Felix Salmon

The economics of Netflix

Felix Salmon
Mar 31, 2010 22:22 UTC

How come Netflix has a market capitalization of $4 billion, on 2009 net income of just $116 million? That’s about $325 per subscriber, even as each subscriber generates on average about $145 in revenue and $10 in net income per year.

Ethan Epstein makes a pretty compelling case that Netflix’s business model is threatened by problems at the US Postal Service: a rise in postal rates would be bad, and the abandonment of Saturday delivery would be much worse.

But the fact is that the economics of Netflix have always been unique and hard to put into old-fashioned business models, and I think they’ve done quite a good job of reinventing the whole way that we pay for consuming movies. By turning it from a cost-per-movie into a cost-per-month, they can somehow charge more money but cause less pain while doing so.

I’m aware that I’m extrapolating wildly from my personal experience here, but in the olden days I hated paying late fees on rented movies, and as a result was an eager and early adopter of Netflix. But pretty much since day one, I’ve paid more money to Netflix in any given month than I ever would have paid in movie-rental fees, including late fees. I just don’t watch that many movies, and the occasional $10 late fee is still much less than the regular $20 or so I pay Netflix. And while Netflix has done a good job of reducing its rates noticeably: my plan has dropped from $23.84 in 2004 to $18.50 now, including tax, that’s still more than I’d ever be likely to pay a video-rental store.

Indeed, I still occasionally get DVDs from my local rental store, because of the way that serious-and-earnest Netflix DVDs tend to pile up unwatched when the whole reason for wanting to relax with a movie in the first place is because you’re frazzled and just want to kick back with something funny or brainless. The Netflix tail is long, but when you have no more than three movies out at a time, your choice is actually much more constrained than at the video store. And similarly with the streaming stuff: it’s great in theory, but in practice it’s going to take me a long while to work out how to hook it up to my video projector.

Yet despite all of that, I’ve been a loyal Netflix customer for nine years now, and I’m likely to continue to pay them their $18.50 a month pretty much indefinitely, bearing them none of the ill will that I used to have towards surly clerks charging me late fees for scratched DVDs. There’s just so much less pain involved, when you pay for access to movies rather than for the movies themselves.

Still, $4 billion seems pretty crazy to me. Netflix is just a middleman, a delivery company. Shouldn’t that be a commodity, rather than something trading on a p/e in the mid-30s?


Felix, Try the one-DVD-at-a-time plan for $8.99 plus tax and maybe that will help solve your issue.

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Adventures in revolving doors

Felix Salmon
Mar 31, 2010 20:45 UTC

Gary Weiss reads the SEC inspector general’s report into its behavior with respect to Allied Capital and David Einhorn, and finds this startling nugget:

The official who supervised the Allied probe got a special “thank you” from Allied. This person (his name is blanked out in the report) left the SEC a year later to work for the company, apparently as a registered lobbyist. The exact position he got is unclear in the report, but we do know that the SEC ethics office had no problem with that. Apparently the SEC’s conflict-of-interest rules can be summed up as a cheery “okie dokie!”

Meanwhile, Ira Stoll finds a bunch of gamekeepers-turned-poachers on the attendee list at an FDIC meeting. Among them are Allen Puwalski, who went from the FDIC to working for John Paulson; John Douglas, who went from the FDIC to a partner position at Davis Polk, where he’s “counseling Citigroup with respect to FDIC matters”; John C. Murphy, who went from the FDIC to a partner position at Cleary Gottlieb; and Kevin Stein, who went from the FDIC to FBR Capital Markets.

It’s all well and good these people moving to the private sector, but do they really need to rub it in by hanging out at high-level meetings held at their former employer?

Stoll also notes the presence at the meeting of Randy Quarles, who moved from being the point-man on many regulatory issues at Treasury to an MD position at Carlyle Group.

And while we’re on the subject, it’s worth noting Matthew Leising’s story about Peter Roberson, who’s moving from his job liaising with banks and exchanges for Barney Frank. He’s now, depressingly, going to be a registered lobbyist for Intercontinental Exchange.

If even Barney Frank’s staffers can’t resist the appeal of the revolving door, there’s really no hope that Frank or anybody else will be able to put an end to the practice. Especially when it regularly benefits cabinet ministers.

