A lot of people are resistant to the current round of bailouts because they amount to corporate socialism. Or because it rewards the jerks who ran the companies amok in the first place, and incents bad behavior. On the other hand, a lot of people are afraid not to bail out the companies that have screwed themselves up so badly because those companies are "too big to fail".
It's true, they are. So fix it.
The only mechanism this country has to break up an excessively large company is anti-trust laws. Certainly under the current administration, no corporation was going to get cut up using that knife, not when huge mergers of huge companies was the mantra.
The problem with these huge companies is not their size, but the lack of diversity they cause.
For those of you who's study of evolution in biology class wasn't stunted by folks who find it to be an affront to their religion, you may recall that a key component of the whole works is diversity. When selection pressures change, some species don't do so well. This is why global climate change is stressing ecosystems as we know them, and so on. Well, if you have a highly diverse ecosystem, some of the species will do just fine in the new ecosystem, and others will die out completely.
This is the natural order of things.
However, if a relative few species are able to excessively dominate and optimize themselves for the existing conditions, the ecosystem as a whole is less able to adapt to change in conditions. Then, when a drastic change occurs, the entire system collapses. Think dinosaurs and comets.
And so, we are stuck in a situation where our corporate ecology is insufficiently diversified. The entire ecosystem has been based on two things: cheap credit and cheap fuel. Cheap credit means it is too easy to borrow and too hard to save. Cheap fuel means it's cheaper to build stuff wherever labor is cheapest and then ship it to where it needs to go.
The only reason the US Auto industry didn't go into cardiac arrest several years ago is that relatively cheap gas made it acceptable to drive an oversized SUV (which were exempt from strict mileage standards due to being 'light trucks' instead of 'cars') and to load it up with luxury items (which give the manufacturer a better profit margin) and then cut the buyer a low-interest long-term loan that has a palatable monthly payment because it stretches things out for six years. On a car that will start to have serious problems before it's three years old.
I recently read an article that pointed out not only the consolidation of the US auto industry over the last century, but also the fact that the UAW has had a monopoly on labor for the US auto industry (except, of course, for all the plants run by non-US companies without unionized labor). Given that the UAWs pattern was to negotiate a contract with one of the big three, and then use that as a template for the other two, it means that effectively, the big three have had no ability to differentiate on their workforce.
So, how do we fix this? Because right now it's banks and auto companies, but before you know it, it will bethe media companies, the telcos, the airlines (who are still merging, see Delta and Northwest), and any other major industry in consolidation mode.
We need the ability, and political will, to prevent dangerous consolidation. If there is going to be a bailout of the big three, fine. But put them into receivership, throw out their contractual albatrosses, and break 'em up. Make Chevy compete with Saturn and Buick. While you're at it, split up the UAW. Give the union some competition for workers and businesses.
So, where is the sex in all this? Did you read all this way just to find it? Alas, there's nothing salacious here. Getting back to evolutionary biology: sexual reproduction is the source of diversity. The combination and recombination of different sets of genes makes for a diverse population. See here for a bit more on that, but companies need more cross-fertilization. US auto companies should be looking not only at how foreign auto companies work, but also at how other industries work and have succeeded. Hire in people from other places. Shake it up a little. Some ideas, some companies will fail. But in the end the system as a whole will be stronger and more successful, and more able to withstand the next downturn.
Monday, November 17, 2008
Thursday, October 2, 2008
Thursday quickie
A couple of quick thoughts, following on the last couple of posts:
First of all, thanks to Uncle Mikey for pimping me over in Uncle Mikey Explains the Inexplicable. If you somehow stumbled here through some other pathway, go over and see his take on the game.
Second, if you're looking for a regular dose of what-the-heck-is-this-stuff in the finance world, but presented in a way that non-finance types can understand, check out American Public Media's Marketplace. I've been listening for the past year and a half because it's on the radio during what tends to be my evening commute. They do a really good job of making sense for the layman about how the financial world works. They also have a weekly hour-long show on Fridays call Marketplace Money that is focused on personal finance. Also very good stuff. It's probably running on your local NPR station, and it also gets podcasted.
First of all, thanks to Uncle Mikey for pimping me over in Uncle Mikey Explains the Inexplicable. If you somehow stumbled here through some other pathway, go over and see his take on the game.
