Wall Street Bailout

What an amazing couple of weeks.

It looks like right now we may be in the middle of the climax of the financial mess which has been building for the past 18 months. At least I hope this is the climax: if there's another act to follow, it will be a doozy. On the other hand, I've been saying since the beginning of the year that I thought we were at or close to the bottom.

Foolish me.

What scriptwriter can resist the natural drama of a $700 billion bailout of the financial system juxtaposed with what was going to be a historic election anyway? I have a bad feeling, though, that when the inevitable movie versions are made my reaction will be the same as often happens when my favorite books are put up on the big screen: "It was OK, but the original was better written."

There's been considerable media coverage and analysis, but not every question has been answered. Here's a little bit of my own analysis:

What Happened?
Since the Great Depression, large chunks of our financial system have been regulated by the government to ensure stability. The tradeoff was basically that banks would have their deposits insured by the FDIC, preventing a run on the bank, in exchange for strict oversight and somewhat reduced profits.

The regulations are designed to help in bad times by ensuring that most banks have enough money to weather most storms. In good times, of course, bank failure isn't so much of an issue.

Over time, however, more and more of the financial system has migrated from the regulated banking world to the unregulated world of money market mutual funds, commercial paper, hedge funds, CDO's, and so forth. That's because it's easier to make money on the unregulated side (no pesky regulations, after all). To feed the appetite for more investment, higher returns, and greater fees, the unregulated side gobbled up more and more of the financial acitivity which used to be handled by regulated banks.

If you're a consumer in the U.S., chances are that at least some of the money you owed to someone was bought, repackaged, sliced, sold, repackaged, etc. Not just mortgages, but credit card payments, student loans, auto loans, etc. all got fed into the machine.

Investors and bankers made so much money so fast that the demand for these investment vehcles was nearly insatiable. It helped that the economy was doing great, and default rates were at historically low levels. Because of that demand, it became really easy to borrow money for almost anything, on almost any terms. That easy credit masked the fact that the value of the collateral (the mortgaged house) was perhaps not as solid as everyone assumed.

When the party ended and default rates started going up, the value of all these investment vehicles inevitably started to drop. In a normal recession, that wouldn't be such a problem, since banks are required to have enough reserves to buffer against a certain level of defaults from the people they loaned money to.

Two things are different this time: first, many of the loans this time around are held by unregulated institutions, whcih are not legally required to hold any particular cushion. The hedge funds and investment banks which own all these slices of mortgages only needed to have enough assets on hand to convince their trading partners that they would be solvent in the near term. Second, house prices went up so far so fast that they came crashing down much faster than anyone thought possible, wreaking havoc on everyone's risk models.

The net result is that, among the institutions who were active in the market for packaged debt, nobody's sure that anyone else has enough assets to cover their obligations, or that they'll have enough assets tomorrow. Confidence is gone, and nobody is willing to do business with anyone else.

How Will $700 Billion Help?
Simple: The governmet steps in, buys a bunch of these investment vehicles which nobody knows the value of (presumably at pennies on the dollar), and takes them off the hands of whoever owns them. Then that hedge fund, investment bank, or insurance agency knows exactly the value of its assets, having replaced hard-to-value distressed debt with easy-to-value cash. Confidence is restored, the system unfreezes, and life goes back to mostly-normal.

The fly in the ointment is setting a price at which the government will buy these distressed securities. If the government (that is, you and me as taxpayers) pays too much, then it takes a loss and winds up subsidizing a bunch of money-grubbing hedge funds. Pay too little and the taxpayers make a profit (which is the American Way after all), but the seller may go bankrupt anyway.

I'm actually not too worried about the government paying too little: presumably nobody is going to be forced to sell us these toxic assets, so they have the option of walkng away if the price is too low. If a few banks and hedge funds go bankrupt despite unloading their bad holdings, then they almost certainly would have gone under anyway. We're no worse off in that scenario, and maybe a little better since at least the dregs of the bankrupt firm will be easy to value.

