Nashville debate

I’m just not seeing the change to believe in.

Yes, during the debate, it became more clear that there is a difference between Obama and McCain. But the differences are in things which hardly matter: domestic policies. Let’s look at:

Tax policy. Yes, it’s true that McCain wants to lower taxes even further for the rich. With a slumping economy, even more people would get caught in the Alternative Minimum Tax and end up paying more. But I can’t worry about that; such plans would never survive in Congress. And for the same reason, Obama’s promises on taxes (cuts for the people making under $200,000; more taxes on people making over $250,000) simply can’t be kept. Obama could campaign on a promise to give every new baby a chocolate éclair, and why not? Congress would end up crafting some compromise with a far less progressive profile, and Obama will shrug, say it’s out of his hands, and it’s the best that could be come up with. So, don’t vote for the guy who promises to lower your taxes – he’s not a dictator, he can’t deliver.

The same goes for health care. Clearly, Obama has a more sane set of suggestions than McCain, even as his proposal falls far short of H.R. 676, which establishes a single-payer health care system in the US and effectively puts health insurers out of business. It doesn’t matter; anyone who lived through the Clinton “plan” in the 1990s can tell you that. On top of that difficulty, Obama and McCain just voted for a massive transfer of wealth to Wall Street, which will constrain what help they can provide to ordinary citizens; expect to see Obama’s proposed expansion of eligibility for federal health insurance go away first.

On issues where the President actually has a lot of latitude, they differ far less. Both would rush troops to Israel were it attacked. Both want to add the Ukraine and Georgia to NATO, effectively forcing our troops there as well in case of a conflict with Russia. Both would violate the sovereignty of any country which may be rumoured to house “terrorists”, including Osama bin Laden. And both speak of “killing” bin Laden, instead of bringing him and his ilk to justice. Such bloodthirsty rhetoric from the two men who would lead a nation built on the concept of laws and justice, where civilized people are glad the Wild West no longer exists.

So, where’s the change we can believe in? In areas where he can’t unilaterally deliver. Don’t be fooled.

Can it get worse?

Okay, here’s yet another reason why letting Paulson buy unrestricted derivatives in secret is a bad idea.

First: I know what credit default swaps (CDSs) are, and I know how they got used to amplify this current crisis. I also am quite aware that they can be used “legitimately” to hedge against risk, even including against non-asset based problems like changes in weather (screwing up airline flights, cancelling outdoor shows, etc). So yes, CDSs are valid tools for risk management; they shouldn’t be removed from the economy, but for heaven’s sake they should be more transparent and better regulated.

Then I listened to this episode of This American Life (you can download it this week for free). What I didn’t know (should I have?) is that people were writing CDSs against assets which they didn’t even hold. They’d bet against the drop of value of, for example, some debt Lehman entered; the insuring counterparty would bet (of course) that the value wouldn’t drop, and they’d collect the “premiums” for a promise to pay later. The insured counterparty would be betting they’d be able to gain the value of the underlying asset (or, more properly, the amount of the underlying loss) if it went down in value, and they were willing to pay for that privilege. This is like the “dead man’s” insurance WalMart was trying to get written against their (non-key) employees. It’s even worse than naked shorts, which of course have to be covered with a real asset at some point. This is trying to make something out of nothing.

There is no economic theory I can think of that can justify this behavior as enhancing the allocation of capital; this is gambling, pure and simple. The legislation enabling the bailout should have very explicitly prohibited the governmental purchase of such swaps; instead, the swaps should be invalidated immediately. Whether the insuring counterparty gets to keep or must refund the premium(s) is none of my concern; although the disposition should probably have been legislated as well, to avoid unnecessary judicial entanglement. Removing the uncertainty of whether insuring counterparties were on the hook for vast amounts of money on absurd gambles would probably go a long way to restoring short-term confidence in counterparty solvency. Long term, these things should be banned outright; a CDS against property (not an act of nature, etc) should require one of the counterparties to actually own the property; and when the property is disposed, the contract expires or goes with it.

We don’t insure office gambling pools; we don’t allow you to write gambling losses off your taxes (except against your winnings); why should we bail out these crooks at all?

