Newsweek/Daily Beast has become something of a media whipping post in the last several months. Editor Tina Brown, Michael Wolff wrote last month, is “the most famous magazine editor of her generation”, “engaged in a desperate and operatic struggle.” This summer, the family of the late Sidney Harman stopped pouring money into the company, and Barry Diller suggested that Newsweek could move into online-only mode.
If Newsweek has had trouble figuring out what it is, it’s also had difficulty determining what is. First, there was Niall Ferguson’s essay on Barack Obama, which featured elided quotes from the CBO, and amounted to “counterfactual history” that Paul Krugman called ”deliberately misleading“. Then there was a cover story on Muslim rage, which Twitter mercilessly mocked. There was also a recycled cover on vegetables and a story on the 10 best presidents in history in which Newsweek printed ”an entirely different version of the list than the one historians submitted.”
So, if you’re confused about facts, have faith: This week’s cover story is unequivocally titled “Heaven is Real“. Former coma patient and Harvard doctor Eben Alexander has a book to sell called Proof of Heaven: A Neurosurgeon’s Journey into the Afterlife. After Alexander fell into a seven-day coma, he had a unique experience: “as far as I know, no one before me has ever traveled to this dimension (a) while their cortex was completely shut down, and (b) while their body was under minute medical observation, as mine was for the full seven days of my coma.”
Heaven, it turns out, looks a lot like the airbrushed side of a ’70s stoner van. Alexander says his coma experience was ”a vast, and incalculably positive, journey”. There was a ride on “a wing of a butterfly” and an-attractive-but-not-necessarily romantically inclined woman who said: “We will show you many things here”. All of the things Alexander did witness were beautiful and perfect and contradictory:
It seemed that you could not look at or listen to anything in this world without becoming a part of it – without joining with it in some mysterious way. Again, from my present perspective, I would suggest that you couldn’t look at anything in that world at all, for the word “at” itself implies a separation that did not exist there. Everything was distinct, yet everything was also a part of everything else, like the rich and intermingled designs on a Persian carpet … or a butterfly’s wing.
As Choire Sicha notes, “Heaven is Real” sounds a lot like the slightly less definitively titled best-seller Heaven Is For Real by Todd Burpo and Lynne Vincent. Vincent, who’s profiled in this week’s New Yorker, seems to be unsure, if wings actually exist in heaven. But, remember, facts are tough, even in heaven: As Alexander points out, “reality is too vast, too complex, and too irreducibly mysterious for a full picture of it ever to be absolutely complete.”
If you’re looking for a slightly different take on existence, Einstein’s letter questioning the existence of God goes on sale on eBay today. The bidding for Einstein’s skepticism starts at $3 million. – Ryan McCarthy
Prepaid debit cards just keep on getting better — ever closer, that is, to the holy grail of essentially replicating the free checking account of yore. Checking was never actually free, of course: it was basically a bait-and-switch, where people thought that they were getting free checking but then got hit with huge unexpected fees when they could least afford them.
But when hidden overdraft fees and the like were made illegal, and bank fees started becoming increasingly salient and obvious, the search for a checking-account replacement began. And there are two big ones: credit unions, on the one hand, and prepaid debit cards, on the other.
I’ve been a bit disappointed in the way that credit unions in general have responded to the new world of banking. As far as I can tell, most of them have been subdued and cautious when it comes to trying to poach customers from the big banks. And many of them actually opposed the Dodd-Frank law which did so much to protect consumers and to prevent banks from running up hidden fees.
For instance, Patrick Adams, the CEO of St Louis Community Credit Union, was a vocal opponent of the Durbin Amendment, laying out a parade of horribles that he was sure would come to pass were the amendment to be signed into law:
Here’s another surefire lock of a bet. You will be more frustrated than ever. Your costs at the bank will be up. Your costs at the retailer will be up. You will be confused as to which retailers accept your debit card and which ones don’t. You will have no clue what the minimums and maximums of your debit card activity will be because there will be no consistency among retailers. As a result, you will carry more cash and more checks.
I took his “surefire lock of a bet”, and eventually we agreed to settle it in July 2012, once the new law had been in force for a year. Adams sent me a grudging email in August, saying that although he would “pay the $100 to your credit union in the name of helping a fellow credit union do the good works of our industry”, he had also learned that he “will never again be lured into sharing information with someone I thought was an interested party from a credit union perspective to only have it placed as a topic for a blogger”.
The point here is that in many cases — see also my article about Missouri Credit Union — credit unions look and feel very much like banks, with the similarities far outweighing the differences. And so while credit unions are nearly always a better deal than banks, they’re generally not being nearly as aggressive as I would like in terms of trying to be a much better deal.
Meanwhile, prepaid debit cards have been improving enormously. Once upon a time they were nearly all rip-offs; now, they’ve reached the point at which they can start to be a real checking-account alternative, without the fees and the kind of haterage which almost all of us feel towards our bank at some point.
The latest card to hit the market is the Bluebird, from American Express and Walmart. The fee schedule, on the left, is very impressive, starting with the first line, a $0 monthly fee. American Express has had no-monthly-fee debit cards in the past, but nothing with the kind of distribution clout offered by Walmart.
On top of that, if you use this card as a checking-account replacement, then ATM withdrawals are free within the reasonably extensive MoneyPass network. In order to qualify for that, you need to sign up for some kind of direct debit, which is easy to set up from most employers, Social Security, and the like. We’ve seen this incentive to use direct debit in the past: Suze Orman’s ApprovedCard has pretty much the same thing, for instance. But it costs $3 a month — and, crucially, it’s expensive to reload if you try to put money on it through means other than some kind of bank transfer.
The Bluebird card, by contrast, can be reloaded with cash at any Walmart: pay for your groceries and put any money you have left over right onto your card. And the Bluebird card offers something else pretty revolutionary as well — you can even deposit checks into your account, for free, using mobile check deposit.
Being able to deposit money into your account for free is a key feature of checking accounts which prepaid debit cards have historically had a very difficult time replicating. This is one area where banks have a clear advantage over other prepaid debit-card providers. If you have a debit card from Chase or US Bank, for instance, then you can deposit money into your account at any of their branches or ATMs. But the bank cards have their own limitations: Chase doesn’t offer bill-pay, for instance, while US Bank doesn’t offer check deposit.
Interestingly, the loophole which is making all these prepaid cards possible is exactly the same as the loophole which prevents Chase from offering bill-pay. The Durbin Amendment to Dodd-Frank forced interchange fees on debit cards to come down substantially, while carving out an exception for prepaid cards. So Durbin allowed the prepaid industry to keep on growing — but because Chase is a big bank, it’s not allowed to offer bill-pay on its prepaid card, since at that point it would fall foul of the rules about the interchange fees charged by big banks on their checking-account debit cards.
One interesting thing about prepaid cards is that they’re easy to start up — and, by the same token, they’re easy to drop. People tend to use a single card for no more than a few months at a time — in stark contrast to the many years that they use a checking account. Especially if you’re moving from job to job, it’s as easy to just get a new prepaid card, most of the time, as it is to set up direct debit onto your old one.
Which helps explain why Green Dot shares are down almost 20% today. Green Dot used to be the exclusive provider of prepaid cards at Walmart; no longer. And given the choice, it makes very little sense to choose one of Green Dot’s cards over the Bluebird: the only real disadvantage that Bluebird has is that it’s an Amex card, which means that it isn’t accepted in as many places as Visa and Mastercard.
So expect to see Bluebird make some serious inroads with respect to the Green Dot user base — and expect, too, that Bluebird users are going to be less likely to graduate to a checking account than Green Dot users were. While most checking accounts offer a lot of things which you couldn’t get with a Green Dot debit card, that list is much smaller once you’ve got a Bluebird card.
The number of unbanked households in the US is rising — it’s now at 8.6% of all households, up 0.6 percentage points in the past two years alone. As prepaid debit cards become ever cheaper and more attractive alternatives to checking accounts, and as online startups introduce their own checking-account alternatives, that number is only going to increase.
