Felix Salmon

The horrifying AAA debt-issuance chart

Felix Salmon
Jul 15, 2011 15:06 UTC

This is why I love FT Alphaville in general and Tracy Alloway in particular: she’ll dutifully read 14 pages into something entitled “The Basel Committee on Banking Supervision Joint Forum Report on Asset Securitisation Incentives” before coming across this chart and immediately realizing just how important it is.


I’ve put a bigger version here for people who want to pass it around in all its horrifying glory, but it’s also worth spelling things out, because it might not be immediately obvious.

The big-picture thing to remember when looking at this chart is something which I’ve said many times before — that it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds. On a micro level, triple-A securities are safer than any other securities. But on a macro level, they’re much more dangerous, precisely because they’re considered risk-free. They breed complacency and regulatory arbitrage, and they are a key ingredient in the cause of all big crises, which is leverage.

At the left-hand side of the chart we see that global issuance of triple-A bonds was more or less nonexistent back in the early 90s. All those Treasury bonds, all those agency securities from Fannie and Freddie, all that Japanese debt — add it all up, and it still comes to essentially zero by the standards of what seems normal today. Check out the left-hand y-axis: it goes up in $1 trillion increments. And we’re not talking stock, here, we’re talking flows: this chart is issuance per year.

(It’s pretty easy to see, looking at this chart, how a company like Pimco can find itself with over $1 trillion in assets under management: that’s now just a small fraction of the bonds issued each year.)

Now zoom back, and look at the chart as a whole: it’s going up and to the right, which says two things. Firstly, the amount of debt in the world is soaring. That’s a bad thing, because debt is much more systemically dangerous than equity. And secondly, the amount of triple-A debt in the world is soaring as well. Which is a worse thing, because triple-A debt is much more systemically dangerous than most other debt.

Then look at the green line. Triple-A debt wasn’t a huge part of the bond market back in the early 90s, but for the past decade it has invariably accounted for somewhere between 50% and 60% of total global fixed income issuance. That’s possibly the most horrifying bit of all: it simply defies credulity for anybody to be asked to believe that more than half the bonds issued in any given year are essentially free of any credit risk.

Finally, look at the way that the maroon bars — structured products, basically — have given way to a scarily large purple bar at the far right of the chart. That’s sovereign debt, and it tells you all you need to know about where the next crisis is likely to come from.

In a nutshell, triple-A debt is dangerous; there’s far too much of it; its growth seems out of control; and the triple-A problem has now become a sovereign-debt problem, in a world where sovereign-debt crises are the most damaging crises of all.

All that said, there are two things worth bearing in mind which make the chart slightly less horrific. The first is that for reasons I don’t understand, the chart ends in 2009, a crisis year when sovereigns pulled out all the stops in their attempt to prevent a global Depression. We’re more than halfway into 2011 at this point, there’s no good reason why the chart couldn’t include 2010 as well. And that might show 2009 as being a bit of an aberration. Does anybody have the numbers for total triple-A bond issuance in 2010, and how much of that was sovereign?

And secondly, any kind of debt-issuance chart is likely to go up and to the right to some extent, just because borrowing needs never go away, and old debt needs to get rolled over. The total stock of triple-A debt isn’t increasing by this many trillions of dollars per year, and it would be great to see a second chart of how much that is increasing, and how much of it is sovereign.

Still, flows matter. If sovereigns start being downgraded from triple-A status, debt is going to get a lot more expensive, and those rollovers — which cost very little in the current interest-rate environment — will really start to bite. And the invidious thing about debt is that it doesn’t go away. Deleveraging is painful, and is often accompanied by inflation or default. And the more debt you have to start with, the more painful deleveraging is going to be. Prepare yourselves.


KenG_CA, something is either AAA or not. Again AAA does not equal risk free nor does it mean there is no fluctuation in price before maturity. What percentage of AAA bonds have actually defaulted?

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Readers won’t share ads

Felix Salmon
Jul 14, 2011 23:05 UTC

Is there a company in the world which isn’t trying to “harness and leverage the power of social media to amplify our brand” or somesuch? I’m a pretty small fish in the Twitter pond, and I get asked on a very regular basis to talk to various marketing types about how they should be using Twitter. A smart organization with a big Twitter presence, then, will naturally start trying to leverage its ability to leverage Twitter by putting together sophisticated presentations full of “insights to help marketers align their content-sharing strategies” and the like. Which is exactly what the New York Times has just done.