John Dugan’s CFPA U-turn

Felix Salmon
Mar 31, 2010 18:08 UTC

Remember OCC head John Dugan’s email to to Cheyenne Hopkins? He told her — and since the article was only published yesterday, I’m assuming it was in the last few days — that a consumer agency could conflict with safety and soundness concerns. “A consumer agency might think that down payments on house purchases should be limited to 5% to promote homeownership,” he wrote, “while a safety and soundness regulator might believe a higher minimum could be needed to ensure lenders don’t make loans that won’t be repaid”.

Compare that to the email he sent Shahien Nasiripour on Tuesday:

“It’s hard to say in the abstract what sort of conflicts could arise, though I don’t think there will actually be many instances in which there is a genuine conflict,” he wrote.

Better late than never, I suppose, especially when he goes on to underline that CFPA measures which “simply reduce a bank’s profitability” are not measures that he would consider to interfere with safety and soundness concerns.

Still, as Shahien notes, Dugan doesn’t exactly have the zeal of the newly converted: he’s still trying to insist on federal preemption, preventing state and local governments from stepping in when and where the OCC proves toothless or asleep at the wheel.

The consensus among those who have long been pushing for a consumer protection agency is that the latest “evolution” in the OCC position is tactical, and a way to preserve as much power for the OCC as realistically possible. I buy that. But if the OCC is now conceding that a consumer protection agency is likely to happen in some form, that’s surely an encouraging sign.

What’s a syndicated bond?

Felix Salmon
Mar 31, 2010 15:06 UTC

The term has been around for a little while now, but only recently has the concept of a syndicated bond been commonplace in news stories, and it seems to have arrived without anybody explaining what it is.

Most of the references to syndicated bonds are coming from Greece these days, so I phoned up George Georgiopoulos, Reuters’s man in Athens, and got him to explain them to me.

The confusing thing here is that only sovereigns issue syndicated bonds, because only sovereigns don’t issue syndicated bonds.

OK, let me try again. As a base case, essentially all bonds are syndicated. If a company wants to issue bonds, it will find a group of banks to underwrite its bond issue and sell those bonds to investors. And if a sovereign wants to issue bonds in a foreign currency, it will do the same thing. None of these bonds are ever referred to as “syndicated bonds”, though — they’re just old-fashioned bonds, or global bonds, or whatever. The existence of a bookrunner and an underwriting syndicate is simply taken for granted.

The exception to that rule is when governments issue debt in their own currency. Normally, that kind of thing is handled through auctions, where a group of primary dealers, who promise to make a market in government debt, bid on new issuance. It’s always possible, however, that such an auction might fail, and that the government won’t be able to issue all the debt that it wants, for lack of bids from the primary dealers.

So Greece has started issuing occasional syndicated bonds, where it does just what companies do when they want to issue debt: it gets a small syndicate of banks together, and the banks underwrite the bond, promising to buy it if there aren’t enough bids in the market. Then they go out and build a book and sell the bond to investors just like they would with a corporate issue. This way of doing things guarantees that the government will be able to sell all the bonds it wants to sell.

Think of it this way: most bonds are syndicated, while government bonds are auctioned. If you see a reference to a “syndicated bond”, that means that a government is not auctioning its bonds, and has decided to syndicate them instead.

Which raises the question: what on earth is a syndicated auction?


I would derive from the article that a syndicated auction is an auction where investment banks solicit orders with amounts, and prices/yields, not just amounts.

When financing was easier to come by, governments would do issue more solo deals, where one investment bank ran the books, even if multiple banks were in the deal. The governments were in the driver’s seat on global deals due to many competitors for the business; they could wring concessions from the one investment bank running the books of the deal.

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Prosecuting insider trading in CDS

Felix Salmon
Mar 31, 2010 14:09 UTC

It’s now been three and a half years since Bloomberg’s Shannon Harrington and John Glover showed that there was a very strong pattern of CDS spreads gapping out in advance of debt issuance by large corporates, which came as a surprise to everybody else. And it’s been three years since I noted that the SEC was going to have a hard time prosecuting insider trading in the CDS market, since CDSs aren’t securities.

Since then, of course, we’ve had a major financial crisis and the introduction of financial regulatory reform which would give oversight of single-name CDS to the SEC. But if you need an example of how slowly these things move, just look at the front page of today’s WSJ, which is reporting on an insider-trading case based on trades and phone calls which took place in July 2006:

The defendants in the New York case argue, among other things, that swaps aren’t securities, but private contracts between financial players outside the SEC’s jurisdiction. Unlike most stocks, bonds and options, swaps aren’t traded on an exchange.

