What Caused the Flash Crash?

So what caused the "flash crash" of May 6th? Today the SEC and the CFTC issued a joint report confirming earlier speculation: it was caused by a large sell order on E-Mini futures contracts, a security that mimics trading in the S&P 500 stock index. Before it happened, the market was already on edge over reports of the crisis in Greece:

At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader [Waddell & Reed Financial of Kansas] initiated a sell program to sell a total of 75,000 E-Mini contracts [at] an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.

The execution of this sell program resulted in the largest net change in daily position of any trader in the E-Mini since the beginning of the year (from January 1, 2010 through May 6, 2010)....Lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other — generating a “hot-potato” volume effect as the same positions were rapidly passed back and forth.

....In the four-and-one-half minutes from 2:41 p.m. through 2:45:27 p.m., prices of the E-Mini had fallen by more than 5%....Between 2:32 p.m. and 2:45 p.m., as prices of the E-Mini rapidly declined, the Sell Algorithm sold about 35,000 E-Mini contracts (valued at approximately $1.9 billion) of the 75,000 intended. During the same time, all fundamental sellers combined sold more than 80,000 contracts net, while all fundamental buyers bought only about 50,000 contracts net, for a net fundamental imbalance of 30,000 contracts.

....At 2:45:28 p.m., trading on the E-Mini was paused for five seconds when the Chicago Mercantile Exchange (“CME”) Stop Logic Functionality was triggered in order to prevent a cascade of further price declines. In that short period of time, sell-side pressure in the E-Mini was partly alleviated and buy-side interest increased. When trading resumed at 2:45:33 p.m., prices stabilized.

"Significantly," says the New York Times, "the report found that the plunge was not caused by any market manipulation but by a single firm trying to hedge its investment position, if in an aggressive and abrupt manner." Does this make me feel any better? Not really. Market manipulation can be monitored and regulated, at least in theory. But a large sell order? If a $4 billion E-Mini dump can wipe out the market just because it's a little jittery over events in Greece, that's not a good sign that the market is inherently very stable. And remember, this stuff all happened within five minutes, with prices apparently stabilized by a five-second trading pause at 2:45:28. This stuff isn't even happening at human speeds anymore. Kinda scary.

Chart of the Day: Healthcare Spending

Dr. Aaron Carroll has finished up his series on healthcare spending, and the chart on the right shows the main areas where America overspends. In short: everywhere. Here is his summary:

It’s been interesting to read the emails I’ve gotten over the last two weeks on this series. Many of you seem to believe I’ve got some secret agenda with respect to how to fix this. I don’t. The truth is that I don’t think there is a simple solution. Some of you on the right think that increased consumer costs will fix the whole thing. It may, for some sectors, but it will do nothing in others. Plus, I think it would negatively affect outcomes. Similarly, tort reform isn’t the answer either.

Some of you on the left think it will be just as easy if you had your way. But even if we went to a single-payer system, and significantly decreased insurance costs, that won’t touch the bulk of the problem. Nor would singling out changes to pharmaceutical spending.

....The final thing is that we have to stop looking for others to blame. We are all to blame. So let’s get past blame entirely, and start dealing with the problem. Our goal isn’t to reduce our spending to that of other countries. Our goal is to reduce spending so that it is in line with GDP. It’s to get spending down to the curve in the above graph. It’s to get spending down to just the green slice of the pie.

The introduction to his series is here, and it includes links to all ten parts. It's worth a read if you want to get a quick, very readable take on why healthcare in America is so expensive without producing results any better than all the countries that spend less than us.

Inside the White House

Joe Klein isn't sure that Pete Rouse is a good choice to replace Rahm Emanuel as Obama's chief of staff:

I don't know Rouse very well. I don't know what his priorities will be. Early reports emphasized his "calming" effect and his long career as a Congressional insider. But if this no-drama White House gets any calmer, it'll be comatose. There's a need for energetic, non-Congressional, non-insider voices in the inner circle. Some wise executives like Pennsylvania Governor Ed Rendell would be welcome.

