Streetwise Professor

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.

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.

Javier Blas of the FT just posted an article about a report “written by a leading academic on commodity markets” on whether commodity trading firms (like Cargill or Vitol) are sources of systemic risk.

What, haven’t heard about that report?  Well, that’s the main point of the story.  The report was spiked by the GFMA, a banking trade association, which commissioned it.  According to Javier:

However, the report was never completed and remained in a “draft” status, after its conclusions went against the interest of the lobby group, three people familiar with the matter said.

So yes, perhaps you’ve guessed by now that the academic in question is me (though you have to read 2/3s of the way through the story to get to my name).  And yes, that’s pretty much what I understood to have happened, though I was never told that in so many words.  It’s nice to have it confirmed by “three people familiar with the matter”, even though it was blindingly obvious to me at the time. *

I call them like I see them.  GFMA didn’t like that.  I wouldn’t change the call, so they sat on the report.  So it goes.

I think GFMA handled this badly even from the perspective of its own interests, though I guess I am not really surprised: this is the way organizations like this tend to behave.  I am sure this has given the report more visibility than it ever would have achieved otherwise, and makes GFMA look bad in the bargain, at least in my (probably biased) opinion.  The regulatory body they were trying to influence-the FSB-was briefed on the findings, and had a draft of the report, so deep-sixing the report only signaled to the FSB that GFMA didn’t like the results, which it probably knew anyways.  Spiking the report also serves to validate the independence of the findings-and of the finder of the findings.  That’s definitely an upside for me.

Working on the report helped me learn a good deal more about the global commodity trading firms, so that’s also a good thing.  I look forward to learning and writing more in the future.

*For the record, the copy of the report “seen by the Financial Times” didn’t come from me.

Electric vehicle manufacturer Tesla’s stock rocketed up last week after the company reported positive earnings and operating cash flow for the first quarter.  The stock had been heavily shorted, and short covering evidently fueled the stock’s take off.

Color me skeptical.  The company was heavily shorted for good reason, and is even more ripe for shorting after the run-up.  (Personal opinion.  Not investment advice.  You’re on your own about that.)

For one thing, although operating results did improve from the (really terrible 3/4Q12), the much hyped earnings number was put into positive territory by two items: a write down of a warrant that Tesla granted the Department of Energy as part of a $465 million DOE loan to the company, and FX gains (mainly on yen).  Not repeatable.  And the first seems highly dodgy to me-a squishy number based on an assumption that Tesla will be able to pay off the loan.

I’m also skeptical because of the near miraculous nature of the turnaround. Mere months ago, the company was in dire straits:

It’s a lucky thing for Tesla Motors shareholders that the U.S. Department of Energy loves the company’s loan applications.

Without the hundreds of millions of dollars Tesla (US:TSLA) has received from the federal government this year, the electric-car maker’s financials would be gasping for air as 2012 winds down.

Given the ugly state of Tesla’s finances — and the company’s sky-high valuation: almost $4 billion — it will rank among the top candidates in Silicon Valley for a 2013 stock collapse, unless it receives significantly more cash next year.

I get a whiff of a company that needed a miracle to stave off disaster.  Maybe it got one, but I am always skeptical of miracles whenever accounting is involved.  And that’s certainly the case here.

The shorts have been bloodied, but they’ll be back.  Indeed, this seems like a typical battle in a war between a dodgy company and short sellers.

But I am most skeptical because of Tesla’s not-really-founder-but-biggest-investor, Elon Musk.

Mr. Musk is Occupy’s favorite crony capitalist.  And Occupy is one of Mr. Musk’s favorite movements.

Yes, once upon a time Musk started a real business, Paypal, that proved very successful without any government help.  That was then, this is now.

Musk has three ventures: Tesla, SpaceX, and SolarCity.  All are heavily dependent on government largesse.

Take Tesla for starters. It received the $465 mm loan from DOE, but it also benefits from a $7500/car federal subsidy for electric cars.  Moreover, it benefits from the State of California’s Zero Emissions Credit program.  In its infinite wisdom, CA mandated that all the major auto companies sell a certain number of zero emissions vehicles.  If they don’t they have to buy credits from companies that do make them-namely, Tesla.  This was also essential in putting the  company in the black in Q1, and the company is sitting on $250 mm worth of these credits.

IOW, Tesla’s profits are courtesy of you, the taxpayer-and also courtesy of the shareholders of Ford, GM, Toyota, Honda, etc.

Next consider SpaceX.  This venture provides evidence of Musk’s love for Occupy: he has promised that this private space venture will go to Mars, and wears an Occupy Mars shirt to make the point.

