"The more I find out, the less I know."

Wall Street Bailout

Tuesday - September 23, 2008 07:35 PM

What an amazing couple of weeks.

It looks like right now we may be in the middle of the climax of the financial mess which has been building for the past 18 months. At least I hope this is the climax: if there's another act to follow, it will be a doozy. On the other hand, I've been saying since the beginning of the year that I thought we were at or close to the bottom.

Foolish me.

What scriptwriter can resist the natural drama of a $700 billion bailout of the financial system juxtaposed with what was going to be a historic election anyway? I have a bad feeling, though, that when the inevitable movie versions are made my reaction will be the same as often happens when my favorite books are put up on the big screen: "It was OK, but the original was better written."

There's been considerable media coverage and analysis, but not every question has been answered. Here's a little bit of my own analysis:

What Happened?
Since the Great Depression, large chunks of our financial system have been regulated by the government to ensure stability. The tradeoff was basically that banks would have their deposits insured by the FDIC, preventing a run on the bank, in exchange for strict oversight and somewhat reduced profits.

The regulations are designed to help in bad times by ensuring that most banks have enough money to weather most storms. In good times, of course, bank failure isn't so much of an issue.

Over time, however, more and more of the financial system has migrated from the regulated banking world to the unregulated world of money market mutual funds, commercial paper, hedge funds, CDO's, and so forth. That's because it's easier to make money on the unregulated side (no pesky regulations, after all). To feed the appetite for more investment, higher returns, and greater fees, the unregulated side gobbled up more and more of the financial acitivity which used to be handled by regulated banks.

If you're a consumer in the U.S., chances are that at least some of the money you owed to someone was bought, repackaged, sliced, sold, repackaged, etc. Not just mortgages, but credit card payments, student loans, auto loans, etc. all got fed into the machine.

Investors and bankers made so much money so fast that the demand for these investment vehcles was nearly insatiable. It helped that the economy was doing great, and default rates were at historically low levels. Because of that demand, it became really easy to borrow money for almost anything, on almost any terms. That easy credit masked the fact that the value of the collateral (the mortgaged house) was perhaps not as solid as everyone assumed.

When the party ended and default rates started going up, the value of all these investment vehicles inevitably started to drop. In a normal recession, that wouldn't be such a problem, since banks are required to have enough reserves to buffer against a certain level of defaults from the people they loaned money to.

Two things are different this time: first, many of the loans this time around are held by unregulated institutions, whcih are not legally required to hold any particular cushion. The hedge funds and investment banks which own all these slices of mortgages only needed to have enough assets on hand to convince their trading partners that they would be solvent in the near term. Second, house prices went up so far so fast that they came crashing down much faster than anyone thought possible, wreaking havoc on everyone's risk models.

The net result is that, among the institutions who were active in the market for packaged debt, nobody's sure that anyone else has enough assets to cover their obligations, or that they'll have enough assets tomorrow. Confidence is gone, and nobody is willing to do business with anyone else.

How Will $700 Billion Help?
Simple: The governmet steps in, buys a bunch of these investment vehicles which nobody knows the value of (presumably at pennies on the dollar), and takes them off the hands of whoever owns them. Then that hedge fund, investment bank, or insurance agency knows exactly the value of its assets, having replaced hard-to-value distressed debt with easy-to-value cash. Confidence is restored, the system unfreezes, and life goes back to mostly-normal.

The fly in the ointment is setting a price at which the government will buy these distressed securities. If the government (that is, you and me as taxpayers) pays too much, then it takes a loss and winds up subsidizing a bunch of money-grubbing hedge funds. Pay too little and the taxpayers make a profit (which is the American Way after all), but the seller may go bankrupt anyway.

I'm actually not too worried about the government paying too little: presumably nobody is going to be forced to sell us these toxic assets, so they have the option of walkng away if the price is too low. If a few banks and hedge funds go bankrupt despite unloading their bad holdings, then they almost certainly would have gone under anyway. We're no worse off in that scenario, and maybe a little better since at least the dregs of the bankrupt firm will be easy to value.

Won't This Cause Inflation?
One of my first worries when I heard about this plan was the inflationary effect of pumping $700 billion of money into the economy (which is essentially what will happen, in a roundabout way).

I'm not as worried about inflation on further reflection. One of the big effects of the housing bubble was to create vast amounts of wealth from thin air as home prices went up, and many people spent a lot of that wealth through cash-out refinancing. Now that housing prices are dropping and investors are deleveraging (reducing the ratio of debt to assets), huge amounts of money are being sucked out of the economy. This $700 billion bailout will serve to replace some of the money which is being vaporized through deleveraging and declining asset prices.

It's also worth pointing out that the government isn't going to just hand out dollar bills. We will get assets in return, in the form of these mortgage-backed securities, and at a discount. As the underlying mortgages are paid off, the government gets to pay off whatever money it borrowed to facilitate the bailout in the first place. If we play our cards right, there might even be a small profit.

Who Are the Winners and Losers?

  • Anyone who sold a house in the past five years and didn't buy a new one (or bought a less expensive house)
  • Anyone who did a cash-out refinncing and was foreclosed on or did a short sale (*these people probably don't feel like winners, since they lost their homes, but they essentially got free money from the bank without having to repay it. This let them live at a higher standard than they otherwise would have been able to for at least a few years.)
  • Anyone who did a cash-out refinancing and manages to keep the house, since they got a bigger line of credit than they would have qualified for otherwise, for at least a few years.
  • Anone in the real-estate or mortgage-broker business in the past five years.
  • Any investor who owned mortgage-backed investment vehicles before 2007
  • Anyone who bought a house in the past five years, unless that house was bought from the proceeds of sellng another house. These people probably overpaid and are now stuck with the debt.
  • Anyone in the real-estate or mortgage-broker business in the past five years. Most of these people are now unemployed or in new carreers.
  • Any investor who owned mortgage-backed investment vehicles during or after 2007. These investors lost their shirts, and many have gone bankrupt.
The interesting thing is that in many cases, the winners and losers are the same people. Hmmm.

Posted at 07:35 PM | Permalink |

Blood in the water on Wall Street

Thursday - March 06, 2008 09:20 AM

The stock market opened down big this morning (30 minutes into trading, the S&P 500 is down well over 1% with no bottom in sight). The news in the Wall Street Journal is alarming: the private equity fund Carlyle Capital failed to meet a margin call last night.

A margin call is the second worst thing which can happen to any investor. It means that the investor borrowed money against its portfolio, and the bank or brokerage is demanding more collateral for the loan because the value of the portfolio dropped too much. The usual response is to add more cash to pump up the portfolio value and reduce the loan amount.

Normally when an investor gets a margin call, there's only a matter of hours to put up enough collateral (or "meet the margin call"). If the problem isn't fixed by the start of trading the next day, the bank or broker will force the investor to start selling part of the portfolio to pay back enough of the loan to satisfy the collateral requirements.

This forced selling is the worst thing which can happen to an investor.

That a private equity fund as prominent as Carlyle Group would fail to meet a margin call is nothing short of astonishing. Aside from the fact that they should have been smarter than to get themselves in this situation in the first place, this was the group all the conspiracy nuts liked to weave their dark theories around, because of the number of prominent politicians (including ex-Presidents) associated with the fund.

There's an old saying among stock traders that you should buy when there's blood in the water. In other words, when a big player is wounded or dying, the forced selling will push prices to an irrational place and that's the time to step in and buy.

This morning there's blood in the water. Too bad I'm already invested.

Posted at 09:20 AM | Permalink |

Economic outlook

Friday - February 22, 2008 11:07 AM

The majority of pundits lately have been thinking deeply about the economy, at least when they're not obsessed with the scandal du jour in the presidential contest.
I'm not a pundit, but I occasionally pretend to be one on the Internet, and I've been thinking about the economy lately. Here's my conclusions:

First, we are probably in a recession. When the dust settles, we'll probably decide that the recession began sometime between November and January.

