Relevant and even prescient commentary on news, politics and the economy.

Customer preference is not transparency?

by rdan

WSJ reports:

Who needs markups? Customers who shop at Eli’s Manhattan, a posh grocery store in Manhattan’s tony Upper East Side, aren’t paying more for individual items — they’re just paying 1.8% more on their bill at the checkout.

Grocery stores find ways to pass higher energy prices onto customers. 
Eli Zabar, who owns the decade-old two-story haunt known for its $12 chocolate bars, $30 imported nuts and $95 hams, told a CBS affiliate station in New York that he wanted to be transparent to his customers about the need to raise prices as his energy bills soar. So he’s affixed tasteful placards in his store that read “ATTN CUSTOMERS: An energy surcharge of 1.8% will be added to every purchase.”

“I am making the increase completely transparent to the customer,” Mr. Zabar told CBS, “to call the public’s attention to how much fuel is being used in the food business.”

It seems his customers would rather not know, as angry patrons told the news channel they wouldn’t be returning to the store, calling the surcharge “outrageous” on top of prices that are already high.

So Mr. Zabar may now opt for what many other food purveyors have chosen to do: mark up the prices of individual items and hope it doesn’t drive customers away. “If the shock and awe is too great then what we’re gonna do is hide it in the cost of goods itself,” Mr. Zabar said. –Kelly Evans

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How did Lehman manage that ?

Robert Waldmann

A commenter over at naked capitalism notes that

$110b of senior LEH debt went from trading .95 to .12 in a matter of days …. If you include the less senior debt that is trading at essentially zero, LEH had $110b hole in its balance sheet. And just days before this, the market was being told and was believing that the $10b disposition of Neuberger was going to solve their funding problems.

Now is there a precedent in this history of bankruptcy–excluding cases of accounting fraud–where bonds collapsed like this once a bankruptcy court opened up the books? I’m thinking the answer is ‘no.’ Which then makes you re-evaluate the premise that there wasn’t fraud at LEH in marking the value of their assets.

Now I may be crazy, but I think that the idea that accounting fraud is required to achieve this is old fashioned and out of date. I think it can be achieved without breaking the laws, such as they are.

Lehman could have made their senior debt worth 12 cents on a dollar in case of default by selling CD insurance on their own debt — lots of it. This would not require any false accounting as they are not required to report this fact.

Now I would be reluctant to believe that a bank could insure its own debt if it hadn’t already happened .

The trader then went on to tell me that Commercial Bank of Korea would sell credit default protection on bonds issued by the Commercial Bank of Korea.

Who would buy a CDS on Lehman from Lehman ? Only a fool ? Well I have another candidate — someone who had bought lots of cash settlement CDSs on Lehman debt from a third party. The payout on a CDS depends on par value minus settlement value. A huge amount of Lehman insurance of Lehman is not very useful to someone who wants to hedge, but it is very useful for someone who wants Lehmen to settle for as few cents on the dollar as possible because, he or she has bought Lehman CDSs from a third party.

Now to Lehman, insuring their own debt is a very very attractive proposition. It is money for nothing unless they go bankrupt and if they are bankrupt well they are bankrupt. The whole source of moral hazard and adverse selection in credit markets is that it doesn’t matter to the debtor how much he goes below zero.

A positive price for Lehman insurance of Lehman makes sense (algebra will be after the jump when I type it up). There was money to be made at the expense of holders of Lehman debt who didn’t think of the possibility of over-insurance.

Is this what happened ? I have no idea, but I guess we will find out fairly soon.

update: My claim about reporting requirements has been contested. I should stress *again* that I am not an expert and add that I know jack about accounting standards.
I have learned a lot from comments here and at crooked timber. I reply at tiresome length in comments at crooked timber and at my home blog.

