The market intelligence firm iSuppli has estimated the cost of the new iPhone 3G S to be $178.96 -- $172.46 of components and manufacturing expense of $6.50. I am not sure how accurate these are, but let's take them to be an estimate of Apple's marginal cost of production. They are probably pretty close.
From price theory, we know that optimal pricing implies the following markup relationship:
(price - MC)/price = 1/elasticity
or in words, the markup of price over marginal cost should be inversely related to elasticity.
Estimates of price are in the vicinity of $600: this is not what consumers pay, but what ATT likely pays for the phone. Using the $600 price and the above formula implies an elasticity of demand of 1.43. Probably not a bad estimate.
There are some interesting questions to think about in regard to what price one should actually use and how the impact of ATT's service revenues affect things. But I think that the above formula has to be based on the price Apple actually receives, and that would be the $600 figure.
Thursday, June 25, 2009
A Dangerous Profession?
News reports this morning are of 70 university professors in Iran being arrested, whereabouts unknown, after meeting with former prime minister and opposition leader Mousavi.
Events in Iran could be some of the more significant in the Middle East since the Iraq War, maybe even more so.
It is striking to see these kind of crackdowns in 2009. Imagine what would be the case in any Western country if text messaging and cell phones were cut off, the internet restricted, and professors were arrested for meeting someone.
Can the current leaders of Iran pull this off? Can a government in this day and age be so intolerant, restrictive and oppressive and get away with it? The bulk of evidence leans toward "no" but China/Tiananmen Square shows it can happen.
My guess is that the current regime will get through the current crisis but that the genie is indeed out of the bottle and things will not be the same. How significant will be the changes and how long they will take are the questions.
Events in Iran could be some of the more significant in the Middle East since the Iraq War, maybe even more so.
It is striking to see these kind of crackdowns in 2009. Imagine what would be the case in any Western country if text messaging and cell phones were cut off, the internet restricted, and professors were arrested for meeting someone.
Can the current leaders of Iran pull this off? Can a government in this day and age be so intolerant, restrictive and oppressive and get away with it? The bulk of evidence leans toward "no" but China/Tiananmen Square shows it can happen.
My guess is that the current regime will get through the current crisis but that the genie is indeed out of the bottle and things will not be the same. How significant will be the changes and how long they will take are the questions.
Saturday, June 20, 2009
The Market for Human Organs
So Steve Jobs, CEO of Apple, had a liver transplant -- see story here.
Interestingly, he had it in Tennessee, not the state that first comes to mind when speaking of the forefront of medicine.
But if your criteria is length of time to wait on the liver transplant list, Tennessee comes up with the shortest wait.
Interesting. Someone with enough money can relocate to a different area, get on the local list, and get a needed transplant before someone with less wealth.
Is that wrong? Should Steve Jobs be on the same timetable as everyone else?
Why do we accept wealth as enabling people to get an advantage in so many things, even many that are life-preserving (a new Mercedes is certainly safer than a used Chevy), but when it comes to things like organ transplants we balk?
Would it be OK if Mr. Jobs could offer cash to a live donor to spare half of their liver (all that is generally needed for a "live" liver transplant)? Is that OK if that person would never have considered donating part of their liver if not for the money? Is it not obvious that offering cash for livers would dramatically increase the supply? Aren't we really interested in saving lives, after all?
Interestingly, he had it in Tennessee, not the state that first comes to mind when speaking of the forefront of medicine.
But if your criteria is length of time to wait on the liver transplant list, Tennessee comes up with the shortest wait.
Interesting. Someone with enough money can relocate to a different area, get on the local list, and get a needed transplant before someone with less wealth.
Is that wrong? Should Steve Jobs be on the same timetable as everyone else?
Why do we accept wealth as enabling people to get an advantage in so many things, even many that are life-preserving (a new Mercedes is certainly safer than a used Chevy), but when it comes to things like organ transplants we balk?
Would it be OK if Mr. Jobs could offer cash to a live donor to spare half of their liver (all that is generally needed for a "live" liver transplant)? Is that OK if that person would never have considered donating part of their liver if not for the money? Is it not obvious that offering cash for livers would dramatically increase the supply? Aren't we really interested in saving lives, after all?
Wednesday, May 20, 2009
Credit Card Charges
The credit card bill is headed for the President's desk, where it is sure to be signed.
Among the more significant items are: teaser rates must last at least six months; payments get applied to the lowest interest rate balance first; and consumers cannot be charged for overlimit fees unless they have asked for permission to go overlimit.
These are significant changes, and there are other ones as well. Some of them I find not entirely disagreeable. Disclosure of terms has not been wonderful, and I think there is the capability of banks to exercise market power on the basis of locked-in consumers: once your credit record gets scarred, you effectively cannot switch banks and your existing lender has you at their mercy.
