The US health care problem is not an insurance problem. The crisis is that Americans want more health care than they can afford. In 2003, the US per capita medical expenditure was $5700. Today, it is estimated at about $8200 per person. The under 65 age group medical expense per person is about 70 percent of the 65 and above average or about $7700. The 65 and above is about $11,000 per person over 65 years old.
Obviously, these are averages. If we do not put people into different health risk categories, then the average family of four has to pay almost $31,000 per year or about $2500 per month for health insurance just to cover the actual medical expenditure in that group. An individual would pay almost $650 per month.
An individual average senior citizen medical cost is about $1000 per month.
Many people find these amounts unaffordable and outrageous. Many users of medical services, government employees, union members, teachers, and other employees with health benefits, are used to having most, if not all, of the cost medical services paid for by a third party. To these users, health care became like air. It became both a necessary item and a free to use item, or at least a very low cost in comparison to benefit item.
The pricing mechanism for health care broke down because users did not bear anywhere near the full cost of the service. In effect, health care became an externality in economic terms to the users. The whole society is paying the costs of those who are heavy users of medical services and it drives non-users to use the service more often.
Most users only have to consider their want of healthcare and do not have to budget and allocate their resources to get it. Without consumers allocating their income for healthcare, the economy's pricing mechanism for allocating investment resources is broken and dysfunctional. It is over allocating investment and resources to the medical industry that otherwise would go to other industries with a better return. Consumers are also using more medical services than they would with a functioning price mechanism.
Any government program must be funded, but to most people their actual expected cost of medical services is higher than they want to or can afford to pay. If people were willing to pay for medical services out of pocket, they would only need insurance for catastrophic illnesses with extraordinarily high expenses.
Most government solutions attempt in part to keep the cost borne by the average user low by subsidizing and shifting some of the unpaid cost to a few others who pay more through higher taxes. This resolution does nothing to restore the pricing mechanism, and usage and cost will continue to grow. When costs are shifted and not borne by the end-user, the government is forced to delay, ration, deny and otherwise restrict services to contain growth in costs and use. The experience of most countries with a government health care system is rationing, delays and denials of services.
The true long-term solution to our healthcare problems is to repair and restore the pricing mechanism for consumer use of health services. One way to do it is to remove the employer tax deduction for health benefits and to end all government employee healthcare benefits. These changes will reinstate the pricing mechanism at the user level. However, the government will need to develop backstop programs for catastrophic illness and catastrophic injury and for consumers who are too poor to pay for healthcare or health insurance.
Once there is a fully functioning pricing mechanism for medical services, most of the problems will disappear. Usage will slow down without any ill effects. Producers will have tremendous incentive to lower costs of services. Consumers will decide how to best allocate their income between health services and other uses of their income. Medical services as a part of GDP will decline. Only cost effective drugs and treatments will be developed and promoted. With a proper government program, the poor and those with catastrophic illness will have medical care at a much lower cost than now.
Our current problems of excessive cost and excessive usage are the result of a broken pricing mechanism. A government program, whether it is government healthcare, government insurance, cost effective restrictions on usage, or other restrictions, will not fix the pricing and medical system. They will create new problems. Only a complete reinstatement of the pricing apparatus at the consumer/user level will solve our healthcare industry problems.
Tuesday, May 12, 2009
Sunday, May 10, 2009
Review Of Two Books On Mortgage Crisis
Economicprincipals.com has an interesting review of two books about the mortgage crisis that turned into our financial crisis. One book is "Busted: Life Inside the Great Mortgage Meltdown," by Edmund L. Andrews. The other book is "Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis," by John B. Taylor.
"We are a very long way from having a broadly agreed-upon story of the crisis that quietly commenced on the afternoon of June 20, 2007. That was when two Bear Stearns real estate hedge funds began to come apart, ushering in a long period of nervous waiting for fear eventually to subside (it didn’t) or panic to break out (it did). Nevertheless, a couple of unusually interesting accounts have appeared recently, one by the New York Times reporter who was covering the Federal Reserve Board, the other by a Bush appointee who, conceivably, might have defused the crisis altogether had he been heeded."
The complete review is at http://www.economicprincipals.com/issues/2009.05.10/404.html
"We are a very long way from having a broadly agreed-upon story of the crisis that quietly commenced on the afternoon of June 20, 2007. That was when two Bear Stearns real estate hedge funds began to come apart, ushering in a long period of nervous waiting for fear eventually to subside (it didn’t) or panic to break out (it did). Nevertheless, a couple of unusually interesting accounts have appeared recently, one by the New York Times reporter who was covering the Federal Reserve Board, the other by a Bush appointee who, conceivably, might have defused the crisis altogether had he been heeded."
The complete review is at http://www.economicprincipals.com/issues/2009.05.10/404.html
Saturday, May 9, 2009
Neither Irrational Behavior Nor Animal Spirits Caused Home Prices To Rise
Many believe that house prices were in a bubble that eventually burst. The drop in home values, with its tremendous wealth losses and foreclosures, caused politicians and the public to look for scapegoats in the financial services industry, including the Federal Reserve. Investigators will need the passage of time from the current crisis to understand its likely causes, but neither irrational behavior nor animal spirits, as some economist claim, caused home prices to rise prior to the significant nation-wide decline.
Use of the terms "animal spirits" and "irrational behavior" as economic explanations reminds me of the patient with a red rash who goes to the doctor and is diagnosed with an ailment that is the Latin phrase for red rash. In both the economic and medical cases, the new terms do not contribute to our understanding and do not assist us in finding preventive or corrective measures. They are just linguistic placeholders until we learn more.
Furthermore, the spirits and irrationality are as likely to be coincident or lagging as leading, and if correlated, not causative. If my neighbors sell their house for a price that surprises me and makes me feel paper wealthy, am I irrational to think that at a future date, I could also sell for that or a higher price. If so, which caused which? If unexpectedly I must relocate and sell my home, am I relying on animal spirits when I buy my new home?
Furthermore, controlled laboratory behavioral pricing and trading experiments may show irrational pricing among the participants, but the lab situation tends to give equal weighting to all participants. It is comparable to going to a party and finding out that everyone there thinks the price of a certain company's stock is going to double, but nobody has either enough money or insight to be a price setter as opposed to a price taker. In the world outside of the experiment, there are many pools of available funds ready to take advantage of over or under pricing of investment opportunities and shrink the mispricing. Additionally, there are real world pricing constraints, such as short selling and signaling from informed sellers or buyers, and other equivalent markets, such as derivatives, etc.
For example, during tender offers, shares become unavailable and on occasion Put Call Parity will break down because shares are unobtainable for shorting or purchasing. In investing and trading markets even in time of "animal spirits," arbitrage relationships do not break down.
In 2005, residential housing was 15.6 percent of GDP. In 20091Q, it was 13 percent. Clearly, the decline in the residential housing sector is contributing to the decline in GDP. If we understood the decline in home prices, which caused the decline on housing related activities, we would understand a lot about our current economic downturn.
Residential housing is composed of two assets, the structure and the land. During the recent housing price run up and collapse, the price to rent ratio increased about 60 percent from 1999 to 2005. From 2005 to 2009, the price to rent ratio declined about 20 percent, so that it is still about 30 percent higher than 1999. Home prices rose faster than rents.
A renter does not have the legal rights of the owner to the land, but both have rights to the occupation of the structure. Since owners did not raise rents in line with residential value increases, is it illogical to conclude that home price increases were either in the land or in the cost of developing and regulatory approvals of a building lot, and not in the structure?
Furthermore, since homes are durable goods with an intergenerational life, expectations about future events that would significantly influence house prices can change and affect prices, both upwardly and then downwardly, before the events reveal themselves to the participants. Home prices would appear to be irrational unless one looked for economic or governmental signals that would modify expectations about events affecting future land prices. Expectations about future regulatory development restrictions, expensive government mandated costs associated with development, such as schools, sewers, roads, etc., or changes in estimates of developing high cost land, such as steep slopes, etc. would modify home prices without the occurrence of any direct home price related event. The fact that expectations about a future event change affects home prices and then reverts prior to that event actually happening, does not indicate irrationality or animal spirits. It could be rational response to anticipated events, still anticipated.
We will need time for events to unfold to show us the causes of the decline in house value. It could be many future factors, such as lower population growth, lower rate of household formations, lower household income growth, deflation, changes in the cost of home building, and many others.
Use of the terms "animal spirits" and "irrational behavior" as economic explanations reminds me of the patient with a red rash who goes to the doctor and is diagnosed with an ailment that is the Latin phrase for red rash. In both the economic and medical cases, the new terms do not contribute to our understanding and do not assist us in finding preventive or corrective measures. They are just linguistic placeholders until we learn more.
Furthermore, the spirits and irrationality are as likely to be coincident or lagging as leading, and if correlated, not causative. If my neighbors sell their house for a price that surprises me and makes me feel paper wealthy, am I irrational to think that at a future date, I could also sell for that or a higher price. If so, which caused which? If unexpectedly I must relocate and sell my home, am I relying on animal spirits when I buy my new home?
Furthermore, controlled laboratory behavioral pricing and trading experiments may show irrational pricing among the participants, but the lab situation tends to give equal weighting to all participants. It is comparable to going to a party and finding out that everyone there thinks the price of a certain company's stock is going to double, but nobody has either enough money or insight to be a price setter as opposed to a price taker. In the world outside of the experiment, there are many pools of available funds ready to take advantage of over or under pricing of investment opportunities and shrink the mispricing. Additionally, there are real world pricing constraints, such as short selling and signaling from informed sellers or buyers, and other equivalent markets, such as derivatives, etc.
For example, during tender offers, shares become unavailable and on occasion Put Call Parity will break down because shares are unobtainable for shorting or purchasing. In investing and trading markets even in time of "animal spirits," arbitrage relationships do not break down.
In 2005, residential housing was 15.6 percent of GDP. In 20091Q, it was 13 percent. Clearly, the decline in the residential housing sector is contributing to the decline in GDP. If we understood the decline in home prices, which caused the decline on housing related activities, we would understand a lot about our current economic downturn.
