Markets Bet Against The Discovery of A Higgs Boson Particle

Observation of the Higgs Boson Particle
Higgs Boson Particle to be observed on/before 31 Dec 2013.


Intrade markets bet against a Higgs Boson particle found before December 31, 2013. The price has dropped from 50 to 29 in the last few months even as the Large Hadron Collider began to smash sub-atomic particles together and record the data of their collisions for analysis.

The Higgs Boson is considered the most likely current candidate for our understanding of mass. If the LHC does not find a Higgs Boson then alternative theories of mass will become much more likely.

if the Higgs Boson does not exist, then the very successful Standard Model of particle physics will have to be reworked.

To date all tests confirm the Standard Model, which unites and explains the three of the four main forces of nature, the weak force, the strong force and the electromagnetic force. It does not explain or unite with the other three forces, the fourth force, gravity. It also does not explain dark matter or dark energy.

Broken Window Fallacy Video

(HT: Cafe Hayek, Don Boudreaux)

ObamaCare Highlights Weaknesses Of CBO Cost Estimating Process

To prevent unrealistic Congressional Budget Office projections of the effects of proposed legislation on the US deficit and budget, CBO must make changes to its process for evaluating the cost of new legislation.

In passing health care reform, Congress was mindful of the Congressional Budget Office's tally over the next decade of the net cost of the final legislation. In particular, Congress manipulated the structure and timing of the law's taxing and spending provisions to meet Obama's $900 billion cost target.

CBO does an honest, best guess analysis of the expected costs of proposed legislation, but CBO works within the cost estimating guidelines established by Congress. For example, CBO projects expected revenues and costs from new legislation under the assumption of a static economy, and it ignores the effect of other likely legislation.

Unrealistically, CBO estimates that new taxes or new mandated employer costs do not change consumption or tax revenue estimates. When economists model tax or price changes, they use more realistic dynamic stochastic general equilibrium (DSGE) models and not static models. DSGE models attempt to accurately reflect behavioral changes caused by tax, cost and price changes. DSGE models of the new health care reform law would show that the new law slows economic growth, slows employment growth, and that tax revenue will be lower than expected.

Furthermore, CBO follows rules that require it to evaluate only the legislation under review and not to consider other likely Congressional laws. For example, in recent years, Congress passed a one-year law delaying legally mandated Medicare cuts. When CBO evaluated ObamaCare, it included the new Medicare cuts in ObamaCare as potential cost savings because they are legally mandated. It ignored the high likelihood that Congress would pass another law delaying or reducing the proposed Medicare cuts. It also ignored that Medicare cost increases were unsustainable and that Congress would pass cuts out of necessity without the passage of ObamaCare.

As a result of CBO's process, the new health reform law contains tax and cost saving provisions that reduce CBO's cost estimate and increase CBO's revenue estimates but that do not reflect realistic, real world, estimates of those numbers.

A President and a Congress who truly cared about the long-term US deficit, the looming high taxes, and the continued affordability of government social programs would modify CBO's process for assessing the costs and revenues of new programs, taxes, and legislation to reflect real world effects.

To accurately reflect the growth, employment, tax and cost effects of new legislation, the CBO must modify its legislative cost and revenue estimating process. CBO needs to switch to a dynamic, as opposed to static, modeling of the economic effects of new legislation. It also needs to take into account likely subsequent legislation that would undo part of the revenue or cost benefits of the legislation under review.

It would make a lot more sense for CBO to give separate numbers and a range as part of its analysis instead of one net number. CBO should give a range, under dynamic modeling, for likely costs and likely revenue of the new legislation and a likely high and low net cost. Additionally, CBO should forecast the effects of the passage of other likely legislation that would significantly affect the costs or revenue impacts of the legislation under review.

The proper changes to CBO's cost estimating process would eliminate a lot of the unrealistic political budget deficit gamesmanship that occurred during the debate for health care reform. The suggested changes would improve the accuracy and usefulness of CBO's forecasts. A better CBO forecasting process will also help the US reduce its long-term budget deficit.

The New Health Care Law Is a Temporary Duct Tape Solution: It Ignores The Basic Economic Forces At Play

Drafting a good [health care reform] bill would have been easy, he [Nobel Economist Gary Becker] continues. Health savings accounts could have been expanded. Consumers could have been permitted to purchase insurance across state lines, which would have increased competition among insurers. The tax deductibility of health-care spending could have been extended from employers to individuals, giving the same tax treatment to all consumers. And incentives could have been put in place to prompt consumers to pay a larger portion of their health-care costs out of their own pockets.

"Here in the United States," Mr. Becker says, "we spend about 17% of our GDP on health care, but out-of-pocket expenses make up only about 12% of total health-care spending. In Switzerland, where they spend only 11% of GDP on health care, their out-of-pocket expenses equal about 31% of total spending. The difference between 12% and 31% is huge. Once people begin spending substantial sums from their own pockets, they become willing to shop around. Ordinary market incentives begin to operate. A good bill would have encouraged that."

From "'Basically an Optimist'—Still: The Nobel economist says the health-care bill will cause serious damage, but that the American people can be trusted to vote for limited government in November," by Peter Robinson in the Wall Street Journal on March 27, 2010.

Just because the new health care reform law was a tough political battle, it will not be the end or the solution to US health care problems.

The new health care law, including its amendments, does little or nothing to undo the economic incentives and forces created by the tax deduction to the employer of the health care employee benefit, the exclusion from employee taxable income of the value of their health care benefit, the expectation that health insurance will cover all health related costs, that health related costs are primarily paid by third party payers with no incentive for the user to limit or negotiate costs, government mandates of excessive minimum coverage, and the inability to risk price insurance.

Any architect who ignores the physical laws of nature, such as gravity and the structural strength of his materials, will watch his building collapse before his eyes. The new health reform law ignores all the economic and incentive forces at play in current health care and attempts to contain these forces through patches and duct tape. The new health care law is doom to failure. It is just a matter of time until the forces created by the employer tax deduction, the third party insurance payment system, and the lack of price transparency to the end user make the new law unworkable.

Additionally, the new law uses extensive government subsidy to avoid accurate price setting and price transparency. Without market pricing, poor allocation of resources and rationing will occur.

Just as gravity never ceases, the old economic forces that remain after health reform will create a mess of US health care costs and use under the new law.

See my December 15, 2009, post, "Health Care Reform Is Easy: Politics Is Hard"

What's Next For US Healthcare?

The new health care law, with or without amendments, is a yet to be built structure. It is an architect's plan of an interpretation of a vision of health care. There are stated and unstated goals that will or will not be met in the final structure once it is erected.

No one truly knows what the final health care system will look like. No one understands how all the parts, all the regulations, all the economic forces, all the wealth distribution, all the changes to health insurance, health care, Medicare, and taxes will interact.

No one knows what GDP effects the new law will have on the health care sector or the entire US economy. No one knows what effect the new spending and most likely increased US debt will have on the Treasury market and on the US dollar.

It will be years before the law is fully implemented and the parts that are set into motion are then again stable.

The Second World War wage freeze indirectly created the employer health care employee benefit and it became one of the prime movers of health care problems 60 years later. Likewise, the new law in a couple of decades will put the US in an economic and political situation it never envisioned.

There are risks to rolling stones down hills. Sometimes, they create avalanches. Sometimes, they are just a few stones rolling down hill.

It is impossible for anyone to say the US will be better or worse for the new law at this time. It will be years before any accurate assessment of the new law will occur.

Like any new house built from plans, there will be some good parts, some minor, easily fixed structural problems, some emergency repairs, some wish list changes and some I learned my lesson never to do again problems.

As of Tuesday, US health care is a ship that has entered uncharted waters. Whether it easily reaches port or faces dangers along the way is unknown. Let us hope enough watchful eyes know how to keep health care on course as it navigates new, uncharted waters. Let us hope the architect's plans of the new structure were enough to build a lasting and sound edifice.

My best guess is that the parts of current health care that people like that are no longer available will be put back into health care. The new parts that people like will stay. Proposed spending cuts that are politically difficult will not be made.

In the end, the US will wind up with an amalgam of old and new health care in a structure that no one envisioned as part of the new legislation with a cost structure very different than projected.