It is also touted as a privately capitalized space venture, which it is, I guess, but it is also almost completely dependent on government contracts.  The private money is attracted by the scent of public money.   Sorry, but a company that is dependent on NASA’s IV for support is not truly a private company: the company is basically a cutout between the investors and the taxpayers.

The company has not exactly covered itself in glory.  It had serious trouble with its initial launches, including an embarrassing episode in which the ashes of Star Trek’s Scotty, James Doohan, were on a SpaceX craft that didn’t make it into space: it crashed instead somewhere in the South Pacific.  Which I guess would have been great if James Doohan had starred in South Pacific.  Don’t worry, though.  As a precaution, some of Mr. Doohan’s ashes were retained, and that part of the beloved actor’s remains did make it into space as he desired.

And speaking of Broadway and movie classics, Musk is auditioning for a role in a summer stock Music Man with his boosterism of SpaceX:

You don’t have to be a believer in conspiracy theories to wonder why senior government officials are so committed to going the commercial route in space. Even a cursory review of SpaceX programs and plans reveals reasons for doubt. The questions begin with a business strategy that isn’t just disruptive, but downright incredible. Mr. Musk says that he can offer launch prices far below those quoted by any traditional provider — including the Chinese — by running a lean, vertically integrated enterprise with minimal government oversight that achieves sizable economies of scale. The economies of scale are possible, he contends, because there is huge pent-up demand for space travel in the marketplace that cannot be met within the prevailing pricing structure. By dropping prices substantially, this latent demand can then be unlocked, greatly increasing the rate of rocket production and launches. When combined with other features of the SpaceX business model, the increased pace of production and launches results in revolutionary price reductions.

There isn’t much serious research to demonstrate that the pent-up demand Musk postulates really exists, nor that the price reductions he foresees are feasible. He has suggested in some interviews that launch costs could decline to a small fraction of current levels if all the assumptions in his business plan come true, and he has posted a commentary on his web-site explaining how SpaceX is already able to offer the lowest prices in the business. It’s hard to look inside the operations of a private company, but SpaceX does seem to be doing all the things necessary to minimize costs such as using proven technology, building as many items as possible in-house, and hiring a young workforce willing to work long hours. And to his credit, Musk has committed over $100 million of his own money to the venture. However, his rockets have major performance limitations compared with other launch vehicles in the market, and they are not yet rated as safe for carrying people. Becoming “man-rated” will necessarily increase the role of federal officials in monitoring SpaceX operations, which is not good news for a business model grounded in minimal government oversight (traditional launch providers say government regulations and overhead charges are a key driver in their own pricing policies).

Downright incredible sounds about right.  It sounds like a con to me.  Especially the whole “economy of scale” thing.  That’s the kind of thing defense contractors say to get the government to buy more units of a plane or ship.  It’s not good economics.

And Musk’s winning personality was on display when questioned about SpaceX’s launch failures:

Mr. Musk recently responded to a question from Space News reporter Amy Svitak about the two-year delay in accomplishing that second Falcon 9 launch by observing, “In the space business that’s on time.” Perhaps he was irritated by the reporter’s implied criticism, but it goes without saying that if astronauts on board the space station are awaiting supplies, a prolonged launch delay could spell big trouble.

What a guy.  Takes your money, and then gets peevish when you accuse him he’s blowing it.

Then there is SolarCity, an installer of solar panels.  The solar industry has raked in $4.1 billion of stimulus money, and the government thinks that SolarCity in particular has played fast and loose with the numbers to  get more than it should:

Last July, federal investigators subpoenaed SolarCity Corp., SCTY +9.10% the largest installer of residential solar panels, as part of a probe into whether solar-power companies received excessive government grants.

. . . .

Even before the Treasury Department’s inquiry into grant applications filed by SolarCity and other installers, House Republicans had questioned the program’s effectiveness in creating jobs. Congress declined to renew the grant program at the end of 2011, and only projects that were being planned by that date can receive grants today.

The government is looking into whether SolarCity and other firms misrepresented the fair-market value of solar systems in order to boost the value of the grants they received. In its suit, SolarCity says two of the company’s subsidiaries received smaller-than-expected grants. The company doesn’t say exactly how much funding it applied for originally, but it says the final grants issued by the Treasury Department were $8 million less than was proper under the law.

But SolarCity is doubling down on the chutzpah, and suing the government, claiming the government has paid it too little!:

Now, SolarCity is pushing back with a lawsuit that alleges the opposite: some of the taxpayer-funded grants it received weren’t as big as originally promised.

The suit, filed quietly in February in the U.S. Court of Federal Claims, comes as SolarCity and other industry players are defending solar-friendly government policies, and it could undermine the industry’s message that solar power will soon be viable without government help.