Residential housing is composed of two assets, the structure and the land. During the recent housing price run up and collapse, the price to rent ratio increased about 60 percent from 1999 to 2005. From 2005 to 2009, the price to rent ratio declined about 20 percent, so that it is still about 30 percent higher than 1999. Home prices rose faster than rents.
A renter does not have the legal rights of the owner to the land, but both have rights to the occupation of the structure. Since owners did not raise rents in line with residential value increases, is it illogical to conclude that home price increases were either in the land or in the cost of developing and regulatory approvals of a building lot, and not in the structure?
Furthermore, since homes are durable goods with an intergenerational life, expectations about future events that would significantly influence house prices can change and affect prices, both upwardly and then downwardly, before the events reveal themselves to the participants. Home prices would appear to be irrational unless one looked for economic or governmental signals that would modify expectations about events affecting future land prices. Expectations about future regulatory development restrictions, expensive government mandated costs associated with development, such as schools, sewers, roads, etc., or changes in estimates of developing high cost land, such as steep slopes, etc. would modify home prices without the occurrence of any direct home price related event. The fact that expectations about a future event change affects home prices and then reverts prior to that event actually happening, does not indicate irrationality or animal spirits. It could be rational response to anticipated events, still anticipated.
We will need time for events to unfold to show us the causes of the decline in house value. It could be many future factors, such as lower population growth, lower rate of household formations, lower household income growth, deflation, changes in the cost of home building, and many others.
Friday, May 8, 2009
New Regulations And Capital Requirements Will Not Prevent Too Big To Fail
Banking is a highly concentrated industry. There are about 5500 FDIC insured banks in the US with the top 10 banks holding most of the assets, loans, and deposits.
There are certainly economies of scale in banking in the larger institutions, but the next lower size tier of banks also probably benefit from many, if not all, of the same economies of scale. Economies do not explain by themselves the extreme concentration of banking. There may be even diseconomies and extra costs for the very large banks in comparison to the next lower tier, smaller banks.
There is a too big to fail size that some large banks strive to reach that offsets the extra costs and diseconomies of the top banks’ size. The extra costs of proposed new constraints and regulations have to be so great as to completely negate the benefit of being too big to fail. We do not have the quantitative data to be sure what kind of new requirements will effectively do the job.
Breaking up big banks is OK if most of the positive benefits of the scale economies remain. Otherwise, we are imposing new banking costs on the customer. The change and extra costs will force an unpredictable behavioral effect at the consumer level of banking with unintended economy wide results.
Stringent regulations and higher capital requirements will not prevent too big to fail banks. Larger banks that can realistically reach a too big to fail size have too much risk taking incentive. These banks will find the weaknesses in the new regulations through analysis or trial and error. Then, these banks will take additional risks in less well-regulated, costly areas until they reach a too big to fail size.
The incentive to become a too big to fail bank is huge. Once a bank reaches a too big size, the bank can take an inordinately large amount of business risk in an attempt to produce a very large amount of income. It becomes a gambler that can bet its entire stake, the whole bank, on a single risky bet without fear that if it loses, it will no longer be able to continue gambling, i.e. the bank will be closed.
The best alternative may be to phase out the too big to fail doctrine completely. However, the banks and the government are then playing a game of chicken, or poker. Will the government really let there be a very large bank failure? Could a bank grow very large just to see if the government is bluffing?
There are certainly economies of scale in banking in the larger institutions, but the next lower size tier of banks also probably benefit from many, if not all, of the same economies of scale. Economies do not explain by themselves the extreme concentration of banking. There may be even diseconomies and extra costs for the very large banks in comparison to the next lower tier, smaller banks.
There is a too big to fail size that some large banks strive to reach that offsets the extra costs and diseconomies of the top banks’ size. The extra costs of proposed new constraints and regulations have to be so great as to completely negate the benefit of being too big to fail. We do not have the quantitative data to be sure what kind of new requirements will effectively do the job.
Breaking up big banks is OK if most of the positive benefits of the scale economies remain. Otherwise, we are imposing new banking costs on the customer. The change and extra costs will force an unpredictable behavioral effect at the consumer level of banking with unintended economy wide results.
Stringent regulations and higher capital requirements will not prevent too big to fail banks. Larger banks that can realistically reach a too big to fail size have too much risk taking incentive. These banks will find the weaknesses in the new regulations through analysis or trial and error. Then, these banks will take additional risks in less well-regulated, costly areas until they reach a too big to fail size.
The incentive to become a too big to fail bank is huge. Once a bank reaches a too big size, the bank can take an inordinately large amount of business risk in an attempt to produce a very large amount of income. It becomes a gambler that can bet its entire stake, the whole bank, on a single risky bet without fear that if it loses, it will no longer be able to continue gambling, i.e. the bank will be closed.
The best alternative may be to phase out the too big to fail doctrine completely. However, the banks and the government are then playing a game of chicken, or poker. Will the government really let there be a very large bank failure? Could a bank grow very large just to see if the government is bluffing?
Thursday, May 7, 2009
Hedge Fund Manager Criticizes Obama's Chrysler Plan
Below is a widely published, circulating, irate hedge fund manager's letter criticizing President Obama's stance on the Chrysler bonds. There are several excellent points in the letter.
Unafraid In Greenwich Connecticut
Clifford S. Asness
Managing and Founding Principal
AQR Capital Management, LLC
The President has just harshly castigated hedge fund managers for being unwilling to take his administration’s bid for their Chrysler bonds. He called them “speculators” who were “refusing to sacrifice like everyone else” and who wanted “to hold out for the prospect of an unjustified taxpayer-funded bailout.”
The responses of hedge fund managers have been, appropriately, outrage, but generally have been anonymous for fear of going on the record against a powerful President (an exception, though still in the form of a “group letter”, was the superb note from “The Committee of Chrysler Non-TARP Lenders” some of the points of which I echo here, and a relatively few firms, like Oppenheimer, that have publicly defended themselves). Furthermore, one by one the managers and banks are said to be caving to the President’s wishes out of justifiable fear.
I run an approximately twenty billion dollar money management firm that offers hedge funds as well as public mutual funds and unhedged traditional investments. My company is not involved in the Chrysler situation, but I am still aghast at the President's comments (of course these are my own views not those of my company). Furthermore, for some reason I was not born with the common sense to keep it to myself, though my title should more accurately be called "Not Afraid Enough" as I am indeed fearful writing this... It’s really a bad idea to speak out. Angering the President is a mistake and, my views will annoy half my clients. I hope my clients will understand that I’m entitled to my voice and to speak it loudly, just as they are in this great country. I hope they will also like that I do not think I have the right to intentionally “sacrifice” their money without their permission.
Here's a shock. When hedge funds, pension funds, mutual funds, and individuals, including very sweet grandmothers, lend their money they expect to get it back. However, they know, or should know, they take the risk of not being paid back. But if such a bad event happens it usually does not result in a complete loss. A firm in bankruptcy still has assets. It’s not always a pretty process. Bankruptcy court is about figuring out how to most fairly divvy up the remaining assets based on who is owed what and whose contracts come first. The process already has built-in partial protections for employees and pensions, and can set lenders' contracts aside in order to help the company survive, all of which are the rules of the game lenders know before they lend. But, without this recovery process nobody would lend to risky borrowers. Essentially, lenders accept less than shareholders (means bonds return less than stocks) in good times only because they get more than shareholders in bad times.
The above is how it works in America, or how it’s supposed to work. The President and his team sought to avoid having Chrysler go through this process, proposing their own plan for re-organizing the company and partially paying off Chrysler’s creditors. Some bond holders thought this plan unfair. Specifically, they thought it unfairly favored the United Auto Workers, and unfairly paid bondholders less than they would get in bankruptcy court. So, they said no to the plan and decided, as is their right, to take their chances in the bankruptcy process. But, as his quotes above show, the President thought they were being unpatriotic or worse.
Let’s be clear, it is the job and obligation of all investment managers, including hedge fund managers, to get their clients the most return they can. They are allowed to be charitable with their own money, and many are spectacularly so, but if they give away their clients’ money to share in the “sacrifice”, they are stealing. Clients of hedge funds include, among others, pension funds of all kinds of workers, unionized and not. The managers have a fiduciary obligation to look after their clients’ money as best they can, not to support the President, nor to oppose him, nor otherwise advance their personal political views. That’s how the system works. If you hired an investment professional and he could preserve more of your money in a financial disaster, but instead he decided to spend it on the UAW so you could “share in the sacrifice”, you would not be happy.
Let’s quickly review a few side issues.
The President's attempted diktat takes money from bondholders and gives it to a labor union that delivers money and votes for him. Why is he not calling on his party to "sacrifice" some campaign contributions, and votes, for the greater good? Shaking down lenders for the benefit of political donors is recycled corruption and abuse of power.
Let’s also mention only in passing the irony of this same President begging hedge funds to borrow more to purchase other troubled securities. That he expects them to do so when he has already shown what happens if they ask for their money to be repaid fairly would be amusing if not so dangerous. That hedge funds might not participate in these programs because of fear of getting sucked into some toxic demagoguery that ends in arbitrary punishment for trying to work with the Treasury is distressing. Some useful programs, like those designed to help finance consumer loans, won't work because of this irresponsible hectoring.
Last but not least, the President screaming that the hedge funds are looking for an unjustified taxpayer-funded bailout is the big lie writ large. Find me a hedge fund that has been bailed out. Find me a hedge fund, even a failed one, that has asked for one. In fact, it was only because hedge funds have not taken government funds that they could stand up to this bullying. The TARP recipients had no choice but to go along. The hedge funds were singled out only because
they are unpopular, not because they behaved any differently from any other ethical manager of other people's money. The President’s comments here are backwards and libelous. Yet, somehow I don’t think the hedge funds will be following ACORN’s lead and trucking in a bunch of paid professional protestors soon. Hedge funds really need a community organizer.
