Healthcare Rights, Ethics and Debates

July 24, 2009

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.

Washington’s Honest Man

July 21, 2009

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.

Defining Excessive Speculation

July 14, 2009

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.

Another Reason Oil Prices Are Falling?

July 10, 2009

Last August, economist Robert McCullough examined the volatility in the crude oil market surrounding the price spike on July 3, 2008 and the subsequent fall in energy prices.  In his final report McCullough examined the many events and announcements that had the potential to impact oil prices over this period.  He found that fundamental factors of supply and demand were not statistically significant, but found (on page 13 of the pdf):

The proxy for the short-lived Commodity Markets Transparency and Accountability Act of 2008 was highly significant. Interestingly, this was the only variable that would have affected excess speculation as opposed to supply and demand fundamentals…. One conclusion to be drawn from these statistics is that the news stories cited by pundits to explain the dramatic spike in oil prices have little or no explanatory power.

In other words, the prospect of regulation of the futures markets had a statistically significant impact on prices.   Let’s fast forward to the steep drop in crude this month.  While there’s certainly been negative news on the economy, we had some negative news at various points while oil doubled from February.  It is at least worth noting that the recent drop in oil coincided with a period in which Washington is seriously considering constraints on excess speculation in the energy markets. 

To the degree that excess speculation is a factor in artificially inflating oil prices, it needs a constant inflow of new money to sustain those prices, just like a Ponzi scheme needs new funds to keep the game going.  It’s hard to imagine money managers continuing to commit capital to commodities at the risk that they might be forced to liquidate if position limits are imposed.

Wal-Mart, Healthcare and Large Cap Outperformance

July 8, 2009

Wal-Mart made headlines last week by endorsing proposals in Washington that mandate employer-provided health insurance.  Fox New’s Elizabeth MacDonald does a good job analyzing the retail giant’s motives in her blog post and identifies competitive advantages that Wal-Mart would enjoy if this coverage were legally required.  In essence, because Wal-Mart already covers many employees and has the pricing power of an enormous company, new universal mandates are more crippling to its competitors.  MacDonald also argues that, by stepping forward now, Wal-Mart ensures a seat at the political table in shaping the legislation, ensuring that the law will be relatively beneficial to the company.

Wal-Mart’s action are a good example of the way that large companies, with their deep pockets and legions of lobbyists, can influence new regulations and legislation to their advantage at the expense of smaller competitors.  The more regulation created, the more the potential for this type of mischief.  This is not to pass judgment on the merits of the issue, but only to observe how large corporations can influence legislation in their favor better than smaller companies, and the more regulation, the greater the potential advantage.

It follows that a period of rising regulation can also be a period of relative advantage for large companies.  I’ve written before that investors should expect large cap outperformanceover the next few years.  The regulatory advantage is no doubt only a secondary or tertiary factor; I’ve tried to test relative large cap performance versus rising regulatory burdens (using proxies like the growth in pages of the Federal Register) and get inconclusive results as there are more important factors.  Nonetheless, logic and anecdotal support this view, and the Wal-Mart/healthcare episode is but one more example.

Certainly, large caps are putting in an unusually strong relative performance for this point in the investment cycle.  Below is the chart, illustrating the long term trends — a rising line in the upper panel indicates large cap outperformance.  Clearly the pronounced trend of  small-cap outperformance since the end of the technology bubble broke in 2006.  Since that time, there has been no pronounced broad capitalization advantage. 

Large vs Small: August 87 through June 09

Large vs Small: August 87 through June 09

It is interesting to note that small caps typically have strong outperformance as cash is being put back into the market after a downturn.  Cash flooding the market simply moves the price of smaller, less liquid companies more than that of larger ones.  This year, the historical pattern has not held true.  Reuters reported recently that cash levels are back to levels not seen since 2007 , and yet small caps performed essentially in line with large caps.  This suggests that there is underlying relative weakness in the small cap segment.  Although low interest rates may continue to drive cash levels lower, investors seeking yield are going to be biased towards bonds anyway.  Clearly the good news for small cap in terms of investment cash flows into equities is now largely in the past.   Superior liquidity, lower perceived risk, higher dividend yields, better ability to exploit emerging market demand, more access to credit, and yes, greater influence in shaping regulation, all point to the possibility of a long-term trend favoring large-cap stocks.