This said, there will be negative consequences -- many consumers will not get offers of credit that they otherwise would have. That will mean that folks who get into trouble and use credit cards to weather the storm (how many of us have not been there) will have to forego more purchases. Let's not immediately think of alcohol and cigarettes, but how about food and medicine??
What bothers me most about the discussion is the naivety that commentators display in talking about the ramifications of the changes. The view that some people have of business is just amazing. Read this New York Time story,especially this quote:
So the thinking is that a business basically has these various faucets, out of which profits flow. If one faucet slows down -- in this case because of regulation -- well, you just turn up the other one. After all, business has to maintain its profitability, right?
If only it were so easy.
If some set of credit card users are currently unprofitable, why are they not already eliminated? Or if the banks could increase profits by changing terms on the "sterling" users, why wouldn't they already have done that?
The answer is, of course, that those free lunches simply do not exist. All faucets are already optimized, producing as much profit as they can. If one slows down, turning the other ones will only reduce profit.
There are some more complicated theories of how some deals will be cut back. Basically the idea is that I might offer things like frequent flyer miles to all users even if I do not make money from charges per se. What I am hoping is that some consumers will take the card for the miles and then end up paying me interest. If the interest rate gets capped by regulation, the whole scheme gets less profitable so I might stop offering the deal.
Understanding the why of things is rather critical.
Among the more significant items are: teaser rates must last at least six months; payments get applied to the lowest interest rate balance first; and consumers cannot be charged for overlimit fees unless they have asked for permission to go overlimit.
These are significant changes, and there are other ones as well. Some of them I find not entirely disagreeable. Disclosure of terms has not been wonderful, and I think there is the capability of banks to exercise market power on the basis of locked-in consumers: once your credit record gets scarred, you effectively cannot switch banks and your existing lender has you at their mercy.
This said, there will be negative consequences -- many consumers will not get offers of credit that they otherwise would have. That will mean that folks who get into trouble and use credit cards to weather the storm (how many of us have not been there) will have to forego more purchases. Let's not immediately think of alcohol and cigarettes, but how about food and medicine??
What bothers me most about the discussion is the naivety that commentators display in talking about the ramifications of the changes. The view that some people have of business is just amazing. Read this New York Time story,especially this quote:
And to make up for lost income, the card companies are going after those people with sterling credit.
So the thinking is that a business basically has these various faucets, out of which profits flow. If one faucet slows down -- in this case because of regulation -- well, you just turn up the other one. After all, business has to maintain its profitability, right?
If only it were so easy.
If some set of credit card users are currently unprofitable, why are they not already eliminated? Or if the banks could increase profits by changing terms on the "sterling" users, why wouldn't they already have done that?
The answer is, of course, that those free lunches simply do not exist. All faucets are already optimized, producing as much profit as they can. If one slows down, turning the other ones will only reduce profit.
There are some more complicated theories of how some deals will be cut back. Basically the idea is that I might offer things like frequent flyer miles to all users even if I do not make money from charges per se. What I am hoping is that some consumers will take the card for the miles and then end up paying me interest. If the interest rate gets capped by regulation, the whole scheme gets less profitable so I might stop offering the deal.
Understanding the why of things is rather critical.
Saturday, May 16, 2009
How Does Closing Dealers Help the Auto Companies?
Can someone explain this one to me? The dealers are independent, and buy cars from the manufacturers at a wholesale price. Yes, there are some volume-based rebates and so on, but nothing that would seem to change my basic view of things.
For any given wholesale price, the manufacturers want to sell as many cars as possible. Or, to put it differently, for any wholesale price, the manufacturers want the final retail price to the customer as low as possible.
This calls for as much competition among the dealers as possible.
Closing dealers reduces competition among dealers and for a given wholesale price causes a larger wedge between that wholesale price and the final retail price.
If there were things that the dealers were doing such as providing information or extra services, then there is a valid reason for the manufacturer to want to limit price competition -- to avoid some dealers from free-riding on other dealers' provision of services.
But in the modern auto world, I don't know what services are being free-ridden on. Consumers can find most information online. All that dealers need to do is to have some cars on the lot for people to drive. The manufacturers can easily require that and even pay for the cost.
Many people get the basic economics here wrong, even people who are pretty smart. They somehow think that competition between dealers on price reduces the price that the manufacturer gets. This is clearly wrong. Or they think that the manufacturers are paying for the dealers' costs. That also is not right.
I cannot believe that the manufacturers and their consultants are getting this wrong. There must be some other contractual obligation that I am unaware of, or there is some freeriding issue that is not obvious to me.
For any given wholesale price, the manufacturers want to sell as many cars as possible. Or, to put it differently, for any wholesale price, the manufacturers want the final retail price to the customer as low as possible.
This calls for as much competition among the dealers as possible.
Closing dealers reduces competition among dealers and for a given wholesale price causes a larger wedge between that wholesale price and the final retail price.
