Another post about Bear Stearns

Google News says it has 385 articles about Bear Stearns at the moment. Which makes me less inclined to talk about it. Also I’m a health economist, who deliberately chose not to enter this world. I don’t know why this stuff is so fascinating to me. Probably for many of the reasons sports statistics are…

The story is Bear Stearns’ plan to bail out one those two near-dead hedge funds. We had seen the other day that Merrill Lynch, not playing the game of Goldman Sachs, Bank of America or JP Morgan, had seized assets for a fire sale. Why? Because Merrill Lynch took Collateralised Debt Obligations (CDOs) to sell – potentially setting up a run on the collateral(s) in question – sub-prime mortgages.

For ‘us’ (whoever ‘we’ are) this was the scary-ish part, because those are debts that equal houses, still, and we’d rather not have any more squeeze on sub-prime-mortgaged houses than we already have. For Bear Stearns (and other banks) a dump of the price of debts they all may own would be the scary part.

In the end Merrill backed out of the auction, like JP Morgan (investment banks are so shy – who knew?). Perhaps Bear Stearns got word to them that they’d cooked something up. Rather than face a market devaluation of assets to which Bear Stearns (and probably quite a few if not all of its peers) are exposed, the bank is pledging USD3.2bn to bail out the fund that gambled on them. Essentially it’s to buy out the creditors, to stop them seizing those CDOs:

Creditors extended $9 billion to the funds which made bets of more than $11 billion, a person familiar with the situation said. Lenders include Merrill, Lehman, JP Morgan Chase & Co., Goldman Sachs Group Inc., Citigroup and Cantor Fitzgerald LP, all in New York. Bank of America Corp., based in Charlotte, North Carolina, Barclays Plc in London and Frankfurt-based Deutsche Bank AG were the other lenders.

I also mentioned this in my previous post: the SEC has already been told to keep an eye out for investment banks over-valuing bonds in order to prevent a run on the underlying assets. In this case those assets are sub-prime mortgages – loans that are looking worse and worse. I don’t know what to draw parallels to first – junk bonds in the 80s or the entire Japanese banking sector in the 80s and 90s.

Since this is a straight loan, not a taking of equity, there’s a question over how funds that blew as much money as these can be reliably expected to turn around enough to cover those losses and USD3.2bn. Meanwhile we still know very little about exposure to the CDOs, especially those built around sub-prime lending. The Bloomberg article suggests pension funds bought into these as well – hopefully not by much. They aren’t doing well (I also didn’t know CDOs had been around for so long – although it makes sense that they came out of the 80s, with all the risky debt going around at the time).

The first CDOs were created at now-defunct Drexel Burnham Lambert Inc. in 1987. Sales reached $503 billion in 2006, a fivefold increase in three years. More than half of those issued last year contained mortgages made to people with poor credit, little loan history, or high debt, according to Moody’s Investors Service.

CDOs may have lost as much as $25 billion because of subprime defaults, Lehman Brothers analysts estimated in April.

Fitch Ratings warned today for the first time that it probably will downgrade some securities from CDOs containing bonds from 2006 of subprime second mortgages, the class of home loans that have been “experiencing the greatest stress.” Standard & Poor’s cut ratings on 45 bonds backed by subprime second mortgages.

So is Bear Stearns is taking a big risk to protect that collateral? All signs point to yes:

The risk of owning Bear Stearns’s corporate bonds also rose today. Five-year credit-default swaps based on $10 million of the bonds rose $2,200 to $48,000, according to composite prices from CMA Datavision. They touched a three-month high yesterday, trading at $49,000. An increase in the contracts, used to speculate on the company’s ability to repay its debt, signals deterioration in the perception of credit quality.

Suggesting that they at least have a lot more exposure to sub-prime mortgages than just the High-Grade Structured Credit Strategies Fund.

Meanwhile the Washington Post has a piece up discussing the market’s reactions. I liked this guy:

“I’m not sure this is the only mis-priced device that has been created,” said Marc Heilweil, president of Spectrum Advisory Services Inc. in Atlanta.

Really? I would have the shock of my bloody life if it was. Heilweil sounds like he took bear-ish positions anyway (probably why he sounds so sanguine). Discussion as well of Fed-watching (sad, when a country has no royal family), and some macro data out next week – sales of existing homes on Monday and new homes on Tuesday. I’ll definitely be back on the issue, then as will, I expect, the much better Big Picture.

Another post about trains

This is yesterday’s news. I went out for a while and lost interest in posting about it, but the CityRail story started me up again. This is England, specifically the London Underground. Click for a full-size version.

Our map is far prettier. TfL’s is so messy.

The news is that Metronet Rail, owner/operator of the Underground, is trying to get back some costs. Metronet got the undergound in a Public-Private Partnership with Transport for London. This is part of Blair’s third way thinking. Essentially in a PPP the government entity is supposed to use public money for the capital, and a private entity deals with the operations (this is unlike the Private Finance Initiatives, where the capital money is private, and they work out a scheme with the government). This sort of thing began with Major’s government, but really took off under New Labour.