It’ll be interesting to see how this case plays out, especially given the much harsher attitudes towards Wall Street in general and credit default swaps in particular that you’re likely to find in the average New York jury pool today as opposed to 2006.

But the first obvious thing that needs to be done here is to give the SEC formal jurisdiction over single-name CDS. Note that this is not one of the cases which Harrington and Glover talked about: those involved information which was obtained legitimately by hedge funds, since hedge funds were involved in the loan syndicates concerned. In those cases, the question was whether the funds were allowed to trade on that privileged information in the CDS market.

This case is slightly easier to prosecute, since it seems to involve a salesman at a regulated sell-side investment bank, Deutsche’s Jon-Paul Rorech, illicitly giving inside information to one of his buy-side clients. That’s illegal whether there’s any trade involved or not, I think.

The second thing which ought to be considered is moving CDS trading onto an exchange, where it can be regulated. And it’s almost certain, at this point, that that’s not going to happen. In fact, I asked Craig Donohue, the CEO of CME Group, about this at yesterday’s Reuters Global Exchanges and Trading Summit. He’s very keen on clearing over-the-counter CDS trades, but he said that he’s come to the decision over the past couple of years that he’s not interested in listing CDS on any of his exchanges directly. The big CDS players are his clients, they make lots of money from their OTC trading, and he seems to have no appetite to start competing with them on that front, rather than simply facilitating the clearing of their trades.

I am hopeful that if and when financial regulatory reform goes through, it’ll give the SEC a bit more in the way of teeth to prosecute rampant insider trading in the CDS market than it has at the moment. Whether we’ll actually see more prosecutions, however, is a very open question, and so long as CDS trading takes place entirely in the shadowy OTC universe, my guess is that the answer will be no.


CDS is nothing short of a gambling vehicle

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Felix Salmon
Mar 31, 2010 04:52 UTC

A great introduction to the sleazy AFA Press by Nick Lyne — Qorreo

Stunning photos of dew-covered insects — Daily Mail

Why Are Thousands of Jews Selling Their Homes for Passover? — The Atlantic

My Global Conference panel with Carney, Ishmael, and Moore — Milken Institute

I like Gawker’s “branded traffic” metric, and wish more sites would make it public — Gawker

The sovereign exit strategy for bank shareholdings

Felix Salmon
Mar 30, 2010 20:41 UTC

There are very few investors for whom a 0% return is just another arbitrary point on the real-number spectrum. In theory, the difference between a +10% return and a +15% return is the same as the difference between a -3% return and a +2% return. But in practice, the latter is much more important, because it spans the crucial zero bound: it’s the difference between making money and losing money.

Much has been written on the behavioral economics of loss aversion, where the pain of losing a certain amount of money is nearly always greater than the pleasure of gaining an identical amount. And what’s true of a country’s citizens is often true of its government, which is why the question of whether or not governments are making a profit on their bank bailouts is an interesting and important one.

Which is not to say that the super-smart dsquared was wrong when he left this comment about whether it would constitute speculation for Treasury to hold on to its Citigroup shares. Quite the contrary, he’s absolutely right:

I had heard the saying “an investment is just a speculation that went wrong”, but it’s a joke, not a sensible principle of money management and not something that can be reversed to give an exit target. If the Treasury is speculating now, it was speculating when it was in the red.

But the point is that if Treasury continues to speculate now, it’s mere speculation. When it was underwater on its investment, it at least could say that it was holding on to its stake until the share price rose enough that it could get its money back. Yes, that’s a form of speculation too. But it’s somehow a more acceptable form of speculation to hold onto an investment in the hope that you won’t lose money than it is to hold onto a profitable investment in the hope that you’ll make even more money.

Indeed, the whole argument about whether or not banks should mark their assets to market is at heart an argument about this very question. If banks hold loans on their books at par, even if they could never get 100 cents on the dollar for those loans in the secondary market, they’re essentially speculating that the value of the loans will return, over time, to more than they lent out in the first place. But they don’t call it speculation, they call it “commitment to our valued clients through thick and thin”, or something like that.

Sovereign investments in banks, it seems, work much the same way:

Switzerland made a profit after selling a 9 percent stake in UBS in August, saying it was confident the bank was on a solid enough footing for it to retreat.

Britain is expected to start selling shares in Royal Bank of Scotland and Lloyds, although that would not happen until after the general election, expected in May.

