Birth Control & the Muslim World—Misconceptions Abound

Updated, 22 August 2013—see entry for Iran.

During a conversation with [name withheld], she mentioned something about how a woman was stoned in Iran for using contraceptives. I mentioned that this seemed unlikely to me, and indeed, I did not believe it was something that happened anywhere. My friend was flustered and little bit annoyed, but she had to admit she had no idea where she'd heard this. I looked it up and discovered (courtesy of the BBC) that Iran, in particular, had a large contraceptives industry, distributed contraceptives free through its national health system, and had mandatory contraceptive education as a precondition to getting a marriage license.

While reading up, I was (a) surprised at how misinformed I was, or, looking at it another way, how odd it was that I had never looked into the matter, and (b) how easily available the information is.

The main historical force driving birth control, based on my (very brief and inadequate) review of many difference countries and cultures is technology: the medical knowledge required to develop safe and reliable BC emerged around 1910, while the materials science required (elastomer production, for example) took off around 1930. Reliability was achieved for most varieties around the mid-1950's.

Most activists might interrupt me here to object that there had to be a movement demanding BC, which is undeniable, but the technology was definitely developed independently. Elastomers and rubber obviously had a huge number of industrial applications, which paved the way for the development of materials suitable for medical use.

(Here follows a summary of what I found, with links):
Read more »

CDO Meltdown (3): Summary of Results

(Part 1, 2)

My previous post summarized a few major aspects of that were well-known about CDOs--mostly notes from the first 27 pages of Anna Katherine Barnett-Hart's thesis, "The Story of the CDO Market Meltdown." However, this is just the first quarter of a 115 pp. paper. What follows is attempt to summarize more of the actual findings peculiar to the paper.

EXAMINATION OF THE CREDIT RATING AGENCIES

The credit rating agencies (CRAs) consist of Moody's, Standard & Poor's, and Fitch. Fitch was a relatively minor player in the CDO sector for reasons that will be investigated in the "Findings" part of this post. Letter ratings by the CRAs have had statutory significance for decades, since pension funds were required by law to invest only in AAA securities.¹ In theory, institutional investors or banks were obligated to practice due diligence; complete abdication of responsibility to CRAs for such an important function seems rather extraordinary.

The ratings supplied by CRAs are supposed to measure the likelihood of fulfillment of the obligations of the underlying security. The securities we are talking about are securitized debt and bonds, or derivatives thereof, and the question that a rating is supposed to answer is, How likely is it that the investor will receive principal and interest on time? In some cases, interest payments and principal are rated separately; in other cases, the only thing being rated is the likelihood of the of the investor getting the initial investment back.²

After 2002, when the CDO became a major investment vehicle, CRA business soared.³ A curious aspect of this boom in ratings demand was that CRAs were now the most important customers for their own product. CRAs rated residential mortgage backed securities (RMBS) or other constituents of CDOs, and then used these same ratings (plus formulae for pooling and diversifying risk) . For purposes of pooling, it was useful to have multiple CRAs rate the same security, and then use it in multiple CDOs. If a CRA was assessing securities already rated by another agency, it would typically "notch" the rating (downgrade it one grade).⁴ So "duplication of effort" was a major source of business.

Of course, "duplication of effort" did not occur as far as due diligence was concerned. Instead, a few data inputs were used to assess the base assets. Ratings did not correlate well with rates of default or with subsequent downgrades, even by the limited metrics imposed by the agencies themselves. But CDOs were supposed to incorporate the broader, systemic risk of loss; this, the CRAs were unable to do.⁵

In the event, the CRAs' own staffs were never able to agree on a single coherent notion of what risk was.

EXAMINATION OF THE UNDERWRITERS

The underwriters were investment banks that created CDOs . By far the largest ABS CDO underwriter was Merrill Lynch, followed at a distance by Citigroup.⁶ Soon the underwriters ran out of asset-backed securities and began to incorporate assets consisting of tranches from earlier CDOs. Merrill Lynch, for example, bought 32% of its own RMBS and CDO issues for CDO repackaging.⁷

Underwriters made the situation worse by carrying the super-senior tranches in off-book special purpose vehicles (SPVs) , justified to regulators by hedging--i.e., purchases of credit default swaps (CDS). Merrill Lynch was thus obligated to write down USD 51.2 billion in the wake of the crisis.⁸

However, there was immense difference in performance of CDOs depending on the originator. Goldman Sachs performed comparatively well, with "only" 10% default compared to 40% for JP Morgan.

Hypotheses

Barnett-Hart lists several hypotheses she tests using a combination of regression analysis and probit analysis (p.36).

• Hypothesis 1A ("The Housing Effect"): Increasing exposure to residential mortgages, specifically subprime and Alt-A RMBS, is associated with worse CDO performance as measured by defaults.
• Hypothesis 1B ("The Vintage Effect"): Increasing exposure to 2006 and 2007 vintage collateral, particularly assets with floating interest rates, is associated with worse CDO performance as measured by defaults.
• Hypothesis 1C ("The Complexity Effect"): Increasing the amount of synthetic collateral, the amount of pre-securitized CDO collateral, and the overall number of collateral assets is associated with worse CDO performance as measured by defaults.
• Hypothesis 2A ("The Underwriter Effect"): Holding constant general CDO characteristics, CDO performance varies based on the underwriting bank.
• Hypothesis 2B ("The Size [of the underwriter's CDO business] Effect"): The performance of an underwriter’s CDOs varies according to the size of their CDO business, with overly-aggressive or very inexperienced banks issuing worse CDOs, as measured by their ex-post defaults and rating downgrades.
• Hypothesis 2C ("The Originator [of the underlying collateral] Effect"): Controlling for the type of mortgages issued, as measured by average FICO, CLTV, and DTI scores, the performance of a CDO depends on the specific entities that originated its collateral assets; in other words, was CDO performance affected by the emergence of banks that acted as both CDO underwriters and collateral originators?
• Hypothesis 2D ("The Asymmetric Information Effect"): CDO performance will be affected if it contains collateral originated by its underwriter, although the performance might improve or decline, depending on the importance of reputation vs. adverse selection and moral hazard.
• Hypothesis 3A ("Recycled Ratings Effect"): The most important factor in explaining initial levels of AAA given to a CDO are the credit ratings of their collateral pool.
• Hypothesis 3B ("The Peer Pressure Effect"): The % of AAA given to a CDO will depend on the number of rating agencies rating the deal.
• Hypothesis 3C ("The Seniority Effect"): Controlling for the default rate of the CDO collateral, senior tranches have experienced more severe downgrades.
• Hypothesis 3D ("The Asset-Class Effect"): The realized defaults associated with a given credit grade varies based on the asset type. Similar to Hypothesis 1A, except that here we're interested in the effect on default likelihood for a given CRA rating applied to CMBS versus RMBS or HEL.
  
