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.

The Punch Bowl Stays: Fed Keeps Interest Rates Low

The Dow Jones closes at a market high today at 17,156.85 after the Federal Reserve met and announced that interest rates will be staying the same.  The reasons for keeping the federal funds target rate in the 0-0.25% range  based on the  FOMC press release are:

  1. The unemployment rate has barely changed and we are under-utilizing labor resources
  2. The housing sector is recovering slowly

While other reasons that they mention seem to support increasing the interest rate:

  1. Household spending and business investment is rising moderately
  2. Inflation is below the Federal Open Market Committee’s long-run goals

However, in the end the Committee felt that to attend maximum employment and price stability maintaining the current interest rate is best. Additionally, the FOMC will buy federal agency mortgage-backed securities at a pace of $5 billion per month (rather than the $10 billion they were buying) and Treasury securities at a pace of $10 billion per month (rather than the $15 billion they were buying). By holding a large amount of long-term securities, the hope is that long-term interest rates will make “financial conditions more accommodating” (i.e. to support mortgage markets). Lastly, the FOMC mentioned that the 0-0.25% federal funds rate will remain even after the asset-buying program dies down, which is set for October.

The video on the bottom of the USAToday article, here, explains why the stock market moves after a Federal Reserve announcement and what has happened over the past four announcements this year. It is a short one minute and thirteen second video, but it is a fantastic way to catch-up with what has been happening with Federal Reserve. Also, here is a neat response after the FOMC announcement from Brad McMillian, the Chief Investment Officer for Commonwealth Financial:

 

“The Fed is not going to take the punch bowl away. They didn’t want to spook the market.”

 

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.

Milton Friedman: In Memoriam, Part 4

Milton Friedman is my grand-teacher. I am one of the lucky few to be able to say that. I have been taught by a Professor Dougan in Public Finance and Price Theory who long ago studied under Friedman at the University of Chicago. Dr. Dougan would tell me that when Friedman would speak in a Chicago seminar, everyone would stop and listen. Friedman would wait until everyone had a chance to speak and then enlighten the entire crowd–graduate students, visiting faculty, and even colleagues, who at Chicago are always extremely brilliant.

friedman youngfriedman old

However, Friedman’s life was not always like that–one in which he spoke and the crowd listened. In the early 1950s and 1960s, economists were busy studying the Great Depression and ways to learn from it. Many economists believed that the price system would lead to monopolies, modern corporations, and unemployment and that more governmental control is needed.  More government control, or a more Keynesian approach, was deemed unsuccessful after the low growth, high inflation of the 1970s.  It was not until then where economists started to listen to Friedman’s theory that prices could allocate resources efficiently. His theory stated 3 important functions of prices: they transmit information about tastes, resource availability and productive possibilities; they perform an incentive for people to use the least costly methods of production and highest valued uses for scarce resources; they determine who gets what by distribution of income. Friedman’s famous 1957 book, A Theory of the Consumption Function, shows that people’s annual consumption is a function of their expected average income, which rebukes  Keynesian theory that people consume on what their current income is.  Other key contributions on microeconomic issues in price theory related to how professional licenses (for dentists and doctors) distorts prices, abolishing the military draft, free-floating exchange rates and a negative income tax.

“When a young man is forced to serve at $45 a week, including the cost of his keep, of his uniforms, and his dependency allowances, and there are many civilian opportunities available to him at something like $100 a week, he is paying $55 a week in an implicit tax. … And if you were to add to those taxes in kind, the costs imposed on universities and colleges; of seating, housing, and entertaining young men who would otherwise be doing productive work; if you were to add to that the costs imposed on industry by the fact that they can only offer young men who are in danger of being drafted stopgap jobs, and cannot effectively invest money in training them; if you were to add to that the costs imposed on individuals of a financial kind by their marrying earlier or having children at an earlier stage, and so on; if you were to add all these up, there is no doubt at all in my mind that the cost of a volunteer force, correctly calculated, would be very much smaller than the amount we are now spending in manning our Armed Forces.” Presentation “Why Not a Volunteer Army” from December 1966, University of Chicago 

Although Friedman’s work in price theory was monumental, many remember him for his work on monetary policy.  In Friedman’s most influential work with co-author Anna Schwartz, A Monetary History of the United States, 1867-1960,  they explain that monetary behavior is independent of nominal income and prices. Showing a time series of data, Friedman and Schwartz state that the increase or decrease in money supply created by the Fed led to all of the deep depressions in 1875-1878, 1892-1894, 1907-1908, 1920-1921, 1929-1933 and 1937-1938.  Before this book, many, such as Keynes, viewed the Depression as a failure of the free market system rather than misguided Fed actions.