This is America. We have a free enterprise system that has worked spectacularly for us for two hundred plus years. When it fails it fixes itself. Most importantly, it is not an owned lackey of the oval office to be scolded for disobedience by the President.
I am ready for my “personalized” tax rate now.
Unafraid In Greenwich Connecticut
Clifford S. Asness
Managing and Founding Principal
AQR Capital Management, LLC
The President has just harshly castigated hedge fund managers for being unwilling to take his administration’s bid for their Chrysler bonds. He called them “speculators” who were “refusing to sacrifice like everyone else” and who wanted “to hold out for the prospect of an unjustified taxpayer-funded bailout.”
The responses of hedge fund managers have been, appropriately, outrage, but generally have been anonymous for fear of going on the record against a powerful President (an exception, though still in the form of a “group letter”, was the superb note from “The Committee of Chrysler Non-TARP Lenders” some of the points of which I echo here, and a relatively few firms, like Oppenheimer, that have publicly defended themselves). Furthermore, one by one the managers and banks are said to be caving to the President’s wishes out of justifiable fear.
I run an approximately twenty billion dollar money management firm that offers hedge funds as well as public mutual funds and unhedged traditional investments. My company is not involved in the Chrysler situation, but I am still aghast at the President's comments (of course these are my own views not those of my company). Furthermore, for some reason I was not born with the common sense to keep it to myself, though my title should more accurately be called "Not Afraid Enough" as I am indeed fearful writing this... It’s really a bad idea to speak out. Angering the President is a mistake and, my views will annoy half my clients. I hope my clients will understand that I’m entitled to my voice and to speak it loudly, just as they are in this great country. I hope they will also like that I do not think I have the right to intentionally “sacrifice” their money without their permission.
Here's a shock. When hedge funds, pension funds, mutual funds, and individuals, including very sweet grandmothers, lend their money they expect to get it back. However, they know, or should know, they take the risk of not being paid back. But if such a bad event happens it usually does not result in a complete loss. A firm in bankruptcy still has assets. It’s not always a pretty process. Bankruptcy court is about figuring out how to most fairly divvy up the remaining assets based on who is owed what and whose contracts come first. The process already has built-in partial protections for employees and pensions, and can set lenders' contracts aside in order to help the company survive, all of which are the rules of the game lenders know before they lend. But, without this recovery process nobody would lend to risky borrowers. Essentially, lenders accept less than shareholders (means bonds return less than stocks) in good times only because they get more than shareholders in bad times.
The above is how it works in America, or how it’s supposed to work. The President and his team sought to avoid having Chrysler go through this process, proposing their own plan for re-organizing the company and partially paying off Chrysler’s creditors. Some bond holders thought this plan unfair. Specifically, they thought it unfairly favored the United Auto Workers, and unfairly paid bondholders less than they would get in bankruptcy court. So, they said no to the plan and decided, as is their right, to take their chances in the bankruptcy process. But, as his quotes above show, the President thought they were being unpatriotic or worse.
Let’s be clear, it is the job and obligation of all investment managers, including hedge fund managers, to get their clients the most return they can. They are allowed to be charitable with their own money, and many are spectacularly so, but if they give away their clients’ money to share in the “sacrifice”, they are stealing. Clients of hedge funds include, among others, pension funds of all kinds of workers, unionized and not. The managers have a fiduciary obligation to look after their clients’ money as best they can, not to support the President, nor to oppose him, nor otherwise advance their personal political views. That’s how the system works. If you hired an investment professional and he could preserve more of your money in a financial disaster, but instead he decided to spend it on the UAW so you could “share in the sacrifice”, you would not be happy.
Let’s quickly review a few side issues.
The President's attempted diktat takes money from bondholders and gives it to a labor union that delivers money and votes for him. Why is he not calling on his party to "sacrifice" some campaign contributions, and votes, for the greater good? Shaking down lenders for the benefit of political donors is recycled corruption and abuse of power.
Let’s also mention only in passing the irony of this same President begging hedge funds to borrow more to purchase other troubled securities. That he expects them to do so when he has already shown what happens if they ask for their money to be repaid fairly would be amusing if not so dangerous. That hedge funds might not participate in these programs because of fear of getting sucked into some toxic demagoguery that ends in arbitrary punishment for trying to work with the Treasury is distressing. Some useful programs, like those designed to help finance consumer loans, won't work because of this irresponsible hectoring.
Last but not least, the President screaming that the hedge funds are looking for an unjustified taxpayer-funded bailout is the big lie writ large. Find me a hedge fund that has been bailed out. Find me a hedge fund, even a failed one, that has asked for one. In fact, it was only because hedge funds have not taken government funds that they could stand up to this bullying. The TARP recipients had no choice but to go along. The hedge funds were singled out only because
they are unpopular, not because they behaved any differently from any other ethical manager of other people's money. The President’s comments here are backwards and libelous. Yet, somehow I don’t think the hedge funds will be following ACORN’s lead and trucking in a bunch of paid professional protestors soon. Hedge funds really need a community organizer.
This is America. We have a free enterprise system that has worked spectacularly for us for two hundred plus years. When it fails it fixes itself. Most importantly, it is not an owned lackey of the oval office to be scolded for disobedience by the President.
I am ready for my “personalized” tax rate now.
Tuesday, May 5, 2009
My Comment To "First, Blame the Regulators"
A comment that I posted today, May 5, in the New York Times Economix Blog. It was in response to Catherine Rampell's piece called, "First, Blame the Regulators." In the blog, she mentions what Gladwell, Taleb, Kuttner and Steiner blame for the cause of the current economic and financial crisis. My post was in response. Also, see my previous post on regulations.
My complete comment is republished below:
Only journalists, writers, academics, politicians and others that have not managed or owned a business in a challenging economic environment could believe that a single, simple solution, a finger in the dam, could have prevented the financial crisis and recession. When a stressed economic and financial system reaches its breaking point, it will break. Afterward, the obvious cracks need repair, but other cracks, just as likely, could have occurred in their place. Only looking at the aftereffect cracks in the wall will miss the accumulated winter snow on the roof that contributed to the problem.
Our economic and financial system cracked under stress and was on the verge of breaking from, among other things, a credit lockup. It will be many years, if ever, that the causes of this worldwide economic downturn will be understood. Experts still debate the causes of The Great Depression, let alone the best preventive and corrective measures. No knowledgeable person believes that causes of recessionary economic cycles are fully understood or preventable.
No one really has a consensus, confirmed idea as to what happened with sufficient economic impact to cause the excessive stress to our financial system or what caused the housing market to overheat and then collapse. To use terms such as "bubbles" or "animal spirits" are not explanations, but they are a linguistic trick that rephrases the problem. It is like a doctor who diagnosis a red rash by telling you that you have a disease that is just the Latin phrase for red rash. It says nothing about causes, treatments or solutions.
Strengthening a weak link of an overloaded tow chain, does not stop the chain from snapping. It just snaps at another point. Strengthen every link in the chain and under enough force, the items attached at the ends of the chain will tear apart, instead of breaking the chain. Continual structural reinforcement will eventually just push the overloading stress to cause the engine doing the pulling to burn out, etc. Extremely stressful forces are too great for any system, including our financial and regulatory systems. Extreme stress will always find the breaking points.
To believe openly that thousands, if not millions, worldwide were lemming-like, economically suicidal, self-destructive and too dumb is beyond arrogance and naiveté. Do these self-aggrandizing pundits think that their simple solutions, such as different probability distributions, different regulations, or wiser elected officials were enough to avoid the crisis, and save the jobs, wealth, prestige and institutions of those affected? Are we so unwise in the ways of the world to believe that if we had only worn the blue shirt (blouse) instead of the white one on that important day, we would be happier today? Did the prospects of a golden calf lead the millions of residential construction workers, bank-lending officers, mortgage originators, homebuyers, mortgage borrowers, investment bankers and the regulatory examiners astray? If only we had listen to the sage advice of these chosen few who saw the light before it was too late, we all would have been saved.
Of course, I wonder how many of these wise men lost money in their home values, retirement accounts and investments. None I would guess. Most of these wise men make some money in the struggling newspaper, magazine or book publishing industries. I cannot wait to hear the great advice they have to tell the struggling companies in this industry. Aw shucks! I forgot. I have to wait until these publishers go out of business to hear the correct solution to the industry's problems. If only publishers had used a cheaper blue ink instead of black and a different font.
My complete comment is republished below:
Only journalists, writers, academics, politicians and others that have not managed or owned a business in a challenging economic environment could believe that a single, simple solution, a finger in the dam, could have prevented the financial crisis and recession. When a stressed economic and financial system reaches its breaking point, it will break. Afterward, the obvious cracks need repair, but other cracks, just as likely, could have occurred in their place. Only looking at the aftereffect cracks in the wall will miss the accumulated winter snow on the roof that contributed to the problem.
Our economic and financial system cracked under stress and was on the verge of breaking from, among other things, a credit lockup. It will be many years, if ever, that the causes of this worldwide economic downturn will be understood. Experts still debate the causes of The Great Depression, let alone the best preventive and corrective measures. No knowledgeable person believes that causes of recessionary economic cycles are fully understood or preventable.
No one really has a consensus, confirmed idea as to what happened with sufficient economic impact to cause the excessive stress to our financial system or what caused the housing market to overheat and then collapse. To use terms such as "bubbles" or "animal spirits" are not explanations, but they are a linguistic trick that rephrases the problem. It is like a doctor who diagnosis a red rash by telling you that you have a disease that is just the Latin phrase for red rash. It says nothing about causes, treatments or solutions.
Strengthening a weak link of an overloaded tow chain, does not stop the chain from snapping. It just snaps at another point. Strengthen every link in the chain and under enough force, the items attached at the ends of the chain will tear apart, instead of breaking the chain. Continual structural reinforcement will eventually just push the overloading stress to cause the engine doing the pulling to burn out, etc. Extremely stressful forces are too great for any system, including our financial and regulatory systems. Extreme stress will always find the breaking points.
