I Love the Wok

Three thoughts on cooking:

1. All prep must be done before cooking starts, and all shopping before prep. Exposing food to air or heat starts fundamental changes that cannot be stopped once they begin. Especially once heat is introduced, you're on the clock!
2. It is obvious that too much heat can ruin a dish. Less obvious, but equally important: too little heat can ruin a dish. (Consider that too little heat means too much time in the cooking medium, which can be a problem whether it's air, water, or oil.)
3. Non-stick is a specialty pan, not a default.
   

The wok combines all three of these, and then some!

More Absurd Pet Pictures

Some more absurdly cute dog and kitten pictures...a few notes:

• I do not pose them like this!  They just get in these positions on their own.
• It's mostly the kitten's idea - that is, the dog usually lies down first, then the kitten finds her and joins in.
• Where the dog has her legs around the kitten, this is not duress - the kitten just sleeps through it.

They pretty much do this every day...

You so STU-PIIIIIIIIID!

Other shoes keep dropping as the credit crisis unfolds, but this one is really impressive:

Beginning in 1999, the Turnpike Authority entered into complex arrangements - known as credit swaps - with three investment banks as a means of raising cash to pay off rising Big Dig debt. Essentially, the banks paid the Turnpike Authority cash for the right to swap interest rates with the agency on future debt payments. The deals, while immediately raising $71.5 million in cash for the agency, left it vulnerable to fluctuations in interest rates.

So the Turnpike insured banks against interest rate changes?  Why would they do something like that?  They have no counter hedge.  Perhaps the Turnpike Authority has a death wish - an insatiable appetite for risk that can only be filled by taking outsized bets on global financial conditions.  (Or, as Bostonians might speculate, perhaps the Turnpike Authority is run by morons.) 

Wait...I've heard this before...the choice of a known quantity or some unknown that might be better, but maybe not...why does this seem familiar?  Oh yes!

Kuni: Ahhh, red snapper. Mmmmm, very tasty. Okay, Weaver, listen carefully. You can hold on to your red snapper...[Hiro-San emerges, carrying a table with a box]...or you can go for what's in the box that Hiro-San is bringing down the aisle right now!!! What's it gonna be? [Phyllis Weaver decides between the Red Snapper and the box. The audience points to the box]

Phyllis Weaver: I'll take the box. The box! [the audience applauds]

Kuni: You took the box! Let's see what's in the box! [Hiro-san opens the box, and the audience gasps: the box is completely empty!] Nothing! Absolutely nothing! STUPID! You so STU-PIIIIIIIIIIID!

The Bloody Mary Approach

The Treasury Department has realized that the best cure for a hangover is...more binge drinking!

I was going to write a snarky blog post arguing about how that the government should bail me out instead of GM or CitiGroup.  But why am I against this plan?

If Treasury buys mortgages with the goal of bringing down rates, they are essentially subsidizing the price of housing.  Given that low interest rates inducing an overheated housing market is exactly what induced this mess, it seems like a step backward.

You can't undo the past.  We all collectively made a bunch of bad decisions about our homes based on temporarily distorted pricing information.  (This podcast has a pretty good explanation of what the implication for money is on our buying binge.)  Life can return to normal only once home prices make sense.

During the boom, plenty of homes we didn't need were built, because prices were artificially high.  If we prop up interest rates, two things happen, neither of which are good:

1. We subsidize overproduction.  That's wasted economic activity.
2. We pay the opportunity cost.  Buying down mortgage rates has no upside for the larger economy or tax payers.  At least with Citi we get a dividend.

The truth is that I'm being over-dramatic.  Housing prices are probably going to go below their eventual clearing level, since buyers are irrationally petrified of buying before the bottom and risk premiums on everything are through the roof.  

My issue here is the same as TARP - how do you set the level of arbitrary government intervention when there isn't shared success.  When we were going to buy toxic waste, the risk was that we overpay or underpay - only one of the banks or tax payers could win.  Here we have the same problem - based on the interest rates we pick, one of home buyers or tax payers will win.

There is one proposal I have seen that at least hopes to address the fundamental problem with the housing market: "property appreciation rights" (PARs).  Basically the idea is to allow home borrowers to sell their upside housing market risk to lenders.

Whoa.  That's a huge change in how houses are priced, and one that we should not take lightly. It has the potential to destroy the middle class and the American dream.

But housing has changed since 1978 - houses now price like stocks - they fluctuate.  It isn't appropriate for individual Americans to own that kind of risk exposure.  If I called my bank and said "I would like to borrow $400,000 so I can speculate in the stock market -- in fact, I am going to buy just one stock, I'll put in $20,000 of my money, and you can have a lean on the stock as collateral", well, I don't think my bank would say yes.  But if I say the exact same thing with a house rather than stock, I'm off to the races, and now I am leveraged 20:1 into a completely non-diversified real-estate position.

PARs would break the asymmetric risk we face today, where home owners get the upside of the housing market and lenders get the downside.  When the market eventually corrects, what we'll see is a tightening of credit as the market adjusts to the fact that home prices can fall.  (With a stock, you can margin about 50%.  Can you imagine having to put 50% down on your home?)  In some ways this whole mess was created by incorrect risk premiums - high leverage positions on homes based on the assumptions that the old rules apply...rules from before MBSs and CDOs and Reagen-era (leveraged) finance.

Under the PAR scheme someone (Government, business, whomever) can go in and refinance a pile of houses at cheap rates.  The up-side for the entity providing the money is the rights on future appreciation, which is the incentive for the borrower to "get of the respirator" and switch to traditional financing as soon as it's possible.  Without this, we have heads-I-win, tails-you-lose, which didn't work out very well last time around.

Turning Crimson

So apparently Harvard's going to take a hit in the economic crisis.  Having put international exposure into my 401k (and watched it get killed) I suppose it is reassuring to know that the best and the brightest got hit the same way.

But wait -- first, these guys had a 23% ROI for 2007.  A 30% hit isn't much fun, but it's only rolling the clock back about 18 months.

But wait -- why are we even asking these questions?  If you are into emerging markets, your time horizon should be really long and your tolerance for volatility should be really high.  I've got this stuff in my 401k - it's about 33 years too soon to be asking the question "how'd we do"? Harvard's been doing this for a long time, and probably isn't looking to liquidate the endowment and cash out any time soon.

If there's a point to this rant it is only this: we (investors) seem to have become obsessed with whether stocks have gone up or down over short term periods (one year, five years, or worse, even months and days).  Have we all forgotten what a stock is?  A stock is a claim on future cash flow from now to the end of all time.  Stocks exhibit enormous volatility and reasonably good long term returns.  If we care about how the market moves, we may not be in the market for the right reasons.

Economics Isn't Science

So first, this clip is just fun to watch.  I have said before that perhaps the best indicator for how to invest is to do the opposite of whatever the talking heads on CNBC are saying to do.

(And I do have to call out the left wing media where it is full of crap -- the idiotic boosterism being put out on these shows is not particularly "right wing" and this is not a right-wing media issue or a Fox News issue...this is a Wall Street industry issue.  Heck, I've heard both Democrats and Republicans try to blame each other for the current financial mess - I don't buy a word of it. For a blow up of this magnitude, everyone has to screw up at once.)

But while Peter Schiff did seem to call the crash correctly, I don't think that his proposed solution is a very good idea (even though he is right about borrowing money to live beyond our means). His idea is to cut government spending, and the fact that he thinks that this is a good idea reveals a major ideological divide within economics between the Keynesians and the Friedmanites.  (These schools of thought do often correspond with left wing and right wing politics...so from a political perspective, Schiff's economics are conservative, or more accurately perhaps libertarian.)

