-25 billion in equity (i.e., 30x leverage) -- when those assets can change in value by 5% in a matter of days? Is this a question of liquidity or of solvency (recognizing that the line between those two concepts is not clear).

"Sarah Palin is No Woman" ??!!!

That is the first line in an editorial in our local newspaper, the Valley News, written by our sometimes-resident liberal columnist Steve Nelson.

The article perfectly defines liberal, elitist smugness and proves the hypocrisy in all the liberal Democratic MSM whining about Republican divisiveness.

I cannot find a link to the entire article (maybe the Valley News should get a tech lesson from McCain), but after that provocative first line, Nelson goes on to argue why Palin does not fit the "social construct" of a woman:

"As well as a biological reality, womanhood, like race, is a social construct...Unlike Obama's understanding of race, Palin doesn't bring an understanding of the social construction of womanhood to her candidacy. She not only fails to recognize or remind us of the reality of historic or contemporary sexism, persistent inequity and gender-based assumptions and biases -- she smugly rejects them."

"Palin is partnering with John McCain, whose record includes: opposing equal pay for equal women; voting to eviscerate the Family and Medical Leave Act; opposing funding for a program to avoid unintended and teen pregnancies...And he has declared the intent to appoint judges who would overturn Roe v. Wade."

"Those positions are decidedly anti-woman."

Mr. Nelson's point is obvious. He, along with the rest of the smug liberal elite, have defined womanhood. If you believe in small government, individual liberty, personal responsibility, and hold to the perfectly intellectually and morally defensible position of being strongly pro-life, fine...just don't think of yourself as a woman. Biological, yes, but in terms of "social construct," no.

This is not divisive, to pit a liberal definition of womanhood against all others? I thought of an apt analogy. Suppose the NRA were to decide that the only members would be those gentlemen who hunt quail with Italian-made over-and-unders that cost thousands, while wearing Orvis clothing and following a purebred retriever. How do we think the deer-hunters of the Upper Peninsula -- or the moose hunters of Alaska -- would respond? Might that create a bit of a wedge in the nation's hunters?

The NRA seems capable of building a tent large enough to accept the diversity inherent in the population of US hunters. Funny that the liberal elite cannot find it in their interests, moral or even basely political, to embrace the diversity inherent in the population of US women.

Among other benefits of the Palin nomination, seeing the paroxysms of fear, anger, and sheer incredulity ("how could any woman hold such a position????) from my dear liberal friends and the MSM are giving me tremendous joy. I have never seen anything cause all the liberal alarm bells to go off so simultaneously and so violently (read the NYT today if you need any more evidence).

It is going to be a fun several weeks. Watching the media destroy their own candidate through their revealing responses to Sarah Palin is unbeatable.

More Signs of Oil Market Rationality

A story on Bloomberg reports that oil prices are down while gas prices are up -- "a strange situation where the products are higher and crude is lower.''

No, not strange at all. What was strange were all the times when refineries were being shut down for weather-related reasons and crude prices were bid up.

More elaborate models are useful, but the basic idea is that if refining capacity is cut, the demand for crude falls. Refined product prices increase, input prices decline, and refinery profits increase.

Oil Falls To $100; No Russian Effect?

The NYMEX crude oil contract is almost at $100, and Brent crude is below $100. We are therefore again right around the inflation-adjusted highs hit back in 1979...and much lower than the $147 per barrel of just a few months ago.

It appears that basic supply and demand forces are making themselves felt. Makes me feel good about my small bet on not signing up for a fixed price heating oil contract this year (they wanted almost $5 per gallon, which seemed to me to be just too steep an insurance premium).

Yesterday, there was talk that the Russians were going to team up with OPEC on oil supply and pricing issues. Not necessarily a full fledged member of OPEC, but a partner. That did not stop the downward trend in oil prices.

If OPEC could get more of the world's oil suppliers into the cartel, then it is true that the incentives of the cartel lean more towards restricting output and higher prices. Marginal revenue from the cartel's perspective decreases in market share, and the cartel also faces a lower elasticity of supply from the rest of the world -- both forces tending to raise prices.

But the issue of course is that as you add more members, the incentives for free riding, and disagreements over objectives, may increase. Personally I would be worried about adding as a partner to my oil cartel a country that holds the world's largest reserves of natural gas.

Think about it.

