Streetwise Professor

May 30, 2013

Who You Gonna Believe, Putin & Lavrov or Your Lyin’ Eyes?

Filed under: Military,Politics,Russia — The Professor @ 8:27 pm

Those who have been paying attention to Russia’s line on its supplying weapons to Syria for the past two-plus years might recall an early defense, offered by both Putin and Lavrov: “Russia is not supplying any weapons that could be used in a civil conflict.”

The S-300 SAM system has dominated the news lately, but the Washington Post has just published the weapons shopping list that Assad provided to Russia.  It includes AKs, various machine guns, grenade launchers, sniper rifles, grenades, small arms ammunition, mortar rounds, and night vision goggles.

All of which is eminently suited for use in a civil conflict.

The Russian story was self-evidently farcical when Putin and Lavrov told it with straight faces.  Now the evidence of the farce is there for all to see.

Not that it will make any difference.  But this makes it obvious that nothing that the Russians say about their role in Syria has any relationship to reality.

May 29, 2013

Who Has the Squeeze Box?

Filed under: Economics,Energy,Regulation — The Professor @ 2:57 pm

The term “squeeze” is used rather imprecisely in financial markets.  To me, the term means an exercise of market power in a financial market, usually a derivatives market, like a futures market, options market, or the securities loan market.

One commonly advanced explanation for the runup in Tesla’s stock price is a squeeze of the shorts.  That is, those who short sold the stock by borrowing it and selling it in anticipation of buying back at a lower price.  In this context the term “squeeze” is not usually used to refer to a purposeful exercise of market power, but it is difficult for the liquidation of short positions to affect prices-and distort them-in the absence of the exercise of market power.

Tesla is a heavily shorted stock: In March, about 40 percent of the float was short.  The stock has experienced a big runup, and one widely advanced explanation is that the shorts have been squeezed.  Given that I wrote the book on manipulation (#4,345,667 on Amazon! But now in paperback! Only $275!-of which I see exactly $0.00! Also on Kindle for a mere $220! How can you pass that up?), I thought I would take a rigorous, data-based look at the subject.

In the absence of manipulation, the forward price of a stock should be the current spot price plus the cost of financing the position at the prevailing interest rate until the delivery date on the forward.  In the absence of a squeeze, the cost/fee to borrow the stock should be small.  However, in a squeeze, it is costly to borrow the stock: the bigger the squeeze, the bigger the cost of borrowing.  This borrowing cost depresses the forward price.  Thus, during a squeeze, the forward price is below the spot price plus financing costs.   The differential between these is a measure of the severity of the squeeze.

I can’t observe borrowing costs directly, and there is no explicit forward market for Tesla stock.  But there is an options market that trades fairly actively.  Given put and call prices, and the associated strike prices, I can use put call parity to estimate an implied forward price:


where c is the call price, p is the put price, K is the strike price, r is the interest rate (I use Libor), and T is the fraction of a year to expiration of the option.  I do this for every strike on Tesla options expiring in May, June, and September: there is one implied forward price for every strike.  I then use the median and average across strikes (for each expiry) to estimate F.  I then compare F to the no-squeeze forward price, which is (1+rT)S where S is the current price on the stock.  (There is little disparity in my estimate of F across strikes, and the mean and median are virtually identical: this gives me confidence that the numbers are solid.)

This figure depicts the spreads between the no-squeeze forward price and the actual forward price: positive values indicate that there is a squeeze:

The figure does provide evidence of the exercise of market power. The spreads widened starting in late-February, and then remained elevated throughout April and into May.  Some of the drift down observed in the spreads derived from the May and June options is a time to expiration effect: the number of days that short has to pay the borrowing cost caused by the squeeze declines as the option nears expiration, leading to a decline in the spread.  This effect is less pronounced for the September options, which is why its spread remains elevated.

On a per day basis, for the June option, the borrowing cost went from about 1.7 cents per day in mid-March and topping out at 4.6 cents/day on 22 April.

Thus, there is pretty compelling evidence of a squeeze during this period.

This can also be illustrated in percentage terms.  That is, the borrowing cost can be converted into an annualized percentage rate, like an interest rate.  This figure illustrates that:

The decline in the May and June percentage rates reflects primarily the increase in Tesla’s stock price. But the numbers are pretty eye-popping.  At the peak, the “interest rate” paid to borrow Tesla stock ranged from between about 25 percent (to borrow until 21 September) and 45 percent (to borrow to 17 May).   Not quite loan-shark levels, but pretty damn high.

This is further evidence of a squeeze. And note particularly the substantial rise in the spreads, measured both absolutely and in annualized percentage terms from late-February through mid-April.  Obviously, the squeeze was building during this time.

The peak of the squeeze, as measured by the spreads (absolute and percentage) was in mid-to-late-April, which corresponds to data on short sales.  Short open interest declined from a peak of 32 million shares on 15 March, and then declined to 27.5 million shares on 30 April.

One other thing stands out.  Note the spike in spreads on 13 May.  Which just happens to be two days before Tesla announced its secondary public offering.

Interesting. Very interesting. I wonder if the SEC is interested.  It should be.

Short squeezes cause the stock to be overpriced.  Squeezed stocks tend to decline subsequently (Jones & Lamont, 2001). The evidence of the squeeze I’ve presented here, and the Jones-Lamont evidence suggests that Tesla’s price should decline.

When?  There’s the rub. Once a squeeze occurs, people are reluctant to short for fear that they may be squeezed again.  In the absence of the countervailing effects of short selling, the fan boys can drive the price to insane levels.  Moreover, as I’ve shown in my academic work, the stock price is increasing in the probability of a squeeze: if (as is plausible) this probability is higher in the aftermath of a squeeze, this means that Tesla’s stock price currently embeds a squeeze premium.

Eventually this squeeze premium will go away, but given the recent experience, in which shorts were squeezed hard, it is possible that this premium will remain in the price for some time.

There is obviously one big question here: Who is doing the squeezing?  I have no idea.  Theories involving obvious suspects, but no evidence to back it up, and no real means to develop that evidence.  The SEC could figure it out, if it had a mind to.  Sadly, based on past experience I’m doubtful it will find the mind, despite the fact that manipulation (including squeezes) is a violation of the securities laws.

And if it bestirs itself, the SEC should look at another Musk company: Solar City.  It has been on a dizzying ride too, and there is evidence of a squeeze here too.  Indeed, the evidence of the squeeze is even more pronounced here.  Note the huge spike in borrowing costs starting at the beginning of the month, after a period of relatively little movement.  Very, very strong evidence of a squeeze:

Very strong.

Is anybody home at the SEC?  I guess we’ll see.

The takeaway from this is that what are sometimes referred to as “technical factors” are present, with a vengeance, in TSLA and SCTY.  Put less euphemistically, both stocks have been squeezed, and pretty hard.  Squeezed, as in manipulated.

The big question: who has the squeeze box?  Anybody home at the SEC who might try to answer that question?

Will No One Rid Me of This Meddlesome Economist?

Filed under: Economics,Politics,Russia — The Professor @ 9:23 am

My friend and accomplished economist, Sergei Guriev, has left Russia.  He has been targeted by the authorities.  Things came to a head when the mouth-breathers from the Investigative Committee (the new Oprichnina that is leading the attack on any and all opponents of the regime) raided the New Economic School where Sergei was Rector.  (He resigned that post, and withdrew his name from consideration for re-election to the board of Sberbank.)

Sergei’s sins (in the eyes of the Putinists) were many.  Most notably, he had defended Khodorkovsky publicly and frequently.  He called for Khodorkovsky’s release: in the same remarks, he said everyone involved in the Magnitsky case should be fired.  Most critically, he was one of a group that evaluated the Khodorkovsky conviction, and concluded that the verdict was a sham.

And this provided the pretext for his current predicament: he affirmed that he had not received any financial support from Khodorkovsky, but the authorities allege that he and the New Economic School had received money from foundations associated with and funded by Khodorkovsky. Some reports also indicate that the authorities were relying on that old standby-a tax investigation.

Does it really matter?  They would have found something.  Anything.

Sergei was very outspoken in his criticism of the Putin economic model.  His views are quite similar to mine, and he expressed them cogently and calmly in many public forums.  This interview from 2011 provides a good example of his critique of Putinism.  Particularly chilling his is demurring from answering the question about whether Russia could collapse: he says that expressing such views could lead to an extremism charge.  However, in 2012 Sergei honestly and bravely stated that Russia could collapse-and in a bloody way.  He associated himself publicly with Navalny.

Like I said.  His sins were many.  Given the growing oppression in Russia, it was perhaps inevitable that he would fall victim to it.

Sergei was closely affiliated with Medvedev.  This is another indication that Medvedev and his circle are being slowly squeezed out of the way.

Sergei is a very brave man.  Fortunately, in this era of the Soft Purge, and perhaps because of his association with Medvedev, he was permitted to leave the country.  Fortunately for him.  Unfortunately for Russia.

Sergei’s departure comes hard on the heels of the announcement that another prominent opposition voice, Masha Gessen, is leaving Russia.

This is disgusting, and leaves me in a cold fury.  It is quite clear that there is no place for smart and decent people in Russian public life, and those who dare speak out against the new tsar and his oprichniki are hounded by “legal” means.  Legal nihilism writ large.  The law as a sword.

Putin the Python is squeezing, squeezing, squeezing, and civil society is suffocating in Russia as a result.   Soon the only people left in Russian public life will be thugs, crooks, and toadies.  And when that day comes, Putin will smile and congratulate himself on a job well done.  For those are his kind of people.  That meddlesome economist, Sergei Guriev, is definitely not.  And that speaks volumes of good things about Sergei.

May 28, 2013

Elon Musk and Ben Bernanke. Separated at Birth?

Filed under: Economics,Energy,Regulation — The Professor @ 6:15 pm

My main issue with Elon Musk and Tesla is government subsidies.  (An issue the WSJ shares, apparently.  Though if commenter David Hoopes is right, they did not arrive at their opinion independently of me, given the echoes between my post and the WSJ’s subsequent oped.  There are definite echoes.)  If Tesla can make it on its own, all power to it.

But I do have my doubts about its ability to deliver, standing on its own two feet.  Though in expressing those doubts, I have to acknowledge that I am in conflict with Mr. Market, who is continuing to push TSLA on its hyperbolic path-up 13.65 freaking percent today.  On what news?  Got me.

My cognitive dissonance is intensified by the litany of bad news coming out about electric autos.  Today Bloomberg ran a long article about the total fail of electric cars in Germany, despite ambitious government targets.  Last Monday, Reuters ran a feature story on how the “road to a greener America is littered with road kill.” And perhaps the biggest news was the liquidation-not bankruptcy mind you, but liquidation-of battery swap innovator Better Place.  This despite $850 million in investment, the support of a major auto company (Renault), and a marketing strategy directed at the most favorable markets (e.g., Denmark, Israel, and Hawaii).

There is a litany of electric car failures.  Perhaps Musk/Tesla can be the exception that proves the rule, but color me skeptical.

Tesla has made waves with its high end Model S.  But Daimler and BMW are about to introduce high end models of their own, and they can certainly beat Tesla on manufacturing cost and quality (given their long history of building luxury vehicles and Tesla’s manufacturing teething problems).  Moreover, the technology is pretty standardized.  People rave about the acceleration of a Tesla, but that’s purely an artifact of electrical motors: the new Daimler vehicle (described in the Bloomberg piece linked above) also has stellar acceleration.

Tesla plans to launch more affordable vehicles, but no one-no one-has succeeded in that space.  The problems inhere in the technology:

“EVs are a really difficult sell today,” the CEO of Toyota’s North American business, Jim Lentz, said in an interview. “Until we see substantial change in battery technology it’s going to be difficult to see EVs really take off.”

Both articles-and many more, to boot-point to a fundamental issue: range and recharging capability.  Here, the failure of Better Place should be truly sobering to the Tesla fan boys.  It was specifically intended to address the range problem through battery switch technology, but sales of electric autos-even in the cherry-picked markets-were too small to make Better Place viable.

And this points out a fundamental chicken-and-egg aspect to electric cars, which in turn helps explain a good part of Musk’s strategy.

The demand for electric cars depends on the availability of charging facilities.  Or, more accurately, the expected availability of charging facilities.  It also depends on the expected speed of recharge, and the expected duration of a charge.

Charging stations seem to be a constant returns to scale technology.  It is easy to expand capacity to reflect demand, just as it was/is easy to expand filling station capacity to accommodate the number of gasoline-powered cars on the road.  Moreover, entry is relatively easy.  That suggests the following simple model.  The number of charging stations will adjust to accommodate the number of electric vehicles.  But this leads to an indeterminacy resulting from a self-fullilling prophecy effect: if a small number of vehicles are sold, there will be a small number of charging stations.  If a large number of vehicles are sold, there will be a large number of stations.  If potential buyers suspect there will be a small number of other buyers, they will anticipate a small number of charging stations, and they will be less likely to purchase (or, more precisely, their reservation price will be low).  If potential buyers think a lot of others will buy, they will anticipate a large number of charging stations, and they will be more likely to purchase (high reservation price).

Thus, there is a bandwagon effect in electric vehicles. The bandwagon works in part through the expected availability of charging services. This has a self-fullfilling element: if a lot of people jump on the electric car bandwagon, it will be profitable for people to invest in recharging facilities.

There are multiple equilibria in these circumstances.  You can have low sales equilibria and high sales equilibria.

This is the perfect situation for a Music Man.  A promoter who gets the bandwagon rolling.  And this is exactly what Musk is trying to do.

Using Twitter in particular, he is trying to convince potential consumers that there will be a huge infrastructure of charging stations, and that these stations will be highly efficient, permitting a recharge in less time than it takes you to fill your SUV with gas.

Several problems here.  The first is that the bandwagon effect may never kick in: it hasn’t so far, despite aggressive efforts by governments to get it started.  The second is that creating a bandwagon is a public good in this instance: even if Musk starts an electric car bandwagon going, given the ability of myriad other auto manufacturers to enter the market, Tesla will only be able to capture a fraction of the sales resulting from the bandwagon.

You might find this analogy a stretch, but I am convinced it is apt: Elon Musk faces the same challenge as Ben Bernanke, and is using the same strategy.  (And hey, the differences aren’t that great.  Without a hair transplant, or plugs, or whatever he did with his pate, by now Musk would be a chrome-dome like Ben!)  Bernanke wants to generate inflation.  His ability to do so depends on his ability to shape inflationary expectations.  There is a self-fulfilling prophecy aspect to this too, and as a result, there are multiple equilibria: you can have low inflation and high inflation equilibria, depending on whether people expect inflation to be low or high. So Bernanke and the Fed have resorted to various public statements to try to shape these expectations.

That is, there is a bandwagon effect in inflationary expectations, just as there is a bandwagon effect in the sales of electric vehicles.  One strategy to get a bandwagon going is the Tinker Bell Strategy: I believe! I believe!  Musk is attempting to get people to Believe! in electric cars through Twitter and other public pronouncements.  Bernanke and the Fed are attempting to get people to Believe! in increasing inflation through public announcements and guidance.

It is a rational strategy for both to follow, given their objectives.  I must say, though, that starting an inflation bandwagon is likely far easier than getting an electric car bandwagon going.  Addressing the recharging issue is a necessary, but not sufficient condition to overcoming consumer reservations about electric cars.  There are so many other limitations on performance that will make people reluctant to adopt.

But I get the strategy.  If you are long Tesla, or contemplating going long, you need to understand what that strategy is and what must happen for it to succeed.  If you buy Tesla, you are essentially buying an option on Musk being able to start a bandwagon, and get the self-fulfilling prophecy to work.

This also explains the need to build a cult of personality around Musk, all the better to enhance his oracle-like status: hence the employment of a Sock Puppet Army, the aggressive attacks on anyone who calls BS on the cars, or the company, etc.

It will either succeed wildly, or crash in humiliating failure.  I think the fundamentals favor the latter, but in a multiple equilibrium world, I can’t rule out the former.

May 27, 2013

Oh, the Irony: Putin Reaps What He Sows

Filed under: Military,Politics,Russia — The Professor @ 2:32 pm

Not much about Russia late, because not much is new.  Putin is increasing his python-like stranglehold on civil society.  The economy is sputtering.  Both foreshadow a period of social and economic stagnation.  This stagnation, in turn, will put pressure on Putin and Putinism.  Putin has always been the equilibrator of the elite, and his ability to do so has depended on the perception that he is popular, and his access to a stream of rents that he can dole out to buy support, and withhold to punish those who cross him.  His crackdown indicates that he realizes that he is no longer broadly popular, and is dependent on the support of the most reactionary elements of Russian society: the elites can see that too, and calculate accordingly.  Further, economic stagnation constrains the ability to use rents to buy support.  Both of these developments can be expected to lead to intensifying conflicts among the elite as Putin’s grip slips, and there is evidence of this: they mysterious departure of Surkov, and the attack on anyone attached to Skolkovo (Medvedev’s pet project) being the most prominent examples.

In other words, the stagnation dynamic is progressing inexorably, and there is little in prospect that will change that.

But Putin will hang on.  What choice does he have?  He is like Midas.  He has, according to credible reports, and in accordance with basic logic, accumulated huge sums of wealth.  Sums that he cannot enjoy fully while President, but which he would lose in a trice if he were to leave power.

There is one story that did catch my eye.  Echoing Putin (more on that below), Rogozin the Ridiculous is sounding the alarm about the parlous state of the Russian naval building program.  The naval rebuilding is the centerpiece of Russia’s exhorbitant rearmament program (accounting for a full 25 percent of expenditures on new equipment), but it is in the hands of state-owned behemoth Russian Shipbuilding Corporation, which mashed together virtually all of the multiple shipyards and design bureaus inherited from the USSR.  The company has proved utterly corrupt and incompetent, and cannot deliver the ambitious shipbuilding program:

The Russian government is ready to step in to sort out the crisis in Russian naval shipbuilding which is threatening to derail the defense procurement program, Deputy Prime Minister Dmitry Rogozin said on Friday.

The government’s direct intervention in the situation is the only way of averting further problems, he said at a meeting with shipbuilding company heads.

“I can see only one option: Direct dialog between the government, the United Shipbuilding Corporation, and private companies working in this field to ensure that all plans are implemented and all problems that have emerged recently are rectified,” said Rogozin, who oversees the defense industry.

“We are planning to sink, and have already sunk big money into shipbuilding but I can’t see any payoff yet,” he said.

Rogozin made his comments the day it was revealed the United Shipbuilding Corporation (USC) is looking for money that was allocated to complete the Nerpa nuclear submarine for India’s Navy. A total of 500 million rubles ($15.9 million) has been lost.

He urged shipbuilders to employ specialists from abroad if they cannot find enough at home and promised to facilitate the granting of Russian citizenship to experts from other countries.

The fact that Rogozin-a pugnacious nationalist-is urging the employment of foreigners tells you everything you need to know about how desperate the situation must be.

There are other signals.  Medvedev just announced that USC would receive state guarantees amounting to billions of dollars to permit it to secure credit for working capital needed to deliver on contracts:

The Russian government will provide 265 billion rubles ($8.5 billion) in state guarantees to defense industry enterprises this year, to ensure weapons are delivered on time in accordance with the national procurement program, Prime Minister Dmitry Medvedev said on Monday.

“The resolution [signed by Medvedev] provides for the allocation of 40 state guarantees worth 265 billion rubles for loans which will be granted to 26 companies from the defense and industrial complex,” Medvedev said.

The provision of state guarantees is the first this year, Medvedev said, and stressed the beneficial effects it would have on the economy as a whole.

“Everything invested in the defense industry has an influence on industry. Actually, the defense sector helps boost adjacent industries,” he said.

State guarantees allow defense enterprises to obtain loans at a time when they face a shortage of working capital and have no other sources of financing, Medvedev said.

Over a half of the state loan guarantees for defense producers this year will go to shipbuilders and developers of intercontinental ballistic missiles, according to the government resolution.

Working capital, folks.  Meaning that the firms don’t have sufficient cash flow and short term financing to deliver on contracts.  That is a sure sign of sick companies.  No other source of financing.  Need I say anything else?

Last Tuesday, Putin delivered one of his hissy fits, this one directed at United Shipbuilding:

Russian President Vladimir Putin criticized the United Shipbuilding Corporation (USC) on Tuesday for delays in delivery of warships to the Russian Navy and demanded the shipbuilders improve efficiency.

“Problems still remain with deadlines and the quality of implementation of orders, including defense projects. In particular, the construction of a number of nuclear submarines and surface ships and their delivery to the navy has been unjustifiably delayed,” Putin said at a meeting with USC officials.

Putin also encouraged the hiring of foreign experts.

This is a pattern for Putin.  He issues ukasi. They are ignored.  So he calls the delinquents together, gives a stern lecture that they must get their act together . . . and nothing changes.

Here’s the irony, which none of the reporting on the subject points out (imagine that): USC is a Putin creation.  It is one of the state owned behemoths that Putin created during the mid-2000s: others include United Aircraft and Oboronoprom.  In his construction of the vertical, Putin created several state-owned monopolies that were intended to be national champions, and achieve efficiency by exploiting economies of scale.  Instead, they have proven to be efficient only at their parasitical ability to extract resources from the state.  They have become black holes, sucking in money, spitting out very little in the way of ships or planes.  Putin’s creations are obstacles in the way of achieving Putin’ ambitions.

The irony is too rich.  Putin is reaping precisely what he sowed.  Couldn’t happen to a nicer guy.

May 25, 2013

I Was Wrong. But Not as Wrong as What I Was Wrong About.

Filed under: Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 7:12 pm

Okay.  I admit it.  I was wrong.

You’re shocked, I’m sure.

About what, you’re asking?

Well, I said that the RFQ provision of the SEF regulation was the worst of the worst of Frankendodd.  After further review, I’ve decided this is incorrect.  Instead, the “available for trade” rule is the worst of the worst.

The basic idea is that a swaps execution facility applies to the CFTC to list a swap contract as “available to trade.”  If the swap meets one (or more) of six rather vague factors, after receiving comments from other market participants, the CFTC will designate the swap as available.

That would be fine, I guess, if market participants had the choice to take advantage of this availability . . . or not.  But no choice is allowed.  (Choice, it is evident, is an anathema in Frankendodd.  DFA is all about making you eat your Brussels sprouts.)

Thus, once the CFTC designates something as available to trade on a SEF, all market participants subject to the SEF rule (i.e., pretty much everyone other than certain end users) must trade the contract on a SEF, or not trade it at all.  Thus, a SEF can effectively force all market participants to trade a particular instrument on a SEF, or eschew trading it altogether.

Great work, if you can get it.  The ability to make people use and buy your services.

This is beyond bizarre. The ultimate transactors internalize most of the costs and benefits of alternative means of executing a transaction.  But under the available to trade rule, they are not able to make the trade-off between these alternative means: once someone else lists a contract as available for trade, they must trade it on a SEF.  Note, moreover, that this someone else-the SEF operator-has an incentive to try to force business his way.  So the entity making the decision does not bear the full costs  and benefits of its action: indeed, it can profit from compelling others to do something that is against their interests.  That’s always a recipe for error.

Of course, the whole theory behind Frankendodd’s SEF mandate is that there is some sort of externality that leads transactors to choose inefficiently to trade bilaterally rather than on a transparent, order driven market. Just what that externality is is not obvious, to say the least: transparency is apparently a big part of that.  But even if you believe that theory, the SEF operator (a) is not going to internalize that externality, and (b) is not going to internalize the other  costs and benefits of forcing the ultimate transactors to use a particular mode of execution.  Thus, the incentives of the party that Frankendodd empowers to make the decision regarding how to trade are not aligned, even remotely, with the interests of the parties its decision affects.

Of course, a SEF must specify contractual terms of what it will make available to trade.  Market participants may try to avoid transacting something ill-suited for trading on a SEF by trading something similar, but with different terms.  But that can fall afoul of the anti-evasion provisions of Dodd-Frank.  Thus, the available to trade provision will result in (a) the coerced trading on SEFs of contracts unsuitable for it, (b) reduced trade (because market participants decide to trade less rather than trade in an inefficient way), (c) regulatory wrangling over whether some market participants are trying to evade the SEF mandate, or (d) all of the above.

Great.  Just great.

The economic justification for the SEF mandate is extremely shaky: that’s why I consider it the worst of DFA.  The implementation details only make it  worse.  These details presume either that (a) market participants don’t know their own interests, or (b) their interests are contrary to broader “social” interests.  (a) is risible, and (b) is highly dubious.  It is even more dubious to delegate to an agent that does not internalize these social interests the power to compel others who certainly bear many of the costs of the agent’s decisions to make choices they would not make voluntarily.

One last thing about the SEF mandate.  It will apparently determine the future leadership of the CFTC.  Gensler will not be reappointed, evidently.  (I shall pass over that in silence.  Need I say anything?) Relative newcomer Mark Wetjen had apparently been the frontrunner to replace him, but Wetjen’s opposition to Gensler’s obsession with RFQ5 has apparently killed his chances at becoming chairman.

My impression is that Wetjen is a serious and conscientious guy who arrived at his opposition to RFQ5 only after serious thought and efforts to determine whether the rule made any sense.  (Of course, since I think the idea made no sense, I believe he made the right call.)  But for some inexplicable reason, the RFQ rule became identified as a blow against banks, so opponents to it have become perceived as tools of the banks.* And that apparently sank Wetjen’s prospects for the chairmanship.

It’s a mad, mad, mad, mad world, folks.   A risible provision of the most inane aspect of Frankendodd will determine the leadership of a regulatory agency that wields incredible powers under that act.

Update: A shout out to Single Dealer Platforms (which is quite generous in linking to SWP), which expressed similar skepticism about available-to-trade before I posted this.

* The episode of my report on commodity trading firms shows pretty clearly that I don’t dance to the tune of big banks: indeed, a reporter told me that the banking group that hired me to do that report is “furious” that my report that contradicts their position has leaked out.  Yet I criticized heavily the RFQ provision.  Thus, being a bank apologist is neither necessary nor sufficient to explain opposition to the RFQ rule.

May 22, 2013

The Energy Permit Raj

Filed under: Commodities,Energy,Politics,Regulation — The Professor @ 9:09 pm

Last week it looked like the Obama administration had decided to be sensible on at least one energy issue-the export of LNG.  It approved a new license (for Freeport LNG) for export to countries with which the US has no free trade agreement.  But the WSJ reports that new Energy Secretary Ernest Moniz is thinking of putting on the brakes again.  Because we need more studies.  No.  Seriously:

Mr. Moniz showed caution about the existing studies. Speaking to reporters after a speech to an energy-efficiency conference here, he said he was “committed to doing a review of what’s out there in terms of impact analyses” before approving more applications to export U.S. natural gas. Critics have said last year’s study didn’t rely on the best data available.

“Right now we have no plans of commissioning new studies, but everything is on the table until I have done my analysis,” Mr. Moniz told reporters after his first public remarks as energy secretary

Sorry.  We don’t need no steenkin’ studies.  The whole idea smacks of central planning.  The presumption should be that if firms are willing to risk their private capital, the benefits exceed the costs.  Any analysis should be restricted to potential externalities.  Real externalities.  Not pecuniary ones.

But these “impact studies” are all about pecuniary externalities.  Namely, they focus on the effects of exports on prices of natural gas, and the effects of natural gas prices on consuming industries (like petrochemicals).  But these price effects are not true externalities that lead to inefficient allocation of resources.   Indeed, restricting exports because of these effects would cause a misallocation of resources.

Pecuniary effects do have distributive effects.  In the case of LNG exports, they affect the distribution of rents between gas producers in the US and foreign consumers on the one hand, and domestic gas consumers on the other.

And that’s what the need to get an export permit does: it permits the government to affect the distribution of rents.  That, in turn, gives rise to rent seeking.  And corruption.

In this context John Cochrane mentions the Indian “permit raj”: there you need to get a permit for everything.  This gives those with the authority to grant permits incredible power.  Power they use to enrich themselves and secure political support.

That is exactly what can go on here.  Those hoping to get a permit have an incentive to exert influence, through lobbying, campaign contributions, and supporting public campaigns on issues favored by the administration.  They also realize that they face substantial risks if they oppose the administration on other issues: “Nice little LNG terminal proposal you have here.  Would be a tragedy if something happened to it.”

The government has no business being in this business, beyond perhaps-perhaps-addressing real externality issues.  But even there, other mechanisms (e.g., liability for pollution) may be preferable to a permitting process.  (Look at how Russia used environmental regulations to drive Shell out of Sakhalin II: any power to permit can be used to expropriate of hold up the party seeking the permit.)

In the US, energy, and particularly the international trade of energy, is particularly raj-like: Keystone II is another example.  This destroys value in myriad ways.  Beneficial investments are delayed, or not made at all, either because the government stops them directly, or the risks and costs of getting approval undermine the economics.  Real resources are used to influence policy.  Since energy investments involve big dollars, the losses can be big too.

People often lament the lack of an American energy policy.  I disagree.  We do have an energy policy, and the Energy Raj is a big part of that policy.  A better policy, by far, would be no policy at all.  Would that the DOE adopt the motto: “Don’t just do something! Stand there!”

I’m not holding my breath, though.  The benefits of the raj to the rajahs are far too great.

Mr. Musk’s Wild Ride-At Your Expense (9 figures in 1 Quarter)

Filed under: Economics,Energy,Politics — The Professor @ 10:51 am

My main beef with Tesla Motors is that it is a major beneficiary of government largesse masquerading as a free market success story.  The company received a $450 million loan from the Federal government to set up operations.  It has just paid back that loan, but does not justify granting the loan in the first place: indeed, it illustrates the heads-Musk-makes-a-lot-of-money-tails-the-taxpayers-eat-it aspect of the loan.  It socialized the risk of loss, and privatized the gains.  That’s bad, on principle.  (Things might have been ameliorated had the warrant the government received allowed it to participate in the upside, but the exact opposite happened: the warrant went away precisely when the stock price went parabolic.)

But the loan isn’t the biggest source of government support. The $7500/vehicle federal subsidy to purchasers and California’s Zero Emissions Vehicle (ZEV) credit program are.  When you look at the value of these subsidies, they dwarf the much ballyhooed profit Tesla reported for the first quarter (and those profits were driven by the write-down of the warrant and non-repeatable gains on yen exposure).

I’ve done some back of the envelope calculations to estimate just how much these subsidies benefited Tesla’s shareholders.  The basic idea is to calculate profits with and without the subsidies based two assumptions about the demand for Teslas: a constant elasticity demand curve and a linear demand curve.

The linear case is easiest to explain.  The equation is P=A-bQ, where P is price and Q is quantity sold.  A and b are constants that need to be solved for.  P and Q are known for the first quarter: I’ll use $75K for P (the average price of a Model S) and Q is 4750.  If Tesla was maximizing profits, it would set its marginal revenue equal to marginal cost, where the marginal cost nets out the subsidies.  The relevant equation is C-S=A-2bQ.  I derive C from the cost of generating revenue reported in the 10Q.  I divide this sum by Q, and then multiply by .6 because the cost number includes some fixed costs (e.g., tooling) and I want marginal cost: it turns out that the results I derive aren’t that sensitive to the multiple.  For S I add $7500 and Tesla’s ZEV credit revenues (reported in the 10Q) divided by the number of vehicles sold.  I now have 2 equations, and can solve for the unknown constants A and b.

I now have all I need to know to figure out revenues (including subsidy payments) net of variable costs.  This totals $206 million.  I can also figure out the price and quantity of Teslas sold without the subsidy.  Absent subsidy, Tesla would choose Q to satisfy: C=A-2bQ, which gives Q=(A-C)/2.  This can be plugged back into the price equation.

Doing this gives a no-subsidy quantity of 3558 (about 70 percent of the with-subsidy sales) and a price of $91K.  Using these numbers, and the assumed unit cost gives a no-subsidy profit (before fixed costs, etc.) of $116 million.

In other words, in this specification, Tesla pocketed about $90 million due to subsidies in one quarter alone.  That represents about 18 percent of its auto sales revenues, and dwarfs its profit even including the one-time boosters.

In the constant elasticity specification, I need to solve for the demand elasticity and the constant multiplying the Q raised to the elasticity.  Given the price, quantity, cost, and subsidy numbers, I can solve for these two constants using the demand equation and the marginal revenue equals marginal cost equation.  Given these constants, I can figure out profits with and without subsidies.

In the constant elasticity case, profit with subsidies (before fixed charges) is again $206 million, and profit without the subsidies is estimated to be $139 million.  So in the constant elasticity specification, subsidies pad Tesla’s profits by $67 million.

These are numbers for one quarter, folks.  This is money out of your pockets, or the pockets of shareholders of Ford, Toyota, etc., who have to buy ZEV credits.  Tesla would still be drowning in red ink absent the fat subsidies.

I sure hope you are enjoying Mr. Musk’s Wild Ride at your expense.  Your enjoyment being completely vicarious, of course, expect for the paying for it part.  That’s something you experience personally.

I would hope that these figures put the hype in perspective.  Tesla cars are fueled by electricity.  Telsa Motors is fueled by government money.  Your money.

One more thing.  Tesla and Musk are neck deep in a relationship with Goldman-Sachs, aka Government Sachs.  Think that it’s just maybe possible that Goldman will deploy its notorious political heft to keep the rain of government manna going?  If you doubt that, can I interest you in a bridge connecting two boroughs in NYC?  Which makes it doubly ironic-and nauseating-that many of the Tesla Kool Aid Gang also declaim against crony capitalism.  Well, so do I, except I at least do so with a modicum of consistency.

May 19, 2013

A Demand Side Theory of Bank Leverage

Filed under: Economics,Financial crisis,Regulation — The Professor @ 7:50 pm

Harry D’Angelo and Rene Stulz have an interesting paper about bank leverage.  It makes a simple point.  Banks’ liabilities-notably, deposits-are someone else’s asset. That asset provides a benefit, namely liquidity, that depositors can’t realize by trading in capital markets, due to some friction.  This intermediation is what makes banks special.  As a result, depositors are willing to hold bank liabilities in exchange for a lower return than bank assets. Banks therefore have an incentive to create these liabilities-that is, to leverage up-to the maximum extent possible, in order to capture as much of this liquidity premium as possible.  This leveraging is a good thing, because it supplies an asset that is highly valued by those who incur high costs to access capital markets directly.

In the D’Angelo-Stulz model, bank equity is the capitalized value of this below market borrowing rate/liquidity premium.  If the liquidity premium is modest, the  supply of liquid claims results in a high debt to assets ratio.  Again, this high leverage is a good thing, because it is the consequence of the efficient supply of intermediation.  Banks access the capital market effectively engage in a form of asset transformation that generates value: those who cannot access the capital markets, or at least not as efficiently, cannot engage in this asset transformation, and they are willing to pay banks who can.  Through diversification and risk management, banks can engage in asset transformation that is valued by depositors.

This paper is most useful as a corrective to the rather annoying Admati et al “Bankers’ New Clothes” arguments that banks are excessively leveraged and should therefore be subjected to far more rigorous capital requirements, e.g., 25 percent equity.   Admati et al rely heavily on Modigliani-Miller type arguments, and D’Angelo-Stulz show that high leverage can be efficient when there is a single deviation from MM assumptions.  Bank debt (at least some forms of it-more on this below) provides a valuable device in the presence of a friction, and therefore issuance of this debt (in lieu of equity) is socially beneficial.

That said, there are some issues with the paper.

First, the formal model is very rudimentary.  It posits that those without access to the capital market are willing to pay an exogenously specified premium for bank liabilities that offer liquidity, i.e., guaranteed purchasing power.  But willingness to pay does not determine the equilibrium price of liquidity.  In a competitive banking market, the equilibrium price of liquidity is determined by the cost of producing it as well.  This is not modeled in the paper.  The marginal cost of engaging in intermediation/asset transformation must be upward sloping in order for banks to earn producer surplus (which, when capitalized, would be the value of bank equity).

Presumably, equity is one of the means by which banks are able to engage in asset transformation that provides reliable liquidity to those holding bank liabilities.  In essence, equity is a means of bonding contractual performance (a point I learned from reading Yoram Barzel years ago).  In the banking context, equity provides a cushion that ensures that depositors will be able to realize the face value of their claims at will-which is the essence of liquidity.  Thus, the reliability of the liquidity banks supply, and hence the premium that depositors are willing to pay, depends on the amount of equity (as well as on the asset side of bank balance sheets).  The paper does not address this interaction, taking equity value as a pure residual value driven by an exogenous liquidity premium that does not depend on bank equity.

Second, although deposits that provide liquidity to investors without ready access to the capital market are one part of bank leverage, banks, and especially systemically important ones, borrow in other ways, and the resulting liabilities do not have the same money-like characteristics as deposits.   The paper does not explain the entire capital structure of banks.  Indeed, it predicts that banks should be financed almost exclusively by the issuance of money-like liabilities.  They aren’t, so the paper doesn’t explain why banks issue debt that does not provide liquidity benefits instead of equity.  (Perhaps it could be argued that banks provide liquidity indirectly, e.g., by issuing corporate paper that is purchased by money market funds which provide money-like claims to investors.  But this still doesn’t explain the issuance of longer term debt.)

Third, this analysis relates primarily to commercial banks that issue deposits.  What about investment banks?  They are highly leveraged, and it’s not so clear that their liabilities offer the kinds of liquidity benefits that drive the results in the paper.  (Theories that argue that banks are too highly leveraged because of deposit insurance subsidies or access to central bank liquidity (at subsidized rates) don’t apply to investment banks either, because those didn’t have access to deposit insurance of central bank liquidity support.)

Fourth, the paper discusses systemic risk, but this discussion is a little glib.  Debt that provides valuable liquidity services under normal circumstances is fragile, and susceptible to runs.  When runs occur, money-like bank liabilities do not provide liquidity.  Presumably, this affects the liquidity premium, which means that it is unclear that banks issue too much debt.  But the paper can’t really address this question because the value of liquidity is specified exogenously.

All this said, the paper is still valuable because it makes an important point.  Existing theories of banks posit that banks are leveraged because debt addresses some sort of agency or information problem.  These are essentially supply-side factors. The D’Angelo-Stulz theory identifies a demand-side driver of bank leverage.

Bank leverage is a big issue now, with Basel III and Brown-Vitter.  Good policy regarding leverage (and hence, capital requirements) requires an understanding of its costs and benefits. Calling attention to the demand for bank liabilities, and the benefits they provide, is an important contribution to such an understanding.

May 18, 2013

Cosmically Craven

Filed under: Military,Politics,Russia — The Professor @ 2:24 am

The fecklessness of the Obama administration’s approach to Russia beggars description.  Suffice it to say that the more earnestly Kerry implores the Russians to facilitate some less messy (not neat, just less messy) transition in Syria, the more abusively Putin and Lavrov behave.  The Moscow “spy” fiasco is part of that.  So are many other things-which I’ll discuss in a bit.

Kerry and Obama should wear “kick [or something more vulgar] me, Vlad” pinned to their backsides.  Hell, maybe they already do.  That would be consistent with the evidence, because Putin and Lavrov are kicking hard, kicking fast, and kicking often.

Look.  The Russians are doubling down on supporting Assad.  They are deploying large pieces of their ramshackle navy to the eastern Med.  (Including tugboats!  There must be tugboats! And I mean plural!) There is one reason and one reason only to do this: to make it virtually impossible for the US to use naval assets to do anything in Syria, including enforcement of a no-fly zone, or more drastic measures.  It is a tripwire.  The extensiveness of the deployment, given Russian naval capabilities, is such that even the blind should see that the Russians are making a major commitment to Assad.

What’s worse, in addition to sending Syria advanced S-300 and Pantir AA missiles, the Russians are supplying Syria with advanced Yakhot supersonic anti-ship missiles.  The Yakhot is a capable system.  The US has been aware of it for some time and presumably has many countermeasures in place, but they do represent a substantial increase in Syria’s capability and will dramatically increase the difficulties of any carrier operations in the eastern Med.

The Pentagon went ballistic at the news. Even Hagel bestirred himself to criticize the move.

But that’s what gets us to what’s worst: the State Department response.  According to Foggy Bottom, there’s no problem because these are not “new sales”:

Jennifer Psaki, a State Department spokeswoman, said Russia had disclosed the sale of the Yakhont missiles in 2011, and she added that U.S. and Russian diplomats were still planning the Geneva conference next month.

FFS.  That’s exactly the Russian line.  Exactly.  Gee, Jennifer, great job you got there, being Sergei Lavrov’s parrot.

I am sure the Navy (and the Israeli Navy) is so pleased that they will only be targeted by previously contracted for weapons, not new sales.  And John “Reporting for Duty” Kerry isn’t the one who will be painted by the Yakhot’s terminal guidance system.  Maybe he should think about those who could be, rather than sucking up to Sergei.

And all this BS about “defensive weapons” is just that.  They provide Assad a shield behind which he can slaughter the opposition with substantially less fear of any intervention.

And insofar as the sanctity of contracts is concerned.  First, since when have contracts ever meant jack to the Russians?  Second, to give an example of how this can be done, just look at how the US stiffed Pakistan for years over F-16 sales.  Where there’s a will, there’s a way.  Russia isn’t delivering weapons because their compelled to: they’re delivering weapons because they want to.  (Uhm, and how would the Syrians enforce a breach, anyways?)

Meanwhile, Kerry and the Brits and the UN are nattering on about some meeting in Geneva between the contending forces in Syria.  Yeah, like meetings in Geneva ever accomplish squat where existential and brutal civil wars are involved.

The Russians are making it very clear they are doubling down on Assad, and will defend his regime to the last.  Their deeds speak volumes.

I’m not advocating or even supporting US action in Syria.  Obama frittered away that opportunity a long time ago.  When wars get to the eating the eating your enemy’s hearts stage (and this by the “moderates” no less), the situation is pretty much beyond salvage, even by Russian tugs.

But it’s best to recognize what Russia is up to here, and state that forthrightly.  Make it plain who is ultimately responsible for the horror that is occurring in Syria.  Chasing after Putin and Lavrov like some pitiful suitor, and regurgitating the Russian party line in a way that undercuts our own military’s serious concerns, is just nauseating.  It’s worse than that.  It’s craven.  Cosmically craven.  And Putin will note that, and act accordingly in other things that matter.

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