Free Bitcoin at MIT

MIT just recently gave each undergrad $100 in Bitcoin for completing a survey. The MIT Bitcoin Project, the group of students heading this initiative, plans to make MIT the global hub for business and research on Bitcoin. This marketing technique also encourages students to seek entrepreneurial activity and  some scholars believe it will have network effects. One post by William Luther, explains these network effects:

“individuals are concerned not only with the characteristics of bitcoin—how its supply is governed, ease of access, security of transactions, etc.—but also who else is accepting bitcoin. The size and composition of the bitcoin network matters. If few others are accepting bitcoin—or, more to the point, if few of one’s trading partners are accepting bitcoin—there’s little reason to accept it.”

 

Clearly there is merit to this reason for giving out “free” Bitcoin. Already, the bookshop at MIT accepts Bitcoin. Other apps are springing up that allow users to pay with Bitcoin as well. What is really interesting is that the MIT Bitcoin Club has a well-designed site encouraging the use of Bitcoin and events to promote it to the public. Although the ease and use-ability of the site is unsurprising based on the caliber of students that attend the university, it is interesting that a student club is going so far as to encourage usage of the Bitcoin by distributing it to students.

A Chocolate-less World or Higher Prices?

There have been lots of news stories lately indicating that “We are running out of chocolate”. Particularly, two companies, Mars and Barry Callebaut, have come out and supported this statement. (See examples, here, here and here.) The fear is that there will soon be not enough production of cocoa compared to what is demanded. On the demand side of things, countries other than those in Europe and America are beginning to love chocolate, such as China. Further, there is an increase in demand for “healthy” chocolate or dark chocolate. Dark chocolate has on average 50% more cocoa than the traditional milk chocolate bars. On the supply side, there is a decrease in production mostly attributable to frosty pod, a fungal disease that has wiped out 30-40% of cocoa production in South America. (The fungus eats the cocoa pod and leaves them at a total loss.)  This has shifted most (70%) of the world’s cocoa production to Africa, which is experiencing extremely dry temperatures. In addition, environmental pressures on cocoa farms have led to an increase in production costs.

CacaoPods2

As a result, there consumers should expect two effects. One, agricultural groups are trying to develop new trees and technologies to increase the amount of cocoa beans. However, a tree variation likely means a change in the taste of chocolate. Second, we eat 70,000 metric tons of cocoa more than what is produced each year and an expectation of 1,000,000 metric tons by 2020. So, prices will be expected to rise on chocolate. The truth is, we are less likely to “run out of chocolate” if the price mechanism is permitted to rise, i.e. if the government does not cap chocolate prices at some nominal level. Rather, supply and demand determines the equilibrium market price.  There is little evidence of government setting chocolate prices around the world, but it is something consumers should be wary about. Personally, I would rather pay $10/bar of chocolate than live in a world where there is a shortage of chocolate.

 

Elinor Ostrom: In Memoriam, Part 6

In this week’s edition of In Memoriam—our series in which we honor 10 noteworthy social scientists who have passed away in recent years—I bring you Elinor “Lin” Ostrom. Lin is the only woman on our list and the only woman thus far to win the Nobel Prize for Economics. Her work has also had a great impact on me personally.

1933-2012

Ostrom YoungOstrom Old

Lin received her PhD in Political Science from UCLA in the 1960’s and spent the bulk of her 40-plus year career at Indiana University Bloomington, where she and her husband Vincent Ostrom founded the Workshop in Political Theory and Policy Analysis. There Lin carried out a research program that was focused on addressing real-world problems—from how organizational theory could offer insight into public administration of local police services in the St. Louis metro area, to identifying the institutional requirements for sustainable local management of common pool resources in Indonesia, to the most effective use of development aid in Africa—and she did so not only through an impressive array of social science methodologies, e.g., econometrics, game theory, etc., but with an emphasis on field research which sought to take seriously the capacity of people in local communities to solve their own problems with appropriate help. In the video below, Ostrom summarizes the Tragedy of the Commons and how local communities can devise strategies to avoid depleting common pool resources:

In keeping with the pattern I established in my Amos Tversky and Herbert Simon posts, I will say a little about Lin’s contribution to the rationality debate.  In the development of theoretical models, Lin warned, researchers should remain well-grounded in the world of real humans:

An important challenge facing policy scientists is to develop theories of human organization based on realistic assessment of human capabilities and limitations in dealing with a variety of situations that initially share some or all aspects of a tragedy of the commons. Empirically validated theories of human organization will be essential ingredients of a policy science that can inform decisions about the likely consequences of a multitude of ways of organizing human activities. Theoretical inquiries involve a search for regularities. It involves abstraction from the complexity of field setting, followed by the positing of theoretical variables that underlie observed complexities. Specific models of a theory involve further abstraction and simplification for the purpose of still finer analysis of the logical relationships among variables in a closed system. As a theorist, and sometimes a modeler, I see these efforts at the core of a policy science. One can, however, get trapped in one’s own theoretical web…Confusing a model—such as that of a perfectly competitive market—with the theory of which it is one representation can limit applicability…

Governing the Commons

People are nested in cultural settings with indigenous norms. Any theoretical account which ignores such phenomena has abstracted away too much from how human decisions are made. When it comes to collective action problems, Lin reminded social scientists that top-down planning by elites is not the only way that collective action dilemmas can be resolved and often not the best way. She called on social scientists to look hard at actual communities and discovery how individuals can often voluntarily cooperate to solve their own problems in ways that make sense on the ground:

What is missing from the policy analyst’s toolkit—and from the set of accepted, well-developed theories of human organization—is an adequately specified theory of collective action whereby a group of principals can organize themselves voluntarily to retain the residuals of their own efforts.

Hat’s off to you, Lin Ostrom!

 

A.K.

Innovative Financial Derivatives

Complicated financial products have not seen their demise, despite the amount of federal regulation that occurred after the recent financial crisis.  Total-return swaps are the latest swap derivative taking the market by storm and causing some people to question the risk of these assets. Total-return swaps are a bit complicated, so let me explain this more simply.

Total-return swaps explained

Let’s say a bank and an investor engage in a total-return swap agreement. Total-return index swaps usually set the “reference” asset, or the asset they are benchmarking to, to be mortgage-backed securities, bank debt, sovereign debt, loans, equities, commodities etc. A bank is guaranteed to get payments throughout the life of the derivative. (A derivative is an asset that derives its value from the performance of an underlying security, entity, loan etc.) An investor gets a % of the total return of an index when the swap derivative contract expires. If this index makes less than what the contract states, the bank gets paid again for this “depreciation” in value. If the index makes more money than what the contract states, the investor makes money.  Essentially, the investor enjoys the cash flow benefits of a total-return swap derivative, without actually owning it. The investor only loses if this security declines in value. In order to “borrow” the security, the investor makes payments to the bank during the time of the contract. This payment is known as a floating rate payment or financing cost. Typically, the floating rate payments that hedge funds, or any investor, makes is a spread in LIBOR. LIBOR is the average interest rate that the average bank will pay if borrowing from other banks. This rate is calculated by London books and is similar to our federal funds rate. Many mortgage interest rates and financial products set their rate according to the LIBOR rate.

This seems complicated, who does this?

Total-return swaps are off-balance sheet transactions for the investor and balance sheet transactions for a bank. Off-balance sheet financing is used to report expenses (like the rental expense for holding this asset temporarily), whereas a balance-sheet will show whether an asset is capitalized (whether the asset was “leased” out). Hedge funds usually engage in total-return swap derivatives, because little money is due up front (and only a small amount of collateral is asked for). Collateral is any asset that a bank can take if an investor does not pay the agreed amount of the loan back.  Total-return swaps allow hedge funds to gain leverage. Leverage can mean that an investor uses borrowed capital to increase the return of an investment or finance their assets more with debt. Either way, leverage can intensify an investor’s gain AND losses. The high potential for upside is what draws hedge fund managers to buy these swaps.

Who bears the risk?

The investor does not legally own the index that the total-return index swap is benchmarked to. The investor has a long position in the market risk and credit risk of the asset. At the expiration of the swap, the investor can choose to buy the asset at the market price from the bank. The legal owner of the asset is a bank and this asset appears on their balance sheet.  The legal owner has a short position in market risk and in credit risk. A long position in an asset means that the holder of this position benefits if the asset goes up. A short position in an asset means the holder of this position benefits if the asset goes down.  If the underlying asset goes into default (say the asset is benchmarked to mortgage-backed securities and they all go into default) then the investor must pay the bank the difference in value from the initial price to the price after the asset defaults.