Solar businesses have cratered around the world: China, Spain, Germany.  The industry is addicted to government support.

Elon Musk has a plan to get rich.  It involves you.  The taxpayer.  You pay taxes.  The government gives huge dollops of that money to Elon.  Elon gets rich.  Who could possibly object? Who could deny Elon’s genius?

He certainly thinks he’s a genius.  He has no hesitations in telling people so.

And there is a kind of perverse genius here.  In the Age of Obama he has found the key to riches.  Get in good with the government-by, you know, sponsoring an inaugural ball.  And then let the government give you the goodies.  Then sue the government if they don’t give you enough goodies.

And then preen before the world, touting your genius-and your environmental credentials. (Pay no attention to that private jet behind the curtain!) (Musk quit the Zuckerberg-created immigration lobbying effort FWD.us because it bought ads supporting politicians who support immigration changes but also had the temerity to support the Keystone pipeline.)

What a repulsive man.

Repulsive, yes, but sadly, Elon Musk is a Man For Our Age, in more ways than one.

There are reports that the CFTC will vote on the SEF rule next week.  The rule had been in limbo for months due to Gensler’s insistence that the rule require those requesting a quote solicit them from five potential counterparties.  Gensler has apparently relented because he could not get the new Democratic commissioner, Mark Wetjen, to join with Chilton and Gensler to vote out the 5 RFQ rule.

The compromise will require users to solicit two quotes for the next two years, and then three thereafter.

Whatever.

On the 1 year anniversary of the DFA, I named the SEF mandate as The Worst of Frankendodd. I haven’t changed my mind on that, though the competition is fierce.  And the RFQ requirement is the Worst of the Worst.  It is defended as a way of  improving competition.

This is at best paternalistic.  It presumes that those who want to enter into swaps don’t know their own interests.  Perhaps Gensler thinks that the buy side suffers from some sort of Stockholm Syndrome after years of captivity to the dealer banks.

In reality, buy side firms-most of whom are extremely experienced and sophisticated-are making trade-offs between competition and information leakage.  They are trying to minimize cost of execution, and have the information and incentive to do that.  Note too that they are required to do this for every trade, regardless of instrument, size, and other factors that may influence the trade-off.  But nope, one size fits all. They should be allowed to make that trade-off themselves, without any guidance from Gary.

RFQ5?  How about RFQ0?

Here’s an analogy.  How would you like it if the government told you how many stores you had to visit before making a purchase?  You know, to make sure that you get the best price.  Call it the CS5 rule.  You have to comparison shop at five stores before making a purchase.  On everything.   Of course, when deciding on whether to shop at one store or five, you trade-off the potential savings (which will depend on the value of the purchase, the good you are shopping for, and other factors) from shopping around more, against the cost (which will vary with the value of your time, how hurried you are, your income, the price of gas, where you live, etc.)  But none of that matters under the CS5 rule.  Want to buy a quart of milk?  Shop at five stores.  For your own good.

Yeah.  It’s that bad.  CS2 would be bad, but not that bad.

Once the SEF rule goes into effect it will be interesting to see how the structure of the industry involves.  There will be a land rush of new SEFs.  I predict there will be a shakeout, and there may well be only a single dominant SEF for each major instrument.  The SEF rule does not, as I understand it, require a SEF to send an order to another SEF offering a better quote.  Which means that the network effects of liquidity will tend to cause trading activity to “tip” to a single SEF for products big enough to support order book trading.

But the whole SEF landscape will also be shaped by the margin rules, the Bloomberg suit over those rules, block trading rules, and on and on.  The rule is not the beginning of the end, it is barely the end of the beginning.

The Obama administration is planning on easing repayment terms for student loans:

The White House proposes that the government forgive billions of dollars in student debt over the next decade, a plan that cheers student advocates, but critics say it would expand a program that already encourages students to borrow too much and stick taxpayers with the bill.

The proposal, included in President Barack Obama’s budget for next year, would increase the number of borrowers eligible for a program known casually as income-based repayment, which aims to help low-income workers stay current on federal student debt.

Borrowers in the program make monthly payments equivalent to 10% of their income after taxes and basic living expenses, regardless of how much they owe. After 20 years of on-time payments—10 years for those who work in public or nonprofit jobs—the balance is forgiven.

This is a statement against interest, and the proposal is hardly surprising, considering the source but I must say: This is a horrible idea.

We are constantly lectured how higher education is an “investment.”  Sometimes it is.  That investment has a rate of return.  What’s important that capital-financial, human, the opportunity cost of student time-earn a return that covers the opportunity cost of capital.  We want individuals whose ROR exceeds the relevant interest rate to make the investment, and those whose ROR doesn’t not to make it.  This isn’t rocket science.