• Hypothesis 3E ("The Super-Senior Effect" : Rating agencies were overly optimistic in giving AAA ratings. CDOs given more initial AAA ratings, in terms of number of AAA tranches and percent of the transaction rated AAA, are now exposed to larger losses. The name for this hypothesis was apparently inspired by Janet Tavakoli (2005), in which she cites the impact on the actual risk of a waterfalled security of a super-tranche. CRAs did not specifically account for the additional risk posed to the smaller AAA tranche by having a larger share of the CDO's liabilities be senior to it.
  
• Hypothesis 3F ("Conflict of Interest"): Conflicts of interest caused by the fee system of credit ratings would result in more aggressive initial ratings, subsequently more downgrades, and worse accuracy in prediction for the CDOs of large underwriters. Barnett-Hart tested this hypothesis by comparing the amount of business the CRAs did with each underwriter with the number of tranche-rating downgrades. A very large downgrade meant a larger favorable bias toward the underwriter, which was (in turn) tested against the volume of business the CRA did for that particular underwriter.
  

In total, thirteen hypotheses about the factors that most severely stimulated the crisis. These hypotheses seem well-chosen because they test market failure under conditions that most closely match perfect competition.

RESULTS OF THE STUDY

About half of the variation in ABS CDO performance was the result of CDO asset and liability properties (Hypotheses 1A-1C). In particular, regressions of asset and liability properties explained almost 60% of the downgrades in ratings for individual tranches of CDOs. The results are summarized on p.91.

Most hypotheses were validated, although it takes a close reading of the result tables to say how validated each one was. CDOs had a strong likelihood of failing if they were created in 2006-2007, were issued backed mostly by residential mortgage securities (as opposed to commercial mortgages , etc.),⁹ and were complex.¹⁰ This is to be expected; narratives of financial crises should rely on failed business models or regulatory systems. Narratives that "expose" a single person or institution as wickedly inflicting the disaster on a hapless financial system are unsatisfying.

Hypotheses 2A-2D dealt with the underwriter contributions to CDO performance, and explained less of the variance in CDO performance. Nonetheless, they were still interesting to economists. Hypothesis 2A involved a simple ranking of underwriters by CDO performance; effect of [collateral] origination and assymetric information (i.e., hypotheses 2C & 2D) was ambiguous. Some collateral originators performed worse than the rest, but mostly the asset composition was a stronger explanation (2C). Likewise, in some cases it helped that the originator of CDOs was a large player, but aggressiveness in growing structured finance departments was not a good sign (2B); and there was considerable variation from underwriter to underwriter as to the effect on using one's own collateral in a CDO tranche (2D).¹¹ These results arguably suggest that underwriters were eclipsed in importance by the fundamental business model applied to CDOs and the strategic position of the particular underwriters. For example, Goldman Sachs was in a peculiarly advantageous position with respect to the underwriters and was not obligated to pursue CDO business aggressively.

(It needs to be added that table 7 summarizing the ranking of CDO underwriters based on (a) CDO default and (b) CDO tranche rating downgrade yielded entirely different results. Goldman's CDOs had the lowest frequency of default, followed by Lehman; but Goldman was ranked 11th for ratings downgrades.)

The hypotheses 3A through 3F pertained to corruption of CRA ratings per se. Here, the hypotheses behaved very differently indeed from what was expected. While attempting to confirm Hypothesis 3F ("Conflict of Interest"), for example, Barnett-Hart ran up against the problem that the ranking of underwriters by ratings demand was the same for all three CRAs. Moreover, the largest underwriters often were the worst. To make matters more ambiguous, the real problem was that there was too little variation in ratings, not to much. Using jargon from behavioral economics, the problem was signals compression: the difference in real quality of securities, from T-bills to Countrywide CES RMBS was huge, and the ratings ought to have reflected this. Instead, the ratings reflected very small differences across the range of underlying reality.

One regression, for example, ranks underwriters by the accuracy of their ratings (table 14, panel B, p.89). The twist, here, is that the ranking reflect the success of the CRAs to make accurate judgments of the underwriters being ranked. It happens to closely match the ranking of underwriters by performance of CDO (where higher ranking means fewer defaults). In effect, the CRAs were "righter" about the best underwriters, and "wronger" about the worst.

Barnett-Hart concludes:

The errors of the rating agencies stemmed from neither conflicts of interest nor preferential treatment given to certain banks. The true culprit behind the rating agencies’ failure was the outsourcing of credit analysis to computer models and the low level of human input used to rate CDOs (p.94).

In a later post I want to address broader conclusions regarding the CDO market meltdown.

(Part4)

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Notes

1. The term "AAA" is used by Standard & Poor's and Fitch; Moody's uses "Aaa." Here et alibi, "AAA" = "Aaa."


2. Tavakoli (2005), p.9; via Barnett-Hart (2009). Barnett-Hart uses the page numbers from the PDF file; here, page numbers are from the issue of the original periodical.
   


3. From exhibit , Senate Permanent Subcommittee on Investigations, April 2010, p.18.
   

   Moody’s gross revenues from RMBS and CDOs increased from just over $61 million in 2002 to over $208 million in 2006. S&P's net annual revenues from ratings nearly doubled from $517 million in 2002, to $1.16 billion in 2007. During that same period, the structured finance group's revenues tripled from $184 million in 2002, to $561 million in 2007. In 2002, structured finance contributed 36 percent to S&P’s bottom line; in 2007, it contributed 48 percent – nearly half of all S&P revenues. In addition, from 2000 to 2007, operating margins at the CRAs averaged 53 percent, far outpacing companies like Exxon and Microsoft, which had margins of 17 and 36 percent respectively in 2007.

   This information added in an update to the original post.


4. Barnett-Hart (2009), p.20


5. Tavakoli (2005), p.10.

   One would think that rating agencies would at least be inter- nally consistent. But that isn’t necessarily true. Even within the same rating agency, portfolio tests and restrictions may vary by deal, and some deals are better protected than others. Different structurers within a rating agency may choose different stress scenarios when evaluating cash flows for an ultimate rating.
   
   [....]
   
   In 2004, Fitch’s model showed such unreliable results for structurers using Fitch’s fre- quently changing correlation matrix that industry observers dubbed it the "Fitch Random Ratings Model."

   With respect to the broader measure of systemic risk: " Conventional general market risk to a portfolio is not captured by ratings." (p.9)


6. Barnett-Hart (2009), p.26. Here is the complete list.
   
   

   This table presents the number of ABS CDO deals underwritten by the top 10 underwriters between 2002-2007. The data were obtained from S&P’s CDO Interface.
   Underwriter	2002	2003	2004	2005	2006	2007	TOTAL
   Merrill Lynch	0	3	20	22	33	18	107
   Citigroup	3	7	13	14	27	14	80
   Credit Suisse	10	7	8	9	14	6	64
   Goldman Sachs	3	2	6	17	24	7	62
   Bear Stearns	5	2	5	13	11	15	60
   Wachovia	5	6	9	16	11	5	52
   Deutsche Bank	6	3	7	10	16	5	50
   UBS	5	2	5	10	16	6	46
   Lehman Brothers	3	4	3	6	5	6	35
   Bank of America	2	2	4	9	10	2	32
   TOTAL DEALS	47	44	101	153	217	135	697



7. Ibid., p.27. Repackaging of CDO securities into a new CDO resulted in a "CDO-squared." The Royal Bank of Scotland did this an average of 5.32 x for its CDO securities. Merrill Lynch did it 4.79x. These were extremes, but Merrill Lynch was the biggest underwriter.