Disclosure: neither the author nor his clients have direct ownership of Wal-Mart stock.  Clients of the author’s firm may own Wal-Mart through discretionary accounts managed by third-parties.

More on the Wheat/Crude Oil Connection

July 6, 2009

Apparently the Senate report of excessive speculation in the wheat market has moved (discussed in this post last week).   All 247 pages of it can now be found here.

Going through the report, one of the footnotes briefly references an op-ed of mine that appeared in the Boston Globe last August and can be found here.

It’s interesting to see the Senate report touch upon the crude oil/wheat connection — the authors are absolutely right to see linkage.  That connection is the fact that we are treating contract markets (whether exchange trades futures or OTC swaps) as if they were capital markets.  These markets were designed with different ends in mind (contract markets are designed for risk transference, while capital markets are designed for investment), and require different rules of governance.  

Whenever I write about the need for regulatory reform in these markets, I get some responses accusing me of everything from gross ignorance of the commodity markets to Marxism.  The need for reform is consistent with broad free-market beliefs, but recognizes that those markets need governance (not necessarily governmental) to protect their integrity.  In the capital markets, everyone accepts the need for prohibitions against front-running customer orders or trading on inside information.  Contract markets need rules, too, (e.g., speculative position limits) and while these rules differ from those that govern investment markets, we should accept that they are no less critical.

The Greening of Corporate America

July 5, 2009

We’ve all seen the new image ads of various corporations claiming to be leading the charge in making the world a better place.  We create better regulation and market governance if we remind ourselves that public corporations are inherently amoral (but not immoral) entities. Their mission is to make profits for their shareholders, not clean up the earth; any social or environmental benefits are either part of a profit-seeking strategy or ancillary benefits.  The folks at “The Onion” lampoon the many coporations that proclaim, “we’re all environmentalists now.”

Guest Post: Insight into the Baltic Dry Freight Index

July 1, 2009

I’ve written before about the Baltic Dry Freight Index as a leading indicator of commodity prices.  I’ve updated the chart of the BDI (dashed line) versus the CRB Commodity Index (solid bars) for the last six months:

Baltic Dry Freight Index (BDI) versus CRB Commodity Index

Baltic Dry Freight Index (BDI) versus CRB Commodity Index

The BDI has become the “darling” of many market forecasters.  However, it is one thing to argue the narrow case of a  relationship between the index and commodity prices (which are increasingly determined by Chinese activity), and quite another to conclude, as many forecasters do, that the BDI is a good early indicator of broad economic acitivity. 

One of the problems with all that chatter about the BDI is that most of the commentators are financial markets professionals who can run a regression.  In other words, people like me.  That is, people who know very little about actual shipping.   Fortunately, I have a friend, Jim Grubbs, who knows a lot about shipping, and kindly agreed to let me share his thoughts as a guest post.  Jim Grubbs is President of JLG Associates, a firm providing strategic consulting services to shipowners and shipping financiers.  He was formerly a Managing Director and Head of Corporate Finance for Citigroup’s Global Shipping Division.  In total he has 35 years of experience in the shipping industry.  His comments and response to my questions:

 I know a fair amount about the supply side of the BDI – the fleet of dry bulk ships.  I know much less about the demand side.  My impression is that there probably is a fair case to be made for corrolation between global GDP and the BDI in the long run, but that market dislocations can screw up this relationship for discrete periods of time, and I believe we are in one of those periods now.  For instance, at present there is an over-supply of dry bulk ships brought about by the excesses of the past several years.  (Think floating real estate).  There is also a large orderbook, most of which will be delivered over the next two years.  Thus I think it is fair to say that the supply side sucks.

Notwithstanding, the BDI has more than doubled in the past few months from a very low level.  In my view, the three main reasons are China, China and China.  The Chinese are locked into a negotiating war on iron ore pricing from their two major suppliers – Brazil and Australia.  Because of this, they have been playing one off against the other and are also ordering from non-traditional suppliers, causing a shift in trading patterns that results in a temporarily greater tonne-mile demand for ships.  In addition, they appear to be buying physical commodities as a hedge against the dollar, again creating short term demand for ships.  The combination of these two factors has overtaxed China’s port capacity, resulting in long periods of demurrage with ships anchoring offshore for days or weeks until there is a berth where they can unload.

