Ticking Thoughts

Follow up to "On the Mortgage Crisis"

2011-11-03T18:48:00.000-04:00

Original Proposal:
Instead of bailing out banks, the government should have used that money to help reduce the mortgages of all homes that were up for foreclosure. This could be done in a cost-neutral way by extending the life of the mortgages and allowing the home owners to eventually pay their debts off. In fact, if the risks were calculated correctly, the government could even make a profit. If the homeowners walk away, the government becomes the homeowner. The bailout approach made the government the lender of last resort. This proposal would have made the government the landlord of last resort. It is the people's land after all.

Followup Analysis:
After re-watching the Inside Job, I thought I'd re-affirm how right I was when I originally wrote "On The Mortgage Crisis" in September of 2008. Looking back, this was one month after the crisis that has still not run it's course began. Seeing the fact that to date all of the bail out money has not been repaid, seeing the fact that the crisis is still affecting the job market, I can confidently say this was the only approach we should have taken.
The part in the film that jumped out at me was the simplified explanation of Credit Default Swaps. I couldn't have explained it better if I tried. Simply put, A CDS is when someone takes out insurance on something they do not own. If the insured item breaks, the owner of the CDS makes a profit; however, as long as the insured item is solvent, the owner of the CDS must continue to pay a premium.
AIG issued numerous CDS that were in essence allowing banks to take out insurance against the successful repayment of mortgages. That is, they were betting that the predatory loans would eventually collapse and the homes would have to be foreclosed. Setting aside the discussions around the ethics and morality of the banks making these bets as they themselves sold and encouraged the issuing of these mortgages, lets take a look at the impact of each dollar spent in the bailout and how it could have been spent more effectively.
The reason AIG was at risk of insolvency was because home-foreclosures were on the rise. For every foreclosure, AIG had to pay out insurance to firms who bet against those mortgages, holders of CDSs. If instead of paying those bets out via the TARP bailout, the money was spend on buying homes to prevent defaults, each dollar spent would have gone much much further. However, this would mean that the profits GS and other banking agencies planned on booking wouldn't get booked.
The plan that was put in place was two fold: one bought junk mortgages from the banks, and the other (TARP) was a loan with strings attached to it. The amazing thing is, that after using the TARP loan to satisfy margin requirements, most banks decided that it was better to unwind and pay off the TARP loans, rather than use this capital to grow their way out of their losses. My understanding is that this was largely done due to the "bonus restrictions" placed on any company that accepted the TARP funding. Putting emotions aside, it is easy to see why execu Give of the non-morgage departments did not like this. If you are paid a 15% bonus every year you have a satisfactory job performance, you will eventually begin to expect this bonus -- for better or for worse, the executives expected their bonuses. I've tried to find out if the executives in charge of the mortgages received bonuses based on satisfactory or unsatisfactory performance; however, I could not find any media outlet that covered this with a level head.

Recap:
As I mentioned, there were at least two ways by which we helped out the banks. The TARP loan was repaired by most banks fairly quickly since they wanted to be able to pay out their annual bonuses. However, the junk mortgages and mortgage based products are still in the possession of the government. If the government were to extend the term of the mortgages as much as possible; thereby lowering the monthly payment requirement for home buyers, these buyers would be able to live in the homes until someone buys it from them. If no one buys the home, the government would continue to make enough money to pay for the interest costs -- further, since the economy would stay balanced, the country as a whole would keep out of a depression, resulting in higher tax revenues for the state. The CDSs would not pay out; however, the government would survive and everyone else would be able to continue to live in the homes they could afford and frankly, when the bets were placed, the bets should have taken into account potential government intervention.

Personal Note:
I took a very long break from writing blog entries. I felt my efforts were depressing me and had no impact. I plan to resume writing. I will finish my articles on how the market works today and how we can restructure it so that the market is incentivized to grow in a safe way.

Related Links:
- Watch the inside job. It only costs $3.99 on youtube, alternatively you can find it on the web: http://www.videoweed.com/file/0ua0illeque98. I urge you to support the film by paying for it though. We need to support the investigative documentary industry.

On Single Payer vs. Public Option

2009-10-27T02:42:00.000-04:00

Proposal:
   The US government should stick to the single payer system that has worked well for Canada.

Brief Analysis:
   The public option being proposed in the United States has all the makings of a disaster. Now I usually stick to economics; however, the obvious game being played by the health care industry enrages me. One of two scenarios will result, either the companies will not lower their premiums, or they will.
   Lets look at what appears to be the winning solution, that is, if the public option leads private companies to reducing their premiums. Then, these companies will simply increase their rejection rates and only "insure" the lowest risk people available. Most people who fall in this boat are young adults who will grow old, eventually falling out of this boat. As a result, these people will end up being pushed off the private plans and back into the public plan. This leads to customers who save for their rainy day by putting all their money in bucket A, but are told that they can only withdraw from bucket B. Basically, everybody looses except the health care companies!
   On the flip side, if the health care companies keep their premiums higher, then the only way they can be surviving in the market is if they have enough demand. Which would only exist if the public option is poorly run due to corruption or if corporate deals force employees into expensive plans.