But the economics here are interesting. I’ve spoken to a number of prepaid debit card issuers, including Chase Liquid and Suze Orman, and they all swear that there’s simply no way they can even break even unless they charge a monthly fee. But now Bluebird has joined Simple in giving out cards where pretty much everything is free, there’s no monthly fee, and you even have access to things like mobile check deposit which are still rare in checking accounts.
And what that says to me is that it’s going to be very difficult to compete as a pure prepaid-debit play, going forwards. American Express and Simple don’t need their debit-card arms to be profitable on a month-to-month basis: they’ve got their eyes on bigger prizes. That’s good for consumers, but it’s likely to mean that the universe of prepaid offerings is going to shrink. If you can’t offer something for free, or very close to free, then increasingly you might as well just not bother.
One of the many consequences of global warming is that it’s now, for the first time, possible to drill under the sea bed of the Arctic ocean. The oil companies are all there, of course, running geological tests and bickering with each other about the potential environmental consequences of an oil spill. But they’re not the only people drilling. Because there’s something even more valuable than oil just waiting to be found under the Arctic.
What is worth so much money that three different consortiums would spend billions of pounds to retrofit icebreakers and send them into some of the coldest and most dangerous waters in the world? The answer, of course, is information.
A couple of days ago, I called a friend in Tokyo, and we had a lovely chat. If he puts something up on Twitter, I can see it immediately. And on the web there are thousands of webcams showing me what’s going on in Japan this very second. It doesn’t look like there’s any great information bottleneck there: anything important which happens in Japan can be, and is, transmitted to the rest of the world in a fraction of a second.
But if you’re a City trader, a fraction of a second is a veritable eternity. Let’s say you want to know the price of a stock on the Tokyo Stock exchange, or the exact number of yen being traded for one dollar. Just like the light from the sun is eight minutes old by the time it reaches us, all that financial information is about 188 milliseconds old by the time it reaches London. That’s zero point one eight eight seconds. And it takes that much time because it has to travel on fiber-optic cables which take a long and circuitous route: they either have to cross the Atlantic, and then the US, and then the Pacific, or else they have to go across Europe, through the Middle East, across the Indian Ocean, and then up through the South China Sea between China and the Philippines.
But! If you can lay an undersea cable across the Arctic, you can save yourself about 5,000 miles, not to mention the risk of routing your information past a lot of political flash points. And when you’re sitting in your office in London and you get that dollar/yen exchange rate from Tokyo, it’s fresh from the oven, comparatively speaking: only 0.168 seconds old. If everybody else is using the old cables and you’re using the new ones, then you have somewhere between 20 milliseconds and 60 milliseconds when you know something they don’t.
Those are periods of time so short that humans can barely notice them. This essay, for instance, is about 900,000 milliseconds long, and it takes me hundreds milliseconds just to say the word “cable”. Which is a word with more than one meaning. To you, it probably means some kind of wire. But to City traders, it means 1.6254, or something very close to that number. Because in the City, “cable” means the pound/dollar exchange rate. And it’s named that after a transatlantic cable which was used to telegraph the exchange-rate information from London to New York as far back as 1858.
So what we’re talking about here is nothing new, in terms of kind. Nathan Rothschild built a significant chunk of his fortune by using a system of couriers who told him the result of the Battle of Waterloo a full day before anybody else in London knew it. And my own employer, the Reuters news agency, was founded on sending financial information between Brussels and Aachen using carrier pigeons.
What’s new is that billions of pounds can be made by having access to information not a day in advance, or an hour, or even a second, but even just a millisecond or two. Stock exchanges aren’t physical places where human beings bargain with each other any more: they’re racks of computers in places like Mahwah, New Jersey, where the cables are carefully measured to be exactly the same length so that no one has an infinitesimal advantage thanks to the amount of time it takes information to travel an extra few millimeters down a wire.
Obviously, only computer algorithms can make money from an information advantage which is measured in milliseconds. It’s computers which are making the decisions to buy and sell: if they had to wait for a human to sign off on those things, they’d never make any money at all. That’s a little bit scary, and not only because of the classic science-fiction stories where computers become so sophisticated that they gain consciousness and start waging battles against the humans who built them.
The more obvious problem with exchanges run by computers is that computers don’t have any common sense. We saw this on the 6th of May, 2010 — the day of the so-called “flash crash”, when in a matter of a couple of minutes the US stock market plunged hundreds of points for no particular reason, and some stocks traded at a price of just one cent. It was sheer luck that the crash happened just before 3pm, rather than just before 4pm, and that as a result there was time for the market to recover before the closing bell. If there hadn’t been, then Asian markets would have sold off as well, and then European markets, and hundreds of billions of pounds of value would have been destroyed, just because of a trading glitch which started on something called the e-mini contract in Chicago.
Most of the trading on US stock exchanges is done by something called algobots, these days. These are algorithms: they’re computers which are programmed to put in orders, take out orders, trade in big size, trade in small size – all according to very sophisticated rules, called algorithms. And one of the ironies about the flash crash is that it was actually caused in large part by algobots not trading. The US has over a dozen different stock exchanges, places where stocks are bought and sold. Most of us have only ever heard of the listing exchanges, the New York Stock Exchange and the Nasdaq. But there are many more you probably haven’t heard of, with names like Arca and BATS, as well as sinister-sounding things called Dark Pools. What happened in the flash crash is that when the trading got completely crazy, the algobots just switched themselves off. This was something they weren’t used to, they didn’t know how to react, and so they just went away. And there was suddenly no liquidity in the market. No one was offering to trade. And with no one offering to trade, the prices just plunged, all the way down to one cent. Because there were no bids in the market any more.
The algobots can be very useful, on a day-to-day basis. If a normal person like me buys a few shares in some company or other, that trade doesn’t even happen on any stock exchange at all. It just happens directly with a broker, an algobot, who’s happy to take the other side of my trade because small individual investors like me are normally pretty stupid, and tend to buy high and sell low.
In any case, if any given stock exchange is an incredibly complicated thing, the fragmentation of the stock exchanges has created a much more complex system yet. Most big banks and stockbrokers — and the algobots they control — have access to all of the different exchanges, and they trade wherever they think they can get the best prices. Since the best prices tend to be found wherever the most traders are trading, you end up with something a bit like six-year-olds playing football: everybody’s running towards the ball at the same time. And the result is these huge waves of activity, where traders move en masse, from one stock exchange to the next, in very unpredictable ways. If you layer that unpredictability on top of the complexity inherent in any system of multiple stock exchanges, you end up with something which will almost certainly break in a pretty catastrophic manner at some point. We don’t know how, and we don’t know when, but there’s an ironclad rule of any system: the more complex it is, the less predictable it is, and the more likely it is to fail catastrophically in some unforeseeable manner.
If Twitter fails, that’s fine. A bunch of people get annoyed, and then they want to express how cross they are on Twitter, and then they remember that they can’t, and that makes them even more annoyed. But little actual harm is done. If the stock market fails, on the other hand, or the bond market, or the foreign-exchange market, or the oil market, that’s really, really bad news. Billions or even possibly trillions of pounds could evaporate.
And that’s the biggest reason why it’s time to start cracking down on high-frequency trading. Virtually every major financial center in the world is trying to work out what to do and how to do it: these decisions aren’t easy, partly because any crackdown on the algobots is likely to have its own significant up-front costs.
After all, high-frequency trading has been genuinely wonderful for small investors like you and me. We might not be particularly clever, but when we put in an order to buy this or sell that, the order gets filled immediately. We pay almost nothing in trading costs — just a few pounds, normally. And we get the very best price in the market: something called NBBO, for “national best bid/offer”. If you look at all the prices being quoted on all of the stock exchanges in the country, we get the lowest price of all if we’re buying, and the highest price of all if we’re selling.