The Keynesians would point out that as everyone braces for a recession, demand is going to fall, and demand falling will cause supply to fall, causing a feedback loop.  I know I might get laid off, so I stop buying corn flakes...now the guy who works at General Mills gets laid off and stops buying X-Plane and now I am laid off - because I prepared for that event - a self fulfilling prophecy.  The Keynesians say that in this circumstance it is important for governments to spend money to help break the feedback loop.

The Friedmanites would argue that efficient economic activity cannot resume until prices have normalized - in order for us to have real growth, we can't have incorrectly priced (too expensive) houses, etc.  Therefore the best thing the government can do is get the hell out of the way, let prices fall until they make some sense, and only then can we get back to having a productive economy -- until that point, investment will be going in the wrong places and be wasted investment, hurting our long term future growth.

The problem is that the Keynesians and Friedmanites, while both probably at least partially correct, have completely opposite prescriptions about what to do.  You can't really do both. And we can't do an experiment where we try both separately to see which advice works better. This is why no one can agree on which theory might be correct (or at least more correct): we can't do the experiment to disprove the theory.*

How do we reconcile these?  Benoit Mandelbrot points out that market pricing isn't the stable equilibrium we think it is - free market prices simply go completely nuts sometimes.  Behavior Economists are starting to explore why this might happen, but one thing is clear: prices sort themselves out eventually, but in the interim they can show periods of extreme weirdness.

So I would say that in looking at housing prices, government policy has to consider both sides of the economic coin:

• Housing prices may become very wrong for periods of time.  We saw our houses become very highly overvalued.  I believe they will swing the opposite way and become highly undervalued.  Buyers have a lot of (partly irrational) fear of buying before we "hit bottom"; this means that the bottom of housing prices will be lower than their natural support level and will then bounce back up, as buyers refuse to buy until they see the bottom.
• On the other hand, houses do need to eventually hit a sane level - there is no other way to have a functioning economy.  No policy that preserves housing prices as they were can make any sense.  (We don't need any more houses - any policy that artificially raises the price of houses and causes more to be built is wasting investment and hurting future useful economic growth that should be happening in other areas.)

I don't think there can be a really good solution to the housing problem, because the only real solution would be to go back in time and stop people from making a number of poor decisions based on incorrect pricing and incorrect assumptions.  But the money has been spent, the houses have been built, and we're stuck where we are.  So all we can do is be pragmatic and try to make the situation as not-bad as possible with very limited tools and a lot of constraints.

* Being a congenital left-winger I am more sympathetic to Keynesian than Friedmanite theory...in particular my complaint is this: because in Friedmanite thinking a central bank fundamentally screws up economic equilibrium, Friedmanites will be able to blame the Federal Reserve for all ills, even if Friedmanite policy is enacted, thus their theory can never be proven wrong by actually trying it.  That is, unless we get rid of the Federal Reserve.

Haggling

I've posted a lot about the roads, because they're one of the first things a Westerner notices in India. (India's driving surpasses China's -- the Chinese stop at red lights.) Before I can really describe some of the other things that happened to us, I need to describe India's pricing system and haggling.

Basically in India, every price is negotiated - imagine that everything is priced like cars in the US. Some goods have an MSRP, which would be the price you should never pay because it's way too high, but most goods are entirely unlabeled (the store has no indication of potential price). The only things that we did not haggle for were restaurant bills and plane tickets. (We even ended up in an argument about what to pay for a metered cab, but that's another story.)

To further complicate things, the merchant can make a pretty good guess about how much money you might based on how you look. Being white, Lori and I scream money to an Indian merchant - whether we're from the US or Western Europe makes no real difference. But our friends in India (who are Indian, but look like they are upper class, with white collar jobs) have the same issue: they go into the negotiation with a handicap. The implications of what it means to have money in India (whether you live there or as a tourist) are complicated enough that I'll devote a separate blog post to them.

Our friend Tanmay has a good rule of thumb: whatever price they offer you, counter with about 1/4 of what they are asking. We had trouble pushing that low, but we were usually able to ask for about 1/3. What we actually paid varied by the situation, was virtually always too high compared to local prices, but was usually a good deal compared to US prices.

A lot of the time I enjoyed haggling, but I think this is because I could haggle while it was novel, then go home to the US and price shop online...having to haggle every day would wear me out, and there were definitely times when we thought "oy, we have to haggle now."

There are some cases of fixed price shopping, but they are invariably expensive by local standards. In some cases it's worth saving the hassle. For example, at a lot of tourist sites, people will offer to be a guide. How much do you pay for this? With strong negotiation you might get a very good price. At some sites the guide rate is posted -- the rate is invariably higher than you would pay if you were a local who could haggle, but it is usually lower than you would pay if you are a foreign tourist who isn't used to pushing on prices all the time.

(For example, the guide rate at many Rajasthani monuments is 100 rp, which is about $2. Guides making $2 for a 30-60 minute tour are doing very well for themselves by Indian standards, but if you're an American you're going to have a lot of trouble getting much below 100 rp, and even if you did, is it worth having an extended haggling session before each monument to save 50 cents?)

I realized a few things about shopping while in India:

• I really don't know what most things should cost...I am used to getting my pricing information from the context of the store dong the selling.
• To shop for negotiated items, you really need to be an expert at what you're buying...there are only a few items that I could really haggle for if I wanted to. Our friend Pooja told us that if you want to make a large purchase in India, you need to rely on a web of trust - that is, friends who know more about the material, and merchants with whom you have some relationship.

My favorite haggling moment was when I managed to get under the skin of the manager of a tourist gift shop at a hotel part-way to Jaipur.  Our driver was having lunch and Lori was browsing the gift shop, trying to haggle down the price of a small purse.  I got into an extended discussion about pricing of flash memory for cameras with the manager, and then sprung my proposal: to trade a card that I had (incorrect for my camera) for another, less valuable card. He would owe me about 300-400 rp, but I was willing to make the trade for only 100.

The manager had no desire to take my second-hand flash card (even though it was in plastic), but I kept working on him, pointing out what a great deal it was, until finally I got under his skin enough that he yelled "No Buying!  Only Selling!"  Having been driven nuts by people trying to sell us tourist crap we didn't want for the previous four days, it was a small victory.

Eventually my rantings about the economy and state of finance and my India posts will end up merging, but that can wait a few more days. There's still a lot more to write about! (I did get the camera off-loaded today, so I will try to post some pics soon...we took 764 pics and movies...)

7.4 Trillion Is Not That Much

In a past post I suggested that $700 billion is not that big of a number when compared to the usual cost of bail-outs relative to GDP.

People are now suggesting that we're at $7 trillion +.  That's a big number, but I think it's a "nominal" number, like when people talk about $47 trillion of derivatives.*  Bloomberg has this nice interactive chart showing who has committed what.

Now 7 trillion is a big number, but a lot of that money isn't going to actually get spent.  For example, 4.4 trillion comes from the Federal Reserve, which is guaranteeing low-risk things like commercial paper and money market funds that aren't really at risk in the first place.  To understand how much of this money we might really lose, we need to look at:

• Panic money: investors are so freaked out that they don't even think the sky is blue anymore...money is earmarked in the unlikely event that the sky is green and investors calm down.  Since the sky is in fact not green, I don't think we have to worry about this money going anywhere.
• Screw-up money: companies made really bad investments, and Uncle Sam is guaranteeing them to prop the institution up.  This is where we could really get in trouble, but no one really knows by how much.  Most of this spending is under Treasury, bailing out CitiGroup, AIG, Fanny Mae, etc.

Even if we ignore the panic money and only look at screw-up money, it's still a lot.  As a final thought on this: we have an immovable object (massive spending) pushing the dollar down and an irresistible force (fear) pushing the dollar up (via a flight-to-safety).  I suspect that when the dust settles, we'll lose our fear but still owe a few trillion in bail-outs, and that's going to make for a rough time for the dollar.