If there were things that the dealers were doing such as providing information or extra services, then there is a valid reason for the manufacturer to want to limit price competition -- to avoid some dealers from free-riding on other dealers' provision of services.
But in the modern auto world, I don't know what services are being free-ridden on. Consumers can find most information online. All that dealers need to do is to have some cars on the lot for people to drive. The manufacturers can easily require that and even pay for the cost.
Many people get the basic economics here wrong, even people who are pretty smart. They somehow think that competition between dealers on price reduces the price that the manufacturer gets. This is clearly wrong. Or they think that the manufacturers are paying for the dealers' costs. That also is not right.
I cannot believe that the manufacturers and their consultants are getting this wrong. There must be some other contractual obligation that I am unaware of, or there is some freeriding issue that is not obvious to me.
Monday, March 23, 2009
AIG and "Payment in Full"
Some press stories note that the Fed is paying holders of AIG credit default swaps full face value. I am not really sure what that means. My understanding of the CDSs is that when issued, they were structured to have a zero value, with the premium being paid just sufficient to cover the insurance liability. If the likelihood of default on the underlying security went up, then there would be a premium paid for that contract. So to say that the Fed (I take this to be the Maiden Lane funds that were set up) is paying full face value is kind of nonsensical. I suspect what is happening is that the Fed is buying a portfolio of underlying securities and the related CDS/insurance for full face value of the underlying security. That makes sense, for a holder of both the security and the CDS would essentially have a guarantee of full payment (so long as the seller of the insurance was going to pay). If this is the case, there is nothing that I see wrong in paying 100% of face value of the underlying security and in fact that makes sense. The transaction eliminates a liability from AIG’s balance sheet and eliminates a need for them to post collateral – and these are the reasons the Fed bailed out AIG in the first place.
AIG and the House of Thugs
The US House of Representatives actually caved in to the rising clamor of populist rhetoric and passed some kind of bill that would ostensibly tax AIG bonuses at 90%.
I only hope that the world sees this as the grandstanding which it is, not as a true willingness to use the United States Tax Code not just as a tool of social policy but as a device to enforce the Members’/Thugs’ code of ethical behavior.
The AIG bonuses do upset anyone, me included, at first hearing. But calmer people think about it a bit and reflect on why they perhaps make sense. There is also a long history -- well, several months -- of Fed and/or Treasury employees dealing with this issue. Our President and his Treasury Secretary would be well advised to stop fueling the populist fires.
Let’s see if the Senate can put the damper on this craziness. If not, Obama’s chickens will have come home to roost.
I only hope that the world sees this as the grandstanding which it is, not as a true willingness to use the United States Tax Code not just as a tool of social policy but as a device to enforce the Members’/Thugs’ code of ethical behavior.
The AIG bonuses do upset anyone, me included, at first hearing. But calmer people think about it a bit and reflect on why they perhaps make sense. There is also a long history -- well, several months -- of Fed and/or Treasury employees dealing with this issue. Our President and his Treasury Secretary would be well advised to stop fueling the populist fires.
Let’s see if the Senate can put the damper on this craziness. If not, Obama’s chickens will have come home to roost.
Wednesday, March 11, 2009
The Meaning of Leadership
President Obama signed an omnibus spending bill today that included 9,000 earmarks worth over $8 billion (yes, that is real money). Several news sources have noted that he signed the bill outside the range of cameras, but he did come out to make comments on the bill and earmarks. Here is part of what he said:
Ah yes, the old Prisoner's Dilemma. Hey, if everyone is feeding at the trough, I am an idiot for starving my constituents.
What a leader would do is eliminate the incentives for everyone to behave like a pig instead of complaining about how legislators act in their own self interest.
President Obama added: "Now, let me be clear: Done right, earmarks give legislators the opportunity to direct federal money to worthy projects that benefit people in their district, and that's why I have opposed their outright elimination. I also find it ironic that some of those who railed the loudest against this bill because of earmarks actually inserted earmarks of their own -- and will tout them in their own states and districts.
Ah yes, the old Prisoner's Dilemma. Hey, if everyone is feeding at the trough, I am an idiot for starving my constituents.
What a leader would do is eliminate the incentives for everyone to behave like a pig instead of complaining about how legislators act in their own self interest.
On Hiring Foreign MBAs
The WSJ today printed an editorial from my colleagues and fellow deans Matt Slaughter and Paul Danos, and me.
The topic is the Employ American Workers Act, which restricts hiring practices of US companies that accepted stimulus and/or TARP funds. Like I said in my NYT post -- see here -- once you accept Federal money, you better be prepared to have them tell you what to do.
In this case, the government's restrictions are especially pernicious. Besides the economic illogic of it, pitting US citizens and foreign citizens against one another is not the way to go. A colleague sent me an email with the words from the Statue of Liberty, and they say it better than anything else:
Some people want to close that golden door -- and they accuse the bankers of being selfish!