That wasn’t true ten years ago. During the dot-com boom, especially, small investors generally had no idea how much they were going to end up paying for a stock they wanted to buy, and all too often their trades could take minutes or even hours to get filled. Today, all individual investors get filled in a fraction of a second: we’ve never had it so good. So if anybody tells you that high-frequency trading is bad for the little guy, and that it means there isn’t a level playing field any more, they don’t know what they’re talking about. Yes, high-frequency traders do make money from small investors, but they do so honestly, just by assuming that whatever those small investors do, the opposite thing is likely to make money. As a result, there’s always someone willing to take the opposite side of the trade whenever you want to buy or sell a stock.
This is a real improvement, which means that the rise of high-frequency trading had genuinely beneficial effects between, say, 2002 and 2007. In those years, the computers helped markets to become ever more efficient and liquid — and they were just in time, too. When the financial crisis came along in 2008, bond markets seized up, but the world’s stock markets actually came through with flying colors. They did what markets are supposed to do: they went down when people were selling, and they kept on falling until they were so cheap that people started buying again. If you wanted to sell, you could always sell, and if you wanted to buy, you could always buy. We take these things for granted, but creating a system which stays that liquid, all the way through such a big crisis, is a real achievement, and the algobots deserve a lot of credit there. After all, imagine what would have happened if you had to phone up your broker at Lehman Brothers in order to sell your shares.
But if you look at what’s happened over the past five years, since 2007, the benefits of high-frequency trading have pretty much plateaued. And the downsides are becoming more and more obvious. There was the flash crash, of course, and then there was the implosion of Knight Capital, one of the biggest and most respected high-frequency trading shops, which released a faulty algorithm one morning and was almost bankrupt an hour later, after losing somewhere in the region of $10 million per minute. If that could happen to Knight, it could happen to anybody. Then there was the botched flotation of one of the stock exchanges, BATS. Once again, its algorithms turned out to be not up to the task. And this was in an expected, rather than an unexpected, situation.
There are more subtle signs, too, which are if anything even more worrying. For instance, look at stock-market volume — the amount of money which changes hands every day. That’s going nowhere: if anything, it’s going down, even as high-frequency traders get bigger and bigger. That says two things.
The first is that real-money investors, the people who the market needs the most, are being scared away by the algobots, because even if the bots are good for the little guy, they’re really bad for big, institutional investors. For big investors, the stock market is more of a rigged game now than it has been in a long time – and they’re taking their ball and they’re going home.
The second reason that volumes are dropping is that the algobots are getting so sophisticated at sparring with each other that they’re not even trading with each other any more. They’re called high-frequency traders, but maybe that’s a misnomer: a better name might be high-frequency spambots. Because what they’re doing, most of the time, is putting buy or sell orders out there on the stock market, only to take those orders back a fraction of a second later, and replace them with new ones. The result is millions of orders, but almost no trades.
I’ll give you one example from a stock with the ticker symbol EFZ. It doesn’t matter what that ticker represents: the computers certainly don’t care. On September 11, between 6:51 and 7:08 in the morning, the US stock markets saw more than 280,000 quotes to trade EFZ. And how many times did it actually trade? Zero.
I can even demonstrate what that kind of thing sounds like. If you map all those offers to buy or sell onto a piano, and play them back, you get something which sounds like this. Remember, each note is an offer to buy or to sell; there’s no actual trading going on.
There’s no value being created here. If the economics of high-frequency trading means that fiber-optic cables get laid under the Arctic ocean, that’s good for everybody. But if it all just devolves into meaningless noise, then something has gone very, very wrong. Especially since the more noise and complexity you have, the bigger the danger that everything could just implode for some unforeseeable reason. Any one of these notes has the potential to be the butterfly wing-flap which results in global disaster. If they’re not doing anybody any good, it makes sense that regulators should crack down on them.
The official Iranian rial-to-US dollar exchange rate has been surprisingly steady over the past several months. That’s somewhat odd, because in 2010, the US and EU imposed tough new sanctions against Iran. But in recent weeks, says the Cato Institute’s Steve Hanke, “hyperinflation has arrived in Iran”:
Using new data from Iran’s foreign-exchange black market, I estimate that Iran’s monthly inflation rate has reached 69.6%. With a monthly inflation rate this high (over 50%), Iran is undoubtedly experiencing hyperinflation.
When President Obama signed the Comprehensive Iran Sanctions, Accountability, and Divestment Act, in July 2010, the official Iranian rial-U.S. dollar exchange rate was very close to the black-market rate. But, as the accompanying chart shows, the official and black-market rates have increasingly diverged since July 2010.
Terrifyingly, the black-market (i.e., realistic) value of the rial recently dropped 60% in eight days. Tougher sanctions in part explain the sudden drop. The US, for its part, seems increasingly unwilling to allow Western financial institutions to pal around with the Iranian regime. Any further reduction in the access Iran’s central bank has to global financial markets would put further pressure on the rial.
Reuters’ Yeganeh Torbati explains how the regime’s attempt to dampen the effects of the currency crisis may have exacerbated the rial’s sudden collapse. As you might expect, the Iranian population is not taking these developments well: Al Jazeera reports that police have clashed with currency protesters in Tehran.
Further sanctions from the EU appear imminent. And that could cause a jittery Iranian regime to pull out the biggest bargaining chip it currently has by closing the Straight of Hormuz. More broadly, Jay Newton-Small rounds up the three most likely outcomes — regime change, a push for greater nuclear capabilities or economic collapse — none of which are particularly heartening. — Ben Walsh
Jack Welch and a collection of NFP truther tweets - Zeke Miller
Jack Welch “is now unavailable for the rest of the day in meetings” - Bloomberg “I wasn’t kidding”: Jack Welch defends his bizarre jobs numbers conspiracy theory - WSJ
How to run your hedge fund from a prison cell - Jonathan Weil
Since 2009, investors have pulled $138 billion from stocks/ETFs and put $1 trillion into bonds - WSJ
An interview with the world’s youngest, most charmingly oblivious hedge fund - Kevin Roose
Last month, I wrote a bit about what you might call the bidirectional causality between the unemployment rate and incumbent political fortunes. On the one hand, unemployment affects happiness, and willingness to vote for the current president. But on the other hand, the rate itself is a political weapon, to be used in, for instance, Republican claims of how many successive months America has had unemployment above 8%.
This morning’s job report is fascinating, in that it illuminates both effects. One not-bad way of judging Obama’s odds of winning the election is to look at his odds on InTrade, which were stubbornly close to 60% for pretty much all of this year. Then, suddenly, in mid September, there was a huge surge. Narrowly speaking, the surge was a result of Obama doing well in important polls. But why were the polls suddenly turning so much in Obama’s favor? Journalists, with their bias towards believing that everything is a result of news, tended to attribute Obama’s newfound popularity to Romney gaffes like his 47% speech. But with hindsight, maybe news had very little to do with it. Maybe the real reason was that according to the household survey, the number of employed Americans grew by 873,000 in September alone.
Which isn’t to say that news is irrelevant when it comes to perceived election odds. For instance, within the first half-hour of the debate on Wednesday, Obama’s InTrade odds fell from 71% to 67%, just on the back of his weak performance. And then, this morning, they spiked right back up again, from 65% to 71%.
This move is about optics as much as it is about reality: with the unemployment rate now below 8%, a key Republican talking point has been neutralized. And for the wonkier types, Obama can now say that he’s created more private-sector jobs in the past four years than George W Bush created in eight. Indeed, if it weren’t for public-sector job losses — exactly the kind of spending cuts that Republicans claim to love — the unemployment rate right now would have a 6 handle.
Those optics explain the frantic and ignoble conspiracy theories from the Republican side: they’re trying to alter perceptions of the number itself, even if they can’t alter the effect that rising employment has on the electorate’s propensity to vote for Obama. Because it seems as though rising employment is giving a significant boost to Obama’s re-election chances — and that from here on in, it will only be helped by the 7.8% headline unemployment rate. It’s a little bit depressing that 7.8% counts as low, for these purposes, but clearly it does — especially considering that it has come down 1.2 percentage points in the past year. I don’t know how much credit Obama can really take for that, but America, right now, seems to be willing to give him the benefit of the doubt.