Total-return swaps today

For example, a total-return swap derivative from JPMorgan Chase is tied to the total-return of the Markit’s iBoxx USD Liquid Leverage Loan index.  Total-return swaps are not new, yet tying them to certain underlying indices, like Markit’s, is new and starting to cause an alarm. The alarm is sounding, because these derivatives are structured like collateralized debt obligations—the financial derivatives that tied risky housing loans into securities that brought about the financial crisis. Without a simplifying explanation like the one I provided above, reading a news article like the one found here from Bloomberg can be confusing for a general audience. Unlike the financial crisis, these new derivatives put a lot more of the risk on the buyer rather than the seller, which makes them less like CDO’s.

As mentioned in the Bloomberg article, these products do not come out of thin air. Investors, in the face of higher federal regulations and interest rates kept arbitrarily low by the Federal Reserve, are finding new ways to make money. With interest rates continuing to be so low, expect more financial innovation to occur.

In the words of Peter Tchir, of Brean Capital LLC:

‘‘We are moving into a phase where there will be more esoteric products. It does start setting up more problems for the future.’’

These problems, in my opinion, will all involve understanding the risk of new financial products. Total-return swaps turn the risk around to the buyer, which mean that if things get out of hand–a financial crisis, or problem, will start from the demand-side rather than the supply-side of finance.

Textbook Price Inflation

The Economist reports that textbook prices continue to climb several times the general rate of inflation:

Textbook Prices

 

But hope is not lost for poor scholars. Foreign editions are easy to find online and often cheaper—sometimes by over 90%. Publishers can be litigious about this, but in 2013 the Supreme Court ruled that Americans have the right to buy and resell copyrighted material obtained legally. Many university bookstores now let students rent books and return them. Publishers have begun to offer digital textbooks, which are cheaper but can’t be resold. And if all else fails, there is always the library.

They note that one of the main reasons for the constant climb is a type of moral hazard: the person deciding which textbook to assign (the instructor) is not the same person who has to come up with the cash (the student). The professor can get an examination copy of the book for free, decide if he/she likes it, and make the call–totally insensitive to whether the marginal value added by the selected text justifies the marginal expense when compared to alternative materials. Some instructors can be quite considerate of cost–I like to think that I am–but instructors are also busy people juggling many responsibilities and trying to find materials quickly which make their own lives easier. Of course publishers are aware of this and market their products accordingly. My advice? Use the secondary markets as much as possible: buy used, buy online, buy the overseas edition, borrow or rent where possible, resell (unless it’s a definite keeper!) quickly before the next edition comes out, or buy a digital edition.

Unintended Consequences…In Porn?

Los Angeles has long been dubbed the king of the porn industry where many X-rated productions are shot. However, last year  film permits were down 90% (40 permits compared to 485) and this year only 20 permits have been issued. This is all a result of a measure that was put up to a vote by L.A. County voters in November 2012 titled Measure B.  This measure was passed and mandated that all male performers must wear a condom. Advocates believed that using a condom would prevent the spread of AIDS, but actors, production companies and fans have responded a bit differently than voters may have intended.

“We’re not shooting in L.A. anymore,” said Steven Hirsch, founder and co-chairman of Vivid Entertainment. “We’d like to stay here. This is our home, where we’ve produced for the last 30 years. But if we’re forced to move, we will.”

Actors are not wearing protection, because fans do not want to see it. Production companies are moving outside of L.A. County to places as far as Europe. In many cases, companies are filming without permits so the potential spread of diseases is not actually decreasing, rather it has just moved elsewhere. (As a general note, porn performers are tested every 2 weeks for HIV and other sexually transmitted diseases. 2004 was the last known case for an actor to contract HIV on set.) L.A. County voters, who may have thought they were acting morally by voting for Measure B, not only took away the right for companies to operate as a way they best see fit, but they also are hurting a $7 billion dollar a year industry…and all the tax dollars that come from it.

Paydays Loans Under Fire

Payday loans are under fire again. John Oliver’s recent piece has got to be the most entertaining to date:

After detailing several scandals and abuses within the industry, Oliver offers polling data suggesting that many people believe payday loans are a necessary evil. Oliver’s response: “That’s why they are so dangerous: people actually need them. But you have to be absolutely sure there are no better options!” Of course, there is a lot of truth to that. Sarah Silverman then concludes the piece with a hilarious (and frightening) list of alternatives to payday loans to cover one’s short-term financial needs. Ironically, the list reaffirmed in my mind that there are many things worse than payday loans…

Also check out this ReasonTV piece in defense of payday lending:

Want to see a meta-analysis of studies showing the effects of payday lending and attempts to regulate it? See my post here. I also find that the payday lending model (absent notable industry abuses) has its virtues–here.

 

A.K.