As far as I can tell firms must report the total fair market value of CDS written as liabilities, but this is not what matters to bond holders. To them liabilities matter only to the extent that they cause bankruptcy and/or affect the value of liabilities or assets in case of bankruptcy. Knowing the expected value of a liability which is worth zero the 99.9 % of the time in which bond holders just get interest and principal and a whole lot the 0.1% of the time in which Lehman brothers is liquidated is of little use to bondholders. Also, as John Quiggin notes, accounts are not published continuously and our latest information on Lehman Brothers appears to date from May 31 2008 which was a while ago.

First a CDS on LEH issued by LEH is definitely not worthless. It can’t possible pay out as described in the terms of the contract, because it only pays when Lehman defaults, but it can pay its stated value times the cents on a dollar payout ratio found by a bankruptcy court. Even in the case of LEH,this will be positive.

Now algebra. I will assume all debt is equally senior. The par value of LEH debt is 1 (for simplicity). They go under with assets equal to y (which must be less than 1 for them to be bankrupt). the payout ratio phi is equal to assets over total liabilities. However the liabilities are not just debt. They include self CD insurance for x units of par which, in theory shold pay x(1-phi). Actual payment on the CDSs is .

phi is given by
1) phi = y/(1+x(1-phi))

Note that phi is not zero, so the CDS has positive value — you don’t have to be crazy to buy it.

This gives a quadratic equation with one solution to phi between 0 and 1

2) phi = (1+x – ((1+x)^2-4yx)^0.5)/(2x)

phi is definitely real and positive. 2 can be rearranged to

3) phi = (1+x – ((1-x)^2+4(1-y)x)^0.5)/(2x)

And y
taking a first order approximation alpha is approximately equal to

4) phi is roughly equal to y/(1+x)

Which is positive.

So total payouts on CDSs are

5) x(1-phi)phi= xy(1+x-y)/(1+x)^2

And the ratio of the payout to the face value is

6) payout/x = y(1+x-y)/(1+x)^2

oh this is odd. take the derivative of the payout/x with respect to x

7 d(payout/x)/dx = y[(1+x)^2-2(1+x)(1+x-y)]/(1+x)^4 = y(2y-1-x)/(1+x)^3

So the payout per unit of self CDS increases in units of self CDS outstanding until the number of units, x is equal to 2y-1. For LEH senior debt, imagine the accounts were accurate (as far as they were supposed to go) and y = 0.95, the value of LEH self insurance would increase in LEH self insurance outstanding until the amount was equal to 90% of total LEH senior debt. That seems to me to be an unstable market.

Now how high would it have to go before it stops making sense to buy CDS from LEH ?

Well that depends on the price doesn’t it. If normal investors like Janet Tavakoli won’t touch it, the price could be very low, say one tenth as much as third party insurance. That would make it optimal to a price taker so long as alpha is greater than 0.1. Obviously I chose 0.1 out of my hat, because it is close to current market estimated phi of 0.12.

Could this have happened ? I don’t see why not. As far as I know it was all legal and profitable to both parties in the contract.

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Initial Impressions of the Debate

Know first that I am not in McCain’s camp–by any stretch of the imagination.

Obama made a stategic mistake: He constantly was willing to give McCain benefit while McCain was constantly on the attack, giving no quarter at all. He never took the argument directly to McCain, instead we heard repeatedly that “John is right when he says….” or “I agree with John when….” Those phrases should never have been uttered, not in a public debate when impressions, not logic, rule.

At the beginning of the debate, McCain was clearly the more uncertain and nervous of the two. But he kept to his script, weaving his patriotism, his fight against pork, his visits abroad into almost every response. Never did he give Obama any credit for anything.

When McCain sidestepped Obama’s criticism (on taxes, for example), Obama should have restated the point, emphasizing that McCain failed to address the issue he (Obama) had just raised.

Obama should have consistently tied McCain to his support for the wealthy, i.e., Wall Street–and to Bush economics. Examples: McCain’s confession of ignorance on economic policy, his support of tax cuts for the wealthy, his admission that he had not even read the initial bailout proposal.

He should never have congratulated McCain on anything….

Obama has some lessons to learn, I think.

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Canceled debate

A link to the past

With new polls showing his campaign dead in the water among California Republicans, Arizona Sen. John McCain has pulled out of a long-scheduled debate with Texas Gov. George Bush, set for Thursday in Los Angeles.