Maybe. Klein suggests that Democrats too often choose congressional insiders as chief of staff while Republicans more wisely choose energetic executives. There's something to that, though I'm not sure Republican chiefs of staff have necessarily been any more dramatic than Democratic ones. James Baker was the ultimate insider, after all, and Andy Card was about as self-effacing as they come.

More generally, though, Klein dings Obama for getting a lot of stuff through Congress but not getting a lot of credit for it. That's probably unfair. Obama has had pretty good legislative success, and the sour public mood is due far more to the long, grinding recession we're in than it is to Obama's public persona. On average, Obama is about as popular today as most other presidents at this point in their terms.

In any case, Klein will probably get his wish shortly. Rouse's influence aside, Obama is almost certain to have a far more combative, White House-centric identity if he has to deal with a Republican Congress starting in January. That worked wonders for Bill Clinton's popularity, and I imagine it will do the same for Obama's.

Where Your Taxes Go

A Third Way report made the rounds yesterday touting the idea of providing taxpayers with a "receipt" when they pay their tax bills every year. They provide an example, which looks like this:

Put aside the technical details for the moment. I don't know for sure if all their calculations are right. I don't know why national defense is left off their sample receipt. Medicare and Social Security are funded from a different set of taxes than everything else and therefore have to be calculated differently. I don't know how you'd divvy up the share of revenue from corporate income taxes, excise taxes, etc. For now, though, let's assume we could work out all that stuff to everyone's satisfaction.

My question is this: who would be in favor of this and who would be opposed? Would everyone's receipt show the same items, or would everyone get, say, the same top five or six and then a random mix of other stuff? Who would decide how to break things out? Would liberals be afraid that people might look at the welfare-related spending and be outraged? Would conservatives be afraid that people might look at the startlingly low numbers for everything after the Big Five (Social Security, Medicare, Medicaid, Defense, interest on the debt) and lose some of their outrage over federal spending?

Technical details aside, this is the kind of idea that everyone should support. Taxpayers should know where their tax dollars are going, after all. And yet, I'll bet that neither party would actually be in favor of this. Why do you suppose that is?

Turning Down the Volume

Fellow MoJoer Nick Baumann draws my attention to a report suggesting that the U.S. Senate isn't completely worthless after all. Here's the evidence:

Legislation to turn down the volume on those loud TV commercials that send couch potatoes diving for their remote controls looks like it'll soon become law. The Senate unanimously passed a bill late Wednesday to require television stations and cable companies to keep commercials at the same volume as the programs they interrupt.

....Managing the transition between programs and ads without spoiling the artistic intent of the producers poses technical challenges and may require TV broadcasters to purchase new equipment. To address the issue, an industry organization recently produced guidelines on how to process, measure and transmit audio in a uniform way.

The legislation, sponsored by Sheldon Whitehouse, D-R.I., requires the FCC to adopt those recommendations as regulations within a year and begin enforcing them a year later. Rep. Anna Eshoo, D-Calif., is the driving force behind the bill in the House.

It's not a done deal yet: the bill still has to go to conference and then get a final vote in both House and Senate. But apparently no one expects that to be a problem unless someone throws a tantrum and decides to shut down the Senate because Barack Obama insulted their dog or something.

Anyway, this is indeed one of my great pet peeves. It's sort of like the Do-Not-Call list: I don't really care about principled arguments on either side. I don't care if this regulation should be considered liberal, conservative, libertarian, fascist, or anything else. I just want the damn volume on advertisements to go down. If the only way to do it were to put a few network chiefs in front of firing squads just to send a message to the rest of them, I'd probably favor that too. Just get it done.

Finally a Winner in Iraq

We might finally have a winner from the March election in Iraq:

Powerful Shiite cleric Muqtada al-Sadr has agreed to support the bid by Iraq's prime minister to retain power, aides said Friday, in a move that could speed an end to the seven-month political impasse and bring dealmaking that may give key concessions to al-Sadr's anti-American bloc.