8. Ibid., p.32. CDS is supposed to be a form of insurance for default (rather than a proper swap), but almost immediately became very popular as a way for non-holders of CDO securities, like John Paulson, to bet against the housing market overall. The counterparties in the CDS transactions received a premium when defaults did not occur, but when they did, suffered enormous losses that required government bailouts to prevent a general run of CDO securities. This was problematic since so much of the money used to bail out the financial system went to pay off speculators like Paulson.


9. This hypothesis is somewhat problematic because such a large share of ABS CDOs were based on housing collateral. Remember, this category excludes the larger pool of synthetic CDOs as well as a smaller group of CDOs based on corporate bonds. RBMS accounted for about 14% of all ABS deals in 2006-2007 (Barnett-Hart, p.9, table 2) , but home equity loans (HEL) were more radioactive still and accounted for another 34% of deals during that period. Of the remaining 52%, another 11% were pre-existing CDOs (which incorporated a slightly different share of HEL & RMBS; see next footnote below). Only about 40% of the total were commercial mortgages or "other": credit card debt, car loans, and so on.


10. Complexity is measured by the coefficients on Number of Assets, % Synthetic, and % CDO. Please note that CDOs were a non-housing asset and "% synthetic" impinges on the 40% of ABS CDOs that were neither housing nor CDO. As it happens, synthetic CDOs performed relatively better than ABS CDOs--they failed at about a fifth the rate of ABS CDOs (See Part 2, Ftnt 4 & 5).
11. For a description of the findings:
    1. Hypothesis 2A, p. 56 & table 7 (p.63, panel A);
    2. 2B p.57 & table 7 (p.64, panels B.1 & B.2)
    3. 2C: p.58 & table 8 (p.63)
    4. 2D: p.59 & table 8 (p.65)

*

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Sources & Additional Reading

Efraim Benmelech & Jennifer Dlugosz, "The Credit Rating Crisis" National Bureau of Economic Research (2009)

Anna Katherine Barnett-Hart, "The Story of the CDO Market Meltdown: an Empirical Analysis" Thesis, Harvard University (2009)

Janet Tavakoli, "Structured Finance: Rating the Rating Agencies " , Global Association of Risk Professionals, Issue 22 (Jan/Feb 2005), p.9; via Barnett-Hart (2009), p.20. Barnett-Hart uses the page numbers from the PDF file; here, page numbers are from the issue of the original periodical.

Dr. Michael Wang, Shwn Meei Lee, & Dr. John Ku, "Risks and Risk Management of Collateralized Debt Obligations" (February 2009)

Yves Smith, "The Role of CDOs in Merrill’s Losses (Updated and Expanded Version)," Naked Capitalism (24 October 2007)

Global CDO Issuance, SIFMA (Excel spreadsheet). Outstanding source on CDO statistics.

CDO Meltdown (2)

(Part 1)

The single most valuable resource on theCDO meltdown is Barnett-Hart (2009); this was a thesis paper submitted for a BA at Harvard University, which received a lot of attention thanks to a favorable cite by Michael Lewis.¹ Fittingly, the thesis has won many honors, and it's pretty impressive to read.

A few points introductory to this essay; first, I'm not an expert and this post is my collection of notes on what I regard as helpful or trustworthy sources. The reason why I am writing about this topic is that it's very important to understanding the financial crisis and its concomitant economic catastrophe. Readers are almost certainly not going to share my political views of the matter, but I think some grasp of the mechanics of the crisis will help out in forming their own.

Second, readers interested in an explanation of CDOs are advised to read my first installment or, better still, the first 27 pages of Barnett-Hart's paper.

Additional Background from Barnett-Hart

Most of the CDO market growth took place between 2002 and 2007; a major driving force was the fact that real interest rates were abnormally low, and institutional investors like pension fund managers were required to invest only in AAA-bond assets. CDOs used the waterfall structure to create putatively AAA tranches from pools of assets of far lower rating. In fact, this would have worked except for the fact that the asset pools were (a) not successfully or adequately diversified (i.e.,the assets in the pool were prone to defaulting all at once), and (b) composed of loans of unprecedentedly poor grade (i.e., the loans were made to borrowers who were almost certain to default).

Another reason was that bank holding companies in the USA were now underwriting securities as well as re-lending deposits as loans. Banks could increase their leverage-to-equity ratio by unloading assets to a special purpose entity (SPE; also known as a structured investment vehicle, or SIV), then harvest the returns from the SPE. In a few years, an enormous share of assets and liabilities of the US banking system (including US subsidiaries of foreign banks) were parked in this shadow banking system.

The cash "freed up" by "selling" loans to off-balance sheet zombies (Barnett-Hart called them "brain dead," p.5) was then lent out again. This ruse allowed a large increase in the supply of loanable funds available to the banking system, and spurred a huge boom in housing prices.

About 13% of CDOs issued were created to vacate the balance sheet of a bank.²

The CDOs were exceptionally complex, large entities; they tended to be just under a billion dollars in size, were divided into 7-8 tranches, which usually included one unrated tranche.³ As they became more popular, structured finance came to be the preferred form of collateral (synthetic CDOs).⁴


CDO performance in the Crisis was highly varied. Quarter of issue, asset type, and underwriter (e.g., Goldman Sachs versus J.P. Morgan) each had an effect that was statistically significant. Bonds incorporated in CDOs generally performed much worse than those that were not (Barnett-Hart, p.12, figure 3). After 2005, synthetic CDOs became the main part of the story, but as of this writing, they remain a comparatively small part of the CDO crisis.⁵

A Digression on Subordination

A very important part of the CDO boom was the role of ratings and the enhanced return relative to ratings that CDOs offered to investors. CDOs were popular with investors precisely because they were rated much higher than the underlying securities taken separately would have been, had they been rated accurately. Credit rating agencies (CRAs) such as Fitch, Moody's, and Standard & Poor's assumed that the underlying securities were pooled and subordinated in a way that prevented serious losses to investors even if the CRA ratings were excessively optimistic.

One of the indices of "safety" (or unlikelihood of failure) was loan subordination. A typical bank borrows money short-term from depositors and lends it long-term to borrowers. In order to make a return on its capital, it must lend the money at a higher rate than it pays out to depositors. If this spread is large, then the bank can increase its reserves and its capital. In either case, the bank's excess of loan revenues over expenditures (i.e., interest paid in on loans less interest paid out on accounts) protects the depositors from default by borrowers. "Credit enhancement" includes this and other ways of reducing the likely cost of default: [putatively] excessive collateral, and credit default swaps (CDS), or "wrapped securities" (securities insured against loss by a third party) are other ways.

Ratings agencies use a complex formula to pool their estimate of the value of these guarantees; the subordination is supposed to reflect the excess of cash flow over obligations as a percentage, with each tranche in the CDO possessing a different subordination value.