McCain campaign officials tried desperately yesterday to put the best face on their withdrawal, even as a new Field Poll showed Bush far ahead among likely Republican voters in the winner-take-all race for the state’s 162 GOP delegates.
Top campaign officials attributed McCain’s decision to Bush’s earlier reluctance to appear at the debate.

“We had agreed to do this debate a long time ago, and Gov. Bush said he wasn’t going to do it,” McCain spokesman Howard Opinsky said yesterday. “We aren’t going to hold our schedule together forever.”

But Opinsky said McCain will debate Bush on NBC’s “Meet the Press” Sunday, a national TV show that will reach millions of Americans.

Still, just last week, the McCain campaign was openly derisive of Bush’s reluctance to commit to a California debate — and promised its own candidate would be there.

“John McCain believes it’s important for the people of California to see and hear the candidates talk about the issues,” McCain communications director Dan Schnur told The Chronicle last week. “Thirty- three million Californians are worth that attention . . . and we’ll be there, either way.”

As recently as Thursday, when he was in California, McCain was talking about his plans to debate Bush; even last night, McCain’s own Web site listed his California debate- watching parties. The CNN-Los Angeles Times debate was the only scheduled head-to-head meeting of the two candidates in California before the primary, a week from tomorrow.

McCain’s campaign said the candidate confirmed to CNN on Thursday that he would not appear. But until yesterday afternoon, when rumors swirled about the pullout, McCain — who has touted his “straight talk” politics — gave no public indication that he intended to duck the nationally televised showdown.

The bait and switch on the debate left the Arizona senator — whose favorite campaign line is “I’ll always tell you the truth” — wide open to blistering criticism from his rivals.

“Clearly, this is more double-talk from the McCain campaign,” said Alixe Mattingly, a spokeswoman for Bush. “Pulling out of this debate at the last minute is an indication that they’re pulling out of California, where McCain’s antagonistic message clearly isn’t working.”

The decision to avoid debating Bush clearly upset some of McCain’s top advisers.

“It’s definitely a mistake, but hopefully, the people of California feel strongly enough about the McCain reform agenda . . . to overlook a staff error and come out and vote for John McCain,” said Schnur, a longtime California political operative. “John McCain is completely committed to California; unfortunately, our staff’s position on this debate sends just the opposite message.”

California Republicans have been worried all along that the two leading GOP candidates are not giving the nation’s most populous state the respect it deserves. Bush’s campaign stop in Los Angeles last week, for example, was his first visit to the state since November.

Bush supporters quietly reveled in McCain’s surprise announcement.

“From a distance, it seems like the `Straight Talk Express’ is careening off the exit ramp in California,” said Leslie Goodman, a Republican communications consultant and Bush backer, in a reference to McCain’s campaign bus. “They claimed they’d make California a priority because it was win or die, and now they don’t care enough to debate.”

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Dear US Citizen, It is your labor being conscripted

by Divorced one like Bush

I just have to get this out because I fear we will not learn from this experience if we do not face up to what really is being put on the line in this crisis: Our labor. I am angry. And I am making this personal. It is personal. I’m speaking to you We the People.

What every solution is proposing in its most boiled down pure form is the conscription of our labor. It is nothing less. Only, it is not conscription for altruistic reasons. It is conscription in service of the most basic of needs: survival.

From this point forward, any gains in productivity will no longer be applied in total toward our quest for a more perfect union and the pursuit of happiness. Think about how much progress will have to be made in labor productivity rise just to offset the $900 billion already tallied and the now additional $700 billion such that we do not lose our current standard of living. If we can not make the increase, how much lost standard of living does this represent? How much more do I have to work, or how much of what I work now will go toward this crisis resolution instead of bettering my life? These are the questions we as citizens should be asking. It’s not like we can all just pay this off by writing a check from our savings. Even if we could, it represents future gains in our personal growth lost.

