Innovation and Commodification

There are fights going on in the banking industry right now that I want to rant^H^H^H^H call attention to. They are issues that most people probably don't know or care about, and yet they will affect our collective quality of life directly.

What do credit cards, mortgages, and over-the-counter (OTC) derivatives have in common? They are all products that are non-uniform - that is, each bank gets to make each product individually.

Defenders of deregulation would argue that the freedom to innovate in any way the banks can imagine is good for all of us, because the innovation leads to efficiency.

Despite having been raised by liberal socialists, I am sympathetic to this argument. I work in a highly deregulated industry (IT/computer tech) and would be at best grumpy if anyone told me how I could go about writing X-Plane.

But is that really the right analogy? I submit that banks don't fear the end of innovation - they fear the beginning of commodification, and we have a perfect analogy in the PC industry.

The computer hardware industry is, to put it bluntly, brutally competitive. It's not an easy part of the industry to make money in. Every year a PC sells for less money, but does more. Poor companies like Dell and HP are caught in the middle of that.

Okay - who are we kidding? No one is crying a river for HP or Dell, but being able to buy a laptop for under $500 is pretty awesome. There is no question that, from a price performance standpoint, whatever economic force is holding HP and Dell (and all of the other manufacturers) feet to the fire is yielding real dividends to consumers.

I believe that the force driving the price of PC hardware down is: commodification. Simply put, all PC hardware is like all other PC hardware. For any given product category, the ways a manufacturer can "innovate" is limited by the implicit rules of the PC ecosystem.

• RAM & Hard Drive: you can increase capacity, decrease latency. But you can't go changing around how the part fits onto the motherboard.
• CPU: you can increase the number of cores, you can increase speed. But you can't change what types of computer programs it runs.
• Graphics card: you can increase how many triangles you can draw. You can increase how much detail you can draw per pixel. But you have to do this via a standard interface.

When the specifications of a product become limited, it can be commodified - produced the same way by multiple manufacturers. Purchasers can easily change between suppliers, which puts intense competitive pressure on manufacturers to compete on the "commodified" axes (that is, the official ways commodities are measured).*

So let's take this back to banking. Look at things the banking lobby hates:

• "Plain vanilla" pre-approved consumer products. This would be direct commodification of anything in the consumer market. When the only thing banks can compete on is interest rate, interest rates are going to get driven down about as low as they can go. (The loss will come out of the banks margin on the product.) It's understandable why they don't like that.

• OTC vs. Exchange Traded Derivatives. This is complicated enough to warrant another blog post, but basically a derivative sold on an exchange is a standardized, commodified derivative, and the companies "manufacturing" the derivatives for trade make only the thinnest margin on large volume.

  By comparison an OTC derivative (a custom derivative made by a big bank for a company - think of it as getting a car designed from scratch instead of just going out and buying a Honda) is sold by one bank . There aren't any comparable derivatives to even check the price against! Which product do you think is more profitable?

Commodification is appropriate when we can quantify exactly how we want to select our products. Commodified memory works because we can standardize all but two variables: size and price. For a given class of memory, we can then buy the cheapest chips.

Could we do that for financial products? Yes! I reject the claim that exotic mortgages are useful for some class of buyers with special needs. If this were true, they would not have become the standard financing vehicle for several years. I think we know what most people want from a mortgage:

• Low up front costs
• Low monthly payment
• Low interest rate

In other words, when it comes to a mortgage, there is really only one variable: price. If that isn't a product waiting to be commoditized, I don't know what is.

If there is a single idea I want to leave you with, it's this: different kinds of innovation are good for different parties, and commodification channels that innovation into avenues that are good for the purchasers of a product. There is nothing anti-competitive about commodification. In fact, I would argue that it is anti-competitive not to have commodification.

Banks like the current system because they can offer products just different enough, just confusing enough, just opaque enough that consumers can't direct purchasing power toward the competitor who provides the best deal. Commodification would make these products transparent, and would make the market more efficient.

In a commodified world, banks would have to innovate, but they'd have to innovate on how to get us the best price on a mortgage, not on how to hide the fees in the hardest-to-find places.

* I would be remiss if I were to pretend that this always works out well. Five years ago, the commodity for CPUs was clock speed, rather than throughput, and the result was the market producing CPUs that ran very fast, but got very little done as they ran.

Is It My Turn Yet?

NAR wants us all to beg congress for an extension to the first time home-buyer's tax credit. That sounds good to me, but I wanted to punch up the text a little bit. Here's my version of the letter.

Dear ________,
I am writing to express my strong support for Congress to extend the $8,000 first-time homebuyer tax credit through 2010.

Throughout this financial crisis, there has been one consistent, clear, and very American policy: if you did something really stupid in the last decade, whether it involved making non-competitive cars that no one wants or designing financial instruments that would lose most of their value while paying hefty bonuses to bankers, congress will bail you out, and the tax payer will fund it. Should housing be any different?

Reports show that home sales to first-time homebuyers increased by 25% in 2009 and now account for 50% of all sales. In addition, the tax credit is reducing the inventory of foreclosures that are sitting on the market, helping our neighborhoods and communities recover. Like the big banks, us home buyers did some really, really dumb things over the last few years, and this government-provided bail-out is helping us "recover" from our mistakes by making future, similar mistakes cheaper.