The topic is the Employ American Workers Act, which restricts hiring practices of US companies that accepted stimulus and/or TARP funds. Like I said in my NYT post -- see here -- once you accept Federal money, you better be prepared to have them tell you what to do.
In this case, the government's restrictions are especially pernicious. Besides the economic illogic of it, pitting US citizens and foreign citizens against one another is not the way to go. A colleague sent me an email with the words from the Statue of Liberty, and they say it better than anything else:
"Give me your tired, your poor,
Your huddled masses yearning to breathe free,
The wretched refuse of your teeming shore.
Send these, the homeless, tempest-tost to me,
I lift my lamp beside the golden door!"
Some people want to close that golden door -- and they accuse the bankers of being selfish!
Tuesday, March 10, 2009
Mark to Market: Gains to come
The mark-to-market, fair value debate is a rich one, with the two sides both having support. In principle, of course, mark to market is great -- market prices impound all relevant information, so they should be used in financial statements and in regulation as well. The issue today is not even how informative prices are (I could argue they are not) but how informative mark to model results are. Without knowing all the parameters that were used to fairly value assets, in the absence of relevant market prices, I think I might prefer just full disclosure of holdings and let me do the valuations (of course, we don't have full disclosure either, so we are really choosing from imperfect choices).
But nonetheless, my belief is that for banks, most securities and derivatives have been marked down to levels that are, at worst, not too much above any sense of true value. Thus, there is a tremendous upside for mark-ups once asset prices begin to rise (and they will). If we repeal mark to market now, banks will be able to take some write-ups, which will of course get reported as profits, just as the writedowns were taken as losses. If we don't repeal mark to market, I expect the gains will come a bit later, as valuation models won't change immediately. The total gains to be reported will be the same, but the timing may well be different. If one believes in some market psychology, I suppose that there could be a differential effect. I am not one to bet on such things, but I could see an argument for keeping mark to model for now and letting the writeups occur with a big bang all at once -- hopefully sometime soon. Since in principle I think mark to market is what we want, we might as well stick to our principles and hold out for what could be some massive writeups.
But nonetheless, my belief is that for banks, most securities and derivatives have been marked down to levels that are, at worst, not too much above any sense of true value. Thus, there is a tremendous upside for mark-ups once asset prices begin to rise (and they will). If we repeal mark to market now, banks will be able to take some write-ups, which will of course get reported as profits, just as the writedowns were taken as losses. If we don't repeal mark to market, I expect the gains will come a bit later, as valuation models won't change immediately. The total gains to be reported will be the same, but the timing may well be different. If one believes in some market psychology, I suppose that there could be a differential effect. I am not one to bet on such things, but I could see an argument for keeping mark to model for now and letting the writeups occur with a big bang all at once -- hopefully sometime soon. Since in principle I think mark to market is what we want, we might as well stick to our principles and hold out for what could be some massive writeups.
Thursday, March 05, 2009
Layoffs, Across the Board Wage Cuts, and Elections
We had our local school budget vote in Hanover on March 3 -- one of the great things about NH that is taken for granted is that we still have significant local control over school issues that matter (like the budget).
On the ballot was a special item: a single ballot measure that asked for an appropriation of around $80,000 to keep one elementary school teacher position. This was over and above the vote on the overall budget. If this single item did not pass, a teacher would lose his/her job and class sizes, especially for the third grade, would increase slightly.
I voted for it, and I usually vote for resources for our schools. I don't have any children in the elementary or middle schools any longer, and just one senior in high school. I do have an interest as a Tuck professor in making sure that our schools are excellent, for faculty recruiting purposes. So that is my disclosure.
One would think, in these times, and with all the outcry for people to take salary cuts to allow others to keep their jobs, that something like this would win by a landslide. At a cost of $17 on average per household (increased property taxes) one could let a teacher keep their job, and at the same time improve the quality of education at the elementary school. Think about it -- this is not a "redundant" position we are eliminating, like many layoffs where the work just no longer needs to be done or even can be done. This is a teacher's position, which if eliminated means more students for the other teachers to deal with.
It barely passed. By 20 votes on a total vote cast of around 1,000.
Now maybe it is my viewpoint, but I see this as interesting commentary on those calls for working people to take salary cuts to maintain the jobs of others. And I don't take it as positive, even though the item passed. What is striking is that so few people were willing to cough up a few more dollars to keep a teacher!
In another post to come, I will lay out why I think the push for wage cuts to preserve jobs is generally ill-advised.
On the ballot was a special item: a single ballot measure that asked for an appropriation of around $80,000 to keep one elementary school teacher position. This was over and above the vote on the overall budget. If this single item did not pass, a teacher would lose his/her job and class sizes, especially for the third grade, would increase slightly.