Second, if you're looking for a regular dose of what-the-heck-is-this-stuff in the finance world, but presented in a way that non-finance types can understand, check out American Public Media's Marketplace. I've been listening for the past year and a half because it's on the radio during what tends to be my evening commute. They do a really good job of making sense for the layman about how the financial world works. They also have a weekly hour-long show on Fridays call Marketplace Money that is focused on personal finance. Also very good stuff. It's probably running on your local NPR station, and it also gets podcasted.
Wednesday, October 1, 2008
Mortgage slaw
Okay folks, we all know we're in this mess because of mortgage-backed securities, right? Good. So what the heck is a mortgage-backed security, how did they become such a problem?
Mortgage-backed securities are a specific type of Collateralized Debt Obligation (or CDO). There are other kinds of CDOs out there, but they all take the same basic form, so let's illustrate with mortgages, 'cause that's what's in our epicenter right now anyway.
In a traditional universe, if I need a mortgage, say for $100,000, I go to my bank. The bank takes $100,000 from other folk's savings accounts and gives it to me. Over the next thirty years, I pay that back with interest, and the bank in turn pays interest to the folks with savings accounts (although they pay less than they take in, thereby resulting in the bank's profit). There's often more to it than that, but that's the general idea.
Now, if I default on my mortgage (i.e. I don't pay), the bank forecloses on my house, sells it off, and hopefully gets enough on that sale to cover however much of the loan I hadn't paid off. If they don't, they have a loss.
With a CDO, the bank takes a bunch of those mortgages (let's say 100 of them), and bundles them up into a corporate entity that holds them. That corporate entity sells bonds to investors (bonds == corporate loan borrowing). The people who took out the mortgages make their monthly payments, those payments are aggregated together and then chopped up and handed out to the folks who bought the bonds. (Of course, the bank skims some money off in between...it's good to be the middleman.)
What does the bank get out of this? An easy way to raise the money to fund more mortgages.
What does the investor get? An easy way to get a steady income while mitigating the risk because of the assumption that while one of those 100 mortgages may go bad, what are the chances of them all failing? (Insert hysterical laughter and 20-20 hindsight here.)
Now, the folks who play these games aren't entirely foolish. They know that there are risks involved. In fact, they built very complicated mathematical models to figure out the risks involved, and then bought insurance for the bonds just in case. This insurance helped get the bonds a AAA rating (the best) so they didn't look like risky investments at all.
Go a step further, now. The scenario I just described is oversimplified even compared to the simplest of CDOs. Many of them got sliced and diced again and again, fed into mutual funds, and so on. Which means it got very very very difficult to actually assess the risk involved. But people didn't care 'cause they were making money hand over fist.
Until the foreclosures started hitting in droves. Oops.
You see, these bonds were used to generate funds for sub-prime loans. These are loans for folks who's credit is shaky enough that they don't qualify for regular loans. Most of them were adjustable rate mortgages, many had "teaser" rates so that the initial payments were low enough that the person could pay, but the real payment kicked them in the butt. Folks fell behind. Went into default. Lost their house.
Eventually, enough houses got thrown onto the market that instead of climbing, house prices started falling. Now you've got folks who are upside-down on their loan (i.e. they owe more than their house is worth) and no hope of refinancing. The foreclosures cascade.
Now the folks on Wall Street start to look at these CDOs they have, and wonder how many foreclosures really are buried in them. They look and realized they really can't tell. And if there is one thing that will turn the bowels of a Wall St financier to water, it's uncertainty. Losing money is one thing. Not knowing how much you just lost...that's, well, unthinkable.
These are folks who had been trading around these CDOs more or less as cash. But now they don't want to buy them, because nobody knows if any one of them is a turd wrapped in pretty paper or not. Which means there is suddenly no market for this stuff. Which makes things sticky when the accounting rules say you have to value things at their current market price.
Which leads us to where we are now, where banks won't lend money to each other because the stuff they'd normally use as collateral for the loans (these CDOs and such) have essentially no value. At least not a value that can be trusted.
So that's the story of mortgage-backed securities, or at least as much of it as I can capture in one sitting.