While I believe the market has improved, I do not think it has fully corrected itself. In order for that to happen, we will have to reach similar levels of bad lending policies (NINJA anyone?) and delusional optimism that housing prices only go up. While this level of psychotic optimism has been hard to find in today's difficult economy, the best way to assure continued housing activity is to extend and expand the credit and to do that NOW. Nothing says "do whatever you want, we'll pay for your mistakes" quite like a government back-stop on bad investments.

We can't wait until late in the year to see what happens. It might turn out that houses aren't worth as much as we paid for them in 2006.
Sincerely,
_______

Now where's the bail-out for grumpy-coffee-drinking-work-at-home-computer-programmers-whose-pets-are-running-around-the-house-like-animals?

Bob Vila would not eat meat by-products (but your dog should!)

I went to a talk by a veterinary nutritionist yesterday at Tufts Vet for Obesity Awareness Day. Her talk was really educational. For instance, I learned that the body that regulates pet food nutrition, content, etc. is called AAFCO (Association of American Feed Control Officials). They seem to be a lot less stringent than FDA regulating human food. Anybody can make a pet food and put it on the market, regardless of whether it meets your pet’s nutritional needs. Moreover, pet food does NOT have to be tested in feeding trials to go on the market. Why does this matter? Well, our pets generally have only one or two sources of food – whatever we feed them on a daily basis (compared to people, who eat a variety of different foods and obtain different nutrients from each one). Our pets cannot synthesize certain vitamins and amino acids, so it is important that their food provide these.

The label will tell you whether or not it’s been tested. Definitely buy one that has been tested. How will you know? Read the labels. Here is how to interpret:

TESTED wording (example): “Animal feeding tests according to AAFCO procedures substantiate that…”

NON-TESTED wording (example): This food has been formulated to meet AAFCO standards…”

Key point here: “formulated to meet” = “HAS NOT BEEN TESTED”

When buying a pet food you also need to look for the words “complete and balanced” on the label. That means the food meets all your pet’s nutritional needs.

Wording (example): “Animal feeding tests according to AAFCO procedures substantiate that XYZ food provides complete and balanced nutrition…”

If the food is appropriate for puppies/kittens, it will say, “provides nutrition for growth of puppies/kittens,” and for adults it will say, “for maintenance of adult dogs/cats.” Foods can be appropriate for both youth and adult stages. But some foods are only for one or the other.

Wording (example): “Animal feeding tests according to AAFCO procedures substantiate that XYZ food provides complete and balanced nutrition for growth of puppies and maintenance of adult dogs…”

The only marketing claim word that means anything on a pet food label is “natural.” So “organic” is just a marketing term. Which is of course the opposite of people food, where “natural” is meaningless and “organic” has to be backed up.

Don’t worry about buying the fanciest food for Fido. More expensive or prettier packaging does not necessarily equal better nutrition. Just make sure the food has undergone AAFCO feeding trials and provides for all your pet’s nutritional needs: “Complete and balanced” – just like FOX News!

Leaving DC

Lori has already relocated to Boston - once W was gone, there was just no reason for her to stay.

Well, after watching this I realized that I have to get out of DC too. Actually, Canada's looking pretty nice.

Edit: this will help wash away the icky feeling you get from watching Glenn Beck fans.

Houses and Finance

You might have thought that my mad rants on finance were totally unrelated to a housing blog. But...it turns out that housing and finance do intersect, in some ways that have turned out to be pretty unfortunate for home-owners.

There are a few financial bloggers who I really like - Mike Konczal is one of them. He wrote a series of guest posts on the The baseline Scenario (another really good finance blog) that are of interest to home-owners who might be asking the question: "how did Wall-Street-style price-insanity infect my local neighborhood?"

The Limits of Arbitrage. This is an idea that has also been explored for stocks, but the basic idea is that if enough people lose their minds and start buying up the price of an asset, it may be impossible for sane, well-informed people to bet against them, making money while forcing the price down. There can be two reasons why people can't "bet against" the bubble:

1. There is no good way to make the bet. For example, if I believe houses are going up, I buy a house. But if I think houses are going to crash, it's a lot harder. If I don't already own a home, I can't sell a house.

   Since I can buy 2, 3, or 4 houses if I want, but I can only sell what I already own (1 house for most home owners) it's a lot easier to make the bet that houses are going up than going down.

2. If you borrow money to bet against an asset, you can go very, very broke. The problem is this: if you bet against asset X, you lose money every time asset X gains money. Your lender isn't going to lend you money once you've lost more than your own share. Put it together and a large enough rise in asset X means you're broke.

   For example: Google is at $100 and I think it's going down. I have $1000 and I borrow another $1000 and short (bet against the stock). I now am short 20 shares. If Google doubles in price to $200 then my initial $1000 only covers half of those shares. At about this time the bank is going to ask me to unwind the trade and give them back their money, because if things get any more out of hands, I won't be able to pay the bank back at all.