Personal Opinion:
   I want to point out strongly though, the single payer system would be unquestionably amazing for America. The Canadian system's biggest enemy is the fact that doctor's leave to work for the states so they can sacrifice their morals for more money. Once the private sector is non-existent, both countries would gain better health care systems, Canadian doctors would stay in Canada, while the US citizens would get health care. (US has more than enough doctors, when doctors aren't paid ridiculous amounts, general practitioners will begin working regular hours, take on more patients and stop retiring early). As a society we invest a lot of money into educating doctors, socially they are given a lot of respect and unfortunately all of the incentives of the current system encourage them to be lazy. How? Simple, if I were to double your salary tomorrow, would you consider working half the time? I believe most people would end up working 75% of the time they use to before, assuming you are paid well to begin with.

On the new proposed Education reform

2009-10-06T19:16:00.000-04:00

Proposal:
   We should strive to make Arnie Duncan's proposal come to fruition.

Brief Analysis:
   This is an excellent proposal. I made a proposal the other day where I suggested using continued education as a means of cultivating community; however, in an interview with Colbert, Arnie Duncan took it a little further. The part that stuck with me is the idea that our schools should be "community centers". This is great! He has managed to paint a picture that in my heart of hearts is exactly what I could never describe but knew I wanted. Parents involved in children learning, parents continuing education, a sense of community, children not entering crime due to boredom! Arnie Duncan just got an A in my book.
   He also makes a great point that we are no longer an agrarian society, we don't need to have summer vacations. Now, I'm all for children having great summer vacations; however, I understand the reality of the fact that a large majority of kids just end up stuck at home, starring at the tv or getting involved in crime.

Related Links:
    - Interview with Arnie Duncan

On Cultivating Culture Through Continued Education

2009-09-19T18:57:00.000-04:00

Proposal:
   The government should provide tax intensives for continued education beyond academia as a means of cultivating culture through social gatherings. It is critical that I point out that the aim should be to cultivate and not preserve culture.

Preamble:
   Please note that this article is not for or against religious practice -- For the record I am agnostic, on any given day the degree to which I believe a God may exist can vary. One thing I do know for certain though, is irrespective of whether or not there is a God, I believe I live my life in such a way that it would does not matter.

Brief Analysis:
   The inspiration behind this proposal is an attempt to try and address the need for social gatherings. Traditionally, most people would gather in churches, temples, mosques or other religious institutions. However, as agnosticism, atheism and even people of faith stop gathering in these traditional means, we as a society begin to lose something good. Many people are already trying to keep people believing in various religious doctrines; however, I think we need to accept the fact that going forward, a large part of society may never have an interest in attending religious gatherings.
   There is an obvious divide that can be widened when gatherings are split among religious lines, but at the same time, throughout history there are many times when we have seen the capacity for great change - for better and worse - that can be driven from social gatherings. In the past few years I've been travelling to many different parts of the world, and one thing that has always stood out to me is the diversity of lifestyles. Further, in North America I have met a number of people who have always expressed a feeling of detachment from their neighbors. For a variety of reasons (discussed below) our society has become less open, and less social. This is especially disturbing to me as a Canadian since we are such a center for immigrants and we could definitely benefit from a more connected lifestyle.
   In small towns everyone can easily get to know each other. There is an interesting mention of the rule of 150 in "The Tipping Point" by Malcom Gladwell. Basically, this alludes to the fact that there is a limited number of people you can know well, because in order to know someone well, you need to know everyone they know. Apparently on average most people can only really get to know 150 people well. As a result, small towns can often have a strong community vibe because there are a lot of people who know each other, in addition to knowing how everyone knows everyone else. The same thing applies to church goers and in countries like India, Cuba and cities like Montreal: everyone gets to know their neighbors. They build up a strong community as a result.
   For a number of reasons this has dissipated from our society, I believe that there is an opportunity here to fill the void being left behind. We can reconnect people through education. I recent started getting into Salsa dancing, and I feel the salsa communities in general are very welcoming, they love teaching each other and making friends. Since most people aren't as invested in the outcomes of their performance, there is less competition amongst those in attendance. Hence, as Randy Paush mentioned in his inspiration speech, we can use continued education, continued sports or dance activities as a means of teaching people important things about life. As he said, you don't put your kids in football leagues so they learn how to play the game, you put them in there so they learn the values of team work, and developing social skills.
   As immigrants come to our country they often never have met people of other ethnicities/religions/race. I honestly believe most people who hold prejudicial values, have not met enough people across a diverse array of backgrounds to come to the natural conclusion that there are more similarities amongst people than there are differences.