If you believe, as I do, that a) the Chinese will eventually hammer the Brazilians into a price they can live with and will resume their normal purchasing patterns; b) there is a finite amount of storage capacity in Chinese ports for iron ore and other commodities and, in any case, there are better ways to hedge against the dollar; and c) once these two things sort themselves out the port congestion will clear up, then you might expect the BDI to head south rather dramatically over the next 6 months or so.

I would like to think that the recent  rise in commodity prices concurrent with the rise in the BDI is a sign of green shoots in emerging nations that might lead to a global recovery, but I can’t wrap my mind around the developing world (with the exception of China) having enough domestic demand to make this happen.  If they can’t export their finished goods, I don’t know that they can sustain their demand for commodities and keep the prices up.  At this point, there are few signs that export recovery is underway – as evidenced by the fact that container shipments to the OECD continue to plummet.  Sorry to be gloomy, but I think we have still not turned the corner economically, although things seem to be getting worse at a slower pace. — Jim Grubbs

Many thanks to Jim for lending his expertise and experience to this blog! — Jeff K.

Why Crude Oil Traders Should Care About Wheat

June 30, 2009

Last week the Senate released a report that concluded that non-commercial participants, particularly index speculators have been disrupting the wheat futures market (for those not inclined to read the 247-page report, there’s a good summary in this BusinessWeek article).   The term, “index speculators,” refers to that new breed of market participant that treats commdodities as buy-and-hold investments rather than as short-term trading vehicles.   Index speculators are often people and institutions one would not associate with speculation — endowments and pensions, for example.  They generally have bought into the notion that a basket of commodities (or commodity futures) is a legitimate investment asset class; this is a view I dispute — I know of no other “investments” where the inherent value can only be realized in the consumption and destruction of the asset.

The wheat report highlights one of the dangers of “overspeculated” futures markets, a condition where non-commercial interests so outnumber commercial participants that the relationship between cash and futures prices (the “basis”) breaks down.  An erratic basis in a commodity futures contract is more than a mere curiosity: it can mean that the futures markets no longer offer reliable risk mangement tools for producers and users.  It’s worth remembering that these markets were never intended to serve investors, but were chartered from the begining to serve the commercial commodity industry.   Dramatic shifts in the basis can also cause severe financial problems for commercial hedgers who must meet margin calls. 

A spike in the cotton basis in March of last year was devastating for that industry.  I’ve often thought that the cotton problem was the “canary in the coal mine,” warning us of dangers ahead.  Wheat going down the same path is troubling indeed.  From the standpoint of greatest economic risk, one must wonder whether crude oil is also heading in this direction.  If crude oil is “overspeculated,” there’s a particular vulnerability given the geopolitical risks that can crop up with oil.  My sense is that much of the oil in storage is part of a cash/futures arbitrage play which means, as I believe happened with cotton, a sudden influx of futures buying would have no natural constraints, sending futures prices soaring.  With the central role energy prices play in the economy and the heavy participation in the crude oil markets by our wounded financial companies, a price disruption of this nature could have far reaching consequences.

Last year there was a great debate about the role of index and other speculators in disrupting commodity prices.  Unfortunately, too much of this debate centered on the oil industry, not only one of the deepest markets, but also one of the most opaque.   It’s simply hard to get the data needed to see the risks in crude.  Looking at smaller markets like cotton, it is easier to grasp that treating commodity futures as investment assets can cause grave problems.  Although the debate is still tainted by politics, it’s good to see that these dangers are getting the recognition they deserve.

Industrial Policy at Calpers?

June 29, 2009

The current edition of “Barrons” carried an interview with Joe Dear, the head of Calpers (California Public Employees’ Retirement System), the largest public pension in the United States.   Calpers behavior is often an important bellweather, as both the size and activist bent of the fund has made it an industry leader.   I may be making too much of this, but if I were a participant in the plan, I’d certainly want clarification of this comment from Dear:

Whether venture capital really helps in a portfolio of our size is an open question. The one mitigating factor is, because the California pension fund is in the home of the high-technology industry, you want to be making moves that, after we consider the investment return, also help the state with respect to the growth of the economy here.

Does Dear believe it is the pension fund’s responsibility to subsidize the venture capital industry even if not fully justified on the investment merits?  Does he believe that Calpers has a special responsibility to support California businesses?

 It’s a curious comment, and perhaps one made without much thought.  However, it makes one wonder whether an element of politics has entered the investment management of the fund.  Our financial crisis has taught us that the ethic of fiduciary responsibility has eroded in many areas — let’s hope not in the pension arena.