Won't This Cause Inflation?
One of my first worries when I heard about this plan was the inflationary effect of pumping $700 billion of money into the economy (which is essentially what will happen, in a roundabout way).

I'm not as worried about inflation on further reflection. One of the big effects of the housing bubble was to create vast amounts of wealth from thin air as home prices went up, and many people spent a lot of that wealth through cash-out refinancing. Now that housing prices are dropping and investors are deleveraging (reducing the ratio of debt to assets), huge amounts of money are being sucked out of the economy. This $700 billion bailout will serve to replace some of the money which is being vaporized through deleveraging and declining asset prices.

It's also worth pointing out that the government isn't going to just hand out dollar bills. We will get assets in return, in the form of these mortgage-backed securities, and at a discount. As the underlying mortgages are paid off, the government gets to pay off whatever money it borrowed to facilitate the bailout in the first place. If we play our cards right, there might even be a small profit.

Who Are the Winners and Losers?
Winners

• Anyone who sold a house in the past five years and didn't buy a new one (or bought a less expensive house)
• Anyone who did a cash-out refinncing and was foreclosed on or did a short sale (*these people probably don't feel like winners, since they lost their homes, but they essentially got free money from the bank without having to repay it. This let them live at a higher standard than they otherwise would have been able to for at least a few years.)
• Anyone who did a cash-out refinancing and manages to keep the house, since they got a bigger line of credit than they would have qualified for otherwise, for at least a few years.
• Anone in the real-estate or mortgage-broker business in the past five years.
• Any investor who owned mortgage-backed investment vehicles before 2007

• Anyone who bought a house in the past five years, unless that house was bought from the proceeds of sellng another house. These people probably overpaid and are now stuck with the debt.
• Anyone in the real-estate or mortgage-broker business in the past five years. Most of these people are now unemployed or in new carreers.
• Any investor who owned mortgage-backed investment vehicles during or after 2007. These investors lost their shirts, and many have gone bankrupt.

Predictable Results

One of the crabapple trees outside our home has a wasp's nest the size of a basketball in it. Yesterday Scooter and Skeeter thought it would be great fun to start throwing stuff at it.

The results were predictable, and Scooter has a nice sting which has swollen his left eye almost shut. He insists it was his younger brother bothering the wasps, but one of the bricks I found on the ground could only have been thrown by Scooter.

No matter. Natural consequences are a Good Thing, we now know that Scooter isn't allergic to wasp stings, and maybe next time they'll know to leave the little meanies alone. Some fights just aren't worth picking.

According to a couple of web sites, wasps get very sluggish and have a hard time flying when the temperature is below 50 degrees. Fortunately we're going through some cool weather now, and the overnight low is forecast to be 47.

First thing tomorrow I'll finish the cleanup.

I have no energy!

I just discovered that in my transition to the new version of iBlog, my entire "Energy" category disappeared.

It looks like the only way to get it back is to recover the entries by hand, a task I'm not likely to complete for a while. In the meanwhile, here is a link to the old energy category page.

Testing....testing...

I was forced to upgrade to iBlog 2.0 (beta) a few weeks ago, and unfortunately it broke all my site templates.

I think I have everything fixed now, but please bear with me if you notice any oddities.

Obama Fat Cats

San Francisco Scuba Map, circa 2050

I'm not sure where I heard that exchange, and I'm not sure if it's true, but it inspired me to perform an interesting thought experiment: what would be underwater if the sea level rose 300 feet?


All of Florida and much of the southeast United States would become a shallow sea. The Mississippi would empty into the Gulf of Mexico somewhere around the confluence with the Ohio River at the southern tip of Illinois.

And San Francisco? It would look something like the map I made (click on the thumbnail for a full-size version). To produce this Map of San Francisco Under 300 Feet of Water, I downloaded a 7.5 minute topographic map from the U.S. Geologic Survey, then traced around the 300 foot contour in Photoshop. I left the water slightly transparent so you can see the layout of the submerged streets and other features.