The "Lonely Planet" Problem

Lori and I are in Goa now - Palolem, to be more precise, and we are again seeing the "Lonely Planet" problem. (It's really not a problem for us here, but the principle still holds.) The Lonely Planet problem is this: when the clever folks at Lonely Planet find some wonderful undiscovered nook in India and write about it, approximately a gajillion tourists all go there and discover that the nook is now no longer undiscovered. Doh!

We first hit this in Jaisalmer with camel safaris. The Sam sand dune became overrun with tourists, so people started going off the beaten path to Khurie. Now Khurie is crowded too - we didn't find that out until we were in Jaisalmer - it's hard to plan everything by remote, but we were able to set up a safari using Ganesh Travels. (They're in Lonely Planet too...)

Palolem is one of the southernmost beach villages in Goa - it's a beautiful beach, maybe 1/4 to 1/2 mile long, with two roads nearby filled with a combination of shops and restaurants and some hotels. Near the beach are thatched huts, which provide the lowest comfort (but probably also lowest environmental footprint) lodging. The lonely planet issue is: Palolem used to be an escape from tourists, but now it is just another tourist beach village.

That's okay with me though; seeing seven cities in ten days was exhausting, and the pace in Goa is a lot slower - it's not crowded like Rajasthan, Mumbai or Delhi. After all the traveling, a few days on the beach is just about right.

Why Did the Cow Cross the Road?

Well, the answer is: it didn't; cows actually have excellent lane discipline -- they tend to go where they are going and not change directions too much. (Goats are much lses predictable.) And it's a good thing, because cities in Rajasthan are pretty much filled with livestock.

If the first thing an American notices in India is the driving, the second thing is the presence of animals everywhere. Cows are simply left to roam free range - both wtihin the city limits and outside; while driving between cities we had to stop several times to let a shephard and his goats cross. There is something very surreal about the whole experience.

The Rajasthani forts are very impressive - they are like the Grand Canyon, I think, in that they are so big and imposing that even if you've seen a lot of pictures, the real thing is awe inspiring due to shear size and improbable location.

As helpful as the Internet is in planning a trip like this, it is difficult to understand the "situation on the ground" without being here - I will try to write up some travel tips once I get back, so that perhaps others who are trying to use Google to plan a trip can have a slightly better picture of what to expect.

Greetings From Udaipur

As I sit down to write this, an elephant just walked down the street past this cyber-cafe. Now that is remarkable for two reasons: first, it was an elephant, for crying out loud. We have seen lots of dogs, goats, and mainly cows in the roads, but this is the first elephantwe've seen go by. Second, the streets here are very, very narrow, so getting an elephant (or a car) down one of these streets is no small matter.

We read an article in the paper on the flight from Mumbai to Udaipur where a Russian dignitary described Indian drivers as "very skilled" - and they are - in that they navigate a road network without any kind of lanes, street signs, or anything else to direct traffic. The first reaction any American has coming to an Indian city (Mumbai and Udaipur have both been like this) is that it is truly a crazy driving situation. Driving here makes China look safe and boring and the beltway look like the Queen's tea.

With that in mind, Udaipur is an amazing city - the palaces are all fantastic - I'm not quite sure what to say about them. The city itself looks quite idealic from across the lake in the evening. The streets of the old city are a bit daunting - narrow, crammed with people and shops and cows and motorcycles and rickshaws...to an American, it is a constant assault on the senses. Fortunately we started in Mumbai with our friends, which helped a lot. Compared to Mumbai, Udaipur is not so crowded, and our friends live in Mumbai and were able to give us a lot of situational awareness.

As we travel around India, I am constantly reminded of China - while they are very different, they are perhaps more like each other than either is like America. The density and crush of people, the buildings, often packed so close together, often barely standing. I will have to describe Mumbai in a separate post - it is its own beast.

A final note: it is heartening that everyone here knows Obama. :-) It is great to have a president that I do not have to be embarrassed about when traveling.

New Chandelier

Lori's parents were in town last week, and as always, did some really wonderful work on the house. Here is our old chandelier, which came with the house. If it looks sort of cheap, that's not because of the picture.



Lori's dad in action!



CC is alwys helpful, particularly when there are heavy things, electricity, and ladders.



The new chandelier:

Warning: Extreme Cuteness Follows

After their morning hyperactivity and bad behavior, CC and Nublet like to snuggle. They both get very sleepy!

1% Money

...And interest rates have been cut again.

Hrm...

• 1998. Asian currency crisis. Rate cut. Dot com bubble.
• 2001. 9/11. Rate cut. Housing Bubble.
• 2008. Sub-prime crisis. Rate cut. ______ bubble.

Wish I knew what _____ is...buy in now, sell before the curve gets vertical.

Asset Bubbles, Cheap Money, and Leverage

Ami sent me an article about how the big banks are not re-loaning their TARP money to those in need. This doesn't surprise me, and it means the TARP money isn't expensive enough.

The whole idea of a capital injection is that it puts tax payers and banks on the same side. If we just buy toxic assets, banks that survive make a profit while we (taxpayers) have junk on our hands. If we buy equity in the bank and they are profitable, we get our money back and then some.

But our goal as tax payers is not to be speculators in distressed financial stock - it is to keep the banking system from melting down. So if a bank has enough money to go on a shopping spree with TARP, the "cost" of that equity isn't high enough. TARP bail-out money needs to be painful enough to existing equity holders that they'll use as little of it as they can.

I've done plenty of ranting about the various fire drills we've been through during the bail-out, but what about the bigger picture? Here's a thought: a return to "healthy" lending levels may not be healthy at all if our previous lending levels were way too high.

Right now the Fed is thinking about whether to further cut interest rates. Ignoring the important question of whether further rate cuts will do any useful short term good, I would suggest that too much capital isn't a useful thing. I am a fan of Mark Cuban's blog, and he says it better than I can in this post.

Cheap money means lower risk premiums, higher leverage, and it makes all sorts of great things possible:

• Leveraged Buy-Outs. (Is this really useful? Ask the employees of Linens N' Things.)
• High Leverage Ratios. (Worked well for Bear Sterns. Heck, it worked great for LTCM!)
• The Carry Trade.

At some point cheap capital doesn't cause us to work more efficiently, it causes us to spend more time playing games with cheap capital.

We've had an internet bubble, a housing bubble...is the way out of the mess really to lay the groundwork of another bubble?

ETFs for a Crazy Market

I like ETFs as a way to buy an index now (as opposed to an index mutual fund) for two reasons:

• The ETF market place appears to be very competitive - you'll find more funds with lower expense ratios. Last year when I went looking for bond funds Van Guard was the only one offering a truly low-cost bond index. A number of larger players are in the ETF space, forcing expense ratios down.
• When you buy an ETF, you get the price as soon as the transaction completes, which is to say, it's pretty close to what you want. When you buy a mutual fund, you put the order in during the day, the day closes, then the price recalculates, then maybe you eat the day's gain or loss. Normally this is a non-issue (and if you have a disciplined approach and simply buy mechanically at a set interval, then who cares). But if you are like me and have to make your buys by hand (I have a SEP-IRA, so no automatic anything) then there's really no reason to be eating a day's gain or loss in the internet age.

Of course, ETFs let you "trade" indices and I can't advocate that. If you want to gamble, you can at least get free drinks in Vegas.

Solar Bubble

I have heard people say that clean energy is the next bubble - over-investment in solar, etc. will cause a bust.

The thing is, bubbles have gotten a bad name, just because this one nearly destroyed the world economy.

Consider the dot-com bubble. Looking back we remember the idiotic stock prices for companies whose business plan was "take random consumer good X, grab 1% of the market via X.com, become bajillionaires", or better yet "lose money on every tranasaction, make it up in volume".