It is not money. It is not the taxes to be paid. It is not the wealth lost. It is the most basic of human life sustaining and rewarding experiences being taken: labor. Our labor. That which provided the bases for the value of our nation’s worth.

That this crisis resolution is being talked about in dollars does a complete injustice to all of the labor that has come prior to this historic moment. The failure of the system, the loss of value, the loss of the integrate of the system is a testament to the abuse (physical and emotional) that the US citizen has been enduring. That the discussions (and I understand that we have to discuss the mechanics to resolve the crisis) by our elected does not come from the perspective that it is our labor being taken, being assigned is the lie we have allowed ourselves to live. We have not made what takes place in our country personal. It is always abstract in our national discussions.

WAKE UP! KNOCK, KNOCK, HELLOOOOOOOO…this is real. This is happening. You are going to be working, laboring, sweating, getting tired, getting fustrated, longer years of work, more worn out in our retirement from now on. No one else is going to be paying this off. You and I will be paying this off.

It is our fault too, because we are the government. WE ARE THE GGOVERNMENT! (Please keep saying this until it is as natural an understanding as is drinking water to stay healthy.) And, that is the dichotomy to this crisis. In the end the abuse we have endured, the labor we have wasted, the labor we will now forfeit to future social maturity is our own damn fault because, for what ever reason or excuse, we failed to labor within the primary structure of our life’s existence that supports all we believed about our wealth: One Voice, One vote.

So learn the lesson. Remember the lesson. Teach the lesson. To not learn, to forget is to forfeit via conscription your most personal possession: Your labor.

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Fiddling While Rome Burns

By Spencer

While Congress fiddles and postures it might be informative to look at two highly reliable leading indicators of world economic growth.

The first is the Dry Ships Index of various daily bulk cargo rates. Over time this has proven to be a highly sensitive leading indicator of world economic activity. About half of the recent plunge in the blue index so far this year has occurred this month.

The second index is the CRB:Index of Industrial Raw Material Prices — it includes no energy or agricultural foodstuffs prices. About one quarter of the drop in this index so far this year occurred since the end of last month.Both of these indicators are signaling that the slowdown in world economic growth is accelerating.

I’ll just remind readers that these are two of the signals that I used as leading indicators of a peak in oil prices earlier this year.

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The House Republican Plan: A Bailout or Worse than No Plan

by Tom Bozzo

I want to recommend that readers make it to the end of Robert’s last post with respect to the disastrous economics of the House Republican (and maybe or maybe not McCain) “insurance” plan (or is that insurance “plan”?). I’ll risk maybe repeating Robert since it’s an important point: either the premiums are subsidized and the losses on the toxic assets end up being socialized by a means that looks less like a bailout for political reasons, or the premiums aren’t subsidized and the plan is maybe worse than nothing. The plan’s basic perversity is that it makes up-front demands on ailing financial institutions which, if they could afford in the first place, the free market fairy would have already solved the problem.

(As a note of political commentary, this isn’t the first Fifth Column insurance-like plan to come out of the House Republicans, some of you might recall the effort to get around the potential problem of inadequate ex post returns for privatized Social Security accounts by having the government guarantee private accounts’ returns. Alas, linkrot has taken away Rep. Paul Ryan’s summary page for the Ryan-Sununu Social Security Personal Savings Guarantee and Prosperity Act.)

Reportedly the Republican plan is vague on the nature of the insurance deal; apparently it would direct Treasury to design something. This should be a neat trick thanks to the adverse selection end of the insurance problem. Remember that for all of the fire directed from the right side of the fence at the GSEs and less financially able mortgage-holders, the GSE end of the sh*tpile has much lower (if increasing) default rates by a substantial margin, as you can see in the graphs in this Econbrowser post. In part, that’s because for their late efforts at self-destruction they were mostly involved in the relatively sensible end of the mortgage business.