Second, I think we're probably close to the bottom right now (but we won't know that for a good six months or more). I base this on these observations:

1) The stock market has been basically flat for a month now, neither moving significantly up or down. We may have actually set the bottom in January, though we haven't moved enough up to be sure that there won't be another bottom in the near future.

2) The Fed is pumping huge amounts of liquidity into the economy, and that money is going to have to go somewhere. Near-term it seems to be going into super-safe investments like government bonds (and especially inflation-protected bonds), but before long investors will start looking for more return, and that means investing money in real businesses and people.

3) Media reports are uniformly and overwhelmingly focused on the negative, and not the positive news--and there is positive news out there, it's just hard to find. I take this as a sign that the mood can't get much worse from here.

Third, just as in the past couple economic slowdowns, all the money the Fed is pumping into the economy right now is likely to lead to a new bubble somewhere in a couple years. Don't believe me? Look at the pattern: the 1992 recession was arrested by easy money from the Fed, which contributed to the dot-com bubble. The 2002 recession was also marked by easy money from the Fed, and that helped pump up the real estate bubble.

This isn't necessarily a bad thing. Financial bubbles (despite the problems when they burst) have a number of desirable side-effects, not the least of which is driving a period of strong economic growth. Bubbles also tend to create massive investment in infrastructure which--even if uneconomical when built--lay the groundwork for future innovations and benefits. For example, a massive amount of fiber-optic capacity was built in the late 90's, far more than would be needed at the time. But the telecoms which lost their shirts on that fiber also created the conditions for cheap bandwidth today and made companies like YouTube possible.

For the most part, the excess housing built this decade won't disappear, and (as long as the population continues to grow) there will be families willing to buy or rent the homes for the right price.

What's The New Bubble?
If you think there's going to be a new financial bubble forming in the next few years, it's very useful to know where the bubble might form. Good candidates are industries or sectors where:

1) Fundamentals have changed significantly for the better recently, and are likely to remain favorable. This could be due to new technology, market conditions, or other circumstances.

2) Returns have been good.

3) There's an element of sexiness or the exotic to pique investors' interest.

The most obvious place is alternative energy: if you believe that oil is likely to remain around $100/barrel or higher for the indefinite future--and this seems a reasonable assumption--then the fundamentals for renewable energy are strong. Combine that with improving technology and dropping prices for renewable sources like wind and solar, and the sexiness of "green energy," and it looks almost irresistible.

What's more, if you believe that renewable energy will ultimately have to replace nearly all our fossil fuel consumption, there's enough demand for renewables to sustain industry-wide growth of 25% to 50% per year for decades.

First Draft of a Renewable Energy Portfolio
To test this investment thesis, I took a stab at building a model portfolio over the weekend. I started with a comprehensive list of alternative-energy related companies (which was hundreds) and applied these criteria:

1) The stock has to be listed on the NYSE or NASDAQ. No pink sheet stocks or bulletin board stocks; any company with serious prospects will have the resources to get listed on a "real" exchange. Also, no foreign exchanges, since those are harder for Americans to buy, and I'm not familiar with the foreign accounting and trading rules.

2) The company has to be primarily focused on alternative energy. This excludes companies like GE, which makes a lot of wind turbines, but makes most of its money elsewhere.

3) No biofuels, because I'm not convinced that biofuels make economic or environmental sense in the absence of government supports.

This left me with 14 companies, all but one of which make solar panels (the other company is a tiny manufacturer of wave power systems).

Also, because this is a hyper-growth industry, I weighted the model portfolio by revenue growth in dollars from 2006 to 2007. That eliminated two companies which actually shrank (one due to an accounting change which I didn't want to bother researching). I also applied a cap of 15% of the portfolio value to individual companies, to keep it from being too heavily weighted towards a couple big Chinese companies.

Of the twelve remaining companies, about 60% of the portfolio wound up in four big Chinese manufacturers of conventional (polysilicon) solar panels, and First Solar, the upstart thin film manufacturer, was another 13.5%.

Unfortunately, this has been a really bad week for my model solar portfolio: all but two of the companies are down for the week, and the portfolio as a whole is down 15%. Apparently one of the big Chinese companies lowered its forecasts because of cost and availability problems with polysilicon, and that pulled down the entire industry (even the companies not using polysilicon).

Volatility is to be expected in this sort of concentrated, speculative portfolio, but I'm really glad I didn't invest any actual dollars in it this week.

Posted at 11:07 AM | Permalink |

Taking the Plunge with Prosper.com

Saturday - November 24, 2007 03:56 PM

I was intrigued enough by the research I did for my article a couple weeks ago that I decided to open a small lending account at Prosper.com, the peer-to-peer lending company. It's been an interesting experience so far, and I'm still learning a lot.
In no particular order, here are some of the things I've discovered so far:

* On average, Prosper.com lenders tend to charge too little interest on the riskier loans: the interest rate isn't high enough to compensate for the higher risk of default (and often isn't high enough to make the expected return match the lower risk loans). For example, if lenders expect 8% interest on a low-risk loan with a 0.5% expected net default rate (i.e. on average lenders lose 0.5% of their principal to defaults on loans of that class), then on a loan with a 5% expected net default rate the lenders should charge significantly more than the 12.5% interest which would make the return the same as the low-risk loan. But that's not what happens on average on Prosper.com; instead lenders are asking less (sometimes a lot less) interest on those risky loans than you would expect. This means that if you're a high-risk borrower, Prosper.com is a great deal for you if you can get your loan funded.

* That said, there is a surprisingly wide range of interest being charged on similarly risky loans: I've observed as much as six percentage points difference in the rate charged for loans which (as near as I could tell) were about equally risky. So, if you're a borrower on Prosper.com, sometimes you win the interest rate lottery and sometimes you lose.

* The name of the game in lending is minimizing default. You only earn 7% to 25% interest on your loan, but if the borrower doesn't pay you can lose 100%. A single bad loan can destroy your performance, unless you've got at least a hundred or so different loans in your portfolio (this implies, by the way, that you need to invest a minimum of $5,000 to $10,000 in Prosper.com if you're going to be serious about it, since the minimum slice each lender can have of a single loan is $50). Any loan can default, but some are more likely than others, and it's best to stick to the very highest rated loans.

* It can take a long time to put money to work. A week to transfer funds into Prosper, several days to go through the bidding process, and then up to a week to actually originate the loan. You earn no interest until the loan originates. Sometimes a borrower doesn't check out (happened to me once already), so you have to start the process all over. Assume you'll be earning no interest for 2-3 weeks while trying to invest your money.

* Standing Orders are your friend. Standing Orders are a mechanism which lets you specify specific lending criteria and an interest rate, and any time a matching loan is available it automatically bids on it. This is handy because it takes the emotion out of bidding, and lets you automatically set criteria which result in an acceptable return for your risk. Too many Prosper.com lenders bid on the emotion, which is why some loans get charged too little interest, and others pay a lot more.

* Keep your expectations modest, and you probably won't be disappointed. The majority of Prosper.com lenders with 20 or more loans (i.e. a minimum of $1,000 invested) appear to be earning between 5% and 7% after taking defaults into account. That might not sound spectacular, but it's significantly more interest than a 3-year CD will pay right now. I suspect (but can't prove) that it may be possible to systematically earn 12% to 14% after defaults, by setting up a careful program of Standing Orders which only bid on loans which pay enough interest to more than compensate for the additional risk.

* Only bid on loans which expire soon. There's no point in tying up your money for the entire ten days it takes some loans to get bid. Set up your Standing Order to bid on matching loans which end the earliest.