The slideshow can be found here, and it’s worth downloading just to see how many photos the NYT art department could find of good-looking young people looking happy in minimalist houses. But it actually includes some interesting insights, too, which were spelled out at a conference yesterday by Brian Brett of the NYT Customer Research Group.

The survey claims to be the first of its kind on why people share content, which is a very good question. A large part of how people enjoy themselves online these days is by creating and sharing content, which is both exciting and a little bit scary for anybody in a media organization. And the NYT methodology was fun, too: aside from the standard surveys and interviews, they asked a bunch of people who don’t normally share much to spend a week sharing a lot; and they also asked a lot of heavy sharers to spend a week sharing nothing. (“It was like quitting smoking,” said one, “only harder”.)

The first striking insight is about the degree to which the act of sharing deepens understanding. It’s not at all surprising to learn that 85% of people say that they use other people’s responses to help them understand and process information — in fact 100% of people do that, and they’ve been doing it for centuries. We always react to news and information in large part by looking at how other people react to it.

But more interesting is the fact that 73% of people say that the simple act of sharing a piece of information with others makes them likely to process that information more deeply and thoughtfully. It’s like writing things down to remember them: the more you engage with something, the more important and salient it becomes to you.

This has interesting implications for anybody including sharing functionality on their website. Something like the Huffington Post Twitter module, when it works, makes such sharing unbelievably easy: it comes pre-loaded with a comment and a link, all you need to do is press the button and the content is shared. If you click on a share button and then click the “tweet this” button, that’s two clicks — a bit harder. If you edit the content of the tweet, that’s more engagement still. If you select a passage to share on Tumblr, that’s even more; if you write a long blog entry about the piece, then you’re really engaged. The easier you make sharing, the more sharing there will be — but you’ll be paying a cost in terms of the strength of the relationship you have with the people who do share your stuff.

Another implication here is that people who share content in laborious ways are more engaged than power users. If you copy a URL, paste it into TinyURL to shorten it, copy the shortened URL, go to the twitter.com website, paste it into the box, add a comment — that’s a lot of work going into sharing, compared to someone who has all that kind of thing automated in a toolbar button. And the greater the amount of effort involved, the stronger the relationship between site and sharer, as a rule.

Up until now, most of the emphasis, when it comes to sharing, has been on sharing as a distribution mechanism — if I tweet a link, thousands of people might see it and maybe even follow that link, so publishers love it when I tweet their stories. It’s still very early days, however, in terms of sharing as a relationship-building mechanism — the way in which when I tweet a link, I strengthen my relationship with whatever or whoever I’m sharing. One thing very few sites do, but which should be much more common, is to automatically include the twitter handle of the author of a story in the auto-tweeted text, along with or even instead of the twitter handle of the site the story comes from. After all, social media is about person-to-person relationships, and that kind of thing can do wonders for a writer’s relationship with the people tweeting their stories.

Brett mentioned at the end of his presentation that email was still the most common form of content sharing — not in terms of the number of people reached, but in terms of the number of people reaching out to others. That’s important too, and has been underemphasized up until now. It’s great to reach new people who see your stuff only after it’s shared with them. But it’s equally great to have such fantastic content that people want to share it, even if it’s just by email. Anybody sharing your content is an especially precious user, who loves your stuff and who should be thanked and cultivated as much as possible. (It should go without saying, of course, that it’s downright idiotic to antagonize those people and accuse them of breaking the law.)

The main theme running through the NYT report is the decidedly unsurprising conclusion that social media is social — people use it to define themselves to others, to stay connected to others, to influence others. Human relationships are vastly more important than brands, which is why it’s hard to build a corporate brand on Twitter, and the companies which manage to do so generally do so in a highly labor-intensive manner, one @-reply at a time.

Which is why it’s fascinating to me that this report is aimed at, and was commissioned in service of, the companies which use the NYT for their brand advertising. Brand advertising is important and powerful, but it’s not particularly social; not all brands can or should be fighting to become the rare Old Spice or Volkswagen with a viral ad campaign. And if you do have a viral ad campaign, you don’t really need or want it on nytimes.com. The press release, however, makes it clear that the findings are aimed very much at advertisers, as opposed to the editorial-technology people who would probably find it much more useful:

“The New York Times has invested heavily in social media across our organization, both in our own business and to create industry-leading integrated opportunities for our valued advertisers. As online sharing continues to grow as a tool for marketers, we saw an opportunity to add value to the conversation, by studying why people share online,” said Denise Warren, senior vice president and chief advertising officer, The New York Times Media Group, and general manager, NYTimes.com. “These findings are part of our ongoing commitment to help advertisers effectively reach and communicate with consumers through engaging, successful and creative campaigns.”