The Effect of Ratings

Earlier, I mentioned that super-senior tranches were supposedly better than AAA, meaning that the waterfall agreement used in CDOs ensured that even market anomalies capable of hitting a AAA security were unlikely to impact a super-senior tranche. This was reflected in the subordination levels for super-seniors: as late as 2007, they were estimated at 22%, compared to <15% for AAA, <10% for AA, and <5% for BBB (Barnett-Hart, p.15, fig.6).⁶

The ratings agencies did not know how to cope with the huge demand for data that investors (and regulators were now putting on them). The financial system was trained to measure performance by returns relative to risk. High risk investments were supposed to have high rates of return; it wasn't especially impressive if they did. With CDOs, investment houses could churn out high rates of return on low risk investments, with AAA rating. This was the essence of "alpha," or performance of a portfolio adjusted for risk.⁷

The great majority of CDOs were issued in order to arbitrage the favorable interest and risk imparted by the CDO structure itself. Hence, the CRAs were major instigators of the CDO mania. Barnett-Hart goes so far as refer to the CRAs as "manufacturing AAA CDO securities from collateral with much lower ratings" (p.23), which certainly fits my understanding of the situation.

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Sources & Additional Reading

1. Peter Lattman "Michael Lewis’s The Big Short? Read the Harvard Thesis Instead!" Deal Journal [blog], The Wall Street Journal (15 March 2010)


2. SIFMA spreadsheet (accessed for this post), in worksheet "CDO Purpose." Refers to period 2005-2010, during which 13% of the USD 1.3 trillion in CDO par value issued was for shadow banking. The remaining USSD 1.1 trillion was used for arbitraging the interest premium offered by putatively AAA/AA securities.


3. Barnett-Hart's paper examines 735 CDO transactions with an average value of $829 million each (pp.7-8). This accounts for about half the USD-denominated CDO transactions issued between 1999 and 2007. During this period, USD-denominated transactions accounted for about three-quarters of the total (SIFMA spreadsheet, "Denomination" tab). Unfortunately, the SIFMA data does not cover CDOs before 2000, but this was a minor year in terms of the total volume. After 2008, total CDO issuance plummeted to a tiny fraction of its 2005-2007 rate, especially in the USA.


4. According to the SIFMA spreadsheet ("Collateral" tab), structured finance was the collateral in 1% of CDO issuance for 2001; it shot up to 63% in 2005, accounting for 91% of the growth of issuance during this period. The reason, naturally, was a shortage of the other types of collateral. Still, the CDOs included as collateral about a half-trillion USD in "high-yield loans."
   
   Barnett-Hart's paper focuses on asset-backed security (ABS) CDOs, rather than structured finance. By February 2009, about half of these deals had been written off ("Half of all CDOs of ABS failed," Financial Times, 11 February 2009, via Naked Capitalism). This accounted for about USD 105 billion in defaults, out of a total of USD 815 billion (as of 9 Feb 2009; see "Banks’Subprime Market-Related Losses Top $815 Billion," Bloomberg). So basically about a third of ABS CDO failed, and these accounted for 13% of losses in the 2007-2008 Financial Crisis.


5. An additional USD 24 billion in losses was attributed to synthetic CDOs ("Warning over CDO losses if CIT defaults," Financial Times-14 July 2009). Since our estimate for synthetics comes five months later than the one for total losses and ABS-based CDOs, it's reasonable to assume the figures for the latter two were higher and synthetics performed much better. If not, ABS-based CDOs ($105 B) and synthetics ($24 B) lost $129 B of the total $815 B lost by the top 100 financial institutions worldwide in the Crisis, or about a sixth of the total. Moreover, ABS CDOs losses accounted for 81% of CDO losses overall.
   
   In view of the fact that over half of CDOs issued during the problem period (2005-2007) were synthetic CDOs, this suggests that part of the design principle of the CDO actually worked.


6. For a prescient critique of the methods used by the CRAs to compute debt subordination, see Xudong An, Yongheng Deng, & Tony Sanders, "Subordination Level as a Predictor of Credit Risk" Real Estate & Urban Analysis, University of Cambridge (April 2006).


7. "Alpha" refers to the rate of return on an investment (or the performance of its manager) relative to the rest of the market. If the manager invests in high risk securities, the return on the portfolio will be likely be higher than otherwise, and such investors will be compensated for greater risk; but higher risk also includes a higher risk of unpleasant surprise. For this reason, people who rate portfolio managers measure "alpha" to compensate for things like the manager's risk preference and the overall behavior of the securities market.
   
   The effect of high ratings on CDO tranches was to permit managers to achieve the illusion of high alphas because they were getting rates of return that exceeded what could have been expected, given the low risk of their portfolios.
   

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Sources & Additional Reading

Efraim Benmelech & Jennifer Dlugosz, "The Credit Rating Crisis" National Bureau of Economic Research (2009)

Anna Katherine Barnett-Hart, "The Story of the CDO Market Meltdown: an Empirical Analysis" Thesis, Harvard University (2009)

Dr. Michael Wang, Shwn Meei Lee, & Dr. John Ku, "Risks and Risk Management of Collateralized Debt Obligations" (February 2009)
Yves Smith, "The Role of CDOs in Merrill’s Losses (Updated and Expanded Version)," Naked Capitalism (24 October 2007)

Global CDO Issuance, SIFMA (Excel spreadsheet). Outstanding source on CDO statistics.

CDO Meltdown (1)

By now, the collateralized debt obligation is surely a household word. The technical nuances of CDOs remain obscure, but the essential problem here was that financial engineers believed that, by using past data they could quantify risk of default, and then pool that risk. Pooling risk, under certain circumstances--explained below--reduces risk to manageable levels.

Those circumstances include two crucial conditions: the risk being pooled must absolutely have zero correlation. Very small correlation is all right--it's not the "zeroness" that's important, it's the certitude that it is low under all circumstances. The other condition, which is really just a reiteration of the first, is that the actions of the financial engineer must assuredly have no impact whatever on the risk itself.

The first condition, in other words, means that an event that affects all the things at risk (e.g., an earthquake hitting a large ratio of properties insured by a particular firm) must never happen. The second condition means that the act of creating an insurance pool, or financial instrument, can never actually influence the risk of the parties themselves (taken as individuals). If the invention of insurance sharply alters the behavior of the insured, then actuarial data is inherently inaccurate.¹

As is now well established, the CDO made credit extremely cheap. This was done by producing an estimate of risk that could be prepackaged into a tradeable security, bundled using a structured investment vehicle (SIV), and sold with a mathematically-inferred projection of return. While credit extended to high-risk borrowers has a high probability of default, this probability was supposedly offset by pooling (with other, lower-risk borrowers) to achieve a suitable investment-grade bond.