Here in Minnesota we would have nothing to worry about--except for all the people moving in to enjoy our newly moderate climate, thanks to the improved proximity to the Gulf of Mexico (hurricanes might become an issue, too). All of Minnesota is well above 300 feet in elevation.

As much fun as it was to make the Scuba Map of San Francisco, 300 feet of sea level rise is close to an impossible scenario. Even if all the ice caps (Antarctica and Greenland) completely melted, sea level would only rise around 200 feet--and no scientists I know of think that complete melting the Antarctic ice sheet is anything close to a realistic possibility.

A more likely outcome of global warming is a sea level rise of a foot or two over the next century--devastating enough, to be sure, but not nearly as much fun to put on a map of San Francisco.

Blogging drought, rainfall glut

The Magic Year

It's always dangerous to extrapolate current trends far into the future, but I've been doing it anyway for solar energy. I got my hands on a data set of the average price of photovoltaic modules over the past 25+ years (in constant 2006 dollars), thanks to Robert Margolis at NREL.

Keeping in mind that the data shows the prices of the PV modules only (not installation), the trend is remarkable: on average, the real price per watt of photovoltaic modules over the past 25 years has tracked almost perfectly to a curve which drops by half every 10.5 years (or about 6% per year). There are a few blips here and there--corresponding to supply and demand fluctuations--but the simple 6% annual drop in prices explains 96% of the variation in PV module cost over two and a half decades.

Given recent advances in photovoltaic technology, there's no reason to believe the trend won't continue for a while longer. It may even accelerate at some point.

At this point, it's natural to ask when solar panels will be cheaper than power from the electric company. You have to make some assumptions about the long term interest rate, how long the modules will last, and the relative cost of installation, and I came up with the answer that solar and grid power will be at parity somewhere between 2020 and 2025.

That's not the whole story, though, since it's reasonable to assume that the cost of electricity will increase faster than inflation for the foreseeable future. That means that while the cost of solar power is going down every year, the savings will go up--and the savings will continue to increase even after the solar panels are bought and paid for.

So in reality, it makes financial sense to install a photovoltaic system while it's still somewhat more expensive than grid power, since over the life of the system the savings will continue to increase. The Magic Year--the year when a brand-new photovoltaic system will pay for itself over its lifetime--depends on the assumptions you use about the inflation rate for electricity, the real interest rate, the life of the system, and so forth.

The Magic Year is 2015
The Magic Year is 2015 using these assumptions:

• The installed price of a photovoltaic system will be twice the price of the modules alone
• The price of the modules will continue to follow the historical curve
• Grid power today costs $0.10/kWh (about the price I'm paying now)
• The real inflation rate for grid power will be 3% (i.e. grid power will increase on average by 3% more than the inflation rate)
• The long-term real interest rate will be 3.5% (i.e. the interest rate will be 3.5 percentage points above the inflation rate)
• One watt of PV capacity will generate one kilowatt-hour of electricity per year (about the factor for Minnesota)
• The system will last 30 years
• After 30 years, the photovoltaic system will have no residual value (i.e. it will need to be completely replaced)

I used a Net Present Value (NPV) calculation, the standard way to figure the current value of future cash flow or savings. If the NPV is negative, then the system costs more to install than it saves over its lifetime; conversely, a positive NPV means the system pays for itself. The breakeven point (NPV = 0) is the Magic Year.

Your Magic Year may be different than mine. For example, in the California desert where grid power is more expensive and a photovoltaic system produces more power over a year, the Magic Year could be as early as 2007 (using the same interest rate and inflation assumptions). In Seattle, where hydro power is still cheap and it's cloudy all the time, the Magic Year could be 2025 or later.

