Streetwise Professor

Tech writers are supposed to be clued into what’s on the cutting edge, but Mike Butcher writing on Skolkovo for Techcrunch is so far behind the wave it’s hilarious.  His piece reads like a 2009 press release:

So, in a typically Russian approach to the problem, it’s come up with Skolkovo, a vast new science-based city, to catapult its economy into a new era of technology and innovation. The Skolkovo Innovation Center will be a planned high technology business area with its own set of laws, designed to encourage science and technology companies. The 400 hectare site is predicted to house over 20,000 people permanently, with another 10,000 commuting in to work. In other words, this is a massive project on a typically Russian scale. But in an untypical breakwith the past the whole project is being run by a specially created non-profit, the Skolkovo Foundation.

Skolkovo was a joke from the get-go, as I wrote about at its inception: a government-directed Silicon Valley is a contradiction in terms, but oh-so-Russian.  But even overlooking the fundamental defects in the concept, anyone paying the slightest bit of attention-which is a group which obviously does not include Mike Butcher-knows that Skolkovo is under an unrelenting attack from the siloviki, and most notably from Alexander Bastrykin’s Investigative Committee, which is leading the campaign against anything remotely liberal or viewed in paranoid siloviki minds as connected with the opposition.  The war against Skolkovo is a war on Medvedev by proxy, and is a rather prominent indicator of Russia’s political trajectory.

Not that you’d learn that reading Techcrunch.

A group of senators from western states, led by Diane Feinstein, have sent Gary Gensler a missive accusing the CFTC of violating the letter and spirit of Frankendodd by failing to register major energy companies (e.g., BP, Shell) as swap dealers.  Each paragraph of the letter is more risible than the one before.

They set the scene by recounting the western electricity crisis of 2000-2001.  This is utterly irrelevant to the swap dealer designation, because swaps had nothing to do with what happened then and there.  Indeed, at its core the crisis was driven by a combination of fundamentals and flawed market design, and even the suspect trading strategies involved physical market transactions rather than swaps.  For instance, none of the Enron strategies like “Fat Boy” or “Ricochet” involved swaps or OTC derivatives generally in any way, shape, or form.  (It’s also rather ironic that one of the things that wreaked havoc with California utilities was that they were precluded by law from engaging in forward transactions to hedge the short position forced upon them by the retail price caps in the restructuring legislation.)

Parts of the letter made me laugh.  Most notably, the senators attack the $8 billion de minimus exemption from the registration requirement.  Their “logic” is that since commodity swaps represent a small fraction (less than one percent) of total OTC derivatives activities, the de minimus level for energy swaps activity should be lower than for financial swaps. Not just lower: “vastly lower.”

They say this “stands to reason.”  Whenever anyone says something “stands to reason” s/he really means: “I can’t give you an actual reason, so I’ll just assert that my conclusion is obvious.”

This gets to the issue of just what the swap dealing designation is intended to achieve.  That’s always been somewhat hazy, but the most charitable interpretation is that swaps dealers are deemed potential sources of systemic risk that require extraordinary regulatory scrutiny.  The risk a particular firm poses to the financial system as a whole depends on its size relative to the entire financial system, rather than to any particular market, so even accepted the premises of Frankendodd the swap dealing designation should not vary by market.  (Indeed, from a systemic perspective, even $8 billion/year on a flow basis is ridiculously small.)

The senators also fret over the possibility that allowing the Shells and BPs of the world to escape the designation will limit the CFTC’s ability to deter manipulation and fraud.  Hardly.  Those things are still illegal, and swap dealing designation will have no impact whatsoever on the CFTC’s ability to detect and deter.  (Which may not be saying much, because all too often the CFTC wouldn’t know a manipulation if it hit the CFTC in the face with a waffle iron.)  (I consider it ironic that these Solons refer to the BP propane manipulation, which was discovered, prosecuted, and punished when the swap dealer designation was not even a twinkle in Barney Frank’s eye.  Bad mental image, I know.)

Relatedly, the senators worry about “transparency”, but all swaps trades will still be reported to central repositories.  The only way the dealer designation matters in this regard is it affects/determines who has to report.  (I shall pass over in silence the fact that the CFTC is at present utterly incapable of utilizing the data reported to the repositories, as Commissioner Scott O’Malia has repeatedly pointed out.)

But most importantly, the senators miss the elephant in the room.  No major energy firm has registered as a swaps dealer because energy firms have shifted trading from swaps to futures.  Another premise (flawed, but there  it is) behind Frankendodd is that swaps are somehow more dangerous to the system than futures.  The legislation and the rules under it imposed more onerous requirements on swaps than futures, in large part to encourage the movement of trading to futures markets.

So if these senators actually applied reason, rather than just hiding behind a stand-in for it, they should be overjoyed that no major energy firm has applied to be a swap dealer.  This should be a feature, not a bug.  It means that market activity has shifted to the venue that these very same senators and others who voted for Frankendodd considered to be the preferred model for trading derivatives: open, transparent, and subject to a rigorous regulatory regime.  Most notably, from a systemic risk perspective, futures are cleared, and one of the major requirements imposed on swap dealers is a clearing requirement.  So the specter of the swap dealing designation, with its associated burdens, has actually led firms to transfer trading activity from the satanic swaps markets to the sainted futures exchanges.  Yay!

But arriving at this understanding would require actual, you know, reasoning.  Not much, but some.

And that is a bridge too far when it comes to the World’s Greatest Deliberative Body.  Which may be a correct description: if so, God save the world.

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:

F=(1+rT)(c-p)+K

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?

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.

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.

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.

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.