Idle Speculation On Why Our Societies Have Become Less Social:
   In my opinion it is fairly obvious that there is a sense of social divide that is introduced when immigrants come to our country and we are not overly welcoming. Simply being over involved in our own lives and not reaching out to the new people in our towns and cities can make them seem unfriendly to outsiders. Toronto and New York are good examples of this, because I know them to be friendly cities; however, this is only the case when I go out of my way to make friends first.
   I think one major factor, which may be overlooked a lot is the campaigns to teach kids 'not to talk to strangers'. I understand the concept and why it came to be; however, with the obsession that followed, I feel that in our society its frowned upon for adults to even say hello to kids. Further, kids never talk to each other because they see their parents always in a hurry going through life without talking to other strangers. People stick to their inner circles - if your new and don't have one, tough. Its very reminiscent to me of high school where the outcasts eventually band together; however, they always have an inner resentment for having been left out. Further, I believe kids are vital in shaping how immigrants behave because their parents who don't know many people talk to their kids a lot about what they did in school. When they are told again and again that they shouldn't talk to strangers -- an odd concept for someone from countries where this is the norm -- the notion can stick. They remember the warning since its a bizarre thing to teach children if it wasn't warranted. I believe its unwarranted.
   I have never been one to let people change the way i live my life because of their stupidity. Though, looking at the number of people who okay with limiting the amount of liquid we can take on a plane, or the number of people okay with going to a billion dollar war as a result of an attack, I guess I may be an exception. Perhaps I can offer another argument: When you know more people in your society, there is a greater chance that you will find out where the perverts are, perhaps even catch them without having to restrict the social development of your kids. Perhaps, when there is always an adult you know around the corner, you wouldn't pick on other kids, or steal for fun.

Conclusion:
   I truly believe in the benefits of social cohesion. We need to have more. I also believe it is in part the governments responsibility to ensure the population is healthy both physically and mentally. Providing people a means of getting to know others through a sort of on-going education program would be a great step in the right direction. Think Sunday school, where instead of learning about literature, you learn about dance, art, math, or anything you want. There are no grades, there is a social aspect and its not a large time commitment. Of course, you can't force people to do this, so the best way is bring it about is to tax those who don't... or rather, give a rebate to those who do :)

Related Links:
    - Tipping Point on Amazon (I encourage you to check other stores as well)
   - Is Canada losing its social cohesion, Are we becoming strangers to each other?

On Cash For Clunkers

2009-08-04T21:46:00.000-04:00

Proposal:
   The US government should abandon the Cash for Clunkers program and adopt a variation of my earlier proposal to boost hybrid car adoption. The variation being that instead of promoting hybrid cars alone, the government could promote fuel efficient cars. This would save the government both be more cost-effective, but it would respect the free market and avoid an otherwise-unavoidable whiplash of a correction.

Brief Analysis:
   The government proposal is exactly what I describe as a flat rate handout. However, instead of discounting hybrid cars, they discounted cars that are 'fuel efficient'. However, the cars are not necessarily fuel efficient, they are simply more fuel efficient than the 'clunkers' that are being turned in. At $4500 a person, this incentive is clearly not cost-effective.
   Early reports are already showing that the government failed to estimate the demand that would be created for making use of the proposed program. This is because of an obvious flaw in the program - a fixed price! Where is the capitalism? Why are we abandoning the free market system? In my earlier proposal I recommended that the government avoid trying to pick a magic rebate amount out of the hat for this very reason. If instead of fixing the rebate amount the government fixed the net rebate that will be paid out, the government could have relied on the free market to determine the most cost-effective rebate.
   Ignoring the fact this program fails to pay for itself, this program has another subtle flaw - an enforced time limit. By stating that the rebate is only available for a limited time, the government essentially forced car owners to make rash decisions. Further, the decisions making of the public may not have been priced in correctly. As a result, buyer's remorse and volatility in the stock market is an almost certain result. We will probably see the reports on this coming out in a few weeks.
   The rational behind the previous proposal is fully outlined here. If you haven't read it, I suggest you do. If you find merit in the proposal pass it on, perhaps it will even make it to your congressman's table.

Related Links:
    - On Hybrid Car Adoption

On Hybrid Car Adoption

2009-06-30T18:00:00.000-04:00

Proposal:
   The government should increase the tax on gas by a small amount to compinsate early adopters of alternative energy cars. This would include hybrid cars. The compinsation should be proportionate to the percentage of alternative energy used by the car in city driving with an inverse square relation to how long they've owned the car. I claim that such a program would be cost-neutral, highly effective and self-regulating.