* Most borrowers are honest, but borrowers can (and have) lied about anything and everything on their loan descriptions. The only thing which can be trusted is the credit report, since it comes from a neutral third party. Therefore, don't ever bid on a loan because of something the borrower says (though it's OK to not bid because of something the borrower says). Most interest rates get bid too low because something the borrower wrote inspires sympathy, trust, etc....don't get caught in that trap. By the way, this is one reason why Standing Orders are so useful: they're strictly "by the numbers."

* As I wrote before, at this stage Prosper.com should be treated like online poker, not a serious investment. Assume you could lose everything, because if the company goes under you just might. On the other hand, if you can afford the loss, it can be entertaining, educational, and sometimes profitable if you're sufficiently disciplined.

Posted at 03:56 PM | Permalink |


Monday - November 05, 2007 01:33 PM

"Personal lending" startup Prosper.com must have recently hired a new PR firm, since it's been all over the place lately. I think I've heard or read three or four radio segments and articles about the company in the past week alone.
The idea is pretty simple: think of it as Ebay for lending. People who want to borrow money (up to $25,000) post a plea online, Prosper.com assigns them a risk rating (based on their credit score), and individual lenders can "bid" to fill some or all of the loan at a given interest rate. If enough lenders are interested, the loan gets made; and if the loan is oversubscribed, then the interest rate gets pushed down. Loans are all fixed interest rate unsecured three-year loans.

It's an idea with a lot of appeal, especially borrowers sick of paying 30% or more for credit card debt, and individuals looking for a better return than the 5% or so currently offered by CDs and other short term debt. Even the safest (lowest yielding) loans on Prosper.com are paying over 10% to the lenders, and the higher risk loans are offering well over 20% interest.

That's before fees and defaults, of course, and there's the rub. Prosper.com takes a 1% fee for all but the highest rated loans, and if the borrower defaults then the lender might not get anything. So the actual return has to be adjusted for fees and defaults.

Fortunately (and to their credit), Prosper.com makes a handy performance calculator tool available, which calculates the ROI for a basket of loans based on criteria you specify, including rating, origination date, and about a hundred other factors. So you can get some sense for the actual returns corrected for fees and default histories (though the calculation could be proven completely wrong if the economy changes and default rates go up or down significantly). And, according to the performance calculator, even after correcting for defaults and fees the returns still look attractive: over 9% for the highest rated loans.

But there's a couple of gotchas and oddities.

Gotcha #1
Looking at the default return calculator, it only includes loans originated between 6/1/06 and 10/6/07, and those where the borrower had no current delinquencies and no more than two recent credit inquiries at the time of the loan.

In other words, the "headline" return isn't the real return for all Prosper.com loans. Playing around with the tool somewhat, I found that including all loans in the performance calculation causes the return to plummet: even then highest rated borrowers only returned a little more than a money market fund, and the lower grades had substantially negative returns. In other words, even the high (20% and up) interest rates charged on those risky loans weren't enough to make up for the very high rate of default.

Worse, in the June-September 2007 quarter, only about half the loans originated at Prosper.com met the "no defaults and two or fewer credit inquiries" test. The rate of return published on the web page is seriously misleading, since it excludes the riskiest half of loans. Someone not paying attention could very easily miss that detail and wind up making much riskier loans than expected.

I presume that the default and credit inquiry information is available to lenders (I don't know for sure since I haven't created an account to see for myself), so clearly lending to people who have current defaults or more than a couple credit inquiries is extremely risky, whatever Prosper.com's rating might be, but this is also an avoidable mistake.

Gotcha #2
There's only a limited amount of data in the loan history, since Prosper.com didn't start making loans until 2006. On a three year loan, that means that not even the oldest loans have gone to maturity (though some have been paid off early), so the reported default rate will be lower than the actual default rate for the full life of the loan. In fact, the preset time frame in the ROI tool excludes the first six months of Propser.com's history--looking just at that initial six months shows an ROI a couple points lower.

In other words, if you want to know the actual historical return on Prosper.com's loans, the answer is "nobody knows because none of these loans has gone to maturity yet." It is a fair bet is that the actual return will be at least somewhat lower than reported by the performance calculator.

It's also weird that the default-adjusted return for riskier loans is actually lower than for the less risky loans. Normally you would expect the riskier loans to return more, even after adjusting for the default risk, since lenders will demand more interest in exchange for the increased risk. But that's not the case.

This suggests to me that at least some of the lenders on Prosper.com aren't doing their homework, and get seduced by the very high interest rates offered on the riskiest loans. Because the interest rate is so high, at least some people aren't properly calculating the default-adjusted return.

Gotcha #3
If you really want to delve deeply into the expected return on a Prosper.com loan, there's no way to get enough historical data to make a meaningful calculation, and it isn't clear exactly how Prosper.com does the calculation.

For example, it's very important to know not just whether a loan defaults, but when. It makes a big difference if a loan defaults in the second month instead of the twentieth. In the latter case, the lender has already recovered over half the capital. It's also important to know what fraction of loans in default ultimately are repaid or written off.

It's also important to know when loans are repaid early, to get a handle on "prepayment risk." How could early payment of the loan be a risk? Simple: there's no guarantee that you can reinvest the money at the same interest rate, and the borrower gets to choose whether and when to repay early. If interest rates drop, many borrowers will refinance (which Prosper.com makes easy), and the lender is suddenly no longer getting the 10% interest he expected to get. On the other hand, if interest rates go up, the borrower has locked in a low rate, and the lender doesn't have the ability to make new loans at the higher interest rate.

In other words, borrowers get the ability to reset their interest rates by prepaying and refinancing, but lenders have no such option. This will always work to the lender's disadvantage.

When to Invest Through Prosper.com
Given all this, I don't think Prosper.com is likely to be a good investment for most people. Lending money is a complex business, and there are a lot of subtle details which can impact your return. Even for big, sophisticated banks lending money to individuals isn't a great business to be in: despite the absurd interest rates, credit card companies make most of their money on fees, not interest. There are some people who might find this model rewarding, however:

1) People willing to do their homework and be extremely smart and careful about the loans they make.

2) People who derive nonfinancial rewards from Prosper.com (for example, the satisfaction of helping someone in need, or the gamelike aspects of the site).

For the most part, however, the extra financial return you might earn through Prosper.com will not come anywhere close to paying for the time and effort to manage their loan portfolio.

And there's also the question of what happens if Prosper.com goes bust: the company has been backed by $40 million or so in VC money, and with that kind of investment the investors are probably looking for the company to have $50 to $100 million/year in revenue in fairly short order. That implies originating several billion dollars/year in loans, and right now they're a couple orders of magnitude shy of that number. It's not clear to me that there's anywhere close to the required level of demand, and if the VCs pull the plug, where does that leave the lenders? Only Prosper.com is allowed to service the loans, and it's not clear that any other financial institution would be interested in taking on that job.

So for now, I'd view lending through Prosper.com as a stodgier version of online poker: do it for the entertainment value, don't expect to actually make any money in the long run, and be mentally prepared to lose everything in the worst case scenario.

Posted at 01:33 PM | Permalink |

Market Meltdown: It's All About Liquidity

Friday - August 10, 2007 10:28 AM

Financial markets are melting down this week, with the Dow down nearly a thousand points from its all-time high (set just a few weeks ago), large hedge funds imploding, computerized trading schemes posting big losses, and Jim Cramer blowing up on national television. Okay, the last one isn't at all unusual.
The trigger for this seems to have been hinted at a few weeks ago when we learned that it wasn't just subprime mortgages going bad, but the prime ones too. To be sure, default rates on prime mortgages are still much lower than on the toxic waste (just a few percent), but that default rate has more than doubled in the past year. That has led a lot of institutional investors to start questioning the value of the bonds they hold which are backed by various slices of mortgages.

Market trauma like this is always about liquidity--that is, the ability to find buyers and sellers for the financial instruments at hand. What's happening this week is that there are no buyers for mortgage backed securities of any sort, because nobody's confident about what they're actually worth.

