This afternoon MarketWatch published an article I wrote that applies the classic game theory problem of “The Prisoners’ Dilemma” to Wall Street’s bonus culture. Read the article here.
Archive for the ‘Regulatory concerns’ Category
Saturday’s Wall Street Journal carried a story (subscription required) on the potential for proposed new CFTC rules to restrict issuance of shares of commodity ETFs. The withdrawal of earlier grants of rule exemptions has already led certain ETFs to suspend new share issuance. As the Journal story notes, this has driven UNG, the natural gas ETF, to trade to a 16% premium to net asset value.
There is clearly an increased focus at the CFTC in protecting market integrity through he imposition of position limits, rules which restrict the amount of interest in a market for any non-commercial entity. To date, most of the truly effective ways of implementing this (e.g., extending the restrictions to the OTC swap market and international regulatory coordination) are still on the drawing board. However, if the CFTC does move forward in this direction there will be significant investment implications.
While the Wall Street Journal focused on the loss of investment opportunities, this is not necessarily so. From a trading perspective, demand for a commodity ETF whose new issuance has become restricted might offer existing shareholders the opportunity for valuation expansion similar to what has already happened with UNG. But such premiums are fickle and fleeting. Investors with long memories may recall the spectacular valuation expansion of the closed-end Germany fund whose market price soared to double its net asset value in early 1990 in the wake of the fall of the Berlin Wall. Then, as likely now, such premiums are unsustainable as lookalike products flood the market with new supply, or investors assess the risks created by such premiums. For ETFs this is particularly problematic, since one of the key selling points of this structure is the elimination of discount/premium valuation worries.
The most likely long-term outcome of any robust CFTC position limits will be a reevaluation of the entire commodity-as-asset-class story at both the retail and institutional levels. As noted in an earlier post, this has always been a suspect concept, more a creation of Wall Street’s salesmanship than reality. Those same product pushers are likely to rediscover that which has always been true — certain commodity related equities offer similar or superior portfolio characteristics to the underlying commodities.
In this regulatory scenario, we may well witness a surge of interest in commodity related equities, assuming of course that the bullish case for commodity prices (primarily emerging market demand and weak dollar) remains intact. Morgan Stanley already created an index of 20 commodity related equities: AA, ABX, ADM, APA, APC, BHI, BHP, CAG, DVN, FCX, GG, HES, IP, MRO, NEM, POT, SLB, TSN, WY, X. Such names may benefit not only from generic interest in commodity related equities, but from specific products, yet-to-be-created, that are linked to this or similar indices.
Interest in energy-linked stocks both on individual merit and as part of packaged index vehicles may well lead the way. Contrary to the claims of the marketers of futures-linked product, energy stock indices correlate well to energy prices, provided you use the right index, such as the Dow Jones U.S. Oil Equipment, Services & Distribution Index. Another index that correlates well to energy prices, the Dow Jones U.S. Oil & Gas Producers Index already has an ETF (the i-Share, ticker IEO).
Strict CFTC limits will indeed close off some avenues for investors. Those funds have been sitting in markets ill-designed for such purposes (see the dangers of this here). However, this will also open the door for inflows into appropriate vehicles in the equity markets, which were designed for just such investments. Investors who can look beyond any new restrictions will recognize some new opportunities.
Disclaimer: neither the author nor his clients have any direct positions in the securities mentioned in this piece. Both may or may not indirectly hold these securities through third-party managers.
In a recent post, I alluded to the need to have a meaningful public debate about healthcare choices in America. Unfortunately, I think that opportunity has now been lost as what could have been an opportunity to forge a national consensus has devolved into a shouting match with our polcymaking class eagerly jockeying for political gain. So goes Washington…
In our financial planning practice we often talk with clients about “playing the movie” of what happens at their death. I’m generally a little less diplomatic and go with the “let’s say you’re hit by a bus…” approach. Either way, while the focus is on estate planning, it also gets into end-of-life choices. While this is an important to discussion to have, I’m not sure it should government-sponsored in the way that some of the House bills propose. Depending on which side of the shouting match you’re on, this element of the healthcare debate is either about empowerment and dignity or the promotion of a death culture.