Brief Analysis:
   In 2007, according to Statistics Canada the net sales of gasoline for use by road motor vehicles was on the order of 40 billion liters. At a taxation rate of say $0.02/L, the Canadian government would collect $800 million. Given the volatility in gasoline prices in recent years, a tax increase of $0.02/L would barely be noticed at the pumps.
    The cost of hybrid cars is on average $1,700 - $11,200 USD more than regular cars. Ignoring all tax incentives that are already in place, if the collected premium was devided amongst new car purchases evenly, at $11,000 that covers the premium for 72,700 cars. In 2008, a little over 1.6 million new cars were sold. Hence, 72,700 cars represents 4.5% of cars sold.
     At first glance 4.5% may seem like an extremely small portion of the total car sales; however, that is sort of the point. Proponents of the free market system argue that government intervention is always a bad thing, and that the market will in time always figure out what is best - and I disagree. As I see it, the market is an amazing linear optimization tool, which eventually leads us to an optimal result, provide the incentives we provide the market with are good. Though, as they say 'garbage in.. garbage out'. We need to provide incentives for the market to be more environmentally friendly.
     So why limit the tax to a small amount? Why not set the tax to $0.20 and have the incentive represent 45% of new cars sold? Because I still believe the free market is an amazing optimization tool. It is far too difficult for us to determine what the proper balance of hybrid vs non-hybrid car sales should be. If the government uses too much influence, incentives turn into manipulation. And as most economists know, historically whenever the government has tried to manipulate the market it has failed - worse, market manipulation eventually leads to a major correction, aka a collapse.
      The second part of this proposal is to avoid provide incentives on a year-to-year basis, and instead providing the incentives to early adopters correlating with the inverse square of time. Additionally, so as to not punish early adopters who adopted before such an incentive is put in place, I'd recommend treating them as if they bought their car in the year the plan is put in action. So every year, the collected revenue would be split amongst hybrid car owners such that new car owners receive $x, owners from the previous year receive $x/4, owners from two years ago receive $x/9 etc.. Now, for the plan to remain cost-neutral, the sum of all payouts would need to equal the amount of revenue that was attained. It is easy to see that after purchasing a hybrid a car owner would receive increasingly smaller payments for being an early adopter. However, rather than receiving all the money in a single year, their payment is spread out over a number of years. In theory if the adoption rate remains at 4.5% exactly, each adopter would receive $11,000 spread out over time; however, in practice, the incentive should result in more than 4.5% of car sales being hybrid cars. At present hybrid sales make up under 2.5% of car sales, while projections have that number reaching 11% in 2013. I dont put much faith in projections, however, when surveyed many consumers agree to being willing to pay at least a $1000 premium for hybrid cars, since the gasoline savings would quickly repay the owners. Hence, the real cost becomes $10,000. Further, as demand for hybrid sales increases, production costs will decrease further increasing the benefit of the collected gas premiums. Since the effects of this incentive would compound over time, it is easy to see why it is highly effective.

      So it is easy to see how this approach would be cost-neutral and highly effective, but what of that last claim? How is this a self-regulating change? and why is this relevant? This all comes back to the notion of the free market. Since the market is a great optimization system, and it would be foolish to believe that in the near future the entire economy will be able to instantly switch from gasoline to alternative energy, we need a self-regulating system that can work with the market to achieve a sustainable balance. The key to the self regulating nature of this proposal is the manner by which the tax is collected. If the government were to simply offer some amount of fixed deduction - as the Canadian and American governments do today - then at a later date, not only will it become difficult to repeal the tax deduction, but in the grand scheme of things, that money is being removed from necessary government programs, or being piled on as debt.

Further, as the demand for hybrid cars grows, the benefits each car owner receives from this program will deminish. Early adopters will get the most out of the plan, which is balanced out by the fact that they would not receive the benefits of cost-reduction attained through their contributions that late adopters would receive. Eventually an equilibrium will be reached where the make up of car purchases is a mixutre of hybrid and gasoline cars. At this point the government can place a similar tax on gasoline at a higher rate (since most car owners would be consuming less) and provide incentives for the economy to move over to more efficient hybrids or cars that run purely on alternative energy.

Side Note:

As a fringe benefit of adopting such a plan, there is a greater chance that consumers would opt to buy a car earlier than they had planned in order to become early adopters. As a result the struggling automotive industry would receive a nice boost that would help them re-outfit their plants to begin mass-production of hybrid cars.

Related Links:
    - The Real Costs of Owning a Hybrid Car
    - Car Sales in Canada
    - Hybrid Sales projection for 2013

On The Morgage Crises

2009-02-21T14:12:00.002-05:00

Proposal:
    The United States government should refinances mortgages for quality homeowners that are struggling or failing to make their mortgage payments. By extending the mortgages, the monthly payments can be reduced. This should be done in a matter that does not force banks to make write offs or suffer undue consequences. Instead, the government should pay a portion of the morgage owner's mortgage every month, in the present, while recovering the costs of the loan (with interest) through the extended lifespan of the mortgage.