Even with mortgage rates at record lows and the Fed’s recent $40 billion per month commitment to the market, mortgages aren’t terribly easy to get these days. Mitt Romney, for his part, blames confusion over “qualifying mortgages“. But the mortgage market is also being held back by the scourge of “put-backs”.
In the post-housing-bubble era, Nick Timiraos reports, mortgage giants Fannie Mae and Freddie Mac have hired “bounty hunter” consultants to apply a ridiculous amount of scrutiny to billions of solid loans from mortgage lenders. If these consultants find even small problems – like a stray deposit in a borrower’s bank account – Fannie and Freddie can force lenders to buy back loans:
“Why do I care about that $100 deposit? Why am I triple checking your credit score?” says Barry Sturner, president of Townstone Financial, a Chicago lender. “Because I’m scared to death of the buyback.”
Despite strong credit scores and an ample down payment, Paul Stone and his wife had problems getting a mortgage in March from Wells Fargo & Co. to buy a $300,000 house in Broomfield, Colo. He says the lender raised concerns about his income. Mr. Stone, a real-estate agent, has worked for the same company for the past 2½ years and earns a fixed salary.
But he relocated to the Denver area from Virginia this year, and he says the bank wanted to see a two-year record of earnings in his new location. His wife eventually got a mortgage with Wells Fargo, using only her income, to buy the house.
If you already have a mortgage, things are weirdly sunnier. Refinancing rates have hit their highest level in more than three years. This recent data, Matt Zeitlin writes, is very good news: Not only are underwater homeowners refinancing but more people are actually paying their mortgages down early.
At the other end of the mortgage spectrum, there’s subprime, which, Bloomberg’s Jody Shenn reports, is a remarkably lucrative, shrinking market. Subprime mortgage bonds – basically bonds containing loans not backed by Fannie and Freddie – are up 30% so far this year, and ”have outperformed almost every other asset class”. Goldman and Cerberus are among the companies launching funds to buy these bonds.
Which isn’t to say there is a large supply of new subprime bonds. Since 2008, only $3.5 billion of these subprime loans have been packaged into securities. For comparison’s sake, sales of bonds containing those safer, government-backed loans hit $1.2 trillion last year alone. – Ryan McCarthy
If there’s one thing that Democrats and Republicans always agree about, it’s the importance of closing loopholes in the tax code. And if there’s one thing that Democratic and Republican administrations are equally incapable of doing, it’s closing loopholes in the tax code. Every loophole has its associated lobby; many of those lobbies are extremely powerful, and all of them are extremely vocal when it comes to their particular carve-out. And when you have powerful and vocal lobbyists on one side, and no one with much of a dog in the fight on the other side, the powerful and vocal lobbyists tend to win.
Which is why I’m a fan of the capped-deduction idea that Mitt Romney first floated on Tuesday, and then brought up again in the debate last night. Here’s what he said on Tuesday:
As an option you could say everybody’s going to get up to a $17,000 deduction; and you could use your charitable deduction, your home mortgage deduction, or others – your healthcare deduction. And you can fill that bucket, if you will, that $17,000 bucket that way. And higher income people might have a lower number.
I want to bring down the tax burden on middle-income families. And I’m going to work together with Congress to say, OK, what — what are the various ways we could bring down deductions, for instance? One way, for instance, would be to have a single number. Make up a number, $25,000, $50,000. Anybody can have deductions up to that amount. And then that number disappears for high-income people. That’s one way one could do it.
Romney’s a step ahead of his campaign, here. When pushed for specifics, spokeswoman Andrea Saul has nothing, saying only that “Gov. Romney referenced one illustrative example” of a way in which he might possibly get revenues without raising taxes. The lack of detail was immediately seized on by the Obama campaign, which decided that if Romney wasn’t going to be specific, then it obviously had to include the healthcare exclusion — the way in which Americans don’t pay taxes on health-insurance costs borne on their behalf by their employer.
But Romney never mentioned exclusions, only deductions. This is hair-splitting territory, but if you’re the kind of person who itemizes your deductions, you know what you’re deducting. The big ones are your state and local taxes; your charitable contributions; and your mortgage interest payments. Meanwhile, you probably don’t even know how much your employer is spending on your health insurance.
And frankly I’m disappointed in the Obama campaign’s response: they’ve come out, now, with a simple argument: any attempt to cap deductions would constitute a middle-class tax hike. Obama won’t raise taxes on the middle class. Therefore, Obama is opposed to any attempt to cap deductions. That’s sad, because in principle the idea is a very good one. And it’s also sad because it reveals that the Obama campaign simply isn’t serious about closing loopholes.
After all, there are lots of ways to close loopholes in a revenue-neutral way, so that the middle class in aggregate pays no more taxes than it does right now. But if you’re attacking deductions, then by definition the people who take those deductions are going to lose out. And if you’re promising that no individual middle-class family will see their taxes rise, then frankly you’re not being serious about tax reform at all.
The Tax Policy Center has an excellent overview of who itemizes deductions. Overall, there are about 158 million “tax units” in America, of whom about 47 million itemize deductions at all. That’s 30% of the total. And if you slice off the people with incomes in the top 20%, then you’re left with 28 million tax returns which itemize deductions out of 135 million returns filed, which is basically just one in five. You could completely eliminate all tax deductions tomorrow, including the horrible mortgage-interest deduction, and taxes wouldn’t rise for the vast majority of Americans. But if you commit to not raising taxes for those 28 million households who do deduct, then you’re never going to get anywhere.
And the Romney approach is a really good one because it dilutes the power of any individual lobby. He’s not picking favorites here, retaining the charitable-contribution tax deduction, for instance, while abolishing the mortgage-interest deduction. He’s saying that you get to keep whatever deductions you like — just up to a certain limit. Martin Feldstein has proposed something similar: his 2% cap would raise $278 billion, which is real money. And Romney actually goes further than Feldstein: instead of the cap rising with income, as Feldstein’s does, Romney’s falls with income, and indeed it entirely “disappears for high-income people”. If you’re high-income, you get no deductions at all.
This would have a massive effect on Romney himself, who gives millions of dollars to charity every year. What he’s saying — and this is a praiseworthy and honorable thing — is that he gives to charity because it’s the right thing to do, rather than because he gets to donate pre-tax dollars. He will continue to give to charity, even if the charitable tax deduction gets abolished, and he will continue to minimize his taxes, as is his right. But he’s just not going to be able to do both at the same time any more, which is fine.
What’s more, the cap on deductions is a bit like the emissions cap in a cap-and-trade system: once implemented, it can be dialed up and down relatively easily. Any time you need a bit more on the revenue side of things, you dial it down. Any time you want to be able to say that you’re doing wonderful things for charities and non-profits, you dial it up. (And in doing so, you’ll get a very handy natural experiment: we’ll really see, with hard empirical data, just how many marginal extra charitable cents get donated for every dollar of charitable-deduction tax expenditure.)
I don’t believe for one minute that even a complete repeal of all deductions would be enough to counteract the 20% across-the-board tax cut that Romney says he wants. But that’s where scoring comes in: presidential candidates can say whatever they like, while presidents, if they’re proposing something revenue-neutral, need the CBO to score it that way.
Romney came out and said, in the debate, that “you’ll never balance the budget by raising taxes” — which is equivalent to a businessman saying that you’ll never increase your revenues by raising your prices. I don’t take his fiscal-policy rhetoric seriously, and I don’t know anybody who thinks it adds up. But all the more reason, then, to welcome sensible proposals when they do occasionally emerge from his camp.
One of the most common economic assumptions is that, broadly speaking, economic growth makes us all happier. Grow GDP, the argument goes, and we all get more stuff, and more stuff makes us happier. But a recent paper, as Izabella Kaminska writes, says “economists [may] be considering too narrow a set of determinants of well-being”.