CNBC Pessimistic Bias: Part Two

No sooner did I finish that last post and a new headline jumped out at me on CNBC:

"Key Mortgage Rate Plunges, But Maybe Not for Long."

The 30 year mortgage rate fell from 6.5 on Friday to 6% today. That is a HUGE one day drop. Sure, it might go up tomorrow. And it might go down tomorrow too. And maybe those physics professors experimenting with dark matter over at CERN will indeed create some kind of maelstrom that will consume the earth. Hey, if we are going to speculate wildly, why not go for broke?

The real question is why I keep watching that dumb channel.

The CNBC Pessimism

MSNBC announced today that Chris Matthews and Keith Olberman were being dropped as anchors of of the channel, at least in part because of criticism of their possible bias -- yippee, I say!

Now maybe NBC should take a look at their financial news service, CNBC. Here is their headline around 4pm today, when the DOW was up almost 300 points:

"For the Markets, Bailout is Hardly a Game-Changer."

The story goes on to say,

"The government bailout of Fannie Mae and Freddie Mac has given investors at least a short-term reason to believe the worst has begun to pass, but it's hardly a game-changer...Market pros remain unconvinced that the rescue plan by itself will be enough to snuff out the Wall Street bears."

Of course, the first point is that to call this a bailout is a bit of a stretch -- with Fannie and Freddie stocks both down to less than a dollar per share, with almost 90% losses today.

But come on guys, the market is up 300 points. How you can you not say that that is a pretty strong vote of confidence in the takeover of the two GSE's? Worldwide, by how many hundreds of billions of dollars did stock markets go up today??

Of course, as one colleague pointed out, this massive increase in wealth could also be from the lead that McCain has taken in the polls and the closing of betting odds in some of the online political markets. I personally, however, attribute the stock market increases to Hank Paulson and his colleagues.

iTunes as Subscription Model?

There are rumours that Apple will announce tomorrow something new and big, having to do with iPods and music in some way. One specific rumour is that they will move towards a subscription model for music pricing: pay a monthly or yearly fee and consume all you want.

I have been saying this for years now. The (social) marginal cost of one more person listening to a song, especially in the digital age, is zero. For economic efficiency, and for maximum revenue extraction, the optimal price for the marginal song is zero. An "entry fee" pricing model accomplishes this. Price the marginal song at zero, get consumers to buy the efficient amount of music (to where their marginal value is zero) and then extract all the value created in one fell swoop with an entry fee.

Apple has to overcome a couple hurdles to implement this. One is that up to now, their marginal cost has not been zero, as they pay royalties on a per song basis, and they are quite high. Second is the property rights issue. Getting an infinite number of songs for one entry fee in one month and then cancelling the service cannot be an option.

Fannie and Freddie

It will be interesting to see how the markets react to the takeover of Freddie and Fannie tomorrow. I predict positive (not for their stocks, but for overall market). There was no immediate reason for the takeover, it was just good action given the overall circumstances and, especially, it was a great time to clean up an age old problem.

I think this quote from Paulson sums up a lot: "These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS."

One can criticize a lot of prior administrations for not cleaning this up before. But sometimes it takes a crisis to give one a reason for action. That is the silk lining in this sow's ear -- finally we get these monsters, manipulated by politicians for their own benefit, out of the public domain (not in the short run of course, but in the medium term).

Those who are calling this a bailout at the taxpayer's expense should think twice. This is a takeover, and it is not being done at a premium. The government is basically dictating quite onerous terms, beginning with the firing of both CEOs and warrants to buy up to 80% of both firms at nominal cost. I think my Ricardian tax liability just went down -- I will in fact go celebrate.

Sunspots

For the first time since 1913, an entire calendar month has gone by without the observance of even one sunspot. See here.

Is this important?

It could matter to climate change, both theoretically and empirically. There is growing understanding that sunspots affect cloud formation on earth, and clouds are a big factor in climate modes -- indeed a factor that is not well understood. Better understanding of what determines cloud type and cover will help forecast climate. On the empirical side, "tests" of global warming at the aggregate temperature level essentially take the actual temperature record and adjust it for things like changes in solar radiation, volcanoes, atmospheric particulants, etc. What is left is presumed to be the effect of greenhouse gases. Summarizing very briefly, the "unexplained" temperature deviation from this process does match up reasonably well with the predictions of climate models (that is, the temperature is somewhat higher than it should be, after adjustment for non-GHG effects).