Mortgage-backed securities are a specific type of Collateralized Debt Obligation (or CDO). There are other kinds of CDOs out there, but they all take the same basic form, so let's illustrate with mortgages, 'cause that's what's in our epicenter right now anyway.
In a traditional universe, if I need a mortgage, say for $100,000, I go to my bank. The bank takes $100,000 from other folk's savings accounts and gives it to me. Over the next thirty years, I pay that back with interest, and the bank in turn pays interest to the folks with savings accounts (although they pay less than they take in, thereby resulting in the bank's profit). There's often more to it than that, but that's the general idea.
Now, if I default on my mortgage (i.e. I don't pay), the bank forecloses on my house, sells it off, and hopefully gets enough on that sale to cover however much of the loan I hadn't paid off. If they don't, they have a loss.
With a CDO, the bank takes a bunch of those mortgages (let's say 100 of them), and bundles them up into a corporate entity that holds them. That corporate entity sells bonds to investors (bonds == corporate loan borrowing). The people who took out the mortgages make their monthly payments, those payments are aggregated together and then chopped up and handed out to the folks who bought the bonds. (Of course, the bank skims some money off in between...it's good to be the middleman.)
What does the bank get out of this? An easy way to raise the money to fund more mortgages.
What does the investor get? An easy way to get a steady income while mitigating the risk because of the assumption that while one of those 100 mortgages may go bad, what are the chances of them all failing? (Insert hysterical laughter and 20-20 hindsight here.)
Now, the folks who play these games aren't entirely foolish. They know that there are risks involved. In fact, they built very complicated mathematical models to figure out the risks involved, and then bought insurance for the bonds just in case. This insurance helped get the bonds a AAA rating (the best) so they didn't look like risky investments at all.
Go a step further, now. The scenario I just described is oversimplified even compared to the simplest of CDOs. Many of them got sliced and diced again and again, fed into mutual funds, and so on. Which means it got very very very difficult to actually assess the risk involved. But people didn't care 'cause they were making money hand over fist.
Until the foreclosures started hitting in droves. Oops.
You see, these bonds were used to generate funds for sub-prime loans. These are loans for folks who's credit is shaky enough that they don't qualify for regular loans. Most of them were adjustable rate mortgages, many had "teaser" rates so that the initial payments were low enough that the person could pay, but the real payment kicked them in the butt. Folks fell behind. Went into default. Lost their house.
Eventually, enough houses got thrown onto the market that instead of climbing, house prices started falling. Now you've got folks who are upside-down on their loan (i.e. they owe more than their house is worth) and no hope of refinancing. The foreclosures cascade.
Now the folks on Wall Street start to look at these CDOs they have, and wonder how many foreclosures really are buried in them. They look and realized they really can't tell. And if there is one thing that will turn the bowels of a Wall St financier to water, it's uncertainty. Losing money is one thing. Not knowing how much you just lost...that's, well, unthinkable.
These are folks who had been trading around these CDOs more or less as cash. But now they don't want to buy them, because nobody knows if any one of them is a turd wrapped in pretty paper or not. Which means there is suddenly no market for this stuff. Which makes things sticky when the accounting rules say you have to value things at their current market price.
Which leads us to where we are now, where banks won't lend money to each other because the stuff they'd normally use as collateral for the loans (these CDOs and such) have essentially no value. At least not a value that can be trusted.
So that's the story of mortgage-backed securities, or at least as much of it as I can capture in one sitting.
Tuesday, September 30, 2008
Financial lubricants
Nobody really questions the fact that the financial world is in a pickle right now. But it's clear that the $64,000 question (or $700 billion) is "What do Wall Street's woes have to do with Main Street?"
Well, a whole lot and not very much at the same time. Mostly, the current crisis has made it clear how complex the financial world has become. Since my "mission" here is to try to see both sides of the issues and (hopefully) find the balancing point somewhere in between, let's see if we can explore it a bit from that perspective.
Actually, let me start at the divergent perspectives, and see if I can capture them.