Anyone wanting to know my personal perspective on these, if you didn’t get it from the CityRail post, should read Monbiot’s book Captive State.

Back to the story. Compared to this, CityRail’s problems are reasonably minor. Metronet is trying to recover about GBP1bn. Of the 3 contracts to upgrade the London Underground, Metronet has 2, and has overspent nigh-on GBP1bn doing so. And it wants TfL to pay for some of it.

“During the first four years of the contract, the costs have been considerably higher than was anticipated by London Underground and Metronet at the time the contract was awarded,” said the company. The year-long review will be carried out by Chris Bolt, the rail industry regulator and PPP contract referee.

Metronet argues that TfL, a publicly owned body, should pay for a significant part of the overspend because it has been forced to carry out work not specified in the contracts.

Needless to say Mayor Ken Livingstone disagrees, blaming incompetent management at Metronet. They will probably go to a referee for the contract, who will review the matter and decide – a PPP Family Court, if you like.

The early indications are not good for Metronet. An initial report by Mr Bolt found that Metronet is responsible for much of the overspend because it has not met the benchmarks of performing in an “economic and efficient” manner.

It gets better:

The prospect of a bill for more than £1bn will increase the pressure on Metronet. Its main lenders have blocked access to a loan and its shareholders could walk away from the contract if the review orders the company to pay all of the extra costs. Metronet’s five shareholders are liable for their initial investment – £350m – and no more. This means that the company could be rendered insolvent if it is ordered to meet all of the overspend.

This probably won’t affect the decision by Chris Bolt, I shouldn’t think. Livingstone has said already this could bring down Metronet. In which case TfL would re-takeover, either spending London’s money or getting some neat loan from Prime Minister Gordon Brown. They might try to sign a new contract with a new operator, but this new contract would be far more unfavourable to London. Like most PFI contracts, it would probably screw Londoners over.

Again, Sydney-siders who’ve seen the mess the government made of the cross-city tunnel will understand this. Most Brits will as well – having seen it all over the country for the last decade, covering every PFI contract from hospitals to toll-ways.

The reasons why I think PFI and PPP approaches to infrastructure-heavy services are a bad idea are pretty standard. Low bids always win, costs are always underestimated, efficiency gains never materialise, ordinary taxpayers always end up footing a higher bill.

Commuters face higher fares

This is going to be a laugh! For those of you not from Sydney (or NSW), news that rail fares will increase is not going to be taken well. At all.

Sydney commuters are facing rail fare rises, following an application by RailCorp to the NSW pricing body for increases of up to $3 for a weekly ticket.

In its submission to the Independent Pricing and Regulatory Tribunal (IPART), RailCorp is seeking an increase of between 20 cents and $1 for a single ticket and between $2 and $3 for a weekly ticket.

There are 2 things going on here. One,

NSW Transport Minister John Watkins said RailCorp had a reasonable case for a fare rise with record investments including new and upgraded infrastructure and new trains to extend the network, increase capacity and improve passenger comfort.

“Currently, CityRail customers only pay a quarter of CityRail’s $2.1 billion annual operating costs,” Mr Watkins said.

Our rail system is privatised – kind of. CityRail is a part of RailCorp. CityRail is the metropolitan part of the state’s rail network.

Beautiful, isn’t it?

A relatively recent ministerial report was not all that laudatory:

According to an inquiry report, “The interaction of metropolitan, suburban, intercity and freight lines and services has resulted in an overly complex system.” This complexity has contributed in part to the organisation being widely criticised for poor reliability and safety. CityRail is also enormously expensive. RailCorp requires a government subsidy of close to $1.8 billion a year—approximately 5% of the state budget and more than three times what it collects in fares.

“There is an overwhelming sense,” the report concluded, “that CityRail does not promote a real commitment to quality, customer focus and a service culture.”

Those are the 2 key points: (i) our state government subsidises the private system like mad, (ii) commuters, travellers and newspaper readers will never be convinced that CityRail is more than a jobs-for-the-boys clusterfuck of privatisation and government corruption. So the argument that a lot has been spent on infrastructure (which actually has just meant trackwork and mass inconvenience since I was an undegraduate (1997-2000), so we don’t have a great perspective on the matter), and needs to be compensated won’t work. Why? It’s a bloody train network. It’s expensive to own and operate, which is why the government had it in the first place. We don’t appreciate privatisation for exactly this reason (more on that in a later post, possibly).

The second argument is ‘fairness’ and equity. Mr Watkins:

“The vast majority of CityRail’s operating expenses are funded by all taxpayers, who don’t necessarily access the service.

“With the rest of the community paying around 70 per cent of costs, and that share is increasing, there’s a strong case for commuters to pay a slightly higher percentage of the services they rely on.”