Inflation is always and everywhere a monetary phenomenon.  The Counter-Revolution in Monetary Theory (1970)

Friedman dedicated his career to furthering monetary policy and proving that increasing money supply just increases inflation. He was a proponent of abolishing the Federal Reserve or creating policy rules to benchmark money supply growth, because monetary policy cannot ever completely smooth inflation and economic fluctuations.

Friedman was born in 1912 to Jewish immigrants in New York. His family relocated to Rahway, NJ (right near my home town) and he attended Rutgers University where he held a degree in Mathematics and Economics. His graduate work was completed at the University of Chicago. He passed away November 2006, but his career includes a Nobel Prize and a stint as an economic adviser to President Reagan among many other great accomplishments. As The Economist said, Friedman is “the most influential economist of the second half of the 20th century, possibly all of it”.

This is a great video of Friedman debunking a young man’s argument about the Ford Pinto:

Dr. Dougan often talks about how Friedman’s Monetary class was the best class he ever had.  I too am thankful for my grand-teacher’s research and insight into price theory and monetary theory. The larger research has been passed down in books and journal articles, but the “family insight” into the life of Friedman adds a personal flare.

SolarCoin: The “GREEN” Bitcoin?

As a followup to my Bitcoin post, there is a new “solar energy” coin in the solar marketplace that operates much like Bitcoin. It is a coin in which people with solar panels can trade in their energy-saving certificates, which they receive monthly for feeding energy into the solar grid, for coins.  However, these coins are currently WORTHLESS in the market (unlike Bitcoin), but if it catches fire with solar panel owners founders say it can be worth $20-$30/coin. The problem is what incentive is there for someone to want SolarCoins? When comparing cash vs. SolarCoins, SolarCoins are not accepted everywhere, they do not store value nor are they a unit of account (i.e. prices of goods are not quoted in terms of how many SolarCoins it requires to buy).  Alternatively, cash does. The only thing that SolarCoin seemingly offers, like Bitcoin, is the money is unregulated and thus “untraceable”.

Okay, perhaps maybe there is another “benefit” of  SolarCoins… it is “green”.

Check out SolarCoins here: SolarCoin article in New Scientist

Is Bitcoin the New Kleenex?

Boston University Finance Professor, Mark Williams, in a published Forbes article today, suggests that Bitcoin will become a shorthand name for digital currency, equivalent to Q-tips for cotton swabs, Kleenex for tissues and Xerox for copies.  Bitcoin is the next “BIG” thing, but Bitcoin is NOT a stock, bond or even company. Rather, it is a virtual currency. In 2013, Bitcoin cost $13/coin, today it is at $864.70/coin. Many speculate that Bitcoin could reach unprecendented values for coins ($100,000) due to a finite amount that can made (21 million to be exact). So, WHAT is this crazy phenomenon called Bitcoin and is it here to stay or is it just speculative?

 

According to Bloomberg Businessweek,

“Bitcoin is the digital currency that thrills nerds, inspires libertarians, and incites the passions of economists who debate the value of money made from nothing but ones and zeroes.”

Bitcoin’s main selling point is that it is decentralized and does not have to go through a clearing house. Bitcoins are “made” on the internet, by mining (a free application that allows you to create these things, albeit not easily). Bitcoins are adjusted by the network site to ensure that the amount is predictable and limited (think supply and demand analysis here in order to keep prices increasing for investors, supply must be increasing slower than demand).  Supply can only expand 25 Bitcoins per 10 minutes. You can use Bitcoin not only as an investment vehicle, but also to pay for many items on the Internet such as food, clothes, toys, computers etc. However, what is the incentive for a company, like Target, to start accepting Bitcoins for payments? Well, Bitcoin charges no fees, so accepting them is financially free, unlike using Google’s payment system or Visa. Further, many exchanges have popped up so a store that accepts Bitcoin, such as Target, can convert Bitcoins into dollars or euros.

 

With nearly a 64% return in a year, Bitcoin is drawing lots of attention, but many question whether it a ‘real’ thing since it closely resembles a commodity, yet, the government is not involved in regulating it.  Investors are putting faith behind Bitcoin because it is fully open-sourced. This means anyone can verify the source code and know exactly how Bitcoin works. Payments can be made without a third-party system and to ensure no fishy business is going on there are peer-reviewed cryptographic algorithms to verify the payments. Remember when I said you can actually “mine” or make a Bitcoin, but it wasn’t easy? Mining is making cryptographic algorithms that certify transactions before anyone else can do it to earn Bitcoins as a payment.

“It’s like a worldwide math competition that resets six times an hour. There are a total of 21 million possible Bitcoins; about half are currently in circulation. The last will be mined in about 2140 at the earliest.”