For the average taxpayer (i.e. Main Street), this is a story about how a bunch of greedy investment bankers made some bad bets and are having to pay the piper. It affects me because maybe my 401k or pension plan bought into some of those bad bets, and if I was close to retirement that's gonna put me a bit less close to retirement. It affects me because a high foreclosure rate in my area may be depressing my home price, but as long as I'm in a 30-year fixed mortgage and not planning on moving real soon, I'll be okay. So why should I be asked to take on a big expense to save these guys who should have known better? Why are government officials who for the past 8 years have been preaching fire-and-brimstone against regulation and government involvement suddenly looking to buy into all of the financial institutions they said needed to be left alone?
For the financial community (i.e. Wall Street) it's obvious why something needs to be done, and they're rather afraid it won't happen in time (hence yesterday's precipitous drop in the markets after the House rejected the bailout bill).
Hmm...but to understand that we need to grok liquidity, the lubricant of the financial world.
You see, banks lend money to each other all the time. And when I say "money", I use it as a specific financial term. Money, or Cash, in the financial world is something that is liquid. It flows. It can be used immediately as needed. You can buy things with it. You can sell things to get it (but someone has to have some to buy with). It is the lubricant of the financial system. When you put your savings into a money market account, as opposed to a savings account or a mutual fund or a CD or some other investment, your money goes into that giant pool of money that sloshes around the world. This, in fact, is why you get a better interest rate on money market accounts than regular savings... the banks have more leeway to play with it, so they pay you better.
So, you've got these money markets that provide flows of money to slosh around the world. When a bank loans money to another bank, they need to provide collateral (just as when you get a car loan or a mortgage the car or the house is collateral for the loan). Often, this collateral takes the form of bonds (basically, a piece of a long-term loan) or other financial "instruments" which are less liquid than the cash being borrowed. This system generally runs smoothly because the bonds that are used as collateral for those short-term loans are rated by agencies, and so the lender in principle has some assurance that it is "good paper" (as opposed to, say, junk bonds that are "not worth the paper they're printed on"). Of course, all of this is in computers these days and very little is actually on paper, but that's beside the point.
In general, this system works. The problem that we're having right now is that it has stopped working. Why? Because banks don't trust each other to have "good paper" to back the short-term loans they're making, so they're not making those short-term loans. It's not that the money doesn't exist. It's that it's not flowing the way it's supposed to flow, because the trust upon which that flow depends has been broken. Once that happens, the bankers are struck with the fear that they won't be able to conduct business the way they want to. Since they can't borrow, they stop lending, which means other banks can't borrow, so they stop lending, and so on.
How does this move from Wall Street to Main Street? Well, the fear (and to some degree, the reality) is that eventually as banks are unable to borrow from each other, they stop lending to us. They stop lending to people who want to buy cars and houses. They shut down the lines of credit that let small businesses operate. (For example, when you buy home heating oil, you buy 150 gallons delivered, and you either have an agreement with the delivery guy or you pay cash on delivery. When he gets his tanks filled, he needs to pay for 10,000 gallons all at once, long before he delivers it to you and your neighbors. And he has to pay the delivery guy even if you don't pay him promptly, etc. So he needs a credit line to float his expenses until the real money comes in.)
So the fear is that the lack of financial lubrication on Wall St. will cascade out into a lack of lubrication in the larger economy, and then it really hits the fan.
Okay...that's all for now. Next episode will be about what we keep hearing about: mortgage backed securities, CDOs, and other things that would never exist if we had kept to the path and never allowed the spheres of "creative" and "accounting" to intersect. These things are at the root of the liquidity crisis, and understanding how they work and came to be and such will help in understanding why this crisis is so widespread and so potentially disastrous.
Well, a whole lot and not very much at the same time. Mostly, the current crisis has made it clear how complex the financial world has become. Since my "mission" here is to try to see both sides of the issues and (hopefully) find the balancing point somewhere in between, let's see if we can explore it a bit from that perspective.
Actually, let me start at the divergent perspectives, and see if I can capture them.
For the average taxpayer (i.e. Main Street), this is a story about how a bunch of greedy investment bankers made some bad bets and are having to pay the piper. It affects me because maybe my 401k or pension plan bought into some of those bad bets, and if I was close to retirement that's gonna put me a bit less close to retirement. It affects me because a high foreclosure rate in my area may be depressing my home price, but as long as I'm in a 30-year fixed mortgage and not planning on moving real soon, I'll be okay. So why should I be asked to take on a big expense to save these guys who should have known better? Why are government officials who for the past 8 years have been preaching fire-and-brimstone against regulation and government involvement suddenly looking to buy into all of the financial institutions they said needed to be left alone?