The decision by al-Sadr would mark a significant boost for Prime Minister Nouri al-Maliki's Shiite-led coalition to secure enough parliament seats to form a new government.

....Al-Sadr's move apparently sets aside past animosity with al-Maliki for a chance to gain a greater voice in a possible new government. Al-Sadr — who has been in self-exile in Iran since 2007 — has denounced al-Maliki's government for its close ties to Washington and a joint security pact that allows U.S. military presence through at least the end of next year.

So we get the same old Maliki government, but with a greater role for Muqtada al-Sadr. I can't say this fills me with hope for Iraq's future, but I suppose it fills me with relief that they're at least going to have a government of some kind. Stay tuned. 

Wall Street's Sigh of Relief

How will we know if the financial reform bill passed in July has worked? A few months ago I mentioned four metrics to watch for:

  • Borrowing rates for large banks
  • Derivatives trading
  • Leverage ratios
  • Industry profitability

Of these, the most important and the easiest to measure is the last one: industry profitability. Once you cut through all the chaff and all the technical details, you're left with a simple truth: a safer, less leveraged banking sector is inherently less profitable than the casino trading and finance-oriented one we have right now—the one that accounted for an astonishing third of all corporate profits in the United States during the Bush era. If profits stay at pre-bubble levels, it almost certainly means that financial reform failed.

It's too early to tell how reform will turn out, of course, but recently we got a disturbing glimpse. The people in the best position to know how the new regulations are going to affect the banking sector are the bankers themselves, and bankers don't seem to be very worried. Researchers at an IBM think tank, the Institute of Business Value, did a survey of top financial executives recently and asked them how the new regs were likely to affect them. Results are at the right: a mere 13% of them thought industry returns would decrease significantly. The vast majority thought returns would be the same or only slightly less.

It's a small sample—only 54 executives—and maybe they're just being overoptimistic. But it's a bad sign that they aren't a little more worried. (Another bad sign: asked about their top concerns, the #3 answer was figuring how to get around the new regulations.)

Of course, there's more to banking regulation than just Dodd-Frank. There are also the new capital standards recently adopted by the Basel Committee, and at first glance they seemed gratifyingly stiff. But they were announced two weeks ago, on Sunday the 13th, and when markets opened on Monday the 14th bank stocks shot up. Yet again, the people who are in the best position to judge the real effect of the new regulations didn't seem too worried.

For now, then, things don't look so good. Both Dodd-Frank and Basel III are improvements, but the best evidence so far—namely the reaction of people with money at stake—suggests that it won't be long before Wall Street is back to business as usual. It's been an opportunity lost.

No Good Deed Goes Unpunished

An internal White House report concludes that money from the stimulus bill has been well spent:

By the end of September, the administration had spent 70 percent of the act's original $787 billion, which met a White House goal of quickly pumping money into the nation's ravaged economy, the report says. The administration also met nearly a dozen deadlines set by Congress for getting money out the door...

Meanwhile, lower-than-anticipated costs for some projects have permitted the administration to stretch stimulus money further than expected, financing an additional 3,000 projects, according to the report..."Certainly, the fraud and waste element has been smaller than I think anything anybody anticipated," said Steve Ellis, vice president of Taxpayers for Common Sense, a nonpartisan watchdog group.

...An independent board established to provide oversight has received just 3,806 complaints — less than 2 percent of more than 200,000 awards. Prosecutors have initiated 424 criminal investigations, representing 0.2 percent of all awards. Typically, 5 to 7 percent of government contracts attract complaints, [Jared] Bernstein said.

According to CBO reports, the stimulus has created 3.5 million jobs and kept unemployment about 1 to 2 percent lower than it otherwise would have been, and apparently it's accomplished this efficiently and with minimal waste. It's a testament to what happens when you take good policy seriously.