It seems to me that the NYT, here, is going along with the fiction that high-profile brand advertising in the NYT can and should be social. If that’s what the advertisers think they want, that’s what we’ll give them. But the smart advertisers will ignore all this — just as they ignored other useless distractions like click-through rates. We know that only idiots click on ads; what makes us think that people who not only click on ads but actively share them will be any smarter?

Viral videos — the rather fabulous K-Swiss one being just the latest example — are all well and good. But high-end websites like nytimes.com are no place for viral videos, or for sharing tools embedded in ads. Those are a bit like the QR codes you see on posters: a sign of fad-following desperation and a good sign that the advertiser doesn’t have faith in the creatives they’ve hired. Brand advertising isn’t and shouldn’t be transactional. And I’m a bit worried that the NYT is enabling those who think it can be.


Just looked through the presentation. While interesting, I have to note that only the NYT can believe that in-person interviews (phase 1) in New York, Chicago, and San Francisco would give them a broad spectrum of data.

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Will the virus claim Rupert Murdoch himself?

Felix Salmon
Jul 14, 2011 19:33 UTC

The News Corp hacking virus is proving both virulent and highly contagious. Rupert Murdoch tried to treat it with amputation, by closing down the News of the World, but the surgery came too late, and he couldn’t prevent the virus from spreading to the Sun and the Sunday Times. At that point, the virus was unstoppable: its next victim was Murdoch’s $12 billion bid to take control of BSkyB. Now, with the UK police investigation barely having started, the virus has managed to jump over the Atlantic: the FBI is getting involved, looking into allegations that Murdoch’s papers tried to hack the phones of 9/11 victims.

This isn’t the investigation under the Foreign Corrupt Practices Act that Eliot Spitzer was calling for, although that might well come next. Both of them would normally seem like a bit of a stretch — it’s far from clear that anybody at News ever successfully hacked into voicemails on US phones, and it’s hard to use the FCPA when there’s no clear financial benefit for the company doing the bribing. But these, of course, are not normal times, and the more the virus spreads the more harmful and powerful it becomes. On this side of the pond, Les Hinton in particular is looking vulnerable; he’s currently running the Wall Street Journal, and if he ends up falling victim to the virus, there’s a chance the WSJ could get infected by association.

This is not an existential crisis for News Corp, a $42 billion behemoth which will continue to exist in one form or another whatever happens. But it’s much more damaging to Rupert Murdoch personally, and to his son James. Both of them are now going testify in parliament on Tuesday, and there’s no way that the experience is going to be a pleasant experience for either of them. They can’t lie — the truth is going to come out sooner or later, and neither will want to risk a criminal perjury trial. But at the same time it will defy credulity if Murdoch claims to have had no knowledge of his newspapers’ techniques, or if James claims that he genuinely thought the illegal activities were confined to one royal reporter at the News of the World.

Amid all the talk, over the years, about who will succeed Rupert as head of News Corp, no one seriously considered the possibility that Rupert might be forced to step down and hand over control to a non-relation. But there’s no doubt that Rupert Murdoch is now a serious liability to News Corp, and that liability wouldn’t go away if he were replaced by James.

Murdoch has always been more interested in power than money, and so the fact that resigning would make his net worth soar means very little to him. (It’s not like he’ll ever spend his billions in any case.) But Tuesday’s grilling will only be the first of many very difficult situations: the UK and US investigations are going to go on for the foreseeable future, and the headlines will continue to come out in a damaging drip for a long time yet.

Rupert Murdoch turned his father’s small media company into a global empire; it has always been his dream to keep News Corp in the Murdoch family for generations to come. But that dream has never looked less likely than it does right now; the virus is closing in on the Murdochs, and their immunity to the virus, which was weak to begin with, is rapidly disappearing. It’s a story fit for the movies: even after huge triumphs like acquiring the WSJ and releasing Avatar, Murdoch could be doomed by his first love — the love of aggressive tabloid journalism. He’s tough: he’ll try to hold out for as long as he can. But he’s human, too. I wouldn’t be at all surprised if someone within News Corp weren’t working right now on a face-saving exit for one of the most successful media moguls of any era.


There is a moment here when formal professional journalism can regain some credibility and relevance. News Corps’ pattern of behavior goes far beyond phone hacking. Can the news media report on the news media. Are there investigative reporters that are willing to report that their associates broke the law, and identify them by name. Not sure I buy the ‘I was only following orders’ defense that some of the News Corps types are pushing.

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The damage already done by the debt ceiling debate

Felix Salmon
Jul 14, 2011 17:55 UTC

Listen to anybody on Capitol Hill, and they’ll tell you that the debt ceiling debate is turning into a complete disaster, with the Republican rank and file such an inchoate mess that it increasingly seems as though no deal will get done at all. Look at the Treasury market, however, where the 10-year bond currently yields something less than 3%, and it looks decidedly sanguine; short-term debt maturing shortly after the drop-dead date of August 2 is similarly unaffected by the news from Washington.

Megan McCardle thinks this shows a “giant disconnect” between Wall Street and Washington — things which Wall Street thinks are easy turn out in reality to be extremely hard, and things which any Wall Streeter would just do as a matter of course can be de facto impossible when political posturing starts getting in the way.

I’m not sure the disconnect is all that huge, for a couple of reasons. For one thing, US default risk is impossible to hedge. US default is an end-of-the-world event, and markets by their nature can’t price such things. Conceptually, there’s no point in buying something which pays off if the world ends, since the world will have ended at that point, and in any case your counterparty won’t be able to make good on the contract.

On top of that, remember that we already hit the debt ceiling on May 16two months ago. Since then, the amount of outstanding Treasury securities — a number which normally rises steadily — has been stuck at $14.3 trillion. The fact that supply of Treasuries has been artificially constrained by the debt ceiling has surely, at the margin, helped to support prices.

And more generally there are still a lot of individuals and institutions who want to buy Treasury bonds. That number might have been falling in recent weeks, but it’s still large. The U.S. is not facing the kind of emergency we’re seeing in the eurozone, where countries want to borrow money but no one’s willing to lend to them. If Treasury asks to borrow money from the markets, the markets will always lend it money; the only question is how much interest they will charge.

This is where McArdle goes awry, incidentally: she’s worried that any new debt issued after August 2 won’t be able to find buyers if Congress doesn’t raise the debt ceiling. But there will always be buyers, and there will always be buyers at yields very, very close to the secondary-market price for Treasury bonds. Treasury bonds are fungible, and to underscore that fact Treasury could easily just reopen old bond issuances instead of creating new ones. That would ensure that there was no way of telling the difference between bonds issued “legally” and bonds issued after the debt ceiling was breached.

Even if Treasury can still sell bonds, however, that doesn’t mean for a minute that breaching the debt ceiling is something which should be considered possible for the purposes of the current negotiation. Tools like the 14th Amendment or even crazier loopholes like coin seignorage would be signs of the utter failure of the US political system and civil society. And that alone could mean the loss of America’s status as a safe haven and a reserve currency. The present value of such a loss? Much bigger than $2 trillion. (Coin seignorage, if you’re wondering, is the right that Treasury has to mint a couple of one-ounce, $1 trillion coins and deposit those coins in its account at the New York Fed. It could then withdraw cash from that Fed account to make all the payments it wanted.)

This is one reason why I worry a lot about clever ideas like Mitch McConnell’s plan to get the debt limit raised through a novel use of the Presidential veto — or, for that matter, Matt Yglesias’s even cleverer plan for Democrats to game the McConnell scheme. McConnell is one of Congress’ foremost tacticians, but cunning tactics on either side of the aisle are the last thing that anybody needs right now.

When Bob Rubin did a nifty sidestep around Congress and magicked Mexico’s bailout billions from some dusty account no one knew about, he was playing a dangerous game. When Hank Paulson and Ben Bernanke stretched the limits of their powers almost beyond the legal breaking point during the financial crisis, their actions were understandable but also set yet another precedent. And so now, when there’s no immediate emergency at all, people are looking to the executive branch to find a way to do the right thing, and thereby giving Congress implicit permission to play out and generally behave with all the maturity of a group of rampaging destructive adolescents.