Check out these quotes from this morning's Wall Street Journal:

From Alain Papiasse, head of BNP Paribas's asset-management-services division: "The market for the assets has just disappeared. Since the start of this week, there are no prices for instruments that carry, directly or indirectly, some types of U.S. assets."

From James Glassman, senior economist at J.P. Morgan Chase: "People are less willing to take the types of risks that they were before."

When liquidity dries up and prices become uncertain, markets move quickly, irrationally, and become much more correlated than usual. Usually this is because of panic selling, though occasionally (as happened at the peak of the tech stock bubble in 2000) markets move up because of panic buying.

This becomes self-reinforcing since, while some investors may be forced to sell (because of redemptions or margin calls), investors aren't usually forced to buy.

I'm not surprised to see that hedge funds and computerized trading schemes are failing in this scenario: rather than seeking inherent value, those types of funds try to exploit slight trading inefficiencies in the market, and their models implicitly assume no difficulty finding buyers and/or sellers. When liquidity disappears, the underlying assumptions of the trading model break down, and losses pile up very quickly. My observation (hedge fund marketing materials aside) has been that hedge funds and quantitative traders tend to make money during fairly normal market conditions, but underestimate the risk of abnormal markets and lose lots of money when things go sour.

So what's next? It's hard to tell, but right now the damage is limited to financial markets, with hyper-aggressive hedge funds and similar vehicles being the most vulnerable. Because of the way mortgages have been sliced up and repackaged, there's little bits of subprime paper hidden in lots of unexpected places, and right now the tide is going out so we're just discovering who's been swimming naked.

The worst case scenario is that investors and lenders become so risk averse that it becomes difficult or impossible for even the highest quality borrowers to get a loan. That could lead to a significant recession, since it would make it hard to buy a house, start a business, or maybe even get a credit card.

The best case scenario is that in a day or two bargain hunters swoop in and start buying some of the bad loans at deep discounts. Some hedge funds will lose money, and a few will shut down completely, but the damage will be limited to a handful of big institutional investors who can afford the losses.

The most likely scenario (as always) is somewhere in between: after a few months, debt markets will reach a new equilibrium, interest rates will tick up a point or two and lending standards will tighten incrementally, but fiscally prudent people and small businesses will still be able to get loans fairly easily. Most of the hedge fund gunslingers will shut down or become much more cautious, but life will be largely unaffected for most people.

Posted at 10:28 AM | Permalink |

Mortgage Flight to Quality

Wednesday - March 28, 2007 09:47 AM

Every market trend contains the seeds of its own destruction. That's just a fancy way of saying that nothing lasts forever.
Right on schedule, just as things seem to be overwhelmingly hopeless as mortgage mayhem makes the front pages throughout the country, there are signs that the drop in the housing market may be playing itself out.

The subprime market (mortgages to borrowers with poor credit) will continue to be a mess for a while. But mortgage rates for prime borrowers have actually dropped lately.

That's due in part to a more stable near-term interest rate environment, and also because all the money coming out of the subprime market has to go somewhere.

The net effect is that for people with good credit and a stable job, interest rates are falling at the same time that subprime borrowers are disappearing from the market and house prices are dropping. If you're a prime borrower, you can suddenly afford a lot more house than you could a year ago. For that group, this could be the best time to buy a house in years.

Combine that with the fact that populations in most metro areas are growing (with a couple of exceptions, like Detroit and New Orleans), leading to built-in demand for more housing, and it starts to become clear that there's a floor forming under real estate prices.

We won't see the wackiness of the bubble again (at least I hope not) for a while--the lack of subprime mortgages will keep people from bidding prices up too high--but sanity and stability should be the order of the day.

Posted at 09:47 AM | Permalink |

Mortgage Meltdown and the Grand Unified Theory of Risk in Financial Markets

Tuesday - March 20, 2007 04:55 PM

The financial news the past few weeks has been dominated by the meltdown in subprime mortgages, and the aftershocks that's having throughout financial markets.
For those not following the story, here it is in a nutshell: During the real estate boom, few mortgages went bad at least partly because increasing prices let homeowners refinance to get out of trouble. This led mortgage lenders to be willing to make riskier and riskier loans, since it seemed that the risk of default was low. The trend to writing riskier mortgages accelerated toward the end of the boom, as mortgage companies tried to keep their profits up in what was a fundamentally slowing market.

As a result, there's a lot of really high-risk mortgages out there right now. But unlike 50 years ago, today's mortgages aren't held by a local bank. Instead, they're combined with other high-risk mortgages, sliced into little bits (called "tranches") and sold like bonds in the financial markets. A basket of even the riskiest mortgages will yield both high quality tranches--which get paid back from the first dollar the borrower repays--and low-quality tranches, which get repaid last (and are unlikely to ever get repaid). The riskiest tranche is often called the "equity tranche," or more informally (and accurately) "toxic waste."

Dividing up mortgages like this is nothing new: stock brokers were selling unsuspecting customers Collateralized Mortgage Obligations (CMOs) way back in the 80's. After a bunch of them went bad, most brokers realized that these very complex securities are unsuitable for nearly all individual investors, and today most are held by sophisticated investors like pension funds and hedge funds.

(CMOs were a big part of the Series 7 exam for a stockbroker's license back when I took it in 1996, but our trainer basically told us that we'd never see one in real life, since no sane individual investor was buying them by that time.)

There's a slightly new wrinkle these days, which is taking the toxic waste from a bunch of CMOs and recombining them and reslicing them into a new set of Collateralized Debt Obligations (CDOs) which have both high risk and low risk tranches. That lets some of the toxic waste get recycled and makes it somewhat easier for financial markets to swallow risky mortgages. The net effect of all this pooling and slicing is that little bits of risky mortgages are held in all sorts of places you wouldn't expect to find them: low-risk bond funds, conservative pensions, money-market funds, and the like. That's because the high quality tranches are--at least in theory--more like a highly rated bond issued by General Electric than a bunch of option-ARM mortgages issued to guys who never had to prove their income.

But because real estate has been strong the past several years, the actual riskiness of some of these securities has never been tested. It's all hypothetical. And now that the mortgages are starting to get into trouble, the supposedly risk-averse investors who bought this recycled toxic waste are getting very nervous.

Hence the meltdown: writing high-risk mortgages depends on the ability to slice them up and sell the parts to risk-averse investors who wouldn't otherwise touch them. As default rates go up, those investors are now starting to think that the whole thing is a house of cards and they're avoiding even the safest tranches. That makes it hard to refinance, which was how troubled borrowers were avoiding default during the boom, so more borrowers are forced to default. That makes the mortgages even riskier, and continues the cycle.

Grand Unified Theory of Risk
This is the third financial meltdown I've seen in my professional career: the first was the asian monetary crisis of the late 90's, the second was the bursting of the dot-com bubble, and now the mortgage meltdown. All three had the same characteristic, which I will boldly proclaim to be my Grand Unified Theory of Risk in Financial Markets:

During a financial boom (or bubble), investors' tolerance for risk increases continually until a crisis ends the boom and restores normal risk tolerance.

The cycle is akin to a relaxation oscillator (think of a toilet tank which fills gradually, then suddenly empties when flushed). The stages are:

1. Improving Fundamentals. The boom starts when a market (be it for stocks, bonds, foreign currency, mortgages, or whatever) goes up for a sustained time because of improved fundamentals. This is normal, until:

2. New Investments. The boom becomes self-sustaining when investors who wouldn't otherwise be involved in the market notice the good performance, and start investing new money. This increases prices across the board, and everyone's happy as long as the prices don't get out of whack with the fundamentals.