Kling On Mankiw On Banks And Modigliani-Miller

A comment I posted on EconLog, "Banks and Modigliani-Miller" by Arnold Kling:

The Fisher separation theorem says that the investors (shareholders, depositors) are not concerned with the investment choice opportunities (the fruit trees) of the bank, as long as the bank invests in positive NPV (net present value) projects. Investors choose their own positive NPV investment opportunities for their own funds separate from the bank's investment opportunities.

MM [Modigliani-Miller] says that the value of the firm, and consequently, the NPV (net present value) of the projects, is independent of the way that the projects and the firm (bank) are financed.

To the extent that a firm can take a tax deduction for interest payments, the deduction is a government subsidy to firms. It allows borrowers to pay, and the lenders to demand, a higher interest rate due to the government subsidy, which by itself should offset the benefit of the tax deduction. If the lender is also taxed on the interest income, then the two taxes will offset each other. If the taxes are equal, then it will be as if there were no interest deduction and if the two taxes are different amounts, a new equilibrium supply and demand point (interest rate cost of borrowing) will occur depending on which tax is higher and by how much. If the two taxes are equal, as they most likely are, the interest deduction will have no effect on leverage. Likewise, if there is only a tax deduction there will be no effect on leverage due to the higher interest rate. It is only when there are different income and deduction tax rates, that there will be some minor leverage effect.

Deposit insurance is a put option (all insurance is a put option) given to the depositor through the bank by the FDIC. Because deposit rates do not risk adjust due to the put, the bank can invest in a greater number of projects with apparent positive NPVs due to low cost deposits. Some of these projects would have a negative NPV if the deposit interest rate adjusted for the riskiness of the project and the bank. The market, however will risk adjust the rate and treat some apparent positive NPV projects as negative NPV projects and decrease the value of the publicly trade stock of the bank.

Deposit insurance fools management, not depositors, as to their available investment projects.

The deposit insurance will have little or no value to the depositor as long as the market value of the assets of the bank is greater than the value of the deposits. The put option will be out of the money. As the market value of the assets declines, due to bad investments, and no longer covers the amount of the deposits, the put option (the FDIC insurance) becomes in the money and increases substantially in value.

Since the bank transfers its assets to the FDIC for the insurance (put) payment of the deposits to the depositors, the FDIC bears all the risk and monetary loss. The FDIC insurance is only paid when deposits exceeds assets. The FDIC pays the full amount of the deposits and loses the excess amount of the deposits over the value of the assets it receives, deposits minus assets.

The essential transparency that is lacking is the value of the FDIC insurance put by institution. However, the publicly traded equity of the bank reflects both the true NPV of the projects on a risk-adjusted cost of financing and reflects the decrease value of the bank due to the value of the put due to the probability of the exercise of the FDIC put and takeover of the bank by the FDIC.

In effect, tax deductions do not increase leverage because it will increase the cost of borrowing and are probability probably completely offset by the tax on interest income.

Deposit insurance allows banks to invest in otherwise negative risk adjusted NPV projects. While deposit insurance allows banks to invest in unprofitable and negative NPV endeavors, the market price of the asset will be independent of deposit costs or deposit insurance. This is the liquidity funding problem. Banks can have enough funds to invest in a positive NPV valued asset that does not have enough market value to roll over as collateral to fund the asset.

Long-term rates are just the (geometric) average of expected short term rates except for the short-term liquidity premium, and banks will on average just make a small liquidity premium spread. Since long-term rates are just expected averages of short-term rates, half the time the short-term rates will be less then the long-term rates and half the time more than the long-term rate [after adjusting for the short-term liquidity premium]. Half the time, the bank will have a positive interest rate spread and half the time it will have a negative interest rate spread.

The New Health Care Law Until The Reconciliation Bill Passes

HR 3590, "The Patient Protection and Affordable Care Act" will be the law of the land and the current version of health care law when signed by the President as expected on Tuesday.

The House also passed a subsequent Reconciliation Bill, HR 4872, "Reconciliation Act of 2010" to amend the health care bill they just passed.

The Reconciliation Bill requires a Senate vote to become law and will not become an amendment to the new health care law until the Senate and the House pass, and the President signs, the same reconciliation amendment.

CBO Scoring Convention Assumes GDP Unchanged By Health Care Reform And Other Laws

When they [CBO] estimate the budget impact of a bill like this [Health Care and Education Affordability Reconciliation Act of 2010], they assume the path of GDP is unchanged....it is just one of the conventions of budget scoring.

From Greg Mankiw's Blog, "A Warning about CBO Scoring."

Did A M3 Decline Blindside The Fed And Cause The Economic Crisis

wondering how M3 has behaved compared to M2 or M1 during this crisis. Based on [Gary] Gorton's discussion it would seem that M3 would better reveal the impact of the crisis.

From "The Correct Money Supply Measure for This Crisis" by David Beckworth on the Macro and Other Market Musings blog.

FYI: Money Supply Definitions from Wikipedia:

• M3: M2 + all other CDs (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements.
  
• M2: M1 + most savings accounts, money market accounts, retail money market mutual funds,and small denomination time deposits (certificates of deposit of under $100,000).
  
• M1: The total of all physical currency part of bank reserves + the amount in demand accounts ("checking" or "current" accounts).

Gary Gorton's paper mentioned by Beckworth with thanks to Mark Thoma is well worth a read. It is an excellent explanation of the mechanism that turned a housing crisis into a banking crisis and an economic recession. The upshot is that the Fed was not watching the repo market as it collapsed and failed to take timely corrective action to replenish this loss of liquidity.

[Addendum: regulation2point0 blog mentioned Gorton's paper on March 6, 11 days before Thoma.]

Large And Small Financial Bubbles Are Similar

Statistically speaking, size doesn’t matter when a financial bubble bursts.

The big crashes may hurt a lot more, but new analyses of “microbubbles” presented March 15 at a meeting of the American Physical Society find that the same mathematical laws underlying massive economic crises are also at work in tiny fluctuations that occur on the order of milliseconds.

The new understanding of economic fluctuations both big and small doesn’t predict when the next economic meltdown will wreak havoc on retirement accounts, said study coauthor H. Eugene Stanley of Boston University. But the results help describe complex financial fluctuations and reinforce the idea that governments ought to have a contingency plan in place for the calamitous collapses that his research describes as inevitable, Stanley said.

From "Big or small, financial bubbles burst alike: Even when they inflate and collapse in milliseconds, the same rules" apply By Laura Sanders in ScienceNews. [Article link updated.]

Intrade Obamacare Security Collapses Overnight: Loses 50% Value

The Intrade prediction market security that tracks Obamacare lost 50 percent of its value overnight as Bloomberg reported "Health-Care Bill Faces Delay as Democrats Struggle With CBO."

The contract closed on Tuesday at 70.3 and last traded this morning as of 3 AM ET at 35.1.

The security terms require 'Obamacare' health care reform to become law before midnight ET 30 Jun 2010.

Users Rationally Reject Security Advice

It is often suggested that users are hopelessly lazy and unmotivated on security questions. They chose weak passwords, ignore security warnings, and are oblivious to certificates errors. We argue that users' rejection of the security advice they receive is entirely rational from an economic perspective. The advice offers to shield them from the direct costs of attacks, but burdens them with far greater indirect costs in the form of effort. Looking at various examples of security advice we find that the advice is complex and growing, but the benefit is largely speculative or moot.

From "So Long, And No Thanks for the Externalities: The Rational Rejection of Security Advice by Users" by Cormac Herley, Microsoft Research. (HT:Slashdot)

Madoff Is A Case Of SEC Dysfunction

Below is a comment I posted on "Regulators are from Mars, Investors are from Venus?" by Lisa Fairfax on the Conglomerate Blog.

Madoff is a case of SEC dysfunction.

Madoff's crime is a simple form of affinity fraud. A gullible group with some cohesion, similarities and member trust is targeted, such as church groups, religious groups, ethnic groups, immigrant groups, country club members, etc. The fraudster relies on members of the group to introduce other members to the fraud. The referral and implicit trust among members of the group makes the job of the fraudster easier than if he targeted strangers.

