Illegal Immigration and the Need for Reform

Article: Wall Street Journal, Immigration Audits Drive Illegal Workers Underground, Miriam Jordan

Interesting article on the front page of today's Wall Street Journal, about the effect that the Obama administration's immigration policy --focusing on those who hire illegals instead of the illegals themselves--has had on undocumented immigrants.  Miriam Jordan's article centers on one Mexican couple, Alba and Eugenio, and their journey from "...prosperity to the economic margins."

from Wikipedia

It is painfully obvious that this country needs immigration reform.  We depend on undocumented workers from Mexico for too much of what gets done here (90% of harvest workers is what I read) to pretend that they are not vital to our economy and we can simply shut them out.  The vast majority of undocumented workers are here to help their families back home and are interested in working hard and staying out of trouble, not getting a free ride or stressing our healthcare, education or law enforcement systems.  Even President George W. Bush understood the importance of immigration reform.  But this one is a political hot potato, endlessly exploited by politicians who are willing to play on the small-minded suspicious nature of some voters who ignore that there is no practical way to draw a 2,000 mile long line down the center of the North American continent and say "you stay on your side and we'll stay on ours."

Unfortunately, Obama's policy of cracking down on employers who hire illegals is much more efficient than previous policies that focused more on border patrols and random crack-downs.  I wonder if Bush, a Texan, had a deeper understanding of this issue than Obama, and sabotaged his own party's ill-conceived attempts at a sealed border by allowing a lax enforcement mechanism.

This country needs to recognize reality.  There is work to be done, much of it unpalatable to U.S. citizens, and there is a large pool of neighbors to our south who are more than happy to do it.  There is no natural border between the United States of America and the United States of Mexico and there never has been.  On both sides of the line there is America, a complicated, racially-mixed, resource-rich continent with long traditions of immigration, migration and freedom.  Attempts to deny who we are will only result in misery, wasted effort and economic hardship on both sides of the imaginary line.

Tough Times for U.S. Coal

Article: WSJ, Coal Strikes a Tough Vein Over Costs, Natural Gas, Kris Maher
The Economist, Natural Gas: Cleaner, Not Cooler

The above article in Friday's Wall Street Journal notes that coal company stocks are down 30% over the last three weeks.  As a shareholder in Patriot Coal (PCX) I can attest to that.  The article cites higher costs due to declining coal seams in Apalachia, as well as increased competition from an increasingly abundant and inexpensive supply of natural gas.  Although coal is still the U.S.'s leading source for electricity generation, it's share has been declining for years, while natural gas' share has been increasing.

from the Wall Street Journal

My main hope for the shares in Patriot Coal is demand from China which is much larger than any other country in the world, and which continues to increase (see my article, Global Coal Consumption and Production, Fun with Charts).

As far as the replacement of coal with natural gas, I think it is a positive development for the country, given that the U.S. has an enormous supply of gas, and it is much cleaner than coal.  There are three articles on natural gas  in last week's Economist magazine, with one noting that while the burning of natural gas is relatively innocuous for human health, especially as compared to coal, which releases harmful soot into the atmosphere, coal actually contributes slightly less to global warming than natural gas.  This is not because coal emits less carbon than natural gas (in fact coal emits almost twice as much CO2 per kilowatt hour as natural gas) but because coal also emits sulphates into the atmosphere, which actually block the sun, and has a cooling effect that partially offsets the warming caused by CO2 emissions.

Shocking! Big Global Custody Banks Don't Give Competitive FX Rates

Article: WSJ, Two States Go After Big Bank on Forex, Tom McGinty and Carrick Mollenkamp

An article in today's Wall Street Journal reports that two states --Virginia and Florida-- are suing their pension funds' custodian bank, BNY Mellon,  for applying unfairly disadvantageous rates to their foreign exchange executions.

Perhaps based on the custody agreement that they signed with BNY Mellon, the states are right, and should get some money back.  But I think there is a significant element of "buyer beware" in these types of transactions.  If you are running an internationally invested pension fund that converts millions of dollars on a regular basis, you need to make sure on a regular basis that you are getting competitive rates.  You need to negotiate and shop around until you get them--not accept your bank's daily rate because (perhaps) it is operationally convenient.

To me, using standing instructions with your global custodian to convert large amounts of funds "automatically" at their daily rate is like using the valet service at the Hyatt Hotel to do 30 pounds of laundry.  Everyone knows its a rip-off and a cash cow for the provider.  If you're in a pinch, let them wash one or two pairs of underwear for you, but unless you have money to burn, don't give them the whole sack.  OK, maybe this is not common knowledge, but if you are managing big money and hiring custodian banks it should be.

BNY Mellon is the largest of a handful of huge players in the global custody world (along with State Street, JP Morgan Chase and Citi).  They now have over $25 trillion in assets under custody.  Since the 1990's they have been at the forefront of what has been a massive shake-out in the global custody business -- small and middle-sized providers have all but disappeared as  BNY have used their "economies of scale" to aggressively lower their prices and either take clients, or buy competitors out wholesale.

data from BNY Mellon annual reports

But asset servicing (another word for custody) is not free.  It costs money to settle trades, to collect and record dividends, to wire money, to issue statements, to withhold taxes, to report to government regulators.  Clerks have to do most of this.  You can try to save money by cutting the number of clerks you hire and automating these processes as much as possible, but then you have to hire more skilled and expensive staff to do the automation, and to solve the messy problems that result when the automation doesn't work as expected.  