3. Increased Risk. As the prices in the market keep going up, they start becoming disconnected from fundamentals. The risk level begins increasing, but nobody notices at first because the market persistently goes up. More enthusiastic commentators proclaim that the market will keep going up forever, or that (against common sense) risk levels are actually lower than before. Some of those who have been investors since step 1 can't figure out the prices and sell; others are enjoying the party too much and stay invested until:

4. Crisis. As long as the market continues to attract new investments, it will keep going up and becoming more risky. At some point, though, there will be a change in the fundamentals (or simply no new investors to be found), and prices will drop. This exposes the high level of risk in the market, which causes the more skittish investors to pull out. The decline accelerates, forcing out more and more investors, until prices eventually reach a level (perhaps months or years later) which attracts investors back in based on the fundamentals.

At this point, the mortgage market is solidly in the Crisis stage, and the only question is how far things will fall and how much collateral damage it will cause. Things will eventually stabilize, but mortgages will be much harder to obtain for marginal borrowers, real estate prices will drop (at least in many markets), and the more exotic mortgages will likely disappear completely--at least until the next real-estate bubble.

The other thing I've observed is that there's always a bubble going on somewhere in the world. In our global economy, there's a lot of "hot money" sloshing around, and what's coming out of the mortgage market right now has to be going somewhere else. I'm just not sure where yet.

Posted at 04:55 PM | Permalink |

Why Economists Make Lousy Businessmen

Sunday - August 27, 2006 08:22 AM

I have a lot of respect for the study of economics in general. But some economists seem so utterly disconnected from reality that I am sometimes amazed that they don't need full-time caregivers. Case in point: Arnold Kling wrote this in Econlog today: Funding Start-Ups

"I have a prejudice against outside funding for start-ups. In Under the Radar, I wrote that "Fundraising is not for businesses. Fundraising is for charities." I was so proud of that line that I used it twice.

"To me, an entrepreneur who looks for investors is like somebody who can't swim who finds himself in the middle of a lake. It's dangerous to go near the drowning man unless you know what you are doing. If you are not a trained lifeguard, chances are he will drown you as well as himself."
Let me see if I understand this correctly. In Arnold Kling's ideal world, all startups would be funded entirely by the founders until they become operating cash flow positive.

Kling is obviously an intelligent individual, so I'm going to give him the benefit of the doubt and assume that he's never been involved in a startup, and hasn't really thought through the implications of this notion. Otherwise, I assume, he would quickly change his mind.

The first mistaken assumption is that an entrepreneur, given a choice, would rather focus on raising money than selling stuff. This is absurd. Speaking as someone who knows a lot of entrepreneurs, and who is one myself, raising money is somewhere below pumping out the septic tank on our list of stuff we enjoy doing. Most entrepreneurs absolutely despise raising money, and would much rather be making stuff to sell (which is why we're entrepreneurs, after all), but it is a necessary part of being a startup.

In fact, to be a founder-funded, at least one of these conditions must be met: (a) It has to be a time-and-materials business, such as a consultancy or a contractor with no significant pre-revenue R&D or infrastructure; or (b) the founders have to be independently wealthy. If condition (a) is met, as it often is for businesses like building contractors or technology consultants, then in practice very few startups raise outside money.

The problem is that condition (b) is almost never met. The vast majority of entrepreneurs are of ordinary means, and cannot afford the high probability that a failed startup would destroy them financially. Yet there are a lot of great ideas out there which require initial development and/or infrastructure before they can start bringing in outside revenue.

Like, for example, Google (which couldn't start selling advertising until it had the infrastructure to support lots of searches). Or Apple, or Cisco, or just about any other successful technology company since the 1950's.

Venture capital (and related capital like angel investors), for all its imperfections, serves an extremely important purpose: it connects individuals who want to take risks with their ideas to organizations which want to take risks with their money. It is extremely unusual to find both in the same person.

Posted at 08:22 AM | Permalink |

Dividend Weighted Index Funds

Wednesday - June 14, 2006 03:27 PM

There's an interesting article in today's Wall Street Journal claiming that, over the past 40 years, a dividend-weighted index fund would have outperformed a market-capitalization-weighted index by over a full percentage point per year with lower volatility.
To anyone who isn't a finance geek, this sounds pretty esoteric. In the context of finance theory, however, this is huge: akin to proving that continents move or (in the analogy the author uses) that the Earth goes around the Sun instead of the other way around.

According to the Capital Asset Pricing Model (CAPM), the official Received Wisdom of finance theory from about the 1960s until the mid-90's, it is impossible to systematically outperform a market-weighted index fund over the long term and with lower volatility.

In recent years, though, CAPM has come under attack on various fronts--mostly from people who have found systematic biases in the way people think about buying and selling stocks (also known as Behavioral Finance). I've also seen some intriguing research showing that one of the mathematical assumptions of CAPM turns out to be more critical than most people believed, and that the mathematical proof of CAPM breaks down completely if the assumption is even mildly violated.

(For math-finance geeks intrigued by the previous statement, here's a quick summary: CAPM assumes that all market participants can have unlimited leverage both positive and negative. In other words, there are no limits to either margin buying or short selling for anyone. In real life this isn't true, of course, since some people can't buy on margin or short-sell at all, and everyone faces at least some limits. Theorists have generally assumed that this real-life restriction didn't change the results of the theory. It turns out, though, that violating this assumption makes the Efficient Frontier nonlinear for any market participant who has a margin restriction, and if any market participants have a nonlinear Efficient Frontier, then the market portfolio will no longer lie on the Efficient Frontier. Sorry for no link, but I read this in a dead-tree journal some months ago.)

The defense of CAPM against all these various attacks has been that, even though stocks may be mispriced from time to time, there is no systematic way to profit from those mispricings without taking on more risk than you'd assume by buying an index fund. It's a sort of Heisenberg Uncertainty Principle of the stock market: stock prices might be wrong, but there's know way to know if they're too high or too low.

But in light of the holes in CAPM, I've been wondering lately if there might be some better way to put together a stock index than by weighting by market capitalization. Market-cap-weighted indexes have been traditional, but there's nothing special about them other than the fact that they are supposed to be the most efficient (i.e. highest return at the lowest risk) under CAPM. If CAPM is wrong, though, then there could easily be other ways to construct indices which do better.

So, it seems, is the case. The claim in the WSJ article is that some other methods of weighting stock indexes do, in fact, outperform a market-cap index.

There are some caveats to this. First is that the author of the article works for a company that sells stock funds which weight by dividends, so there's a conflict of interest.

The second is that there may be something special about the period of time from the mid-60's to today. Four decades is a reasonably long time to test a theory like this one, but the markets have been known to have multi-decade trends in the past. Just because this strategy would have worked in the past doesn't mean it will continue to work in the future.

Finally, dividend weighting is effectively a form of value investing. Studies in the past have shown that value investing can outperform growth investing over time, and it tends to be less risky, but there will be years when value investing underperforms and even looks stodgy. So don't expect to impress your buddies at the country club by talking about your dividend yields.

Posted at 03:27 PM | Permalink |

French Bread and Circuses

Tuesday - March 28, 2006 02:58 PM

I'm far from the only American to be mildly astonished at the massive rallies and protests in France right now over the proposed new labor law. One news report claimed that three million people turned out in the streets--that's 5% of the entire population of the country, and equivalent to 25 million people protesting in the U.S. The object of their collective derision is a reform of French labor laws which would make it relatively easy for companies to fire young employees during the first two years of their job. After that time, existing laws would kick in which make it nearly impossible to fire anyone.
France's labor laws have long been the equivalent of Rome's infamous bread and circuses [supposedly the old Roman Republic bankrupted itself because politicians kept promising free bread and circuses to all citizens without levying enough taxes to pay for it all]. The French government, after all, doesn't have to pay the salaries of people who are nearly impossible to fire even if they are incompetent or unneeded. So, if you are a French citizen living in France, once you find a job you are pretty much guaranteed employment until you retire, die, or quit (you'd be foolish to quit, though), or the company goes out of business. In addition, you can't be forced to work more than 35 hours/week (in fact, it may be illegal to even voluntarily work more than 35 hours/week--I'm not entirely clear on the details).