The base-case scenario is, still, that the debt ceiling will be raised, somehow. But already an enormous amount of damage has been done: the US Congress has demonstrated clearly that it can’t be trusted to govern the country in a responsible manner. And the tail-risk implications for markets are huge. Think of the speed with which the Egyptian government collapsed earlier this year, or the incredible downward velocity of News Corporation right now. When you build up large stocks of mistrust and ill will, nothing can happen for a very long time. But when something does happen, it’s much quicker and much worse than anybody could have anticipated. The markets might not be punishing the US government at the moment. But the mistrust and ill will is there, believe me. And when it appears, it will appear with a vengeance.


Salmon isn’t much of a negotiator and I wouldn’t want him anywhere near crucial negotiation. I could see his palms sweat and his eyes twitch in between sentences.

The big problem with this piece is it isolates out the debt ceiling from the debt. That wrenches the current negotiations out of the context of federal government spending and taxation. That’s a killing mistake and makes this piece worthless.

Let me add some of that back in and maybe Salmon can start to make sense of what’s going on.

The USFG is projected by everyone to take rapidly increasing shares of the US GNP under even very optimistic assumptions. That’s a certain catastrophe for this economy: economists estimate that 25-35% of GNP for all levels of government maximizes growth. Under Democratic proposals and baselines, the USFG takes at least that amount, just for itself, for decades to come. That is a catastrophe for economic growth: it entombs our economy in a permanent rotting decay.

That problem isn’t solved with more tax revenue, it is exacerbated. Because it is certain that politician-weasels will spend every penny of revenue and use more revenue to leverage even more spending. There is NO prospect that Obama or the Democrats would make any substantial spending cuts in the foreseeable future. The Obama budget that was unanimously defeated this Spring increased spending across the board, in fact.

The debt is a related, but distinct issue from the total portion of the economy that politicians take to hand over to their cronies. And escalating debt also crushes the future by undermining economic growth. More importantly, my son is 1 year old and unless we take action, his life chances will be substantially undermined. He and your sons and daughters will be handed massive debt that they will have to pay back. That is, by my account, evil. What sort of moral disaster thinks its ok to consume today and force their children to pay for that consumption the rest of their lives? Evil.

This moment is a chance to do something meaningful about both of those problems. To scale back the size of the federal government and to meaningfully lower federal debt. Felix Salmon, Megan McCardle, Harry Reid, and Barack Obama need to think things through, this one time, and do the right thing, this one time. Instead of what they are doing.

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It’s not easy, being a financial advisor

Felix Salmon
Jul 14, 2011 05:03 UTC

Last week, Scott Bell wrote a wonderful and heartfelt post about what it’s like being a financial advisor.

I’ll tell you to sell something because a trend is broken or a target is reached, or you need money and I picked that one… the one that went up still. And I’ll hear about it whenever something else is down.

We’re supposed to have read that great article on page 5 of the business section in the LA Times about GE. And when I say I didn’t, I can actually feel the shock and disgust oozing through the phone. The disappointment…

We’re supposed to know about every single product being advertised and whether the new one is better than the one we have. We’re supposed to be compared to every portfolio at your friends’ next cocktail party…

I don’t have a magic bullet or crystal ball, but somehow I’m still supposed to know. Even though you know I don’t know, you still have it in your head that I do (or else why are you paying me). And this irrational double talk in your head only shows its face when your greed or fear kick into overdrive. You know, the time you are least logical for us to talk about your money.

It really is a gruesome job, being a broker — the kind of people who hire you tend to have ridiculous expectations when it comes to what you can do with their money. (Anything less than 10% annualized is a disappointment, as a rule.) They all want to outperform the market, they all want high return with low risk and they are quite happy contradicting themselves on a regular basis.

And on the other side of things, it’s not much easier being a client. A reader sent me a note today that they got from their broker. It advises a big restructuring of their portfolio: a bunch of funds should be sold and a bunch of similar funds should be bought. The asset allocation ends up pretty much the same, but the vehicles change. And in the course of an eight-page letter, the reason for doing this mass purge is dealt with swiftly indeed:

The funds we are recommending that you sell have in the most part demonstrated performance that has not been in line with our expectations and we feel you would benefit from switching into more prosperous and more diversified holdings…

The property sector has experienced a turbulent time since the financial crisis and in most part has not fully recovered and we feel there are better opportunities in this sector for you to benefit from.