Recent News:
    been set aside to deal with the mortgage crises was increased to a total of $0.9 trillion. One of four conditions Obama urged the Treasury to follow was that the money must be used, was that the money be used to aid home owners who are about to have their homes foreclose on them. As far as I can see, there have not been any concrete proposals as to how this money would be used in a manner that is both fair and effective.

Brief Analysis:
    It is my intention to demonstrate that the proposal is fair, effective and viable. To begin, we need to define fairness. Rewarding failure or poor decision making is a moral hazard, and considered unfair, while at the same time bankers should not be punished for being greedy. Agents acting out of their own best interests are doing exactly what they are expected to do, it is difficult to argue that this is worthy of punishment. The true fault lies in the system itself and those that are charged with its maintenance.
   When the systemic failure of the mortgage industry took place, a large number of homes were foreclosed because homeowners couldn't make their payments. Usually, banks would use the homes they had as collateral as a means of recouping their losses. However, when the supply of houses on the housing market sky rocketed, the price of homes plummeted and the banks were forced to write off the value of the houses and take significant losses. This lead to a repetitive cycle when the banks laid off workers, or sold off positions in the stock market to balance their books. This of course spread the losses to other industries with investment portfolios and created a feedback loop.
    In order to break this feedback loop, the rate at which houses go on sale needs to be brought back under control. The proposed idea would accomplish this by reducing the number of homes that get foreclosed. Further, by providing banks and home owners incentive, the participation of both parties can be guaranteed. Of course, it wouldn't be fair if neither guilty party suffered the consequences, which is why banks that wish to take part in such a transactions should forgo their collateral (the actual property) to the government and take a hit on the profit they would have made if their clients had not failed to make their payments. So banks that made the bad loans loose some profit, and homeowners that failed to met their obligations are forced to delay the day when they would own their own home, in addition to paying more interest in the long term.
    In terms of viability, the banks have a vested interested in taking part in such a program since they can turn a situation that is a loss into a small/medium profit. Further, by taking advantage of such a system they can relieve the selling pressure on the housing market and recoup more of their losses from the smaller number of homes they do foreclose on (because the owners have no viable method of paying even a reduced mortgage offered by such a plan). Homeowners benefit as well by seeing their property values slow down the rate at which they are falling, and are provided a lower monthly mortgage rate. Since most people will never own a home in their life span (consider how many people over 40 have more than 25 year mortgages), this is not the worst punishment. Since all parties that would need to be convinced have something to gain from the proposal, the viability of the proposal is pretty high -- all affected parties should gladly participate.
   The last characteristic of the proposal I wanted to demonstrate was effectiveness. As mentioned above, the proposal has built-in incentives for all parties involved, the bad-lenders, bad-debt holders and the tax payer. As a result, adoption should be high and the program, since it has a neutral or slightly positive return to taxpayers in the long run adoption should follow.

Side Note:
   I love Jon Stewart's program; however, recently he's been promoting the idea of buying back consumer debt as an alternative to injecting cash into banks. Although this sounds good at first, when you factor in the expected returns banks have already priced in on loans that were unlikely to be paid in full in the near future, banks will have to take a loss in accepting early pay offs of debt. Further, this unfairly punishes the taxpaying members of society who are debt free.

Disclosure:
    I do not have stock in any banking firms. I do however, own RIMM, APPL and GOOG, while the majority of my position lies in SPY against which I sell covered calls.

References:
   - Jon Stewart's views on repurchasing consumer debt.

On Brokerages Facilitating Short Selling

2009-01-12T08:47:00.002-05:00

Proposal:
     Naked shorts should not be allowed. Additionally, a rental market should be created where stock holders can rent out their shares (giving up their ability to sell those shares). Since these shares can be rented, they would be an ideal market for bears to rent shares of companies they wish to short. To make this market work, brokers should not be allowed to retain ownership of stock held by their clients, allowing the original investors to decide whether or not they wish to rent their shares for short sale.

Recent News:
    Yesterday the FED announced that they were going to ban naked short sales. While this is a long overdue move, there is still a lot more that can be done to improve the incentives that drive the self-calibrating nature of the stock market.