For the financial community (i.e. Wall Street) it's obvious why something needs to be done, and they're rather afraid it won't happen in time (hence yesterday's precipitous drop in the markets after the House rejected the bailout bill).
Hmm...but to understand that we need to grok liquidity, the lubricant of the financial world.
You see, banks lend money to each other all the time. And when I say "money", I use it as a specific financial term. Money, or Cash, in the financial world is something that is liquid. It flows. It can be used immediately as needed. You can buy things with it. You can sell things to get it (but someone has to have some to buy with). It is the lubricant of the financial system. When you put your savings into a money market account, as opposed to a savings account or a mutual fund or a CD or some other investment, your money goes into that giant pool of money that sloshes around the world. This, in fact, is why you get a better interest rate on money market accounts than regular savings... the banks have more leeway to play with it, so they pay you better.
So, you've got these money markets that provide flows of money to slosh around the world. When a bank loans money to another bank, they need to provide collateral (just as when you get a car loan or a mortgage the car or the house is collateral for the loan). Often, this collateral takes the form of bonds (basically, a piece of a long-term loan) or other financial "instruments" which are less liquid than the cash being borrowed. This system generally runs smoothly because the bonds that are used as collateral for those short-term loans are rated by agencies, and so the lender in principle has some assurance that it is "good paper" (as opposed to, say, junk bonds that are "not worth the paper they're printed on"). Of course, all of this is in computers these days and very little is actually on paper, but that's beside the point.
In general, this system works. The problem that we're having right now is that it has stopped working. Why? Because banks don't trust each other to have "good paper" to back the short-term loans they're making, so they're not making those short-term loans. It's not that the money doesn't exist. It's that it's not flowing the way it's supposed to flow, because the trust upon which that flow depends has been broken. Once that happens, the bankers are struck with the fear that they won't be able to conduct business the way they want to. Since they can't borrow, they stop lending, which means other banks can't borrow, so they stop lending, and so on.
How does this move from Wall Street to Main Street? Well, the fear (and to some degree, the reality) is that eventually as banks are unable to borrow from each other, they stop lending to us. They stop lending to people who want to buy cars and houses. They shut down the lines of credit that let small businesses operate. (For example, when you buy home heating oil, you buy 150 gallons delivered, and you either have an agreement with the delivery guy or you pay cash on delivery. When he gets his tanks filled, he needs to pay for 10,000 gallons all at once, long before he delivers it to you and your neighbors. And he has to pay the delivery guy even if you don't pay him promptly, etc. So he needs a credit line to float his expenses until the real money comes in.)
So the fear is that the lack of financial lubrication on Wall St. will cascade out into a lack of lubrication in the larger economy, and then it really hits the fan.
Okay...that's all for now. Next episode will be about what we keep hearing about: mortgage backed securities, CDOs, and other things that would never exist if we had kept to the path and never allowed the spheres of "creative" and "accounting" to intersect. These things are at the root of the liquidity crisis, and understanding how they work and came to be and such will help in understanding why this crisis is so widespread and so potentially disastrous.
Tuesday, May 27, 2008
Health Care "Markets"
The health care system in the US is broken. Anyone who tells you otherwise is selling something. And that, I think, is part of the problem. Our health care system has been dominated by a market philosophy which simply doesn't work.
Why doesn't free-market philosophy apply to health care? Because in order for market forces to do their job, sellers have to have discretion over what they offer at what price, and buyers have to have discretion over what they buy and when. Under those circumstances, if a particular seller is charging more than the market will bear, buyers go somewhere else or hold out until the price drops. If the quality from one provider is insufficient to satisfy the demands of the buyers, they'll look for higher quality elsewhere (even for a premium price).
So, what are the factors in the health care world that break this model:
1) Limited choice of insurers: Generally, due to the employment-based foundation of the health insurance system, people have little or no choice about what insurance provider or policy to take. Pretty much, it's a take-it-or-leave-it proposition. Technically, one could waive the employer-provided insurance and buy separate insurance out of pocket, but between the tax incentives and the employer contributions, it is simply not an option for the vast majority of people. So instead you get a single choice negotiated by the employer.
