Continuous Productivity

Just a Reminder...

Contrary to popular opinion, housing prices will not necessarily rebound:

Moneyball Missed the Reserve Clause?

Great article arguing that although baseball is an inefficient market, it is not a completely free market:

The problem with likening the market for baseball players to an equity market is that the former is not a genuinely free market. The reserve clause binds players to the team that drafted them for the first six years of their career; during this time they cannot become free agents and sell their services to the highest bidder. So the intrinsic value of a highly productive player will rise, but he will not necessarily be paid his market value until he has completed his “indentured servitude” (as Lewis termed it). Thus it is not surprising that while payroll cannot tell us anything about wins, it does a pretty good job of predicting a team’s average age: young players are much cheaper.

To understand how much the reserve clause matters, let’s look at the young talent on the Oakland squad Lewis chronicled. Shortstop Miguel Tejada hit 30 home runs for the low, low price of $290,000 in 2000. Two years later, when he won the American League MVP, he made only $3.5 million (I know, but it’s all relative). His free agent contract, which he signed with the Baltimore Orioles after the 2003 season, was for $72 million over six years. Eric Chavez (whom the A’s actually did sign to a long-term market-value contract in 2004) produced 32 home runs in 2001 for $625,000.

Mark Mulder, Tim Hudson, and Barry Zito, the A’s “big three” pitchers, led the team to the 3rd, 2nd, 1st, and 1st American League ERA ranking, respectively, from 2000 to 2003. In 2001, when the A’s won 101 games, the combined salary of Tejada, Chavez, MVP-runner up and all-star first baseman Jason Giambi, Mulder (21 wins), Hudson (18 wins), and Zito (17 wins) was under $8 million. In the first year after each player’s “indentured servitude” ended, the six made a total of $43 million. The A’s won even though they were poor because they did not have to pay their young players what they were worth.

Giambi, who won the MVP in 2000, epitomizes the economics of baseball. He joined the Yankees as a free agent after the 2001 season. In that first year with his new team, he made more in salary than in the seven years he spent in the A’s organization combined. This turned out to be some deal for Oakland. As the San Francisco Chronicle’s Vlae Kershner recently pointed out, Giambi produced about half of his career home runs and RBIs in an A’s uniform. For that output, the team paid about 9 percent of his career earnings (up to the end of last season).

Just as the A’s could not have afforded to compete without the reserve clause during their “moneyball” run, no small-market team could compete without it today.

Why Athletes Go Broke?

An extremely irritating article that tries to tie in supposed athlete stupidity to the current financial mess:

Ismail played two years in Canada and 10 in the NFL, estimating that he earned $18 million to $20 million in salary alone. He made an abortive NFL comeback attempt in 2006, never getting beyond workouts with the Redskins, and then navigated the reality-TV circuit (Pros vs. Joes, Ty Murray's Celebrity Bull Riding Challenge). Today he does a Cowboys postgame show on Fox Sports Net. As cautionary tales go, Ismail's could've been worse: He has his Notre Dame degree, and he never filed for bankruptcy, had legal trouble or got divorced. Yet he lost several million dollars, he admits, through "total ignorance."

It began in the winter of 1991 when he sank $300,000 into the Rock N' Roll Café, a theme restaurant in New England designed to ride the wave of the Hard Rock Cafe and Planet Hollywood franchises. One of his advisers pitched the idea as "fail-proof, with no downsides," Ismail recalls. He never recouped his money and has no idea what became of the restaurant.

Lesson learned? If only. After that Ismail squandered a fortune funding not only that inspirational movie but also the music label COZ Records ("The guy was a real good talker," says Rocket); a cosmetics procedure whereby oxygen was absorbed into the skin ("We were not prepared for the sharks in the beauty industry"); a plan to create nationwide phone-card dispensers ("When I was in college, phone cards were a big deal"); and, recently, three shops dubbed It's in the Name, where tourists could buy framed calligraphy of names or proverbs of their choice ("The main store opened up in New Orleans, but doggone Hurricane Katrina came two months later"). The shops no longer exist.