Tying repayments to income totally undermines those incentives.  Hey, go get a low earning degree, one that has a poor rate of return-and likely, a negative rate of return-and you will make lower payments!  What could go wrong?

This reduces the cost of pursuing low-return majors, so we will have more graduates with psych or anthro degrees who will work in retail and fast food and other low-wage occupations.   That is horrible.  The exact opposite of what we want.

Try doing this at your local bank, by the way.  Not too many I know of advertise their wonderful Loser Loan Programs: “The worse your financial performance, the lower your payment!”

Yes, I know the idea is to provide insurance against income losses due to illness, or job loss, etc., but that insurance will be rife with moral hazard.

Another example of the problems when the government intervenes in the capital allocation process.  That worked out so well in the housing market, didn’t it?  This will work out no better.  It will raise expectations and saddle people with heavy burdens, thereby contributing to disillusionment and anger.

It is also highly cynical and manipulative.  Those most likely to get hurt are those who are least able to evaluate the costs and benefits of getting a college education.  Moreover, Obama administration policy is already screwing the young in ways that could teach the Kama Sutra some things, and this will add to that, all in the name of helping those who get screwed.

It is perhaps another example of what Raghuram Rajan identified as a feature of US polices ostensibly intended to reduce inequality.  He specifically focuses on subsidizing homeownership, but this is exactly the same thing that goes on with student loans.

Education can be a great thing, if you make wise choices.  One thing I’ve been on about for years is that learning programming is an important skill.  You don’t have to be a programmer, but you should know some programming.  It is a functional skill, and also helps you learn to think logically and precisely.  So I agree with this WSJ piece.

Unfortunately, easing student loan terms along the lines proposed by the administration will not provide incentives to do that.  It will provide incentives to do the opposite, and hurt most those it is intended to help.  Like the title says, run when the government-and especially this administration-says they’re doing something to help you.

That high pitched noise you hear is the shrieks of those who are Shocked! and Disgusted! by historian Niall Ferguson’s drawing a connection between Keynes’, umm, Bohemianism and his economic views.  That moral avatar Henry Blodget (banned from the securities industry for life, by the way) describes what Ferguson says as “bizarre and offensive”:

Speaking at the Tenth Annual Altegris Conference in Carlsbad, Calif., in front of a group of more than 500 financial advisors and investors, Ferguson responded to a question about Keynes’ famous philosophy of self-interest versus the economic philosophy of Edmund Burke, who believed there was a social contract among the living, as well as the dead. Ferguson asked the audience how many children Keynes had. He explained that Keynes had none because he was a homosexual and was married to a ballerina, with whom he likely talked of “poetry” rather than procreated. The audience went quiet at the remark. Some attendees later said they found the remarks offensive.

Well, this idea didn’t spring first from Ferguson’s fertile imagination-or febrile imagination, as his critics would have it.  Joseph Schumpeter, leaving out the gay bits, made essentially the same point in his chapter on Keynes in his Ten Great Economists From Marx to Keynes: “He was childless and his philosophy of life was essentially a short-run philosophy.”  That was written in 1951, and of course homosexuality just wasn’t mentioned then.  One could argue that ironically, the greater acceptance of homosexuality is precisely why Ferguson today could make explicit what Schumpeter only hinted at in the benighted 50s.

Schumpeter was a giant as an economist.  He knew Keynes.  He knew Keynes’s milieu. He was one of the greatest historians of economic thought.  He was also unconventional in his private life, though in a different way.  So he speaks with some authority.  Not that one should automatically defer to such authority, but when someone like Schumpeter says it, you know it’s not the unconsidered musings of an ignorant man.  It is the considered opinion of a highly knowledgeable one.

But he was also a furriner at Harvard, so that must be it.

Schumpeter attributes other aspects of Keynes’s thought to his personal history.  The quoted line is in a section that argues that Keynes was a patriotic Englishman, and that his scientific and policy works were not so coincidentally closely aligned with Britain’s interests:

Like the old free-traders, he always exalted what was at any moment truth and wisdom for England into truth and wisdom for all times and places.

Ironic, isn’t it, inasmuch as Ferguson is a rather outspoken admirer of the British Empire?

The fact that Keynes married, and that his wife apparently miscarried, does raise questions about the theory that Schumpeter advanced and Ferguson repeated (if you assume the child was Keynes’s-quite a leap in itself).  But neither gainsays the fact that Keynes’s view was, clearly, focused on the short-run, and expressed virtually no interest in the implications of his policy recommendations for future generations.

This controversy raises the question: what is the point of the biographies of intellectuals, anyways, if there is no connection between their personal lives and their intellectual works? Unless such a connection exists, intellectual biography that explores private lives is nothing more than People Magazine for eggheads.  Keynes’ biographer Skidelsky goes into lurid detail about Keynes’s private life, and concludes that it was an important part of his worldview.  (Skidelsky puts forward some thoughts on the role of intellectual biography here.)  Skidelsky was able to document in such lurid detail precisely because Keynes recorded his exploits in such lurid detail.  It was obviously something very important to him.  Given this importance, is therefore hardly outlandish to suggest that there is a nexus between his personal life and philosophies, and his professional writings.

All that said, there is a difference between understanding-or at least conjecturing about-why Keynes wrote what he wrote and determining whether what he wrote is good economics or a good guide to public policy.  Making the latter determination is a matter of logic, mathematics, and empirical analysis.  If Keynes’s inspiration came from a ouija board, but turned out to be logically airtight and empirically validated, so what?  If it turns out to be logically flawed and empirically invalidated, what possible difference could its intellectual-or psychological-origins matter?  (I am in the latter camp, obviously, regarding Keynes’s work.)

I sense that the hysterical attack on Ferguson for his views on Keynes reflects the left’s view that Keynesianism must be defended at all costs, and anything and anyone that could raise any doubts about Keynes must be terminated, with  extreme prejudice.  Add to that the very PC urge to shout down anyone who dares express the view that sexual orientation could influence worldview in a negative way-the selfsame people are often quite willing to claim that it can affect it in a positive way.  So I guess orientation can affect thought and behavior, but only in a good way.  Uh-huh.

Note that the question to which Ferguson was responding was not about the theoretical rigor or empirical content of The General Theory.  He was asked to contrast Keynes’s philosophy with that of Burke.  He answered. You can find things that Skidelsky-an ardent admirer of Keynes-has written that would support what Ferguson said.

All in all, I consider this a tempest in a teapot.  I really couldn’t care less about the connection, if any, between Keynes’s sexual orientation and lack of progeny and his theories: what I care about is the connection between his theories and reality.  And that connection is very tenuous, in my view.

This tempest has all the usual roots of a faux controversy.  Ferguson is a bête noire on the left, notorious for his muscular, and at times brutal, advocacy of conservative (more properly, classical liberal) positions.  He said something that those who despise him can jump on.  And they are jumping on it, taking offense with relish.  (By the way, I find any criticism of an argument that focuses on its alleged offensiveness to be inherently subjective, often manipulative, and revealing of an inability to attack its substance.  Highly unpersuasive, in other words.  I’d also note that he gave the remarks at a conference put on by an investment firm, and I imagine that most of the audience was high net worth individuals and their investment advisors.  Supposedly-though the source for this obviously dislikes Ferguson-the audience was uncomfortable after Ferguson’s remark, and many were offended.  So much for the rich being right wing knuckle draggers with too much money.)

I was surprised and disappointed to read that Ferguson made a fulsome apology.  I seriously thought that he wouldn’t give a flying ‘f, and would in fact double down.  But perhaps it shouldn’t be surprising, given the history at Harvard.

I am counting down the seconds until the demands that he be banished from Harvard start flying, apology or no.  Liberal in Good Standing Larry Summers was defenestrated as Harvard President, for crissakes, of uttering a politically incorrect remark.  And this after he groveled.  If they can drive out the President of the university, and a former Treasury Secretary in a Democratic administration, eliminating the mere Tisch Professor of History, a conservative no less, should be child’s play.

While they’re at it, maybe they should posthumously de-tenure Schumpeter. But why stop there? For having the temerity to utter such a politically incorrect statement, by all rights they should re-enact what was done with Cromwell upon the Restoration.  You know, dig up his corpse, and draw and quarter it.  For what he said, he obviously deserves nothing less.

The FSB is contemplating designating commodity trading firms like Cargill and Glencore as systemically important.  No, not that FSB: The Financial Stability Board, a group of global regulators established in the wake of the financial crisis.

The reason for this is, apparently, that these firms are engaged in shadow banking.  The linked Reuters story mentions two types of activity.

First, commodity trading firms extend trade credit and working capital to their customers.  Second,  some use securitization to raise funding.

The FSB is rightly concerned about shadow banking, but the kinds of activities that commodity trading firms engage in is quite different from some of the activities implicated in the crisis.