2) Limited choice of medical providers: Once you get outside a major metropolitan area, the number of potential providers drops to the point where there is very little competition. In rural areas, there may only be one hospital in any sort of reasonable distance. Maybe there's only one local doctor, or a single local group practice.
3) No basis for comparison. How can you evaluate the quality of care from various providers? The information on care quality is difficult to find, especially in meaningful form. Patient confidentiality means there's no easy way to change that, too.
4) "The best for everyone." Here we get into some of the squishy cultural issues. There is a desire in our culture to provide everyone with the top-notch care available. Everyone wants the best, newest, most effective treatment option. I'm not saying they shouldn't -- I certainly would. However, often the newest, best, most effective treatment option is much more expensive than the basic version. Compare the cost of a 10-day course of penecillin or another generic antibiotic to a 10-day course of one of the newer, name brand versions. Maybe the name-brand is time-released so you only have to take it twice a day instead of four times. Or maybe you only take a 5-day course instead of 10. But for how much more cost? For me, not much, because I'm lucky enough to have a good plan that has fairly low co-pays on prescriptions. But if I was paying cash and had to choose between $200 for the high-end and $5 for 40 tabs of penicillin? I'd have to think about that. It's a tough issue. Insurance obscures the true costs so people have no incentive to make reasonable decisions. When you're sitting in the doctor's office, the focus is on the medical side, not the financial side. The doctor may or may not know offhand what the relative prices are, and a lot of people are probably not going to feel comfortable saying, "gee doc, is that expensive? Is there a cheaper option that will get the job done?"
What else is out there?
Why doesn't free-market philosophy apply to health care? Because in order for market forces to do their job, sellers have to have discretion over what they offer at what price, and buyers have to have discretion over what they buy and when. Under those circumstances, if a particular seller is charging more than the market will bear, buyers go somewhere else or hold out until the price drops. If the quality from one provider is insufficient to satisfy the demands of the buyers, they'll look for higher quality elsewhere (even for a premium price).
So, what are the factors in the health care world that break this model:
1) Limited choice of insurers: Generally, due to the employment-based foundation of the health insurance system, people have little or no choice about what insurance provider or policy to take. Pretty much, it's a take-it-or-leave-it proposition. Technically, one could waive the employer-provided insurance and buy separate insurance out of pocket, but between the tax incentives and the employer contributions, it is simply not an option for the vast majority of people. So instead you get a single choice negotiated by the employer.
2) Limited choice of medical providers: Once you get outside a major metropolitan area, the number of potential providers drops to the point where there is very little competition. In rural areas, there may only be one hospital in any sort of reasonable distance. Maybe there's only one local doctor, or a single local group practice.
3) No basis for comparison. How can you evaluate the quality of care from various providers? The information on care quality is difficult to find, especially in meaningful form. Patient confidentiality means there's no easy way to change that, too.
4) "The best for everyone." Here we get into some of the squishy cultural issues. There is a desire in our culture to provide everyone with the top-notch care available. Everyone wants the best, newest, most effective treatment option. I'm not saying they shouldn't -- I certainly would. However, often the newest, best, most effective treatment option is much more expensive than the basic version. Compare the cost of a 10-day course of penecillin or another generic antibiotic to a 10-day course of one of the newer, name brand versions. Maybe the name-brand is time-released so you only have to take it twice a day instead of four times. Or maybe you only take a 5-day course instead of 10. But for how much more cost? For me, not much, because I'm lucky enough to have a good plan that has fairly low co-pays on prescriptions. But if I was paying cash and had to choose between $200 for the high-end and $5 for 40 tabs of penicillin? I'd have to think about that. It's a tough issue. Insurance obscures the true costs so people have no incentive to make reasonable decisions. When you're sitting in the doctor's office, the focus is on the medical side, not the financial side. The doctor may or may not know offhand what the relative prices are, and a lot of people are probably not going to feel comfortable saying, "gee doc, is that expensive? Is there a cheaper option that will get the job done?"
What else is out there?
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