Compare that to the U.S., where nearly all employees are "at will" meaning they can be fired for almost any reason at almost any time. I say "almost" because there are some limits: you can't be fired for being black, a woman, or a religious minority, for example; and under some circumstances (massive layoffs) companies may have to give notice. In the U.S. you can even be fired for refusing to work overtime (as long as the company pays you appropriately). There may also be some contractual limits, such as the CEO who gets a multi-year guarantee.

What that means is that where an American company can afford to make hiring mistakes (you can always fire excess or incompetent employees), a French company will have to think long and hard before bringing someone on. A mistake will be very expensive for a very long time.

In practice it isn't quite so extreme. American companies are often reluctant to fire even very incompetent people just because firing people is difficult, expensive, and emotionally draining for the managers. And I strongly suspect that some of the French labor laws are routinely ignored (when I was in investment banking, we hired a French banker and I asked her how French investment banks worked within the 35-hour workweek when us Americans had a hard time in the business with less than 60 hours/week. She shrugged and said that "nobody asks how many hours I work, and I don't tell."). There are also ways for companies which can't fire someone to "encourage" them to "quit" (I saw this, too, when I was working as an investment banker and my company had a manager who lost an internal power struggle after we were acquired. He couldn't be fired, since he had a multi-year multi-million dollar contract, but he was given a desk in a closet and made to do menial paperwork--for $3 million/year--until his contract finally expired and he quit).

The net result is fairly predictable: in America, where the inherent risk of hiring someone is low, companies hire and fire people constantly. The unemployment rate is relatively low, and if you lose your job you can probably find something (maybe not what you want) within a few months. In France, where there's tons of risk in bringing on a new employee, companies are extremely reluctant to hire, and the unemployment rate--especially among young people--is very high. But once (if!) you get a job, you can pretty much hang on to it forever.

Which system is "better" is largely a philosophical question (i.e. what's more important: stability or growth?). But the two systems are fundamentally incompatible in a global economy.

As an American, the idea that someone might have to spend a whole two years of her career at risk of being fired is pure culture shock. I'm on my third career already, and I don't think I've ever had a job I considered secure.

"You want security, get a burglar alarm."

Posted at 02:58 PM | Permalink |

Inverted yield curve

Thursday - December 29, 2005 08:50 AM

The yield curve has now officially inverted. That means that short-term interest rates are now higher that long-term interest rates, at least for some maturities.
An inverted yield curve is very often a signal of an upcoming recession (which I discuss at some length in this article). But in the topsy-turvy world of finance, there are always those who prefer to stick to their own preconceptions than listen to a reliable indicator.

So, predictably, the headline in today's Wall Street Journal is "Economists Question Bonds' Predictive Power: Economists are questioning whether the bond market's yield-curve inversion presages a downturn."

This sounds vaguely familiar. When have I heard that before? Oh yeah, in 2000, the last time the yield curve inverted, the headlines were about how it was all different this time. The stock market had had a huge runup, the federal government was running a massive surplus (remember that?), and so there couldn't possibly be a recession coming.

We all know what happened next.

In truth, the Wall Street Journal article is much more balanced that the headline--for example, the reporter points out that a yield curve inversion has only been a false signal twice in 50 years, and one of those two false signals was due to the collapse of Long Term Capital Management in 1998 (which actually could have led to a recession, if it hadn't been managed better).

And it is possible that this time around will be different.

But I wouldn't count on it.

You should assume that there very probably will be a recession between now and the end of 2007. Anything else is just wishful thinking.

Posted at 08:50 AM | Permalink |

Gas got expensive again

Thursday - December 08, 2005 04:31 PM

Following up on my earlier posts about the price of natural gas....
The recent cold snap (we went from September to January without stopping in between) has led to a spike in natural gas prices , which are now above where they were post-hurricane (the graphs I link to seem to be updated only every few days; the Wall Street Journal reported that today's gas price closed above $15/million BTU). As per usual, futures prices are lagging.

Minnegasco has set its December gas price at $1.19/therm, down $0.20/therm from November, and reflecting some (but not all) of the lower gas prices we saw up until the last week or so. But this price is still $0.20/therm above last year.

I'm not too thrilled about higher gas prices, but it will make it easier to save the cost of our fireplace insert, if and when it ever gets installed.

Speaking of which, we did manage to get an earlier installation date. The new date is December 20th, more than a week earlier than the prior date of December 29th. And I also reminded the scheduler that we can be flexible if there's a cancellation.

Posted at 04:31 PM | Permalink |

The New Program Trading

Wednesday - December 07, 2005 01:42 PM

There's a Wired article up today about making money through semi-automated and even fully-automated stock trading becoming more popular among certain individual traders and small funds.
The article is all very interesting, and I even know a few people who are doing this (they claim to be making money, though of course I can't verify those claims--and properly calculating stock trading returns is harder than it seems at first glance). But if this is really becoming as big as the article claims, I wonder what effect it is having on the stock market as a whole?

Program trading got a bad rap in the late 1980's, when it was blamed for the 1987 stock market crash. The problem in 1987 was not just program trading: it was the fact that all the programs were following the same strategy (called "portfolio insurance"), and furthermore, that the portfolio insurance strategy creates a positive feedback loop. That is to say, portfolio insurance programs buy when the market is going up and sell when the market is going down, reinforcing whatever trend the market is taking. In October 1987, the market took enough of a dip that the feedback loop got out of control, and the market crashed.

[Aside 1: It was called "portfolio insurance" because the buying and selling pattern was designed to mimic the behavior of a put option, selling the entire portfolio when the price drops to a certain point. The idea was that the program could minimize risk by selling off stocks when the market drops, just like buying an actual put option limits how much money you can lose if the stock price goes down. The fatal flaw was that the people who invented the strategy assumed that the market is always liquid; that is, that you can always find a buyer or a seller at or close to the current stock price. But when the market crashed, the liquidity went away, and buyers of stocks were hard to find at any price.]

[Aside 2: Feedback loops come in two flavors: "positive" and "negative." Positive feedback loops reinforce whatever the underlying trend is, and make systems unstable because they lead to runaway conditions. Negative feedback loops oppose the underlying trend, and make systems more stable because they oppose change. An example of a stock trading strategy which creates a negative feedback loop would be "Buy Low, Sell High."]

Portfolio Insurance was largely discredited after the crash of 1987, when it not only failed to perform as advertised (it didn't prevent anyone from losing money when they needed the protection most), but it actually made things worse.

After 1987 program trading never went away, but there were some important changes. First, the markets imposed "circuit breakers" which cut off all program trading under certain conditions (mainly when the market drops a certain amount. Nobody seems to be too worried about runaway feedback loops pushing the market up). More important, the programs started following different strategies. No longer did you have the situation where so much money was programmed to follow the same trading strategy. So the risk of runaway feedback loops was mitigated somewhat.

But all program trading buys and sells based on market trends, and so basically boils down to a feedback loop. Current programs are much more complicated than the old portfolio insurance, but it can still be described as nonlinear feedback loops with variable delays. What's more, when taken in aggregate (i.e. adding up the effect of everyone's program trading strategy), it still boils down to a complex feedback loop.

The people doing the program trading tend to be very secretive about the exact models they're using, since they don't want everyone copying their trading strategies (which, ironically, probably means that many of them are following the same trading strategies, since there are a handful of obvious things most people will think of without realizing that everyone else is thinking of the same thing). But from what I've been able to glean through conversations and reading online, the vast majority of the current crop of programs are trend-following. That is, they attempt to identify a trend, then pile on.