To be clear, each new algorithm that is computed to verify a transaction makes it more complicated to solve the next algorithm. How complicated are things getting? Well, in 2010, ordinary desktops become too slow for the mathematical crunching needed. Large computers are required to mine the data with savvy math and computer knowledge required to keep up with the mathematical coding. However, 10 minutes of your time can pay 25 Bitcoins (~$25,000).

Also, in terms of trusting Bitcoin, no one organization or individual can control Bitcoin, or so the site’s fact page boasts. However, 47 people own 29% of all outstanding Bitcoin; and 75% is owned by just 10,000 people. The last 25% is owned by roughly a million small investors. In comparison to Google, 1,667 institutions hold approximately 87% of Google shares in which these institutions (such as Vanguard, State Street, J.P. Morgan Chase) each have millions of individual investors. So, are the elite few that own Bitcoin the ones speculating and really driving up the prices? Many countries seem to think so. Bundesbank, Germany’s central bank, is warning people of the speculative risk or in other words irrational exuberance behind the stock’s inclining value. China went ahead and blocked the country’s Bitcoin exchanges from accepting new Bitcoin “cash” and banned anyone from accepting Bitcoin trades.The EU even warned that they will take no part in bailing out losses from Bitcoin and warned against the investment.  The U.S. so far has not made such a bold statement, but economists everywhere are collecting data. In a National Bureau of Economic Research (NBER) working paper, economist David Yermack shows that Bitcoin is more volatile than any sovereign currency and does not serve a traditional money role as a unit of account or store of value, although it is performing as a medium of exchange.  Based on the volatility of Bitcoin, he claims that the inclining in values are due to speculation and not actual value that people should put faith in.

Based on economist predications, I think there is still time to invest and make some money, if you have $864.70 for one Bitcoin that is.  With the potential returns high and intellectually stimulating work, computer geeks, math whizzes and technology gurus are flocking in droves to mine for Bitcoins first.  A start-up company claims that one fast computer working to come up with these algorithms can yield approximately $150,000/year.  Therefore, I see no reason in the immediate future for Bitcoin to run dry since demand is very high right now, while supply can only make incremental, steady increases. However, in the long term I do not think Bitcoin is a viable alternative to dollars as it stands little chance to run free too long. With high profits to be made, everyday citizens are not just the ones who want in, but surely the government will, too. Taking a cut of the profit from investors in Bitcoin clearly takes away the competitive advantage Bitcoin serves as an Internet marketplace currency.

If you want to buy Bitcoins or learn how to get some, here is a pretty good site to help you get started.

“Effective” Monetary Policy Under Bernanke?

My posts this week are all going to involve the Federal Reserve and answering some important questions revolving recent monetary policy and a soon to be newly appointed chairperson. Today I want to review the monetary policy under Bernanke’s reign as Chairman and discuss whether it was effective or not to lead our country.  Many news outlets have given the Federal Reserve heat in recent years of their monetary policy  and some have even compared Ben Bernanke to Walter White, the meth dealer on AMC’s hit show Breaking Bad. (#6 I believe is particularly true.)  However, was the Federal Reserve policies from 2006 to now effective?

Ben Bernanke’s Qualifications

Bernanke graduated Harvard in 1975 with a B.A. in economics and in 1979 from MIT with a Ph.D. and held professorial appointments at MIT, NYU, Stanford and Princeton.    He has long been involved in the economics of our country as a visiting scholar at the Federal Reserve Bank of Philly, Boston and NY from 1987-1996, an Academic Adviser to the Federal Reserve Bank of NY in 1990-2002, and a member of the Board of Governors from 2002-2005.  This was all before becoming the Chairman of the Council of Economic Advisers (CEA), which is a twenty-person committee that advises the President on economic policy from 2005-2006.  In 2006, President Bush appointed Bernanke as Chairman of the Board of Governors  to succeed Alan Greenspan who held an 18-year term at the Federal Reserve (you can be reappointed despite a 14-year term ‘limit’). More or less, Ben Bernanke was highly qualified to become the Federal Reserve Chairman in 2006.

Monetary Policy under Bernanke 2007-2009 during the crisis

–        The Federal Open Market Committee, FOMC, cut the discount rate, which is the lending rate from the Federal Reserve to banks, by a cumulative 325 basis points (3.25%) until it hit 2% in April 2008.

–        In October 2008, the discount rate was cut to 1% and later to a target of 0-0.25% as the President Bush signed into law the Emergency Economic Stabilization Act of 2008, which TARP was set up under.

–        The FOMC also cut the fed funds rate to a target of 0-0.25%. Both the fed funds and discount rate are in the same target range today.