Brief Analysis:
    I've reposted a link to Max Keiser's People and Power report on the "death of a dollar", which discusses the dangers of allowing naked positions. Its fairly obvious why naked shorting is a bad idea so I will not go into it in depth, unless someone requests I do so.
    Currently, brokers are allowed to lend stock held by their clients to other clients who can sell the stock as long as they promise to buy the stock back later and return it to the original owner [more details here]. It is my claim that there is an underlying problem with this set up; the current set up violates a fundamental assumptions of the free market that "behavior is economically rational".
    Lets consider what happens if brokers were not allowed to rent their clients' shares, instead, clients had the ability to choose whether or not they would rent their shares out. Lets say our investor, Joe, truly believes a company will go up so he buys the shares and does not plan on selling his shares anytime soon. If there is demand for shorting the companies shares, then Joe can find someone who wants to short the companies shares and rent his shares to them for a fee. Since, Joe is in it for the long haul and believes the stock is headed up, it doesn't hurt him to let others try to profit from short term dips. Of course, Joe is going to want the shares back at some point, so he must work out a time limit with respect to any shares he rents out. When renting his shares out, economically rational behavior would be to look for the person willing to pay the highest rental fee. The rental fee offers Joe a guaranteed income on his shares as compensation for the opportunity cost Joe incurs by not trying to profit off of short term dips. Great. Clearly allowing share holders to rent their shares out for themselves is economically rational.
    To understand why allowing brokerages to rent shares held in a client's margin account leads to economically irrational behavior, one has to look at the incentives that drive a brokerage. Maximizing Profit. Brokerages earn a large sum of money from the transaction fees they charge their clients. These transaction fees are usually either a flat rate, a function of the number of shares involved or sometimes the profit made on a position. As a result, when brokerages try to maximize profit, they will also try to maximize transactions. To maximize transactions, it helps that they can lend their clients share's to another client or brokerage that wants or has a client that wants to short a particular stock. The key factor here is that the supply of shares available for rent is not dependent on demand. With a fixed supply, any changes in demand should directly affect the price. The image here shows how with a fixed supply curve, a decrease in demand should lower the price. Similarly, an increase in demand should increase the price; however, since brokers have the incentive to maximize transactions, they have the incentive to lend and borrow irrespective of the demand for rented shares. This leads to economically irrational behavior since people can easily borrow shares of a company irrespective of what the demand for renting such shares is.
    An efficient market works well, in my opinion, because of all of the feedback systems built into one to make it a self-regulating system; however, when brokers are allowed to lend shares of their clients, the market does not benefit from self-regulation. Hence, allowing brokers to lend the shares held by their clients leads to economically irrational behavior of the market.

Thought Experiment 1:
What is wrong with proposing that brokerages continue to be able to lend the shares held by their clients and at the same time they charge clients a fee based on the demand for shares they are holding short? Hint: consider what happens when large brokerages try to skip exchanges altogether and fill transactions internally.|

Thought Experiment 2:
   What factor other than stock and rental fee would a the share rental market discussed in this post have to into account. Remember this market would have to be an economically rational market. Hint: take a look at how stock markets differ from options markets.

Related Links:
- People and Power: "Death of a Dollar"
- Who Benefits from Share Rentals?
- Free Market Assumptions
- Wall Street's Top Firms Increasingly Resorting to Internal Trading

On Allowing Naked Positions For Liquidity

2008-12-19T18:19:00.006-05:00

Proposal:
Make it illegal for firms to enter into naked positions on any security. Of particular interest is a firms ability to enter into naked short sale positions for stock.

Brief Analysis:
I find the SEC's use of the word liquidity in their definition of naked shorts grossly misleading. It is my understanding that liquidity refers to the ease with which an asset can be converted into cash. This definition has led financial advisers to encourage their clients to seek liquid assets as they can come in handy in the event of an emergency. In fact, it is my believe that this word has many positive connotations associated with it, which is why I felt the SEC's justification of allowing naked short sales as a gross abuse of the word.

"Indeed, in certain circumstances, naked short selling contributes to market liquidity. For example, broker-dealers that make a market in a security generally stand ready to buy and sell the security on a regular and continuous basis at a publicly quoted price, even when there are no other buyers or sellers. Thus, market makers must sell a security to a buyer even when there are temporary shortages of that security available in the market."

- SEC

     It is clear from the description that naked shorts are permitted to facilitate order executions. Rather than state this, the SEC states the purpose of naked shorts is to improve liquidity. One may argue that there is a strong correlation between order executions and liquidity; however, analyzing the effects of a typical transaction and a transaction involving the sale of a naked short shows this statement is a fallacy.
     In a standard transaction, there are two parties involved, a buyer and a seller. One or both of these parties could be opening a new transaction or closing an existing transaction on their books. If they are closing a transaction, then they are liquidating their assets; if they are opening a transaction, then they are doing the opposite - solidify their position, if you will.
     With a transaction involving a naked short, there is the sale of shares the seller does not posses with the promise to attain the necessary shares in a reasonable time-frame. that is, the seller is selling the shares before they can find someone to borrow them from. In a transaction involving the naked shorting of stock, there is only one party involved in the transaction - the seller. Feel free to read over that again, the transaction involves only one party. If you find yourself questioning the absurdity of even allowing such a transaction, believe me you are not alone, I'll cover the implications of this in more detail in another post.
   The seller of a naked short is always opening a transaction. A naked short sale does not have a buyer, so it is entirely the case that all naked transactions are the result of a new transaction. This is the key point. If all transactions are new transactions, then all transactions lead the involved party to solidify their position - not liquidate it. Hence, allowing naked short selling does not improve liquidity.
     Further, I submit that the allowance of naked short selling reduces market liquidity! Consider what happens when a naked short sales are not allowed. The seller must find a buyer who is willing to purchase the shares, or sit out of the transaction altogether. Hence, there is a chance that the seller will engage in a standard transaction. This means a buyer will be involved in the transaction. Now if this buyer is closing a transaction on their books (that is they initially short sold the same stock), then they are liquidating a position. Viola, an increase in market liquidity.
   Naked positions decrease liquidity. Period.