Share prices for RBS and Lloyds have risen close to the average price at which Britain bought its stakes and the government is becoming increasingly confident of making a profit on the billions of pounds it has pumped in.

A full exit could take many years in many countries, however. Sweden, which pioneered NAMA-style schemes, is still a big shareholder in Nordea after it stepped in to rescue lenders in the early 1990s.

The pattern here, from the U.S. to Switzerland to Britain to Sweden, is clear: you hold on to your stake until you’re in the black, and then you sell it. Yes, that’s a form of speculation. But it’s clearly an acceptable one.


Holding on to an investment cannot really be classified as speculation. A fundamental concept of accounting is a going concern concept. If I believe that the business is a going concern, then holding on to my investment rather than trying to generate higher returns by churning the portfolio cannot be termed as speculation.

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Why wine isn’t an investment

Felix Salmon
Mar 30, 2010 19:40 UTC

Swiss researchers Philippe Masset and Jean-Philippe Weisskopf have a new paper out claiming to demonstrate that if you add wine to a portfolio of financial assets, that decreases your risk, increases your returns, and helps you out (if you care about such things) on the skewness and kurtosis fronts as well. Leslie Gevirtz writes up the results here, and Reuters graphics supremo Silvio DaSilva has even put together some pretty charts from the paper here.

I’m very skeptical about this result, however, for four main reasons.

  1. The number of people genuinely investing in wine — that is, buying with an eye to selling it, rather than drinking it — is still tiny, but Masset and Weisskopf are probably right that it’s growing. “The resulting improvement in transparency and liquidity has rendered this market even more attractive for investors,” they write, but I’m not so sure: I suspect that wine’s relatively low asset-price correlation during the financial crisis was entirely a function of the fact that it wasn’t really an asset class in the first place. If and when it becomes an asset class, then correlations are bound to rise, especially in times of crisis.
  2. Incredibly, Masset and Weisskopf treat wine as a cost-free investment: in the world of their paper, it costs nothing to sell wine, it costs nothing to store and insure wine, and it costs nothing to buy wine, over and above the hammer price at auction. On planet earth, of course, none of these things is remotely true. So far, I have yet to see a story on wine as an investment which takes into account reasonable estimates for these costs. If and when such a study comes along, I’m pretty sure that wine will suddenly look much less attractive as an asset class.
  3. There’s enormous survivorship bias in the dataset. Masset and Weisskopf looked back at the wine market between 1996 and 2009, and then cherry-picked the regions which, in hindsight, turned out to have the greatest volume at auction. Then they took the wines from those regions and cherry-picked again, choosing only wines which traded at least once a year. So the 1982 Barbaresco Riserva Santo Stefano, for instance, made the cut, as it rose sharply in price between 2002 and 2009. But a neighboring Barbaresco which sold for just as much in 2002 would be ignored if it didn’t appear at auction in 2003 or thereafter. An investor in Barbaresco in 2002 would have no way of knowing which one was going to go up and which would end up impossible to sell, but by the lights of Masset and Weisskopf, the one which went up a lot was entirely representative.
  4. This isn’t a buy-and-hold market: you have to know exactly when to sell your wine before it becomes passé. Masset and Weisskopf try to spin this as a good thing, saying that they “discard wines that are viewed as antiques and not as wine as such” and that doing so “eliminates wines that are mostly illiquid and are traded infrequently”. Without dwelling on the metaphor of a “mostly illiquid” wine, the problem here is that Masset and Weisskopf seem to think that it’s possible for investors, en masse, to buy wine when it’s young and sell it at a profit when it’s middle-aged, but before it gets old. Of course, they can’t: who’s meant to be buying all that middle-aged wine? This strategy is all well and good so long as there aren’t enough wine investors to move the market. But if wine-as-an-investment ever takes off, that’s certain to significantly increase the supply, and therefore decrease the price, of good middle-aged wines being sold before they get too old. And when that happens, the returns from a wine-investment strategy could easily turn negative.

To get an idea of how Masset and Weisskopf think, check out this chart:


The thing to note here is the way that all the different wine regions have been rebased to 100 in 1998, as though people first decide how much money they’re going to spend on wine and then work out how much wine that will buy. Masset and Weisskopf don’t provide the actual datapoints in their paper, so I don’t know how much the average Rhone wine was going for in 1998 compared to the average Bordeaux. (And, of course, remember that we’re not actually talking about the average Rhone wine here: we’re talking only about the Rhone wines which, in hindsight, turned out to be the ones that wine lovers wanted to buy at auction. If you bought an obscure Rhone wine in 1998, which Robert Parker then started extolling in 1999, you would have made lots of money; if he didn’t, it probably wouldn’t make the index.)