I voted for it, and I usually vote for resources for our schools. I don't have any children in the elementary or middle schools any longer, and just one senior in high school. I do have an interest as a Tuck professor in making sure that our schools are excellent, for faculty recruiting purposes. So that is my disclosure.
One would think, in these times, and with all the outcry for people to take salary cuts to allow others to keep their jobs, that something like this would win by a landslide. At a cost of $17 on average per household (increased property taxes) one could let a teacher keep their job, and at the same time improve the quality of education at the elementary school. Think about it -- this is not a "redundant" position we are eliminating, like many layoffs where the work just no longer needs to be done or even can be done. This is a teacher's position, which if eliminated means more students for the other teachers to deal with.
It barely passed. By 20 votes on a total vote cast of around 1,000.
Now maybe it is my viewpoint, but I see this as interesting commentary on those calls for working people to take salary cuts to maintain the jobs of others. And I don't take it as positive, even though the item passed. What is striking is that so few people were willing to cough up a few more dollars to keep a teacher!
In another post to come, I will lay out why I think the push for wage cuts to preserve jobs is generally ill-advised.
Gore on the Warming Debate (Oops, I'm sorry, there is no debate)
Al Gore had a great little exchange with Bjorn Lomborg, as reported in the Wall Street Journal:
Right, climate change is not a matter of theory. Then what exactly is it? Empirical evidence without any theory to tell us how to interpret the data?
I don't know what the political system of the Maldives is, but if the NH legislature were to pass a bill saying that we needed to build a coastal defense against sea rise, I would not give it a minute of thought (but it would be amusing).
And, even if there is a significant human element to climate change, does it automatically follow that resources should be devoted to climate change rather than to other problems?
You should be wary when people move to close off debate. How many "certain" things in economics and finance have been challenged successfully after having been broadly accepted? Several for sure (the CAPM being perhaps the number one example).
But he was challenged by Mr. Lomborg, the Danish skeptical environmentalist who thinks the world would be better off spending more money on health and education issues than curbing carbon emissions.
“I don’t mean to corner you, or maybe I do mean to corner you, but would you be willing to have a debate with me on that point?” asked the polo-shirt wearing Dane.
“I want to be polite to you,” Mr. Gore responded. But, no. “The scientific community has gone through this chapter and verse. We have long since passed the time when we should pretend this is a ‘on the one hand, on the other hand’ issue,” he said. “It’s not a matter of theory or conjecture, for goodness sake,” he added.
As an example, he pointed to a new addition to the budget for the island nation of the Maldives: “Funds to buy a new nation.”
Right, climate change is not a matter of theory. Then what exactly is it? Empirical evidence without any theory to tell us how to interpret the data?
I don't know what the political system of the Maldives is, but if the NH legislature were to pass a bill saying that we needed to build a coastal defense against sea rise, I would not give it a minute of thought (but it would be amusing).
And, even if there is a significant human element to climate change, does it automatically follow that resources should be devoted to climate change rather than to other problems?
You should be wary when people move to close off debate. How many "certain" things in economics and finance have been challenged successfully after having been broadly accepted? Several for sure (the CAPM being perhaps the number one example).
Tuesday, March 03, 2009
Lloyd Blankfein's Views
For those who have not seen it, Lloyd Blankfein, CEO of Goldman Sachs, gives a nice overview of lessons learned in the Financial Times. See here.
I cannot agree more on his point that the financial services industry has destroyed a lot of trust. I am not sure what they have destroyed more of -- trust or wealth.
The thing that bothers me most is the destruction of trust in markets generally. There will be a wholesale shift to the public sector. It won't surprise me to see some Eastern European countries shifting seriously back to a communistic mentality, thinking that they were actually better off back then. I for one think that is very wrong.
One source of optimism is that sales of Atlas Shrugged have been soaring. The Economist had the original story, but here is a link from another paper.
I cannot agree more on his point that the financial services industry has destroyed a lot of trust. I am not sure what they have destroyed more of -- trust or wealth.
The thing that bothers me most is the destruction of trust in markets generally. There will be a wholesale shift to the public sector. It won't surprise me to see some Eastern European countries shifting seriously back to a communistic mentality, thinking that they were actually better off back then. I for one think that is very wrong.
One source of optimism is that sales of Atlas Shrugged have been soaring. The Economist had the original story, but here is a link from another paper.
Saturday, February 28, 2009
AIG, Maiden Lane, and Buying CDOs
I have another question concerning AIG and CDOs that maybe someone can help with. The Fed set up Maiden Lane II and III as special purpose vehicles to assist in the bailout of AIG. These funds buy the underlying CDOs that AIG wrote insurance on. Once the funds own the underlying CDOs, they can extinguish the CDS written on them (thus saving AIG from collateral calls and further writedowns). So here is the question: If one of the big problems with TARP was how to buy mortgage backed securities from the banks, how is the Fed managing to buy tens of billions of mortgage backed securities to bail out AIG? It would seem a particularly difficult transaction since the holder may own the CDO as well as the CDS, ie,, the insurance. So does the Fed just have to pay 100% on the dollar? Well, that would explain how they can get the deals done.