On the basis of this advice, the broker is recommending a six-figure decision representing an enormous proportion of his client’s net worth — and the advice, boiled down, comes down to a pretty tautological “we’re recommending this course of action because we think you will benefit from it”.

The deeper thing going on here is what might charitably be called a momentum trade, or what might less charitably be called a sell-low strategy. First you pick your sector, then you pick funds in that sector. If the funds do well, that’s great; if they do badly, then you sell those funds and instead you buy funds which did do well over the time period in question. Then, next year, presumably, you rinse and repeat.

If you’re a remotely normal person, you’re not qualified to pick stocks and neither do you have the self-confidence to even try. So instead you outsource your stock-picking and buy mutual funds. But this just shunts the problem down the road: if you’re not qualified to pick stocks, what qualifies you to pick mutual funds? After all, there are just as many funds to choose from as there are stocks. So you punt again and outsource your fund-picking to a financial advisor. And all the while you know you’re still not much better off: however many stocks and mutual funds there are, the number of financial advisors is greater still. If you can’t pick a stock or pick a mutual fund, what makes you think you can pick a financial advisor?

The relationship between you and your advisor, then, is a bit rocky from the beginning: you’re paying the advisor to pay mutual fund managers to invest your money in stocks which might well underperform. There’s a lot of fear and greed in there, neither of which make for particularly clear-headed conversations or decisions. And then to make matters worse, your advisor is likely to treat you like he treats most of his other clients. That means that he’ll recommend you do something or other on a regular basis, since most clients think a broker who doesn’t do anything is wasting their money. (In fact, a broker who does do something is probably wasting their money; a broker who doesn’t do anything is saving them money. But most clients don’t think that way.)

All of which is why my standard advice to everyone is to simply buy index funds and rebalance every so often, if and when you get around to it. Because it’s silly having an advisor if you don’t take their advice — but at the same time there’s no particular reason to believe that your broker’s advice is particularly good, or that something like a “sell the funds which have underperformed of late” strategy is actually a sensible one, or is liable to work well over the long term.

And it’s hard to have that kind of meta-conversation with your broker, too, because brokers don’t get paid nearly as much as they used to and are often not particularly smart or sophisticated. (I hasten to add that smart and sophisticated brokers aren’t necessarily better at being brokers; they just might be a bit better at giving a good answer to questions like “does it make sense to sell funds which have gone down in value, and if so, when should you do so”.)

If you look at the 14-figure sums being managed by financial advisors, it’s easy to see how incompetence and rampant emotion and waste and fraud and messiness can easily result in billions of dollars flowing from dumb investors to the smart Wall Street crowd every year. And it’s equally easy to blame Wall Street generally, and brokers in particular, for that waste. But irrational and emotional individual investors deserve their own fair share of the blame. Financial advisors are dealt a nasty hand, much of the time. So before we blame them for things which seem wrong, we should probably ask ourselves what exactly we’re hiring them to do in the first place and whether our expectations are remotely reasonable.


I think that the key to having a good client/advisor relationship is good communcation, just like it is with anything else. Threfore, I would argue, a lot of the problems both clients and advisors have is because they do not effectively communicate with each other about what they want to get out of the relationship.

When my wife and I first hired an financial advisor nine years ago, we interviewed ten different candidates, explained very clearly what we wanted to get out of the relationship, and have been very happy with our advisor we chose ever since. He knows how we think, we know how he thinks, and we have a successful and productive relationship.

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Felix Salmon
Jul 14, 2011 04:55 UTC

Felix Salmon and Henry Farrell on Bloggingheads, talking Murdoch, eurocatastrophe, and even Google+ — BhTV

Wired.com publishes the full chat logs between Lamo and Manning — Wired

UK Passport Delays at British Embassy in USA: there’s no excuse for this at all — UK Passport Delays

Piers Morgan was an expert in phone hacking in Jan 2001 — Guido Fawkes

Are principal writedowns bad for bank equity?

Felix Salmon
Jul 13, 2011 16:43 UTC

Steve Waldman has a fantastic reaction to my post about principal reductions, saying that “accounting is destiny”:

If a bank has a loan on its books valued at par, and it offers a principal reduction, it must write down the value of the loan. It takes a hit against its capital position, and experiences an event of nonperformance that even the most sympathetic regulators will have no choice but to tabulate. If a bank has purchased a loan at a discount, however, the loan is on the books at historical cost. The bank can offer a principal reduction down to the discounted value without experiencing any loss of book equity.