But note that, like so many things, this is a test of a joint hypothesis: that the adjustments are correct, and that the climate models are correct. If the adjustments are wrong, then what appears to be a correct climate model is actually wrong. Since solar activity (sunspots) has been high since 1940, and since that is theoretically and empirically related to warming, could it be that the adjustment to the temperature record for this effect has been too small? That would leave more of the observed warming to be explained by the models.

At any rate, if we are at a real low period for sunspots, and if that continues, we could be in for some cooling.

Home Run for Palin

I don't think that anyone can argue with the assessment that Sarah Palin delivered a dynamite speech tonite. Her poise, her message, her confidence, her humor, her family...everything was in place.

What I simply cannot believe is how many times in the half hour after she stopped I have heard comments about how Palin did not write the speech, that she just read it. But, according to one woman pundit, she should still get some credit because reading the teleprompter is hard.

I just cannot believe it. How many politicians write their own speeches? Did we hear anything about Obama's speech being written for him, or George Bush's even? Or Reagan's? Or have we ever heard about how someone did well because, after all, using the teleprompter is hard?

The hypocrisy in this world will kill me yet.

My prediction is that the wolves will be out to get Mrs. Palin. Watch out.

Sarah Palin!

After an initial hiccup, I have come around to thinking that Palin is a great choice. Sure, it would be nice if she had some more executive experience, but I have always said you cannot cherry pick people's traits and history. As it is, she puts Obama's experience to shame -- raising five kids by itself does that!

The choice is evidence of McCain's independence and reinforces his role as outsider and maverick. Tell me -- which ticket more convincingly represents the opportunity for change: the candidate from the Senate with the most liberal voting record, and the VP who has spent his whole adult life in the Senate, or the nontraditional McCain and the woman governor from Alaska?

Palin could come from my family. Check out these pictures. Fisherman, hunter, snowmobiler...and as close to a Yooper accent as you can get.

Now on the abortion issue, I am undecided, although what I really hate is the hypocrisy of the "choice" argument. But if the Republicans wanted to show the world what they mean by respect for life, what better choice could they have made than Palin? She shows that you can choose life and still have a life. Who can't respect that position?

The liberals are going to go crazy trying to tear her down. I suspect she will be disowned by the liberal feminists. The pictures of her with dead fish, furs, and rifles are just going to be too much.

McCain is serious about cutting the budget, and Palin could help. The biggest thing I hold against the Republicans, and W. in particular, is that they have let government spending get out of control. McCain/Palin are indeed a return to the small government roots of the Reagan Republican party that I respected.

This is going to be an interesting few months. I can't wait to get my McCain/Palin signs out in my yard.

John Edward

I never trusted John Edwards. His phony populism was just way too obvious. Now he says this:

""'m saying you asked me about that photograph. I don't know anything about that photograph, I don't know who that baby is. I don't know if the picture has been altered, manufactured, if it's a picture of me taken some other time, holding another baby…I have no idea. I was not at this meeting holding a child for my photograph to be taken I can tell you that."

I was not at this meeting for my photograph to be taken...

How can someone running for president do something so patently stupid?

The subprime crisis has indeed made me lose some respect for many decision makers on Wall Street. Now Edwards makes me lose even more respect for Washington.

Some Economics of iPhone Pricing

With the introduction of the new iPhone, Apple has changed its revenue model quite significantly. With the first iPhone, the shared revenue model for Apple/ATT was a relatively high price for the phone and “reasonable” monthly rates for the cell service itself. Apple sold the phones themselves or to ATT, who likely marked them up quite significantly to make a margin on their sale, and Apple also got a cut of the revenues from the cell phone plans. That was an interesting revenue model, and a departure from the industry standard, which is characterized by the cell phone carriers subsidizing the purchase of handsets by consumers and no revenue sharing with the handset manufacturers. The new iPhone is being advertised as "twice as fast, and half the price," and the overall Apple/ATT pricing model is more like the industry standard, with ATT taking a loss on the sale of the phone itself, while no longer paying Apple any revenue from the monthly charges.