Trend following always creates a positive feedback loop (almost by definition). So even though there is a diversity of trading programs out there today, they're mostly pushing the market in the direction of more volatility.

[Aside 3: These program traders are constantly refining their models, since as people catch on to a given method it tends to become less effective. But if you're in a market of trend followers, how do you make money? By being the first to spot the trend and jump on before everyone else. So I suspect what is really going on is that everyone is tweaking their programs to make them more and more sensitive, perhaps without even realizing that's what they're doing. Anecdotally, I have a hunch that a lot of people don't really understand their computer models. They just trust the computer and the data.]

By the way, trend following is not inherently a bad strategy. Trend following works because there are natural buyers and sellers in the market (that is, people who trade to build or liquidate a portfolio position, rather than day trading to catch a short term trend). If there's someone trying to accumulate a million shares of Google, for example, then that buyer is creating his own little mini-trend. All the program traders are hitching a ride, and essentially forcing the buyer to either pay more or stop buying. It is effectively a mechanism which seeks out the highest price the natural buyer is willing to pay.

The really interesting question is whether there's any way to make money by exploiting all these positive feedback loops and trend following behavior. I suspect there is, though it might take a fair amount of capital to make it work.

The strategy would basically be this:

Step 1: Create a trend.

Step 2: Let the programs amplify the trend.

Step 3: Bail out before the natural buyers or sellers bring the stock back to reality.

Step 1 is simple. All you need to do to create a trend is buy or sell enough stock to start moving the price. Depending on the stock, this might just take a few hundred shares, or it might take millions. Multiple small trades may be more effective than one big trade (I don't know for sure), though the brokers often split trades up into multiple transactions at slightly different prices.

Step 2 is also simple. If you've chosen a good stock (that is, one with lots of trend-following traders, but few natural buyers or sellers), then it will happen all by itself. The key to making this strategy work is achieving positive amplification of your trend. Sort of like in a laser, you want your initial trade to induce other trades, which will induce other trades. You need the stock to move enough, and with enough volume, that you can execute step 3 at a profit.

Step 3 is the tricky step. Part of the reason it is tricky is that the market makers (the human ones, at least) are wise to the behavior of the trend-followers, and they'll also be trading against the trend as it matures (knowing that all those day traders will go the other way in a short while). In addition, natural buyers and sellers (which are the inherent price-stabilizing mechanism of the stock market) will see the trend as an opportunity and trade against it. So there's an element of timing and especially not being greedy.

Probably the hardest part of this strategy is choosing the right stock. You want one you can move (enough to create a trend) with the capital you have available. In addition, you want one with a lot of trend-followers (so boring industrial stocks are probably out), and you need to find a time when the stock is ripe for trend amplification. Good candidate stocks will have a lot of inter-day price volatility but not much movement over days or weeks, high trading volume compared to the number of shares available to trade, and probably a certain amount of "buzz" or sexiness.

You also need to keep in mind that this is a zero-sum game (actually, negative-sum game when you consider commissions). By creating trends for the trend followers to amplify, then cashing out, you are literally taking money from the trend followers' collective pockets. Every dollar of profit you make is a dollar of loss for the program traders, since at the end of the day everyone has cashed out. This will, over time, drive the program traders out of whatever stocks you're trading and/or lead them to refine their models (probably making them less aggressive). So after some time, you will have to try something else.

Posted at 01:42 PM | Permalink |

DRM and Price Discrimination

Monday - November 21, 2005 03:09 PM

Digital Rights Management (DRM) is not, and never has been, about fighting piracy. DRM does nothing to stop the true pirates in China cranking out millions of DVDs and CDs for pennies a pop, and isn't even all that effective at keeping unauthorized copies of movies and music off of online services.
Instead, DRM is about price discrimination for movies, music, and similar intellectual property. Of course, the RIAA and MPAA won't acknowledge that fact, probably because price discrimination tends to be extremely unpopular, while fighting piracy at least sounds fair. But the reality is that while DRM is nearly useless for stopping piracy, it is very effective at allowing the distributors of content to charge different prices to different people for the same product.

I wrote a pretty lengthy article on price discrimination a couple years ago, and the capsule summary is this: different people are often willing to pay different prices for the same product. A company can maximize its profits (and often offer lower prices to a wider market) by figuring out how to charge as much as possible to each person. However, price discrimination violates most people's sense of fair play, and is deeply unpopular. Dramatic price discrimination (such as used to exist in airplane ticket prices) is often an indicator of price collusion or a de-facto monopoly.

Price discrimination in content is as old as the paperback: popular books are released first in expensive hardcover editions, and people eager to read it are forced to pay $25 or $30 for a copy of a novel. Some months later, when demand for the expensive edition has dropped, a paperback edition is released, and everyone who is willing to pay $6 (but wouldn't pay $30) for the book buys a copy. And while a hardcover is more expensive to produce than a paperback, the bulk of the price difference between the paperback and the hardcover is pure profit.

The same thing happens with DVDs: after a few months, the price to own a movie tends to drop dramatically. Recently Costco was selling a complete set of Lord of the Rings DVDs for $30, about half the price you would have paid if you bought the movies when they first came out. And in music, if you like a song you may pay $0.99 for a copy through iTunes. But if you really like a song, you may pay an additional $2.49 to buy it as a ringtone (even though the ringtone is a short version which isn't really suitable for anything other than letting you know your girlfriend is calling).

(And you probably won't be happy about paying twice for the same song, even if you felt it was worth it, which is more proof of how people hate price discrimination.)

And let's be perfectly clear that every business in the world practices some form of price discrimination. Things like sales, volume discounts, senior-citizen discounts, etc., are all ways to set different prices for different customers. But nobody likes feeling like they paid too much, and some of the more dramatic price discrimination schemes leave a company's best customers feeling like chumps.

But the function of DRM schemes is to create barriers for customers to do certain things they might reasonably want to do. Nobody would pay $2.49 for a ringtone if they could just copy the song they already own onto their cellphone. But the existence of this barrier allows the rightsholder to charge come customers $0.99, and other customers $3.48 for the same song. Some customers will figure out how to copy the $0.99 song into their cellphones, but those aren't the people who would pay the extra $2.49 anyway.

I don't believe that there is anything inherently wrong with modest price discrimination. Indeed, it is necessary for the proper functioning of business, since it allows a company to figure out what customers are willing to pay.

The problem with most DRM schemes is that they try to limit a customers' use of a product (and charge more to remove those limits). They break the model of I-bought-it-so-I-own-it. And that's going to make customers upset. Worse, some of those schemes (like Sony's various ham-handed music DRM attempts) can actually cause damage when they try to prevent customers from doing things they expect to be able to do.

If content companies want to enable price discrimination, they should stop focusing on subtracting value from the customer's experience so they can sell it back. Instead, they should look for ways to add value that customers will be willing to pay more for.

Posted at 03:09 PM | Permalink |

The Market Works (pt. 2)

Wednesday - November 09, 2005 12:57 PM

A couple weeks ago, I commented on the fact that oil consumption in the U.S. dropped 3% in the wake of higher post-hurricane prices. This reduced demand has led to a collapse in gasoline prices at the pump, with the price of gas here in Minneapolis now about 20% below pre-Katrina (it was about $2.45/gallon before Katrina hit, and is now just barely above two bucks).
The same thing is happening in natural gas. A few days ago, a report came out showing that demand for natural gas is down, and is expected to stay down for the rest of 2005. As a result, the price of gas has collapsed, dropping to under $9/million BTU. The futures markets are lagging the spot market, but unless demand springs back up it is probably fair to assume that the futures prices will come in line.

Part of the drop in demand is due to warmer-than-normal weather here in the upper midwest. But a big chunk in the drop is also due to millions of consumers making the decision to turn down their thermostats to save money.