Of course this is a matter of mere accounting. Whether or not a bank takes a capital hit has no bearing on whether a principal reduction will increase the realizable cash-flow value of the loan.

But accounting is destiny. The economic value of a bank franchise, both to shareholders and managers, is intimately wound up with its accounting position. A bank whose books are healthy may distribute cash to shareholders and managers, while a bank whose capital position has deteriorated will find itself constrained. A well-capitalized bank is free to take on lucrative, speculative new business, while a troubled bank must remain boringly and unprofitably vanilla.

This is, basically, the muddle-through approach to troubled assets. If you keep them on your book at par, then you can claim to be well capitalized, and use all that capital to pay yourself well and expand into new businesses. Eventually, with luck, those businesses will be successful enough that they make enough money to cover the losses on the assets when they’re finally realized.

But the real world doesn’t always work like that. See David Reilly’s very good piece on Bank of America today:

BofA maintains it has ample capital and can grow into new, more stringent capital requirements by 2019. The trouble is investors might not be so patient…

BofA is juggling mortgage problems as the economy and housing again look shaky. Markets already have shown what they think: BofA’s shares trade at about 50% of book value and about 85% of stated tangible book value. This means investors think either its assets are overstated or liabilities understated.

BofA needs to put questions about its mortgage risks firmly to bed. Or it needs a thicker equity cushion.

In other words, there are two different ways of looking at bank equity. One is Waldman’s way, where you take the bank’s stated assets, subtract its liabilities, and are left with its equity. And then there’s the more common and salient way of doing things, which is just to look at the share price. While it’s true that regulators do worry about accounting equity, they pay attention to share prices too. (That’s one reason that they weren’t worried about banks during the subprime bubble: the shares showed very little risk there.) And when it comes to paying employees and opening new business lines, a healthy share price is in much more useful than any accounting fiction.

Investors know how much subprime junk is buried on the balance sheets of America’s biggest banks, and they take that into account when they value those banks’ shares. If the banks, through principal reductions, can increase the real value of that junk, Wall Street will likely reward them rather than punish them. Even if that means taking a write-down on assets which everybody knows are worth significantly less than 100 cents on the dollar.


“Felix, capital ratios for banks are (broadly) calculated as capital over assets. Keeping non-performing assets at inflated par value increases the denominator of the equation and actually deflates capital ratios.”

Accounting. Balance sheets balance. When assets are written down, a matching entry needs to be written down on the liabilities & equity side of the balance sheet. That writedown is to retained equity, which is part of capital. Since assets are larger than capital, an equal decrease to both assets and capital results in lower capitalization ratios. Felix is right.

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The new dynamics of Netflix

Felix Salmon
Jul 13, 2011 14:15 UTC

I’ve received some very interesting reactions to yesterday’s post on Netflix, including David Leonhardt reminding me about his profile of the company five years ago.

There are three parts of that article which are particularly interesting today. The first is the thesis that Netflix’s success is based in large part on a long-tail model.

Every day, almost two of every three movies ever put onto DVD are rented by a Netflix customer. “Americans’ tastes are really broad,” says Reed Hastings, Netflix’s chief executive. So, while the studios spend their energy promoting bland blockbusters aimed at everyone, Netflix has been catering to what people really want.

The second is the idea that the economics of Netflix were far from obvious:

The stock trades for about $27, down about $12 from its 2004 high. One fifth of its shares are on loan to short sellers betting it will fall further.

You can understand the doubts, too. At a time when cable and phone companies are running fat data pipes into homes, Netflix can seem a lot like the Sears catalog of the early 21st century.

And the third is the look forward to Netflix’s own streaming offering:

The company has been hiring engineers to build its own download site, which, with a familiar brand name and all that information about what people like to watch, may be formidable.

But it could be years — 5? 20? — before downloading approaches the size of the DVD business.

Netflix’s stock, of course, has turned out to be a veritable wonder over the past five years: it’s currently at $291 per share, more than ten times its level when Leonhardt was worried about its prospects. It turns out that while people were worried about Netflix at $27 per share when it was based on a long-tail model, they’re much more excited about Netflix at $270 per share when it’s based on a live-streaming model.