The Chairman of the FSA, the UK’s chief financial regulator, Adair Tuner (lead author of the eponymous 2009 review into the financial crisis) has been even more direct in his criticism, once calling most financial activity “socially useless“. Robert Skidelsky writes that Turner’s new book, Economics after the Crisis, attacks three basic economic tenets:
The first is that the object of policy should be to maximize Gross Domestic Product per head; the second, that the primary means of doing this is to create freer markets; the third, that increased inequality is acceptable as long as it delivers superior growth. The attack is devastating, leaving little of the policy edifice of the past thirty years standing.
Turner is not alone on the first point. None other than Fed Chairman Ben Bernanke has endorsed including well-being and quality of life into economic measurement. Joseph Stiglitz has gone so far as to call the obsession with GDP a “fetish“. The OECD has championed its “Better Life Index“, under the brave assumption that humans should be provided with things like housing and a clean environment.
There’s some recent evidence that supports the Happiness School of Economics. China’s GDP has quadrupled in the last twenty years, but economics professor Richard Easterlin says that happiness hasn’t increased with it: “If anything, [Chinese] are less satisfied than in 1990, and the burden of decreasing satisfaction has fallen hardest on the bottom third of the population in wealth”. China is not alone: over the last forty years, happiness has fallen in countries where income has increased.
Easterlin is not a newcomer to this issue — he’s been studying the connection between economic growth and happiness since the 1970s. His work is the basis of the so-called Easterlin Paradox, the idea that rich countries don’t get happier when they get richer.
Most of the recent gains in GDP have gone to the rich, and Kevin Drum’s short version of the financial crisis points to the direct role of inequality in causing the meltdown. Meanwhile, Martin Wolf, also pointing to recent economic research, wonders if we can continue to assume that indefinite growth is possible at all. “For most of history, next to no measurable growth in output per person occurred”, he notes. — Ben Walsh
Oxpeckers The Atlantic has comments enabled for an article written in 1870 - Michael J. Altman
Jerry Seinfeld’s hilarious letter to the NYT on the usage of the word “really” - NYT
The FT is likely for sale after Pearson CEO steps down - Bloomberg
What Nate Silver reads - Atlantic Wire
Mr. Einhorn, the president of Greenlight Capital, noted that Taco Bell’s new upscale menu, Cantina Bell, would lure customers away from Chipotle, which offers higher-priced options.
Can Taco Bell really lure customers away from Chipotle? I decided to find out, with the invaluable help of Food & Wine’s Kate Krader, and Reuters’s very own Anthony De Rosa.
The results? In a word, no: there’s simply no way that Taco Bell, even with its Cantina Bell menu, can hold a candle to Chipotle. If you’re used to Chipotle, you might be tempted by Taco Bell’s lower prices — but there’s no way you’ll be tempted by its food.
On the other hand, if you look at the results of polling from YouGov BrandIndex, the perceived quality gap between Chipotle and Taco Bell does seem to be narrowing, and Taco Bell is now perceived to be higher quality than fast-food chains in general.
This is not unprecedented: as you can see, at the beginning of May, Taco Bell actually scored higher on this metric, which is the result of subtracting the percentage of poll respondents who think a brand is “low quality” from the percentage who think that brand is “high quality”. But it does seem undeniable that Taco Bell is doing reasonably well these days, on the quality-perceptions front, while Chipotle’s advantage is shrinking.
Still, I very much doubt that’s going to result in any kind of exodus from Chipotle to Taco Bell — and the reason is that these chains get judged on very different criteria. Do I think that Chipotle is low-quality or high-quality? Ask me that, and I’ll compare it to the Mexican restaurants in my neighborhood. Ask me the same question of Taco Bell, however, and I’ll compare it to other cheap-and-crappy fast-food joints frequented in large part by stoners with the munchies. You could ask the same question about the business-class seats on American Airlines and the economy-class seats on Singapore Airlines: many respondents would say that American’s business class was low quality, while Singapore’s economy class was high-quality. But that doesn’t mean that they would prefer coach class on Singapore to business class on American.
In other words, there’s an important expectations game going on here. America’s consumers now take it for granted that Chipotle is really good by fast-food standards; Taco Bell’s new Cantina menu, by contrast, is basically an attempt (and not a particularly successful one, if my taste test is any indication) to bring the chain up into the realm of “maybe I could possibly eat this while sober”.
Taco Bell has something of a cult following among the young and inebriated. When “marketing strategist” Laura Ries said that a Doritos taco wouldn’t turn Taco Bell into “a more authentic Mexican restaurant”, Joseph Alexiou responded, quite rightly, that she “clearly has no clue about what attracts people to Taco Bell”. After tasting one of these abominations yesterday, I can attest that it is a truly nasty thing: an unidentifiably oleaginous brown gloop acting as glue between two sides of a radioactive-orange shell which tastes like someone dropped a pound of salt into a vat of Irn-Bru and then solidified the result.
Obviously, there is a market for Doritos Locos Tacos. But equally obviously, that market is not the same as the market for Chipotle burrito bowls. Taco Bell might do well in future, and Chipotle might do badly. But Taco Bell is no more going to eat Chipotle’s lunch than I’m ever going to touch a Cantina burrito again.
Susan Dominus has a big 7,500-word NYT Magazine feature on the rise and fall of Ina Drew, featuring a couple of bland quotes from Jamie Dimon but nothing — nothing on the record, at least — from Drew herself. (We’re told explicitly about four different people who declined to comment when approached by Dominus, including “London Whale” Bruno Iksil and his boss Achilles Macris; Drew is not one of the four.)
The story, as Dominus presents it, is a tragic one. Drew was a highly competent and highly successful trader, who used her deep knowledge of the markets to stay one step ahead of the quants and the rocket scientists who coveted her job. But then she decided that she needed a group of quants and rocket scientists herself, and after she came back from her year-long battle with Lyme disease, which kept her out of the office for most of 2010, she never really regained full control or understanding of what the London office was getting up to.
Dominus actually puts forward two subtly different narratives of what went wrong. The first is that the quants ultimately managed to snow her — that in her final months at JP Morgan, Drew basically didn’t know what was going on in London, and was out of her depth:
At some point in December of last year, a former executive from the group says, Drew checked in with Macris and Martin-Artajo about the position while the two men were in New York. They answered, but the executive, who understood the trade, remembers thinking that they did not give as full an answer as they could have. “I think they glossed over details to the point where Ina knew the product, the size they were trading, but she did not know what the true P.& L.” — profit and loss — “impact could possibly be in a stressful scenario,” he said. She was asking the right questions, he said, but did not seem to be picking up on what was not being said…
By the second week in May, the stress had taken a toll. A colleague saw Drew walking around the executive floor, her mascara smeared. A slight tremor in her hand left over from her illness seemed worse, a physical symbol of her emotional state. Although she still came to work dressed impeccably, she had lost weight and looked somber, almost shut down. The week that the bank decided to make a public disclosure, 20 senior people gathered in a meeting room on the 47th floor. Everyone went around the room and spoke about what they had found out and what still needed to be learned. After about 45 minutes, with the meeting drawing to a close, Drew, uncharacteristically, still had not said a word. Finally, John Hogan, the chief risk officer for the bank, asked: “Does anyone need anything? Need some help?” Drew raised her hand. “I need help,” she said. It was a white flag.
But there’s a second narrative, too — which is that the trades were actually not completely stupid, that they could actually have worked out OK in the end, and that it wasn’t the markets so much as “complicated, interlocking human dynamics” which ultimately did Drew in:
Maybe Drew still believes — as Macris does, according to people at the bank — that the position could have worked out given enough time. Maybe if she had asked the right questions sooner, her traders would have been forced to clarify or she would have sensed danger before it went out of control. Many systems failed and perhaps, too, her judgment.