You might say Ismail had a run of terrible luck, but the odds were never close to being in his favor. Industry experts estimate that only one in 30 of the highest-caliber private investment deals works out as advertised. "Chronic overallocation into real estate and bad private equity is the Number 1 problem [for athletes] in terms of a financial meltdown," Butowsky says. "And I've never seen more people come to me about raising money for those kinds of deals than athletes."

The article goes on to imply that the supposed higher rates of failure for athlete financial investments is that they are trying to hit a homerun:

Hunter, who in November 2007 signed a five-year, $90 million contract, has been able to absorb the loss. But innumerable other athletes have not been so lucky. Former (and perhaps future) NFL quarterback Michael Vick filed for Chapter 11 bankruptcy last July and recently put his mansion in suburban Atlanta on the market. That's partly because he is unable to repay about $6 million in bank loans that he put toward a car-rental franchise in Indiana, real estate in Canada and a wine shop in Georgia. "It's always so predictable," Butowsky says. "Everyone wants to be the next Magic Johnson."

But Johnson is the rare, luminous exception of tangibility gone right. In 1994 he started a chain of inner-city movie theaters and diligently built a business empire. Today Magic Johnson Enterprises includes partnerships with Starbucks, 24 Hour Fitness, Aetna and Best Buy, and its capital management division has invested over a billion dollars in urban communities.

And that's the theme of the entire article. The basic premise being that athlete's are too stupid to handle their own money and piss it all away due to the stupidity. I find this premise annoying for a couple of reasons:

1. The rate of failure for athletes in ventures is no higher, I'd bet, than the general rate of failure for all ventures. In fact, private equity pros (the funds that invest in everything from startup Google to bankrupt Newspapers) don't hit at a higher rate than athletes.

2. I know many "educated" professionals from healthcare, technology, and finance that have lost money on everything from real estate, to private equity, to even public markets and bonds. Does that make those guys idiots as well?

The purpose of this article is, basically, to paint athletes with the brush that they are stupid and the few that are successful are geniuses. It's no different, I suppose, than the majority of articles in the Financial Times profiling business luminaries that made money when the rest of the world was losing it.

There are some valid points about divorce and wasting money on tangible toys. But, again, this is no different than the 30-year old banker that makes a couple million bucks, gets divorced, and pisses away his fortune. The case of excess capital dissolving is common across all industries and types of people. The last decade is an example of excess capital (credit-driven, but still excess) that led to massively wrong investments and stupid decisions.

The author could have made a broader point that making money with new ventures and investments is hard. It's a rare skill with a whole lot of luck, and most of the world just can't do it. Instead, we have another "stupid" athlete article.

Geitner Plan Explained

One of the best explanations of the government involvement in attempting to stabilize the economy:

Q: What is the Geithner Plan?

A: The Geithner Plan is a trillion-dollar operation by which the U.S. acts as the world's largest hedge fund investor, committing its money to funds to buy up risky and distressed but probably fundamentally undervalued assets and, as patient capital, holding them either until maturity or until markets recover so that risk discounts are normal and it can sell them off--in either case at an immense profit.

Q: What if markets never recover, the assets are not fundamentally undervalued, and even when held to maturity the government doesn't make back its money?

A: Then we have worse things to worry about than government losses on TARP-program money--for we are then in a world in which the only things that have value are bottled water, sewing needles, and ammunition.

Q: Where does the trillion dollars come from?

A: $150 billion comes from the TARP in the form of equity, $820 billion from the FDIC in the form of debt, and $30 billion from the hedge fund and pension fund managers who will be hired to make the investments and run the program's operations.

Q: Why is the government making hedge and pension fund managers kick in $30 billion?

A: So that they have skin in the game, and so do not take excessive risks with the taxpayers' money because their own money is on the line as well.