Prelude To Next Post:
     Lets call it what it is, the SEC is trying to increase the number of orders that get filled. If their short sellers can't find a buyer, the SEC decided to allows them to sell the shares anyway. A similar situation can arise if naked buying is allowed (naked call option purchases for example). In an upcoming post I will discuss why the SEC's goal to maximize order executions is also a bad goal. In fact, I will demonstrate that it is breaking the free market.

Apology:
     I apologize for the lack of posts lately. I have written many drafts but am not fully satisfied with the posts yet. I am trying to improve the readability and quality of my posts. If you notice any errors or find places where I am not as clear as I could be, I encourage you to email me your corrections/suggestions.

Related Links:
    - Division of Market Regulation: Key Points About Regulation SHO -- scroll to Section II. Naked Shorts
   - Bloomberg's Financial Glossary

On "How to Unfreeze Bank Lending"

2008-10-08T00:54:00.005-04:00

This is a great opinion piece by Robert C. Pozen, with which I agree fully.

Background:
The source of the current financial crisis is the uncertainty of whether or not a bank will be around tomorrow. So instead of trying to provide incentives that make banks more willing to lend to one another, why not provide a mechanism for banks to lend to parties they don't trust - without taking on unnecessary risk! Yes, read that again, the idea sounds ridiculous, but with the right proposal this idea is a super hit.

Proposal:
Pozen suggests the government should guarantee short term loans to institutions the government deems well-capitalized. The marvelous part about the idea is that he suggests charging a small fee in exchange for providing this service. Its an excellent concept, essentially the government would be acting as an insurance company, a company that insures short lived loans.
In a normal market an insurance company who drives all of their business from insuring short term loans wouldn't last long, because high quality borrowers can usually get a loan without a guarantor; however, in a market that is as unstable as the current market, such an insurer would thrive. I can think of no better way to put a significant portion of the $700 billion to work. In fact, if the government is good at choosing who it insurers, there would be no cost incurred. If only a small number of borrowers default, then the fees charged may cover the bulk of the cost.
Although it would be great to see a corporation step in and take advantage of this money making opportunity, as is often the case, private enterprise can only do so much. The urgent need for such an insurer suggests the government should take charge of the situation.

Kudos:
I'd like to send a big kudos out to Mr. Pozen for an excellent idea. Its great to see people proposing solutions rather than dwelling on past or present faults in the soci-economic system that is our country.

I have no association with Mr. Pozen, in case your wondering who this guy is, then fromt he article, his qualifications are as follows:

Mr. Pozen is chairman of MFS Investment Management.

On Rate Cuts for Liquidity

2008-03-10T22:51:00.029-04:00

The Proposal:
    We should provide the federal reserve with a new regulatory instrument that aims to reduce the incentive for new bearish trades made with borrowed funds. This can be accomplished by regulating the amount of margin available to new positions based on whether or not they are bearish.

At Issue:
    On January 22nd the stock market continued an aggressive downward spiral leading the Federal reserve to issue an emergency rate cut of 0.75%. This rate cut came amongst a fury of other rate cuts. Are rate cuts an appropriate way to deal with a market that is dropping very fast? The Federal Reserve Bank of New York has an excellent historical list that shows the discount rate and the federal funds rate over the past few decades.
    These recent cuts have brought the overnight lending rate to 2.25% from 5.25% a year ago. Though, it should also be noted that the rate has been lower historically, as recent 2004 and 2003. In the past providing liquidity by cutting the lending rate has usually lessened the load of recessions; however, I feel the present situation is vastly different than any the US economy has faced. The events of September 11 came in the midst of the boom cycle, leading to an out-of-season recession. To lesson the burden of that recession the government lowered the interest rates. Although they raised them again after the economy began booming again, the rate today would have been higher if they were not forced into cutting drastically earlier. A higher lending rate would have provided the Federal Reserve more breathing room when it came to cutting the lending rate to provide liquidity to the market.