To make a crude analogy, the problem is akin to being a term life insurer faced with a prospective customer who’s known to have had a cancer diagnosis but won’t (or to make the analogy a little better to the financial situation maybe can’t) let you see his full medical records. Assuming the customer’s spouse isn’t an extremely wealthy beer distributor, the problem isn’t that the customer doesn’t have a relatively urgent demand for insurance. Just based on the public information, the insurance would have to be sold, if it’s going to represent something other than a gift from the insurance company’s shareholders, at a much higher price than the customer would have paid had the insurance been sought back when cancer was mistakenly thought to have been vanquished. The insurance design trick is to avoid having the customer shake on the deal and then say “sucker,” not least because the customer may live to see the payout eliminating any element of poetical justice.

There may be things you can do to make pooling work like mandating participation (in which case the financially healthy subsidize the financially sick), but certainly we’re out of totally-free market territory already. And it doesn’t seem trivial to ensure full participation, since it’s necessary not jus to identify the universe of “financial institutions” but also the assets requiring insurance. So this may be administratively a lot more complex and in some ways intrusive than letting institutions volunteer assets under a mechanism that discourages them from dumping their lemons at non-lemon prices.

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The Bailout: The Role of Government and the Value of the Assets

By Stormy

In small decisions lie big issues. America’s approach to the financial crisis reveals fault lines and contradictions in our approach to some very fundamental issues. Those fault lines and contradictions signal–and may even require–a profound rethinking of the role of government and our conception of our place in the world.

Take, for example, one of the knottier problems in the present bailout plan: What is the worth of the assets to be removed? Ten cents on the dollar? Twenty cents? Thirty cents? Zero?

The question is absolutely crucial; yet it may prove intractable. If the government overpays, firms stand to make a bundle. If the government underpays, firms may be pushed over the edge. Some may fall if anything but the full price is not paid. And some that can weather the storm would gladly have those bad assets taken off the books, a real Christmas bonus if you will.

And yet the fact may be: No one may know for sure. And are we willing to let the market place decide? Are we willing to take that risk? What are our options here?

Brad Setser points out that Sovereign Wealth Funds–such as the China Investment Corporation, the Government of Singapore Investment Corp, and others–have already poured about 55 billion into troubled U.S. financial firms. These cash infusions were investments, not gifts, not bailouts–investments. With those investments SWF’s began to exercise influence and control.

The question now is: Should the U.S. simply use that cash to buy a stake in some companies–or even purchase some of them outright? Brad puts it this way:

Is it really better to reward the banks’ existing equity investors — remember, they own the financial institutions that made the bad bets that led the financial system to seize up – to avoid a US government equity stake?

If the U.S. government simply takes the bad debts off the books, it runs two risks. The first is determining exactly what those debts are worth–with all the uncertainty mentioned above. The second is that the U.S. government is now one big bank with lots of bad debts. And we know who will pay those debts. You and me.

On the other hand, as one wag noted: “With equity comes control.” Control and influence has been an on-going issue whenever foreign interests–especially government sponsored ones–have purchased a significant equity stake in any important U.S. firm or asset.

If the U.S. government buys an equity state, then we certainly are on our way to socialism–like it or lump it. (Some commentators assert that we have already taken that step with AIG.) The irony, of course, is that those who most loudly espoused open markets and capitalistic enterprises took the first steps towards socialism. (If the market place should determine asset value, then perhaps the government should be one of the bidders.)

How much of a future does individual, freewheeling capitalism have in a world increasingly dominated by larger and larger players, larger and larger problems? When individual players become too large to fail, must the largest entity of all–the government–inevitably come to the rescue? And what do we do when problems become so large that private enterprise simply does not work.

Some of the problems we have faced in the past two decades have raised this last kind of question about the role of government.

Health care is a good example. We know that our health care is a mess, more expensive here than elsewhere; yet we have stubbornly refused to surrender our belief that private enterprise and competition are working. Costs continue to escalate; shopping for the best policy is almost a full-time job. One wrong accident or wrong illness can easily bring bankruptcy and destitution. Meanwhile, we tinker at the periphery. Slowly, kicking and screaming, we may finally throw up our hands, throw out the insurance companies–and go to a fully funded governmental program, along with the requisite fee schedules.