Saving for the Magic Year
There are a lot of assumptions and an uncomfortable amount of extrapolation which go into calculating the Magic Year, but it seems reasonable to assume that 2015 will be the year to install a photovoltaic system here in Minnesota (give or take a couple years). She Who Puts Up With Me and I have decided to run with this assumption, and start putting aside some money every month with the idea of saving enough by 2015 to install a PV system big enough to bring our net electrical consumption to zero. We're also putting aside enough to pay for a major upgrade of our heating and air conditioning system at the same time--which might include switching to a geothermal heat pump.

In the meanwhile, we'll keep burning firewood in the winter--the stove has now paid for itself with gas savings--and doing smaller energy upgrades along the way like windows and lighting. 2015 is only seven years away, and by then we hope to have our net home energy use down to zero.

Inscribed on Charlton Heston's Tombstone

"Okay, you can take my gun now."

50! *

Blood in the water on Wall Street

The stock market opened down big this morning (30 minutes into trading, the S&P 500 is down well over 1% with no bottom in sight). The news in the Wall Street Journal is alarming: the private equity fund Carlyle Capital failed to meet a margin call last night.

A margin call is the second worst thing which can happen to any investor. It means that the investor borrowed money against its portfolio, and the bank or brokerage is demanding more collateral for the loan because the value of the portfolio dropped too much. The usual response is to add more cash to pump up the portfolio value and reduce the loan amount.

Normally when an investor gets a margin call, there's only a matter of hours to put up enough collateral (or "meet the margin call"). If the problem isn't fixed by the start of trading the next day, the bank or broker will force the investor to start selling part of the portfolio to pay back enough of the loan to satisfy the collateral requirements.

This forced selling is the worst thing which can happen to an investor.

That a private equity fund as prominent as Carlyle Group would fail to meet a margin call is nothing short of astonishing. Aside from the fact that they should have been smarter than to get themselves in this situation in the first place, this was the group all the conspiracy nuts liked to weave their dark theories around, because of the number of prominent politicians (including ex-Presidents) associated with the fund.

There's an old saying among stock traders that you should buy when there's blood in the water. In other words, when a big player is wounded or dying, the forced selling will push prices to an irrational place and that's the time to step in and buy.

This morning there's blood in the water. Too bad I'm already invested.

Economic outlook

Ten Business Lessons

Really Frozen North

Plus a new feature this year: the Temperature Roller Coaster. Most years, when we go into the deep freeze, we get a week or maybe ten days of consistently subzero temperatures, barely struggling into positive territory in the mid-afternoon if at all. This time around, we're getting short little bursts of bitterly cold temperature, followed by a warmup a day or two later, and then another plunge a few days to a week or two after that.

This week was especially remarkable, as shown in the graph:


Over a 36-hour period, we went from +45 degrees to -15 degrees, a 60-degree swing. In the temperature plot you can almost see the exact minute the arctic cold front passed our house.

The weather service likes to measure these things in nice 24-hour chunks, and on that basis this was apparently the biggest drop in decades. It was a little surreal to be walking around outside with no jacket on Monday, then all bundled up and worried about the car starting on Tuesday.

Welcome to Minnesota.

This week, they're forecasting a snowstorm on Monday, and more moderate temperatures (nothing below zero). We're past the midpoint of winter, there's noticeably more daylight now than back in late December, and it will get harder and harder for those arctic airmasses to compete against the warmer air coming from the Gulf of Mexico.

We've also now completely consumed the five cords or so of firewood I'd stockpiled in the garage, so I'm now starting to move wood in from the outside piles. The wood in the garage lasted until February, almost exactly as long as I'd predicted. The supply is looking good, though I'm spending a fair amount of time picking through the piles to find the best wood to burn while it's still relatively cold out. The lighter wood (mostly cottonwood) is best for burning in the spring, when we don't need to keep the stove going all the time. It just burns too fast for the middle of winter. The biggest problem is that I've still got something like eight cords of cottonwood, most of it in large unsplit pieces. That's almost half a season's worth of wood, which is good, but there's so much of it that I'll be spending a lot of time splitting, stacking, and moving it.

On the other hand, it was all free. Beggars can't be choosers.

New Weather Page