Drew was someone known for her grasp of the big picture, for internalizing historical trends and economic cycles to the point where her gut instincts were almost always right. She was also someone known for having a personal touch. But in this instance, she seemed incapable of grasping the complicated, interlocking human dynamics that can’t be measured by reassuring models — the idea that a position could be leaked, that the press might bear down, that the regulatory environment could compound all those problems.
This narrative is much less believable. For one thing, pretty much all positions work out “given enough time”. But markets are all about timing. This argument sounds suspiciously similar to the testimony of Joe Cassano to the Financial Crisis Inquiry Commission: hey, if you hadn’t forced me to unwind my positions, my positions would have ended up making money! It’s a pretty silly argument from anybody who’s been in the market for more than about five minutes, and it’s especially silly were it to come from someone like Drew who has been a trader for decades.
And more generally, the whole point of being a trader with gut instincts, rather than a quant staring at computer models, is that you’re reacting to the whole world — the real, messy world, where hedge funds will leak your positions to the WSJ and Bloomberg, and where regulators don’t like nasty surprises — rather than just to the easily-tractable numbers in a VaR model.
With hindsight, it’s clear that Ina Drew was in some ways a human version of one of those clever financial strategies which works until it doesn’t. She was by all accounts an excellent manager with incredibly loyal staff — except when she set up the London office of the CIO, which managed the lion’s share of her billions, and which didn’t respect her at all. As a trader, Drew was extremely attuned to the vicissitudes of the markets — at least until she took her leave of absence, after which her fabled spidey-sense seems to have deserted her.
What’s missing from Dominus’s story is any indication of whether or how Drew was actually managed. Over her years at Chemical Bank, as it slowly transformed and grew into today’s JPMorgan Chase, Drew amassed ever-increasing quantities of money and power. Eventually, as Dominus says, she “had direct control over more money than most players on Wall Street — on the level of the top asset managers in the country, including BlackRock and Pimco”. The trader had become an asset manager, and in a very real sense she was competing with the rest of the bank: before anybody at JPMorgan could lend out a single dollar, they essentially had to persuade Jamie Dimon that the risk-adjusted returns from doing so would exceed the returns which he could get by just giving that dollar to Ina.
Drew was very good at managing and investing the money she was given, and the reward for that skill was that she got given ever-greater amounts of money — over $350 billion, in the end. But at that point, her job had changed both qualitatively and quantitatively from the job she had proven herself good at. Qualitatively, much less of her job involved trading rates in New York, and much more of it involved highly-complex derivatives trades in London, something she was never particularly comfortable with. And quantitatively, running $350 billion is both a blessing and a curse. On the one hand, you can “whale” on the market and push your counterparties around, much like a poker player with a monster stack. On the other hand, if you ever do get forced to unwind your position, you’re toast.
The big difference between Drew and pretty much everybody else on Wall Street is that she never needed to unwind anything: during the crisis, when everybody else was panicking and deleveraging, her positions only grew. In many ways, she was one of the biggest recipients of everybody else’s forced unwinds. But then, when the tables were turned, she proved to be just as human as everybody else.
One man, more than anybody else, had the job of looking at that $350 billion pot of money and wondering whether it was simply too big. And there’s no indication that Jamie Dimon ever did that. Bank clients, borrowers: they had position limits. But Ina Drew never did: she would happily accept all the money Dimon funneled her way. In a weird way, she wasn’t just Dimon’s employee, she was also his counterparty: she was the person with whom he would entrust JP Morgan’s balance sheet when he had nothing better to do with it. And it doesn’t seem that anybody at JP Morgan was worried about that particular counterparty risk — not even when Drew was out of the office for a year, and especially not when she returned to increasingly fractious internal politics.
If there’s a villain in this story, then, it’s not Iksil or Macris or anybody in London: it’s Dimon. The buck stops with him, and yet he’s somehow emerged largely unscathed, with a stock price back in pre-Whale territory and a glossy double-page Annie Leibovitz portrait in Vanity Fair. Dimon’s ego has only grown since the whale crisis: “Honestly, I don’t care what second-guessers say in life,” he tells Dominus. “If anyone in the company knew, they should have said something.”
The question, of course, is whether Dimon would have listened. Dimon needed his own spidey-sense: he needed to be able to tell the difference between vicious internal politics and back-stabbing, on the one hand, and genuine reports of risk-management failures, on the other. When it came to the CIO, he couldn’t do that. And it’s far from clear that he’s learned his lesson.
We’re entering a strange time in the politics of the American economy. If Congress doesn’t act by January 1, a series of expiring tax cuts and automatic spending cuts will kick in. This “fiscal cliff” or “taxmageddon”, the CBO says, will send us back into recession and slash GDP.
More specifically, almost 90% of Americans would see their taxes rise by an average of roughly $3,500 per household, according to a report released yesterday by the Tax Policy Center: “Average marginal tax rates would increase by 5 percentage points on labor income, 7 points on capital gains and 20 points on dividends.” Households in the top quintile of income would see their after-tax income fall 7.7%; those in the lowest quintile would see this income would fall 3.7%.
But the NYT reports today that top senators have something resembling a plan. With the threat of a recession looming, the Senate has decided to revisit policies it couldn’t pass last year.
First, there are hints of a possible agreement on a deficit reduction target that seems somewhere near the $4 trillion over a decade that a bipartisan group of lawmakers called for last fall. If that doesn’t work, a second plan would kick in, possibly including Social Security cuts or something like the Simpson-Bowles proposal that was obliterated in the House in May. Paul Krugman is not pleased, calling the possible safety-net cuts “politically stupid as well as a betrayal of the electorate”. And, finally, senators have also come up with a way to delay automatic spending cuts – sequestration, in budget-speak.
Which isn’t to say this will happen before the election: “negotiators will not even try to determine how much money would come from the three components until after the voting.”
Bruce Bartlett, a former Reagan and George H.W. Bush policy staffer, makes the case for patience, suggesting the fiscal cliff is actually more like a steep hill. Bartlett agrees with Peter Orszag and William Gale that the best time for a budget deal is after taxes have risen on Americans:
The virtue of the Orszag-Gale strategy is that it changes the political dynamics. Once taxes have risen on everyone, legislation restoring the status quo ante for all except the wealthy would be scored as a tax cut. While doing this before Dec. 31 would be a violation of the pledge, doing so after Jan. 1 would not.
The problem with this approach is that there’s some evidence that congressional ineptitude has already hurt the US economic mood. Top US CEOs have less confidence in the economy than at any point in the last three years. Gavyn Davies sees signs in August’s economic data that companies are holding off on capital expenditures because of concerns about the fiscal cliff. (Ed Yardeni agrees.) Treasury prices, according to BofA, are already beginning to price in fiscal risks. And all summer, we’ve readmore than a few scary features that suggest businesses have started pulling back.
The question, as this analysis from PIMCO suggests, isn’t whether we’re going to fall off the fiscal cliff – it’s just how far we’ll fall. — Ryan McCarthy
Merrill is offering Morgan Stanley brokers $1.5 million to jump ship – WSJ
EU report calls for bank bonuses to be paid in debt – Irish Times
PwC will get paid $1 billion to consult on foreclosure reviews - Francine McKenna
On some level, complaints about modern air travel are absurd. Think about that famous Louis CK bit: “You’re flying! It’s amazing!…You’re sitting in a chair, in the sky!” But Gary Shteyngart’s awesomely scathing rant about American Airlines relays an experience bad enough to go beyond Tyler Brûlé’s the walk-to-my-gate-was-too-long-and-I-had-to-interact-with-plebes shtick:
You, American Airlines, should no longer be flying across the Atlantic. You do not have the know-how. You do not have the equipment. And your employees have clearly lost interest in the endeavor. Like the country whose name graces the hulls of your flying ships, you are exhausted and shorn of purpose. You need to stop … Flight 121 from Paris to New York began on a clear autumn afternoon. It ended over 30 hours later.