–        The Federal Reserve created emergency lending facilities and currency swap agreements with 14 central banks around the world.  Emergency lending facilities examples are Term Auction Facilities, Primary Dealer Credit Facility and Term Securities Lending Facilities.

–        Required banks to hold more capital after doing stress tests

–        Bought long-term securities from banks of up to $600 billion via open-market operations in November 2008. The amount of securities bought was increased to $1.25 trillion dollars’ worth of mortgage-backed in March 2009, $200 billion worth of agency debt and $300 billion of long-term Treasury debt.

  • When the Fed buys bonds the increased demand for them caused prices to go up and yields to go down. Continued buying of bonds “can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors’ expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms,” Ben Bernanke at the 2012 Jackson Hole Conference.

Additional Monetary Policy Post the “Great Recession”

–        In November 2010, the FOMC announced it would by an additional $600 billion of longer-term Treasury securities until 2011. Another term for this is quantitative easing or QE2. QE 1 was considered the large Treasury security buying during the crisis. QE2 is considered for the period post crisis.

–        In August 2011, the FOMC announced a new maturity extension program (MEP) in which the Fed would purchase $400 billion of long-term Treasuries and sells an equivalent amount of short-term securities. This program has been extended into 2013. The increased demand for long-term bonds by the Fed increases the price of the Treasuries while lowering the yield-to-maturity which puts a downward pressure on long-term interest rates.

A Brief Look at the Effectiveness of the Monetary Policy during the Crisis

There is no definitive answer to the question of whether monetary policy during the crisis was successful or not successful for two reasons. First, it is impossible to measure a counterfactual—what would the economy have been like with zero or less Federal Reserve intervention? It has been speculated that the economy would have taken longer to start to expand, but there is no alternative to measure this against.  Second, it is hard to talk about the effectiveness of the Federal Reserve’s policies and programs in a measurable way.  If we talk about the effectiveness as measured by the Federal Reserve’s ability to follow its dual mandate which states that:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

then, monetary policy has been effective.  The Federal Reserve has kept the price level relatively stable (inflation has been under 2% and not drastically changed over the past 4 years) and unemployment is contained and decreasing to our natural rate (unemployment has fallen from a 10% high to 7.3%.)  However, if effectiveness is determined by economic growth and GDP growth than the Federal Reserve’s monetary policy has fallen short of the U.S.A.’s typical 2-3% GDP growth.

One of the positive consequences that some economists (paper 1, paper 2, paper 3) have estimated from the large scale asset purchases by the Fed are that 10-year Treasury securities have lowered by 80-120 basis points or 0.80%-1.20%. There has been significant decline on yields on both corporate bonds and mortgage-backed securities as well.  Lowering yields allow companies to borrow to invest in their businesses at a cheaper cost. In March 2009, the stock market started to increase. The stock market is a leading economic indicator and its bolstered stock prices are indicative of a positive economic outlook.

However, a negative consequence is that large scale asset purchases are that the private market can be crowded out of private investment in bonds, which can lead to future problems with liquidity when the Federal Reserve phases out their large scale buying.  This has generally not been true as private bond buying has not drastically been decreased.  However, large scale buying by the Federal Reserve also lends itself into a moral hazard argument—the United States’ monetary authorities are ready to help with little regard to cost.  The cost is not necessarily the monetary cost of buying bonds, but rather the future cost of increased liquidity—inflation.  Further, banks can take on as much risk as they want and a bailout (not only via Congress), but through the open-market will occur.  Although the Federal Reserve can always sell bonds, decrease liquidity, raise fed funds and discount rates to curb higher inflation, expected inflation expectations have increased slightly.

 

Why the Fed, under Bernanke, Chose the Policies they did

Bernanke has studied economic recessions and is widely considered an economic expert on the Great Depression.  Other notable monetary economists such as James Tobin and Milton Friedman have shown in research that if the Fed bought long-term securities during the Great Depression it would have helped recovery.  Further, during the Bank of Japan’s crisis in the 1970s, a large-scale purchase would have prevented deflation. This was due to very tight monetary policy in Japan and an illiquid market. Bernanke’s strategies were a drastic alternative to the Federal Reserve’s strategy (or lack thereof) after the Great Depression.

 

…But, Were the Policies the Best they Could be?

The two large recessions in our country’s history, the Great Depression and the Great Recession, had very different monetary policy solutions and a very different rate of recovery. Post the Great Depression, there were many stagnant growth years until WWII where economic output increased at dramatic rates.  Meanwhile,  following the most recent recession our country’s GDP was positively growing, but very slowly. I believe that only time, and a future recession in magnitude in which to compare to, will determine whether the Fed used the best policies during 2007-2009. Otherwise it is hard to determine whether recent monetary policy just serves as one extreme, while monetary policy following the Great Depression served as an opposite extreme.