But there is another aspect to an investment bubble. A technology bubble simply means we have overshot and put too much capital to work on the new frontier, whether that be railroads, the internet, or solar panels.

One result of the mis-allocation of capital is chaos in the financial markets; if you look up bank panics on wikipedia, you'll see that what we have now is a period of relative calm compared to the second half of the 19th century, during which we have the bank panics of 1873, 1893, 1901, and 1907. One of the main cause of those first panics was massive overinvestment in railroads and the instability of stock prices linked to that sector. (Really rich people doing really naughty stuff is another cause.)

But another result is really cheap infrastructure! In the case of the 19th century, all the railroads you can eat and then some - in our case, really cheap fast internet. (You'll hear bloggers talk about "dark fiber" - that's fiber optic line put down during the dot-com bubble that still hasn't been used, waiting for someone to buy it at bottom dollar.)

The solar people are talking about reaching "grid parity" - that is, the day that solar becomes as cheap as fossil fuels. What would happen if we over-invest and they over shoot? Cheap solar panels for all! To me, this would not be a bad thing. A glut in production would help make solar significantly more competitive - we'd effectively have market-driven dumping of solar panels which would help drive a conversion to renewable energy (which I believe is in the long term very good for the US, and even the whole world).

The housing bubble is so destructive because we all depend on our houses having relatively constant value to keep our lives running. Sector bubbles are only destructive if:

• The sector long-term over-extends. This did not happen in the dot-com bubble. For about a year I had a lot of friends emailing me about work, but the surplus of software labor got mopped up surprisingly quickly. The investors were right about the growth of the web, just not exactly right.
• The asset price is tied to people's financial security.

On this second point, I see it like this: people's retirement security should not be tied to stocks, because stocks sometimes lose a ton of value very rapidly, and don't get it back for a long time. We used to say people should be 100% out of stocks by retirement age; then the 1982-2000 bull market tempted us with greed and complacency.

Food for thought: can you imagine what would have happened if we had gone through with Bush's (idiotic) plan to let people treat their social security taxes as a 401K (and invest it in stocks)?

• For one thing, a lot of that money would have flooded into the stock market, pushing up peak valuations significantly higher than the 14k dow* we saw.
• We would still have had the pull-back when the debt markets blew up. We would have just fallen a lot further.
• That would mean an even larger contraction in bank capital...it would have been this credit crisis on steroids. Would we have survived it?

If there are two lessons for retirement finance from this whole mess, I think it is this:

1. Given 50% of stocks held by those over 50 and the massive volatility in the market, I question whether it makes sense to give the average American more choice in how he or she allocates his or her retirement money. I'm all for freedom, but we have to ask: were we all better off when we got defined-benefit pensions? Have we just been tempted by the possibility of riches into accepting the risk of losing all of our retirement? When the market tanks, do a lot of people not say "thank God for social security"?
2. The financial industry is really good at taking our money....see all of the fees and other such rip-offs that go along with 401ks. The only winners of privatizing social security would have been the mutual funds that got to take 2% of our retirement money every year.

I realize there are serious philosophical questions here about personal and collective responsibility...a crisis like this makes us re-evaluate our principles. This is good! Our previous principles might not be wrong, but it's good to question them and think hard about them; the rules of the finance game are set by all of us to meet a greater good - they are not immutable laws of physics. We all need to think hard abou what kind of world we want to participate in creating.

* I don't think the dow is a very good measure of the stock market (and the stock market is not a very good indicator of much of anything, except for the current market price of stocks), but the numbers (14k, above 10k, below 10k) are easy to remember.

A New Member of the Family

It was only a matter of time before a kitten followed Lori home from the vet's office. This is "Nubblet".






Nubblet really, really likes to sleep on my laptop keyboard - perhaps because the MacBook Pro runs pretty hot and keeps her nice an warm.



I'm on TV!

$700 Billion is Not That Much

I admit to having ranted about the bailout and, in doing so, tossed around the number $700 billion like it is a really big number. And it is. It is more money than I have - roughly $700 billion more! But a few thoughts to put this in perspective:

• $700 billion is about 5% of GDP, at least by last year's numbers. That's not that expensive; the average banking system collapse usually costs a country 13-16% of GDP, depending on whose research you look at, and sometimes a lot more.
• The worse things get, the cheaper it becomes for us to bail banks out. This is the perverse nature of the world economy; because US Government debt is still considered the safest of the safe, every time the news gets worse (requiring more bailout money) the financing our government pays on bailout money gets even cheaper.
  

At one point the real return on T-bills went to zero - that is, people would loan the US government money for nothing! At that rate, we can afford to bailout the titanic with a bucket.

The scenario that scared me most about a year ago was that we would hit this crisis and a dollar crisis at the same time, and the fall of the dollar would make government financing very expensive. But that hasn't happened; this graph shows the Euro falling relative to the US dollar as things get worse. As much as people are worried that the US is in for some pain, they are more worried that Europe won't be able to apply the right medicine.

To quote Alex Bloomberg from "This American Life", the worse the US Government does, the more people want to loan us money. It's a strange, strange, strange world.

Let's Buy Us Some Banks

An apparent trend in the various bail-out plans in the US, UK, and Europe: whatever one country does, all of the other ones have to do. Ireland, for example, was one of the first to start guaranteeing all bank deposits, and their move started to pull cash away from the UK. In the end, every country will have to adopt the strongest safety net of any country to prevent a flight to safety.

It also looks like the US will actually buy some banks. This is a good thing for three reasons:

• How much do we pay for a toxic MBS? No one knows. There is no market for them. How much do you pay for a bank? That's easy, there is a stock price. (It's not real high, but it does exist.)
  
• If we are going to give the banks some money, what do we get in return? If we buy a piece of the bank, we get a piece of their profits should they survive. No taxation without representation, so to speak.
• The only way a bank gets more capital to invest when we buy an MBS is if we pay too much! (If we pay the amount they have "on the book", then the buy-out looks like a net change of zero for them.) So when we buy toxic assets we have to overpay or hurt the bank. By buying the bank itself, the bank can do better.

Of course, this sort of sucks for current bank management and current bank investors. We should not care! The bank lobby hates the idea of tax payers having equity, and that alone is an endorsement in my mind.

The bank lobby, in trying to claim that buying the banks is a bad idea, say that this would scare away outside private investment. George Soros, who is the kind of outside investor we need, disagrees:

http://www.ft.com/cms/s/0/d68e10cc-8f45-11dd-946c-0000779fd18c.html

And of course I reiterate what I've said before...besides the problem of over-paying for toxic assets and not knowing what to pay for toxic assets, the government shouldn't own mortgages that are in high default - too much political pressure to not liquidate the houses by foreclosing. I hate to be in favor of foreclosures, but there is no light at the end of the tunnel until we work the sub-prime crud out of our system - delaying that process only makes it hurt longer.

Other ranty points:

• McCain is crazy to want to lower corporate taxes - they just had record profits for years...why would they need lower taxes? Money doesn't grow on trees! They're not going to do more business with lower taxes, they're just going to pay less taxes.
  
• I can't tell what McCain plans to do about houses from his web site. The devil is in the details: buying mortgages at face value is a terrible idea - it's a cash give-away to banks, just like TARP if TARP buys assets. (It appears that TARP will let the treasury buy assets or equity.) Buying the mortgages at face value is a bail-out to banks with poor lending discipline and, by artificially propping up home prices, stops the market from clearing to sane price levels.

The government does need to provide mortgage financing at good interest rates to credit-worthy borrowers, but banks need to eat the loss on their loans.

Another Good Financial Podcast

There is very little media on finance that is both accessible to a general audience, and comprehensive and thorough in its reporting.

"This American Life" has done a second finance podcast, and it's pretty good: Another Frightening Show About the Economy, which is a follow-up to The Giant Pool of Money.