The fact is, by marking down their fees so aggressively (they average around 1 basis point or 0.01% of assets under custody), banks like BNY Mellon have put themselves in a situation where there is a constant hunger for costs reduction (ie, cutting heads) and revenue enhancement.  Foreign exchange has been an important revenue source for global custodian banks, at least since I first studied the topic back in the early 1990s.  They need the revenue, the same way that a bar that gives away free food needs to sell drinks.  No, their rates are not competitive, and their method of calculating them is not transparent.  But if you are an investor in international markets you should know what a fair rate is, and there is nothing stopping you from going out and negotiating your own forex deals, either with the custodian's own funds desk or with a different counter-party.

Now, whether BNY Mellon's rock bottom fees are an example of monopoly pricing is a completely different issue.

Education: States Fail to Raise Bar

Article: Wall Street Journal, States Fail to Raise Bar in Reading, Math Tests, Stephanie Banchero

A page 2 article in today's WSJ mentions a troubling report published yesterday by the National Center for Education Statistics.

According to the report (which admittedly is based on 2009 data), 35 states have passing grades on their standardized reading and math exams which are below the "basic" level on the national NAEP exam, including my home state of New York.

from www.wsj.com

I am no expert on this topic, but it seems to point to a dumbing down of standards in most of the fifty states, at a time when many developed countries, and some emerging ones, have more literate and numerate populations than we do.   Joanne Weiss, chief of staff to Secretary of Education Duncan said it showed that "low expectations are the norm" in too many states.

This may be the most important issue for the long term health of our nation.  Are we arrogant enough to think that we can pay off 14 trillion in debt, build health care and retirement systems that can handle the growing demographic overhang without bankrupting us, and reverse global warming, and do it all without the help of the upcoming generations?

Education is a big complicated issue.  I have heard that part of the solution may be finding the "secret sauce" that certain teachers have that allows them to reach students and motivate them to learn.  Apparently the Gates foundation has been funding such "R&D" efforts.  But can this secret sauce really be identified and applied?  Or is it the result of commitment, experience and hard work, like any other professional expertise?

Conservatives say that more school choice through voucher programs and the like is the answer.  It is tempting to think that freeing up individual families to vote with their feet will lead the magic hand of the market to throw up educational solutions that work.  But I wonder: of the 13 OECD countries who outscored us in reading,and the 24 who outscored us in math, how many had free-market voucher programs?  Any?  Wouldn't a good starting point be to look at other countries, see what actually works, and try going with that?

My opinion, for what it's worth, is that to turn around our public education system we must attract the best and the brightest to teaching.  This may have been what happened generations ago, when many exceptional women went into teaching for lack of better choices.  Now, with a wide open labor market, I fear few of the best people want to dedicate their lives to public school teaching.  Sure, low salaries may be part of the problem, but salaries for university professors are also low, and somehow this doesn't deter extremely bright people from going into academia.  People from all over the world come to the USA to attend our universities, and young, talented academics are willing to accept a sub-standard living standard to teach in them.  Why should public primary schools be so different?

One friend with teaching experience told me that the problem with teaching as a career is not the salaries, but the manner in which we educate our teachers.  According to her, teaching colleges focus very little on the subject matter being taught, in favor of a focus on softer theories of education.  This psychological / sociological focus suits many of the budding teachers --who were not all that passionate or knowledgeable about literature, math, or science to begin with-- but does not serve the children well.  If we want to create a more rigorous, hard-core education system, do we need to start with our teaching colleges?

Yesterday's Market Excitement

In case, you haven't heard, the U.S. stock market was down big time yesterday.  The Dow Jones Industrial average dropped 634.76 points, or 5.5%.  This had something to do with Standard & Poor's downgrade of the U.S.'s credit rating from AAA to AA+ on Friday evening, but exactly how much is an open question.  The Wall Street Journal's front page headline this morning was: Downgrade Ignites a Global Selloff, but the unavoidable irony is that prices of Treasury bonds were up yesterday (yield on the 10-year note, which moves inversely to price, was down to 2.339%, its lowest rate since January 2009).  And repo markets, the main wholesale funding market by which Wall Street banks lend each other money using U.S. securities as collateral, were largely unaffected.

The sell-off seemed to be caused by a general flight from risky assets into safer ones, such as U.S. treasuries, gold and Swiss Francs, which in the past has been the result of fear of a double-dip recession and default and contagion in Europe.  Perhaps the downgrade just added an extra element of panic to the equation.  Or perhaps large market participants were afraid that the downgrade would cause politicians to do something stupid in reaction to what should be a non-event, what philosophers call an epi-phenomenon, like the smoke from a passing train, or the after-the-fact commentary by a sportscaster.  President Obama's speech certainly did nothing to stem the downturn.