So what’s the good outcome? This end-of-life discussion has renewed interest in “Soylent Green,” a 1973 movie with Charlton Heston and Edward G. Robinson, in which the government facilitates suicide of the elderly as a population control method. The whole movie was a great reflection of the zeitgeist of the 1970s — Malthusian visions of limitations, starvation and an environmentally decimated Earth. As 36 years have passed since its release, we’re now much closer to movie’s 2022 setting, and I’m happy to report that the screenwriters dismal vision of the future is not on track! I have not seen the movie since being a teenager, but it has always stuck with me, particularly the haunting demise of Edward G. Robinson’s character, Sol. Courtesy of the healthcare debate, you can now find this scene on YouTube:
Last week Popular Mechanics published a fascinating interview with Dean Kamen. While most people associate Kamen with the (frankly odd) Segway, most of his inventions are in the medical device field. He makes the very good point that, when healthcare costs are viewed over time, it becomes apparent that the route to cheaper and more productive care is through innovation. High costs today are, in part, investments in less expensive treatments down the road. In the current parlance, our existing system already “bends the curve” for a given illness. His analysis certainly doesn’t resolve the debate, but is worthwhile perspective and very worthwhile reading.
IMPORTANT UPDATE (8/7/9 10:30 a.m.) — Please see the comments of my reader “David – NC” below. He caught the error in my calculations and is absolutely correct. The breakeven for a reasonable tradeoff (an 18 mpg clunker turned in for a 28 mpg new vehicle) is 89,090 miles not the 17,640 miles I incorrectly stated. Even under my flawed numbers, the program made little sense from a conservation standpoint — given David’s proper numbers, the cash for clunkers program clearly has no conservation benefits. Thank you David.
There’s been a tremendous amount of press discussing the “cash for clunkers” program. Although ostensibly an economic stimulus measure, proponents of the plan also argue that replacing old, less fuel-efficient vehicles with newer models will enhance energy conservation. In an op-ed in yesterday’s Washington Post, author Gwen Ottinger points out some of the fallacies in the “new is greener” rationale, e.g., confusing efficiency with consumption in appliances, or not taking into account the energy used in the manufacture of the new good.
Although I regard the economic rationale with suspicion, the conservation argument is at least worth examining. That is, even if it doesn’t make economic sense, is there some social good (energy conservation) that is served? The core issue is the amount of energy used in the manufacture of a new automobile and whether that is offset by added fuel efficiency. There are so many variables and assumptions here, that a rough estimate is as good as any. I came across a website with two different estimates for the amount of fuel used in the manufacture of an automobile and its component parts. Perusing the internet, the higher number, 42 barrels of oil, seems to be making the rounds as an accepted estimate. The methodology on these numbers looks a little problematic, but if you assume an oil price of $70/barrel, that means that the energy component of the cost of an average car is $2,940, which seems in the right ballpark relative to the overall cost of the car.
Assuming the 42 barrel number, this equates to 1,764 gallons. Making a further assumption (not correct, but probably accurate enough) that we can use 1:1 equivalency between oil and gasoline, we can ask at what point does the energy conserved through higher fuel efficiency of a new vehicle offset the energy used in the manufacture of that vehicle. Assuming a 10 mpg efficiency difference between the clunker and the new car, the energy usage breakeven is achieved at 17,640 miles.
Based on average driving rates, this suggests that a conservation break-even point is reached at about 18 months, and after that there are net gains in fuel conserved. However, there is a major flaw with this reasoning — it assumes that 1) the old clunker and the new car will be driven equal amounts, are 2) that the clunker will go on forever. A quick perusal of the list of car models being turned in suggests the problems with this argument. Most of the clunker cars are 10-15 years old and presumably have 100,000 to 200,000 miles on them. In a 2+car family, these are probably not the car you take on the long trip, for fuel efficiency let alone the reliability at that age — I would guess that these clunkers are currently driven only half as much as the average car. Moreover, cars of that age are in their final years anyway and would have been replaced within a few years. This added overlay of real world considerations suggests that, in reality, there is no meaningful conservation gain in the cash-for-clunkers program.
Today’s Wall Street Journal features a misguided editorial blasting the CFTC for considering constraints on oil speculation. The piece serves as a good reminder of how often those schooled only in the stock and bond world misunderstand the function of the futures market and the role of speculators within that arena. The Journal’s editors and others are trying to apply the rules of those capital markets to contract markets like commodity futures. This makes no more sense than trying to play a game of baseball by the rules of football. In real life, as in the sports analogy, playing by the wrong rules leads to chaotic consequences.
Misconception #1: who should determine price? In the capital markets, speculators and investors determine the price of securities. This is not the way the commodity futures markets are supposed to operate. Commodities are consumables, not investment vehicles. Economic efficiency demands that the price be determined by those that produce or use these resources. The role of the speculator in price discovery should only be on the margin, testing the limits to see when commercial demand or supply enters the market. Speculators in these markets should not be the primary determinants of price.
“Overspeculation” or “excessive speculation” exists when speculators become primary drivers of price. When this happens, commodities are no longer efficiently allocated — if prices are driven below the point where commercial supply and demand meet, shortages result. When prices are driven to excessively high levels, economically wasteful inventory buildup is created; Nobel laureate Paul Krugman recently reversed his opinion on the impact of speculation, pointing to huge oil stores as evidence that oil prices have been artificially inflated. More dire consequences also can be the result of these price distortions, including unnecessary and economically damaging price volatility and even the potential for a systemic crisis in the oil industry and it financiers.
Misconception #2: We need all this speculation for liquidity. The commodity futures markets absolutely need a healthy amount of speculation to bridge the gap between commercial interests who may not be in the market at the identical time. But just like any powerful medicine, an overdose causes more harm than good. Speculation is good only up to the point where speculation becomes the main determinant of price.
There has been a great amount of confusion between volume, open-interest and liquidity. Traditional speculators are short-term traders who are indifferent to being long or short the market — such volume indeed creates liquidity. Much of the problem has been created by the new breed of non-commercial participant, particularly the commodity indexed funds which are long term holders and are overwhelmingly oriented to the long side of the market. They represent not liquidity, but a big fat bid, which actually drains liquidity from the markets by crowding out long commercial interests.
Misconception #3: Investors need unconstrained access to the commodity markets to protect against inflation. The idea that commodities are the only inflation hedge available to investors has been heavily promoted by those that profit from selling commodity-linked products. This is simply a myth promulgated by Wall Street marketing departments. As I’ve written about before, investors have very real, and possibly superior, alternatives, from TIPS to commodity linked equities.
Misconception #4: Position limits are an abridgement of free market rights. The confusion of capital markets with contract markets comes into play here. The imposition of constraints on non-commercial participation is not about heavy-handed regulation, but about appropriate market governance. In the capital markets, I know of nobody who complains about rules against front-running, touting or insider trading. Those are rules designed to protect the integrity of capital markets. Contract markets like futures exchanges need rules to protect their integrity as well. It’s just that different markets require different types of rules. In the futures markets, integrity implies that commercial interests determine price, and this requires governance that restrains non-commercial participants. Speculative position limits are one of the time-tested ways to ensure this critical integrity.
Informed people of good will can argue whether the markets are indeed “overspeculated” at this point. We can reasonably debate whether position limits are the appropriate response, or whether whole different types of governance are needed. One can perhaps even argue whether the risks of overspeculation to the economy should be balanced against the risks to Wall Street profits from curtailing their activities. However, those that argue that the futures markets should play by the rules of the capital markets merely reveal their ignorance.
I have written very little about the healthcare debate because I do not consider myself sufficiently informed to add much value. However, I’ve seen others make some valuable contributions, which are worth sharing. In last weekend’s NY Times, bio-ethicist Pete Singer brings some honesty to the debate, in his opinion piece, “Why We Must Ration Health Care” (free registration may be required). The thought that more patients could be served at lower cost without rationing is simply beyond belief to me — there simply aren’t enough inefficiencies to wring out of the system, and if there are, political intervention usually isn’t a very effective means of eliminating them. This is just common sense. Reducing health costs will involve rationing, but this is not necessarily a bad thing, just a realistic assessment. The question really is how that rationing should occur, and whether this should be done by government, private business sector or individual choice.
The appropriate role for government is at least partially dependent on whether health care should be regarded as a right. This blog has many European readers who may take for granted that health care is a universal right. However, this is by no means a consensus opinion in the United States. A good friend in California city government told me about battles over cable television access in his town — many residents regarded affordable cable as a “right.” In some ways, health care seems closer to the right to cable than, say, rights like freedom of speech or freedom of religion. After all, rights to healthcare ultimately mean rights to someone else’s time, money or expertise… not exactly “unalienable rights.” I came across an opinion piece from Congressman John Campbell, a Republican out of California that attempts to wrestle with some of these issues; yes, it’s a political piece, and I know nothing about Campbell and his other views, but I think he tackles these issues in a common-sense, intelligent way.
None of this is to negate the need for an intelligent U.S. healthcare policy. As medical technology continues to improve, it’s likely that we’ll see more applications that provide limited returns for large costs — some kind of rationing, led my government effort, may well be desirable. Whether healthcare is a right, a critical part of a social safety net, a middle class entitlement, or none of these, is all a matter of debate as well. The key word here is “debate.” These are weighty issues that deserve more thought, time and public input than we’ve given. The argument that, “if we don’t act quickly, we won’t ever have a solution” is highly unsatisfactory. It may be that we’ve had no solution in the past because either there is no real consensus on the tradeoffs, or the proposed policies are worse than the current realities. I, for one, am happy to see the healthcare debate move along a slower path.
My father used to do professional arbitration as a sideline of his law practice. He taught me a terrific lesson from this experience: “You generally know that you’ve gotten a fair outcome when both sides are equally unhappy with you.” I’m reminded of this wisdom when I see the spotlight being placed on the Congressional Budget Office (CBO) and their assessment of the financial consequences of healthcare reform. The CBO is the traditional whipping boy for whichever party is in power and is trying to drive a fiscal agenda. Over time, the CBO seems to do a good job of making each political party equally unhappy, so, on this basis alone, has probably been a pretty fair and honest servant of the public. The current administration, to its credit, has so far not been excessively critical of the CBO, despite the fact the the Office has been delivering some very bad news in terms of the effectiveness and costs of the major health care proposals.
We’re fortunate to have Doug Elmendorf as the Director of the CBO. I knew Doug in college and followed his work at the Brookings Institute — he’s a highly regarded economist and is carrying on the tradition of independence in his office. I only just realized that the CBO has a “Director’s Blog,” authored by Elendorf and his team. The blog is an invaluable resource for getting plain language, objective summaries of the CBO’s analysis of major policy proposals. This was started by Elmendorf’s predecessor, Peter Orszag, now director of the Office of Management and Budget (OMB). The OMB now has a blog as well, courtesy of Orszag, but this is a much more political office and makes no pretense to objectivity.
While Orszag deserves credit for starting these blogs, the CBO blog, with its greater objectivity, is of much more interest. I’ve added the CBO blog link to my list of sites of interest for “Overspeculation, Regulation, and Economic Policy.” Everyone who cares about the future of the U.S. should read Elmendorf’s post from last week, “The Long-Term Budget Outlook.” The opening sentence of the post:
Under current law, the federal budget is on an unsustainable path, because federal debt will continue to grow much faster than the economy over the long run.
Sometimes honesty is painful.
The Commodity Exchange Act was passed in 1936. The legislation mandates that regulators prohibit “excessive speculation,” but never defines the term. In the current public debate about the role of speculation, there’s been some understandable unease as we all should feel discomfort at the thought of prohibiting any transactions in a free market system. It’s important to move towards a definition of “excessive speculation” if our policymakers are going to comply with existing law properly and if we are going to have functioning commodity markets.
It should be understood that “speculation” in the commodity world is a specific, technical term which has no ethical connotations. Speculation is simply those transactions entered into by entities with no legitimate commercial interest in the underlying commodity (or related commodity – e.g., an airline might legitimately hedge jet fuel costs with heating oil futures). The university endomwent manager making a permanent allocation to a commodity index is just as much a “speculator” as the day trader trying to make a quick buck in pork bellies. In other words, if you’re not a bona fide hedger, by definition you’re a speculator.
The introduction of OTC commodity swap contracts puts a slight twist on this definition. Wall Street’s swap desks are essentially “pass through” entities — if a swap desk is offsetting risks underwritten to a legitimate hedger, then their futures positions should be viewed as hedge positions; conversely if they are offsetting risks to say, an indexed endowment or to a commodity ETF, these should be considered non-commerical, speculative positions. The swap industry has tried to argue that every position they take is a hedge for some contract they’ve written — to my thinking this is an intellectually dishonest argument; the key factor is the commodity exposure of the end client, not the intermediary.
So just when is speculation “excessive”? In theory, the price of futures and derivatives should be a reflection of physical market pricing. That is, the price of consumable, commercial goods should be set by the consumers and users of such commodities. This makes good economic sense for allocating resources. The activities of non-commercial futures and OTC derivatives market participants should not determine the pricing. The reality has always been more complex — traditional speculators have served to bridge the momentary lack of a match of commercial interests (i.e., buyers and sellers not coming together at the exact time), and in doing so, set a market price. Speculators have also served to push the boundaries, finding out where commercials will enter the market, thus performing a price discovery role. However, in each of these traditional roles, commercial interests are “in the drivers seat” and the prime, long-term actor in setting price.
A good definition of “excessive speculation” is the market condition where non-commercial interests set the price. This occurs when speculative interests dwarf commercial volume and crowd out commercial transactions at a given price. The textbook belief is that this can never happen on the assumption that commodity prices are extraneous to derivatives market activity, and that there is an infinite supply of capital on both side of the market. Under such a theoretical system, when long speculators push up the price above the “true” level, for example, an adequate number of shorts will come in to stabilize prices. This is clearly an idealized and inaccurate set of assumptions as there is no known “true” price, speculative capital is not infinite, nor is it now neutral (many new entrants, e.g., institutions indexing, have a long bias). In the real world, speculation can be excessive.
Many commodity markets today display symptoms of excessive speculation. The breakdown of the basis (relation between physical and futures prices) and lack of convergence (cash and futures prices aligned at time of delivery) in certain agricultural commodities, the unusually high corellation with financial assets, and the huge buildup in oil inventories all bear witness to prices being distorted by non-commercial interests. The Wall Street firms that have profited from promoting and facilitating this participation are steadfastly denying the obvious evidence — they know that the simple recognition of this excessive speculation would compel regulators to act.
The crafters of the Commodity Exchange Act were right to worry about excessive speculation. When commodity prices are distorted by speculators, we all bear the economic burden – prices set too low cause disruptive shortages, those set too high result in wasteful inventory buildup. Distorted prices can send the wrong signal to the Federal Reserve and to investors. Erratic basis and convergence can financially ruin commercial participants and render the markets commercially unusable. The United States built up a huge competitive advantage in credible commodity exchanges — all this could be lost, too.
There are few higher economic callings for our regulators than ensuring the integrity of our financial markets. The policymakers of 1936 understood the dangers in “excessive speculation.” The CFTC begins public hearings on rules designed to protect against just this danger today. Let’s hope they get it right.