To believe openly that thousands, if not millions, worldwide were lemming-like, economically suicidal, self-destructive and too dumb is beyond arrogance and naiveté. Do these self-aggrandizing pundits think that their simple solutions, such as different probability distributions, different regulations, or wiser elected officials were enough to avoid the crisis, and save the jobs, wealth, prestige and institutions of those affected? Are we so unwise in the ways of the world to believe that if we had only worn the blue shirt (blouse) instead of the white one on that important day, we would be happier today? Did the prospects of a golden calf lead the millions of residential construction workers, bank-lending officers, mortgage originators, homebuyers, mortgage borrowers, investment bankers and the regulatory examiners astray? If only we had listen to the sage advice of these chosen few who saw the light before it was too late, we all would have been saved.
Of course, I wonder how many of these wise men lost money in their home values, retirement accounts and investments. None I would guess. Most of these wise men make some money in the struggling newspaper, magazine or book publishing industries. I cannot wait to hear the great advice they have to tell the struggling companies in this industry. Aw shucks! I forgot. I have to wait until these publishers go out of business to hear the correct solution to the industry's problems. If only publishers had used a cheaper blue ink instead of black and a different font.
Monday, May 4, 2009
Signaling And Mortgage Securities
My response to Arnold Kling's post "that securitzation depended on false signals of soundness."
Signaling is important in finance, but there were economic incentives to misread the signals of mortgage securitization. Additionally, there were regulatory structure issues that prevented corrections to the misread signals. Both problems are fixable.
Both investment banks and commercial banks must maintain capital against their assets. In both, the amount of capital (not identical for the two types of entities) for mortgage securities was determined by formulas that used the credit ratings of the SEC recognized credit rating agencies, NRSROs. A better credit rating required less capital.
Mortgage originators derive their income from fees, which need a continuing volume of new mortgages. Originators did not hold mortgages for their interest income and a principal agent problem occurred. As long as there were buyers of packaged mortgages (securitization), including lower quality mortgages, originators could replenish their limited amount of lendable funds and continue to generate fee income without regard to the deteriorating quality of the new mortgages.
The commercial banks and investment banks (buyers) preferred securitized mortgages with lower capital requirements, which were the higher NRSRO credit rated securitized mortgages. The buyers could put up less capital against these assets, purchase more of them with their existing capital base and derive a higher income.
If the buyers, the commercial banks and investment banks, monitored and analyzed the quality of the securitized mortgages correctly and read the signals, these buyers would have had to put up more capital against theses investments, purchase less of them and reduce their income.
The regulators accepted the credit rating agencies' ratings and their lower capital requirements. For a buyer to question the ratings, the buyer would have to accept lowering its income, putting higher capital against the assets and investing in fewer of them. To the commercial banks and investment banks, it was a clear cost benefit decision. The benefits were lower capital versus higher capital, higher income versus lower income, and more securitized mortgages versus fewer securitized mortgages. The costs were higher potential defaults and higher potential losses. Post WWII history made the benefits appear to outweigh the costs even on a risk-adjusted basis.
The NRSRO rating agencies depended on the volume of their ratings of mortgages to produce a continuing fee income stream. A lower rating meant the buyers would use more capital and there would be fewer mortgages for ratings. Each of the rating agencies jeopardized their reputations and brands through lowering the quality of their rating methodology for securitized mortgages. However, the SEC's NRSRO limitations and designation hurdles protected the ratings agencies, limited competition and ensured the existing NRSROs that they would not lose their current or future business clients or ratings income stream.
The regulatory structure for NRSRO designation prevented customers from turning to other rating agencies for mortgage securities ratings. The regulatory structure for capital, which depended on NRSRO ratings, economically inhibited the commercial banks and investment banks from doing their own analysis of the potential for losses in the packaged mortgage securities.
The problem that occurred was not lack of proper signals of the deteriorating quality of mortgage securities. There were many, including who was sourcing the mortgages, the existing decline in home prices and the increasing level of defaults. The buyers ignored the signals.
The prevalent signals were overridden and ignored due to the structural problems created by the regulatory structure for NRSRO designation and the NRSRO credit rating used for determining capital levels.
A successful securitization process does not need credit ratings and NRSROs. However, since commercial banks and investment banks are required to hold capital against their investments, a new methodology for determining capital levels without NRSROs and credit ratings is needed.
The problem was not false signals, but structural and regulatory issues that prevented buyers from reading and using the available correct signals.
Signaling is important in finance, but there were economic incentives to misread the signals of mortgage securitization. Additionally, there were regulatory structure issues that prevented corrections to the misread signals. Both problems are fixable.
Both investment banks and commercial banks must maintain capital against their assets. In both, the amount of capital (not identical for the two types of entities) for mortgage securities was determined by formulas that used the credit ratings of the SEC recognized credit rating agencies, NRSROs. A better credit rating required less capital.
Mortgage originators derive their income from fees, which need a continuing volume of new mortgages. Originators did not hold mortgages for their interest income and a principal agent problem occurred. As long as there were buyers of packaged mortgages (securitization), including lower quality mortgages, originators could replenish their limited amount of lendable funds and continue to generate fee income without regard to the deteriorating quality of the new mortgages.
The commercial banks and investment banks (buyers) preferred securitized mortgages with lower capital requirements, which were the higher NRSRO credit rated securitized mortgages. The buyers could put up less capital against these assets, purchase more of them with their existing capital base and derive a higher income.
If the buyers, the commercial banks and investment banks, monitored and analyzed the quality of the securitized mortgages correctly and read the signals, these buyers would have had to put up more capital against theses investments, purchase less of them and reduce their income.
The regulators accepted the credit rating agencies' ratings and their lower capital requirements. For a buyer to question the ratings, the buyer would have to accept lowering its income, putting higher capital against the assets and investing in fewer of them. To the commercial banks and investment banks, it was a clear cost benefit decision. The benefits were lower capital versus higher capital, higher income versus lower income, and more securitized mortgages versus fewer securitized mortgages. The costs were higher potential defaults and higher potential losses. Post WWII history made the benefits appear to outweigh the costs even on a risk-adjusted basis.
The NRSRO rating agencies depended on the volume of their ratings of mortgages to produce a continuing fee income stream. A lower rating meant the buyers would use more capital and there would be fewer mortgages for ratings. Each of the rating agencies jeopardized their reputations and brands through lowering the quality of their rating methodology for securitized mortgages. However, the SEC's NRSRO limitations and designation hurdles protected the ratings agencies, limited competition and ensured the existing NRSROs that they would not lose their current or future business clients or ratings income stream.
The regulatory structure for NRSRO designation prevented customers from turning to other rating agencies for mortgage securities ratings. The regulatory structure for capital, which depended on NRSRO ratings, economically inhibited the commercial banks and investment banks from doing their own analysis of the potential for losses in the packaged mortgage securities.
The problem that occurred was not lack of proper signals of the deteriorating quality of mortgage securities. There were many, including who was sourcing the mortgages, the existing decline in home prices and the increasing level of defaults. The buyers ignored the signals.
The prevalent signals were overridden and ignored due to the structural problems created by the regulatory structure for NRSRO designation and the NRSRO credit rating used for determining capital levels.
A successful securitization process does not need credit ratings and NRSROs. However, since commercial banks and investment banks are required to hold capital against their investments, a new methodology for determining capital levels without NRSROs and credit ratings is needed.
The problem was not false signals, but structural and regulatory issues that prevented buyers from reading and using the available correct signals.
Sunday, May 3, 2009
Heavy Cost Of The Principal-Agent Divide
Good article in Financial Times, "The heavy cost of the principal-agent divide" by John Authers on how principal agent problem contributed to the current financial crisis and mortgage mess.
"When we invest or borrow, we are at least one remove from the producer. The person who decides to lend you a mortgage will not bear the risk of your failing to repay it. Instead, that risk is securitised and sold in the form of a bond on the securities market.
...
But the splitting of principal and agent over the past few decades has exacerbated the financial problems that now bedevil us. Most obviously, this affects mortgage lending. The people who authorised “toxic” subprime mortgages in the US did so knowing that they would not have to bear the risk. They had an incentive to lend as much as possible but not to ensure that as much money as possible came back."
"When we invest or borrow, we are at least one remove from the producer. The person who decides to lend you a mortgage will not bear the risk of your failing to repay it. Instead, that risk is securitised and sold in the form of a bond on the securities market.
...
But the splitting of principal and agent over the past few decades has exacerbated the financial problems that now bedevil us. Most obviously, this affects mortgage lending. The people who authorised “toxic” subprime mortgages in the US did so knowing that they would not have to bear the risk. They had an incentive to lend as much as possible but not to ensure that as much money as possible came back."
Saturday, May 2, 2009
Global Warming And Cap And Trade Markets Are Not Like Other Markets
Global warming trading markets are not identical to a typical goods, commodities, equity or debt trading market. A US Cap and Trade market in CO2 must overcome several, not so easily resolved, problems.
While all trading markets that have regulatory oversight will have some distortions due to their governing regulatory process, the costs of market distortions and failure of a trading market intended to protect the continuing habitability of our planet are potentially more devastating than failures in other pricing markets. The result of one is inhabitability of the planet versus the investors' wealth losses result of the other.
Arbitrage is a part of all trading markets. It occurs not just in identical goods in different markets, but also in equivalent and substitutable goods. Additionally, there is the potential for regulatory arbitrage.
Some and certainly not all of the known problems needing solution for a successful US Cap and Trade market in CO2 are:
Imported Goods
Identical and substitutable products produced outside of the US and sold in the US must have identical or higher greenhouse gas pricing per unit of greenhouse gas emission as US produced products. Otherwise, the US buyer (industrial, government or consumer) will substitute the cheaper foreign produced goods with a higher greenhouse gas emission than US produced goods, and worldwide greenhouse gas emissions will increase.
Process Substitution
The pricing in a cap and trade market may create undesirable substitution into other greenhouse gases so that the result is a greater global warming effect. For example, methane is about 25 times more potent than CO2 in its global warming effect. If the total cost of substituting into a methane emission process is not at least 25 times greater than the costs to obtain a CO2 permit purchased in a Cap and Trade system, a producer of CO2 could cost effectively substitute a methane process. However, there will be no reduction in the effect of global warming greenhouse gases and there might even be an increase in a detrimental effect. Since the market will determine the permit prices, how do we prevent economically beneficial substitutions that hurt the climate?