Based on the Wilshire 5000 Total Index, which represents the total value of the U.S. stock market, the market has lost about $2.6 trillion since late July.  Unless you are an S&P sovereign debt analyst, this is quite a chunk of change--about $8,500 for each man, woman and child in the U.S.

data from finance.yahoo.com

Certain stocks were especially hard-hit in yesterday's sell-off: Bank of America and Citi were both down over 15%.  I lost quite a bit on the latter, not to mention Caterpillar, a Germany ETF and others.  Despite stern warnings from CNBC commentators --like lifeguards at Jones Beach--  that it is extremely risky for individuals to trade in such market conditions, I nibbled, and bought a bit more Citi at its new marked-down price.  Of course it dropped as soon as I bought it.  This morning, I saw that Citi was trading at less than half of its book value, and bought some more, using up the bulk of my available cash.   As of this writing, Citi is back up 12% on the day, so maybe I made a good decision -- for now.

Petroleum Consumption and Production: More Fun with Charts

Do we really consume that much oil?

Last Thursday's post Global Coal Consumption and Production: Fun with Charts made one conclusion unmistakably obvious: China uses several times more coal than any other country.

Today I used more data from the U.S. Energy Information Administration to make a chart representing global petroleum consumption and production, and the conclusion is different, but just as obvious.  The U.S. uses a lot of oil -- also several times more than any other country.

Just to sniff-test the numbers a bit: the data says the U.S consumes about 20 million barrels of oil a day.  At $80 per barrel, this comes to $1.6 billion per day, or over $500 billion per year.  Is this right?  Guesstimating a little more, we know that in the U.S., the primary use of oil is to make gasoline, which is mainly burned in cars.  Out of a population of 300 million Americans, if 100 million spend an average of $10 on gas each day, this comes to $1 billion every day, without even counting other uses of petroleum.   From another perspective, Exxon Mobil reported $384 billion in revenue in 2010.  Based on this, the figures in the chart look "reasonable".  And we do use an awful lot of oil.

Debt Deal: The Aftermath

from www.whitehouse.gov

Although pendulums swing both ways and there is still plenty of time until the 2012 elections, it seems clear that the debt deal hammered out last week, and the subsequent Standard and Poor's downgrade of the United State's credit rating was a serious political set-back for President Obama.    Here are some memorable words from the press:

Kurt Anderson

Kurt Andersen, New York Times: Of course, a lot of us swooned over Obama partly because he seemed so prudent, straightforward and even-keeled. But now, with Republicans spectacularly applying the Madman Theory for the first time in domestic politics, Obama’s nonconfrontational reasonableness isn’t looking like such a virtue. [brilliant article, compares Obama to Nixon]

Joe Nocera

Joe Nocera, New York Times: I still think it was terribly wrong for the Republicans to use the threat of default to  insist on massive spending cuts, though President Obama also deserves blame for playing his hand so poorly.






Lexington, The Economist: Any assessment of Mr. Obama needs to acknowledge that when he was elected he inherited the in-box from hell.... Now he faces the opposition from hell....But Americans want their Presidents to be winners, not victims.

Peggy Noonan

Peggy Noonan, Wall Street Journal: ...speeches aren't magic.  A speech is only as good as the ideas it advances.  Reagan had good ideas.  Obama does not.

Holman Jenkins

Holman W. Jenkins, Jr., Wall Street Journal: Tax reform is the political fulcrum for addressing the growth shortage, the fiscal crisis, and our runaway health-care prices problem.  It's the one idea that reaches across the partisan divide.  It might be the only thing that can save the Obama presidency. [Good point!]

Stock Market Revisited

Following up on Wednesday's post, How to Lose $1 Trillion in Nine Days, let's take a look at how much wealth was destroyed as a result of yesterday's "interesting" market --a gut-wrenching drop of over 500 points (4.3%) in the Dow Jones Industrial Average. (See WSJ's, Stocks Nose-Dive Amid Global Fears)

Data from finance.yahoo.com

The grand total is ... a loss of $1.6 trillion in the U.S. stock market -- approximately $5,000 for each man, woman and child in the country, to give some kind of idea.

The good news is that gold and T/Notes have increased in value -- I wish I had more than a sliver of my portfolio in these instruments.

As of this writing, the market is down again, after beginning the day with a sizable increase on the back of the weekly jobs report.  The main concerns that are causing people to sell are weak economic news, and worries about fiscal deterioration in Italy and Spain.

Global Coal Consumption and Production: Fun with Charts

There is a lot of interesting data freely available on the web.  The data I used to produce the below chart comes from the U.S. Energy Information Administration, which is full of data, statistics and reports on the United State's and world's energy usage.

This time I have concentrated on coal, an old-fashioned and dirty energy source, which is still hugely important in the economic activities of much of the world, including the USA.

The sky-blue and burgundy bars on the chart represent total production and consumption of coal, in billions of tons, and match up to the left-hand scale.  The orange line represents the net over or under-production of each country (ie, production minus consumption), and matches up to the right-hand scale, which is in hundreds of millions of tons.  The graph does not include all of the countries that are in the EAI database; to make it legible  I only selected those that had some kind of significant production or consumption of coal.

So what can we glean from the above?