Some forms of securitization contributed significantly to the crisis.  Most of the most dangerous forms involved significant maturity transformation, and direct ties to big banks.  SIVs that funded portfolios of mortgage securities with short-maturity corporate paper, that were backed by liquidity puts provided by sponsoring banks are the prime example of this.  When investors began to doubt the value of the underlying assets, there were runs on the SIVs: they could not rollover their paper, and sponsoring banks ended up taking the now toxic assets back onto their balance sheets.  This was a big problem because the banks were highly leveraged; their main business is to provide credit; and they are essential components of the payment system.

The securitizations that commodity trading firms have engaged in, like the Trafigura program mentioned in the Reuters piece, are (a) far more limited, and (b) very different.   In particular, these structures do not involve the kind of maturity mismatch that was the Achilles heel of the SIVs.  Indeed, if anything, to the extent there is maturity transformation it is the opposite of the type that proved problematic in the crisis.  The underlying assets are very short dated (such as receivables) and/or very liquid (like inventories of aluminum in LME warehouses).  The assets typically have shorter maturities than the liabilities issued to fund them.  Indeed, one of the challenges of these structures is to replenish the assets as they mature.  Traditional SIVs had to rollover their liabilities: commodity trade securitizations have to replenish their assets.  The former is far more problematic than the latter because the run risk is far greater.

Moreover, historically the default rates on the trade receivables that are securitized are very, very small.  The extent data are for all trade receivables, not just commodity trade receivables, but the credit losses are trivial.

I also find little reason to be unduly concerned over the  the granting of trade credit and extension of working capital funding through prepayments and other arrangements.  Consider prepays, where a trading firm may provide funding to a refiner, say.  The commodity trader may fund the input (crude oil), and in exchange receive refined products.   The refined product is essentially collateral for the financing provided to buy the input.  Moreover, the value of this collateral can be hedged in most cases, limiting the credit exposure of the commodity firm extending the credit.   This is often quite different than extending credit to fund illiquid, hard to value, long maturity assets that cannot be hedged.

The commodity trading firm has a comparative advantage in marketing the output.  Moreover, due to its knowledge of the industry and the particular firms involved, it likely has information that makes it the most efficient creditor.  It knows more about the market and the particular borrowers than most banks.

The foregoing suggests that the credit risk and maturity transformation risk involved in commodity trading firm shadow banking activities is far less than that involved in the kinds of shadow banking that proved highly problematic during the crisis.  But credit losses are conceivable.  What would happen if commodity trading firms suffered big credit losses?

It’s hard to see how this could seriously threaten the stability of the financial system or the global economy.  Commodity trading firms aren’t that big: if Glencore is too big to fail, so is Kraft, or a similarly sized company.  Their assets are dwarfed by those of the big SIFI banks: they are about as big as many middling banks you’ve probably never heard of.  Moreover, the commodity trading firms are far less leveraged than big banks.  Furthermore, their capital structures are far less fragile, because they involve little maturity transformation: their short term liabilities are largely matched against short term assets, such as hedged commodity inventories.  The firms provide financial intermediation, but unlike banks, that’s not their primary function, so they are not as vital to the credit supply process as banks.  They are not essential elements in the payments infrastructure.

Commodity firms provide valuable logistical services, but the assets, human and physical, that they utilize are readily redeployed.  If one company goes bust, its assets can be redeployed so that the trade in commodities can continue.

Some of the shadow banking activities that commodity firms engage in actually take risk out of the banking system.   A major reason for the development of securitization in commodity markets was that big banks-especially French banks facing difficulties in securing dollar funding-cut their funding to commodity firms.  So the firms turned to securitization and thereby transferred the risk to the capital markets.  And unlike the case with SIVs sponsored by banks, there isn’t a backdoor by which this risk can make its way back to bank balance sheets.

I would also note that commodity trading firms do not benefit from deposit insurance, and so don’t pose the same moral hazard concerns as banks that do.

So I find few parallels between the kinds of shadow banking that proved so dangerous during the crisis, and the kinds of shadow banking that commodity firms engage in.

Commodity firms are first and foremost logistics specialists that engage in financing transactions to facilitate that business. A couple of other historical experiences suggest that such logistical intermediaries are not systemically important.

In 2002, the entire merchant energy sector in the US imploded.  These firms-companies like Enron, Dynegy, Mirant, and Williams-were primarily logistical intermediaries that provided financing and risk management services to their clients, just as global commodity trading firms do.  Not just one of these firms imploded.  The whole industry did: the stock prices of the firms in this business fell by about 90 percent between April and July of 2002.  But gas and power continued to flow. The impact on the US economy was barely measurable.