Q: Why then should hedge and pension fund managers agree to run this?

A: Because they stand to make a fortune when markets recover or when the acquired toxic assets are held to maturity: they make the full equity returns on their $30 billion invested--which is leveraged up to $1 trillion with government money.

Q: Why isn't this just a massive giveaway to yet another set of financiers?

A: The private managers put in $30 billion, but the Treasury puts in $150 billion--and so has 5/6 of the equity. When the private managers make $1, the Treasury makes $5. If we were investing in a normal hedge fund, we would have to pay the managers 2% of the capital and 20% of the profits every year; the Treasury is only paying 0% of the capital value and 17% of the profits every year.

Q: Why do we think that the government will get value from its hiring these hedge and pension fund managers to operate this program?

A: They do get 17% of the equity return. 17% of the return on equity on a $1 trillion portfolio that is leveraged 5-1 is incentive.

Q: So the Treasury is doing this to make money?

A: No: making money is a sidelight. The Treasury is doing this to reduce unemployment.

Q: How does having the U.S. government invest $1 trillion in the world's largest hedge fund operations reduce unemployment?

A: At the moment, those businesses that ought to be expanding and hiring cannot profitably expand and hire because the terms on which they can finance expansion are so lousy. The terms on which they can finance expansion are so lazy because existing financial asset prices are so low. Existing financial asset prices are so low because risk and information discounts have soared. Risk and information discounts have collapsed because the supply of assets is high and the tolerance of financial intermediaries for holding assets that are risky or that might have information-revelation problems are low.

Q: So?

A: So if we are going to boost asset prices to levels at which those firms that ought to be expanding can get finance, we are going to have to shrink the supply of risky assets that our private-sector financial intermediaries have to hold. The government buys up $1 trillion of financial assets, and lo and behold the private sector has to hold $1 trillion less of risky and information-impacted assets. Their price goes up. Supply and demand.

Q: And firms that ought to be expanding can then get financing on good terms again, and so they hire, and unemployment drops?

A: No. Our guess is that we would need to take $4 trillion out of the market and off the supply that private financial intermediaries must hold in order to move financial asset prices to where they need to be in order to unfreeze credit markets, and make it profitable for those businesses that should be hiring and expanding to actually hire and expand.

Q: Oh.

A: But all is not lost. This is not all the administration is doing. This plan consumes $150 billion of second-tranche TARP money and leverages it to take $1 trillion in risky assets off the private sector's books. And the Federal Reserve is taking an additional $1 trillion of risky debt off the private sector's books and replacing it with cash through its program of quantitative easing. And there is the fiscal boost program. And there is a potential second-round stimulus in September. And there is still $200 billion more left in the TARP to be used in other ways.

Think of it this way: the Fed's and the Treasury's announcements in the past week are what we think will be half of what we need to do the job. And if it turns out that we are right, more programs and plans will be on the way.

Q: This sounds very different from the headline of the Andrews, Dash, and Bowley article in the New York Times this morning: "Toxic Asset Plan Foresees Big Subsidies for Investors."

A: You are surprised, after the past decade, to see a New York Times story with a misleading headline?

Q: No.

A: The plan I have just described to you is the plan that was described to Andrews, Dash, and Bowley. They write of "coax[ing] investors to form partnerships with the government" and "taxpayers... would pay for the bulk of the purchases..."--that's the $30 billion from the private managers and the $150 billion from the TARP that makes up the equity tranche of the program. They write of "the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money..."--that's the debt slice of the program. They write that "the government will provide the overwhelming bulk of the money — possibly more than 95 percent..."--that is true, but they don't say that the government gets 80% of the equity profits and what it is owed the FDIC on the debt tranche. That what Andrews, Dash, and Bowley say sounds different is a big problem: they did not explain the plan very well. Deborah Solomon in the Wall Street Journal does, I think, much better. David Cho in tomorrow morning's Washington Post is in the middle.