The people who still think of Netflix as a queue-and-DVDs site, I think, are a bit like the people who think of Amazon as a bookstore, or of Apple as a computer maker. The whole reason that Netflix is at $270 a share rather than $27 a share is streaming, and if you have a subscription-only account at Netflix, the famous queue, which I loved, disappears entirely.

The queue was a great way of putting together a list of movies you really wanted to see, and then going through them slowly, at your own pace. Sometimes certain movies weren’t available, but that was OK — there were always other movies that were available, and you knew that sooner or later the ones that weren’t available would show up.

With a streaming-only account, however, all of that goes away. Let’s say you’re having a dinner conversation about arthouse thrillers featuring an A-list actor and a much less well-known but very beautiful female co-star, where nothing much happens amidst lingering shots of beautiful scenery. With the old Netflix, you could put The Passenger and The American into your queue next to each other, and probably watch them back-to-back, if you had four hours to spare. With streaming-only Netflix, you wind up being faced with something unhelpful like this:


There’s no option to add either movie to your queue; instead, your only choices are to sign up for the DVD option at $8 per month, or to watch something completely unrelated. If and when Netflix does manage to get either of these movies into its streaming library, you’ll never know.

Which is one reason why Netflix is going to serve up many fewer highbrow films on instant streaming — that’s what happens when you kill the queue. The long-tail business model turned out not to be the salvation of Netflix after all; rather, all that matters is convenience. The Passenger‘s not available? Never mind, let’s watch Frankenstein Must Be Destroyed instead.

What does this means for the future of Netflix? Probably a small minority of arthouse types will defect to GreenCine, but they won’t be numerous enough that anybody at Netflix will care. There’s always a tension between quality and and convenience — Kevin Maney wrote a whole book about it — and there’s no doubt which one wins in the marketplace: convenience, every time.

Netflix got its toehold in the market by being more convenient than Blockbuster; it’s now doing to its DVD business what it initially did to DVD-rental shops. The wonderful long-tail qualities turn out to have been an incidental benefit more than a core value proposition. The streaming service will be the main part of Netflix; the DVD service will be kept on by the arthouse long-tail lovers who don’t go to GreenCine.

The big questions is what will happen to the people wanting to see blockbuster recent releases. Will they sign up for Netflix DVDs? Will they move to Redbox? Or will they just make do with whatever happens to be available on streaming? Any ideas?


As the COO of Fandor (a new streaming service for people who love great independent movies), we’ve been seeing signs of this change for over a year from Netflix’s behavior in the film acquisition market. About a year ago they started backing off on streaming licenses for independent movies, and about six months ago started curtailing their purchases of long-tail DVDs.

So Felix is right — and it’s now becoming clear to everyone the shift in Netflix’s business model to mainstream content (tv and movies) and away from long-tail (or even mid-tail) independent, documentary, and international films. It’s a sensible business move – for one reason, it lets them free ride on all the marketing dollars that Hollywood puts behind their content.

The Independent published a great interview with Netflix on this subject in January. (http://www.aivf.org/magazine/2011/01/ne tflix_distribution_independent_diy_filmm akers) They’re only interested in content with proven “queue demand.” Query what that means anymore if they’re moving away from the queue for streaming customers?

That’s fine with us — it creates opportunity for companies like Fandor to help out customers who are looking for interesting, thought-provoking movies beyond what Big Hollywood has to offer.

Our belief: on-line delivery is critical to the success of independent and international film because it directly attacks the biggest obstacles people face to discovering and watching those movies: easy access, risk-free exploration, and ability to spread the word about great movies via word-of-mouth.

That’s what we built Fandor to do. I invite your readers to check us out at http://www.fandor.com!

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Felix Salmon
Jul 13, 2011 05:49 UTC

Simon Dumenco’s open letter to Peter Goodman on HuffPo’s aggregation — AdAge, see also

Rupert Murdoch facing BSkyB defeat as parties unite in call to drop takeover — Guardian

More than 75% of bike-car collisions are caused by errant motorist behavior — Buzzdata

Jim Impoco on Anthony DeRosa: “This is a fellow who had no editorial authority whatsoever!” — Beet

Robert Whitaker on The New York Times’ Defense of Antidepressants — Psychology Today

Newsweek.com Will Cease to Exist on July 19 — NYMag