• China is by far the largest producer and consumer of coal in the world.  In fact, I had to scale back the size of China's bars in order to keep them from making the smaller countries' unreadably small. 
• China is relatively self-sufficient when it comes to coal, but for the last couple of years have had to import a small percentage of their demand.  Because of the huge size of this demand, it has led to economic opportunities for countries such as Australia and Indonesia.
• India appears to be a similar story to China, on a smaller scale, though with an even larger coal "deficit" than China's.
• USA, which gets about 50% of its electricity from coal, is the second largest producer and consumer, but still less than a third of China in both production and consumption.  In recent years it has gone from being a net consumer to being a net producer.
• Besides India and China, the largest net consumers of coal are the developed export-led economies of East Asia --Japan, South Korea and Taiwan-- which consume moderate amounts of coal but have virtually no production of the mineral.
• The developed countries of Western Europe -- including Germany, France, UK, Italy, Spain-- are all net importers of coal, with modest consumption but very little production, though  Germany, which produces and consumes more than the others is a bit of an exception.
• The largest net producers (exporters) of coal are: Australia, Indonesia, Russia, South Africa, Colombia, Vietnam, Kazakhstan, USA and Canada.
• I had some difficulty arriving at absolute dollar equivalents for the tons of coal represented here.  I read that coal prices are relatively stable, but can vary greatly depending on the type and grade of coal, and the location and method of shipment.  To get a ballpark figure, we can put a value of $20 on each ton of coal, which basically implies flows in the tens of billions of dollars for the largest markets.

How to Lose $1.1 Trillion in Nine Days

As I started writing this, it seemed clear that the U.S. stock market would be down for its ninth consecutive day. However, by the time I finished the market was nearly flat for the day, and it remains to be seen if the losing streak will be 8-days long, or 9+ days long (the latter not being seen since 1978).

There are numerous articles and commentaries about the reasons for this downturn (see today's WSJ: Economic Fears Hit Global Markets), some key ones being:

•  low numbers in several economic indicators (the ISM Manufacturing Numbers, ADP payroll figures, recent lowering of GDP growth figures)
• seemingly endless worries about the fiscal situation of several European countries
• growing inflation in emerging markets.

Those of us who were expecting a jump in the market as a result of the debt compromise at the beginning of the week have been disappointed; the markets seemed to have expected this to happen all along, and any positive effect was overshadowed by the weak economic data.

data from finance.yahoo.com

In an attempt to get a handle on exactly how much wealth is involved in this market downturn, I put together the above chart with Excel, using data on the Wilshire 5000 Total Market Index, which is a good proxy for  the size (i.e., market cap) of the U.S. stock market.  Bottom line: just over $1 trillion in value lost (much of it on paper only) in just over 1 week.  This is in the U.S. alone -- globally I would guess it is closer to $2 trillion.  Numbers that get kicked around during Washington debt negotiations aside, $1 trillion is a LOT of money -- think $3,000 for each man, woman and child in the U.S.  

Of course, the market could bounce back up just as fast as it fell, which would be nice, though I doubt it.  Meanwhile, such a loss cannot be good for the economy; people with money in the market will tend to spend less as they see their wealth diminished.  

Advances in Facial Recognition Technology

Articles:
The Economist, Face Recognition: Anonymous No More
The Wall Street Journal, Face-ID Tools Pose New Risk, Julia Angwin

from HuffingtonPost.com

Imagine if you could instantly find out the name and identity of a stranger on the street simply by taking a photo of his or her face.  Imagine if you could take a photo of a roomful of people, upload it to your computer, then run software which would give you a list of names, home towns, birth-dates, and possibly even Social Security numbers.  It appears that in the not-so-distant future, using Facebook and commercially available facial recognition software, this could be a reality.

The two above articles refer to a study done at Carnegie Mellon University by Alessandro Acquisti, Ralph Gross and Fred Stutzman, in which they were able to identify faces with 30% accuracy, using PittPatt facial recognition software to compare them to faces on Facebook profiles.  This modest success rate is sure to improve as facial recognition software and overall computing power improve, and as the use of social networks becomes more ubiquitous.  And this is just with freely available commercial software: who knows what police and security forces are capable of doing today?  Will we see the end of privacy and anonymity in our lifetime?  Is this something to be concerned about, or just one more feature of modern life?  Or is the sad reality that for most of us who are not wanted criminals, celebrities or great beauties, no one would bother trying to identify us anyway?

Spanish PM Rodríguez Zapatero Calls Early Election

Articles:

Wall Street Journal, Spanish Leader Calls Early Election, Jonathan House

El País (Spain), Final de Ciclo, Editorial 7/17/2011

El País (Spain), Rubalcaba: “Tuvimos ocho años para pinchar la burbuja y no lo hicimos”

Rubalcaba and Zapatero
from Iberosphere.com

The Spanish Prime Minister, José Luís Rodríguez Zapatero, called for early elections on November 20, ahead of scheduled elections in March, 2012.   Spain is suffering from an unemployment rate of over 20%, the highest in the developed world.  Zapatero's socialist PSOE party was handed losses in key regional elections is May.  Left-leaning newspaper, El Pais, has been called for elections "as soon as possible", and said that the leader has not given any reasonable hope for relief to the five million unemployed, and the 300 thousand who have lost their homes in the last 3 years.  They have gone so far as to say that the November date was too late, and that sooner would be better.