Producers will continue to look for processes than emit gases that are believed neutral for global warming based on our current knowledge and that do not need a Cap and Trade permit. Of course, scientific knowledge is always expanding and changing. These alternative emissions may be discovered subsequently to be detrimental to global warming or other as potentially harmful climate effects. In other words, we may reduce CO2 but not global warming or climate harm. This is a societal benefit, proxy mismeasurement problem.
Permits As Investments
Any Cap and Trade system must not interfere with process innovations that decrease CO2 (and other greenhouse gas) output. In other words, producers of some particular goods may have no incentive to invest in new equipment that will lower greenhouse gas emissions because all the manufacturers of those goods will see a wealth loss in their permits greater than the cost savings and benefits of the new lower greenhouse process.
Price Increases
It is likely, but not certain, that the additional cost of purchasing a permit in Cap and Trade will increase prices to buyers of the produced goods. Price increases are not certain because competition does not always allow production cost increases to be passed on to buyers. If the industry cannot achieve pricing that allows for a fair return on its investment, the industry will disinvest and eventually go out of business. However, if the price is increased, competitors with alternative lower greenhouse gas emission, equivalent processes and products will see an opportunity to enter the business whereas before the additional costs of Cap and Trade, the lower pricing did not give these new competitors an economic incentive to enter the business. It is uncertain how government will respond to a price increase or to industry competition. Based on the likely political effects of a price increase, especially if it is significant, politicians will chastise the industry and call for it to lower prices or as likely, the politicians will enact price controls. Both could be detrimental to the survivability of the particular industry. Another potential political outcome could be that the industry with a high cost cap and trade permits may not be competitive against a new competitor that either does not need a permit or can produce at a lower level of greenhouse gas emission. Will we see a replay of the current auto industry crisis in a different industry and how will the politicians respond? Will the political reaction ensure the continuation of a high level of greenhouse gas output?
Incentive to Decrease CO2
Since Cap and Trade fixes the amount of unwanted emissions output, how will we allow for innovations that decrease detrimental emissions over time that matches industries' abilities to innovate without negatively affecting output? Will a fixed allowable amount of CO2 and other greenhouse gases distort and remove the incentives for process innovations that lower CO2 and other greenhouse gas emissions?
Alternative Energy
Will the US allow investment into alternative processes that lower greenhouse gas emissions but have other practical and political problems, such as nuclear energy, wind energy in the visual landscape, etc.? Won't permit prices have an additional price volatility related to changes in potential government energy policies?
Permit Price Volatility
How will industry respond to the normal Cap and Trade permit price volatility that exists in all trading markets? Will the volatility have unwanted effects?
Hedging
Will industry use hedges to offset changes in permit prices and will government desired outcomes be different with hedging than without hedging?
While all trading markets that have regulatory oversight will have some distortions due to their governing regulatory process, the costs of market distortions and failure of a trading market intended to protect the continuing habitability of our planet are potentially more devastating than failures in other pricing markets. The result of one is inhabitability of the planet versus the investors' wealth losses result of the other.
Arbitrage is a part of all trading markets. It occurs not just in identical goods in different markets, but also in equivalent and substitutable goods. Additionally, there is the potential for regulatory arbitrage.
Some and certainly not all of the known problems needing solution for a successful US Cap and Trade market in CO2 are:
Imported Goods
Identical and substitutable products produced outside of the US and sold in the US must have identical or higher greenhouse gas pricing per unit of greenhouse gas emission as US produced products. Otherwise, the US buyer (industrial, government or consumer) will substitute the cheaper foreign produced goods with a higher greenhouse gas emission than US produced goods, and worldwide greenhouse gas emissions will increase.
Process Substitution
The pricing in a cap and trade market may create undesirable substitution into other greenhouse gases so that the result is a greater global warming effect. For example, methane is about 25 times more potent than CO2 in its global warming effect. If the total cost of substituting into a methane emission process is not at least 25 times greater than the costs to obtain a CO2 permit purchased in a Cap and Trade system, a producer of CO2 could cost effectively substitute a methane process. However, there will be no reduction in the effect of global warming greenhouse gases and there might even be an increase in a detrimental effect. Since the market will determine the permit prices, how do we prevent economically beneficial substitutions that hurt the climate?
Producers will continue to look for processes than emit gases that are believed neutral for global warming based on our current knowledge and that do not need a Cap and Trade permit. Of course, scientific knowledge is always expanding and changing. These alternative emissions may be discovered subsequently to be detrimental to global warming or other as potentially harmful climate effects. In other words, we may reduce CO2 but not global warming or climate harm. This is a societal benefit, proxy mismeasurement problem.
Permits As Investments
Any Cap and Trade system must not interfere with process innovations that decrease CO2 (and other greenhouse gas) output. In other words, producers of some particular goods may have no incentive to invest in new equipment that will lower greenhouse gas emissions because all the manufacturers of those goods will see a wealth loss in their permits greater than the cost savings and benefits of the new lower greenhouse process.
Price Increases
It is likely, but not certain, that the additional cost of purchasing a permit in Cap and Trade will increase prices to buyers of the produced goods. Price increases are not certain because competition does not always allow production cost increases to be passed on to buyers. If the industry cannot achieve pricing that allows for a fair return on its investment, the industry will disinvest and eventually go out of business. However, if the price is increased, competitors with alternative lower greenhouse gas emission, equivalent processes and products will see an opportunity to enter the business whereas before the additional costs of Cap and Trade, the lower pricing did not give these new competitors an economic incentive to enter the business. It is uncertain how government will respond to a price increase or to industry competition. Based on the likely political effects of a price increase, especially if it is significant, politicians will chastise the industry and call for it to lower prices or as likely, the politicians will enact price controls. Both could be detrimental to the survivability of the particular industry. Another potential political outcome could be that the industry with a high cost cap and trade permits may not be competitive against a new competitor that either does not need a permit or can produce at a lower level of greenhouse gas emission. Will we see a replay of the current auto industry crisis in a different industry and how will the politicians respond? Will the political reaction ensure the continuation of a high level of greenhouse gas output?
Incentive to Decrease CO2
Since Cap and Trade fixes the amount of unwanted emissions output, how will we allow for innovations that decrease detrimental emissions over time that matches industries' abilities to innovate without negatively affecting output? Will a fixed allowable amount of CO2 and other greenhouse gases distort and remove the incentives for process innovations that lower CO2 and other greenhouse gas emissions?
Alternative Energy
Will the US allow investment into alternative processes that lower greenhouse gas emissions but have other practical and political problems, such as nuclear energy, wind energy in the visual landscape, etc.? Won't permit prices have an additional price volatility related to changes in potential government energy policies?
Permit Price Volatility
How will industry respond to the normal Cap and Trade permit price volatility that exists in all trading markets? Will the volatility have unwanted effects?
Hedging
Will industry use hedges to offset changes in permit prices and will government desired outcomes be different with hedging than without hedging?
Tuesday, April 28, 2009
Why Wall St Salaries Are Still High
Alternative job opportunities, including entrepreneurship, determine pay scales. It is a bidding contest where the best and highest value use of the intelligence, motivation, education, risk taking and other employment related characteristics of employees determine their salaries. A business is a salary price taker and not a price setter. Wall St. and other businesses that pay high salaries, such as law firms, for talent can only adjust their business models, to the extent allowed by competition, to see if they can afford the going rate for the talent they want to hire. High salaries, like capital investment, are also barriers to entry for new competition and offer a competitive advantage to firms that can afford to pay them.
The fact that there were losses or that results did not justify the pay scales after the fact is irrelevant. The competitive market salary requirement at the beginning of the process for the type of individual employee characteristics desired is what is relevant.
Suppose several horse owners have potentially winning racehorses in the same big purse race, should not each owner hire the best jockey he can afford. Obviously, after the race, the hiring of only one jockey made sense. It is irrational to say after the race that the other, losing owners paid too much for their jockeys and that they should have saved money and used lower paid, average performing jockeys.
The same logic is true for evaluating innovation. Suppose the government or industry believes that a cure can be found for a devastating disease at a reasonable but high research cost. If the research is funded and undertaken, but after a sufficient time no cure or other innovations are found, the original funding was still appropriate. It is the expectations at the beginning of the research process that determines if the funding is appropriate for innovation.
In addition to the competitive advantage, Wall St. needs self-sufficient, confident, intelligent, risk taking, business loving employees to succeed. These types of employees have many career options, including international employment, entrepreneurship, and successful business careers. They also have many education choices and can be doctors, top law firm attorneys, etc. The fact that there were financial industry losses and bad past investments and products does not change Wall St's future need for these types of people.
To be against Wall St salaries is the same as saying that market determined salaries are irrelevant. It is the same as saying that job and employee characteristics are unimportant and that everyone should get the same salary, which can be whatever the government wants including minimum wage.
The fact that there were losses or that results did not justify the pay scales after the fact is irrelevant. The competitive market salary requirement at the beginning of the process for the type of individual employee characteristics desired is what is relevant.
Suppose several horse owners have potentially winning racehorses in the same big purse race, should not each owner hire the best jockey he can afford. Obviously, after the race, the hiring of only one jockey made sense. It is irrational to say after the race that the other, losing owners paid too much for their jockeys and that they should have saved money and used lower paid, average performing jockeys.
The same logic is true for evaluating innovation. Suppose the government or industry believes that a cure can be found for a devastating disease at a reasonable but high research cost. If the research is funded and undertaken, but after a sufficient time no cure or other innovations are found, the original funding was still appropriate. It is the expectations at the beginning of the research process that determines if the funding is appropriate for innovation.