China's Money Man

An insightful interview with Gao Xiqing at the Atlantic. He made an especially interesting comment about compensation:

Individually, everyone needs to be compensated. But collectively, this directs the resources of the country. It distorts the talents of the country. The best and brightest minds go to lawyering, go to M.B.A.s. And that affects our country, too! Many of the brightest youngsters come to me and say, “Okay, I want to go to the U.S. and get into business school, or law school.” I say, “Why? Why not science and engineering?” They say, “Look at some of my primary-school classmates. Their IQ is half of mine, but they’re in finance and now they’re making all this money.” So you have all these clever people going into financial engineering, where they come up with all these complicated products to sell to people.

I don't know quite what he means by that. I am hoping his view is not as simplistic as it sounds. Making the statement that people should be compensated equally just because they go into science and engineering is ludicrous. In fact, the most innovative companies that were science/engineering related have been compensated very well (see Gates, Bill; Brin, Sergey; Dell, Micheal; etc.) I don't know how you'd even begin to implement something like he suggests without stifling innovation (unless of course we are talking about really redistributing wealth). Commercializing science and engineering is as important, if not more important, of a skill as pursuing science for the sake of science and research. Without the ability to "productize" inventions, the great masses would never reap the benefits.

Loose Lending Leads to Jail

During the high times, you couldn't go to a party or event where you didn't run into the wealthy "mortgage guy" or "condo-flipping doctor". It's amazing how loose lending standards will make anyone believe he was a real estate maven. There will be many more of these cases coming to light:

Eve Mazzarella was a Las Vegas success story. The high-school dropout and former housemaid moved to the Nevada city in 2000 from Seattle, got a certificate from the ABC Real Estate School and started selling houses in what would become the hottest market in the country.

In 2006, Mazzarella recorded sales of $13.8 million and made the National Association of Realtors' ``30 Under 30'' list, which names the best young agents in the nation. Mazzarella started her own company, Distinctive Real Estate & Investments Inc., in December 2003. She whipped around town in a Mercedes-Benz sport utility vehicle. She planned to build a three-story office building in Vegas's shabby downtown north of the Strip and preserve a historic house on the site by lifting it onto the roof.

Her competitors were impressed. ``She was an up and comer with a brilliant future,'' says Forrest Barbee, a broker at Prudential Americana Group, a Las Vegas agency where Mazzarella once worked.

The dream ended at about 5 a.m. on March 13, when federal agents smashed through the door of a stucco home on a quiet, grassy cul-de-sac looking for Mazzarella, 31, and her husband, Steven Grimm, 45, an erstwhile mortgage broker.

The day before, the U.S. Attorney for Nevada had indicted the couple on 6 counts of bank fraud, later revised to 13. Prosecutors say the pair recruited fake -- or ``straw'' -- buyers to apply for loans to purchase 227 properties worth $107 million. They told the straw buyers they would pay the mortgages. Then they skimmed thousands of dollars from each of more than 432 transactions, the indictment says, stashing the cash in 80 bank accounts.

Just Walk Away

Faced with seemingly never-ending falls in the value of their properties, some American home-owners are taking radical action; they are choosing to walk away from homes and their mortgages.

In May 2006, at the height of the housing boom, Karen Trainer bought a $500,000 apartment in California - with money borrowed from her bank.

By this year, Karen still owed $500,000 on her mortgage, but her apartment was worth $200,000 less.

So she was deep in negative equity and, to make matters worse, the interest rate on her loan was about to increase.

"I thought 'this is crazy'," Ms Trainer says. "It just does not make financial sense."

I know this article wants to make it seem like this is some sort of radical financial solution, but this is actually how the banking system works. It's called default. It's been happening for a very long time.

Having said that, I think there is some accuracy in the notion that at an individual level, the stigma associated with default has decreased. I mean it's much easier to blame the economy and government rather than taking accountability and understanding how real estate prices and mortgages work. Well, there's always the government there to bail you out.