Rodriguez Zapatero was elected in March, 2004, just after the terrorist bombing in Madrid commuter trains, which killed 191 people and caused over 2000 injuries, on March 11, 2004.  Zapatero's predecessor, José Maria Áznar, of the conservative Partido Popular (PP) had positioned himself as a leading supporter of George W. Bush, and had sent Spanish troops to Iraq, despite large public opposition in Spain.   When it became clear that the bombs had been set off by al Qaeda (despite early attempts by Áznar to blame Basque separatists), many Spaniards reacted by giving a surprise victory to Zapatero, who had pledged to pull Spanish troops out of Iraq.  Shortly after being elected, Zapatero made good on his pledge.  He was re-elected in early 2008, before the real estate sector, and then the economy, crashed.

It is interesting to see that in today´s El País, it is reported that socialist candidate Alfredo Pérez Rubalcaba said: "We had eight years to pop the bubble, and we didn't do it."  It looks like Spain will have a conservative government by the end of the year.

Debt Ceiling: the Story that Won't Go Away

New York Times: The Centrist Cop-Out, Paul Krugman
Wall Street Journal: House Postpones Vote on Boehner Debt Plan, Naftali Bendavid and Carol E. Lee
Wall Street Journal: Lending Markets Feeling the Strain, Liz Rappaport and Matt Phillips

The ongoing "crisis" over increasing --or not-- the Federal debt ceiling has become unavoidable.  It is all over the news; one plan after another has crashed and burned as unable to pass the Congress (House Postpones Vote on Boehner Debt Plan); the stock market is down for its 5th consecutive day; Wall Street's industry association, SIFMA, has been holding conference calls to hammer out the operational nitty-gritty of how to handle a debt default that really should not be happening (Lending Markets Feeling the Strain).

This morning I watched CNBC as Becky Quick hammered Maryland Democratic Representative Steny Hoyer for blaming the other side, and not doing enough to avert the crisis.  But in his op-ed today, Nobel laureate Paul Krugman argued that the news media, in its attempt to be even-handed, has neglected to squarely place the blame for the deadlock where it belongs: on the "extremism" of Congressional Republicans.  I agree with him.  Though all agree that long term deficits and debt--caused largely by health-care and retirement costs and wars-- are out of hand and must be addressed, there is absolutely no reason to link action on this to the short-term operational decision to lift the debt ceiling.  Other developed countries do not even have a debt ceiling.  It was the decision of Congressional Republicans to use the debt ceiling as a weapon to dismantle social programs which the majority of Americans want and expect.   The absolute refusal to allow the expiration of the "temporary" Bush tax breaks on the wealthiest Americans is deeply irresponsible.  America already has the greatest gap between rich and poor of any developed country on earth and it has been steadily widening--is this good for our nation?   All compromises, including the latest one worked out by Republican House Speaker Boehner, have foundered on the insistence by some to maintain the tax burden on the wealthiest at its lowest level since the 1920's.

I hope this will be resolved.  I hope the debt ceiling will be lifted.  I hope that both sides will be steadfast in building consensus for an aggressive plan to put the fiscal house in order, with a sensible mix of spending cuts and fair revenue enhancements, which economists agree is the proper course of action.  But if the Republican intransigence continues, I have a guess about what will happen.  There will be a temporary government shutdown which will be resolved in a matter of days or weeks; we will not default on our debt, but there will be a delay in cutting checks and providing services.  Lots of money will be wasted digging out from the mess that the temporary shut-down will cause.  And in 2012, tea-party affiliated Congressmen who came in in 2010 with a "mandate" will be swept out just as quickly.  Remember Newt Gingrich in the 1990s?  It could happen again.

Natural Gas: Fracking in Europe

Article: Wall Street Journal, Fracking Pioneers Pierce Europe, Guy Chazan

 El Mundo (Spain), The United States' Dirty Energy Revolution, Pablo Pardo

Chesapeake Energy natural gas well in Bradford County, PA
from www.csmonitor.com

One of the biggest stories of the last few years is the growth of unconventional sources of energy.  In the U.S., this mainly means petroleum from the oil sands of Alberta and natural gas from shale, the latter being retrieved via a process known as “hydraulic fracturing”, or “fracking” for short.

The following article from Spain’s El Mundo: The United States’ Dirty Energy Revolution --translated into English on the website WatchingAmerica.com-- gives a good overview of how unconventional energy is transforming the “energy panorama” in the U.S, mainly by making the country much less dependent on world energy markets, and poses the question of whether this “revolution” will spread to Europe.

The WSJ article talks about an early effort to explore fracking in Southern England.  At this time the drilling has been halted, as the result of a minor earthquake, which some say was caused by the drilling.

I have recently become very interested in where the world gets its energy.   This topic is vitally important economically, politically, environmentally, and most importantly, for my investment portfolio.

As far as natural gas and fracking go, I have learned the following:

• Natural gas burns very clean (think of a gas stove), though it does produce carbon dioxide (CO2), the main greenhouse gas.
• It is estimated that the U.S. has at least 100 years supply of unconventional shale-based natural gas.
•  Fracking is a highly controversial practice, as there is evidence that it can lead to polluted aquifers.
• Fracking has been temporarily banned in New York State, but continues in Pennsylvania, Texas, Oklahoma and other areas.
• In Europe, fracking has been banned in France, but is being attempted in Poland, Northern Germany, the UK, and according to the El Mundo article, in Cantabria, Spain.
• One think tank estimates that Europe has at least 60 years of energy reserves in extractable natural gas, though I understand this to be a very preliminary estimate.
• Natural gas can be used to fuel vehicles, but in the U.S. very little infrastructure to provide it (i.e., gas stations) exists at this time.  When I lived in Spain ten years ago I saw buses and taxis that ran on natural gas.
• Natural gas is generally transported via pipelines.  In the absence of such an infrastructure it can be converted into liquid natural gas (LNG), and transported in ships, but the process is currently expensive and difficult.  