In addition to the competitive advantage, Wall St. needs self-sufficient, confident, intelligent, risk taking, business loving employees to succeed. These types of employees have many career options, including international employment, entrepreneurship, and successful business careers. They also have many education choices and can be doctors, top law firm attorneys, etc. The fact that there were financial industry losses and bad past investments and products does not change Wall St's future need for these types of people.
To be against Wall St salaries is the same as saying that market determined salaries are irrelevant. It is the same as saying that job and employee characteristics are unimportant and that everyone should get the same salary, which can be whatever the government wants including minimum wage.
Sunday, April 26, 2009
Did The 2007-08 Oil Price Shocks Cause The Current Recession?
James D. Hamilton, Professor of Economics at the University of California, San Diego, posted an interesting piece on the Econbrowser blog, on how the 2007-08 oil price shocks contributed to, if not caused, the current recession.
It is nice to see an economist focus on realistic initial causes and contributing factors to the current economic problems. Many other economists are too focused on blaming the financial industry and inflated house prices. The latter economists have to resort to undefinable and indefinite causes such as animal spirits.
It is nice to see an economist focus on realistic initial causes and contributing factors to the current economic problems. Many other economists are too focused on blaming the financial industry and inflated house prices. The latter economists have to resort to undefinable and indefinite causes such as animal spirits.
Tuesday, April 14, 2009
Merton Speaks
An one and a half hour speech by Harvard Business School Professor Robert C Merton on March 5, 2009. His insights on finance are always refreshing. He speaks about embedded options in assets and their relation to the current crisis.
Monday, April 13, 2009
We Are Medically Over Insured:
Thoughts On Government Health Care
We are medically over insured and paying excessive premium costs because of it. We also need to distinguish between private health insurance purchased by employers and individuals and the government entitled medical care systems of Medicare, Medicaid and other government-mandated health programs. They are two different problems with two different solutions.
The private insurance system is fixable without a need to resort to a government medical health care system. It requires a reinstatement of market pricing mechanisms. The government medical entitlement system, Medicare, etc., is much more difficult to fix. Obama's call for government medical health care is really an attempt to broaden the coverage base of the Medicare system to include all individuals under 65. It would increase the tax base, dilute the voices of seniors about benefits and costs, and allow for an increase in premiums and a decrease in medical benefits to seniors.
Fifty years ago families had major medical insurance. It covered the in-hospital costs of the hospital stay, including doctors, medicine, diagnostic procedures, surgery, anesthesia, etc. It did not cover doctor visits to his office or prescription medicines filled at a pharmacy. People paid the out of pocket costs for medicines and doctor visits. It did not cover voluntary surgeries, but it did cover the hospital costs of a pregnancy including birth. The insurance was affordable.
Thirty years ago, employers only provided major medical and it covered the hospital and doctor costs of the birth of children. People paid for doctor office visits and medicines. They did not overuse the health care system because they were aware of the costs to them.
A decade ago, one could not purchase a major medical insurance policy for their family and themself because no insurer in my state offered that type of coverage. Recently a TV advertisement offered an ala carte medical plan where the insured could choose their own medical benefits. However, some state do not allow insurers to offer that coverage to its residents. Some states are forcing their residents to buy more health insurance than they want. They are forced to buy a comprehensive health insurance policy that covers doctor visits and medicines.
Under a major medical plan, people would save money even if they paid the full costs for daily medicines and regular doctor visits. They buy more coverage than they want or need. They overpay and they have an economic incentive to get back the value of their overpayment by visiting the doctor more often than they would with a less comprehensive but more affordable policy. Their medical coverage unnecessarily increases their use of medical services and increases health care costs. Also, they are subsidizing the patients and doctors who overuse the medical system and they have no economic incentive to monitor their costs. In addition, neither major medical nor comprehensive health insurance covers their potential need for long-term care and catastrophic insurance.
In all other types of insurance, people have freedom to design their own plan. They can choose and purchase basic minimum coverage and add extra benefits for an additional cost. In health insurance, the available benefit options are much more limited.
A simple change that would permit an insurer to offer a minimum policy with add-ons in all 50 states would lower health insurance costs. Also, changes that allowed policies that distinguished between hospitalization and doctor visit benefits would lower costs. Additionally, consumers would have a true incentive to monitor and restrain medical costs because there would be more patients paying their own out of pocket medical costs. Those patients that want full medical coverage could get that type of policy but at much more realistic costs, that reflects their usage patterns. Employers who offer medical benefits would also offer both types and employers would see a cost reduction because some employees will choose the less expensive option.
Health insurance costs are excessive because the market pricing system is not working. Part of the failure of the market pricing mechanism for health care is due to our tax system of allowing employers to deduct the cost of employee medical benefits and part is due to restrictive state regulations. Changing both would allow market pricing to work and influence demand and costs at the consumer level.
Fixing government entitlement medical systems, such as Medicare, are much more difficult to design. These programs are the real costs problems facing our government and taxpayers and not private health insurance. Political ramifications constrain the choices and discussions of changes to these government medical systems. The fix however is not to bury this problem in a broadened government entitlement health care system.
The private insurance system is fixable without a need to resort to a government medical health care system. It requires a reinstatement of market pricing mechanisms. The government medical entitlement system, Medicare, etc., is much more difficult to fix. Obama's call for government medical health care is really an attempt to broaden the coverage base of the Medicare system to include all individuals under 65. It would increase the tax base, dilute the voices of seniors about benefits and costs, and allow for an increase in premiums and a decrease in medical benefits to seniors.
Fifty years ago families had major medical insurance. It covered the in-hospital costs of the hospital stay, including doctors, medicine, diagnostic procedures, surgery, anesthesia, etc. It did not cover doctor visits to his office or prescription medicines filled at a pharmacy. People paid the out of pocket costs for medicines and doctor visits. It did not cover voluntary surgeries, but it did cover the hospital costs of a pregnancy including birth. The insurance was affordable.
Thirty years ago, employers only provided major medical and it covered the hospital and doctor costs of the birth of children. People paid for doctor office visits and medicines. They did not overuse the health care system because they were aware of the costs to them.
A decade ago, one could not purchase a major medical insurance policy for their family and themself because no insurer in my state offered that type of coverage. Recently a TV advertisement offered an ala carte medical plan where the insured could choose their own medical benefits. However, some state do not allow insurers to offer that coverage to its residents. Some states are forcing their residents to buy more health insurance than they want. They are forced to buy a comprehensive health insurance policy that covers doctor visits and medicines.
Under a major medical plan, people would save money even if they paid the full costs for daily medicines and regular doctor visits. They buy more coverage than they want or need. They overpay and they have an economic incentive to get back the value of their overpayment by visiting the doctor more often than they would with a less comprehensive but more affordable policy. Their medical coverage unnecessarily increases their use of medical services and increases health care costs. Also, they are subsidizing the patients and doctors who overuse the medical system and they have no economic incentive to monitor their costs. In addition, neither major medical nor comprehensive health insurance covers their potential need for long-term care and catastrophic insurance.
In all other types of insurance, people have freedom to design their own plan. They can choose and purchase basic minimum coverage and add extra benefits for an additional cost. In health insurance, the available benefit options are much more limited.
A simple change that would permit an insurer to offer a minimum policy with add-ons in all 50 states would lower health insurance costs. Also, changes that allowed policies that distinguished between hospitalization and doctor visit benefits would lower costs. Additionally, consumers would have a true incentive to monitor and restrain medical costs because there would be more patients paying their own out of pocket medical costs. Those patients that want full medical coverage could get that type of policy but at much more realistic costs, that reflects their usage patterns. Employers who offer medical benefits would also offer both types and employers would see a cost reduction because some employees will choose the less expensive option.
Health insurance costs are excessive because the market pricing system is not working. Part of the failure of the market pricing mechanism for health care is due to our tax system of allowing employers to deduct the cost of employee medical benefits and part is due to restrictive state regulations. Changing both would allow market pricing to work and influence demand and costs at the consumer level.
Fixing government entitlement medical systems, such as Medicare, are much more difficult to design. These programs are the real costs problems facing our government and taxpayers and not private health insurance. Political ramifications constrain the choices and discussions of changes to these government medical systems. The fix however is not to bury this problem in a broadened government entitlement health care system.
Sunday, April 12, 2009
Regulations Relocate Risk Taking
Calling for more regulation or a super regulator is a kneejerk reaction that will not prevent future problems. Too often, regulations are about penalizing and criminalizing a past activity after its weaknesses become apparent. Businesses do not like to continue activities that lose money and garner bad publicity. They will change or stop to prevent further damage to their sales and profits before government regulation is proposed or enacted. Allowable activities will be how a financial institution or any regulated company makes it money and profit. Company growth by necessity comes from allowable activities.
Companies and managers will always seek ways to increase sales and profits. Even without bonuses and stock options, managers want their companies to grow to allow for more internal promotion opportunities, raises, benefits and status. The unemployed and new job entrants want companies to grow so there are open positions for them.
There are and will always be people who take greater risk in all aspects of their lives including at their workplace. These workers or bosses will always finds ways to push the envelope. Many times, pushing against the boundaries is good because it leads to better products, processes, cost savings, new jobs and new businesses. Sometimes, pushing the envelope will lead to product, process or company failures. Capitalism is about risk-taking and it has benefited our country and people greatly over the last 200 years. Our standard of living and job growth is still the best in the world. It occurred because capitalism rewards risk-taking.
Regulations do not stop risk taking. At best, regulations relocate the risk taking to a different part of the business or economy. Where there is risk taking, there are both successes and failures. Future market place failures will continue to occur, but in different businesses or products than in the past. However, there are and will continue to be enough successes to make the failures worthwhile. Regulations are about closing the barn door when it is too late. Regulations do not prevent future product and business failures. If they do, capitalism will die. Without risk, there is nothing new and with risk, there is failure.
Companies and managers will always seek ways to increase sales and profits. Even without bonuses and stock options, managers want their companies to grow to allow for more internal promotion opportunities, raises, benefits and status. The unemployed and new job entrants want companies to grow so there are open positions for them.