Furthermore, the experience of the Fukishima earthquake and tsunami suggests that even if the failure of one or more major commodity firms did disrupt commodity logistics for a time, the implications of this for the global economy would likely be small.  The earthquake and tsunami created huge disruptions in supply chains, especially in automobiles and electronics.  Trade was severely disrupted.  But the impact on the global economy was almost immeasurably small.  Studies undertaken by several governments found that the Japanese disaster shaved a tenth of a point or two off global GDP growth.  The financial aftershocks were minimal, even in Japan.  If the world economy can survive such a literal seismic shock that seriously disrupted supply chains in high valued manufacturing, it can almost certainly survive the failure of a big commodity trader.  Or two. Or three.  Especially since the Fukishima disaster destroyed or disrupted physical assets in a way that the financial distress of a commodity firm with redeployable assets would not.

I’d be more persuaded by the FSB’s concerns if it would provide a description of the mechanism by which commodity trading firms can be the source of financial contagion, or the channel through which contagion can be communicated from the financial sector to the real economy.  As those who have read my writings on clearing can attest, I can have a pretty vivid imagination about how contagion can propagate, and despite giving this considerable thought, I haven’t found a plausible mechanism.

In some sense, it seems that the FSB is like Mark Twain’s cat that wouldn’t sit on a hot stove after it had been burned, but it wouldn’t sit on a cold one either.  Once burned by shadow banking of one kind (the kind tightly tied into the banking system), it seems afraid of any kind of shadow banking.

And I have a pretty good idea who is stoking those fears.  I know, as the result of personal experience, that major banks involved in commodity markets are chafing under the restrictions imposed on them, and resent the fact that commodity firms that are their competitors in certain activities are not subject to the same restrictions.  I know they have been importuning the FSB to identify commodity trading firms as systemically important, and to impose bank-like disclosure and capital requirements on them.  All the better to hamstring the competition.

How I know this, I can’t say.  But I’m just sayin’.  You can take it to the bank, as it were.

Too big to fail is a self-fulfilling phenomenon, in large part.  It would be far less of a problem if governments could credibly commit not to bail out certain firms.  It becomes much harder to make such credible commitments when those firms are identified as systemically important.  Therefore, regulators should be very reluctant to confer the “systemically important” label.  Very reluctant.   Objectively, there are few reasons to consider big commodity trading firms-even the biggest ones-systemically important. All the more reason to eschew conferring that designation on them.

In other words, sitting on a cold stove isn’t dangerous.  The FSB should be smarter than the cat in Puddin’ Head Wilson.

The most recent controversy over HFT stems from this WSJ story about the CME.  In a nutshell, computerized traders receive confirmations of their trades before information about those trades is disseminated to the market at large.  As in a few milliseconds before.  But in an electronic world, a few milliseconds can be decisive.

One example of a particularly informative trade is when an away-from-the-market limit order is executed.  This means that a market order of sufficient size to blow through the quote size at the inside market was submitted.  Given that orders and communicate information, and that the bigger the order, the more informative it is, knowing before anybody else that such an order has been executed can provide valuable information.

The implications of this depend on how the information is used.  A trader (or, more accurately, a bot) that gets this information can use it to take liquidity aggressively.  For instance, it can use information gleaned from a big, price-moving crude oil buy to submit an aggressive order in heating oil or RBOB, thereby picking off resting limit orders that cannot adjust to the new information.  Or, as the WSJ article suggests, the bot can use the information derived from the NYMEX CL trade to take liquidity from ICE Brent or NYMEX lookalike futures.

This kind of trading exacerbates information asymmetries, and all else equal, increases spreads, reduces depth, and increases trading costs for the uninformed.

But the “all else equal” part of the statement doesn’t necessarily hold.  This presumes that the amount of capital devoted to HFT is constant.  But that’s not true in the long run.  If these sorts of advantages generate profits, that will attract more capital into HFT.  Moreover, note that the strategy just outlined involves placing limit orders, and then reacting when those limit orders are executed.  Competition to get the information advantage will lead to more aggressive quotes, and quotes in bigger size.  In the long run equilibrium, this competition will dissipate the rents from the information advantage.

Therefore, if there is any reason to reduce this speed advantage (either by slowing down some traders or speeding up the dissemination of trade execution information to the market at large), it is to prevent the investment of excessive capital into HFT.  The effect on spreads and depth in equilibrium is ambiguous.

Moreover, there are other possible uses of the information advantage that are clearly socially beneficial.  An HFT market maker-who is likely making markets in a variety of contracts-can utilize the information to revise limit orders either in the market in which the execution occurred, or in other markets, especially those that are closely related (again, consider the CL/HO or CL/RB example).  Using the speed/information advantage in this way reduces the HFT market maker’s vulnerability to getting picked off, and makes it willing to supply liquidity more aggressively.  This tends to reduce trading costs, and does not lead to the rent seeking that in the long run equilibrium tends to result in an inefficiently large HFT presence.