Arctic Princess Natural Gas Carrier
Courtesy of  www.ships-info.info

Because of its abundance, cheapness, and the fact that it does not have to be imported, many see natural gas as the solution to the United State's  energy problems, at least in the short-to-medium term.  To the extent that we are concerned about global warming and CO2 emissions, other green energy sources (wind, solar, etc.) may be preferable, but these technologies are not yet economically viable.  Assuming the dangers of fracking can be addressed or mitigated, the use of natural gas to replace sources of energy such as coal and petroleum –and possibly nuclear power—seems highly probable.

Profits Are Up, What About Jobs?

This WSJ article by David Wessel gives an interesting analysis of why we have not seen job growth commensurate with the recent growth in corporate profits.

Courtesy of Wall Street Journal

Yes, unemployment is a complex and multi-layered issue, with a mixture of  long-term structural factors and short-term economic factors.  As labor productivity goes up, businesses can use fewer staff to generate a profit; labor is less mobile than it used to be because many people are stuck in homes with underwater mortgages and cannot move; the housing market (and therefore construction) is stuck in a medium-long term rut; our educational system does not produce workers with the high-tech skills that many businesses need (also in today's WSJ: U.S. Business Leaders Press Senate Panel for More Work Visas); executives are uncertain about the effects of Obama-care, Dodd-Frank,  etc, etc.

However, I wonder how much this might have to do with incentives that are out of wack.  Corporations focus on setting up a proper compensation system so that senior executives' incentives are aligned with shareholder's incentives --basically CEOs and other fat cats are paid very little in wages and receive most of their compensation in stock or options.  Executives make more when profits go up.  But regular employees simply receive a wage, and executives have every incentive to reduce costs (i.e., other people's salaries) as much as possible.

My first question which has nagged at me as I studied corporate governance: why the big difference between senior executives and other employees?  In the end, aren't they all supposed to make an important contribution?  As a customer, if I go into a Starbucks, the performance of the guy making the coffee is much more important to me than the performance of the CFO--why does the corporate governance structure make a qualitative distinction between the two?  Why are a few people given the privilege of having their compensation "aligned with the shareholders' interests" --which means they may have earnings measured in the millions-- while others have earnings measured in the tens of thousands, and can get canned at the drop of a hat, by some brilliant new cost-cutting executive?

Executives have a big incentive to cut costs and get rich in the process.  But isn't there some benefit to having long-term stable, loyal employees, to treating employees as valued partners, not to mention the "Corporate Social Responsibility" that many corporations preach in their annual reports?  Perhaps so, but my sense is that these are factors that will generate benefits over the long term--years and decades-- and require patience and skill to capitalize on.  Cutting heads, if it can be done without driving customers away in the short term, generates a quick jump in the bottom line.  Traditionally, another big disincentive to laying  people off wholesale were the unions, which have all but disappeared in the private sector.  No, I do not advocate a system like Spain's, where unions made it nearly impossible to fire under-performing employees, thus leading to an 10% structural unemployment rate (now around 20% due to the bursting of their real estate bubble).  But look at the growing discrepancy in pay between executives and line employees in the US, look at the gap between rich and poor, look at corporate profits, and look at the unemployment rate.  And then maybe take a look at the tax structure.

Executives who get paid mostly in stock or options make most of their income from capital gains, which are taxed at 15%.  Other employees get salaries, which are taxed based on a sliding scale, with a maximum rate of 35% (25% for incomes between $34,500 and $83,600).  This is the U.S. government doing its part to make employee wages even more expensive for corporations, relative to what they pay executives, therefore increasing the incentive to use salaried employees as little as possible.   Is this really what we want to be doing?

Why can't we have a fair, simple tax structure which values work as well as deal-making?  And why can't we have an informed, well-educated work force?  Is this too much to ask?

Astonishing Household Wealth Gap Between Whites and Blacks, Hispanics Increases

Wall Street Journal: White Minority Wealth Gulf Widens

Washington Post: Wealth gap widens between whites, minorities, report says

This was an eye-opener.  The story was that while the recession destroyed household wealth across the board, it had a worse effect on Blacks and Hispanics than on Whites.

Courtesy of Wall Street Journal

But what strikes me is the following: while the median White household has some modestly significant wealth, the median Black and Hispanic household has virtually nothing.  Yes, the gap widened, but qualitatively it was the same story after the recession as before.

Meanwhile, Congressional Republicans fight tooth and nail so that the marginal tax rates on those making over $250K per year cannot possible go up-- rates which Warren Buffet pointed out are often close to 15%, much lower than the rate on middle-income earners.

I am all in favor of fair, simple taxes, and of the U.S. being a meritocracy.  Naive redistribution of wealth is not the answer.  But it is in everyone's best interest for us to have a level playing field.  It must start with education.  You should not have to be from a rich family to get a good public education.  If we could effectively address the educational slide in our country relative to the rest of the world, I think it would mark the beginning of the reversal of such disheartening statistics.