The SEC has prosecuted affinity frauds for years. Yet, it does not ask questions during an exam to determine if the investors have any commonality that would suggest the possibility of an affinity fraud. A simple question such as how did you find the investor would have indicated to the SEC that most of Madoff's investors were referrals from a few small social circles and indicated the extremely high likelihood of affinity fraud.

Similarly, standard audit procedures include selectively confirming transactions with third parties, such as vendors, banks, customers, etc. Only in the last year, after Madoff, has the SEC adopted these well-established audit procedures. A true audit process would have found that the assets did not exist. The SEC at the time of Madoff's fraud did not even have standards for outside audit firms or standards to determine if there were possibilities of conflict and collusion between the auditors and the firms.

Furthermore, Madoff's reported long run of positive returns to investors should have been a signal to the SEC. The returns were too good to be true and unlike the returns of other investment managers. Several banks and brokerage firms did not do business with Madoff because his returns were suspicious. Why is the SEC isolated from the information available to other investment firms on the street?

We have an SEC that does not incorporate its own knowledge of fraud into its examinations, does not use standard business practices and audit procedures and has isolated itself from common industry knowledge. It is not due to a lack of staff or funding. It is an SEC internal cultural problem. The SEC had enough funds to investigate and examine Madoff. The SEC did a poor job and did not find any problems.

The Madoff case shows that the SEC is ill prepared to protect investors. The Commission needs to develop heuristics based on its history with investor fraud and act more wisely with the funds and tools it has. It needs to improve communication between itself and firms on the street. It needs to rid itself of most of its lawyers and remove the adversarial process that is part and parcel of its culture.

If one actually reviewed the SEC's ability to prevent investor fraud since its founding, I think one would probably find that the SEC does a poor job of preventing investor fraud.

GDP Bond Addition To My February 18 Post "Limits Of Econometric Models ..."

The following is an addendum to my February 18, 2010 post, "Limits Of Econometric Models Of The Macro-Economy". It is reprint of a comment I wrote in early 2009 about using GDP bonds to reveal investor expectations of future US GDP growth.

Why not try a different approach to forecast the economy directly based on rational expectations and the securities markets. Along the lines of TIPS securities, the US Treasury (at the insistence and lobbying of economists) could issue securities whose prices are transparently dependent on future GDP. Different, acceptable forms of securities based on future GDP are possible.

One form could be a US Treasury bond that had a semi-annual interest payment that was a single, fixed percentage (determined at issuance time by a Treasury auction process) of published US nominal GDPs (nominal since cash flows are discounted by nominal interest rates) at the time of the scheduled semi-annual interest payments. Issuance of securities with differing maturities and with the aging of seasoned securities would allow computation of a GDP forward rate yield curve and computation of expected future real GDP growth for different periods. Of course, some might want to make corrections for tax effects, risk premiums, and other possibly distorting and biasing effects.

Another possible form of the security could be a discounted single principal payment at maturity bond that paid a fixed percentage (also determined at issuance through an auction) of US published GDP at time of maturity. Obviously, this percentage would be cumulative for the missed interest payments during the life of the bond, similar to principal only US Treasuries.

Whatever final forms this type of security took, as long as it is transparently dependent on future GDP, it would allow the computation of future real GDP expectations for different future periods. Additionally, other securities based on different macro-economic values can be developed.

A GDP security would also allow for event studies of the US economy and for studies of real time price movements due to government, geo-political, Fed and other actions. The volatility of these securities' prices will reflect a measure of the uncertainty of future GDP growth faced by businesses and others that must make decisions in anticipation of future economic growth. The securities could be used to determine a risk premium of the US economy and to see if it is time varying. It would also allow event studies of the effects of governmental actions on different future period GDPs.

Businesses could use options, futures and other derivatives on these securities to cheaply hedge against future GDP slowdowns and downturns. For example, while the auto industry, and other manufacturing industries, can hedge many raw material and commodity input costs, the new security would allow for a hedge for an unexpected economic slowdown that would cause an excessive inventory buildup.

Therefore, if macro-economic modeling has shortcomings, possibly some of them can be overcome by the use of the expectations embedded in a GDP dependent US bond. Of course, the assistance of the US Treasury Department in issuing a bond of this type is essential.

The above is a reprint of a comment I originally published over a year ago, February 13, 2009, on "Why Macro-Econometric Models Don't Work" on the EclectEcon blog.

Full Lehman Bankruptcy Examiner Report Publicly Available

The law firm of Jenner & Block is providing links to the 2200 page Lehman bankruptcy examiner report in nine PDF parts. The chairman of Jenner & Block, Anton R. Valukas, is the Examiner.

The Lehman Examiner's report is available here.

Scientists, Social Scientists, Economists Do Not Understand Statistics

Still, any single scientific study alone is quite likely to be incorrect, thanks largely to the fact that the standard statistical system for drawing conclusions is, in essence, illogical. “A lot of scientists don’t understand statistics,” says Goodman. “And they don’t understand statistics because the statistics don’t make sense.”

****

“Replication is vital,” says statistician Juliet Shaffer, a lecturer emeritus at the University of California, Berkeley. And in medicine, she says, the need for replication is widely recognized. “But in the social sciences and behavioral sciences, replication is not common,” she noted in San Diego in February at the annual meeting of the American Association for the Advancement of Science. “This is a sad situation.”

From the excellent article, "Odds are, it's wrong: Science fails to face the shortcomings of statistics" by Tom Siegfried, ScienceNews, March 27th, 2010; Vol.177 #7 (p. 26).

Also see my previous blog, "Limits Of Econometric Models Of The Macro-Economy."

Why New Drug Prices Are So High

Recently, Pfizer abandoned the development of a new drug after spending a billion dollars. Finding new drugs and navigating the FDA regulatory process is a risky endeavor. As Pfizer and other drug companies know, there are few successes, many failures and the cost of searching for and finding effective new medicines is high.

Despite the high costs of developing new drugs, the actual production cost of an effective and approved drug can be low. Companies that make generic versions of useful drugs can take advantage of low production costs and sell the medicines at a reduced price, once the original patents lapse. These generic drug companies do not have to recoup the funds they paid for finding, developing, proving effectiveness and marketing. They know the chemical formulas for the approved medicines, which work and have a market.

Let's make up an example to see how a generic drug company can sell a drug for a significantly lower price than a developing drug company can.

Let's say only 1 in 10 drug prospects is effective, gets regulatory approval and has a consumer market. If pharmaceutical companies spend a billion dollars on each of these prospective drugs, for each $1 billion spent on a successful drug, they spend $9 billion on unsuccessful drug efforts.

To attract funds to invest in new drug research, companies and investors expect a fair return for their money. Companies however do not know beforehand which drugs will be successful and which will be failures, which will pay them a return and which will lead to investment losses.

Let's say for this example a realized 5 percent return on the invested funds is a fair return. Since there is only a 1 in 10 chance of a successful drug and getting the fair return, an investor in all the drugs would like to see a 50 percent expected return from each project. Since there is a 1 in 10 chance of success, a 50 percent expected return from a project is a 5 percent expected value.

For a $1 billion investment, the investor wants a return of $50,000,000 but to get that $50,000,000 return, on average, $10,000,000,000 is invested. The $10,000,000,000 must have an expected 5 percent fair return and profit of $500,000,000. Only 1 in the 10 investments will succeed and the successful $1 billion investment must pay $500,000,000 to have a fair 5 percent return on the total $10 billion invested, which is a 50 percent return on the one successful drug's investment of $1 billion.

Suppose, a generic company can sell a drug to make a 5 percent return, but a research and development drug company must make a 50 percent return. The research drug company must make a profit that is ten times the amount of the generic company.

Let's say a generic drug company can make a pill for 60 cents and sells it at 70 cents (10 cents profit) to make a fair after tax profit. The developing drug company must sell the same drug at $1.60 to make a fair return ($1.00 profit).

When politicians and consumers look at a drug's selling price and costs, they look at only that drug's production costs and investments. They only look at the successful drugs in the marketplace. They ignore all the false starts and costs associated with those failed efforts. To stay in business and attract new investment funds, a pharmaceutical company must be able to recoup its lost funds on unsuccessful efforts in the profit it makes on successful drugs.