Shteyngart’s experience is unfortunately an extreme example of a larger pattern. Since mid-September, half of all American Airlines’ flights have been delayed, while competitors’ on-time rates are 90%. The underlying reason for that abysmal record, Matthew Yglesias writes, is how the airline’s parent company has treated its labor force since filing for bankruptcy last year. One of the company’s aims (along with cutting its debt load) was to cut labor costs: It pays around $600 million more a year in employee salaries and has $200 million a year more in pension costs than its competitors. It also does spectacularly silly things like own a $30 million London townhouse. And looking back at the company’s 2010 financial statement, labor costs, while relatively high, are not rising that quickly.
Last month, a judge allowed the company to shred its contract with pilots. At that point, Yglesias writes, American lost the “active cooperation of skilled pilots who are capable of judging when it does and doesn’t make sense to request new parts and who conduct themselves in the spirit of wanting the airline to succeed” (translation: American pilots may be intentionally delaying flights). Ground crew and flight attendants agreed to new, more “flexible” contracts. Shortly thereafter, the company notified 11,000 workers they were at risk of being laid off. Owners of $450 million in bonds of American’s parent company aren’t happy either — they’re suing, claiming that the company’s planes, used as collateral for the bonds, are falling in value and no longer sufficiently secure the debt.
American Airlines is not alone in facing the ire of prominent writers. TechCrunch’s Michael Arrington has savaged Delta in the past for poor service. The fact is that when you have a miserable experience on US airlines, that’s probably because the employees are being treated miserably themselves. – Ben Walsh
On to today’s links:
Billionaire Whimsy Billionaires “feel that they have become the new, vilified underclass” - Chrystia Freeland
“The sense of victimization is one part narcissism, one part greed, and one part tactical” - Felix
Apple controls the world’s largest hedge fund you’ve never heard of - Zerohedge
Regardless of who wins the election, you can kiss the payroll tax cut goodbye - NYT
Obamanomics, a study in massively underestimating the severity of the downturn - NYT
“One of the more ridiculous concepts that’s ever been invented in accounting” may be rolled back soon - WSJ
Big win for the bank lobby: Judge kills Dodd-Frank derivatives position limits - Bloomberg
IKEA vanishes women from catalog in Saudi Arabia - WSJ
Greece is entering its sixth year of a “vicious spiral of austerity and recession” - Reuters
$20 billion in costs, just $200 million in revenue: Spam’s “externality ratio” is 100 to 1 - Tim Harford
Three researchers from MIT’s Laboratory for Financial Engineering, including Andrew Lo, have an intriguing new paper in Nature Biotechnology. They start off by noting that pharmaceutical companies are doing a very bad job at turning R&D expenditures into profits, and suggest an alternative: special-purpose “megafunds” of between $5 billion and $15 billion, which issue debt and equity securities, and then use the proceeds to invest in a diversified portfolio of a couple of hundred biomedical R&D projects.
There are a number of good ideas in here. First is the simple benefits of diversification. A $200 million research project with a 5% chance of success is a gamble. But if you bundle up 50 such research projects, even if there are some pretty strong correlations between them, your probability of success becomes much higher. You won’t make 60 times your initial investment, of course, as you would if you just invested in one project and it worked out. But investors tend to prefer safety to risk: they’re generally happier with a very high chance of getting a 10% return than they are with a very low chance of a 10X return.
On top of that, when researchers are working hard on a project which is going nowhere, there are often many institutional forces at play which keep that project going for longer than makes economic sense. If those researchers are part of a megafund which is developing some much more promising therapies, by contrast, they might be quite eager to move over to one of those teams. Especially when 15% of the profits from any given drug are set aside for the team which developed it.
And for all that the pharmaceutical industry has doubled its R&D spending over the past decade, from $68 billion in 2002 to $127 billion in 2010, there’s now a 20-year backlog of oncology compounds waiting to be investigated, and record numbers of medical and life-sciences PhDs who would love to be able to do those investigations.
Finally, the model of having a pharmaceutical company which funds itself with equity and debt and then which devotes some portion of its cash to R&D — that model doesn’t seem to be working very well these days:
The trend of increasing complexity and risk implies that the traditional financing vehicles of private and public equity are becoming less effective for funding biopharma because the needs and expectations of limited partners and shareholders are becoming less aligned with the new realities of biomedical innovation. The traditional quarterly earnings cycle, real-time pricing, and dispersed ownership of public equities imply constant scrutiny of corporate performance from many different types of shareholders, all pushing senior management toward projects and strategies with clearer and more immediate payoffs, and away from more speculative but potentially transformative science and translational research.
The translational part of the pipeline seems to be especially underfunded these days: while $22 billion was spent on basic research in 2010 and $125 billion was spent on clinical development, less than $7 billion was spent on the “translational efforts” which transform the former into the latter — something the Milken Institute calls “the translational valley of death”. That’s always been an area which appeals more to venture capital than to established pharmaceutical companies, but even the venture capitalists these days are concentrating more on later-stage drug development, not least because the sums of money needed to fund a wide range of translational projects, most of which will fail, are so enormous. Venture capital is all about return on investment, and the up-front investment needed in the biomedical space has been rising steadily, even as it has been falling sharply in technology. You can get monster returns on much lower investments in tech than you can in medicine.
So, what are the MIT people proposing? Basically, a special-purpose vehicle which would act as a “preclinical incubator” for early-stage projects and then shepherd them through to final approval, generating cash along the way by selling assets, if it needed to, to pay creditors. The vehicle would be funded by a mixture of equity and debt: the simple model in the paper has $15 billion in total capital, comprising $6 billion of senior debt yielding 5%, $3 billion of junior debt yielding 8%, and $6 billion of equity. If everything went according to plan, the senior and junior debt would get paid off in full, and the equity would ultimately realize annualized returns in the low double digits. Not exactly a home run, but still a decent uncorrelated long-term return.
The authors see this as a great time to try this kind of thing, because interest rates are so low that bonds yielding 5% and 8% respectively look incredibly attractive, especially if they’re uncorrelated to broader fixed-income risks surrounding the nexus of banks and sovereigns. What’s more, with “venture philanthropy” very trendy these days, it’s possible that the fund could raise a lot of money from foundations which want to invest their money in a way which could help ultimately provide the world with great new drugs which will save millions of lives. Some foundations might even step in to provide a guarantee on the megafund’s debt, which would bring the yields down substantially and allow it to raise even more money up front.
Still, I’m very skeptical that this idea is going to see the light of day, and the main reason is the sheer scale needed. In finance, as in most other areas of life, people want to start off small, and see if something works, before they scale up and go big. And this model, in particular, involves a whole new asset class — or, really, a whole new set of asset classes. Investors don’t like putting billions of dollars into something untried and untested, especially in a world where the returns to R&D spending have been declining steadily for many years.
It’s possible that the problem with R&D returns is a function of constraints that public companies have, and venture capitalists have, but which megafunds wouldn’t have. It’s possible — but it’s far from certain. And there has to be a pretty good chance that a brand-new megafund, making all the mistakes that a brand-new anything makes, will see zero or negative returns on its first go-round.
On top of that, the MIT model has both the senior and the junior bonds paying out coupons from day one, with the senior bonds repaying all their principal in years 3-4, and the junior bonds repaying their principal in years 5-6. That’s a lot of money to pay out in a relatively short amount of time, given that it takes a good 10 years for a drug to go from initial development through to approval. As a result, I fear that the megafund would be forced to sell its prime assets while they were still young, giving the biggest returns to the buyers of the assets rather than to the shareholders in the fund. And then there’s the wind-up date: the fund would have to liquidate after a certain amount of time, no matter how well it was doing, and no matter how crappy the market was for its assets that particular year.
There would also be very little alignment of interests between bondholders and equity holders in the megafund: the shareholders would want to hold on to everything, while the bondholders would want much more conservatism.
It seems to me that the permanent-capital model of a pharmaceutical company with an R&D department is actually better suited to the purpose than a megafund would be. Its “preclinical incubator” can be a permanent thing, rather than just lasting for a few years before being wound down. It can issue highly-rated unsecured debt on the strength of its cashflows from current drugs, and it can spend as much time and money as it takes to develop drugs, rather than being forced to sell half-baked projects at an inopportune time.