What About Japan?

Article: The Economist, Japan's Debt: The Domino that Never Falls

Courtesy Japan National Tourist Organization

One of the reasons that I love The Economist is that it does not ignore the world's third largest economy.  There is always one article, and often two or three on Japan each week, even when the country is not being devastated by earthquakes and tsunamis.  Last year, China passed Japan as the second largest economy in the world, but China has a population that is ten times Japan's, and all manner of natural resources.

From a 2007 BBC News Article

Japan, despite myriad problems --natural disasters, the largest government debt in the world (225% of GDP, compared with Greece's 144% and USA's 100%), few natural resources, a shrinking, aging population, a hidebound government-- is still a prosperous country where a large majority of the population is middle-class and well-educated.   And as pointed out in this week's article in the Economist, it is the place where bond investors run when there is uncertainty in other developed countries.  Because of debt problems in the US and Europe, the Japanese yen is now stronger than ever, at around 78 yen to the US dollar.  This is bad news for Japanese exporters, as well as tourists who visit Japan from overseas.  When I visited in 2007 I remember I got 140 yen for each dollar.  Economically, at least, I'm not looking forward to my next visit.

I'm not sure why Japan is still a safe haven for investors.  I think it has something to do with how their debt is funded.  The article points out that households alone have assets of nearly twice the national debt.  The Japanese are great savers, and tend to put their money in savings accounts, traditionally in the postal banking system.  The banks invest the deposits in Japanese Government Debt (JGBs).  Most JGBs are owned domestically, not by foreigners--in contrast to the US, where close to half the debt is owned by foreigners, who, at least in theory, are free to divest at any time.  In Japan, perhaps, there is more political and social pressure to keep the deposits in JGB's.  Not to mention that it would be difficult to find safe and liquid investments in which to place such a huge volume of deposits ($16 trillion in household assets).  They would probably have to move overseas, and be subject to all manner of exchange rate and political risk.

According to the Economist, referring to the JGB market, "...the risks of a confidence crisis, though not necessarily imminent, cannot be ruled out."  Who can tell what would happen in such a case?    Would the crisis of the PIGS (Portugal, Ireland, Greece and Spain) look small in comparison?

from www.uprofish.com

I think we can learn about the importance of education from Japan.  They became the world's second (now third) economy not because of a huge land mass, oil or minerals, or military and political dominance.  It was largely due to their talented, disciplined, educated population.   When we think about what is going on in the USA, I hope we don't forget an important long-term priority:  not deficits, jobs, healthcare or energy, but education.  In my opinion education is the most important item in the list, because even if we botch the other priorities, educated future generations will be able to make additional progress.

US Default: Neon Swans

Last year, as a hedge against inflation I bought a moderate position of 10-year US Treasury Inflation Protected Securities (TIPS). I have watched the value of these securities go up by more than 10% -- not because of 10% inflation, but because of falling interest rates. I feel tempted to sell them to cash in on the unrealized gain. Perhaps gold would be better as an inflation hedge anyway (though I have read there is no clear correlation), and I can be fairly certain that at some point in the next ten years interest rates will creep up again from their absurdly low present levels, and I will lose my 10% gain if I hold the TIPS to maturity as I originally intended.

Now, with the various branches of the government flailing about in so-far fruitless attempts to raise the debt ceiling and avoid default by August 2, I wonder if it might be a good time to sell. On the other hand, no one else seems to be selling -- yields on US Treasuries do not seem to be rising and falling based on political news about the debt ceiling--the market is sanguine, and it almost seems unpatriotic to sell at this point

Jason Zweig's column in today's Wall Street Journal refers to the possibility of a default or downgrade of US Treasury debt as a neon swan: "an event that is unthinkably rare, immensely important and blindingly obvious", riffing on Nassim Taleb's "Black Swan". He remarks that "many investors seem to be coping with what seems like an obvious risk by simply closing their eyes."

This puts me in mind of the temporary Newt Gingrich-led government shut-down of 1995. I was working in the client administration area of a large international financial institution, which was custodian for a good chunk of US Government Debt held by Japanese institutional investors--billions of dollars worth of T/Notes and T/Bonds. At that time, we used to receive a pile of faxes every day from our customers in Tokyo: inquiries on everything from fee bills to 1 penny rounding differences on multi-million dollar settlements. There was virtually nothing on the looming government shut down which was all over the press, and how it would effect them.

I wish I had kept a journal back then.  As I recall, a day finally did come that we did not get paid interest on some Treasury issues (the operations staff had to manually reverse automatic postings that the system had made) I approached the head Japanese relationship manager, and asked him how we would explain this to the customers. He asked me to draft something. I made a brief write-up, explaining that processing of the payments had been delayed because of the government shut-down, which they had probably read about in the newspaper. The fax went out, the payments were made a couple of days late, and we never heard anything more about it.

There are about $14 trillion of US Treasuries outstanding, and foreign countries hold over $4 trillion, of which China and Japan each hold about $1 trillion (see http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt) . Maybe the market is sanguine because there is so much money involved --the vested interests are so powerful-- that no amount of political in-fighting can change the basic facts. I also suspect that any S&P, Moody's or Fitch downgrade will also be a non-event. Those who hold debt balances in the hundreds of billions will do their own analysis, and make their own decisions, regardless of what a few analysts in an office in Manhattan decide.