We also need some perspective here.  I consider it beyond hilarious that the WSJ has a video embedded in the online version of the story that has many images from the floor.  (And these days, one of the floor’s main functions is to provide visuals for stories on trading-especially the trader’s-head-in-his-hands shot on days when the market falls a lot.  Pictures of servers aren’t nearly so dramatic.)

Why hilarious?  Well, the floor was the epitome of time and space advantages to a select few.  A select few who paid for the privilege.  I remember distinctly a trader telling me: “Why do I spend $500,000 on a seat? Because I get to see the price before anybody else.”

Exactly.  The floor was the meat version of colocation.  Or the carbon based life form version, if you like.  Those on the floor could see the execution prices, and bids and offers, and order flows, that those off the floor could not.  They profited accordingly.  Which is why the marginal guy on the floor-the least efficient trader-was willing to pay hundreds of thousands of dollars in some cases to get on the floor.

In 2002 or so I wrote a paper titled “Upstairs, Downstairs” (still a working paper) which showed that floor traders earned a rent as a result of their time and space advantage: upstairs traders could not supply liquidity as effectively as floor traders due to their information disadvantage, and this meant that floor traders faced limited competition in supplying liquidity.  Moreover, exchange limits on membership meant that entry could not dissipate these rents.  But by reducing the time disparities between liquidity suppliers advantage, electronic trading increased liquidity supply: upstairs traders were no longer operating under a time and space handicap.  Trading costs and rents decline. And that decline in rents is precisely why floor traders fought electronic trading so fiercely for years.

So yes, in today’s electronic markets some traders have a speed advantage.  But this disparity is nothing when compared to that which existed in the floor days.

Which is why I can’t really get all that spun up over the WSJ story, or most of the other stories about how unfair markets are.  Everything is relative.  No, the playing field isn’t perfectly level today, and along the lines of yesterday’s post, it may be in the interest of the CME to take measures to make it more level.  They say that they are.  But arguably the field is more  level than it has ever been.  It’s certainly far more level than in the heyday of the trading floors.  Don’t get nostalgic for the days when market makers were meat, not machines.  The table was tilted in their favor, bigtime.  Much more than today.

Krugman and others have been doing a victory dance, claiming that the Reinhart-Rogoff work on the relationship between debt and growth has been repudiated.  Hardly.  The R&R spreadsheet error (but I repeat myself) is embarrassing, but of minor consequence.  The other criticisms leveled by Thomas Herndon, Michael Ash and Robert Pollin are matters of judgment and interpretation, not definitive error.

James Hamilton has a balanced overview, as do Betsy Stevenson and Justin Wolfers.   Matthew Klein dissects the matter of New Zealand, which proves pivotal in the analysis.

Not surprisingly, Niall Ferguson is quite scathing in his criticism of Krugman’s gloating.  Ferguson just points out the obvious.  There is a limit to debt, and accumulation of too much debt leads to either default or inflation.  You can’t borrow a trillion (or about 6 percent of GDP) forever, or even for a modest period, without coming a cropper.

The most interesting part of Ferguson’s analysis draws an analogy I’ve used before: between governments and Enron.  (And Niall is nice, not pointing out that Krugman took Enron’s checks as an “advisor.”)  What do they have in common?  Hiding huge liabilities off balance sheet.  Well, that’s not really correct.  Governments don’t have proper balance sheets.  ”Government accounting” is something of an oxymoron.  But in the main, the point holds.  The debt that was on Enron’s books was only a fraction of its actual liabilities, and the official debt of the US government (and most governments, for that matter) is only a fraction of its (and their) actual liabilities.  Indeed, Medicare, Social Security, loan guarantees, and so on are so large compared to official debt that the US government makes Ken Lay and Jeff Skilling and Andy Fastow look like petty grifters.

So debating whether debt greater than 90 percent of GDP results in a substantial reduction in growth is really a sideshow.  The US is around that level now (somewhat over it when all government debt is counted, somewhat under it when only debt in public hands is)-but when you tote up only Treasury bonds, notes, and bills.   When you add it the off-balance sheet items, 90 percent looks like the epitome of prudence and thrift.

Of course the government has off-balance sheet assets too-like its taxing power.  How do you value that? (Which is perhaps one of the reasons governments don’t keep formal balance sheets.)  But that taxing power is not unlimited.  What’s more, due to the deadweight costs of taxation, it is precisely using that “asset” that can be a drag on growth.

All in all, though, when you consider the true state of US government finances and count all the liabilities, the academic debate over whether there is a growth threshold when debt hits 90 percent of GDP appears, well, academic.