New drugs are expensive and cost more than the later generic version because the cost of finding and proving the effectiveness of new medicines is high. The generic drug companies do not bear the cost of finding new medicines and can set drug prices based solely on production costs, which are a small part of the cost of most drugs.

The price of a new drug represents more than the cost of its development and production. It also represents a fair return on all the funds invested, including the investments on the failures without which the drug company could not find and bring to market successful medicines.

Capital Is The Fool's Gold Of Banking

Is capital important for the health and safety of the banking industry? Was a shortage of capital the reason there was a financial crisis and would higher capital levels prevent another crisis? Wasn't liquidity the real cause of the recent banking problems?

One of the proposed solutions to prevent another banking industry crisis is to require banks to hold more capital. However, the banks that needed bailing out or failed in the recent crisis all satisfied the existing capital requirements. Capital is just a naive and confused patent medicine approach to a complex problem.

Bear Stearns and Lehman failed because they had a liquidity crunch and Citibank needed government help because it was experiencing a run on the bank, a liquidity shortfall.

Capital is a balance sheet approach to bank supervision and control. It is a regulatory concept computed by a regulatory formula. It does not represent the residual liquidation value of the bank after its debts are paid. It does not represent the bank's net worth, the accounting or market value of the bank's assets less its liabilities. It does not represent the future earnings capacity of the financial institution. It does not measure the liquidity health of a financial institution.

Regulators establish guidelines for bank capital levels and monitor the capital levels of banks. Governments, and their agencies, such as the banking industry regulators, cannot act arbitrarily. Capital levels are the way that the government banking regulators justify their actions. When capital levels are threatened or below regulatory requirements, federal banking supervisors act to preserve deposits, and the deposit insurance fund. They close banks, merge unhealthy banks with healthy banks, or put banks under protective orders with restrictive requirements. They act with a consistent, predefined purpose and as such are not easily subject to judicial review to overturn the regulators' actions and interventions. Capital levels are just trigger points that allow the government to act in a consistent manner.

Suggested proposals to prevent another crisis are mere refinements to the current capital requirements. The arguments for change are that the risk adjustments were inadequate, incentives were wrong; the levels were too low, or inconsistent, etc. However, any set of capital rules will not cover all situations, will create a new set of economic incentives and will always be too low for some catastrophe, just as a dike cannot restrain all levels of water.

Often a banking crisis is a liquidity crisis. Customers notice bank problems when banks are having a liquidity problem, a run on a bank, because the bank does not have the funds to pay depositors' withdrawals or the funds to make loans.

Regulators like high capital amounts because it allows them to delay classifying a bank as a troubled bank and delay government intervention. It does not guarantee an improvement in the deposit insurance fund or a positive net worth at a bank. It does not measure or help a bank's liquidity needs.

Capital does nothing to prevent liquidity problems at banks. When a bank is experiencing a shortfall of funds, the institution must borrow funds to pay depositors, and fund new loans and meet daily cash needs. To borrow funds, a bank must often put up collateral, assets it has on its books. Usually, the liquidity lender to a bank wants the collateral amount, in market value, to exceed the amount of funds lent. Bear Stearns failed because as it needed more liquidity, the value of its collateral was decreasing due to the declining value of real estate and the increasing default rates on mortgage loans. Some of its mortgage backed securities it was using as collateral declined in value by as much as 70 percent. Eventually, Bear ran out of collateral and could not fund it daily operational needs.

Capital is nice to talk about because the regulators find it easy to measure, not subject to dispute or interpretation under the regulations and consistently applied to all banks. It is easy to explain when a bank is above or below required capital levels and requires government involvement.

Liquidity is a much more difficult concept to use because the liquidity needs of each bank are different and can vary within an individual bank over a short time. It is more difficult to monitor, more difficult for the public to see when a bank is short of funds and more difficult to explain to politicians and the general press. Furthermore, publicly disclosing a liquidity shortfall at one bank can create a panic and run on another bank. Using liquidity as a guideline for bank troubles can cause a broader financial problem and make it much more difficult for regulators to contain a problem to a sole bank.

The contagion in the recent crisis was, in effect, a run on the banks. Everyone feared that the financial institutions were running out of liquid assets and that the collateral was declining in value in excess of the liquidity needs of the institutions. There was a wide spread fear that the banks did not have enough cash for their daily operational needs.

Capital is easy to understand and for regulators to measure. It is a convenient and acceptable trigger for regulatory intervention. Capital, however, does little to minimize future banking problems. It does nothing to promote the best practices for preventing future banking crises. Capital does not promote good banking, which must include asset diversification, sound business strategies and decisions, quality management, expense control and strong, sustainable earnings.

Reform, instead of focusing on capital levels, should instead focus on promoting sound banking practices as previously mentioned. Best business practices are the best way to prevent another crisis. Raising capital requirements by itself does not promote best practices. It just makes the regulators feels happy and allows them to offer patent medicine to those in search of a tonic.

Capital is a fool's gold that has little value, if any, in a severe financial crisis. The real gold is asset diversification, sound business strategies and decisions, quality management, expense control and strong, sustainable earnings.

More Funding And Staffing At The SEC Will Not Reduce Fraud

The following is a comment I posted on the Conglomerate Blog, "Funding the SEC: Dependent on the Kindness of the Regulated?" by Erik Gerding.

What indications are there that more funding and staffing at the SEC will reduce fraud? The failure to stop Madoff was not due to a shortage of staff or inadequate funding. Dysfunction at the SEC is the core issue. For example, the IRS has statistical profiles of IRS returns to identify likely tax evaders. In all its existence, the SEC has failed to develop a manageable, efficient system to identify fraud at the corporate level, at the investment level, or to evaluate the likelihood that an investor complaint to the SEC is true.

SEC staff investigated Madoff and fundamental procedures that have been in existence in auditing for decades, such as verifying payments, receipts and funds at other institutions, were not part of SEC investigations until after Madoff.

Madoff is a form of affinity fraud, which is a type of fraud the SEC has known about for years. It is based on investor commonalities to form referrals based on unfounded trust. Immigration groups based on country of origin, religious groups, country club membership, etc and other forms of referrals allow affinity fraud to succeed. Does the SEC even attempt to determine if the investors are part of an affinity group that would alert the SEC that there is a high likelihood of affinity fraud? It did not at Madoff. Does anyone remember ever seeing an ad or other outreach informing the public of this kind of fraud? The SEC has a 2009 pamphlet (after Madoff) and a 2006 press release, but what is the best preventative measure at the investor level and at the SEC to limit affinity fraud?

Option backdating was discovered because a professor published a statistical study showing its likely existence. Shouldn't a SEC priority be finding and funding research in important areas of potential fraud to help it efficiently identify corporate fraud? More staff would not have found backdating.

The SEC today is like a ship lost at sea that keeps asking for more stargazers to help identify its position instead of asking for a GPS navigation system. It is a 1930s organization with a 1930s culture that does not know how to function in the modern world. It is heavily staffed with lawyers whose culture is to avenge a fraud instead of prevent a fraud.

More money and staff are not the answer. A complete rethinking and restructuring is in order.

Furthermore, contractual legal rights are a powerful mechanism for protecting the rights of parties to commercial transactions. In fact, most transactions are based on contractual protections as opposed to regulatory protections. Shareholders and other interested private parties, and not the SEC, often sue to enforce their legal rights in securities transactions, when courts have recognized their right to sue to protect themselves.

While the counterfactual of life without 75 years of an SEC is difficult to envision, the existence of the SEC did not prevent major securities and investor fraud. Additionally, the SEC is always requesting more funding and staffing to investigate and litigate fraud. It is unclear that the 33 and 34 Acts have decreased fraudulent activities.