The Proposal:
    The proposed method should only be applied to new positions. Forcing a change in the margin requirement of existing positions would falsely cause a number of trades to be pushed into a margin call, independent of whether or not the trader left themselves adequate breathing room. Since these calls would lead to a forced booking of profit or loss, the market would move as a direct result of government intervention. This would grant the reserve to much power in the form of influencing the general trend of the market (leading to over inflated markets and an eventual crash when people loose faith in the system).
    Instead, the idea is to prevent the amount of borrowed money that is put into the market. Since this money is borrowed from brokers, who borrow from banks who ultimately borrow from the government, it makes sense that the government be able to restrict the amount of leverage available in one direction or the other. This would not necessarily slow down the sharp swings in the market, based on the efficient market hypothesis, injecting liquidity is only going to increase the number of trades not the value of the market's assets. Most traders are aware they need to pay back their margin so this should come as no surprise.
    Such an instrument would be a finer tool to use rather than the blunt tool of reducing the overnight lending rate, in terms of what the reserve has been trying to accomplish over the past year.

Related Links:

- Federal Reserve Bank Press Release

- Historic Fed Rates

On Dollar Parity

2008-01-04T04:43:00.006-05:00

The Proposal:
    Lets debase the Canadian dollar by printing cash and use this cash to momentarily pay off Canadian debt. Once the US dollar rises again causing the Canadian dollar to dip to unacceptable lows, lets rebase the dollar with a time-value equivalent in cash.

At Issue:
    Dollar parity may sound great but that is not the case. Since the current dollar parity was not brought about by a rising Canadian economy and instead was a result of a weakening American economy, who happens to be Canada's largest trading partner, Canada is presented with a unique opportunity.

The Details:
    At present we have over $600 billion dollars of debt. Approximately $500 billion of that is due in Canadian dollars. By devaluing the Canadian dollar, we devalue some of our debt, while increasing the value of the remainder of our debt. According to statcan our current M3 figure for 2007 was $1.12 quadrillion. The M3 figure is largely regarded to be the best measure we have to measure the total amount of money a country has in circulation, deposits, investments, etc. Based on the M3 figure, the Canadian debt is about 0.0446%, which is not a substantially large figure. This is not a surprising ratio, since Canada is a country in a good financial standing and a sizable economy.
    It is my observation that most western governments adhere new classical economics religiously. That is to say, they fear government intervention, it doesn't mean that the government does not intervene, rather it refers to the fact that they feel it is absolutely the last resort. However, modifying the overnight lending rate is govenrnment intervention - even if this task is managed by a second party such as the Bank of Canada or the Federal Reserve. I am also fully aware of the stigma the debasement of a currency carries. When discussing the debasement of a currency, usually thoughts of Germany in the 20's, Hungary after the second world war or more recently Zimbabwe creep into our minds. However, the horror stories are a result of hyper-inflation as a result of unjustified currency debasement. Currencies are debased on are regular basis, debasing a currency in-and-of-itself does not lead to hyperinflation.
    A higher dollar in theory to most people means lower prices for goods in Canada and cheaper travel abroad. Although the later holds true, the recession in the US will undoubtedly spark lower spending in Canada, including foreign travel. With respect to goods, if the US dollar were to bounce back in 2-3 years Canadians would never see any savings. Companies have an incentive to silently raise their prices since the depression in the US will cut their profits from other sources. Additionally, it takes a number of years for products to make their way through the retail pipelines, meaning the price changes would take a while to be observed - if ever (since a restoration of a high US dollar would mean companies can keep the prices high even for goods that were imported for cheap).
    Dollar parity is clearly not good for Canadians and it clearly hurts the exporters in Canada by reducing their profits. So why not debase the Canadian dollar excessively? Well, the answer to that is to prevent hyperinflation. Debasing the Canadian dollar to increase the profit for exporters is unjustified as far as foreign currency traders and Canada's business partners are concerned. However, when a country pays off its debt, the dollars it prints have an intrinsically higher value, since they carry less debt. By paying off our Canadian debt we can provide foreign and domestic parties that deal with Canadian dollars a more reliable currencey.
    The key to this entire proposal is the word 'momentarily'. Because if the country decides this is something it will do independent of whether or not the economic climate makes it a favorable option, then foreign parties will have no faith in the rate at which the M3 of Canada will grow. As a result, investing in Canada will become a risky en devour since your money will be debased. By letting traders know that this debasement is only going to be done while the US recession (which is likely to last a year or two) is in progress, traders can rely on the fact that in 2 years everyone holding Canadian dollars stands to benefit from the savings we make on interest.
    We stand to save a years worth of interest on half a trillion dollars. Thats not a small figure, especially if we still make our annually payment, since it lets us pay off our foreign debt and put money in the bank for when the debt is rolled back in. Of course, this is a little simplistic since one would need to take the debt agreements into consideration, such what the interest rate on the debt is (if it is less than what could be attained today, then it doesn't make sense to pay it off and reacquire it at a higher level).

Editorial Note:
    This article was modified on Nov 26th. I do not retract anything from my original post, which can be found here. The editing was mainly done to bring this post up to date with the rest of my blog. I am trying to make my posts more concise based on reader feedback.

Related Links:
- CBC's coverage of the dollar reaching parity
- Statcan report of Canada's net debt over the past five years
- Statcan report of Canada's money supply
- Nafta Fast Facts