THE CDO: A SHORT DESCRIPTION

A collateralized debt obligation (CDO) is a type of structured finance product, in which the originator creates an entity like a special purpose vehicle (SIV) to own loans and distribute payments on certificates. The CDO represents a claim many different potential kinds of assets:

• investment grade and high-yield corporate bonds;
• emerging market bonds;
• residential mortgage-backed securities (RMBS);
• commercial mortgage-backed securities (CMBS);
• real-estate investment trusts (REIT) debt;
• bank loans;
• special-situation loans and distressed debt.

The first CDOs were used for repackaging high-risk corporate bonds and convertible bonds, but later developed into an entire parallel banking system.^2,3

CDOs are generally classified as "cash" or "synthetic." A cash CDO consists of a pool of bonds or loans. Their asset value is tied to the cash flow of the underlying assets, which consists of payments on the principle and interest.

Synthetic CDOs sell credit protection via credit default swaps (CDS) rather than debt-based assets. The CDO's asset value is pegged to specific tradeable assets, but it emulates the capital gains of the assets with derivatives (rather than ownership); hence, it is more highly leveraged. The collateral comes from a cash deposit by the depositor/investor.

The CDO pays out returns at maturity to investors at different levels of priority. In the event that there is widespread default, some of the tranches are guaranteed first, second, or third priority of repayment. The highest-risk [equity] tranches, with a high nominal rate of return, take any hits in the event of default. This is called a "waterfall structure."

CDO asset pools were quite large; typically, they involved nominal values of about USD 500 million to >USD 5 billion.⁴

RATINGS

Click for larger image

A crucial aspect of the CDO boom was the role of the ratings agencies, Moody's, Fitch, and Standard & Poor's. These agencies are quite old, but their business model has evolved over the last 40 years. Originally they were paid to rate securities by investors, who paid for their ratings. This business model dried up and was superseded by a new one in which the issuers of securities paid for the ratings.

There was an obvious conflict of interest in this arrangement, but structured finance and tranching made it worse. That's because the ratings for CDO issues were extremely important to the creation of a shadow banking system, in which liabilities could be parked off bank balance sheets, without the usual reserves or capital adequacy; and because ratings were so important to the design of CDOs.

Because of what a CDO is, it requires the ratings agencies to collude in the design and ultimate strategy of CDO-style structured finance. The tranches are rated separately; in theory, the superior senior tranch of 2006-vintage synthetic CDOs were actually better than AAA, since they had AAA-assets as collateral.⁵

COLLATERALIZATION

A critical part of the narrative was collateralization. A debenture is a debt instrument (like a bond) that is not backed by any collateral. Most bonds are debentures; CDOs supposedly would be safer than debentures because the creditors could, in the event of default, auction off the collateral. As we now understand, this collateralization was to allow the crisis to spill over more readily into the real economy.⁶ This was because CDOs created a bubble in housing prices (millions of people could borrow more than before, and bid up the price of housing--see Warren & Tyagi, 2004)

The effect of collateralization was most obviously to create not only a huge gap between the bubble price and the bust price of houses; it also flooded the rest of the credit markets with loanable funds for consumption. Arguably, this is a strategy that is not readily available for economies whose currency is not the universal reserve currency. That's because rapid expansion of the money supply is liable to lead to capital flight (interest rates fall below a competitive level). But it has a disproportionate effect on consumption, since entrepreneurs are guided by other considerations besides cheap loanable funds. This may explain why the US has such a large and persistent trade surplus. In any event, the CDO meltdown has led policymakers to wonder how the financial system could remain both innovative and stable.

(Part 2)

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Notes

1. There is evidence it has a modest impact on the insured, but over time this impact has been statistically neutralized. See my post on "The Curmudgeon's Fallacy." Actuarial data, whether for insurance companies or financial instruments, seeks a stable estimate of risk so that the potential for loss is accurately priced. If the methods of assessing loss potential produce results that change frequently over time, then those methods are not useful for managing the probable costs of loss.


2. List of assets from Fabozzi, Davis, & Choudhry (2006), p.119


3. For a summary of the "parallel banking system," see Tobias Adrian & Hyun Song Shin, "The Shadow Banking System: Implications for Financial Regulation" , Federal Reserve Bank of New York Staff Reports, no. 382 (July 2009)


4. The largest CDO I was able to locate was MAX 2008-1 A1, with a notional value of USD 5.4 billion; it was underwritten by Deutsche Bank, which retained 94% equity in it. See Yves Smith, "Debunking Some AIG/Fed/CDO Theories," Naked Capitalism (4 Feb 2010). Smith cites disclosures of Maiden Lane III LLC transactions by Federal Reserve.


5. "A 'Rational' Explanation of the Financial Crisis" Macroeconomic Resilience (November 2009)
   


6. The real economy is distinguished from the financial sector. Usually there is some insulation between the real economy of goods and services, and the "not-so-real" economy of stocks and derivatives.
   

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Additional Reading

Anna Katherine Barnett-Hart, "The Story of the CDO Market Meltdown: an Empirical Analysis" Thesis, Harvard Kennedy School of Government (March 2009)

Frank J. Fabozzi, Henry A. Davis, & Moorad Choudhry, Introduction to Structured Finance, John Wiley and Sons (2006)

Michael S. Gibson, "Understanding the Risk of Synthetic CDOs" Trading Risk Analysis Section, Division of Research and Statistics, Federal Reserve Board (July 2004)

Elizabeth Warren & Amelia Warren Tyagi, The Two-Income Trap: Why Middle Class Parents are Going Broke, Basic Books (2004). This book provides an invaluable explanation of how financial institutions and the two-income family combined to create a bidding war for houses in attractive neighborhoods. Warren & Tyagi wrote before the 2008 Financial Crisis but described a growing emergency in household finance that had burgeoned during the 1990's.

Credit Write-downs: Creditflux's list of credit write-downs announced since the start of the subprime crisis. Creditflux write-downs (Microsoft Excel Spreadsheet, 78 kb)

"Global Cash Flow and Synthetic CDO Criteria" Standard & Poor's Structured Finance

Counting the Cost: the Financial Crisis

Disclaimer: I am not an expert in this field; these are my notes as I research these topics using the usual internet/public library resources. In many cases, links have been added to subsequent posts in this blog. Apologies in advance for any mistakes of interpretation.

How much will the financial crisis cost the US taxpayer? Most of the attention has focused on the Troubled Asset Relief Program (TARP), a $700 billion package initially designed to restore financial markets by buying up troubled assets. That's understandable, but it mainly reflects Congressional debate over a smallish share of the overall government response. According to Barry Ritholtz, et al., that government response was predominantly administered by the Federal Reserve System, and is measured by capital stakes.

An additional component of the bailout, also far surpassing the TARP agreement, is outlays by the Federal Deposit Insurance Corporation (FDIC). The FDIC approved the Temporary Liquidity Guarantee Program (TLGP) in October; it provides a guarantee of non-interest bearing deposits up to $250,000 instead of the usual $100,000.

TARP and the FHA "Hope for Homeowners" programs were designed mainly to inject a stream of payments into the huge pool of obligations taken on by federally guaranteed agencies.

Here follows a review of the items on Ritholtz's list.

Federal Reserve System

The Federal Reserve System took on potentially $5.8 trillion in liabilities in response to the initial wave of banking failures. Here are the programs it has created for coping with the catastrophe.