Why did they switch to the industry standard revenue model, with ATT now subsidizing the phones and Apple not getting any of the revenue stream from the monthly charges? To answer this, I think the best thing to do is to consider why the industry standard model makes sense for anyone. The answer to this was really given in an earlier post of mine on the economics of iTunes/iPod pricing: see here. Interestingly, the essential pricing features of the iPhone/cell service bundle are not different from that of the iPod/iTunes. Of course, one big difference is that with the iPod/iTunes bundle, Apple owns both parts, whereas with the iPhone/cell service we have Apple and ATT each controlling one part of the bundle. More on that issue at the end of this post. For now, let's think how we would price the iPhone/cell service bundle if we controlled both parts.

With the iPod example, I argued that the optimal pricing scheme would be a relatively low price on the iPod and a markup over marginal cost on the songs. The rationale is based on price discrimination across different classes of consumers. In a perfect world, you would want to set the price of songs at marginal cost to get all consumers to buy the "efficient" number of songs, generating a lot of what we call consumer surplus. Then you would make each consumer pay for the hardware, the iPod, exactly what that stream of consumer surplus is worth. This scheme would maximize profits from the bundle. Of course, we don't live in a perfect world, most notably, Apple cannot figure out what each consumer values the bundle at and make them pay exactly that. If we take the simple case where Apple can charge only one price for the hardware/iPod, then they will want to price the iPod "low" and price the songs at more than marginal cost. Such a pricing scheme manages to get even low-value consumers to buy the iPod, while getting a lot of revenue from those consumers who will purchase a lot songs.

These ideas extend naturally into the cell phone market. An integrated handset/cell service provider would want to price the handsets "low" to get the low-value, price sensitive consumer into the market (there are a lot of such folks) while extracting significant revenue through the monthly charges (which are clearly priced way above marginal cost).

There is a further reason for this "subsidized" handset cost model in the cell phone market that is not present with iTunes and songs. In the cell market, you can offer consumers a lot of different monthly plans, thereby further segmenting and discriminating across the consumer segments. Again, think that your basic objective is to get all types of consumers into the market, charging each type as close as possible what they are willing to pay for the bundle of the handset and the service. One of the key constraints you face in doing such pricing is cannibalization -- if you offer one type of consumer a low overall bundle price, your high end consumers might find that kind of scheme attractive as well, and you will lose the ability to extract maximum revenue from those high end consumers.

If you charge a high handset price, this cannibalization problem will be real tough. With a high handset price, the only way to get the price sensitive consumers into the market is to offer some monthly plan at a very low price. But such a plan might also be attractive to your high end consumers. With a subsidized handset price, you can charge relatively higher monthly prices and still get the price sensitive consumer into the market, and you can charge even higher monthly fees to the folks who are going to talk a lot and put a real high value on that service.

For other analogies, think of IBM in the old days pricing its computers, or copy machine pricing. IBM used to lease its mainframe computers at rockbottom prices, extracting revenue from consumers' use and purchase of the punch cards (Ha! Anyone out there remember those?) Copy machine pricing is similar. A lot of restaurant franchise revenue models also use this. Individual restaurant franchise owners must pay a lump sum for the franchise, but then they also pay a markup on their purchase of ingredients. You get better overall revenue extraction by keeping the franchise fee "low" and using the purchase of ingredients to essentially extract differential value based on usage. Cell phone pricing is very similar.

So the industry standard model makes sense, and Apple/ATT have moved to it. Why did they not take it on in the first place? Mistake? Maybe. Or maybe it was related to a dispute between the two companies. There is tremendous opportunity for disagreements between Apple and ATT in their joint venture. Some disagreements will just be over different beliefs about market size and growth. When two parties to a transaction differ in their beliefs about value, you will often see contingent pricing contracts: we disagree over the value, so instead of one or both of us having to take a risk, let's make the price contingent on actual value to be determined later. That is essentially what the revenue sharing did, giving Apple more revenue the more customers that would sign up. Perhaps Apple was putting its money where its mouth was, showing ATT that it was willing to take the risk of not signing up nearly so many customers as Apple believed they would.

These ideas on possible disagreements between Apple and ATT raise an interesting question. One of the beauties of iPods/iTunes is that Apple owns both the hardware part of the bundle and the "consumables" part of the bundle. That minimizes disagreements and distortions in the pricing and delivery of the overall bundle. (The integrated ownership by Apple of the hardware and operating system in their core computer market is another example of how well integration can work.)