There are and will always be people who take greater risk in all aspects of their lives including at their workplace. These workers or bosses will always finds ways to push the envelope. Many times, pushing against the boundaries is good because it leads to better products, processes, cost savings, new jobs and new businesses. Sometimes, pushing the envelope will lead to product, process or company failures. Capitalism is about risk-taking and it has benefited our country and people greatly over the last 200 years. Our standard of living and job growth is still the best in the world. It occurred because capitalism rewards risk-taking.
Regulations do not stop risk taking. At best, regulations relocate the risk taking to a different part of the business or economy. Where there is risk taking, there are both successes and failures. Future market place failures will continue to occur, but in different businesses or products than in the past. However, there are and will continue to be enough successes to make the failures worthwhile. Regulations are about closing the barn door when it is too late. Regulations do not prevent future product and business failures. If they do, capitalism will die. Without risk, there is nothing new and with risk, there is failure.
Thursday, April 9, 2009
Incomplete Valuation of Geithner Summers Toxic Asset Purchase Plan
All the analysis and discussions I have read about the US government's toxic asset purchase plan are incomplete. Many of the discussions focus on the non-recourse FDIC loan for up to 85 percent of the purchase price of the assets, but forget to mention the FDIC contingent liability for the deposits.
All of the discussions overlook that the FDIC is on the hook for the deposits of the bank through FDIC deposit insurance. If the toxic assets own by the bank are worth substantially less than their book value, the FDIC will make up the difference to the depositors. For example, if a banks has $200 of deposits and $200 of market value assets, the FDIC will have zero liability. If the $200 of assets are only worth $100 because a $100 of the assets are toxic and worth zero, the FDIC is liable for the $100 difference.
When the FDIC provides a non-recourse loan to private investors to purchase the assets, the FDIC acquires a contingent liability for the loan. The cash from the loan goes to the bank to purchase its assets. The asset purchase lowers the FDIC deposit contingent liability on the deposits by the amount of the cash.
Effectively, the FDIC's deposit contingent liability is transformed into a non-recourse loan with a contingent liability of default by the borrower. The private public partnership purchase of toxic assets does not increase FDIC contingent liabilities. It just transforms them from a deposit liability to a loan default liability.
All of the discussions overlook that the FDIC is on the hook for the deposits of the bank through FDIC deposit insurance. If the toxic assets own by the bank are worth substantially less than their book value, the FDIC will make up the difference to the depositors. For example, if a banks has $200 of deposits and $200 of market value assets, the FDIC will have zero liability. If the $200 of assets are only worth $100 because a $100 of the assets are toxic and worth zero, the FDIC is liable for the $100 difference.
When the FDIC provides a non-recourse loan to private investors to purchase the assets, the FDIC acquires a contingent liability for the loan. The cash from the loan goes to the bank to purchase its assets. The asset purchase lowers the FDIC deposit contingent liability on the deposits by the amount of the cash.
Effectively, the FDIC's deposit contingent liability is transformed into a non-recourse loan with a contingent liability of default by the borrower. The private public partnership purchase of toxic assets does not increase FDIC contingent liabilities. It just transforms them from a deposit liability to a loan default liability.
Tuesday, March 24, 2009
The Mark To Market Obsession
The current debate about mark to market accounting is really a debate about assessing the ongoing viability of a financial company, especially a bank. Financial institutions and other companies are more than just a portfolio of their assets and liabilities. They are also businesses. Mark to market and historical price valuation of a balance sheet provide little, if any, information about the continued viability of the company's operations. Overly focusing on balance sheet values confusingly compares an institution to a closed end mutual fund.
Truthful income statements that accurately reflect revenues and expenses provide a clearer picture to the world of a company's ability to sell products at a price to cover expenses and provide a return to the owners. Income statements tell us whether a company has a successful business model. Its balance sheet does not. If businesses were only their balance sheets, every company with investors would succeed. Every restaurant would be crowded and profitable.
The long life of many financial assets is often the excuse for mark to market, but it does not change the worth and viability of a bank's ongoing business model. Currently, accounting income statements smoothed the earnings of loans and investments held to maturity. They attempt to match the future income against future losses and expenses. One problem is that an income statement can distort the view of a company's earning power if gains and losses from mark to market are included.
Modified versions of balance sheet mark to market are regulatory tools used to assess regulatory capital levels in investment banks, broker dealers, commercial banks and other financial institutions. The regulators monitor capital. The regulators can require a bank to raise more capital, which decreases the return to the previous investors, but avoids a government takeover and a complete loss to investors.
If the bank has insufficient regulatory capital, the government can close a bank even if the bank's future business model is valid and will be profitable,. The reverse is also true. A bank with a bad business plan can stay open if it has sufficient capital to satisfy the regulators.
A little over a year ago, Bear Stearns ran into funding problems. It posted collateral against its borrowings. As its collateral value diminished, Bear ran out of collateral to allow its debt to roll over. It faced a liquidity crisis. Investment banks mark to market every night. Changing mark to market methodology is not currently an investment banking industry concern and changes would not have solved Bear Stearns' collateral and liquidity problems.
Bank regulatory capital at large institutions pose two threats. Insufficient regulatory capital depresses stock prices because of the very real threat of a government takeover of the bank. It also depresses stock prices because the bank has to raise new capital and diminish the earnings available to the previous capital investors. In the current environment, mark to market has increased these threats to the continuation of the bank and to the previous investors. Naturally, these threats have caused an increase in the banking industry and in investors in the call for a change to mark to market use.
Mark to market debates are red herrings. The real issues are when should the government takeover a large troubled bank? How should the government deal with large troubled banks? Should we force them to raise new capital? Should the government invest in them, nationalize them, close them, merge them, etc? What do the regulators do about systemic risk?
Let us get off the mark to market obsession and deal with the real underlying issues affecting our banking system.
Truthful income statements that accurately reflect revenues and expenses provide a clearer picture to the world of a company's ability to sell products at a price to cover expenses and provide a return to the owners. Income statements tell us whether a company has a successful business model. Its balance sheet does not. If businesses were only their balance sheets, every company with investors would succeed. Every restaurant would be crowded and profitable.
The long life of many financial assets is often the excuse for mark to market, but it does not change the worth and viability of a bank's ongoing business model. Currently, accounting income statements smoothed the earnings of loans and investments held to maturity. They attempt to match the future income against future losses and expenses. One problem is that an income statement can distort the view of a company's earning power if gains and losses from mark to market are included.
Modified versions of balance sheet mark to market are regulatory tools used to assess regulatory capital levels in investment banks, broker dealers, commercial banks and other financial institutions. The regulators monitor capital. The regulators can require a bank to raise more capital, which decreases the return to the previous investors, but avoids a government takeover and a complete loss to investors.
If the bank has insufficient regulatory capital, the government can close a bank even if the bank's future business model is valid and will be profitable,. The reverse is also true. A bank with a bad business plan can stay open if it has sufficient capital to satisfy the regulators.
A little over a year ago, Bear Stearns ran into funding problems. It posted collateral against its borrowings. As its collateral value diminished, Bear ran out of collateral to allow its debt to roll over. It faced a liquidity crisis. Investment banks mark to market every night. Changing mark to market methodology is not currently an investment banking industry concern and changes would not have solved Bear Stearns' collateral and liquidity problems.
Bank regulatory capital at large institutions pose two threats. Insufficient regulatory capital depresses stock prices because of the very real threat of a government takeover of the bank. It also depresses stock prices because the bank has to raise new capital and diminish the earnings available to the previous capital investors. In the current environment, mark to market has increased these threats to the continuation of the bank and to the previous investors. Naturally, these threats have caused an increase in the banking industry and in investors in the call for a change to mark to market use.
Mark to market debates are red herrings. The real issues are when should the government takeover a large troubled bank? How should the government deal with large troubled banks? Should we force them to raise new capital? Should the government invest in them, nationalize them, close them, merge them, etc? What do the regulators do about systemic risk?
Let us get off the mark to market obsession and deal with the real underlying issues affecting our banking system.
Saturday, March 21, 2009
Was There A Home Price Bubble?
Regions with the greatest price appreciation during the “housing bubble” were the areas with the most home development. If the prices in the housing market were irrational, developers would have tried to make abnormally high profits. In addition, there would have been a rush to sell land to developers and share in some (all) of the abnormal profits.
Material plus labor costs increases would not account for most of the appreciation of new home prices. Substitutes exist for many house components and material suppliers could increase production.
However, land cost increases might have accounted for a large part of the appreciation. Landowners would have shared in the excess profits available to developers by raising the price of future home plots. Additionally, the marginal cost of land increases as development occurs. The land in an area that is the cheapest to build upon is used first. As development continues, the land remaining for development is the more costly, requires greater preparation and has more government regulatory approval uncertainty.
I havenor not seen anything about home builders making abnormal profits for their risks. I have also not seen anything about the developers’ land and plot preparation costs to show that there were abnormal profits to developers.
Unless developers were showing extraordinarily high rates of returns on their investments, I would go with efficient markets as the most likely and not a housing bubble. I would guess that demand for undeveloped land with high marginal development costs and risks was responsible for most of the price appreciation called a housing bubble.
Material plus labor costs increases would not account for most of the appreciation of new home prices. Substitutes exist for many house components and material suppliers could increase production.
However, land cost increases might have accounted for a large part of the appreciation. Landowners would have shared in the excess profits available to developers by raising the price of future home plots. Additionally, the marginal cost of land increases as development occurs. The land in an area that is the cheapest to build upon is used first. As development continues, the land remaining for development is the more costly, requires greater preparation and has more government regulatory approval uncertainty.
I have
Unless developers were showing extraordinarily high rates of returns on their investments, I would go with efficient markets as the most likely and not a housing bubble. I would guess that demand for undeveloped land with high marginal development costs and risks was responsible for most of the price appreciation called a housing bubble.
Wednesday, March 18, 2009
New Regulations Really Do Not Fix Problems
It is unclear that new regulations fix a problem. The causative events of the problem often cease to exist before regulations are proposed. Additionally, many problems that require government intervention to protect the public are usually those that receive a lot of public media attention.