Let's hope I'm right.

$157 Billion Greek Bailout

This morning's Wall Street Journal speaks of a new $157 Billion Greek bailout: Greece Gets New Bailout as U.S. Nears Brink

An admission of defeat by all involved: ECB President Trichet was unable to avoid a "technical default"; German Chancellor Merkel was unable to avoid spending more of her frugal citizens' money.

The Dow went up over 1% yesterday, partly on this news, which at least showed some leadership by Europe, and brought some certainty.

On the other hand, there are a lot of questions:

What about Greece's primary deficit? The country is spending more than it takes in, even before it services its debt. On this basis, they will run through any and all bailout money that they receive (around 100 billion in 2010, over 150 billion in 2011 --quite a bit for a country with a GDP of around $310 billion). I wonder if major political reforms/purges will be needed in order to accomplish the necessary economic restructuring.

Suggestion number 1: stop worrying about Turkey. I understand that a part of the problem has been huge unnecessary military expenditures over the years, which I can only assume have been accepted by the population because of anti-Turkish paranoia. Maybe leadership in some sort of Eastern Mediterranean free trade zone would help Greece's economy.

Suggestion number 2: Sweep out the Greek political class, and put people who are not implicated in the current mess in charge. Dominique Strauss-Kahn should be available soon :)

Will the technical default cause CDS contracts to pay out? WSJ's Steven Fidler says "probably not", because the deal for private sector contributions is voluntary, then follows up by asking "What use is default insurance if there's a default and no payouts?" (see A Guide to the New Deal in Athens: How a 'Selective Default' Works)

If you ask me, Credit Default Swaps (CDS) should not be allowed. I cannot buy insurance against your house burning down, because I have no "insurable interest", and doing so would give me an incentive to set your house ablaze. The word "swap" in the CDS acronym is a fig leaf, just put there to allow lawmakers to pretend that they are not insurance, and can be used by financial institutions in an unregulated fashion. New regs are trying to change this, but the CDS market is still murky and opaque -- its been 8 years since Warren Buffet called these and other derivatives "financial weapons of mass destruction". A large part of what makes a Greek default so scary is that it is impossible to tell what exposures are out there, and what dominos will fall if Greece stops paying off.

What is a Repo Squeeze?

In November, The Fed called in the primary dealers of government securities for a talk because of concerns that they had been engaging in a type of activity known as a "repo squeeze". What exactly is a repo squeeze?

If you want a thorough answer to this question I recommend the following article from Mr. Mark Fisher of the Atlanta Fed: http://www.frbatlanta.org/filelegacydocs/fisher_2q02.pdf

If you want a quick and dirty answer, here is my attempt.

A repo squeeze is an attempt by one of the primary dealers to reap rewards by exploiting the periodic scarcity of a certain security: the so-called "on the run" T-Note.

The on-the-run T/Note is the most recently issued T/Note--the last one to be auctioned by the Fed.

The on-the-run T/Note is considered the most liquid security in the world, so it is often used as a hedge or source of funding. Dealers who have a short or long position in any treasury will often hedge this position by taking an offsetting position in the on-the-run T/Note. They will use repos or reverse repos to fund these positions.

A repo can be seen as a way of funding a long position by raising cash. You "repo out" the bonds you are long and get cash collateral in return. When you close the repo, you return the cash collateral + interest and get back your bonds. A reverse repo can be seen as a way of funding a short position by raising bonds: you "reverse in" the bonds, and pay out cash in return. When you close the reverse you return the bonds and get back your cash + interest.

The tricky part has to do with the fact that the on-the-run Note is often in high demand. Those who are willing to repo it out are awarded a premium in the form of a spread. These bonds are said to be "specials" That is to say, when you close the repo you will have to pay a reduced interest rate on the cash collateral. There is a simple opportunity to earn a profit here, by investing the cash at a higher rate than the reduced rate you will have to pay.

So where does the squeeze come in? As noted by James Clouse of the US Dept of the Treasury, the repo squeeze can be "an exercise in monopoly pricing". If you have a sizeable portion of on-the-run treasuries that are special, you can make money by repoing them out. But in certain cases, you can make even more money by holding back some portion of your sizeable position, therefore creating a scarcity of the on-the-run note, and making the position that you repo out even more special.

You can still fund your entire long position by doing a "tri-party repo" on the portion that you decide to hold back. In a tri-party repo, the bonds that you repo out are parked at a tri-party custodian account (usually BONY or JP Morgan Chase). You will have to pay the General Collateral rate on this repo (therefore no simple profit-making opportunity on this position), but the scarcity that you thus create will make the portion you do repo out even more profitable.

Why does the Fed care about this? Quite simply, when primary dealers squeeze an issue, investors have a hard time getting a hold of it, and trades fail.

The Fed is afraid of any practice which may cause the government securities market to seem less attractive to investors. At the present time the US government has issued debt over $8 trillion (i.e., the national debt). Because US Government obligations (mostly T/Notes) are generally regarded as the most liquid and safe financial instruments in the world, the government has a low cost of borrowing. Anything that undermines this reputation has the potential to increase the government's cost of borrowing.

So the Fed takes the possibility of repo squeezes very seriously.