• Commercial Paper Funding Facility: created 7 October 2008, shortly after a disastrous meltdown of the commercial paper markets (Bloomberg; see chart). Accepts newly issued 3-month unsecured and asset-backed CP from eligible issuers as collateral in exchange for funds (3 months).
  
• Term Auction Facility: created 12 December 2007. Up to 90 loans to depository institutions (thrifts, savings banks, credit unions) for emergency reserves, supplementing the usual interbank reserve lending. Not a permanent institution, but a series of auctions of funds held every two weeks. The banks successfully bidding must provide suitable securities as collateral.
  
• Money Market Investor Funding Facility: created 21 October 2008 to provide liquidity to money market funds; object to prevent sales of assets in falling market (debt deflation).
• MBS Purchase Program: created November 2008 to buy mortgage-backed securities from FNMA, and FHLMA (Fannie Mae, and Freddie Mac; known collectively as the GSEs). This was intended take the place of the suddenly-defunct market for MBS collateralized debt obligations (CDOs). This is not the same thing as the project of re-absorbing the GSEs themselves. In terms of financial risk, this is probably qualitatively riskier than the other programs.
• Term Securities Lending Facility (TSLF): created 11 March 2008 & renewed 3 December; lends Federal Reserve holdings of US Treasury securities to NY Fed primary dealers.
  
• Term ABS Lending Facility (TALF): created 25 November 2008; loans to entities buying asset-backed securities (ABS); borrowers required to not be originators of the ABS.
• Credit Extensions (mostly AIG): large number of different interventions to salvage network of CDS counterparty liabilities; includes at least $122 billion (apparently, not the same money as the $150 billion of TARP funds authorized as of 9 November specifically for AIG). Most money ever directed by the USG to any single enterprise (NY Times).
  

Federal Deposit Insurance Corporation

The Temporary Liquidity Guarantee Program (TLGP) was rated at costing potentially $1.4 trillion, although so far it has not cost anything yet--it is an extremely new program, and we don't know how many banks are likely to default on their largest deposits.

The FDIC also provided Citigroup with $306 billion in loan guarantees (Bloomberg), with Citigroup required to absorb the first $29 billion in losses, and 10% of losses after that--for a potential maximum liability to the FDIC of $249.3 billion. The FDIC provided a similar loan guarantee of $139 billion to General Electric (Bloomberg). Ritholtz lists the current amount for this line item as 100% of the maximum, which presumes an implausibly disastrous collapse of Citigroup and General Electric asset value.

US Treasury

It may come as a surprise to learn that the Treasury Department's role in the federal government response to the financial crisis was small potatoes. There are two main programs, the Troubled Asset Recovery Program (TARP) and the GSE bailout (separate and distinct from the MBS purchase program).

SOME REMARKS

This is where I was supposed to carefully review all of the programs and their interplay, and make some assessments. One meta-assessment is that James Hamilton of Econbrowser (7 October) was unable to say, and he really is an expert (I'm just trying to learn about this). The reason is that the financial system has certain metaphysical obstacles to consequential analysis: there's no agreement on what this relationship of debt to economic output really means.

Having examined several of the programs set up by the Federal Reserve and the Treasury, I think I can understand why the approach taken was so complex: each industry had to be treated differently. For example, while money market funds usually rely on commercial paper markets for investor return, they have constraints and problems that are distinct enough to need different approaches. But the complicated arrangement of credit triage supplied by the Fed to its [still more] complicated patient means unpredictable results and unpredictable market response.

When I was studying theories of monetary policy, like the debate over "commitment versus discretion" (see Dotsey 2008), the papers and textbooks described a world of macroeconomic stability. A bad monetary policy might lead to a monotonic increase in bond yields, but it was a well-behaved catastrophe. I understood that this was an introduction to the idea, and meant to help students understand the basic terms of the debate, but it did not occur to me that the real controversy would erupt during a multi-dimensional crisis in which many different financial markets were flying apart. Here, there were no rules to commit to: the contribution of economic theory to debate in this crisis has been to grumble about moral hazard.

What we are really discussing here is something that economic theories do not describe in any meaningful sense of the word "describe," and something more akin to a turbofan engine. Except that a turbofan engine was designed and produced by a single firm, and its operating principles are well known to the designers or mechanics. The financial system was designed by no single entity, and its relationship with the real economy is mired in doubt.

Having said that, it seems to me that a big part of the rescue program sketched above is multiple layers of liability. A homeowner borrows money from a mortgage originator, who sells the mortgage to an investment bank. The investment bank creates an SIV and sells the mortgage to it, in exchange for a stream of payments to depositors. The mortgage may be insured against default with a credit default swap, whose counterparty is a hedge fund. The hedge fund may hedge its CDS liabilities with put options on the same CDO, and the counterparty to the puts may be another investment bank that finances with commercial paper. That commercial paper, finally, finances the original homeowner's money market fund. The same liability is repackaged, leveraged, and perhaps even multiplied through options and credit default swaps.

The Fed's program, in effect, rescues each layer. Party A uses some federal funds to repay B, who uses that plus more federal funds to repay C, and so on. This increases the Fed's exposure but reduces the unit risk of that exposure.

However, it seems clear that this post can never be more than a bookmark, which I will need to revisit as the situation unfolds.

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Sources & Additional Reading

Barry Ritholtz, "Calculating the Total Bailout Costs" and "$7.8 Trillion Total Bailout Commitment," The Big Picture (November 2008)

Bloomberg:

• "Funds' Flight From Commercial Paper Forced Fed Move"(October 2008)
  
• "GE Wins FDIC Insurance for Up to $139 Billion in Debt" (12 November 2008)
• "Citigroup Gets Guarantees on $306 Billion of Assets" (24 November 2008)

Econbrowser (James Hamilton's blog)

• "Term Securities Lending Facility" (15 March 2008)
• "Balance sheet of the Federal Reserve" (7 October 2008)

Federal Reserve System sites:

• Olivier Armantier, Sandra Krieger, & James McAndrews, "The Federal Reserve’s Term Auction Facility," FRB of NY (July 2008)
• Michael Dotsey, "Commitment versus Discretion in Monetary Policy" FRB of Philadelphia (accessed December 2008)
• "Forms of Federal Reserve Lending" FRB of NY (accessed December 2008)
• "Commercial Paper" Federal Reserve Board (accessed December 2008)
• "Term Securities Loan Facility" FRB of NY (accessed December 2008)
• "Term Asset-Backed Securities Loan Facility" FRB of NY (accessed December 2008)

Marco Arnone & George Iden, "Primary Dealers in Government Securities: Policy Issues and Selected Government's Experience" Working Paper, International Monetary Fund (March 2003)

"Financial Crisis – News and Resources" page at Morrison & Foerster, LLP website (outstanding!)