AIG, Foreign Banks, and the Role of Regulation
There is an underlying story in the AIG fiasco that does not get adequate attention. See, for instance, Joe Nocera's generally excellent piece in the NYT today, or for a piece from last September that makes my point really well, see this article in International Financial Law Review.
AIG was engaged in a big way in regulatory and ratings arbitrage. Many commentators fault the regulatory system for failing to monitor and control AIG, even though there were regulators sitting in AIG's US headquarters continuously. Perhaps part of the problem was that the Financial Products Group was based in London. It is probably a lot harder to regulate things offshore.
And why was the FPG in London? Well, I cannot find figures on it, but there is certainly a lot of qualitative evidence that European banks (French, German) were very big buyers of AIG's credit default swaps (read: insurance). Why? Because Basel II, the international banking regulatory accord, specified the amount of capital required to be held against different classes of assets. If you could get a AAA rating on assets (insurance, I think, was actually the key), then the amount of capital you needed was much lower (doesn't this sound like the issue with the US investment banks and leverage -- indeed it is). So how can we get a AAA rating on some of our subprime assets? In steps AIG, with their credit default swaps.
So the banking regulatory system, set up to a great extent by the Europeans, created a demand for the insurance that AIG was more than willing to sell.
What is to blame? The regulation that created the demand, or the lack of regulation that allowed AIG to persist? Not clear to me. Some of both, no doubt -- and some serious lack of oversight at AIG themselves.
Perhaps it does come back to what more and more people tell me: you need the overall leverage restrictions on the banking system. If you start parsing risk and saying these kinds of assets need x% capital, and another kind of asset only y%, you are asking for regulatory and ratings arbitrage. And just like with illegal drugs, once the demand is created, it is very hard to restrict supply.
I wonder how much European banks really are benefitting from the US taxpayer's bailout of AIG. Why is Treasury and the Fed so willing to do this? Are they extracting something from the European banks? How long will it take before we hear about the sorry state of European banks (of course some of that has come out already, but I suspect not nearly all of it).
AIG was engaged in a big way in regulatory and ratings arbitrage. Many commentators fault the regulatory system for failing to monitor and control AIG, even though there were regulators sitting in AIG's US headquarters continuously. Perhaps part of the problem was that the Financial Products Group was based in London. It is probably a lot harder to regulate things offshore.
And why was the FPG in London? Well, I cannot find figures on it, but there is certainly a lot of qualitative evidence that European banks (French, German) were very big buyers of AIG's credit default swaps (read: insurance). Why? Because Basel II, the international banking regulatory accord, specified the amount of capital required to be held against different classes of assets. If you could get a AAA rating on assets (insurance, I think, was actually the key), then the amount of capital you needed was much lower (doesn't this sound like the issue with the US investment banks and leverage -- indeed it is). So how can we get a AAA rating on some of our subprime assets? In steps AIG, with their credit default swaps.
So the banking regulatory system, set up to a great extent by the Europeans, created a demand for the insurance that AIG was more than willing to sell.
What is to blame? The regulation that created the demand, or the lack of regulation that allowed AIG to persist? Not clear to me. Some of both, no doubt -- and some serious lack of oversight at AIG themselves.
Perhaps it does come back to what more and more people tell me: you need the overall leverage restrictions on the banking system. If you start parsing risk and saying these kinds of assets need x% capital, and another kind of asset only y%, you are asking for regulatory and ratings arbitrage. And just like with illegal drugs, once the demand is created, it is very hard to restrict supply.
I wonder how much European banks really are benefitting from the US taxpayer's bailout of AIG. Why is Treasury and the Fed so willing to do this? Are they extracting something from the European banks? How long will it take before we hear about the sorry state of European banks (of course some of that has come out already, but I suspect not nearly all of it).
Friday, February 27, 2009
Back from Behind Enemy Lines: Redistribution Logic
See my post immediately below about my venture onto the New York Times' blog, Room for Debate.
I am really surprised, and somewhat dismayed, at the vitriol heaped on my comments, and on me personally. Wow. Several lessons to be learned there, mostly concerning the nature of the NYT readership and the curious trust that liberals give the Federal government on some issues (the wisdom of the stimulus bill) but not on others.
But one set of comments in particular stood out and showed me the redistributionist, entitlement mentality that is now quite prevalent. Look at these quotes:
Let's leave aside the fact that in 2006, the top 1% of the taxpayers in this country paid 40% of the personal income taxes while earning 20% of the income.
The more important issue here is the tone in the above quote: The other 99% MUST share in only 80%...the remaining 99% of us...have ONLY A CHANCE TO EARN FAR LESS THAN 1% APIECE...