But let’s say that Rhone wines were a quarter of the price of their Bordeaux counterparts in 1998, and a third of the price in 2009. No self-styled wine investor would ever allocate on an equal-investment strategy, investing say $10,000 in each: investors are always going to be overweight the most expensive Bordeaux. If you ran this same chart on the basis of average price per bottle, rather than rebasing everything to 100, it would look very different indeed — and would be much more representative of how wine investors actually view the wine market.

At its heart, this paper is an exercise in highly-theoretical number crunching, and bears little if any relation to the real world. If you want to go out and buy fine wines, that’s great. But don’t kid yourself that you’re making an “investment”. I should know: I still own a case of 1963 Croft which my grandfather bought for me when I was born. I’m not a huge port fan, and haven’t been drinking it. But I wouldn’t be at all surprised to hear that storage costs alone, since purchase, exceed its market value. Of course, if my grandfather had bought me first-growth Bordeaux instead of port, then that might not be the case. But he didn’t have the benefit of Masset and Weisskopf’s hindsight. They shouldn’t assume that he did.

Update: Masset and Weisskopf respond in the comments.


Do you have an update to this article, circa spring 2014?

Have you watched “Red Obsession”?

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John Dugan, protector of predators

Felix Salmon
Mar 30, 2010 15:15 UTC

In the wake of Andrew Martin’s searing profile of him last week, the last thing John Dugan needed was to be quoted in the American Banker looking like even more of a banking-industry shill. Yet here’s the quote he gave Cheyenne Hopkins for her (sadly firewalled) article on whether safety and soundness conflicts with consumer protection:

“One area that stands out is loan underwriting,” Dugan said in an e-mail. “For example, a consumer agency might think that down payments on house purchases should be limited to 5% to promote homeownership, while a safety and soundness regulator might believe a higher minimum could be needed to ensure lenders don’t make loans that won’t be repaid.

Given the significant role that loose underwriting played in the financial crisis, I think it makes sense to provide an exemption from the consumer agency’s jurisdiction for credit standards.”

Why on earth would a consumer protection agency ever limit down payments on house purchases? Does Dugan think that the government is going to step in and forcibly prevent people from paying cash for a property? Is he so confused about what consumer protection entails that he thinks it would involve setting minimum — as opposed to maximum — amounts of leverage? Has he already forgotten so much of the crisis that he thinks that homeownership is likely to be considered something unequivocally good for consumers, as opposed to the largest financial risk that most consumers will ever take?

The fact is of course that loose underwriting is as bad if not worse for consumers as it is for banks, and no consumer financial protection agency is going to condone it. After all, if banks lose money on bad underwriting, that’s because their consumers can’t pay back their loans — and if they can’t pay back their loans, that means they’re in bad financial shape. You don’t protect consumers by encouraging them to get into bad financial shape. This is not rocket science.

Yet Dugan wants to prevent the consumer protection agency from looking at credit standards! The reason of course has nothing to do with worries that the agency will force the banks to loosen up on underwriting, and everything to do with worries that it will prevent predatory lending and loan pricing based not on the likelihood of repayment but rather on how much money can be squeezed out of the borrower.

Honorable banks who want to profit from their customers’ financial well-being have nothing to worry from a consumer protection agency. Dishonorable financial institutions who want to squeeze their customers dry before moving on to the next sucker do have something to worry about. And its those institutions that Dugan is trying to protect. For shame.

Update: Many thanks to American Banker, which has now taken down its firewall for this story. So go read it!


I read Mr. Duggan’s quote somewhat differently than Mr. Salmon apparently has:

“For example, a consumer agency might think that down payments on house purchases should be limited to 5% to promote homeownership,”

I interpreted that to mean that he was worried that a Consumer Protection Agency would try to limit the down payment to a MAXIMUM of 5%.

“while a safety and soundness regulator might believe a higher minimum could be needed to ensure lenders don’t make loans that won’t be repaid.”

Although I agree with you that abnormally low down payments present a hazard for the consumer as well as the lender, I can also see the possibility of a consumer protection agency coming out in favor of looser and looser standards.

They may come under political pressure or from potential homeowners themselves to try and force somewhat loosened standards to protect them from too rigid standards that would keep them from realizing their “American Dream”.

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