Forget CSI: DNA Matching Putting The Innocent In Jail

...increasingly DNA is being used for a new purpose: to target the culprits in cold cases, where other investigative options have been exhausted. All told, U.S. law enforcement agencies have conducted more than 100,000 so-called cold-hit investigations using the federal DNA database and its state-level counterparts, which hold upward of 7.6 million offender profiles. In these instances, where the DNA is often incomplete or degraded and there are few other clues to go on, the reliability of DNA evidence plummets—a fact that jurors weighing such cases are almost never told. As a result, DNA, a tool renowned for exonerating the innocent, may actually be putting a growing number of them behind bars.

***

When analyzing DNA, scientists ideally focus on thirteen markers, known as loci. The odds of finding two people who share all thirteen is roughly on par with those of being hit by an asteroid—about one in a quadrillion in many cases. But the fewer the markers, the higher the probability that more than one person will match the same profile, since relatives often share a number of markers and even perfect strangers usually share two or three.

***

In 2006, for instance, a Chicago judge ordered a search of the Illinois database, which contained 233,000 profiles. It turned up 903 pairs with nine or more matching DNA markers. Among geneticists and statisticians, these findings have eroded faith in the FBI’s DNA rarity statistics, which were based on data from just 200 or 300 people and are used by crime labs across the country.

From "DNA’s Dirty Little Secret: A forensic tool renowned for exonerating the innocent may actually be putting them in prison" by Michael Bobelian in Washington Monthly.

Reconciling Lower Doctor Pay With Rising Health Care Costs

As reported on Bloomberg, "Doctors’ Hours Fall for a Decade, Adding to a U.S. Shortage" by Pat Wechsler:

Feb. 23 (Bloomberg) -- Work hours for U.S. doctors dropped steadily for more than a decade, mirroring a decline in inflation-adjusted fees and worsening a nationwide physician shortage, a study said.

Doctors’ hours per week fell to an average of 51 in 2008 from 55 in 1996, after two decades of being almost unchanged, according to research published today in the Journal of the American Medical Association. The report showed the slide was linked to a falloff in fees paid to physicians. The charges declined 25 percent after inflation from 1995 to 2006, according to an index measure of fees going to doctors.

Physicians are working less and are being paid less. Health insurance companies and hospitals are not making exorbitant amounts of money. For example, see Mark Perry's Carpe Diem blog, "Profit Margin: Health Insurance Industry Ranks #86."

Health costs have been growing faster than the US economy and faster than inflation. If not from doctors and hospitals, where are the costs increases in medical care coming from? It is highly unlikely, the pharmaceutical industry can account for the enormous growth in health care spending.

As more of the costs of health care are shifted from our out of pocket costs to health insurance, it makes sense the cost of health insurance will rise. The problem is discovering why the costs of total medical care have also risen so much faster than the economy and inflation.

Is it simply just a change in consumer preference? Do we just use more medical services, which include doctors, nurses, medical and lab technicians, medical equipment, lab tests, drugs, etc., but no one cost item is overpriced. Do doctors make less because we are spending more on medical services other than physicians?

The open question is how much of the shift in consumer preferences for more medical services are related to the reduction in the consumers' out of pocket expense? If the shift is due to third party payers than the answer to controlling our medical spending is to shift more of the costs sharing to the consumer. It can be accomplished by removing the tax deduction for employer health care benefit and by shifting Medicare and Medicaid more towards a voucher system similar to food stamps with a backstop for catastrophic illness and injury.

If third party payers do not exaggerate the shift to more medical care, than there is not any reason to control our medical costs. The issue then becomes government affordability of government programs and vouchers probably could best control government medical costs. Under a voucher system, the government's yearly costs are limited but individuals are free to seek as much health care as they wish.

It is obvious, that we are seeking to "fix" our medical system and reduce health care costs without a clear understanding of the drivers of health care spending. Without detailed knowledge of the problem, it is highly likely any "fix" will create more problems than solutions.

Making Health Care Worse

Despite the rampant inefficiencies and extremely high costs of health care in the United States, it is still possible to make the American health care system even more inefficient and more costly. Regrettably, the health care bills passed by the House and Senate would do precisely that by saddling an already burdened system with more mandates, higher taxes, and less flexibility.

From the comprehensive Wall Street Journal article, "Bending the Curve": What Really Drives Health Care Spending" by Jason Fodeman, M.D. and Robert A. Book, Ph.D.

Limits Of Econometric Models Of The Macro-Economy

The following is a comment I posted On Econlog, "Macroeconometrics and Science" by Arnold Kling about the limits of econometric models of the macro-economy.

There is also the "Lucas Critique". Lucas said that economic models derived from historical data could not be used to recommend effective changes to government policies because the past relationships in the data are dependent on the effects of policies in place at the time of the data. Predictions based on past data will miss the effects of new policies and produce incorrect predictions unless the relationships in the model are calibrated for the new policy. One needs to build a model where the internal relationships (coefficients) vary depending upon policy recommendations. It requires an understanding (or at least an assumption) on how policy affects economic outcomes. It can become a tautology. The model predicts what it is set to predict. If a model is calibrated to predict that policies A, B and C will move the economy to long term trend, then a recommendation to use policies A, B and C will show in the model that the economy is moving towards its long term trend. The model will become the basis for a recommendation that was assumed as part of the model in building the model.

Additionally, when models are not validated against out of sample data, there is the problem of data mining and spurious results. When a 100 economists run a 100 different, independent models on historical data looking for economic and theoretical explanatory relationships, even at a 90 percent statistical significance level, there will result 1000 (100x100x.1), different models that meet model acceptance criteria.

Out of sample data tests would drastically reduce the number of acceptable models from 1000 to a much lower amount. Those that survive may again be spurious, because at the 90 percent significance level, the probability is that 100 out of the 1000 will survive and look meaningful. These 100 models exist based on luck without any need for there to be any economic meaning to their internal relationships. They can even be inconsistent with each other and known economic theories.

Economists then derive explanations to match the model results instead of vice versa. Data mining and spurious models can lead to inconsistent policy recommendations among economists.

It is like a gambler's hot streak at the roulette table, where the bettor develops superstitions about why he is winning, such as color of his shirt, etc. Economic policies based on the surviving models are equivalent to a gambler's idiosyncratic behavior that he thinks changes the odds at the roulette table and enables him to win. Each gambler has a different reason for the winning streak. Like different schools of economists.

The scientific method is based on the concepts of hypothesis testing against data and reproducible results. Model building is the reverse. The data is used to derive the hypothesis and it is not tested against new data (out of sample) to see if it is reproducible.

Both the Ptolemy (Earth centric) and Copernican (Sun centric) views of planetary motion were internally consistent with the data on planetary motion known at the time. Both were accurate in predicting future planetary position (actually, Ptolemy's method, revolving around the Earth, initially was more accurate than the Copernican method).

However, it is extremely unlikely that Sir Isaac Newton could have developed his theory of gravity under the Ptolemy system. Newton's gravity requires rotation around the larger mass body, the Sun, and not the Earth. While an equivalent gravitational system could probably have been mathematically built in a Ptolemy system, it would not be as simple to comprehend or visualize as the Newtonian system.

Expectation theory is in many ways equivalent to Copernican theory, but that is another long and controversial discussion. Suffice it to say, many economic models are inconsistent with expectation theory.

The above is a comment I posted On Econlog, "Macroeconometrics and Science" by Arnold Kling.

[See my March 16, 2010 addendum post: "GDP Bond Addition To My February 18 Post 'Limits Of Econometric Models ...'"]

States Short $1 Trillion For Public Employee Retiree Benefits

State governments face a trillion-dollar gap between the pension, health-care and other retirement benefits promised to public employees and the money set aside to pay for them, according to a new report from the Pew Center on the States.

From "States Sink in Benefits Hole" by Amy Merrick in The Wall St. Journal.

The Multiple Solvency Goals Of Regulatory Reform

Everyone most likely agrees that the proposals for regulatory reform of the banking industry are attempts to lower the insolvency risk of financial institutions. The various regulatory reform mechanisms place prohibitions on bank activities and assets, increase a bank's required capital, or increase regulatory powers and oversight of the banks.

Solvency (Insolvency) is a single word with several meanings, but each definition requires different protective measures to protect solvency and prevent insolvency. The individual connotations are often unidentified in proposals or discussions and much of the debate about banking reform is really confusion over which form of insolvency the new rules are trying to avoid. Discussions of the ineffectiveness of a proposal often result from confusion over which form of solvency the rule is protecting as much as it is about the effectiveness of the proposal.

