economics

Here is a great series on High Frequency Trading. I was most intrigued by this:

It’s important to note that market making is nothing new. In the era when stocks were traded in 1/8ths and 1/16ths, market making was done by humans working in the pit. A single human trader would often run a market making strategy on larger stocks with significant volume. Later on, from the 1980’s to the early 2000’s, human daytraders would often fill this role. To a much lesser extent they still do.

Automated trading systems have replaced these human market makers for a very good reason – cost. For a strategy (and note: this strategy works only for a few securities, no human can track hundreds of stocks mentally) to be worth a financial professional’s time and effort, it must generate at least $20-200k profit each year (this assumes a human smart enough to daytrade would work for $20k/year). In contrast, a single server in a data center can run hundreds of strategies at a cost closer to $50k/year, and they can do it faster and more accurately than any human.

…Suppose that at precisely 10:31:30:000 AM, new information becomes available which suggests that it will now be profitable to place a buy order at $20.07 – perhaps a press release has hinted that the price will go up, or a correlated security has just gone up in price. Because of this, both Mal and Jayne want to change the price on their orders to $20.07. Whoever happens to be fastest will rise to the top of the book:

This is why automated market making has morphed into high frequency trading, and why so much effort is poured into creating low latency systems. Whoever places their order first will be the most likely to trade.

It’s interesting that progress in this market is defined as the degree to which machines talk to and understand each other.

The immediate ability to profit from technological advances means computers will be autonomously driving market liquidity before they’re driving cars.

What is the value of something?

Here’s Pete Warden with the best explanation for what Facebook gets in Instagram. Many commentators have gotten caught up in the comparison of valuations between the New York Times and Instagram (both $1bn). Don’t be fooled, this is deep stuff.

The best answer for what something’s worth is the amount of money you can make from buying it. To a pure trader, most everything is inherently valueless, they simply buy and sell assets to flip them. Economically, all they do is provide liquidity. Markets *really* work only when interested parties transact with heterogenous uses for the assets. One man’s trash is another man’s treasure.

To Facebook, Instagram is worth $1bn. To Facebook, the NYT is worth far less than $1bn because they would probably destroy quite a lot of value by buying it. To Microsoft or Yahoo! Instagram may well be worth a lot less than $1bn. Heck, Instagram may well not be worth $1bn to Facebook, either, but Facebook *thinks* it is at the moment.

And that’s as satisfying an explanation as you can get. Talking about an abstract “price” for something is nonsense.

Dane-o sent me this article on the possibility of a Student Debt bubble. I’m often wary of Zero Hedge: they are an odd mix of great analysis and sensationalist extrapolation.

The core of the story is that Jamie Dimon is pulling back hard on his student loan business. I’d divide my interest in this topic into a few areas: 1. If student loan defaults went bananas, should I be worried about systemic risk? 2. Are student loan defaults going bananas? 3. What does all this mean for higher education?

Ok, let’s start with 1. Is the student loan market systemically important?

First, how big is it? One estimate is 1 trillion (and that’s a high/overstated number), which is bigger than I’d expect. But my favorite view on the Great Recession is that even the housing collapse would have been a trivial shock if not for monetary tightening. And the US Mortgage market is about 10 trillion.

And you can walk away from your mortgage, wheres lenders have “broad powers” to seek repayment on student loans. Bankruptcy isn’t an option. That means that lenders aren’t going to feel much pressure to write the suckers down. No solvency risk means no systemic risk.

So why exit?

Probably because though they won’t sink the ship, they aren’t lifting the boat. Much is made of the large number of delinquent student loans. And 27% at 30 days past due is big. But in mortgages, at least, a lot of loans are ‘cured’ between 30 and 90 days, after which they’re considered in default. And anyway, you can’t kill a student loan with bankruptcy.

Following the chain of links leads us to an American Banker piece:

The CFPB recently began accepting student loan complaints on its website.