Unfortunately, it's also a testament to how little most people care about good policy and competent execution. As near as I can tell, it's practically conventional wisdom these days that the stimulus package was a complete bust—and all because the Obama administration initially made a lousy projection about the future course of the recession and suggested that the stimulus package would reduce unemployment to 8 percent. If their forecast of the depth of the recession had been correct and they'd predicted, say, 11.5 percent unemployment without a stimulus package and 10 percent with it—which is what happened—elite opinion about the stimulus would probably be completely different.

So there you have it. Good policy and good execution gets you bubkes. All it takes is one wrong forecast number to wipe it all out. Welcome to the real world.

Endgame for AIG

The New York Times reports today:

A.I.G. Reaches Deal to Repay Treasury and Fed for Bailout

This is good news. But take it with a grain of salt. Here's the part about repaying the Fed:

The insurance giant [] owes the Fed about $46 billion in two forms: about $20 billion in borrowings under the original revolving credit facility, and a $26 billion preferred stake that the company must redeem....The company said it would use its own resources to pay back the $20 billion in loans....In addition, the Treasury has agreed to help the Fed sever its ties with A.I.G., by providing the means for the company to redeem most of the Fed’s $26 billion in preferred interests. That money will come from the unused portion of an emergency assistance package that the Treasury made available to A.I.G. as its troubles reached a peak in early 2009.

OK. So AIG is going to pay back $20 billion by selling off some assets, but the other $26 billion comes from tapping into unused parts of the existing Treasury rescue package. So now AIG will owe the Treasury even more. How is that going to be paid off?

The Treasury will come out of the transaction with a larger preferred stake in A.I.G....Once the Fed has been fully repaid, the agreement calls for A.I.G. to exchange all of the Treasury’s preferred shares for 1.65 billion shares of common stock....When the exchange from preferred to common has been done, the Treasury will be able to sell its common shares on the public markets, something it is expected to do gradually over time.

This might work! Then again, when the government starts selling off billions of shares of AIG stock, whether slowly or not, it might not. Only time will tell. Basically, though, the Treasury now owns 92% of AIG, and taxpayers will get paid back only if and when it sells that stake. Once this deal is complete I think Treasury will be on the hook for about $50 billion or so in outstanding loans to AIG, so if AIG's share price holds up at around 40 bucks while Treasury's shares are dribbled out to the market, we the taxpayers will end up in decent shape on the whole deal.

Vegetable Research Grant Needed

Adam Ozimek rants about vegetables:

[Alice] Waters and her organization are touting a new study showing that school gardens get kids to eat more vegetables. This isn’t surprising, but how much does it impact their lives once they graduate? Are future blue collar workers really going to take the time to grow themselves vegetable gardens in window boxes outside their apartments?....From every description of these programs I’ve read they have an obsession with local, fresh, organic, and growing your own food. The obsession should be on quick, easy, delicious, and inexpensive. These sets of descriptors are damn near antonyms.

If you can get kids to eat and prefer frozen vegetables then you’ve got a sustainable improvement in diet and nutrition. If you get them to like fresh organic vegetables they’ve grown in the garden or bought at the farmers market, then you’ve temporarily instilled in them the tastes of upper middle class people with enough time and money on their hands for such luxuries.

If people like Alice Waters and Jaime Oliver want wider support for heathy schools movements they need to purge them of the wasteful upper-class liberal obsession over local, fresh, and organic foods, and instead focus them on practical and sustainable lessons like how to prepare frozen vegetables cheaply, quickly, and deliciously.

I feel ideally situated to report objectively on this since the only vegetables I like are tomatoes, and they aren't even really vegetables at all — though the Supreme Court has decreed otherwise. In any case, I figure they're close enough, and better than eating nothing vegetable-ish at all.

But back to all those upper-class liberal vegetable gardens in local schools. Haven't they been around long enough for someone to do a serious study of this?1 You know the drill: interview ten thousand 30-year-olds, control for a whole bunch of variables, and then do a regression that plots years of tending vegetable gardens in school vs. current consumption of vegetables. Let's settle this thing once and for all.

1In fact, longer than you think. My mother says her first grade class had a little garden, and that was back in 1938.