A sensible banking reform package first requires clear articulation of its goals and a determination that the industry modifications will achieve their desired results of protecting the banking institutions and the payment system from the many forms of insolvency.

To help with the process, I am republishing some definitions of insolvency that I first blogged about, "Understanding The Different Meanings Of Insolvency" from almost a year ago.

Solvency can take various forms:

Regulatory

There is regulatory solvency, which wants banks to have adequate and sufficient capital to meet regulatory and legal solvency tests. These tests determine if there will be a regulatory takeover or shutdown of the institution. When one speaks of too big to fail, one generally means that an institution failed the regulatory solvency test, but the regulators are too timid to take it over or shut it down.

Net Worth

There is GAAP (Generally Accepted Accounting Principals) positive net worth, which requires banks to have a positive net worth, more assets than liabilities, on their accounting statements, using the appropriate applicable accounting rules even if they require market value or other measures of the accounting value of the assets and liabilities on the bank's balance sheet.

Economic Value

There is the positive economic value of the bank as an operating entity, which requires an assessment that the bank will be able to pay back its debt and replace its capital if regulators allow it to continue to stay in business, despite its failure to meet other solvency tests.

Liquidation Value

There is positive liquidation value, which looks for a positive value after liquidation of the bank at today's market prices. Personally, I believe that most of the media and the public mistakenly believe that regulatory solvency and capital is equivalent to having positive liquidation value. It is not in most cases. In many cases, due to high leverage and due to many balance sheet assets not valued at current market prices, a bank's liquidation will fail to produce enough value from the assets to payoff the liabilities.

Liquidity

Finally, there is liquidity, which attempts to insure that bank has sufficient cash for its daily operation by holding cash, readily marketable securities and other assets that can easily become cash without a significant loss of value. Many banking crises begin as liquidity crises because as an institution starts to face operating difficulties other institutions are reluctant to lend it money or do business with it without additional assurances, such as more collateral.

Each of these five definitions of solvency behaves differently under different economic scenarios, risk taking and market conditions. Specific regulatory mechanisms to protect each form of solvency are therefore different. A scheme to protect one form of solvency is often inadequate by itself to protect another. Additionally, some schemes may overprotect and unnecessarily burden another form of solvency.

The ultimate goal is to protect the financial institutions and therefore regulatory proposals for reform need to deal with each type of insolvency. To guard each form of solvency, there will be overlapping requirements, over protection of some forms of solvency and unnecessary rules to shield against other forms of insolvency. A perfect regulatory reform package will prevent all forms of potential insolvency. In the end, an excellent regulatory reform package will significantly lower the insolvency risks in the banking industry.

How Radio Gave State Residents A National Identity

Increasingly, people ceased to refer to themselves just as Pennsylvanians, Coloradans, Californians, Oregonians, or Texans; radio brought the nation into their homes and gave them a national identity. A single event, a boxing match, an inauguration, a football game, a concert, a comedy sketch, a political speech, or a sermon, gave Americans the chance to share in a common experience.

The above is an excerpt of a quotation appearing in Matt Young's blog post, "The Radio boom and economic effects" on Better Economics.

John Stossel Video Excerpt on Crony Capitalism

https://www.youtube.com/watch?v=wWsa3xbBgKA

If We Don't Know Where We're Going, How Can We Get There, Or What Is Affordable Health Care?

It only took Uwe Reinhardt, a Princeton economics professor, frequent NY Times health care contributor and Obama health reform supporter, a year into Obama's health care reform to understand that to get anything successfully accomplished the parties involved need to understand the goals and objectives. Read the following excerpt from Reinhardt's post (and also his complete post) on The New York Times Economix blog, "What Is ‘Affordable’ Health Care?"

Health insurance is just a means by which needed health care can be made “affordable” to Americans when they fall ill. Therefore the proper target of health policy should be the family’s total outlay on health care, including out-of-pocket spending. That total outlay on “needed health care” should be made “affordable.”

Which requires us to define concretely, for practical purposes, what we mean by “health care” and “affordable,” pedantic as that may sound. Politicians should be forced to be utterly clear about it.

Usually we think of “health care” loosely as the services performed or products prescribed by health care professionals, notably physicians. But those services and products range all the way from pure consumption goods widely regarded as the recipient’s financial responsibility (e.g., purely cosmetic surgery or Botox injections) to acutely needed care widely viewed as a social good that should be available to everyone, regardless of ability to pay for it (e.g., health care after a serious accident or heart attack).

In between lies an entire spectrum of health care products and services which some people regard as “medically necessary” but others not. For example, is in vitro fertilization a “needed” health care service? Is Viagra a “needed” health care product?

Of course, I see it as a failure of the Obama administration to take a leadership role in setting the health care reform objectives and specifics. See my previous post, "Obama Does Not Know How To Be A CEO."

Is There A Benefit To More Medical Care And More Health Insurance?

A comment I posted on Megan McArdle's Atlantic blog, Asymmetrical Information, "Firming Up the Argument" and on Marginal Revolution blog, "How many people die from lack of health insurance?" by Tyler Cowen. They both wrote about the lack of benefit of increasing health insurance coverage.

It is easy to change the cause of death, but it is very difficult to delay death. The major changes that have decreased mortality and increased life expectancy are farming (vs hunting), washable clothing, clean water, antibiotics and job safety. Most of the recent gains in life expectancy are probably due to better prenatal care than anything afterward. We are probably at the stage where the cost benefit is outside the medical field. Reductions in accidental deaths, homicides, and suicides would probably do more to increase life expectancy in the US than more medical care.

Are we at the point in US medical care where the marginal benefit to society from more health care no longer is greater than the marginal cost? Is there really a need for more medical insurance coverage? Maybe the reason medical care is getting so expensive in the US is that we are at the point in medical care where we have to spend more than the benefit, where each dollar's worth of gain cost more than a dollar.

Can Three People Agree On The Meaning Of "Fairness"?

Comment I posted on Carpe Diem, "What Does German Beer Have to Do with Fairness?" by Mark Perry.

"Fairness as equal treatment does not produce fairness as equal outcomes," by Thomas Sowell.

[My comment.]
I do not think three people could agree on what "fairness" means.

In golf and horseracing, there is handicapping, which is an attempt to remove beginning advantages to give all an equal chance of winning.

In the US, philosophically, we want to believe that all groups are capable of the same results, i.e. the same percentage of doctors, lawyers, police officers, firefighters, millionaires, successful entrepreneurs, CEOs, college graduates, homeowners, etc.

If one believes handicapping is "fair" to undo socio-economic or competitive disadvantages, then group outcomes should be statistically equal. For these believers, unequal outcomes at the group level indicate ineffective handicapping. It indicates a need to improve the "fairness" of the handicapping process to produce equal outcomes.

If one believes, "equal treatment" does not allow for handicapping, does not include school admission preferences, affirmative job action, remedial help, extra time on tests, etc., then equal outcomes will not occur because family socio-economic status predicts many of the outcomes and groups sort by socio-economic status in the US.

Different people can disagree whether "fairness" of equal treatment includes "handicapping".

There is also often a failure to distinguish the characteristics of the subgroup at the hiring or acceptance level from the characteristics of the whole group, and we often focus on subgroup "fairness" in place of group "fairness".

For example, suppose two groups, A and B, are very similar, except the top ten percent of Group A want to become lawyers and the top ten percent of Group B want to become doctors. What is a fair outcome at the top medical schools and top law schools?

By measurements of skills, test scores, grades, etc, we should expect more Group A's to be admitted to top law schools than Group B's. Additionally, we should expect more Group B's to be admitted to top medical schools than Group A's. Should medical and law schools allow the disparate outcome or should they equalize their admission rates for Groups A and B?

Different religions, race, country of origin, socio-economic status etc. groups rank careers and other aspirations differently and those rankings within the groups will sort each group differently. If one group ranks firefighting as a career over retail store management and the other group ranks retail store management higher, is it fair to want each job category to contain the same percentage of each group? Are the gate keeping tests and hiring processes that result in different outcomes "unfair" when group career preferences differ? Is it "unfair" if different career choices have different total life earnings effects?