Andrew Ross Sorkin & Mary Williams Walsh, "AIG May Get More in Bailout," New York Times (9 Nov 2008)

Joe Weisenthal, "Explaining The AIG Black Hole," Business Insider (30 October 2008)

Neil Irwin, "Fed Prepared to Prop Up Money-Market Funds," Washington Post (22 October 2008)

Speculation and Prices

With oil prices continuing to hover around $135/barrel (or €85/barrel), the speculation hypothesis has widespread support. That's the theory that high prices of commodities generally reflects illegitimate financial market activity. I'm trying to keep an open mind but none of the arguments I've seen are convincing.

To me, the big headache is establishing a mechanism by which either (a) high futures prices drive up oil spot prices, and (b) how high flows of money into the forward markets (futures & options) influence the strike price of the commodity.

(For an introduction to this topic, see my post "Commodity Prices and Speculators.")

To some readers, these may seem like very dumb questions. If a lot of people are trying to abandon US dollars as a store of value, then they will want to buy up large tranches of oil future contracts, or perhaps options. That naturally drives up the strike price. When producers see that the strike price is rising, they naturally want to withhold stocks from the market in anticipation of still higher prices. Refiners likewise respond to the high forward prices by hoarding it. This drives prices even higher.

There are two steps to this explanation: one explains how a lot of currency flowing into commodity forward markets can drive up the strike price, and the other explains how a rising strike price can push up the spot price. Both steps are problematic. First, options can be traded at any of a wide range of strike prices.¹ At the time of this writing, Brent crude was trading at about €87 per barrel. Options must exist for €85- and €89-barrel Brent, and probable for a wide range of prices above and below that. Also, new options are written each day for spot ± €0.50/barrel, so that options are tradable from €57-89/bbl (reflecting, in other words, the range of prices over the previous six months). So it's possible for a lot of speculative money to flow into the options market at lower strike prices. Buying an option for 100 barrels of Brent that expires in 3 months with a strike price of €68/bbl means an outlay of about €1,900; should the price fall to €80/bbl, then your loss will be €700, or 36% of your initial investment. If the strike price is €89, then the option is "out of the money," and costs very little; but then you're betting that the price will rise above €90 and stay there long enough for you to cash out.

When the market for options is extremely brisk, naturally the money goes to the people writing them: in theory, suppliers of the underlying good, but also some daredevils who may write "naked options" on [say] shipments of crude they don't own. Options can absorb immense amounts of speculative money, since anyone can write them and most will expire as worthless scraps of paper. They provide no benefit to the person writing them other than the fee and favorable price movements. Basically, they are a hedge: if you are a supplier and you write a lot of call options at the current price, you are locking in the strike price as the most amount of money you will make, but if you understand the market well, then you can reap a handsome profit when your product's price falls well below the strike price. Conversely, you might be a refiner who buys a lot of crude at the current high price; you anticipate that the price will rise even more, so you write put options and sell them to suppliers in which you promise to buy crude at €90/barrel. If the price does indeed go to €100, it sucks to be you but at least you got the money from selling the options to cautious suppliers.

Nevertheless, it's hard to see how this can influence the actual price of the underlying commodity. Writing options does allow buyers and sellers to recoup a modest amount of money from unfavorable movements of the market; when money flows from the non-financial sector into options trading, the effect is to shield options "customers" from some of the consequences of unfavorable movements (giving them time to prepare for new business conditions), while partly compensating "writers" for losses incurred by unfavorable movements.

(See here for an exceptional scenario.)

Futures are a different matter. Taking crude oil (again) as our example, there's a global demand of about 83 million bbls. per day; supposing about 10 million bbls. are sold as future contracts well in advance. Normal derivatives traffic ensures minimal price risk to suppliers and refiners. Then, so to speak, Satan enters the garden in the form of hedge fund managers desperate to park $10 million per day of new money. The hedge fund buys a large number of futures, but it has no intention of taking delivery of all that oil; instead, when the futures near maturity, it sells them to a major (i.e., one of the large multinational, vertically-integrated oil companies). The problem is that the oil company can choose between buying the inflated future or a lower spot price.


David Kruse, President, CommStock Investments, wrote an editorial describing precisely this scenario:

Cash commodity markets however, run the risk of becoming the tail swung by price discovery of futures exchanges that are not based on commodity market fundamentals but on the capital investment flows in and out of the commodity sector. The connection between cash markets and respective futures markets differs between commodity markets....

When funds dominate the futures trade, a fundamental distortion can occur. We believe it has occurred in soybean prices this winter. U.S. soybean carryover was projected to reach 565 million bushels this year which eclipses the previous historical carryover record of 346 million bushels in 1998-99. Global soybean carryover is record. We could have a flat out soybean crop disaster in 2006 and not run out of soybeans next year. Why did the market call for so many more acres of soybeans when carryover was already at an all-time record? The market didn't, funds did. November new crop soybeans traded $1 above fundamental market values all winter, producing incentives for farmers to plant more soybeans which the USDA says they strongly responded to.

In this case, the mismatch produced a soybean glut (in 2006).

Over the years different Usonian commodity futures markets have adopted cash settlements. Prior to 1982, when a future expired, you either took delivery or else arranged a cash sale of the commodity to someone who wanted it. Then the Commodity Futures Trading Commission (CFTC) allowed indexed commodities and cash settlement.² While CFTC regulations are designed to prevent destructive speculation, it is worth noting that massive futures trading could easily lead to suppliers learning to anticipate the market's preferences for cash settlements rather than tangible delivery; and lead to sales of contracts for several times the actual volume of goods being sold. Note that CFTC regulations are supposed to prevent this; however, the much-discussed InterContinental Exchange (ICE) based in Atlanta, Georgia, allows one to trade virtual commodities over the web in London and Dubai.

This was extremely important because futures are very highly leveraged instruments. Typically one pays about 5% of the value of the underlying commodity (so, for 100 bbl. of WTI, $675 plus premium)³; in theory, this allows one to claim very large pools of oil for very little money. A squeeze is a situation in which a trade goes long by an amount that exceeds the actual physical capacity that can be loaded during the month. Then the trader claims delivery, knowing that the supplying parties will not have sufficient supplies to meet their obligations. This drives up the price, but the effect is of very short duration (usually a couple of weeks, at most).
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NOTES:
1 An option is similar to a future except that options are binding on only one party, while futures are binding on both buyer and seller. A [call/put] option is a tradable right to [buy/sell] a commodity at a fixed price on or before a given date in the future. For an explanation of options and how they work, see "Factors affecting Options...." For our purposes, "options" are understood to be American style, i.e., they can be exercised at any time prior to expiration.

2 Leo Chan, "Cash settlement and price discovery in futures markets," Quarterly Journal of Business and Economics (Summer 2001). The mechanism for cash settlement works like this: supposing the commodity price rose $10/unit over the period the investor held it. Rather than take delivery, the investor merely accepts a payment of $10 (minus some fee), and the supplier sells the product to another buyer for cash. Assuming the price falls by $10, the investor pays the supplier; in both cases, the transfer of money effectively cancels out the price change (as far as the supplier is concerned).

3 The premia on futures and options varies with the number of futures/options bought. Very large trades involve very small premia per contract/option. Different brokerages have very different schedules of forward premia.