I am not saying this will happen–or that it should happen. What I am saying is that what we have is not working. The role of government is still an issue.

The majority of Americans believe that government is the problem, not the solution. That government governs best that governs least. That old saw may have been true a century ago when the nation and its problems were far smaller and less complex. Is it still true today?

That belief has been central to how we have approached almost every issue. Even now, as Bush, Paulson, and Bernanke still do not fully recognize what is happening. In simply removing the bad debts, they are, in a sense, playing the capitalist game. They still believe that private, unfettered enterprise is the answer. Once the bad debts are removed, all will be well. We can return safely to the old game.

But most realize that the bailout may simply privatize the profits and nationalize the losses. Most are not willing to open their checkbooks. They want to know how they, as taxpayers, will benefit. The complaint about more golden parachutes is not an idle one. It calls into question how wealth is being distributed, how jobs are being lost, how the majority of us struggle daily to stay afloat. Now, whether they realize it or not, most have a real stake in this latest exercise. They may begin to ask for a equity stake; the government should make a little money for them–or, at the very least, save them money. If government is to be involved, why should it not benefit the vast majority?

This kind of thinking may well spread to other areas as well–foreign policy, for example. Our latest foreign adventures in Iraq and Afghanistan have been pursued with little regard to cost–at least as far as the average citizen is concerned. They have been luxuries, luxuries they we may now ill-afford.

As long as few American lives were lost, we did not have to worry. What if Haliburton soaked the government? Some purists were disturbed; most could not care. At best they whined a bit, drank some beer, and watched survivor t.v. They were comfortable.

Now, many are deeply worried about their own financial future. Why should they spend good taxpayer dollars in bringing “freedom” to others? If others want freedom, perhaps they should earn it themselves. (But whoever believed that tripe about bringing freedom to the world anyways? Sloppy thinking is always a luxury–but not anymore.) The party is over; time for serious reflection.

We are fast approaching the time when we will have to think even further outside the box, remove our ideological blinders, and look directly at the problems of this century–and fashion our solutions so that they address the problems, not confirm our beliefs. The financial debacle is only the first of a number of problems that we will face in the next ten years.

After the financial crisis is over, we will have to address the issue of trade and jobs. What exactly is the engine that will bring this country out of the doldrums? And how do we fashion it? What will be government’s role. Some want the government just to invest in infrastructure in order to create jobs–and bolster the economy.

Can we simply build infrastructure without addressing the issue of trade? Does a government just build infrastructure and hope for the best? Do we continue to construct trade agreements that encourage companies to flee our shores for cheaper labor elsewhere?

And further ahead lie resource depletion, pollution, and global warming are ahead–in that order. All of these problems will necessitate rethinking the role of the government.

Fractured as well is our view of our place in the world. New American Century? America projecting its power into every corner of the world? I do not think so. Already the cracks in that argument are appearing as we listen to McCain and Obama discuss Iran.

Will we still be powerful enough to dictate terms, simply refusing to talk with our adversaries–Iran– (as McCain suggests)–or do we engage them (as Obama wants)? While some would see Obama’s approach as saner and more logical, the approach is, nonetheless, a tacit admission that we may no longer be in a position to dictate terms. The implications for the Middle East are enormous. Taking a more modest approach will bring its problems as well as its rewards.

Ironically, as we have celebrated the glories of capitalism and the individual, our government has become increasingly intrusive into spying on its citizens–all in the name of safety. How do deal with this? What is the role of government here?

I do not have the answers, but I do know that we will have to address the issue of governance along with who we are and what we believe. The issue is slowly but surely coming to the fore.

Old platitudes will simply not work. They have become brittle and useless as arguments. Our country is fractured with contradictions. Big Brother must spy; yet we believe in individual rights. Big government must bailout Wall Street; yet we believe that the market place knows best. Big Brother should stay out of health care; yet our health care is on the verge of collapse. The list goes on and on. The old order is dying. It will not go easily into any night.

Who would have thought that the arrogance that produced the “The Project for the New American Century” would so quickly have been brought to heel.

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