Not to be Socratic about it (because look at what they did to him), but is the Transport Minister suggesting a user-pays approach to Fire, Ambulance, etc. services? We find it hard to believe the government who gave us the execrable cross-city tunnel is going to start lecturing us on who should pay for a transit service.

Moreover Sydney is, geographical, enormous, and highly suburbanised. If the Transport Minister wants everyone to hit the Motorways in disgust at the train service, he’s going the right way about it (those are privately-run, also). And that really will be a nightmare.

The economics of this are reasonably straight-forward. The costs, fixed and variable, of owning and operating a train network this extensive are very high (which RailCorp knew going in, and which the state government knew going in, which is why the idea that consumers and residents are the ones making the mistake now is so insulting).

Again, from my current undergraduate economics textbook:

The Natural Monopoly: high costs of production, with market power. In an unregulated market the firm would charge the price P_M, supplying only Q_M, which would maximise profit. The Allocatively Efficient price (the amount of quantity and price optimal for society as a whole) would be P_E with the greater quantity Q_E. In this case a lower ticket price, and more people taking the train, but less profit for RailCorp. So much less that they lose money (the intersection of Marginal Cost MC and Average Revenue – the demand curve – is below Average Total Cost, meaning RailCorp loses money. This is what I mean by very large fixed/infrastructure costs).

The Productively Efficieny price and quantity, meanwhile, is the intersection of Marginal Cost and Averate Total Cost – technical efficiency, or minimum cost production, exists outside the demand curve. In the case of CityRail I think the optima are farther out, but the principle still applies. The regulated price and quantity P_R, Q_R give the producer a little bit of profit – keeping them in the market – while getting quantity as high as it can, benefitting consumers (or in this case, commuters)

Today’s announced price increases with take P_R a little higher, and Q_R are a little to the left (or a lot – it depends on the slope of the dark blue line for rail travellers in Sydney). The argument we’re given is that the dark orange ATC curve has moved up, because of all the investment paid in by RailCorp. Economically this makes sense. The missing piece of the puzzle is that the market for CityRail doesn’t actually look like this. P_R is still loss-making to the tune of nearly AUD2bn per year. Essentially for CityRail the ATC curve is higher than the AR/demand curve at nearly every point. Meaning they will never make a profit, because to do so would mean charging higher prices than any of us will pay, and we won’t ever take the train.

Which is exactly why the Transport Minister is wrong. Taxpayers will always subsidise train travel by CityRail customers. Moreover, the marginal impact of that subsidisation per state taxpayer is insignificant, far less than the marginal impact of lumping the price hike on commuters, who are much smaller in number.

Which is also exactly why train networks like this don’t work when privatised. If the Average Revenue lies below the Average Cost, there isn’t a profit to be made – unless you can bid low and take the state government itself for the ride. Which is pretty much what is happening. People will and do say private equals more efficient. With different operators of different networks, profit-making at every level of improvement in infrastructure, and the need for independent regulation and oversight? I disagree. And I reckon every one taking a CityRail train today will agree with me.

Pollies’ pay rise towers over gain for workers

Premier Morris Iemma is refusing to cap salary increases for MPs, despite limiting pay increases for public sector workers in the budget.

NSW MPs will receive a 6.7per cent increase, while rail workers, nurses, teachers and public servants will receive 2.5per cent.

The other day the news was Federal MPs getting thumping great pay rises. Both parties do, naturally. It was followed by costs released for travel by former MPs, which were also far above that of the ordinary Australian (who would have to pay for theirs, anyway). I suggested that in the simplest terms Howard should take the blame, because his party is in charge. But ‘money-grubbing politicians’ has a lot of buck-shot in it, so to speak.

It would appear Labor Premier Morris Iemma (if you follow that link, can you explain to me why his Parliamentary Activity is listed in such a bizarre fashion?) has decided to do bugger-all to help out his party at the federal level by reminding every New South Welshman that Labor is at least as greedy – perhaps worse, in fact, because the Federal MPs just fattened their own pay-packets. Iemma’s government did it at the same that they were limiting pay increases for public servants.

They also did it at the same time that (also Labor) Premier of Victoria Steve Bracks did the opposite: Victoria’s state MPs are getting the standard 2.5%. Which rather puts, on balance, Labor on the off-side of the greedy politicians ledger (although to be fair, after 12 years of Labor government in NSW there isn’t much we do expect of our state legislature anymore). That could also be my own state-based parochialism in suggesting the actions of Iemma carry more weight than those of Bracks. I think, though, that between politics and the media, Iemma’s decision is going to be seen as Business As Usual, not that taken by Bracks.

John Howard will be pleased as punch. I should be very surprised indeed if this doesn’t go in as evidence to prove his claim that a federal Labor government would leave wall-to-wall Labor governments and subsequent economy-bollocksing-up. NSW voters would certainly believe it. More on that in a second…