Long: in finance, a "long position" in a security or commodity is a position where one benefits if the price goes up. This includes writing a naked put option, buying the underlying commodity, buying futures for delivery of that commodity, or buying call options for same commodity, are all examples of "going long" or "taking a long position."
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SOURCES & ADDITIONAL READING:

Senate Committee on Comerce, Science, & Transportation: Hearings, 3 June 2008

• Testimony of George Soros
• Testimony of Prof. Michael Greenberger, Univ. of Maryland
  

"The Role of Market Speculation in Rising Oil And Gas Prices" (PDF), Permanent Subcommittee on Investigations, United States Senate (27 June 2006)

The FTC & net neutrality

(Series on Communications Law, USA)

I was alerted by a series of posts that alleged that the Federal Trade Commission (FTC) had abandoned net neutrality. This is not exactly accurate, and I'd like to start over and explain to readers (in brief) the meaning and status of net neutrality. Top FTC officials are hostile to the concept of net neutrality, since the FTC regards its primary mission to devise and promote legal standards that favor export revenue. Should Internet neutrality be enshrined into law, the FTC believes it will be undermining the telecommunications sector's ability to capture rents from its infrastructure. This issue has come up during a period where the FTC is entirely beholden to the telecoms, and it has continuously advertised its position that it believes what is good for AT&T is not only good for America, but the epiphany of justice as well.

However, as an arbiter, the FTC needs to validate its position in trade law; it may not rule by whim. Hence, it has published endless "studies," which amount to editorials that might have been written by attorneys for the major telecom firms. It is Congress that must decide.

The Internet uses a system of packet switching to transmit very large amounts of digital information over existing telephone, coaxial cable, and DSL lines. In the past, when people used telephone lines solely to communicate orally, the effect was analogous to a train, which occupied the track (so to speak) for the entire duration of the phone conversation. If we pretend that all roads consist of one lane, and that they are interchangeable with railroads (so that, for example, it were possible for trains to use—and tie up—the highway for half an hour at a stretch), then the analogy is nearly perfect. Only one train headed for one destination may occupy one track at a given time. This is compatible with the immense loads that trains—or telephone conversations—carry. A 100-car train may carry about ten thousand tons of freight; a telephone conversation, a continuous stream of rich audio data. In contrast, digital transmissions need only communicate a finite string of bits. This is equivalent to thousands of little Vespas buzzing onto and off of the highway. Even when an internet connection is active, its connection to the server can be analogized to an intermittent traffic of a few hundred scooters. Naturally, other scooters can fit in between them with ease. During the course of an internet session of (say) two hours, the volume of data transmitted may well be equivalent to a telephone conversation of one or two minutes. That means that several scores of internet connections may have the same telephone load as a single telephone call.

Of course, the TCP/IP protocol makes this possible by arranging the data into packets of fixed duration, which then flow through like cars through a busy city center. The Internet Protocol acts like a system of traffic codes and signals that coordinate the packets so that they flow smoothly. The interesting thing about this is that, with improvements in data compression technologies, it is (ironically) possible to use the Internet to transmit audio files as bit packets, more efficiently than as analogue streams—the thing that telephone lines were created to do. Another point to bear in mind is that the Internet and the IP protocol have evolved over time so that most traffic now occurs over broadband connections, in which data is transmitted hundreds of times more rapidly. The physical constraints of 1990's-era telephone lines have been superseded by ethernet and coaxial cable, but this merely means that the load of potential data that can be transmitted has physically increased, without a drastic shift in the prevailing rules.

Now, in the past the IP system has been utterly, relentlessly neutral. The analogy to cars moving through a vastly busier traffic network, with vastly increased capacity, still holds. Stoplights don't award faster access to the cars of wiser and busier people, at the expense of cruisers and idle wastrels. In fact, the physics of vehicular traffic is somewhat different from that of internet connections; so in my TRON-like universe, packets marked "Priority A" are awarded with closer spacing (and hence, greater volume) than packets marked "Priority B."

The vast majority of internet connections are provided by telephone companies, which created the system of "pipes" based on the presumed mixture of conventional telephone calls and broadband internet connections. The premium on telephone service is so huge that it makes telephone monopolies immensely profitable; from a financial/business perspective, internet service is just a way of getting additional revenue at little marginal cost. The problem is that services such as voice-over-internet protocol (VoIP) would mean that the main revenue stream for telephone companies would be cut off. Instead, people would use the phone company for internet connections, if that. A huge number of Usonians already get their phone service through their wireless service anyway. With technologies like Bluetooth and Wi-Fi, a Skype subscriber can actually use her cell phone at work or at home, and get VoIP service as if she were communicating through a headset plugged into her computer. That would effectively cut out the PCS companies as well as the landline telephone companies.

One way of getting their money back is for telephone companies to use a strategy known in basic economics as "discriminatory pricing." This means that people using the Internet more heavily (as, for example, those who get movies or VoIP through it) would pay a premium, but get better service. Better service, in this case, would mean VoIP packets would get a higher priority.

It's interesting to note that a mass migration of telephony and television services to IP channels of delivery would lead to a new business model under which broadcasters networks, cable TV providers, and telephone companies would all become virtually indistinguishable businesses, all providing a mixture of IP-related services. In the same way that all financial services in the United States were allowed to merge into nationwide supermarkets of finance, it seems likely that all entertainment and communications services in the country would become a single amorphous sector of the economy. And just as supporters of the financial supermarket concept argued that there would be increased competition among financial service providers, so members of the telephone companies are arguing that they face increased competition from VoIP (which is usually delivered over phone company lines). In order to support innovation in Internet multimedia, some form of discriminatory pricing will be required.

Where this is alarming is when the ISP's and search engines collude to apply a discriminatory pricing model to websites. We're already accustomed to search results offering the lowest prices on "The Damned of the Earth."* In the future, search engines like Google or Yahoo! would have to tweak their search algorithms to reflect the new primacy given to bandwidth-intensive services, like... CNN, Fox News, and so on. In effect, the Internet would become extremely skewed towards commercial media, and net-based activism would be vastly more difficult.

However, at this time, I am not aware of there having been any recent developments on potential legislation.

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SEE ALSO: Video on net neutrality (RSNL&A)

*Not a reliable result; The Damned of the Earth is a notorious book by Frantz Fanon, and also a line from the French version of "The Internationale." I recall conducting a search in the hopes of finding the text online, and instead was offered "The lowest prices on..." OK, I thought it was really funny.

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SOURCES & ADDITIONAL READING: "We Still Need Net Neutrality Legislation," David DeJean (4 July '07); "FTC Net Neutrality Report Tortures Logic," Net Neutrality, Policy Blog; "FTC abandons net neutrality," Vnunet.com; "Navigating Between Dystopian Worlds on Network Neutrality" (PDF), speech by FTC Commissioner Jon Leibowitz (Feb 2007) & "FTC Chairman Addresses Issue of 'Net Neutrality'," FTC (Aug 2006); Oligopoly Watch, "Oligopoly and network neutrality" (21 Jan 2006);