Just Say NO

Congress and the Administration have announced a bailout package for Wall Street which they hope to pass as soon as possible during the week of 29 September 2008. Here’s why the bailout still is a bad idea:

• It’s still not clear that private capital can’t purchase these “toxic assets” from the institutions that hold them. The rumours of a government bailout have distorted the market to prevent any incentive for private firms to assign any value to these shaky mortgages and their derivatives.
• The Treasure Secretary (Paulson) is authorized to purchase both mortgages and derivatives. Derivatives should not be purchased with taxpayer money; they’re crap, and should be allowed to stay underwater if the underlying mortgages can’t be rescued.
• There should be some ceiling/cap on the price the government pays for these poorly underwritten instruments (mortgages, CDOs, and the useless credit default swaps which underlie them). There’s no restriction on this being just another huge transfer of public money to private interests, rewarding them for absurdly risky behaviour.
• There’s no public shaming of the idiots who got themselves and the rest of us into this mess: in particular, the credit/risk analysis organizations which gave absurdly high ratings to aggregations of bad mortgages (Moody’s, Standard and Poor’s, etc), and there’s little identification of AIG and its ilk for hedging the risk of these mortgages without any intent to pay out (but every intent to collect their transaction fees and “premiums”).
• MOST IMPORTANTLY, there’s no requirement for transparency; we really need to know what the magnitude of the problem is, how many swaps have been underwritten, what their scope is and who the counterparties are, so we can truly evaluate the magnitude of the mess and determine which financial institutions are functionally insolvent.I don’t see how Congress and Paulson can assign market values to the crap they’ll be buying with our money, without knowing the outstanding inventory.

FREE MARKETS CAN ONLY WORK WITH TRUSTWORTHY COUNTERPARTIES AND GOOD INFORMATION. Without transparency and trust, this exercise is going to just waste $700 billion of our tax dollars. SO CONTACT YOUR FEDERAL LEGISLATORS AND TELL THEM THIS BAILOUT IS UNACCEPTABLE!

The (stupid) future of the Electric Car

Wired Magazine, in their Sep. 2008 issue (on the newsstands, but I can’t link to the article yet) has a cover story about an Israeli company called Better Place which is trying to develop an electric car ecosystem “to eliminate oil” as a transport fuel.

First things first. The young visionary who founded the company, Shai Agassi, is impressive; his goal is ambitious, and he’s clearly got the enthusiasm and credibility to bring important partners on board to realize his vision (he’s purportedly already raised $200 million to fund the startup). The plan is to create an area-wide (country-wide in Israel and small countries) grid of electrical charging stations and battery-replacement shops, charging car owners for recharging and battery replacements. This new company would in essence control the new fuel for their automobiles – stored electricity. They would not create or sell the cars themselves (and that would be insane anyway); the goal is to convince auto makers to use their battery and charging technology in new auto lines. To make things easy on car owners (and to hopefully drive adoption), they plan to have on-board software to calculate trips and battery capacity and to locate nearby charging stations and battery replacement shops, and charging stations will be easy to use with swing-out arms to automagically plug your car in for a charge.

This is attractive to a number of different constituencies. People concerned about the environment like the idea of removing oil entirely from transportation; hybrids (whether the 2-mode systems like the Prius or the superior “range extender” technology of the Chevy Volt) don’t do that and will still require gas stations and a gas creation and distribution ecology into the foreseeable future. Car manufacturers might find the idea of having a single standardized battery technology appealing, although to counter that, it may constrain their ability to optimize and/or differentiate their cars sufficiently. Electrical utilities might decide that this approach would bring them an expanded market for electricity much faster than hybrids will; hard to tell. Governments may find the idea of potentially being independent from foreign oil compelling and may subsidize the effort for that reason.

Here are some reasons why this scheme could be a bad idea for governments and consumers:

1. Presented as a complete ecosystem for purely electric cars, the idea appears air-tight and compelling. However, after any modest reflection, it doesn’t seem to provide much of an advantage over the hybrid technologies which are already farther along in production and which will not put any one company in a monopoly position on batteries, software, or charging technology. Because batteries are large, dense, and expensive, electric cars will always have a limited range; so how you extend that range is still open to debate. The vision of Better Place works fine in a small dense area like Israel or Denmark (perhaps even for much of Europe) – when you run out of range (or are about to) you find a local place to plug in or get a new battery. Now imagine doing that for driving across the US Midwest or Southwest, or really across any sparsely populated area. The hybrid technology answer to running out of charge is to bring the extension with you; and, when that runs out, you can still take advantage of the already deployed gasoline infrastructure until you get to a charging place.
2. Government subsidies (direct or in the form of tax breaks) should not be used to create monopolies. If any government subsidies are extended to Better Place they should extract a number of firm concessions in the business model (and to be fair, for all we know, these may already be in the business plan, but they should be conditions anyway). First, the charging infrastructure should be treated much like a deregulated residential power grid, phone system, or pipeline; Better Place may be allowed to install the chargers and extract a fee to cover their use and maintenance, but car owners should be able to buy their power from any operator. Similarly, Better Place should not be allowed to operate the battery-replacement shops directly or indirectly, but should instead be required to franchise them out (they are likely to prefer that anyway as it shifts the bulk of the capital investment to the franchise owners). Finally, the batteries themselves should have a number of different suppliers; Better Place should not the sole source or broker for the battery technology (and they might not want to be anyway).
3. Privacy is a big issue; you can forget about it with these cars. Every time you plug in to charge your car you are announcing your location to a central server; and that’s only if the on-board software in the car isn’t already reporting that on a constant basis so it can find nearby charging stations and swap-shops anyway. Compare that to fueling your car and charging it at home; if you use cash at the gas station (and Citgo even encourages that by giving a 3-4% discount over the credit price) then you aren’t being tracked at all by anyone.
4. Allowing Better Place too much control over the specification of the battery technology would potentially stifle innovation in the design of the actual automobiles. Because of all the design issues for high-energy-density auto batteries (heat, safety, discharge, operating temperatures, size, longevity, etc.), auto makers need to be able to design all kinds of trade-offs when creating electric cars. I think that in the end, auto batteries will be a lot like lead-acid car batteries or even more varied like laptop batteries; there’s standardization of the input (charging), output (12V/5V, etc), and the macro units themselves are built from mostly standardized cells. But you typically can’t use your SUV’s battery in your sedan, or your Toshiba laptop battery in your Dell or Lenovo, and in fact, you might not even be able to use the same battery across two laptops even from the same vendor. For different models, they make different trade-offs; and this is good. Trying to force a standardized battery profile just to facilitate the “battery bay” swapping would be a bad idea.
5. What’s the profit model in automated battery swapping facilities? Will people pay a huge amount of money to do that ever, periodically, on a regular basis? Is there any analogue in the sealed-lead-acid battery world? Of course the charge lasts a lot longer in SLA batteries, and they don’t get swapped out as often. How many swaps per day/month/year would have to make this profitable for a shop, at what cost per swap? Put another way, what kind of capital investment would a shop require, and how long would a shop take to see a return on their investment?

In the end, although I like this guy’s vision (a future without oil for transport) and his dedication to the concept, I really think this is not a good way to go about it. I’m fine with getting a range-extender hybrid, since I don’t typically anticipate needing range extension during the work week. With that technology, I’m planning to get as close to an infinite number of miles per gallon as possible, and that’s good enough for me.

When all you have is a hammer, every problem looks like a nail

The Federal Reserve can only fiddle with interest rates, but that manipulation may have little effect on the fundamentals of the current economic slowdown.

Without doing much analysis (I’m a doctor, Jim, not a rocket scientist), it seems there are at least two major drivers for the current economic problems. Inflation does not seem to be driven by a surplus of capital for spending – the type of condition that can be addressed by raising interest rates. Instead, it seems pretty clear that inflation is coming at the low end, as the CPI spikes due to the high cost of goods affected by the cost of transportation and farming inputs (driven by the high price for oil). A way to address this rise in prices is to help lower the cost of oil, or to have the government capture some of the oil profit (taxes on excessive profit, increased exploration royalties) and use that for capital/infrastructure investment. One way to damp the wild speculation in oil prices would be to increase the margin requirements for commodities traders; with margin requirements at 5% – 7%, they are betting on prices and trading oil with other people’s money. Increasing the margin requirement to 50% – 75% means having more capital in the game, and will likely damp the amount of churn in the market. It will hopefully shake out a lot of the speculators while allowing producers and end consumers to hedge prices properly.

The other major economic driver seems to be a huge drop in consumer confidence as the subprime mortgage fiasco unfolds. People caught in loans they can’t pay are forced to walk away from their homes or to cut spending back drastically to pay their mortgage. Other homeowners worry that a large number of houses coming on the market for sale will create downward pressure on their own home values and erode their own equity, perhaps even forcing them underwater. And of course whatever spending was fueled by home refinancing or equity loans will likely dry up, as fewer homeowners are willing to use their equity to finance shorter term expenditures. It seems the best way to shore up consumer confidence will be to allow courts and judges to reset or annul mortgages, refinances, and equity loans which were obtained with fraudulent information, where it can be demonstrated that the fraud was perpetrated by the broker or loan originator, not the applicant. To the extent that applicants participated in fraud to obtain loans or commissions, they should be punished. Profits and commissions obtained through fraud should be clawed back by their organizations to pay for the write-offs; or, if particular organizations are unable to withstand such losses, they should be allowed to go out of business and not be bailed out.

How will it help to have financial institutions bear the brunt of the mortgage meltdown? After all, won’t that dry up capital available for credit? Yes – but when the Fed talks about raising interest rates, they’re trying to effect the same thing anyway. And squeezing fraud, speculation, and unnecessary risk out of the system can only help shore up confidence in the system and convince borrowers that when they enter into a debt obligation, both sides believe it can be reasonably paid off.