No, sorry, that is not the way this country or any market economy works. Actually, everyone has the chance to get into that top 1%. It might take some effort. You are not going to get there from complaining. It might take several generations -- of parents sacrificing for their children, who then move up, and give the next generation an even better chance. I come across loads of people like that who are in the top earning categories.
It may have been forgotten by many, but the beauty of this country is indeed that everyone has opportunity to become great, and to get respect and wealth.
I am really surprised, and somewhat dismayed, at the vitriol heaped on my comments, and on me personally. Wow. Several lessons to be learned there, mostly concerning the nature of the NYT readership and the curious trust that liberals give the Federal government on some issues (the wisdom of the stimulus bill) but not on others.
But one set of comments in particular stood out and showed me the redistributionist, entitlement mentality that is now quite prevalent. Look at these quotes:
The result is that 1% of America’s wealthiest families take home 20% of the nations earnings.
Think about that. Does that seem fair to you?
The other 99% of Americans must share in only 80% of our country’s earnings. While 1% of the wealthiest Americans enjoy 20% of our nation’s earnings, the
remaining 99% of us, on average, have only a chance to earn far less than 1% apiece of the money our nation produces every year.
Let's leave aside the fact that in 2006, the top 1% of the taxpayers in this country paid 40% of the personal income taxes while earning 20% of the income.
The more important issue here is the tone in the above quote: The other 99% MUST share in only 80%...the remaining 99% of us...have ONLY A CHANCE TO EARN FAR LESS THAN 1% APIECE...
No, sorry, that is not the way this country or any market economy works. Actually, everyone has the chance to get into that top 1%. It might take some effort. You are not going to get there from complaining. It might take several generations -- of parents sacrificing for their children, who then move up, and give the next generation an even better chance. I come across loads of people like that who are in the top earning categories.
It may have been forgotten by many, but the beauty of this country is indeed that everyone has opportunity to become great, and to get respect and wealth.
Thursday, February 26, 2009
Republican Governors Rejecting Fed Money?
I did a guest post on a New York Times blog tonight; they asked me to comment on why some governors might reject Federal stimulus money. Seems to me that they don't want to get caught in the Federal bear hug, but I doubt that they will actually go through with their threat to turn down the money.
At any rate, I seem to have riled up a few NYT readers.
Check it out here: http://roomfordebate.blogs.nytimes.com/2009/02/26/when-to-take-a-federal-hand-out/
At any rate, I seem to have riled up a few NYT readers.
Check it out here: http://roomfordebate.blogs.nytimes.com/2009/02/26/when-to-take-a-federal-hand-out/
Thursday, February 19, 2009
The Obama Mortgage Plan
I understand the desire to help those homeowners who have problems with their mortgages.
But I also believe there is a need to get mortgage-related assets off the books of the banks and into the hands of less risk-averse investors. This must be the biggest potentially mutually beneficial exchange since...well, the Resolution Trust Corporation.
The new mortgage plan has a mixed set of consequences, some unintended. I fear that it throws a lot more uncertainty into the valuation process. It will also take some of the more clearly profitable mortgages out of the pools -- which could be a plus. On the first point, uncertainty, it would seem to make the valuation of mortgages and mortgage backed securities even more difficult. Who is now going to be in default? How do we assess likely default rates if the feds are encouraging the lowering of interest payments? How does all this work within the confines of contract law in the context of mortgage backed securities? Senior tranches may prefer foreclosure and liquidation to stretching things out and accepting lower payments - if they can even be forced to accept lower payments. But more to my point, who is going to bid a reasonable price to buy senior MBS from banks with this kind of uncertainty? Have we made the valuation problem easier or more difficult?
On the second point, taking out the most profitable mortgages, the plan makes it easier for mortgagees to refinance at lower rates. Great for them, and this gets full payment of principal into the hands of the trusts holding the mortgages, which will in turn pay off the senior tranches according to priority. That is good, for as those tranches are repaid, the securities are retired and the holders can book what is likely to be a profit. What is left, however, is truly the most toxic -- mortgages that cannot qualify even for these generous (moral hazard-inducing!) restructuring terms. What this implies for the valuation of the remaining lower tranches is probably not pretty.
But I also believe there is a need to get mortgage-related assets off the books of the banks and into the hands of less risk-averse investors. This must be the biggest potentially mutually beneficial exchange since...well, the Resolution Trust Corporation.
The new mortgage plan has a mixed set of consequences, some unintended. I fear that it throws a lot more uncertainty into the valuation process. It will also take some of the more clearly profitable mortgages out of the pools -- which could be a plus. On the first point, uncertainty, it would seem to make the valuation of mortgages and mortgage backed securities even more difficult. Who is now going to be in default? How do we assess likely default rates if the feds are encouraging the lowering of interest payments? How does all this work within the confines of contract law in the context of mortgage backed securities? Senior tranches may prefer foreclosure and liquidation to stretching things out and accepting lower payments - if they can even be forced to accept lower payments. But more to my point, who is going to bid a reasonable price to buy senior MBS from banks with this kind of uncertainty? Have we made the valuation problem easier or more difficult?