“I think there’s going to be a lot of emphasis and focus … in terms of what is deemed to be fair and what is over the line with collections and marketing,” Petrasic says, warning that “the challenge for the CFPB in this area is going to be trying to figure out how to set consumer protection standards without essentially eviscerating availability of the product.”

Outstanding student debt, including private and federal loans, has topped $1 trillion, surpassing previous estimates, the CFPB reported earlier this month.

More regulation, uncertain cash flows. Sounds like a plain old fashioned crappy business. Not much of a story.

What matters, to me, is the fact that the government owns most of this business and appears to be picking up share as private firms rush out. Higher education reform will be high on the agenda in the coming budgetary armageddon. Those costs have to come down somehow.

US the richest and most productive economy in history. And it is spending an all-time record *proportion* of that all-time mass of wealth on health care and education.

Education is not the most productive sector in the world. It’s just the fattest in the world.

via Tyler Cowen we are sent to FT Alphaville for a some serious brain damage. I have training in both bond markets and monetary macroeconomics but have no real practical experience in either, so I know only enough to be dangerous here. Beware.

With that, let’s of course talk about how bond markets affect monetary policy.

Banks borrow money. In the olden days, they’d borrow it from you and me (deposits) and lend it out for profit. Sometimes the banks would make enough bad loans that borrowers would all simultaneously freak out and try to withdraw all their money. Loans can’t be called that fast. Bank run… Bust.

A big part of Bernanke’s academic legacy is describing the nasty things that happen when an economy is starved of credit after an epidemic of bank runs.

Deposit insurance stops this problem because the olden days creditors (us) never have to worry about getting their money back.  But these days there’s a new channel for bank runs: shadow banking.

Here’s how a shadow bank works: you have a treasury bond or some highly rated corporate debt but you WANT cash. So you borrow money overnight and pledge that bond as collateral then go make some money with that cash. That’s shadow banking.

The point of the FT post is that shadow banking is huge and absolutely TANKED during the crisis. There’s lots of interesting discussion in that piece on this point. Here’s a graph (there are may more)

This had the effect of sucking money out of the economy, perhaps not quite like what happened in the Great Depression but certainly more than the experts thought they saw in 08-09.

I really liked this quote:

6) How does this understanding of the crisis jive with Gary Gorton’s theory of what happened? Recall that Gorton’s story wasn’t just about collateral values plunging and haircuts rising in repo markets. It was that certain types of debt used as collateral flipped from being information-insensitive to information-sensitive. And this flip wasn’t limited to subprime MBS, which would have caused only minor stresses.

His argument wasn’t about the relative safety of the collateral as its value fell. It was about the collateral going from safe to unsafe just because lenders in repo markets realised that it could potentially fall. So they pulled out en masse and hiked haircuts even when the collateral wasn’t subprime-related, and voila you’ve got a crisis. This was partly an issue of repo market transparency, but it also reflects a different, more binary understanding of what triggered the crisis.

Summary: on a one-day time horizon, highly rated corporate paper wasn’t risky until it was. And if that stuff was used for repo loans then the repo system stops working.

What nobody really understands, even now, is how important the repo system is. Even though Scott Sumner thinks it doesn’t matter.

Lots of talk about how we’ve progressed since 1949. Here’s one graph. (and more and more).

I like thinking of it like this (using this dataset to see that we are about 2.75x the 1949 median income level)

As pointed out in the original Atlantic piece and in this awesome Tyler Cowen piece, our relative consumption is shifting away from super competitive ‘making things’ sectors and towards protected domestic service-oriented industries.

We’re spending similar amounts of money on food and apparel, etc. We’re spending much of the gains made since (and that’s a LOT of gains) on services and housing.

And housing’s a funny one because it’s simply rent paid to an owner of capital. Shouldn’t we be bidding for opportunities in productive industry rather than stocks of housing?

Read Tyler Cowen.