So would the joint value of the iPhone and cell service be greater if they were both owned by the same company? Should Apple and ATT get together much more formally? Interestingly, the market capitalization of Apple is about $150 billion while the market cap of ATT is only $1.2 billion. And Apple has cash on hand of around $9 billion (end of March 2008).

Ethics on the Internet/Apple App Store

A couple years ago some applicants to MBA programs got into deep trouble when they followed the advice of an internet posting on how they could access hidden pages on the ApplyYourself website. The link allowed them to see whether they had been accepted to the school or not a little earlier than the schools meant for them. One person characterized it as "sneaking a peek at your Christmas presents early" while others viewed it as a very serious breach of ethics. I fell somewhat in-between, but more on the side of it not being a huge crime. One thing is that the code for the pages being viewed was available by looking (view source code); the software developer had made an error. On the other hand, it was pretty clear that the applicants should not have been seeing the letter early, so they should have known better.

So today I have been trying to access the App Store in iTunes to see what cool things would be available for the new iPhone. I downloaded the newest version of iTunes, but I could not find the App Store anywhere on it. Then I found this story on the internet and sure enough the author was kind enough to include a link that took me to the App Store in iTunes.

Now given that the iPhone is not on sale until tomorrow, have I done something wrong?

There are some pretty cool apps that will be available.

And knowing Apple, if they had not wanted me to see the App Store, they would not have made it available, period. But why isn't it available for viewing on iTunes 7.7?

Heating Oil Price Protection Plan Shenanigans

I think there is something funny going on with some home heating oil price protection plans.

I am not generally a huge supporter of class action law suits, but if there are any enterprising lawyers out there, this one might be worthwhile. I am concerned about the impact of higher heating oil prices on lower income households in the Northeast and would be very upset if anybody was behaving in an opportunistic way to make that situation worse.

Let us be clear that I am not accusing any company of inappropriate behavior, but let me sketch what I have noticed. I will not name any companies at this point. Interestingly, I described the potential for this problem earlier this spring to my colleague at Tuck, and I said I would wait to see what happened. Sure enough, it happened.

Here is my personal situation. Last summer, I contracted to buy around 800 gallons of heating oil at a fixed price. I spread the payments across 11 months, paying a fixed and constant amount each month. The fixed price I contracted for was around $3.20 per gallon.

Now this winter, although very snowy, was not all that cold. Thus, by March and April, I had not yet used up all 800 gallons that I had contracted for.

That made me wonder what would happen if I did not use all 800 gallons.

A check that came in the mail today answered my question: the 140-odd gallons left on my contract as of May 30 were worth, at my contracted price of $3.20, about $450. My heating oil company sent me that refund check today.

Now I would have preferred to get the 140 gallons, which at current heating oil prices ($4.85 per gallon!) would be worth about $680. And, on the other side of the transaction, my delivery company clearly prefers to pay me the cash value of my contract.

I suppose that if I read the fine print, somewhere in the contract I signed last year, it would say that the company could pay in cash (using old prices of course) for any unused gallons.

It is not the settlement in cash that concerns me. It is a more subtle opportunity for opportunistic behavior.

I had noticed back in mid spring that my tank was low and that I had not received any deliveries for some time. Therein lies the possible problem. The heating oil company clearly knew that heating oil prices in the open market were way above last year's fixed prices. Therefore, every gallon they could avoid delivering would mean roughly $1.65 (4.85-$3.20=$1.65) of profit (or avoided expense, however you want to view it). In fact, at one point during this year, I had to call my company because they had not delivered for some time and I was on empty.

So what if the heating oil companies were purposely letting customers' tanks run low, thereby minimizing the amount of oil they would have to buy at open market prices and deliver at the old, lower fixed price? That would smack of opportunism, would it not? (Don't be fooled into thinking that the companies would not care, since they might have bought enough oil to cover expected deliveries early in the year at lower prices as well. They well might have locked in prices, but that doesn't mean that they still don't want to part with oil that is worth $1.65 more per gallon than they are going to get for it!)

If I were a lawyer, I would be interested in seeing if delivery policies were changed in the springtime. Maybe some low income households should get an even bigger check than they might already have received. Or at least, the delivery company could deliver the fuel that was contracted for so that low income households don't start the fall with an empty tank. That is what I have right now -- an empty tank and a check for $450 instead of a tank with 140 gallons of fuel oil worth $680. Not exactly peanuts.

Some Thoughts on iPhone/Blackberry

I am looking forward in the next few days to getting iPhones for my entire family. My Verizon agreement is up, so I am a free man!

There are a couple big questions in how the iPhone will do in the market, with the biggest one in my mind being how far it will penetrate the business market, which is of course currently dominated by Blackberry (something like 16 million users, mostly business, and growing rapidly).

There are a couple reasons why business penetration has been and will continue to be somewhat tough for the iPhone. Until the new 3G version, users could not link to Microsoft Exchange servers, making access to corporate information difficult if not impossible. This is not unlike the problem that Macs have had. I use a Mac at Tuck, and since Tuck is on an Exchange server, for years I had to use a Dartmouth email server instead of the Tuck server.

The new iPhone has enterprise capability so that problem technically is solved.

But the second big issue is inertia. Even now, with access by the Mac to the Tuck network wide open, my IT folks still recommend Wintel machines, and most faculty shy away from Macs thinking that there will be access problems. I suspect the iPhone will run into this as well -- until IT departments start supporting the iPhone, individual employees will have to stick with RIM or other such products.

On the other hand, there are some huge positives. It is dangerous to judge from anecdotal evidence, but I see the "pull" demand for the iPhone as being really strong. Individual faculty love the iPhone, for its applications, its ease of use, its hipness, and they are going to buy it whether Tuck IT supports it or not. Seeing that, I am already hearing that our IT group will be gearing up to support the iPhone as an approved device. If we are at all typical, this could be a tipping point for Apple and cracking the business market. The technical barriers are gone, and the transaction costs of switching over have been minimized by Apple's genius designs.

You can read all over the place about the reasons Blackberries are still better. Hmmm.....a keypad, really? And I do think that the potential for software development off the Apple platform is huge and will have a huge impact.

So, this gets us to the questions of strategy. Blackberry is huge, Apple is still tiny in the smartphone market. And Apple, at least initially, went after the consumer market, not the core business market of RIM's.

This sounds like a classic judo economics strategy. A small entrant comes in, with a strategy that credibly is going after only a small part of the incumbent's market. If the incumbent believes the entrant's strategy, its optimal response will generally be to accommodate the entry, that is, to not engage in a huge battle for the lost market. Besides the assumption that the entrant is going after only a small part of the market, accommodation being the best response also requires retaliation by the incumbent to be generalized. That is, if the incumbent can respond in a targeted fashion, such as reducing price only to those customer segments that the entrant is going after, then that would naturally be an optimal response. It is when a response must be across the board that accommodation looks attractive: the entrant is essentially saying, why would you the incumbent want to spoil the rest of your market just to fight little old me?

Note that this discussion applies most clearly to price responses, but it also applies to product innovations. I imagine that RIM is furiously looking for ways to improve its products to fight the iPhone. But to the extent that these new features will be costly, and that they will have to be implemented across the board, the above judo strategy logic applies.

A big point though is that it is not at all clear any more that Apple is working the judo strategy. When they were going after the consumer market, RIM could RIP (rest in peace). But now, Apple has cracked the enterprise barrier. Can RIM accept the loss in market share that might be forthcoming? Or should they respond aggressively -- with pricing and with new costly products and features?

I don't have the necessary pricing and cost information to do even back of the envelope calculations. My intuition, however, tells me that Apple is going to grab a reasonable portion of the business market almost no matter what RIM does. There are some segments that are just pretty indefensible against the iPhone. RIM has this huge mass of users, and they are all using pretty much the same device even though they have different tastes. The iPhone will appeal to maybe 20% of them in such a strong way that RIM might as well just kiss them goodbye -- judo works, those customers are not worth fighting for. After those low hanging fruit, however, I think the iPhone will have a tougher time, to a great extent because of inertia. RIM can slow iPhone's penetration into that thick 80% with some incremental pricing and product improvements, and that will probably be optimal over this generation of products. The iPhone will gradually move deeper and deeper into the business market, but again, much of that will be indefensible so RIM's best response is just to enjoy the cash flow from those customers while it lasts.

This is a fair amount of speculation. I will have some more ideas once I get my new phone and I see how quickly Tuck's IT department can get it up to speed.