What Makes The Banking Business Different From The Non-Financial Business?

A major business difference between banks and non-financial companies occurs at the Gross Margin (aka Gross Profit Margin) level. Gross Margin represents the difference between sale revenues and the cost of goods sold as a percent of the revenues. In banking, this measure is called the Net Interest Margin. It represents the difference between the average interest rate the bank receives on loans and the average interest rate the bank pays out for its deposits and other borrowed funds. Gross and net interest margins do not include other business expenses.

For the 3rd quarter of 2009, the Net Interest Margin for all banks in the US averaged 3.36 percent. See St. Louis Fed data and the following chart.

Source: St Louis Fed

(Click chart to enlarge.)

In non-financial industries, a 40 percent or higher gross margin is common. (See Wikipedia Gross Margin).

The low margin in banking compared to non-financial industries leaves little room for recovery from management mistakes, makes banking a high volume, low profit business and pressures banks to use high leverage.

For example, suppose a bank lends a $100, the borrower defaults and the bank recovers $0 and is out the $100. Let us say the bank has a net interest margin of 3.33 percent. The bank needs to make 30 other loans that do not default just to make back the principal (equivalent to a $100 cost of the goods sold) it lost from the defaulting borrower.

Now let us look at a non-financial company, such as a retailer than has a 50 percent gross margin. The retailer is selling an item for twice as much as it costs. The retailer is selling an item that costs $50 for $100. Let us say that someone comes in to the store, takes the item and leaves without paying for it. Shoplifting an item is equivalent to a borrower who gets funds from a loan and does not pay it back to the lender bank.

If the retailer sells another item, it will make back the $50 it paid for that item and have $50 left to cover the expense to the item it lost.

Non-financial companies have an easier time recovering from bad business decisions that lead to losses than banks. A few sales in a non-banking business can quickly recoup losses made from unfortunate events or bad business decisions.

In banking, many successfully repaid loans (sales) are needed to recover from bad luck and poor management decisions.

The lower margins in banking pressure banks to create high volume businesses, which requires more funding and necessitates high leverage and loan securitizations. Additionally, the profit dynamics of the banking industry makes managements' business mistakes more likely to be devastating to the firm with a much lower chance of recovering from a mistake.

Unless reformers explicitly deal with the banking industry business pressures of low margins, high volume and high leverage, their proposals will fail and future banking crises will occur.

People that blame incentive compensation packages for making bankers want high volumes to get high bonuses are naïve and simplistic. Banks paid incentive compensation packages because banking is a high volume business. Similar logic pertains to loan securitization, which allows banks to increase their volume of lending business.

Business forces in banking created the needs for the common practices that many blame for the financial crisis and these same forces left bankers with little room to recover from mistakes.

Reforming and restructuring the banking industry by narrowing bank business opportunities, decreasing leverage, and restricting banker behavior based on symptoms and not causes, will do nothing to improve the banking industry environment in the US.

Exactly the opposite of many proposals, such as the Volcker Rule, are needed to improve and protect the banking industry. Banks need more avenues of high profit margin businesses, more ways to leverage funds to increase volume, and more ways to generate income, such as fee, trading and investment banking income that are not dependent on loan repayment. Additionally, banks need better ways to recoup their funds from defaulting loans and unfortunately, the President and his cabinet have done just the opposite.

As banks transition into business models that allow them to generate income in higher margin businesses, leverage will decrease, the risk of financial calamity will decrease, uses of incentive bonuses will decline and the likelihood of another financial crisis will diminish.

Based on what I have read and heard in the media so far, I am not hopeful that regulatory changes to the financial industry will occur that actually help prevent future crises.

Elizabeth Warren's Views Increase Financial Product Costs To Consumers

My comment to "Fine Print, Deceptive Pricing, and Buried Tricks" by Mark Thoma on Economist's View blog:

The explanation is too simplistic and continues the paternalistic attitude of Elizabeth Warren. Her paternalism includes her call for plain vanilla products and her call for a consumer financial product protection agency. She is a firm believer that consumers need protection and are unable to fend for themselves in a multi-product marketplace. Her view about credit cards is only one view and is probably wrong. If she were running an auto company, she would never understand why they have different models, different options, and different colors and have cars that sell for different prices. She wants us to return to the days when only white refrigerators were available and all Ford Model-T cars were black.

She tends in many of her examples to use only the consumers after they triggered a provision instead of the broader marketplace of all the product users at time of card issuance. She does not understand the false positive effect.

For instance, universal default does positive things. As Citi learned, it helps sell credit cards. The consumer is rationally responding to the positive effects of Universal Default at the time of card issuance. It allows Citi to issue cards at a lower rate than it would otherwise to individuals where Citi is unsure of their credit default risk. The uncertainty to Citi at time of card issuance of future default risk would normally require Citi to issue cards at a higher interest rate to people of both high and low risk for which Citi lacks enough information to distinguish from each other. Universal default shifts the risk from a guess at issuance time to an actual future event that increases credit risk, such as a future credit card default or late payment on another card.

Additionally, universal default acts as incentive to some cardholders to maintain their higher credit rating, which motivates some cardholders to maintain better credit. These people might not have taken the card without the motivating provision.

Looking only at the cardholders after their interest rate increased because of a trigger of the universal default provisions is the wrong universe of individuals. These people did things that if they had done it prior to the issuance of Citi's credit card would have resulted in an initial higher interest rate to them or a denial of their application for the credit card. They benefitted both from having credit for the period prior to their universal default trigger and for having a lower interest rate than their ultimately revealed credit rating deserved.

Sure, they are upset at having to pay a higher rate, but the alternative would have been a higher rate earlier in their credit use or no credit at all. Furthermore, other individuals are attracted to the credit card because of the extra motivation it provides to maintain a good credit rating.

Unsurprisingly, when Citi removed the positive benefits of its cards their card issuance rate declined. They removed the lower interest rate, the motivator for keeping good credit and the no false positive effect, i.e. putting lower credit risk people in with the higher risk higher interest rate people,

Nobody likes paying more for anything. We do not need an Elizabeth Warren for that. She focuses on only those who are paying more without focusing on those who are paying less and she is misleading. If a cost benefit to all credit card holders were done, she would see that many more cardholders benefit from lower rates due to universal default that the high interest rate to the small number who trigger universal default. Those that trigger universal default would have paid more in higher interest rates much sooner than they did by triggering the provision.

The Elizabeth Warrens and those that share her paternalistic and narrow understanding of the economics of banking have unnecessarily increased credit card costs to all of us.

US Productivity Imperiled By President's Budget And Escalating Debt

Today our productivity growth is imperiled by the anti-investment tilt of the president's budget plan for escalating federal debt. Even conservative estimates of effects of federal debt on interest rates (by Eric Engen of the Federal Reserve and me in the 2004 National Bureau of Economic Research Macroeconomics Annual) suggest that the last Obama budget blueprint would lead to a one-percentage-point rise in Treasury interest rates as the economic recovery takes hold. The consequence—lower business investment and real GDP 4% lower than it would otherwise be by the next presidential election—compromises our future.

From "Toward a Different Fiscal Future" R. Glenn Hubbard in the Wall St. Journal.

Mr. Hubbard is dean of Columbia Business School, and he was chairman of the Council of Economic Advisers under President George W. Bush.

Five Job Creation Myths

"Five myths about how to create jobs" by James Manyika and Byron Auguste, Washington Post, Sunday, February 7, 2010.

Historical Look at Labor Market During Recessions: Dallas Fed Reserve

To put the recession’s labor- market impact into perspective, we compare the past two years to previous downturns, including the Great Depression. We also examine the data commonly used to assess labor market conditions. While unemployment rates and nonfarm payroll losses are widely reported, a firm grasp of what they measure is critical to understanding what they tell us about the current state of the labor market.

The above excerpt and the following charts are from Economic Letter—Insights from the Federal Reserve Bank of Dallas, Vol. 5, No. 1, January 2010, Federal Reserve Bank of Dallas, "A Historical Look at the Labor Market During Recessions" by Enrique Martínez-García and Janet Koech.