Thoughts on today's market melt-down:

1. The stock market has demonstrated clearly that it is ludicrously irrational. Who in their right mind liquidates their holdings when the Dow is down 400 points? (And yet clearly a lot of people thought that that was a good idea today...) A series of financial melt-downs (1987, 1998, 2000, etc.) have made academics question the idea that the market prices stocks efficiently. Hopefully today put the nail in the coffin of an academic model that was pure, simple, and pretty much wrong.
2. Stocks have to occasionally go nuclear. If they didn't, we'd all buy more of them (since they return more than bonds), driving the price up until the yield was the same as bonds. That extra money you get from a stock is payment for being first in line to be kicked in the nuts when things go bad. Occasional spectacular crashes have to be expected.
3. If these first two points seem to contradict each other (in point 1, I argue that markets are not efficiently priced, in point 2 I argue that they are), the contradiction comes from time. Over fairly short amounts of time, the markets can do just about anything. The kind of equilibrium of supply and demand that I describe in point 2 can easily be overwhelmed by massive panic, per point 1.
4. Finally, if you are young and thinking "this bail out is going to cost me", there is a silver lining...stocks have been overpriced, for a while now; the out-sized returns delivered from 1982 to 2000 are due to people being willing to pay more for stocks (and thus the value of stocks being driven up by increased demand). That kind of growth is not sustainable forever - think pyramid scheme. The end result of stock returns due to "demand growth" is overpriced stocks. Stocks have to fall in order to be able to return decent returns. (During the fall, as demand evaporates, stock prices will fall, producing negative returns, even if the economic fundamentals behind the underlying companies are solid.)

I heard a scary statistic on NPR: 50% of equities are owned by people over 50. (This may not be true after today...who knows.) Stocks can be a great investment vehicle for people with a long time horizon, but I fear that too many years of smooth sailing has caused us all to collectively forget just what a stock is and how it behaves.

Why I Thought TARP Was Bad

TARP (the "$700 billion bailout bill") is now dead, and the markets had their hissy fit, then bounced back, and are now continuing to be grumpy. I was going to write a "top ten reasons TARP is bad" blog, but that's water under the bridge. But I've had enough people ask me why I didn't like it, let me try to spell out my (highly convoluted) thinking.

My main concern with the entire process of congress trying to get behind a bailout bill is that it's not really clear what problem they're trying to solve. The way I look at it, we have four groups of beleaguered souls:

1. Home owners who are unable to pay due to the lack of refinancing. Home owners get in trouble if they either overpaid for the house and don't have equity (which means they aren't eligible for a loan large enough to refinance) or their credit isn't adequate in the current climate.
2. Banks that, due to making poor investments (read: mortgages and their derived products) are no longer solvent.
3. Companies unrelated to the housing market who are unable to get financing (short or long term) to do business because of problems in the more mundane parts of the credit markets.
4. Everyone else (let's call them "tax payers") who have seen the value of all of their savings depleted due to a weak dollar. (This group is not usually mentioned as part of the crisis, but I think it is long to leave them out...the dollar has been severely bruised over the last few years, and the treasury spending half a trillion dollars or more is only going to make it worse. Tax payers lose twice - in the taxes they pay and in the value that is inflated away.

Groups 1 and 2 are fundamentally at odds with each other - every bit of relief granted to home owners makes insolvent banks that much worse off, and vice versa...either the home owners pay up (somehow) and the banks' mortgages are good, or they don't and they're not.

I believe that different action is required to address different problems. My issue with the treasury plan is that I don't see any scenario where buying things helps a lot. (That is actually not true - it's close to true though.)

If the treasuy buys distressed assets, then the question is "at what price". If the price is high, this helps solvency (if the toxic waste is worth what the banks thought it was, they're not insolvent), but the tax payers take it on the nose. The government's only alterantive would be to somehow force home owners to pay up - I don't see any way they can do this...it would be water from a rock.

If the price is too low, then this is good for home owners (because the treasury can pass the savings on to the home owners by writing down the mortgage and refinancing) but it just locks in bank insolvency.

If there were some kind of middle ground, then theoretically the treasury could do both. That is, if banks wanted to sell at a lower price than is likely to be reclaimed from holding the assets, then there would be a win-win situation. But if it was likely that the assets would return to that price, we wouldn't be having this crisis. In other words, when it comes to sub-prime the problem is solvency, not liquidity. (If the problem was liquidity, then this could be solved with repos and other loans, and no permanent buying would be necessary.)

I am all in favor of the government buying and writing down mortgages to market price. In that case, TARP is problematic because it doesn't set a clear mandate for the treasury to do that - it lets Paulson pay as much as he wants.

I expect the government to be a very gentle bank -- I can't see the treasury foreclosing very effectively - the political blow-back would be too strong. So I think you can make an argument that treasury shouldn't own mortgage-derived products at all, but for now I'll say that if they do, they need to buy them so cheaply that they never have to put the screws to home owners to pay taxpayers.

There are two groups of economic thinking on the crisis: one group believes the fundamental problem is liquidity. (I am in this camp.) When liquidity is the problem, the solution to insolvent banks is to let them go bankrupt, wiping out equity and part of the junior debt. The assets are then resold to someone who can do something useful with them and business continues. This scheme effectively "clears" market conditions by punshing debt-investors in banks. To me this is more than just acceptable - it's necessary. If we have a policy of bailing out financial institutions in a way that protects debt holders, financial debt will be priced as if it has a government guarantee, and the next insolvency crisis will be a lot worse. All investors earn their returns by buying risk - bond holders bought risk and now they need to collect it.

The other group of thinking is that banks are undercapitalized. In this school of thought, liquidity won't help if there essentially isn't enough money to loan out. TARP could help this in that one solution is for the government to buy equity stakes in banks, something permitted by the bill. But then we get into a big set of problems: does the indication that using TARP is necessary indicate weakenss on a bank that causes a panic? Does the risk of government buy-in at a low price scare off needed private-sector investment? Does government buy-in at a high price protect equity investors that do not deserve protection?

My answer to this is: different solutions for different problems.

• The fed should continue to use its balance sheet to provide liquidity to "mundane" credit markets (commercial paper and friends). If the fed needs a bigger balance sheet, I'm okay with that; that's one use of government money. Since everyone goes to cash and T-bills when things get scary, expanding the balance sheet seems okay to me.
• Insolvent banks should be closed down and rolled up quickly and quietly to "clear" markets by wiping out equity and junior debt holders in the financial industry. It has to happen. When we look at the "bubbles" the real bubble was in financial services - that is, wall street making collectively too much mony off our GDP by taking a percent. That can't continue - the financial mechanism is over-built and needs to shrink, and that means losses for investments who bought at the top. No one would have suggested propping up pets.com - or Country-Wide!
• Fanny and Freddie should be used sparingly to provide refinancing in some cases. In other words, the government should continue its policy of subsidizing mortgages. We've been promoting home ownership this way for a long time - we really can't stop now, at a time when mortgage financing is difficult to come by. Fanny and Freddie are a mess, but they're on the books like they always should hav been, so at least we can understand how much we're in for.
  

Financing would be aimed at home owners who would be able to pay their mortgage if financed at sane market rates (e.g. a fixed rate, not the ugly end of an ARM), and applied in cases where the banks can be convinced to write down the loan to bring the home owner above water.

These points aim to do several things:

• Keep liquidity flowing to business. We're in for a recession -- that's inescapable and happens any time one sector is massively overbuilt; we couldn't not have a recession given how many people were involved in making houses. We really don't need more houses!
• Help the market "clear" as fast as possible. There is only so much we can do because you don't know which mortages will be bad until more of them reset. But generally we should aim to let the market find its "real" price, rather than slow the decline. Only once bonds and houses are priced fairly will economic activity resume. (Just watch a home buyer in this market - the big fear is "what if we haven't hit bottom yet".)
• Prevent a foreclosure spiral in housing prices. The danger is that foreclosures force housing prices to artificially "undershoot" to a lower-than-bottom price, which causes foreclosures that otherwise would not have happened. The government needs to ensure that there is enough mortgage lending to prevent this from happening due to a lack of credit.