On the second point, taking out the most profitable mortgages, the plan makes it easier for mortgagees to refinance at lower rates. Great for them, and this gets full payment of principal into the hands of the trusts holding the mortgages, which will in turn pay off the senior tranches according to priority. That is good, for as those tranches are repaid, the securities are retired and the holders can book what is likely to be a profit. What is left, however, is truly the most toxic -- mortgages that cannot qualify even for these generous (moral hazard-inducing!) restructuring terms. What this implies for the valuation of the remaining lower tranches is probably not pretty.
The 2004 Leverage Regulation
I did have the chance to ask a retired risk officer from a major bank his views on the 2004 leverage regulation change.
To brazenly and hopefully honestly summarize, he definitely lays a fair amount of blame on that change. Not everything, of course, and there are some caveats. Somehow he was even able to pick the firms that he thought would have shown the biggest response to it, and his predictions pretty well matched up with the Wikipedia graph noted in earlier posts and comments.
It still surprises me that the binding constraint on risk was a government regulation. I would have thought that the folks whose livelihood depended on survival of the firms, as well as counterparties, would have induced a more conservative stance than the loose regulations allowed. Lesson learned.
To brazenly and hopefully honestly summarize, he definitely lays a fair amount of blame on that change. Not everything, of course, and there are some caveats. Somehow he was even able to pick the firms that he thought would have shown the biggest response to it, and his predictions pretty well matched up with the Wikipedia graph noted in earlier posts and comments.
It still surprises me that the binding constraint on risk was a government regulation. I would have thought that the folks whose livelihood depended on survival of the firms, as well as counterparties, would have induced a more conservative stance than the loose regulations allowed. Lesson learned.
Tuesday, February 17, 2009
Heated Arguments over Crowding Out
Will the fiscal stimulus work -- will the increase in government spending cause GDP to increase and unemployment to decrease?
One of the key issues is what economists call "crowding out". I hate to give just a simple explanation of it, because as you will see, economists have been attacking one another over simplistic (and some not too simplistic) explanations. But anyway, crowding out refers to the possibility that an increase in government spending will cause spending by other agents (especially businesses) to spend less. If that were to occur, then there might be no overall increase in aggregate demand, and no stimulus.
See here for a piece by John Cochrane at Chicago titled "Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?" Gene Fama gives his own thoughts in a new blog feature on the DFA website. See here and here for some rather testy responses by DeLong and Krugman.
It is enlightening to read the comments on either the DeLong or Krugman sites to get a sense for who is reading those blogs.
At any rate, when I was in graduate school at UCLA in the early 80s, crowding out was a huge question. You can address it pretty well by the old IS/LM model. I am not a macroeconomist, but my casual observation from the later 80s and 90s is that the crowding out argument did pretty well, and the standard Keynesian "government spending will increase GDP" result was relegated to the "tired models" shelf, to be brought down in honor only in extreme times. Well, it certainly has come back with a vengeance.
With governments worldwide heading to the capital markets in a real big way, I don't see how we won't get some crowding out. Yes, there is another equilibrium with higher world income and higher consumption, government spending, and higher private investment too -- that is the rosy view with little crowding out and big multiplier. There is a less rosy view, with just slightly higher world income, much higher government spending, and less consumption and investment.
One of the key issues is what economists call "crowding out". I hate to give just a simple explanation of it, because as you will see, economists have been attacking one another over simplistic (and some not too simplistic) explanations. But anyway, crowding out refers to the possibility that an increase in government spending will cause spending by other agents (especially businesses) to spend less. If that were to occur, then there might be no overall increase in aggregate demand, and no stimulus.
See here for a piece by John Cochrane at Chicago titled "Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?" Gene Fama gives his own thoughts in a new blog feature on the DFA website. See here and here for some rather testy responses by DeLong and Krugman.
It is enlightening to read the comments on either the DeLong or Krugman sites to get a sense for who is reading those blogs.
At any rate, when I was in graduate school at UCLA in the early 80s, crowding out was a huge question. You can address it pretty well by the old IS/LM model. I am not a macroeconomist, but my casual observation from the later 80s and 90s is that the crowding out argument did pretty well, and the standard Keynesian "government spending will increase GDP" result was relegated to the "tired models" shelf, to be brought down in honor only in extreme times. Well, it certainly has come back with a vengeance.
With governments worldwide heading to the capital markets in a real big way, I don't see how we won't get some crowding out. Yes, there is another equilibrium with higher world income and higher consumption, government spending, and higher private investment too -- that is the rosy view with little crowding out and big multiplier. There is a less rosy view, with just slightly higher world income, much higher government spending, and less consumption and investment.
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