The public and the entities modify their behaviors prior to any regulatory effects. For example, peanut butter sales are down due to the recent salmonella problem and the responsible company closed. Peanut butter companies across the US have or are modifying their production processes to prevent a recurrence and parents are choosing other foods for their children.
Undoubtedly, the government will issue new food production regulations and take the undeserved credit for "fixing" the problem. The reality is that regulations are often parallel to the corrective change in behavior, but not the cause.
Since there will be an industry and consumer change in behavior after a negative event prior to regulations, the concern about regulations becomes whether they match (codify) the natural reaction of the public and the industry or whether they distort the natural reaction and cause new problems. In addition, sometimes other industries use similar methods or inputs for different purposes but must modify their behavior and cost structure to comply without any of the benefit.
As for the current financial crisis, the first cause is not yet determined despite the public media and politicians. Most mortgage defaults and foreclosures are limited to a few states, California, Florida, Arizona, and Nevada. Yet house price declines are a national problem even in areas of the US with below historical average defaults and foreclosures, such as the Northeast. Supposedly, we were in a housing bubble, yet the areas of the US with the greatest appreciation were the areas with the greatest increases in the number of new housing stock. Since when does economics allow for price increases when there is an increase in supply and more than enough to meet demand?
Similarly, studies of subprime mortgages (see St. Louis Fed) show that at the end of three years, eighty percent of these instruments cease to exist through refinancing, repayment, etc. Due to their high loan to value ratios, when house prices declined subprime defaults dramatically increased because the homeowner could not refinance the mortgage or repay the mortgage through a sale of the home. In other words, house price declines happened before the defaults happened and were in fact a cause of the increase in subprime defaults.
If defaults did not cause the decline in house prices, what did? What structural changes were occurring in the US economy to make homes worth less across the US and not just in areas of overbuilding and high mortgage defaults?
Bear Stearns went bankrupt about a year ago for liquidity reasons. It was unable to continue to post collateral to fund its revolving debt. The market value of Bear's mortgage collateral declined substantially in value. It no longer had sufficient collateral to continue its operations. The mystery is that on a cash flow basis at that time and currently, the collateral is worth much more than the market price. What other factors besides mortgage defaults and foreclosures depressed and continue to depress the price of mortgage securities?
Until the underlying causes are determined, any regulatory response "fixing" the financial system has an excellent chance of missing the mark and causing significant future structural problems for the US economy.
The public and the entities modify their behaviors prior to any regulatory effects. For example, peanut butter sales are down due to the recent salmonella problem and the responsible company closed. Peanut butter companies across the US have or are modifying their production processes to prevent a recurrence and parents are choosing other foods for their children.
Undoubtedly, the government will issue new food production regulations and take the undeserved credit for "fixing" the problem. The reality is that regulations are often parallel to the corrective change in behavior, but not the cause.
Since there will be an industry and consumer change in behavior after a negative event prior to regulations, the concern about regulations becomes whether they match (codify) the natural reaction of the public and the industry or whether they distort the natural reaction and cause new problems. In addition, sometimes other industries use similar methods or inputs for different purposes but must modify their behavior and cost structure to comply without any of the benefit.
As for the current financial crisis, the first cause is not yet determined despite the public media and politicians. Most mortgage defaults and foreclosures are limited to a few states, California, Florida, Arizona, and Nevada. Yet house price declines are a national problem even in areas of the US with below historical average defaults and foreclosures, such as the Northeast. Supposedly, we were in a housing bubble, yet the areas of the US with the greatest appreciation were the areas with the greatest increases in the number of new housing stock. Since when does economics allow for price increases when there is an increase in supply and more than enough to meet demand?
Similarly, studies of subprime mortgages (see St. Louis Fed) show that at the end of three years, eighty percent of these instruments cease to exist through refinancing, repayment, etc. Due to their high loan to value ratios, when house prices declined subprime defaults dramatically increased because the homeowner could not refinance the mortgage or repay the mortgage through a sale of the home. In other words, house price declines happened before the defaults happened and were in fact a cause of the increase in subprime defaults.
If defaults did not cause the decline in house prices, what did? What structural changes were occurring in the US economy to make homes worth less across the US and not just in areas of overbuilding and high mortgage defaults?
Bear Stearns went bankrupt about a year ago for liquidity reasons. It was unable to continue to post collateral to fund its revolving debt. The market value of Bear's mortgage collateral declined substantially in value. It no longer had sufficient collateral to continue its operations. The mystery is that on a cash flow basis at that time and currently, the collateral is worth much more than the market price. What other factors besides mortgage defaults and foreclosures depressed and continue to depress the price of mortgage securities?
Until the underlying causes are determined, any regulatory response "fixing" the financial system has an excellent chance of missing the mark and causing significant future structural problems for the US economy.
Sunday, March 15, 2009
Understanding The Different Meanings Of Insolvency
A link to the Bronte Capital Blog on the different and many meanings of bank insolvency. It is an excellent discussion of insolvency. Much of the confusion in the public debate over bank insolvency has to do with the many meanings of the concept.
The following quotation from the Bronte Capital Blog explains the five types of insolvency.
"There are several definitions of solvency here – and it is not clear which definition people are using. Here is a list:
* Definition 1: Regulatory Solvency. Does the bank have adequate capital to meet the solvency tests imposed by regulators?
* Definition 2: Positive net worth under GAAP. Does the bank have positive net worth under GAAP accounting (ie yield to maturity with appropriate provisions when YTM is required or mark to market otherwise)?
* Definition 3: Positive economic value of an operating entity. If the bank is allowed to continue to operate it will be able to pay all its debt and replace its capital?
* Definition 4: Positive liquidation value. If you liquidated it today at current market prices it would have positive value.
* Definition 5: Liquidity. Does the bank have adequate liquidity to operate on a day to day basis?"
The following quotation from the Bronte Capital Blog explains the five types of insolvency.
"There are several definitions of solvency here – and it is not clear which definition people are using. Here is a list:
* Definition 1: Regulatory Solvency. Does the bank have adequate capital to meet the solvency tests imposed by regulators?
* Definition 2: Positive net worth under GAAP. Does the bank have positive net worth under GAAP accounting (ie yield to maturity with appropriate provisions when YTM is required or mark to market otherwise)?
* Definition 3: Positive economic value of an operating entity. If the bank is allowed to continue to operate it will be able to pay all its debt and replace its capital?
* Definition 4: Positive liquidation value. If you liquidated it today at current market prices it would have positive value.
* Definition 5: Liquidity. Does the bank have adequate liquidity to operate on a day to day basis?"
Friday, March 13, 2009
Government Regulated Medical Programs Create Social Costs
Both cost effectiveness and comparative effectiveness of medical treatments do not consider the economic social costs imposed on the patient. These studies do not save money. They shift the costs from the medical system to the patient as social costs that have a measurable dollar value. The studies do not include these social costs.
For example, there are often two or more antibiotics to treat an infection. One is usually an older antibiotic that is cheaper and the other is newer and much more expensive. The older antibiotic often will eradicate some, but not all of the possible bacteria. The newer antibiotic will often eradicate a much broader range of bacteria in a shorter course of treatment time.
In a cost or comparative benefit comparison, the recommendation is always to prescribe the older antibiotic first. It is the cheaper. If the first antibiotic is unsuccessful, the uncured patient returns to the doctor after making another appointment. It is at the second appointment that the doctor writes the prescription for the second antibiotic.
The comparative and cost benefit analyses do not include the costs imposed on the patient. In our example, the costs imposed on the patient such as time off from work to go to the second doctor visit are not included. The social costs to the patient of the discomfort and suffering from the uncured ailment are not measured. The increased risks to the patient of having the ailment for a longer time such as having the infection spread, etc. are not included in the costs. The delay and wait time until a curable treatment is implemented is not measured in these studies.
The lack of measuring social costs in any government managed or regulated medical system allows the government to say it is saving money. When the studies include the dollar value of social costs, such as rationing, treatment and diagnosis delays, need for additional treatments and the risk of a worsening medical condition, the benefits of cost and comparative analyses disappears.
Remember, there is no free lunch. The profit motive constantly pushes all companies, even the medical providers, continually to reduce their costs as much as possible to maximize their profits. Part of the costs we pay enable us as patients to have quick access to doctors and quickly effective treatment. To reduce costs in the medical system means that some costs will shift out of the medical system to the consumer as social costs. The costs shifted to us will include rationing, delays, denials, older and cheaper medicines and technologies.
For example, there are often two or more antibiotics to treat an infection. One is usually an older antibiotic that is cheaper and the other is newer and much more expensive. The older antibiotic often will eradicate some, but not all of the possible bacteria. The newer antibiotic will often eradicate a much broader range of bacteria in a shorter course of treatment time.
In a cost or comparative benefit comparison, the recommendation is always to prescribe the older antibiotic first. It is the cheaper. If the first antibiotic is unsuccessful, the uncured patient returns to the doctor after making another appointment. It is at the second appointment that the doctor writes the prescription for the second antibiotic.
The comparative and cost benefit analyses do not include the costs imposed on the patient. In our example, the costs imposed on the patient such as time off from work to go to the second doctor visit are not included. The social costs to the patient of the discomfort and suffering from the uncured ailment are not measured. The increased risks to the patient of having the ailment for a longer time such as having the infection spread, etc. are not included in the costs. The delay and wait time until a curable treatment is implemented is not measured in these studies.
The lack of measuring social costs in any government managed or regulated medical system allows the government to say it is saving money. When the studies include the dollar value of social costs, such as rationing, treatment and diagnosis delays, need for additional treatments and the risk of a worsening medical condition, the benefits of cost and comparative analyses disappears.
Remember, there is no free lunch. The profit motive constantly pushes all companies, even the medical providers, continually to reduce their costs as much as possible to maximize their profits. Part of the costs we pay enable us as patients to have quick access to doctors and quickly effective treatment. To reduce costs in the medical system means that some costs will shift out of the medical system to the consumer as social costs. The costs shifted to us will include rationing, delays, denials, older and cheaper medicines and technologies.
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