And while I’m sure that the MIT researchers did the best simulations they could with their “historical oncology drug-development databases with over 700 compounds in various stages of preclinical and clinical development from 1990 to 2011″, I have very little faith that the past performance of drug-development dollars between 1990 and 2011 is a particularly good guide to what one might expect going forwards. After all, there were two big spikes in biotech returns over that period, the larger one being the dot-com bubble. Since 2001, returns have barely been positive, and I’d love to see the results of the simulations if they used just 2001-2011 data rather than 1990-2011.
In short, while there might be a certain amount of interest out there for a modest initial attempt at this kind of thing, the fact is that a modest initial attempt wouldn’t be good enough. In a world where a successful drug needs over $1 billion in development costs before it comes to market, and where 95% of bright ideas eventually fizzle out and die, a megafund really would need to be mega-sized in order for the diversification benefits to really kick in. And while Andrew Lo is a very good salesman, I don’t think even he could raise $15 billion or $30 billion for this, or any other, experiment.
Why do billionaires feel victimized by Obama? Chrystia Freeland asks that question in the New Yorker this week, and comes back with answers we’ve all heard before: in short, it’s not the policies, it’s the rhetoric.
Of course, this doesn’t stand up to scrutiny; it never did. If the rhetoric is getting overheated on either side, it’s definitely on the side of Obama’s opponents, rather than Obama himself. Chrystia finds multiple violations of Godwin’s law, not among foaming-at-the-mouth Tea Party types, but even from cosmopolitan financiers:
Some of the harshest language of this election cycle has come from the super-rich. Comparing Hitler and Obama, as Cooperman did last year at the CNBC conference, is something of a meme. In 2010, the private-equity billionaire Stephen Schwarzman, of the Blackstone Group, compared the President’s as yet unsuccessful effort to eliminate some of the preferential tax treatment his sector receives to Hitler’s invasion of Poland. After Cooperman made his Hitler comment, he has said, his wife called him a “schmuck.” But he couldn’t resist repeating the analogy when we spoke in May of this year. “You know, the largest and greatest country in the free world put a forty-seven-year-old guy that never worked a day in his life and made him in charge of the free world,” Cooperman said. “Not totally different from taking Adolf Hitler in Germany and making him in charge of Germany because people were economically dissatisfied. Now, Obama’s not Hitler. I don’t even mean to say anything like that. But it is a question that the dissatisfaction of the populace was so great that they were willing to take a chance on an untested individual.”
There’s a limit to how far you can go asking people to justify their Hitler analogies, so Chrystia asks Cooperman about his “never worked a day in his life” comment. It turns out that by “working”, Cooper means that Obama “never made payroll. He’s never built anything”. In other words, this is very much the Romney version of the great-men-of-history worldview: one where a handful of visionary builders use their skills to create jobs for the masses and wealth for themselves. Recall Nick Lemann, profiling Romney in last week’s New Yorker:
He talks to voters businessman to businessman, on the assumption that everybody either runs a business or wants to start one. Romney believes that if you drop the name of someone who has built a very successful company — Sam Walton, of Wal-Mart, or Ray Kroc, of McDonald’s — it will have the same effect as mentioning a sports hero.
If you’re the billionaire principal of a business you built yourself, then you are very likely to see the world through this lens — and as a result, you’re very likely to be very supportive of Romney’s candidacy. In that sense, it’s hardly a surprise that the Romney campaign, and its affiliated Super PACs, has raised more money than the Obama campaign: Romney, more than any presidential candidate in living memory, aligns himself completely with the views and interests of the 0.01%. And given how much discretionary cash the 0.01% has lying around, getting the support of that key group can give a candidate a serious fundraising advantage.
This, I think, is one third of the answer to the question of why billionaires feel victimized by Obama. In America’s two-party system, you’re given a simple choice: this guy, or the other guy. If you find yourself in wholehearted agreement with one of the two, then the other one becomes the enemy, the obstacle standing in the path leading your guy to the White House. And under the rule of the narcissism of small differences, everything which separates your guy from the other guy becomes a monstrosity to be fought at every turn, and a grievance to be nursed and rehearsed ad nauseam. (Liberals, in truth, are even better than conservatives at this kind of thing: just remember what they thought of Reagan, whose policies were not particularly to the right of Obama.)
You can’t ascribe all of the billionaires’ grievances back to Romney — after all, they predate his candidacy. But Leon Cooperman’s letter is dated November 2011; I don’t think it’s entirely a coincidence that it was written just as Romney’s InTrade odds of winning the Republican nomination had surged to about 70%. So I see something else going on here — the second third of the answer. And that’s the way that after the stock market rebounded sharply in 2009, financiers switched rapidly from Fear mode to Greed mode.
During the 2008 election, Obama received significantly more Wall Street money than McCain, for one very good reason: Wall Street trusted him and his egghead technocrat advisers to do whatever was necessary to prevent their world from imploding. And that’s exactly what they did. Geithner, Bernanke, Summers, and the rest of the Obama economic team threw everything they could at the markets: they were the liquidity provider of last resort, they took that role seriously, and they did exactly what was necessary to save the US — and, for that matter, the global — financial system. McCain, by contrast, never came across as being particularly competent on that front, treating the financial crisis more as an excuse for political stunts than as a serious existential threat.
After 2009, however, Wall Street felt that the crisis was over. Yes, unemployment was still unacceptably high, growth was unacceptably low, and the real economy was still struggling. But never mind that: Wall Street profits were enormous, corporate profits were hitting record highs, and bonus season was just around the corner. America’s financiers no longer needed Washington to save them from ruin; now all they wanted was for Washington to get out of the way, and to let them prosecute their profit-making strategies as aggressively as they wanted. And they were in no mood for gentle reminders from Washington that if it wasn’t for the public sector they’d all have been wiped out.
It’s notable that all of the 0.01% moaning about Obama in Chrystia’s piece are financiers of one stripe or another. The financial sector was the first to rebound out of the crisis, and in many ways is the sector of the economy least exposed to the plight of the 47%. Hedge fund managers like Leon Cooperman don’t make their money from little people; indeed, it’s quite amazing how rich you need to be before people like Cooperman think you actually have money. For instance, Cooperman tells Chrystia, of a cardiologist friend of his who has accumulated some $10 million in savings, that “it was shocking how tight he was going to be in retirement”, especially since “he needed four hundred thousand dollars a year to live on”.
Which brings me to the final third of the answer to the question of why America’s billionaires are feeling so victimized: I think that in fact most of them simply don’t. Most billionaires are not financiers — and you don’t see Mark Zuckerberg or Mike Bloomberg or Larry Page kvetching about how Obama hates them. Neither do you see a lot of old money (the Waltons, the Mars family) pouring money into Super PACs. They might be conservative; they’ll almost certainly vote for Romney. But they’re not airing grievances in the way that Chrystia’s financiers are doing. The rhetoric that Chrystia is picking up on started I think with Jamie Dimon, and then spread around his environs; but it’s not particularly contagious outside Wall Street circles.
Financiers are among the most alpha of all billionaires, the most aggressive, the most attuned to the idea that no matter how rich you are, if you’re not making money then you’re losing. And from a purely tactical perspective it makes all the sense in the world for them to go on the offensive against Obama. After all, they might have it good now, but they’d have it even better under Romney, and at the margin the more they move public opinion in their direction — and especially the opinion of the 535 members of the public who sit in Congress — the better off they are.
So my feeling is that the sense of victimization is one part narcissism, one part greed, and one part tactical. It’s not a very pretty sight, and it’s not very easy to feel particularly righteous about. Which is one reason that people like Anthony Scaramucci — an early high-profile Romney supporter — set up echo-chamber dinners where such feelings can be stroked and reinforced. What’s depressing is that the likes of Al Gore and Antonio Villaraigosa are happy to attend those dinners, and provide little if any pushback.