 

 

  

  

  

A historical look shows that the labor market impact hasn’t been as severe in the current recession as it was in the Great Depression. While the latest episode has a lot in common with the post-World War II experience, it’s unusual in the length and depth of its labor market reach. It was the acceleration of employment losses after October 2008 that transformed an otherwise average recession into the worst episode since World War II.

Read the entire article here.

Finra Investigating Mary Schapiro's Pay As CEO

Finra’s board of governors will review allegations that Securities and Exchange Commission Chairman Mary Schapiro — along with other senior Finra executives — received excessive compensation when she was chief executive of the self-regulatory organization for the brokerage industry.

From InvestmentNews, "Finra executives overpaid? Its board wants to know" by Sara Hansard.

Economics Defined!

From Despair, Inc.

Future Medicare Costs Exaggerated In Obama's Budget To Make ObamaCare Look Prettier [Updated Diagram Weblink]

For the first time by any administration in memory, the Obama budget forecast rejects the Medicare Trustees’ projections for long-run healthcare cost growth. Why would the White House do this?

The Obama administration’s fiscal year 2011 budget continues a pattern of ignoring independent analysis and rigging economic assumptions to meet political goals. For the first time by any administration in memory, the Obama budget forecast rejects the Medicare Trustees’ projections for long-run healthcare cost growth. The reason: the Trustees’ projections undercut the administration’s narrative that increased federal control over private sector healthcare could painlessly reduce Medicare and Medicaid costs. The Obama budget instead assumes long-term health cost growth at twice the rate projected by the Trustees.

***

...population aging is by far the biggest contributor to entitlement spending over the next several decades and will be the principal cost driver through the mid-2050s. Partly as a result of these analyses, Orszag’s successor at the Congressional Budget Office, Douglas Elmendorf, altered the agency’s presentations to more accurately reflect aging’s role.

In other words, even if healthcare overhaul managed to “bend the cost curve” and reduce per-capita health spending, the surge of retirees collecting Medicare, Medicaid, and Social Security benefits would still push government spending ever upwards. Thus, the facts undermine the administration’s argument for greater regulation over private-sector healthcare.

From "Obama Budget Rigs Healthcare Numbers" by Andrew G. Biggs in the Journal of the American Enterprise Institute.

How Do Dating Women Estimate A Man's Financial Worth?

Women find a man more attractive if he is sitting in an expensive car than if he is sitting in a modestly priced car, according to a study reported in the British Journal of Psychology by Dunn, M., & Searle, R.

The finding confirms common wisdom and is not particularly surprising. Every dating man and every dating woman knows men with money are more desirable. More interesting are the questions the researchers did not study or attempt to answer.

Do males pay for the 'added' benefit associated with expensive cars through higher car prices? Do the carmakers reap higher profit margins as a result? What percentage of an expensive car's price is due to the attractiveness factor?

If the 'attractiveness' value of a 2 - 3 year old prestige car in good condition remains comparable to a new car, the residual (trade-in) value of a prestige car, as a percent of original value, will be higher than for a non-prestige auto. Both cars' physical value will depreciate, but the 'attractiveness' value should remain and lower the percentage depreciation loss of an expensive car. We should expect cars with 'attractiveness' value to retain more of their original value after a few years than cars without an attractiveness factor.

The higher residual values of expensive cars lead to lower leasing costs versus buying, which increases the number of potential male owners in lower income groups. More male owners will help maintain higher profit margins and higher residual values.

For women, there is a negative effect. More leasing will remove the accuracy of the wealth-filtering signal of expensive cars by allowing less wealthy men to drive the expensive cars.

Consistent with the study, common wisdom is that expensive cars maintain their trade-in value better than less expensive cars.

Since leasing does not require as much income or wealth as buying and muddies the signal sent to women about an owner's richness, women should be less impressed by expensive cars that are widely leased versus purchased. I wish the researchers had expanded their study to look at different makes of expensive cars to see if different expensive cars had different attractiveness effects to women.

I would expect that women would rank the attractiveness of males with prestige cars that have a higher proportion of leasing lower than the attractiveness of men with prestige cars that have a lower proportion of leasing.

Additionally, it would be interesting research to see what if any corrective actions women take to prevent and discover male deceit about wealth signals.

It is a marketplace, requiring price discovery, with asymmetric information about wealth. A more comprehensive study could show how dating women improve their information and accuracy of estimates of a man's wealth.

Where Are Obama's Foreign Exchange Advisers?

Obama is saying is that the U.S. would be better off if the dollar weakened against the yuan. This is nothing but shoddy thinking. A weaker currency can never make an economy stronger. A weaker currency may make U.S. exports cheaper, but a weaker currency also makes imports more expensive. Devaluing one's currency is thus a fool's game, since it benefits one segment of society (exporters) but harms everyone else (consumers, who have to pay more for the imported goods they purchase).

From "Obama clueless on FX rates" by Scott Grannis on Calafia Beach Pundit.

US Budgeting Process A La Carte

1. We're still hungry! Is there more to eat?

2. Yuck! It taste awful. Can't we have something else for dinner?

The Fallacy Of "Helping the Environment"

the earth constantly changes according to natural law and that no particular state is preferred. Nature, less man, has no purpose - it just is. Given these facts, what exactly do people mean when they wish to "help the environment"?

The above excerpt is from "The Fallacy of 'Helping the Environment', Can the Earth be Dirty, and True Human Sustainability" by Doug Reich on The Rational Capitalist Blog.

Thoughts On Why Closed-End Funds Often Trade At NAV Discounts

Closed-end funds have investment advisers who can change the holdings of the fund consistent with the investment strategy.

Closed-end funds do not regularly redeem shares. Redemption occurs at the termination date of the fund.

Closed-end funds, because they need not worry about redemption, can buy infrequently traded shares. When a readily available market price is unavailable, funds employ a pricing methodology.

Closed-end funds pay a dividend, sometimes in excess of the dividends received from the fund's investments. The shortfall comes from the investment capital of the fund.

Buying a share in a closed end fund is buying the right to the fund's termination value (not to its NAV, Net Asset Value) and the dividend payouts of the funds. The value of these rights can deviate from NAV without violating efficient markets.

Suppose a fund is holding $1000 and has 10 shares. Each share's NAV is $100. If the fund will terminate in one year and does not invest in anything other than cash, the fund will trade at a discount to that $100 per share. The fund is giving up an investment opportunity, which let us say is 10 percent. A $1000 payment made one year from now is worth (discounted value) about $909.09 today. Its efficient market price is to trade at a 9.09 percent NAV discount.

If the fund buys illiquid and infrequently traded securities, then the premium or discount to the NAV can reflect a disagreement between the market price and the methodology used to value the underlying investments. During the financial crisis, financial institutions discounted anticipated cash flows and valued CDOs at $X. The market placed a lower value on the CDOs because it anticipated a higher default rate. The market and the financial institutions used different estimates of future payments to derive values, resulting in different valuations of the same CDOs.

If the investment adviser creates uncertainty about the fund's future investments, the increased risk above the riskiness of the current holdings can result in a discounted market price to NAV.

Additionally, closed-end funds can borrow and there is increased leverage and loan default risk to consider. There are also tax effects since closed-end funds do not pay taxes and shareholders pay the taxes on the investments, which can have a positive or negative value and can cause funds to trade at premiums or discounts.
.

High Caloric Restaurant Meals Are Not Cause Of Obesity

Although people do eat more when they eat in restaurants, Matsa and Anderson found that diners compensate for those typically highly caloric meals by curtailing what they eat at home during the rest of the day.

From "Are Restaurants Really Supersizing America? Restricting restaurant meals may not trim Americans’ expanding waistlines" based on the Research of Michael Anderson And David A. Matsa on Kellogg Insight.

It is also unlikely that posting calorie counts of foods at stores and restaurants will help fight obesity. People keep their daily total calorie consumption relatively constant.

Clay Shirky Video On Social Media Information Overload

Web 2.0 Expo NY: Clay Shirky, "It's Not Information Overload. It's Filter Failure." His website is shirky.com