So there it is. In my next blog I'll solve world hunger.

Conspiracy or Stupidity?

In my previous post (which I must admit was mostly an angry rant to the bailout) I implied that the current disaster is intentional.  In particular, financial entities are profiting (compared to how they would have faired) by extending the US Government's protections that it provides home-owners.  (That is, in its attempt to save home owners, we'll have to bail out a bunch of non-home-owner rich folks as well.)

But - that's not really fair - we can't assume conspiracy where stupidity and luck will explain the situation.  In particular, I think it's more likely that the existing financial morass is an emergent behavior of a very, very poorly designed system, and those who will get bail-outs are getting so by coincidence of where they landed and not by a plan to leverage poorly designed housing policy.

I have heard congressmen argue that Wall Street was duping Main Street out of their home equity by selling them ARMs that would force a refinancing.  Same situation -- an emergent behavior, not an intention.

Fundamentally in the crisis we have two middle-men and a blind buyer.

The first middle-man is the mortgage broker.  His mission is clear: sell more mortgages.  I you make a fee per mortgage and have zero skin in the game as to what happens to that mortgage, what do you do?  You sell as many as you can, no matter how ugly they are.

The second middle-man is the investment bank that turns the mortgages into securities, perhaps even several times.  If you make a percentage of the size of the deal, what do you do? You do as many deals as you can.

Now both middle men can get stuck holding the goods, if the contracts are written such that the middle man has to take the loan back.  But here I fear the whole industry suffers from the same problem as the blind buyers: asymmetric risk/reward.

Buying all of these goods were, well, all sorts of entities....banks, hedge funds, pension funds, the investments end up everywhere.  In particular, they end up anywhere that someone is willing to buy an investment that they don't understand as long as Moody's says it's really safe and it returns a few points better than cash or T-bills.

I believe that in the short term there is no fix.  There is only the necessary steps to keep the patient alive and what we do in the long term.

• The US Government should not buy anything.  We really should not buy mortgages.  I'll blog about that later.
• The Fed needs to continue to enter repo agreements against illiquid (but not insolvent) assets to prevent financial seize-ups.
• In the long term, we need to redesign the financial system to balance risk and reward.  As long as the decision makers reap benefits when they gamble but someone else pays when they lose, they're going to bet the house, the car, and the grandchildren.

Finally, I think it's important to keep an eye on the fuzzy line between liquidity and solvency in the financial debate going on.  If a bank is illiquid, there are short-term band-aids for that.

But if an institution is insolvent, the equity holders (stock holders) and bond holders need to take one for the team.  The customers need not suffer (see WaMu's failure - bank customers are unaffected - only investors in the bank itself are hosed) but we can't let investors get a free ride on a failed investment - doing so encourages bad investment...it's free poker chips to the gamblers.

Sarah Palin: Framing the Debate

As a defeated lefty, I have to admire the GOP for framing political debate to their advantage.

To that end, I think Sarah Palin is a pretty brilliant choice as VP for this reason: even if they lose the debate they win.

At best us lefties, who are totally distracted by Palin, prove that she is not qualified to be president. (Duh.) Is this really a victory? People voted for Bush Sr. despite Dan Quayle! I don't think a VP can be enough of a liability to warrant getting so off message.

Only one thing wins it for the democrats: "McCain is Bush Jr., and look at the mess we're in."

Bob Vila Does Not Have $700 Billion

It's been a while since I've put up a good financial rant, but today deserves one, because these are special times.  I have a superb deal for you:

• You give me $700 billion in cash.
• I will give you $700 billion in bad mortgage bonds, toxic derivative products, and whatever fertilizer I happen to have in my garage right now.

Foo - I'm too late.  Uncle Sam is already signing you up for that deal.

Asymmetric Risk

At the core of the entire financial disaster is asymmetric risk.  Any time you have a situation where the party who takes a loss is different from the party who takes the gain, the party that takes the gain is going to try their hardest to make the transaction happen.  This asymmetric situation is everywhere:

• A home buyer who is not required to make a down-payment (zero percent equity) gets the up-side of a rise in housing price, but transfers the down-side risk to the bank.
• A mortgage broker that makes a commission on a mortgage but doesn't hold the mortgage makes money on the deal but doesn't get penalized if the mortgage goes into default.
• A bank that has FDIC insurance, but does not have to back up its risky investments with capital holdings gets the up-side of the risky investments but gets bailed out for the down-side. (See below.)

Fundamentally what we have is a situation where risk has been transferred (often using derivatives) from the party making a profit to a party that has insurance (whether real or implied) from Uncle Sam.

Grass Fires

Derivatives are the vehicle that makes this possible.  Basically a derivative is a contract that obligates parties to perform a financial transaction (one that will usually be really bad for one party) but does not require the party at risk to hold any money in reserve.

In the good old days, your bank took deposits from working people, loaned money out in mortgages to home owners, and kept the interest rate difference as profit.  Now since working people always want their money bank but home owners sometimes default, the bank had to keep a little bit of deposit money aside (its reserves) just in case; the size of that reserve has to be proportional to the risk of the home owners failing to make their mortgage payments.

Derivatives have no such capital holding requirements.  To see how insane this is, let's look at a "credit default swap" (CDS) - one of the most ludicrous inventions ever.  A CDS is basically insurance on a bankruptcy.  Here's how it works:

• You have $100 in General Motors bonds and are a little bit worried that GM might go under.
• I have $100 in treasury bills.
• We enter the following contractual agreement: in the event that GM does go broke, I will swap my treasury bills for your (now quite worthless) GM bonds.
• You will pay me some money right now to take this idiotic deal.

So basically what we have is bond insurance - you pay me a small premium, and in the rare event of a default, I insure you.  Now here's the rub: I don't have to keep the treasury bills locked away!!!  Heck, I don't even have to keep a fraction of them locked away.  I can go spend them on beer and pray that GM doesn't go broke.

Of course, this has some unfortunate effects.  Perhaps your GM bonds had a low rating because GM is in deep doo-doo.  But if you buy some insurance from me, you can "enhance" the credit of the bonds...GM bonds + insurance are a lot nicer than GM bonds.  But what happens if I, the writer of the insurance, go broke?  Your GM bonds instantly turn back into a pumpkin, so to speak.  At that instant, any other deals that made sense only if GM bonds are good is now quite screwed up.

And this is the nature of counter-party risk.  If you enter into a derivative contract and you need that contract to be valid for your business, you take on the risk of the other side of the contract going broke.

The experts told us that derivatives would spread risk and make the system more robust.  They were half right - derivatives definitely spread risk.  Derivatives on risk is like on a grass fire.

Selling Uncle Sam

Now we can start to see why Uncle Sam is considering spending $700 billion dollars to buy a huge pile of toxic waste.  If you have counter-party risk, it becomes in your interest to keep the other party alive.  Uncle Sam's umbrella of protection has been wrenched out from over the small depositor and home owner and extended to wall street through the mechanism of derivatives.

John Hussman has a great explanation of how you can hook Uncle Sam into insuring things that the tax payers really should not be insuring:

First, suppose that Citibank gets money from its depositors at a floating rate, and lends to mortgage borrowers at a fixed 6%. Now GM issues bonds yielding 7%, and enters a swap with Citibank, in which Citibank pays GM 5% fixed in return for floating. (Specifically, both parties agree on some notional principal, say $100 million, and each makes payments to the other, determined by multiplying a fixed or floating interest rate by that principal amount. The market for this sort of transaction is huge).

Well, now GM is paying an actual interest rate of floating + 2% (pay 7% to bondholders, get 5% from Citibank, pay Citibank floating). Meanwhile, as compensation for the credit risk it has accepted all around, Citibank earns a fixed 1% margin regardless of interest rate movements (pay depositors floating, get 6% from mortgages, pay 5% to GM, get floating from GM). Neat. And since Citibank is federally insured at the depositor level, and “too big to fail” at the institutional level, Uncle Sam is now a counterparty that effectively shares the risk in the case that GM or homeowners default. Similar transactions serve to swap risky corporate and mortgage borrowing into safe government agency paper issued by Fannie Mae and Freddie Mac.

The financial alchemy is in Citibank exposing itself to risk (and making money by doing so) without reserves.  Remember the good old days?  Well, in this transaction Citibank didn't put any money inside to cover the case where GM goes under.  (If GM goes under, Citibank is left writing mortgages at fixed rates while paying depositors a floating rate.  If interest rates go up, Citibank will lose money with every transaction.  But Citibank has no "nest egg" of cash stashed away to cover this case.)

Simply put, if you can get Uncle Sam to be counter-party to another entity, Uncle Sam has to protect the other entity.  And thus here we are, trying to bail out all of Wall Street.

Extending the Umbrella

Let's go back even further - how did we get here?  We have a policy in this country (the "American Dream") of subsidizing home ownership in the form of tax breaks and credit enhancement.  Basically Uncle Sam is willing to spend money to get you to buy a home by:

• Providing tax breaks for mortgage interest (which creates an incentive to borrow money, not save, and makes financing of houses effectively cheaper).
• Keeping interest rates low, which also makes financing cheaper.*
• Providing credit enhancement to borrowers (that is, guaranteeing mortgages).

To this last point, the Government does this both by writing guaranteed mortgages (FHA, etc.) and also by creating Fanny Mae and Freddie Mac - two companies that write mortgages.  Fanny and Freddie make mortgages cheaper by using their good credit rating to get cheap financing for home buyers.  Why would Fanny and Freddie have a good credit rating if their job is to make housing a little bit too easy to get?  Simple: we all assumed that the government would bail them out if things got ugly.  And of course, that is exactly what happened.  As a net transaction, Fanny and Freddie represent Uncle Sam backing up a huge number of home buyers on their mortgage.

So we have the government providing credit enhancement.  How can Wall Street profit off of this?  Simple: they need two things:

• They need a lot of people to buy homes and utilize that credit enhancement, so that it can then be transferred.
• Wall street then needs to find a way to transfer that credit enhancement from the individuals doing the borrowing to other parties, who will pay a fee for this.

Getting people to utilize the credit enhancement is pretty easy: offer them cheap financing. Offer them all the up-side of a market increase without the down-side by writing nothing-down mortgages.

You then write products that are tied to this sea of government-backed paper and you pull in Uncle Sam as a counter-party.  You sell this off with the wink-and-a-nod that the products are credit enhanced because you-know-who is a counter-party.  The huge chain of derivatives and "engineered" financial products spreads the risk all over the place, and thus spreads Uncle Sam's umbrella all over the place.

If Uncle Sam walks away and lets Wall Street go down, the chain of derivatives guarantees it hurts "main street", the little guy, for whom cheap housing was invented.  This is the true price of subsidized housing.

Only Pain Will Heal

Besides a huge credit mess, what we have is overproduction: too many houses and too many mortgage bonds.  The only way out is to stop making houses and mortgage bonds for a while. And this is where I have the greatest fear; falling prices for houses and mortgage bonds is the market's way of dealing with the extra product floating around.  

If the Government starts spending hundreds of billions of dollars to prop either, that is money spent on an inefficient and overproduced part of the economy, destroying real investment in future US growth.  But I fear that the debate in Washington is on who gets the bail-out, not whether there should be a bailout.

* I know, there is an immense amount of hand-waving in that statement and it isn't really supportable.  In fact, this whole rant scrambles cause and effect pretty thoroughly.  But I must point out that this is the nature of asymmetric risk; parties may not have known Uncle Sam would bail them out, but they didn't have to care, since they were in a position to make all the profit and take none of the pain.

Going For Broke

Lori got an awesome graph in her mail the other day - it was her Van Guard 401k statement from a former employer. This is a "2040" plan - that is, they mix the stocks and bonds for you according to theoretical models so that you can retire in the year 2040. As 2040 draws closer, they move from stocks to bonds so you get higher return on higher risk when young, but the bottom doesn't drop out of your retirement 3 days before you need it.

Due to the employment duration and market performance, the graph was a simple straight line going from "more" to "less". The caption had some marketing drivel about preparing for retirement...extrapolate the line out and Van Guard will have carefully lost all of her money by the time 2040 rolls around.

Now it could be a lot worse - the expense ratios on Van Guard's plan are really low, and we have to accept that stocks are risky and there will be periods like this when the market gets the hell beaten out of it.

But what caught my attention was the mix. For someone retiring in 32 years Van Guard recommends 90% stocks and only 10% bonds! Wow! (By comparion, the "old" models would have been 70% stocks.)

Hrm...how did we get here?

• Nerdy analysts look at historical stock-bond returns and recommend a 70-30 mix.
• Lots of people put 70% of their retirement into stocks via mutual funds.
• This increases demand for stocks, their value goes up and up and up.
• Stocks now have a higher historical return.
• Nerdy analysts recalculate. The mix should be 80-20 because stocks are even better than we thought.
• People put even more money into stocks!
• Stocks go up even more.
• Now stocks have an even higher historical return.
• Nerdy analysts recalculate...

I think I hear Adam Smith laughing at us...

Bob Vila Would Never Club a Robotic Baby Seal

...Because they're too cute apparently. I must admit that, having heard the story before viewing it on the web, I imagined the robotic baby seals to be cuter than they really are.

Now part of me thinks that when we are using a robotic pet to comfort the elderly, we have really, really lost our way.

But the truth is, I am a technological grumpy-old-man, and the war between the young and old regarding technological integration (that is, integration of technological into the domain we would have reserved for "life") is being lost every time a new baby is born.

Having had my formative years before the internet and instant messaging and ubiquitous wireless technology, the notion of asking someone out on a date (or ending a relationship) via text message or posting all of your personal information on a MySpace page strikes me as moderately ridiculous.

But to my own self I must be true: I am a fossil. Human beings, when presented with these technologies (among others) see nothing unusual - we integrate every technology we develop into our lives. I don't think my 2-year-old nephew sees any difference between the remote control and wooden blocks. They are all simply objects to be explored, touched, chewed on, and mastered until, like all tools and technologies, they are an extension of him, part of the fabric of human life.

My negative reaction initial to robotic seal pets* (besides being caused by a lack of coffee) comes from a line in the sand that is crossed when technology starts to affect us emotionally. But this is a ludicrous line in the sand; all technology affects us emotionally, even ones that are not supposed to. (Tell me there isn't enough hate caused by Microsoft Windows Vista to start a war!!) We connect emotionally to our cars and computer programs, perhaps because we connect emotionally to everything.

And robots don't have a monopoly on button-pushing. In "The Truth About Dogs" Stephen Budiansky argues that dogs are fundamentally parasites. A successful parasite attaches to its host using a property of the host so integral to its survival that the host cannot "close the door" on the parasite . In the case of dogs, by triggering all of the responses that make us care for children, they obtain food, shelter, medical care, toys, belly rubs, and in some cases trips to spas. If we didn't think dogs were cute, we'd probably toss our babies out on the street too.