Unfortunately, our gas company only sets prices once per month, and the November gas price has already been set at $1.39/therm, up from $1.33/therm in October, and up from $1.00/therm last year (one therm is 100,000 BTU, so if the spot market price for gas is $9/million BTU, that's $0.90/therm. The gas company adds about $0.11/therm for distribution, so if the gas company had set the price today it would be right around $1.00/therm). For the rest of the month we'll still be paying the higher price, though it is probably fair to assume that the December price will be considerably lower.

Of course, if there's a big cold snap, then demand will inevitably go back up and all bets will be off.

My reaction is mixed. On the one hand, I'm pleased to see that the market is working as it should, and that demand is dropping and prices are coming down.

On the other hand, a lower gas price means we won't save as much money with wood heat this winter. At $1.50/therm, every time I fire up the wood stove with a full load of firewood, it will save us around $4-$5. But at $1.00/therm, we only save $2 or $3. Repeat that enough times over the course of the winter, and it makes a big difference in the amount of money we save.

Put another way, if the goal is to save $1,000 on our heating bill this winter (remember that the wood stove insert costs about $3,400), I'll have to burn about 225 loads of firewood if gas costs us $1.50/therm. But I need to burn about 350 loads of firewood if gas is only $1.00/therm.

Of course, if gas is cheaper we wind up paying less overall. It just doesn't give us as much fun in being able to boast of huge dollar savings.

Posted at 12:57 PM | Permalink |

How 'bout that: the market works!

Tuesday - October 25, 2005 04:34 PM

I saw the statistic recently (sorry, no citation) that U.S. oil consumption fell 3% last month as compared to the year-ago month.
That, of course, is in response to the surge in oil and gas prices over the past year and especially in the wake of the gulf hurricanes in late summer. And as a result, gasoline prices here in Minneapolis are actually about 15% lower than they were before Katrina hit (but still quite a bit above last year).

A 3% drop in national oil consumption is remarkable, astonishing even. It demonstrates just how quickly people will adjust their behavior based on a sudden jump in prices.

And, frankly, there a lot of simple and painless things many Americans can do to save gas short of buying a new hybrid car. Drive the sedan instead of the SUV. Walk for short trips. Take a bag lunch to work instead of driving to a restaurant. Go to the mall once a week instead of twice.

People have been buying hybrid cars, too, and for every fuel-efficient compact sold, there's a gas guzzling SUV not sold. Even after just a few months that will have an impact on how much oil we consume.

But the real question is whether people will go right back to their old habits now that gas prices are dropping.

Posted at 04:34 PM | Permalink |

Managing the Yield Curve

Friday - October 14, 2005 11:49 AM

There's a nice summary article up at the Christian Science Monitor about the flat yield curve, the chance that it might become inverted, and why it matters to you my dear readers.
Normally interest rates are higher if you borrow or loan money for a longer period of time (credit cards being the extreme exception). A five year CD pays more interest than a one year CD, which pays more interest than a savings account. But sometimes this isn't the case: when interest rates are about the same no matter how long you borrow money, that's called a flat yield curve.

And when interest rates actually go down for longer term loans, that's an inverted yield curve.

Historically, an inverted yield curve often precedes a recession. This is one of the more reliable predictors of an economic slowdown, meaning that it is somewhere between the Superbowl score and reading tea leaves.

Question 1: Does an inverted yield curve predict or cause a recession?
I don't know the answer, but I suspect it is "both." You can make an argument either way.

On the one hand, an inverted yield curve is a signal from the bond markets that they expect future short-term interest rates to be significantly lower than today, and that there isn't much demand for long-term borrowing. These conditions happen when lots of people think that there's uncertainty about the economy, so the inverted yield curve is sort of the collective prediction of millions of borrowers and lenders thinking that the economy will be worse a year from now than it is today.

On the other hand, an inverted yield curve can cause a recession by enticing investors to focus on short-term investments which pay a higher interest rate. This can make it harder to borrow for capital projects, and can be a cause of a recession. Why should a bank write a 20-year mortgage at 5% interest, when they can earn 6% with less risk by buying short-term treasury bonds? In other words, an inverted yield curve sucks all the appetite for risk-taking out of the economy.

Question 2: Can the yield curve be managed?
The yield curve is set by bond markets, but short-term interest rates are already managed by the Federal Reserve, which adjusts its overnight interest rate up or down to try to control inflation and smooth the economy.

There's only one entity which might conceivably have the clout to manage the entire yield curve: the U.S. Treasury. By borrowing at the long end of the market (30 year bonds, for example) and retiring shorter term bonds, the yield curve can be made steeper. Alternatively, by borrowing mainly in shorter durations, the yield curve could be made shallower.

I don't know if even the U.S. Treasury has the financial muscle to actively manage the spread between short and long-term interest rates. But it might be possible.

Question 3: Is managing the yield curve desirable?
If you believe that an inverted yield curve causes rather than merely predicts a recession, then it makes sense to manage the yield curve to smooth out the ups-and-downs of the economy.

The trick would be maintaining a yield curve steep enough so the economy is healthy, but not so steep that investors start taking foolish risks. The argument that an occasional recession is healthy (because it weeds out weaker players) also still stands.

Also, I'm not sure how you would manage things to keep the economy healthy and inflation at bay.

But just asking the question is intriguing.

Posted at 11:49 AM | Permalink |

The Economics of Firewood

Tuesday - October 04, 2005 02:45 PM

As I work to procure and stock firewood for this winter, I'm learning that the economics of firewood are unusual.
Here in suburbia, firewood is basically a waste product. Urban and suburban forestry produces more waste wood (both logs and woodchips) than can readily be consumed in our gardens and fireplaces. Since only a few nutcases like me actually attempt to heat using firewood, there's basically no substitution effect between firewood and other fuels like oil and natural gas (though there is a power plant in St. Paul which burns woodchips to generate heat and electricity).

But firewood is also very bulky and heavy, and labor-intensive to transport and prepare for burning. So buying large quantities of firewood is relatively expensive, between $150 and $500/cord delivered, though this is still cheaper than the equivalent amount of natural gas heat at today's prices. This expense is mostly labor and transportation.

For someone who is trying to save money by heating with wood, the net result is that if I try to buy the wood from a dealer, I'll lose a large fraction of my cost savings. But if I'm willing to put in several person-days of labor, it isn't hard to find places where I can get free firewood in exchange for hauling it away. Granted, the quality isn't always the greatest (hardwoods like oak and maple have twice or more heat value per cord than lesser-grade wood, and "green" or fresh wood has a higher moisture content and doesn't burn as well), but if the price is right, I can just burn more of it.

So far, I have about 3/4 cord of firewood split and stacked and ready to go. I have probably another 1-2 cords in the backyard ready to be split and moved closer to the house, some of which is partly rotten and so not good for much in the way of heat. There's an old downed treetrunk in our yard which has been dead but off the ground for several years, and is probably good for another half cord or so. All the wood in my backyard has to be moved close to the house before the ground freezes, since our backyard is on a steep slope and it isn't practical to move logs up the hill when the ground is icy.

In addition, my parents have a large yard with several downed trees which I can cut up and haul off, for another cord or two. So between my yard and my parents', we should have enough wood for this winter. I'd like to have 3-4 cords stocked for the winter, which should be enough to run the fireplace flat out for most of the winter.

For next year, I've identified a couple of large trees in our backyard which need to come down to make room for other, more desirable species. I also suspect that finding free firewood will be easier in spring than in fall.

Posted at 02:45 PM | Permalink |

Wow, that was fast!

Wednesday - September 14, 2005 01:46 PM

Gas prices in Minneapolis today are about a nickel below pre-Katrina levels.
Granted, in the Midwest we don't get any of our fuel from the damaged infrastructure along the Gulf coast, but I never would have expected the Katrina effect to wear off so quickly.

Posted at 01:46 PM | Permalink |

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