   Of course, this sucks for me - if Google later crashes down to $10, I'll never see my money - the bank forced me to sell at the worst time because I ran out of credit! Why does this matter? It matters because people can use credit to bet that an asset will go up. If they can't use credit to bet that an asset will go down (without risking the bank pulling the rug out from under them) then the amount of money betting on a rise (amplified by borrowing) will dwarf the bets on a fall, and the people betting on the price going down won't be able to "hold down" the price.

Phew. So what does this mean for houses and stocks? It means that even if smart, clever people could have predicted the bubble (some did, it remain arguable if enough did to make a difference) those smart people might not be able to keep prices sane because of structural problems with the markets. The only thing you can do is get out of the asset class entirely while the bubble goes by and wait for things to calm down. This is possible for stocks but more difficult for houses.

Prepayment. Mike is a financial engineer, so his articles can get technical, but I think prepayment is worth looking at. Cynics like me might accuse the banks of speculating on rising housing prices when they wrote all of these lame loans, but how do you make the link?

In The Giant Pool of Money NPR financial reporters explore the idea that with low interest rates and a lot of international capital, there was a huge desire for mortgage debt. In Infectious Greed Partnoy argues that often derivatives were sold to clients who didn't know what the hell they were doing.

So you can put together an argument and say "oh - the banks made subprime loans because hedge funds, insurance companies, pension funds, and other pools of money wanted the derivatives that come from subprime loans, and were too stupid to see the risk." But this doesn't explain a strange market inversion, where sub-prime mortgages were in higher demand than prime mortgages, creating incentives for brokers to push them. (A broker might make a higher fee on a subprime loan, but only because the originator set things up that way - e.g. the broker gets paid more for subprime if the originating bank wants that loan...why does the bank want a subprime mortgage?)

Here Mike suggests an answer: the prepayment penalty in a sub-prime mortage changes the very nature of what a mortgage is. One of the weird features of prime (normal) mortgages is prepayment. Owners pre-pay when interest rates fall (making a re-fi a good idea). This really sucks for the lender. If I offered you a CD that has a 5 year term but will drop to a 1 year term only if interest rates fall, would you accept it? Heck no!

(If I understand my financial engineering, mortgages have "negative convexity". Basically the longer a loan, the more its value changes with interest rates. But a mortgage's time span goes down when interest rates fall due to prepayment. So a mortgage is a loan whose duration is longer when interest rates are going up. Since a loan's value (to the lender) is inversely proportional to interest rates, this is about as bad as it gets: a loan that changes its value a lot when its value falls but only a little bit when its value goes up. If this seems totally one-sided, it is...this one-sided lender-is-hosed pricing comes directly out of the one-sided nature of pre-payment. Prepayment is heads-I-win-tails-you-lose, with the winnings for the borrower and losses to the lender.)

But if you can soak your borrower with a 4% penalty every time they prepay and encourage the borrower not to run the mortgage to its full 30 year duration (by having horribly high floating interest rates after the first few years) well....now we have something. We have a mortgage without this "negative convexity".

There's only one problem: it's a subprime mortgage - we might not get our money back. And now we can connect the dots. To the lender, a subprime mortgage has less interest rate risk but higher credit risk. And the credit risk of a mortgage has everything to do with housing prices. Ergo: the subprime mortgage as a speculative instrument exposing banks to rising real-estate prices.

(Of course we can see the problem now: as a way to speculate on housing increases, a subprime mortgage is a bit like selling a put option - you make a little money when you win but lose a lot when you lose. In the case of the mortgage, the most you make is the higher interest and prepayment penalties. The most you lose is a huge chunk of the mortgage. Which is exactly what has happened.)

More Brain-Melting Pet Photos

In "The Truth About Dogs", Steven Budiansky makes the case that dogs are essentially a successful parasite. Harsh? Perhaps, but his argument provides a lot of insight into the human-pet relationship.

A successful parasite is one that takes advantage of a mechanism in the host that the host cannot live without. (If the host could live without the mechanism, the selection pressure from the cost of the parasite would slowly extinguish the required mechanism.)

Pets fit this criteria - they get us 30-somethings with our ticking biological clocks that have been snoozed for year after a year to devote our important resources (read: food) to pets instead of our own offspring. Fortunately pet food is pretty cheap. It's a good thing the pets don't have a taste for filet mignon.

I think Lori and I may be infected: we can spend hours babbling about how good the pets are and how sleepy they get. Perhaps the parasitic infection is melting our brains?

Anyway, what follows can be thought of as a chronic condition.

I am in your office paying your billz! Can haz stamps?

Corporate-espionage-kitteh is stealin your secretz.

(Without our kodez u is 2 yearz behind us. With our kodez u is 4 yearz behind us!)

Warning: absurdly cute.

I can haz kitteh?

Apartment-kat sez: upstairz neighbor is makin too much noize!

O hai...big sister, you is good pillow.

Mixed Messages About Flying Under the Influence

When we bought the house 3 years ago it came with this totally awesome biplane made entirely out of Coors Light beer cans. I find it simultaneously wonderful and revolting.

I am very tempted to send it to Austin as a house warming gift...