As Lori and I sit around blathering about how cute it is that the dog is rolling around under the bed or that the cat approves of the new sofa (as shown by sleeping on it) we realize that we have animals in the house that have reduced our mental functioning, and in the process, mooched hundreds of pounds of pet food. If Martians came to do a documentary on human culture I am sure the narrator (who would sound just like Morgan Freeman) would say:

"This human pair has become infecting by a dog and a cat. The animals play on the humans nesting instincts, diverting their normal course of development. The humans do not yet have offspring, but instead foster the dog and cat."

In the end I think Daniel Ariely's view makes sense; we humans are hopelessly hard-wired for some irrational behavior. Whether it's another species that wants a free meal, or a robotic baby seal engineered by researchers, we are going to attach to things emotionally whether it makes any sense or not. We can't change who we are. All we can do is be aware of our human heritage and navigate the murky waters of technological change as best we can.

* If someone makes a robotic baby seal with laser beams mounted on its head, I will be the first to buy it!

This Is My Day

CC and Nala's relationship has come a long way in almost a year; originally we could not have them in the same room, and we had a gate or door separating them at all times. We've reached a point now where I don't have to separate them at all.

The turning point in their relationship was when Nala decided it was more fun to hit CC than run away from her. Nala's previous owners declawed her - if she had a little more firepower they would have found a balance of power much quicker (basically the dog doing whatever the cat wants). Instead this drama plays itself out probably about once a day.

Now I must admit, I did intentionally allow this to happen by asking the dog to come sniff the cat once I had the camera ready. It's a situation with a predictable course:

1. Dog decides she really, really, really needs to smell the cat - perhaps the cat smells different than yesterday? You never know!
2. Dog attempts to smell the cat, usually by jamming her nose as close to the cat's belly as she possibly can.
3. Cat decides she does not like the dog doing this and hits the dog, perhaps 8, 9, 10 times in a row.
4. While it didn't happen this time, the cat usually then immediately washes her paws because she has "dog cooties", which are totally gross.
5. Cat decides to leave and go somewhere else.
6. Dog whimpers because the cat doesn't love her.

Never a dull moment.

These days I have been catching both of them sleeping in the same room (once even in my office) fairly close together, e.g. dog on the floor, cat on the chair, or cat on the dog's bed, dog on the floor...but the cat is always on alert so I haven't been able to get a good picture yet.

Ah, CNBC

http://www.cnbc.com/id/15840232?video=753754816&play=1

I have a simple rule of thumb for resolving economic questions: whatever the loud guy shouting on CNBC says is wrong. Ergo, there is oil speculation.

This argument has been thrown out before: because the spot price is based on real oil, "paper speculators" (index funds that buy and sell futures to avoid actually ever having the oil) then the real price of oil (the spot price) can't be influenced by speculators.

To paraphrase the Simpsons, Rick Santelli makes a very loud point.

His argument is essentially that if there's a lot more people speculating on oil going up then down, then when those speculators defer receiving the oil, they'll pay a premium since no one wants the oil (supply and demand).

Of course, that is exactly what's happening: the market is in contango - that is to say, there is a cost to paying someone else to hold your oil for you (so you can lock in the speculative gains). The index speculators are paying month to month. (Of course, they are rolling from 2 months to 1 months, at least in the case of Barclays oil ETF.)

So how can the spot price be affected? Simple: oil producers are in a perfect position to make a killing off of the contango.

Imagine I drill for oil in my back yard and can produce a barrel of oil a month. I enter a futures contract (locking in a higher price due to contango) to deliver in two months and put the oil in my garage. At the end of the month I look at the market and see that I can make a profit by selling another two-month contract while buying a one-month contract.

That one-month I bought perfectly balances the one I sold (two months ago, so now it's a one-month) and the barrel of oil in my garage backs the new two-month. I make (for free and risk free) the roll yield the commodity indexes are losing.

Of course, I've shut my well down. Is this a big problem? It depends on what I'd rather have: oil in the ground or dollars (which I'm making anyway).

Of course I don't even need an oil well to play this game - I could just buy one barrel of oil, sell it forward, and start rolling the contract. Essentially contango pays people to store oil.

So when you invest in rolling oil futures, you really are hoarding oil - contango is the "rent" you pay someone else to do the dirty work of stashing your barrels somewhere. (But you most certainly have a real claim on a real resource - that's what a futures contract is. No one is going to do anything else with "your" oil until the contract is settled.)

So what about the spot price? If this is all about contango and negative roll yield, why are we paying $4+ at the pump? What ties the spot price to the futures price? (Santelli's argument is that since the speculators only play with futures, they can only move futures prices.)

The answer is arbitrage. In a situation where the prices of futures contracts have gone much higher than spot prices, oil producers can make a ton of money with zero risk. They sell less oil on the spot market and more using futures contracts. As long as the price difference is larger than the storage cost, the producers make a profit, and the spot price goes up (due to a lack of supply).

Yellow Books

I enjoy spotting the yellow "X for Dummies" books in Barnes & Nobles...the topics that the books hope to explain to dummies strike me as, well...ambitious. Still, "Currency Trading for Dummies" cracked me up.

By comparison, I thought "Hedge Funds For Dummies" was a fitting title - with the hedge fund manager taking 20% of the profits and 0% of the losses, how could a hedge fund be for anyone else? :-)

Wicked Good Eggs

I read The Omnivore's Dilemma and strongly recommend it. Even if you don't agree with Pollen's opinions on food culture (I do, but that's just my opinion, not something I would argue about) I believe the book is a good for its treatment of farm economics, something that city slickers like myself might not be aware of.

The factor that I think is now so relevant (with both high food and high oil prices) is the chain of subsidies and non-renewable inputs that goes into our food.

• It starts with oil, something we can't make more of, and something we don't really have (to the scale that we require) in the US. I'll blog about oil some other time, but for now let's just say that starting the chain with oil gets us off on the wrong foot.
• The oil is used to make fertilizers...basically you couldn't grow corn to the quantity we do without adding a lot of fertilizer, and that process requires energy, which in the US means fossil fuels. (I suppose that we could move some of our energy dependence to nuclear power - I am for this, and not just because I could then blog that the beginning link in a bag of Dorritos is Uranium!)
• The farmers grow a pretty huge amount of corn - the Government pays them to do so, allowing them to spend more on production costs than the corn is worth.
• That makes corn so cheap that we go feed it to cows who aren't even supposed to be eating corn (and get really sick from it).*
• This ends with a Quizznos add telling us that for $5 we should get more meat!
• Actually, it ends with us all getting really fat.

When I look back at the entire chain of events, it strikes me as completely absurd, and more importantly really inefficient! A lot of expenditure for something (in this case fast food) that isn't even that great. I'd like my taxes back, I can live without fast food, thank you.*

But it turns out that Polyface Farms, which is featured in Pollen's book, delivers to the DC metro area via buying clubs. So Lori and I signed up.

Now I do have to admit that while signing up makes my liberal conscience feel good, the amount of food we ordered is a drop in the bucket of our total callorie consumption - we're going to have to find sustainable sources for a wide range of other types of food.

But the point of this blog post is not that Polyface is sustainable, with almost no outside non-renewable inputs. It is that their eggs are magical.

Lori and I try to buy the freshest eggs we can, but Polyface eggs are in a different dimension. I found this out last night when making meringues and zabaglione; the meringues whipped in perhaps half the time normal eggs would and became so thick as to lower the RPM of the mixer. The initial beating of the yolks takes significantly more effort than with your regular store-bought yolks-break-by-looking-at-them variety.

Forget sustainability and the planet, I would like all my food to be farmed the Polyface way because the quality is unreal!

* There is now a fork in the road - we could go down a different path and use our cheap subsidized corn to make fuel...sort of like the fuel we used to make the fertilizer to grow the corn. I've read that the output-input energy ratio for Ethanol is 1.2 (that is, it's a slight win, prodcuing 20% more energy than it took to make) but 1.2 is still totally lame.