Oil Lottery

North Dakotans are becoming instant millionaires because of oil:

Landowners in western North Dakota have a much better chance of striking it rich from oil than they do playing the lottery, say the Stohlers. Some of their neighbors in the town of about 120, from bar tenders to Tupperware salespeople, have become "overnight millionaires" from oil royalty payments. "It's the easiest money we've ever made," said Lorene Stohler, who worked for decades as a sales clerk at a small department store. State and industry officials say North Dakota is on pace to set a state oil-production record this year, surpassing the 52.6 million barrels produced in 1984. A record number of drill rigs are piercing the prairie and North Dakota has nearly 4,000 active oil wells.

I wonder if this money lasts longer than the typical lottery winnings.

Billers and Players at EconLog

A very interesting post by Arnold Kling at the EconLog.  He very concisely defines the economic differences between entrepreneurs and workers:

As Taleb points out, there are safe professions where you charge by the hour, so I might call them Billers. As a Biller, your earnings tend to have a high floor but a low ceiling. Think of an accountant.

What Taleb calls scalable professions are ones where you are not limited by what you can charge for an hour. Recording artists, professional baseball players, entrepreneurs, corporate CEO's, and financial speculators enjoy scalability. But, as Taleb points out, they have to compete in tournaments where there are a few winners and many losers. So we can call these sorts of people Players.

Both Wallstreet and the technology industries have done an amazing job in not only delineating between "players" and "billers", but also rewarding "billers" (via outsized bonuses and stock options).  That is not the case in the healthcare industry.  Although, there are certain specialty physicians that garner tremendous compensation, the bulk of the "billers" just get a standard salary that is not tied to performance.  IThat leads to tremendous inefficiencies because compensation focused "billers" are constantly jumping around for the highest paying job.  Also, "billers" not so focused on money are stagnated, never realizing the potential rewards had they been rewarded like "billers" on Wallstreet and Silicon Valley.  I can see that structure leading to "billers" looking at their profession as "just a job" and not really being motivated to innovate and foster change.  Just look at the (lack of) progress in the healthcare industry as it lags significantly behind finance and technology in the last decade. 

Wal-Mart and Income Inequality

Very interesting post at the Freakonomics blog by Steve Levitt:

When people talk about inequality, they tend to focus exclusively on the income part of the equation. According to all our measures, the gap in income between the rich and the poor has been growing. What Broda and Romalis quite convincingly demonstrate, however, is that the prices of goods that poor people tend to consume have fallen sharply relative to the prices of goods that rich people consume. Consequently, when you measure the true buying power of the rich and the poor, inequality grew only one-third as fast as economists previously thought it did — or maybe didn’t grow at all.

Why did the prices of the things poor people buy fall relative to the stuff rich people buy? Lefties aren’t going to like the answers one bit: globalization and Wal-Mart!

I find it amazing how many economists and pundits dismiss the impact of buying power. Just look at countries like India where as recently as a decade ago, the bulk of the population did not even have telephones. Compare it to India now where even the poorest carry cell phones. And that is just one example of the buying power increase that is a direct result of globalization and cheap labor.

Gee Really? Sex and Money are Related?

A new brain-scan study may help explain what's going on in the minds of financial titans when they take risky monetary gambles _ sex. When young men were shown erotic pictures, they were more likely to make a larger financial gamble than if they were shown a picture of something scary, such a snake, or something neutral, such as a stapler, university researchers reported.

The arousing pictures lit up the same part of the brain that lights up when financial risks are taken.

"You have a need in an evolutionary sense for both money and women. They trigger the same brain area," said Camelia Kuhnen, a Northwestern University finance professor who conducted the study with a Stanford University psychologist.

I find these sort of studies very interesting.  They sort of try to confirm what many of us could have guessed intuitively.