Intellectual Ore

About three weeks ago, I was walking through TriBeCa, when for no particular reason, it hit me that everything was just…expensive.  From $25 dinners to million-plus housing, I got the sense that the people that lived there must have a lot of money, the way they seemed willing to throw it around.

The funny part is, they don’t.  This article by Forbes gives some statistics on ZIP code 10013, also known as the “Triangle Below Canal” (TriBeCa).  Even with a median house price of $1.875 million, the median income is only $49,314.

Something is very out of whack with this scenario.  Mortgage payments with 20% down on a house valued at $1.875 million would be around 9,000/month, more than double the median income.

With income/house price ratios like these, it’s hard to see how the “mortgage crisis” didn’t come sooner.  Are these people all perpetual renters in an area with an insanely low rental yield?  Maybe a few Swiss bank accounts are at work?  I wonder, is there any literature exploring the correlation between median house price/income versus house price volatility?  With ratios getting into 2.18:1, I can’t understand how the valuations stay as high as they do in TriBeCa.

I was heading to work on the 2/3 last Thursday when I saw a gentleman perusing Taleb’s Black Swawn.  Being that this is one of my favorite books, I was inclined to ask the gentleman’s opinion of it; as it happens, he was an actuary en route to a discussion about the book.  An actuary reading Taleb is something like a Christian reading the Quaran, so I knew right away that I was speaking to an extremely open-minded person.  He explained that in the course of his work at Standard and Poor’s, he’d seen the insurance industry shoot itself in the foot by systematically underpricing risk.  When disaster strikes, he explained, insurance companies lose a lot of money, but shortly after, premiums go up as disasters seem “more likely” in retrospect.  Faced with a glut of new premium money, the companies seek to expand the business they’ve written, and end up competing each other to a price point below the actuarially-derived zero-profit point, into loss.

When I explained that I was an engineering student, he contrasted his profession with mine, explaining that both, despite the proliferation of highfalutin models, require a pragmatic spirit capable of seeing beyond the limits of models.  It’s rare to meet someone so open-minded, especially over the age of 40; I was thoroughly impressed with this man’s intellectual accomplishment.

Blaming “speculators” for stratospheric oil prices seems to be fashionable nowadays in American politics.  Here are two opposite views of what’s going on:

First, an open letter signed by 12 airline industry CEOs:

Since high oil prices are partly a response to normal market forces, the nation needs to focus on increased energy supplies and conservation. However, there is another side to this story because normal market forces are being dangerously amplified by poorly regulated market speculation.  

Twenty years ago, 21 percent of oil contracts were purchased by speculators who trade oil on paper with no intention of ever taking delivery. Today, oil speculators purchase 66 percent of all oil futures contracts, and that reflects just the transactions that are known. Speculators buy up large amounts of oil and then sell it to each other again and again. A barrel of oil may trade 20-plus times before it is delivered and used; the price goes up with each trade and consumers pick up the final tab. Some market experts estimate that current prices reflect as much as $30 to $60 per barrel in unnecessary speculative costs.

The reliably pro-free market Economist sees things differently:

More importantly, neither index funds nor other speculators ever buy any physical oil. Instead, they buy futures and options which they settle with a cash payment when they fall due. In essence, these are bets on which way the oil price will move. Since the real currency of such contracts is cash, rather than barrels of crude, there is no limit to the number of bets that can be made. And since no oil is ever held back from the market, these bets do not affect the price of oil any more than bets on a football match affect the result.

My thoughts?  Check out my comment on the Economist article.  Suffice to say, blaming speculators reflects a fundamental misunderstanding of how futures markets work.  There is always a market for immediate purchase and delivery of oil; economists call this the “spot market”.  That futures prices have tracked spot prices so closely strongly suggests that futures are fairly priced with regard to physical oil.  Even if futures prices were off, the “open interest” of the market has no bearing on how many barrels will be physically sold.  Furthermore, the claim that “the price goes up with each trade” completely flies in the face of how financial markets work.  To borrow a quote, “These guys don’t know the difference between preferred stock and livestock!”

It’s all demand; the data is in my paper.

UPDATE: I forgot to include a link to Bloomberg, discussing a Goldman Sachs report that the fundamentals are to blame for recent oil prices.  (Notably, an Economist reader opined that Goldman Sachs is “Public Enemy #1″.)  One interesting thought that’s since come to mind: if the fundamentals don’t warrant the price, there very well could be a big risk premium built it; but still, this isn’t “speculation”, it’s the market perceiving the risk of a supply disruption, and pricing accordingly.

Ben Bernanke opined this morning on the Fed’s ability (more properly, inability) to regulate non-bank financial firms.  A central point of the speech was the need for Congress to give the Fed greater “explicit oversight authority” to regulate clearance, financing, and the credit risk inherent in OTC derivatives contracts.  Additionally, the speech addressed the need for having a process to dispose of a failed institution’s assets in an “orderly” fashion.  The speech took a very even tack between the costs and benefits of increased regulation; it really made for a great start to my morning.

Given how important robust payment and settlement systems are to financial stability, a strong case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems.