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My perspectives as an investor and consumer

What does energy independence mean?

BillONeil_Adakame Does the implementation of energy independence and environmental stewardship need to be linked?  Can each aspect be tackled separately or in some order of priority?

Energy independence, considered on its own, would mean that the sources of energy that feed our consumption come from within the United States.  Environmental stewardship would involve lower emission of pollutants and greenhouse gases during the production and consumption of each additional Btu of energy.

We currently seem to be tackling two massive issues at the same time with aspects of each pulling in opposite directions and hindering the advancement of either.   It seems to me that we would be able to step closer to accomplishing both if we tackle energy independence first.  When we control the input-output elements of our nation’s energy, we can better direct our efforts towards environmental stewardship.

The schematic below provides a summary of energy sources, and energy consumption, in the United States in 2007 as compiled from Energy Information Administration data.  In order to compare the various sources, I’ve converted the normal units of each into Btu.  The colors representing the various sources are consistent within the consumption sectors.  This will, hopefully, facilitate quick comprehension of the dynamics between the energy sources and consumption sectors.

The United States consumed 101.6 quadrillion Btu of energy in 2007.  85% of the energy we consumed (in Btu) was provided by petroleum (39%), natural gas (23%), and coal (22%).  64% of our petroleum consumption and 16% of natural gas consumption came from imports.  The United States is a net exporter of coal.

US_Energy_Picture_2007In order to wean ourselves off imported petroleum and natural gas – energy independence – while reducing pollutants and greenhouse gases at the same time – environmental stewardship, it would require the replacement of petroleum and natural gas with renewable energy.  Herein lies the challenge of tackling these two major issues at the same time.

Since 96% of our transportation needs are met by petroleum-derived products, the replacement fuel from renewable energy sources would have to serve as transportation fuel.  This practically eliminates solar, wind, geothermal, and hydro-electric or 48% of 2007 renewable energy production.  Only 17.4% of the 3.6 quadrillion Btu of biomass directly contributed to transportation through fuel ethanol and biodiesel.   There would, therefore, have to be a 41 fold increase in the production of fuel ethanol and biodiesel to replace current petroleum imports, not to mention the complications associated with setting up infrastructure for the replacement fuel.

I don’t pretend to be an expert in energy infrastructure nor claim to have the perfect solution.  However, one viable alternative I see would be to focus the efforts of renewable energy on the nation’s electric grid.  As can be seen in the schematic, the electric power sector is one area where all sources have some contribution, especially natural gas and renewable energy.  More importantly, almost all sources of renewable energy can be used for the generation of electricity.

Natural gas, according to various sources, is an abundant resource within our country and cleaner burning than petroleum or coal.  Measuring natural gas in the ground is no easy job, and it involves a great deal of inference and estimation. With new technologies, these estimates are becoming more and more reliable; however, they are still subject to revision.  Three different organizations – Energy Information Administration, National Petroleum Council, and Potential Gas Committee – estimate that the technically recoverable natural gas resources are about 1.5 quadrillion cubic feet.  In comparison we produced 19.3 billion cubic feet of natural gas in 2007.  In other words, our technically recoverable resources of natural gas are 77,000 times greater than the total production in 2007.  Technically recoverable resources include both discovered and undiscovered resources that we currently have the technical capability to extract.  Keep in mind that just because a resource is technically recoverable doesn’t mean that it is economically recoverable, where the parties involved have a financial incentive to extract it.  Update: On June 18, 2009, the Potential Gas Committee updated its resource numbers for natural gas to 1.84 quadrillion cubic feet.

If clean coal technology is more of a story than a reality, we could focus our efforts on unconventional natural gas – the most abundant form in the United States – and renewable energy (solar, wind, geothermal, hydro-electric, and biomass) such that they become the major contributors to each additional Btu added to the electric power sector.

Transportation, on the other hand, would seem to require one source of power the way gasoline has served consumers and diesel has served commercial vehicles in the past.  The infrastructure that is needed to support fuel consumption – filling stations, fuel transport – is the main reason for such a requirement.  The ability to go to any gas station and fill one’s vehicles with the same kind of fuel made the adoption of cars and light trucks easier for consumers.  I believe the same will be required for the next source of power for consumer vehicles.  Electricity is one such option.

Consumer-based transportation (light trucks and smaller vehicles) can gradually be shifted to run on electricity through improved battery technology and recharge stations.  8.8 million gallons of gasoline and 3.4 million gallons of diesel were consumed for transportation purposes last year.  Since most of the gasoline is used in cars and light trucks, replacing it with electric power should be sufficient to eliminate the importation of petroleum as the US production of petroleum should be adequate to meet the needs of heavy duty trucks and industrial applications.

Shai Agassi is one of the leaders in the area of electric vehicle services, such as recharging stations, and is currently implementing his vision in Israel.

Experts estimate that the capacity of the electric grid will have to double in order to facilitate a major shift towards electric vehicles, which is why I believe it important to focus all current natural gas and renewable energy efforts to increasing electric capacity.

An added benefit is the the ability to change the mix of sources for electric power generation down the road as we continue to make strides in renewable energy in terms of efficiency and scale.  For example, we may be able to wean ourselves off coal and nuclear followed eventually by natural gas.  No matter what the input mix and how long it takes us to get there, consumers can rest assured that the output will remain the same – electricity, which will continue to power their homes and vehicles into the future.

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Filed under: Energy, Government, Politics, , , , , , ,

Scientifically exploring solutions to health care

BrianDettmer_WheelAs America considers major health care reforms, can its crafting of policy benefit from scientific guidance?    Ryan Moore, co-author of a study published in The Lancet, a leading international medical journal, thinks so.  Seguro Popular is Mexico’s ambitious plan to improve healthcare for its estimated 50 million uninsured citizens.  The publication was the culmination of a collaborative study of Seguro Popular between Mexican health officials and researchers from leading American universities.  As a result of this study, U.S. policymakers are encouraged to scientifically explore solutions to America’s own looming healthcare crisis – an experimental approach with the potential for providing objective answers to even the most controversial and politically charged questions.

“If the administration has done arms-length science and has involved third parties, like the researchers who were involved in this study, then the case that the administration can make for continuing these programs is much stronger,” said Moore, an assistant professor of political science at Washington University in St. Louis. “They’re more likely to get at the truth – it’s good politics and it’s good science.”

The article, “Public Policy for the Poor? A Randomized Assessment of the Mexican Universal Health Insurance Program,” details a massive, two-year field experiment designed to evaluate Mexico’s push to bring better healthcare to communities ranging from remote villages to crowded urban areas. The study turned dozens of Mexican communities into real-world laboratories where causal effects of the insurance program could be empirically measured and evaluated at the household level as new services rolled out in phases across seven Mexican states: Guerrero, Jalisco, Estado de Mexico, Morelos, Oaxaca, San Luis Potosi and Sonora.

Moore and colleagues developed the experimental design, wrote public-use software to implement it and then “tied their own hands” by publishing a preliminary study detailing exactly how the experiment and analysis would be carried out – a process designed to insulate findings from after-the-fact political meddling.

Researchers identified 74 matched pairs of communities that shared similar demographic and health conditions, and worked with Mexican officials to conduct household surveys capturing a baseline snapshot of each community’s health status. Then, working independent of the Mexicans, researchers randomly selected one from each matched pair of communities for early introduction of Seguro Popular, establishing a controlled framework in which individual changes in health experiences in one community could be empirically compared to control conditions in the matching community.

“This was the largest randomized health policy evaluation ever undertaken,” Moore said. “We the researchers were involved in experimental design, and in charge of data collection and analysis at the other end. Mexican officials had no control over the results and we had full freedom to publish what we found.”

Residents in test areas were encouraged to enroll in Seguro Popular, and participating Mexican states received funds to upgrade medical facilities and improve access to health services, preventive care and medications. Follow-up surveys show the program is making a difference on its primary objective, documenting a 23 percent reduction in families experiencing catastrophic health expenditures.

According to Moore, “If money is put into a program targeting the poor to receive health insurance, and if that program is well structured, then the poor can actually see reductions in the amount they pay out of pocket for health care. That may seem obvious, but it’s not. Designing a program that’s targeted in a certain way may not mean that resources actually reach the people it’s intended to reach.”

In fact, the Lancet study identified areas where Seguro Popular needs improvement, showing it’s been slow in reaching some residents. Surprisingly, researchers found no measurable, first-year effect on medication spending, health outcomes or utilization of health services. The bottom line, Moore said, is that without objective empirical evaluations of new programs, it’s difficult to say whether funds are being spent effectively.

“This example of arms-length field experimentation and policy evaluation demonstrates how social science can contribute to bettering individuals’ lives,” said Moore. “A great deal can be gained when policymakers are willing to let science steer the evaluation process, when they’re willing to subject themselves to the possibility of being wrong. When they do that, not only is better public policy made in the long run, but we have a stronger case to make for successful policies in the short run.”

Moore is confident the Seguro Popular evaluation template could be used to guide healthcare reforms now contemplated by the Obama Administration. He points to the State Children’s Health Insurance Program, known as SCHIP, as an example of legislation that already incorporates incentives for states to experiment with funding and services. Some Medicare reform plans encourage experimentation as a way to answer questions about what works best, both on cost and quality of care.

If America wants to be ready to make large-scale changes in its health system, now is the time for small-scale testing. “If researchers are allowed to select these test areas — using scientifically and statistically valid methods -– we’ll be able to use experimental methods to do good science, to cut through the politics and get the answers we need,” Moore said. “We can get at truth using these randomized experiments.”

Filed under: Government, Health, Politics, , , , , , ,

Stressing out the banks

juliedavidow_stress01

One of the programs created under the TARP is the Capital Assistance Program (CAP).  The CAP was designed to promote confidence in the financial system by ensuring that the nation’s largest banks have sufficient capital cushion against larger than expected future losses.  A stress test, called the Supervisory Capital Assessment Program (SCAP),  was crafted and implemented by the Federal Reserve and the Treasury to aid them in assessing said capital cushion.  Details of the stress test were released to the public by the Federal Reserve on April 24th, through a 21-page white paper.  I present here a synopsis of the white paper.

All domestic bank holding companies (BHCs) with year-end 2008 assets exceeding $100 billion were required to participate in the SCAP.  According to ProPublica, 19 firms fell under this requirement.  They are listed in the second table below.  These 19 firms hold 66% of the assets and 50% of the loans in the US banking system.  They were asked to project their losses, and available resources for absorbing these losses, for 2009 and 2010 based on two economic scenarios — a baseline scenario and an adverse alternative.  The table below lists the components of the economic scenarios and the effect of the baseline and adverse conditions on each of them.  The supervisors, then, assessed whether their capital was adequate for them to function during this period.

fedeconomicscenariosfor2009_2010

Step 1: Loss Projections. BHCs were asked to project losses for 2009 and 2010 for 12 separate categories of loans held in the accrual book, for loans and securities held in the available-for-sale (AFS) and held-to-maturity (HTM) portfolios, and in some cases for positions held in the trading account.  The losses were to be consistent with the economic outlooks in the baseline and more adverse scenarios.  The BHCs were instructed to estimate forward-looking, undiscounted credit losses, that is, losses due to failure to pay obligations (“cash flow losses”) rather than discounts related to mark‐to‐market values.  The required assessments were broadly classified as:
19largestbanksbyassets20091

  • First and Second Lien Mortgages: institutions provided detailed descriptions of their residential mortgage portfolio risk characteristics – type of product, loan-to-value (LTV) ratio, FICO score, geography, level of documentation, year of origination, etc.
  • Credit Cards and Other Consumer Loans (e.g., auto, personal, student): portfolio information included FICO scores, payment rates, utilization rates, and geographic concentrations.
  • Commercial and Industrial Loans: based on the distribution of exposures by industry
  • Commercial Real Estate Loans: included loans for construction and land development, multi-family property, and non-farm non-residential projects.  Information such as property type, loan-to-value ratios, debt service coverage ratios, geography, and loan maturities was provided.
  • Other Loans: farmland lending, loans to depository institutions, loans to governments, etc.
  • Securities in AFS and HTM Portfolios: majority are public-sector securities such as Treasury securities, government agency securities, sovereign debt, and high-grade municipal securities. Private-sector securities include corporate bonds, equities, asset-backed securities, commercial mortgage-backed securities (CMBS), and non-agency residential mortgage-backed securities (RMBS).  Supervisors focused on evaluating the private-sector securities.  Loss estimates were based on an examination of 100,000 of these securities.  Loss estimate, and subsequent “write-down” to fair value, for each security was determined based on credit loss rates on the underlying assets, consistent with loss rates for unsecuritized loans listed above.
  • Trading Portfolio Losses: estimated by applying market stress factors to the firm’s trading portfolio based on actual market movements that occurred between June 30 and December 31, 2008.
  • Counterparty Credit Risk: the risk that an organization is unable to pay out on a credit-related contract when it is supposed to, which directly impacts a firm’s earnings and the value of its assets.  The action taken by the firm to account for this risk is referred to as credit valuation adjustment (CVA).  Supervisors focused specifically on a firm’s loss estimates for mark-to-market losses stemming from CVA associated with market shocks applied to assets in trading books.

Step 2: Resources to Absorb Losses. Institutions were also instructed to provide projections of resources available to absorb losses under the two economic scenarios.  These include the pre-provision net revenue (PPNR) and the allowance for loan losses over the two-year horizon.

  • PPNR is the income after non-credit-related expenses that would flow into the firms before they take provisions or other write-downs or losses.
  • BHCs supposedly had some allowance for loan and lease losses at the end of 2008.  They were required to estimate what portion of this allowance would be required to absorb potential future credit losses on their loan portfolio under each economic scenario.  This calculation could either result in depletion of the year-end 2008 reserves (if there is adequate allowance) or indicate the need for building the reserves (if the allowance is inadequate).

Step 3: Determination of Necessary Capital Buffer. Supervisors examined two main elements as indicators of capital adequacy – pro forma equity capital and Tier 1 capital.

  • Pro forma equity capital was estimated by rolling tax-adjusted net income (PPNR minus credit losses minus reserve builds) for the two-year horizon through equity capital.
  • Tier 1 capital is composed of common and non-common equity, with the dominant component being common stockholder’s equity.

The initial assessment of the capital adequacy, or lack thereof, was conveyed to the BHCs in late April and is expected to be released to the public on May 4th, 2009.  As yet it is uncertain whether the publicized results will reveal much about the banks.

Filed under: Business, Economy, Government, , , , ,

Understanding the PPIP

davidellis-flow1-07sOn March 23, 2009, the Treasury Department released details of the Public-Private Investment Program (PPIP), which is one of the programs under the TARP aimed at restoring financial stability.

The details of the program were complicated enough to elicit a standalone post.

The Problem. According to the Treasury, one of the problems plaguing the financial system is that of legacy assets – real estate loans held directly by the banks (“legacy loans”) and securities, or tradable financial instruments, backed by loan portfolios (“legacy securities”).  The true value of these assets has been brought to question. As a result, there is uncertainty surrounding the balance sheets of the institutions holding these assets.  Markets don’t like uncertainty as is evident from their performance, especially that of bank stocks, over the last 12 months.

Proposed Solution. The program’s intent is to repair the balance sheets of these institutions by moving the legacy assets off the hands of banking institutions and into the hands of investors.  Cleaner balance sheets could make it easier for banks to raise capital and increase their willingness to lend.

Principles of the Proposal. Treasury will use $75 – $100 billion in TARP money to become co-investors with the private sector, with backing provided by the FDIC and the Federal Reserve.  The “investment partnership” will, thus, be able to purchase $500 billion to $1 trillion of toxic mortgage assets (both residential and commercial) from banking institutions that currently carry them.

There are two separate approaches, one for legacy loans and the other for legacy securities.  Initially, Treasury will share its $75 – $100 billion equity stake equally between the two programs with the option of shifting the allocation towards the option with the greater promise of success with market participants.

  1. Legacy Loans Program: Suppose a bank has a pool of mortgages with $100 face value that it wants off its hands.  It approaches the FDIC, which determines whether it wants to leverage the pool at a 6-to1 debt-to-equity ratio.  If it decides to go ahead, the pool is auctioned by the FDIC.  Several private sector investors are hoped will bid.  The private sector bidder with the highest bid would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.  Let’s say the highest bid is $84.  Of this purchase price, the FDIC would guarantee $6 of every $7 in investment, or in this example, $72.  This is debt financing.  The remaining $12 is equity financing, which is shared equally by the private investor ($6) and the Treasury ($6).  The private investor would then manage the servicing of the pool of purchased assets.  The private investor and the Treasury would each be able to purchase $14 worth of assets for every $1 of their own money (14-to-1 leverage).
  2. Legacy Securities Program: Treasury will approve up to five fund managers for this program.  A fund manager, for example, submits a proposal and is pre-qualified to raise private capital.  The Treasury plans on being a joint-venture partner.  Let’s say a fund manager is able to raise $100 of private capital for the fund.  The Treasury will co-invest $100 in equity financing along side the private investor and will provide an additional loan of $100 (debt financing) to the “partnership” fund.  Additional requests for loans up to $100 will also be considered by the Treasury.  As a result, the fund manager has $300 – $400 in total capital for purchase of securities.  The fund manager has full discretion in investment decisions.  This program will be incorporated into the previously announced Term Asset-Backed Securities Loan Facility (TALF) whose original goal was to provide debt financing (non-recourse loans) to buyers of newly created consumer and small business loans.

The PPIP program has thus far met with lukewarm reception from the private sector, which is noteworthy given the necessity of their participation.  On a conference call to analysts and investors last Thursday, Jamie Dimon, the CEO of JP Morgan and, currently, the go-to guy for the US government on financial mergers/takeovers, said that they will not take part in the PPIP.  “We’re certainly not going to borrow from the federal government because we’ve learned our lesson about that,” said the Chief Executive.  Wells Fargo and US Bancorp are noncommittal.

It remains to be seen whether the Public-Private Investment Program will succeed in getting credit flowing again or further reveal corporate fear of business decisions driven a government that’s looking solely in the rearview mirror.

Filed under: Business, Economy, Government, , , ,

Take a look under that TARP

barsness_bigbluemountainIntimidated and confused by all the programs initiated by the government within the past 12 months?  Don’t beat yourself up.  We are in the majority.  Let’s try and shed some light on these programs and gain some understanding into the allocation of our taxpayer dollars.

On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (EESA) was signed into law amidst a tailspin in the financial markets.  The Troubled Assets Relief Program (TARP) was established under the EESA with the goal of stabilizing the financial system of the country and, hopefully, preventing a systemic collapse.  Under this law, the Treasury was granted authorization to spend up to $700 billion towards the purchase of troubled assets and the injection of capital into banking institutions.

The TARP has several programs under it:

  • Capital Assistance Program (CAP): to promote confidence in the financial system by ensuring that the nation’s largest banks have sufficient capital cushion against larger than expected future losses.  Financial institutions have to undergo a supervised stress test to be deemed eligible.  The stress test requires these institutions to make some assumptions. The banks would have to assume that the economy shrinks by 3.3 percent in 2009 and remains flat in 2010.  Assumptions will also have to include a decline in house prices by 22 percent this yearUnemployment should rise to 8.9 percent this year and reach 10.3 percent in 2010.  Big banks – those with consolidated assets greater than $100 billion – are required to carry out the test by the end of April.  If regulators assess that an institution does not have enough capital under these assumptions, they would have to raise the required capital either in the private markets or from the government.
  • Consumer and Business Lending Initiative (CBLI): a joint initiative with the Federal Reserve.  The goal of this program is to unfreeze consumer and business credit markets by providing financing to private investors willing to purchase assets backed by auto, student, small business, and credit card loans.  Under this plan the Federal Reserve will provide $200 billion in lending and the Treasury will support it with $20 billion in credit protection.
  • Making Home Affordable Program: an effort to stem the tide of foreclosures and declining home values through the employment of three initiatives:
    1. A refinance for 4 to 5 million people who took out loans owned or guaranteed by Freddie Mac and Fannie Mae
    2. A $75 billion loan modification program aimed at preventing foreclosures by targeting 3 to 4 million at-risk homeowners
    3. Support low mortgage rates by strengthening confidence in Fannie Mae and Freddie Mac through increased funding commitments to the two entities
  • Public-Private Investment Program (PPIP): to repair balance sheets throughout the financial system through the Legacy Loan Program and the Legacy Securities Program.  The loan program will facilitate the purchase of troubled loans from banks while the securities program will attempt to move the highly illiquid securities (such as mortgage-backed securities and collateralized debt obligations) off the balance sheets of banks and into the hands of investors.  The PPIP is conducted in conjunction with the FDIC and the Federal Reserve.  $75 to $100 billion in TARP capital is combined with private capital.  FDIC and the Federal Reserve will provide leverage for the private capital thereby increasing purchasing power to $500 billion-$1 trillion.  Remember how excessive leverage was our financial system’s undoing?  Looks like we’re going back to the same well in order to rescue the selfsame.  I may have to post another article just on the intricacies of the PPIP.
  • Capital Purchase Program (CPP): created in October 2008 to provide immediate capital to stabilize the financial and banking system, and to support the economy.  It is a voluntary program in which the US Government, through the Department of Treasury, invests in preferred equity securities issued by qualified financial institutions.  The goal is to invest up to $250 billion.  As of the April 10th report by the Treasury, $198.8 billion has been invested.
  • Asset Guarantee Program (AGP): under this program, Treasury will guarantee certain assets held by systemically significant financial institutions. Assets to be insured are selected by the Treasury and must have been originated before March 14, 2008.  In return for this assurance, the government collects a premium from the financial institution, the value of which is determined through actuarial analysis.  Citigroup seems to be the only institution so far to have qualified, and tapped into, this program or forced to do so.  It has received a guarantee on up to $5 billion of its assets to date.
  • Targeted Investment Program (TIP): the goal here is to stabilize the financial system by reducing the chance that one firm’s distress will threaten other financially sound businesses, institutions, and municipalities.  The program is implemented through investments in these unstable institutions.  Citigroup and Bank of America are the lucky ones chosen for this program, each receiving $20 billion through investments in preferred stock with warrants.
  • Automotive Industry Financing Program (AIFP): instituted to prevent a significant disruption of the American auto industry.  Most of the aid has been through the issue of loans, which have so far totaled $24.7 billion.  $5.5 billion has gone to Chrysler Holding and Chrysler Financial.  $19.2 billion has gone to General Motors and GMAC.  The notable exception is Ford Motor, which stayed away from government support and has taken this opportunity to separate itself from the other two.  New York Times has an article on how this company managed to stay independent.
  • Systemically Significant Failing Institution Program (SSFI): to prevent disruptions to financial markets from the failure of institutions that are critical to the functioning of the nation’s financial system.  This domain is reserved for those rarest of institutions – ones that made the worst business decisions of, at least, the past decade, and threaten to cut us all off at our knees.  The lone inhabitant of this realm is American International Group, Inc. or fondly referred to as AIG.  The taxpayers have used $40 billion from this program to prop up this company.  This is in addition to the ~$90 billion it has drawn from the credit-liquidity facility created for it by the Federal Reserve.

Now that you’ve taken a look under the TARP what impressions are you left with?

Filed under: Economy, Government, , , , , ,

Redefining the paradox of thrift

cycleschange41There is a story in The Scriptures about a man named Joseph, who had the gift of interpreting dreams.  One unfortunate event after another led him to the king’s prison where he had served for two years.  One night, Pharaoh, the king of Egypt, had two dreams both of which troubled him inordinately.  In one dream, seven healthy cows, standing by the river Nile, were devoured by seven sickly ones, which were none the better for it.  In the other dream, seven plump ears of grain were consumed by seven thin and blighted ones.

Of all the wise men in Pharaoh’s court, Joseph turned out to be the only one who could interpret the dreams.  He explained that both dreams referred to the same thing – two consecutive time periods, each seven years in duration.  The first seven years would be ones of plenty but they would be followed by seven years of hunger and famine.

Not only did Joseph have an interpretation, he also had a plan to address the inevitable downturn.  For the first seven years, the time of abundance, the Pharaoh was to collect 20% of the harvest throughout the land of Egypt and save them in storehouses.  These “savings” would be used to feed not just the people of Egypt, but also of neighboring lands who were going to be affected by the dearth during the subsequent seven years.

As the story goes, Joseph’s interpretation of the dream was accurate and the implementation of his strategy positioned Egypt to not only survive the famine but to provide for her neighbors.

I am reminded of this story every time I hear the phrase, “the paradox of thrift” in the media.  Paradox of thrift is also referred to as the “paradox of saving” and was presented by the economist, John Maynard Keynes.  According to this paradox, if everyone saves more during times of recession, then aggregate demand will fall resulting in reduced savings by the population as a whole because of decreased consumption and economic growth.

Here is an example of the paradox in microcosm.  When you save more now than you did last year (as a percentage of your income), you do so by reducing spending because the chances of one’s income rising in a recession are low.  One of the ways you reduce spending may involve cutting expenditure on dining out.  As a result, your local restaurant feels the pinch.  It responds to the altered environment by cutting pay for its employees, reducing work hours or laying some of them off.  Regardless of the nature of the restaurant’s response, the employees’ incomes are reduced.  They, in turn, spend less.  When taken in aggregate, this could lower economic growth as represented by Gross Domestic Product (GDP), because 70% of GDP is based on consumer spending.

Economists of the Keynesian vein believe that spending needs to come from somewhere to stimulate the economy during a recession.  If the consumer has decided to clamp down on spending, it’s the government’s responsibility to pick up the slack.  Herein lies the impetus for the American Recovery and Reinvestment Act of 2009.

I don’t dismiss the paradox outright as do economists that follow the Nobel Laureate, Milton Friedman.  However, the context seems to be turned on its head.  There are certain principles in the story that I recounted earlier that seem to have been abrogated by our society:

  • Always remembering that nothing continues in perpetuity i.e., there is a cycle or season to everything.
  • Times of recession follow periods of growth and vice versa.
  • Preparing for famine needs to be a part of living in abundance.
  • If you have prepared during good times, then you will be in a position to support your community during tough times.
  • If you are in a position to help others during the community’s or nation’s dearth, then you ought to do so.

To me, this is how the paradox should be played out during a recession.  The key is for us to act from a position of strength, not weakness.  A strong position would mean low or no debt and cash reserves sufficient not merely for ourselves but also to support others.  Unfortunately, most of us find ourselves in the contrasting position – that of minimal cash reserves and a mountain of debt.  Opportunities for investment, career advancement or change, societal impact, etc., are all presenting themselves, yet we feel impotent.

However, our story need not end there.  That is the beauty of cycles.  When one passes, another one arises.  What is required of us is a reaffirmation of the principles we once abrogated – to build towards a position of strength and then, operate from that position.

If you are operating from a position of weakness, don’t allow economists to guilt-trip you into spending under the guise of saving the rest of the population.  You can’t help anyone when you are withering.  If, however, you find yourself in a strong position these days, then use this opportunity to impact your community whether it be through investments, doing business with local establishments, or supporting your favorite charities.  Those of us who are not in your position will be inspired by you and aspire to join you in these efforts during the next cycle.

Filed under: Economy, Government, , , , , , ,

To the creditor go the spoils

spinning_into_debt_by_m0nk3y504Through my earlier post, “Do you know where your money is?”  you were made aware of the amount of federal debt our nation has accumulated ($10 trillion) and the alarming rate at which it is projected to grow over the next ten years (60%).  As you know, debt does not exist in a vacuum.  Every dollar of debt has to be financed by someone.  I can only get a mortgage if a creditor (bank, mortgage originator, etc.) is willing to  finance the desired amount.  Each dollar spent beyond my means has to be facilitated by a credit card company, a bank, a family member, etc.  The creditor or lender expects the borrowed amount (the principal) to be paid back with interest.  Such expectations are based on the creditor’s understanding of my credit worthiness or my ability to pay back the borrowed amount.   The creditor is taking a risk in lending me the money since there is always a possibility that I won’t be able to pay back.  This risk usually comes at a price for me and a reward for the lender.  The price/reward typically takes the form of interest.  Therefore, the more credit worthy I’m deemed, the lower the risk for the lender and lower the interest I’m charged (usually) for the benefit of credit.

Same is the case with the federal government.  The $10 trillion in debt has to be financed by someone1.  About $6 trillion of it is financed by the public and is referred to as public debt.  The public constitutes states, corporations, individuals, and foreign governments.  The rest (~$4 trillion) is in intragovernmental holdings, a vehicle by which the federal government borrows money from other governmental agencies.  The largest borrowing of this kind (56%) is from the Social Security Trust Fund.  I can see some eyebrows being raised as you read this.  However, the story gets even more interesting.

Public debt can be broadly classified as marketable and nonmarketable securities.  Marketable securities can be resold by whoever owns them.  These are made up of Treasury Bills, Treasury Notes, Treasury Bonds, and Treasury Inflation Protected Securities (TIPS).  Marketable securities represent 90% of public debt.  Nonmarketable securities cannot be resold and are primarily consisted of savings securities, special state and local government securities, and Government Account Series securities.

Majority of public debt (52%) is held by foreigners.  China is the largest of these creditors with $740 billion in US Treasury securities (as of January 2009).  The creditor always holds the upper hand in a relationship.  The more I owe someone, the more they are in a position to exert control over my decisions.  Such exhibition of control doesn’t always have to be overt.  Merely an unspoken threat will suffice.  China’s latest inferences to the quality of US credit is but one example of the poor ramifications of ever increasing federal debt in the hands of foreign governments.  Their negotiating leverage as a trading partner gains power with each passing year.

There is another issue to consider.  Additional debt will have to be issued in order to fund all the stimulus packages.  This debt will need financing from foreign creditors.  As I mentioned earlier, an entity’s credit worthiness plays a big part in the kind of financing deals it can garner.  Both Standard & Poor’s and Moody’s have raised concerns over the ability of the US to maintain its triple-A rating in the long run.  If the quality of US sovereign debt is in question, we may have to pay higher rates in interest to find enough buyers.  These buyers could also seek additional benefits, such as trade deals that are skewed in their favor, a bigger say in international policy, etc., in order to continue financing our debt.

So no matter what our government says about trying to exact trading concessions from partners like China, remember this – it’s the entity that holds the debt that always controls the board.

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1 GAO-08-168 Financial Audit: Bureau of the Public Debt’s Fiscal Years 2008 and 2007 Schedules of Federal Debt

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Use leverage to transform health care in the US

ailing_healthcare_by_frantzwahWe all understand to some extent that our health care system is in dire need of reform.  Do we know what its condition really is?  Allow me to paint a picture.

What is the current and projected state of health care in the US?

National Health Expenditure (NHE) is defined as the total health care spending in the United States.  According to Centers for Medicare & Medicaid Services (CMMS), which quantifies health spending on an annual basis, the NHE grew 6.1% to $2.2 trillion in 2007, or $7,421 per person.  In comparison, this cost was $75 billion or $356 per person in 1970.  Health care spending currently accounts for 16% of our Gross Domestic Product (GDP) and is projected to grow by an average of 6.2% per year between 2008 and 2018.  At that rate the NHE will have reached $4.5 trillion in ten years and account for 20% of our GDP.  Healthcare spending has exceeded overall economic growth (GDP) annually by an average of 2.5 percentage points since 1970.

80% of health care spending goes to hospital care (37%), physician and other professional services (29%), and drugs (14%).  Many doctors complain that the system is now turned on its head where more and more of each healthcare dollar goes to cover administrative costs associated with the first two categories than to pay professional fees.  The facilitator of the doctor-patient relationship has become the principal entity.  Meanwhile, the doctor-patient relationship is now there to support the facilitator.

Private health insurance and out-of-pocket payments accounted for the largest part of health spending (55%) in 2007.  Public programs like Medicare, Medicaid, etc., comprised 45% of NHE.  While worker’s earnings and overall inflation has increased ~30% since 1999, health insurance premiums have grown 119% during the same period.  This usually means that workers have to spend more of their income each year on health care to maintain coverage.  These effects may either be direct – through increased worker contributions for premiums or reduced benefits, or indirect – such as when employers forgo wage increases to offset increases in premiums.  I gather you’ll agree with me that neither of these options is ideal.

Due to the influence of the recession and the leading edge of the Baby Boom generation becoming eligible for Medicare, average annual spending growth by public payers is expected to outpace that of private payers.  As a result, CMMS projects that public programs will overtake private insurance and reach 51% of NHE by 2018.  Not only will it be necessary for us to allocate greater portions of our income to employer-covered insurance premiums and Medicare, there is no guarantee that it will be sufficient to bear the imminent burden on our health care system.

How can this problem be addressed?

Victor Fuchs, Professor of Economics and of Health Research and Policy at Stanford University, proposes tackling health care reform around four essential principles: coverage for the uninsured, cost control, coordinated care, and choice1.  According to him, any reform which does not cover these essentials is doomed to fail.  In addition, any reform plan that is not controversial is certain to be inconsequential.

Dr. Benjamin Carson has one such controversial and ambitious plan.  Dr. Carson, who has served in a medical advisory role for both President Clinton and President Bush, suggests the idea of a medical endowment where ten percent of the cost of health care be set aside annually in an endowment fund2.  The interest from the endowment would be used initially to cover health care expenses for the uninsured and underinsured, the first C of Prof. Fuchs principles.  He envisions growing the fund to such a size in 15-20 years that it can cover most of the country.  He has initiated a pilot program at Johns Hopkins Medicine.  The fund, called the Benevolent Endowment Network fund, will be started off in pediatric neurosurgery, expanded to all of neurosurgery with the hope of eventually covering the entire hospital.

On the corporate side, Wal-Mart is slowly positioning itself to be a force in health care through a controversial plan for tackling the second C – cost control.  I call it controversial because Wal-Mart tends to elicit a visceral reaction from many people, who view the company as “pure evil.”  I merely present the company as one of the potential forces necessary for true health care reform to be accomplished.  In September 2006, the company introduced $4 30-day prescription pricing for 291 generics in the Tampa Bay, FL area, which was available to the uninsured.  It has since expanded the program to 49 states covering 350 generics and 1000 over-the-counter medications.  Pricing now includes an option for a 90-day prescription for $10.  Several pharmacy chains, including Target and K-Mart, were forced to follow suit.  Anecdotal evidence from my pharmacist friends, who work for other chains, suggests anger at this move.  Meanwhile, many consumers applauded the move.

The company is now looking to shake up Pharmacy Benefits Management (PBM).  It announced a pilot with Caterpillar to provide 2500 prescription drugs to 70,000 of its employees, spouses, and retirees.  If successful, it is sure to try expanding the deal with other employers.  This, in turn, could help employers cut their costs related to prescription drug coverage.

The third leg in Wal-Mart’s stool is electronic medical records (EMR).  According to an article in the New York Times, Wal-Mart has decided to team its Sam’s Club division with Dell and eClinicalWorks to market hardware, software, installation,maintenance, and training to physicians’ offices.  They will be mainly targeting small physician groups where 75% of the nation’s physicians practice.  Another initiative in the works for Wal-Mart is telemedicine in collaboration with NuPhysicia, LLC.

Michael Porter, University Professor at Harvard Business School and Director of the Institute for Strategy and Competitiveness, has a plan for tackling the third and fourth C’s – coordinated care and choice.  He proposes a value-based health care delivery system where players strive to create value for patients rather than capturing more revenue, shifting costs, and restricting services.  The centerpiece of this strategy involves bundled reimbursement for an entire care cycle instead of individual services like doctor visits, MRI scan, radiologist consultation, biopsies, etc.  He provides examples of institutions such as The Cleveland Clinic and MD Anderson Cancer Center where disease-based integrated practice is bearing fruit.

Despite the various forces working to address the four C’s, one important issue that I see missing is that of preventive medicine.  I proffer this as the most important piece for the long term viability of any health care reform that’s implemented.  Most reform ideas center around the reduction of current health care burden which are all remedial in nature.  In fact, our entire nation’s health care focus seems to be on treating the disease.  Even the preventive measures mainly target regular screenings.  The assumption here is that some type of disease is inevitable; so let’s try to nip it in the bud through screenings.  What about the notion that many diseases may be prevented if we actively engage in a lifestyle that’s healthier this year than it was the last?  A friend of mine (hat tip CJC) made a statement recently which I believe to be true:

No health care reform or plan in the world can bear the burden of overweight and obesity and the complications that arise from it.”

According to the National Institutes of Health, two-thirds of us are overweight and one-third are obese.  Overweight and obesity are known risk factors for several diseases.  Certain diseases can trigger other complications and multiply the cost associated with treating them all.  For example, people with diabetes spent $190 billion for health care in 2004, nearly seven times the $28 billion they spent specifically to treat diabetes.  A sizeable portion of the total spending for these people went to the treatment of conditions that are common complications of diabetes3.  So leverage, in this case, works against us and multiplies the burden on the health care system.

However, leverage may be employed to our advantage, as well.  What if we take personal responsibility for our long term health through healthier eating and more physical activity?  We may be able to reduce conditions of overweight, and obesity and diseases like diabetes, heart attack, stroke and other related disorders.  As a result, we will find ourselves making fewer doctor visits outside our regular check-ups.  Fewer complimentary services are ordered by our primary physician.  All of this reduces the burden on our health care system.  Health care providers can, in turn, focus on patients with diseases that are out of their control and provide better value.  Meanwhile, consumers may be willing to apply some of the savings from their reduced insurance premiums to cover the uninsured and underinsured.  The four C’s have a better chance of success in providing coverage for all of us because less strain is put on by each of us.  And the best part: this leverage monetarily costs us next to nothing.

All it requires is one question and small steps to answer it: How can I live healthier this year than I did last year?

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1 Health Reform: Getting the Essentials Right by Victor R. Fuchs

2 The vision of the Benevolent Endowment Network fund by Dr. Ben Carson

3 Roehrig C., et al. National Health Spending by Medical Condition, 1995-2005.  Health Affairs.  Volume 28, Number 2 (2009): pp 358-367.

Filed under: Business, Economy, Government, Health, , , , , , , , , ,

Do you know where your money is?

paper_money_macroOn February 26th, President Obama laid out his administration’s budget proposal for 2010.  The entire document, with a great marketing title of “A New Era of Responsibility,” contains 112 pages of words and an additional 21 pages of tables.  Believe it or not, this is actually a summary of the detailed version that will be released in April.  Ironically this administration makes it no easier to understand how our government is spending our money.  In fact, the US Government Accountability Office has complained about this ambiguity in budget proposals for the past twelve years.  I point this out to you because we should not confuse strategy with ineptitude.  I would probably employ ambiguity as well, if I were they.  In the chapter, “On Military Strategy,” the Huainanzi has this to say about the use of ambiguity:

“It is important that strategy be unfathomable, that form be concealed, and that movements be unexpected, so that preparedness against them is impossible.  What enables a good general to win without fail is always having unfathomable wisdom and a modus operandi that leaves no tracks.”

Unless someone knows clearly what you are up to, they cannot hold you accountable.  When it comes to the democratic process, an uninformed electorate is one that can be easily swayed.  Rhetoric is a politician’s friend, whereas clearly delineated items in a financial statement are not.  This is not to say that financial statements are immune to manipulation but the task is more cumbersome than the spin of a wordsmith.

I looked around the web to see if anyone had succinctly presented all the information contained in the budget proposal.  I could not find any that were comprehensive enough.  So I decided to undertake the task.  My goal was to distill everything down to two or three tables which can be understood by anyone within a few minutes.  I must confess that this task took me days to reasonably connect the dots.

The federal fiscal year starts on October 1st and runs through September 30th of the following year.  The budget has a spending side (outlays) and a tax revenue side (receipts).  There are two basic categories of spending: mandatory and discretionary.  Mandatory spending contains entitlement programs, such as Social Security and Medicare, which are provided by law.  This accounts for approximately 60% of annual outlays.  Discretionary spending is appropriated annually by Congress and can be split into defense and non-defense spending.  Defense spending typically absorbs 50-60% of the discretionary outlays.

Table 1 itemizes federal outlays by governmental agencies.  obamabudgetoutlays2009Click on the table to see it in detail.  The agencies are listed in decreasing order of the amount allocated to them annually.  Federal spending is projected to be $3.9 trillion in 2009, an increase of ~$1 trillion from 2008.  $497 billion of it is allocated to the Treasury Department for the Troubled Asset Relief Program (TARP) and a placeholder for potential financial stabilization.  Even after the one-time allocation to the Treasury expires, federal outlays only settle to the ~$3.6 trillion level for the remainder of President Obama’s current term.  The slack is going to be picked up by mandatory spending for the departments of Health and Human Services, Social Security Administration, and “Other Mandatory Programs,” which are conveniently not listed.  The Department of Defense will see spending levels drop from ~$700 billion (including the cost of Iraq and Afghanistan war) to $670 billion in 2010, a decrease of less than 1% of total federal spending.

Actual spending amounts for “Other Mandatory Programs” are not listed anywhere.  obamabudgetmandatory2009The best I could do was look at the contribution of mandatory spending by various agencies to the budget deficit.  Table 2 lists these contributions.  This is an example of the ambiguity that I am referring to.  You’ll notice several agencies with “No Significant Change.”  From a strategy perspective, this looks much better than listing the actual amounts of spending.  Spending cuts can be made to look rather large when actual spending amounts are not given.  For example, a $500 million spending cut seems large but is insignificant if the reduction comes from an agency that sees $500 billion in annual spending (0.1% spending cut).  The biggest contributor to the increase in 2009 deficit, from the mandatory spending category, is the Department of Treasury.  Notice how convoluted this statement sounds.  Ambiguity.  The less we know, the fewer questions we ask.

$250 billion is allocated to the Treasury in 2009 as a placeholder for the potential stabilization of financial markets.  The Department of Education will see some changes, as well.  Pell grants will be converted from the discretionary category to the mandatory.  Entitlements for financial intermediaries under the Family Federal Education Loan Program will be eliminated.

Health reform initiatives will begin in 2011 and be ramped up during the President’s second term (2013-2016).  During this period savings will be wrung to the tune of $75 billion annually through Health Savings and limiting tax liability from itemized deductions to 28 percent.

Table 3 summarizes the Federal Budget and compares it with the last two obamabudgetsummary2009years of the previous administration.  The revenue side of the budget (receipts) comes mainly from taxes of various forms.  Individual income taxes (45%), Social Insurance taxes like Social Security and Medicare (36%), and Corporate taxes (12%) contribute the bulk of receipts.  They are estimated to decrease this year and the next primarily due to job losses and shrinking of corporate profits.  Couple that with increased federal spending and deficits are projected to increase almost four fold to $1.7 trillion in 2009 and settle around $600 billion by 2012.  Even more shocking are the numbers associated with our federal debt, which is projected to increase by 60% from $10 trillion in 2008 to $16 trillion in 2012.

If I told you that my personal financial plan over the next four years is to live increasing below my means (greater deficits) and increasing my debt by 60% would you consider this era of mine as being responsible?  If a publicly traded corporation told you that it is going to be losing money on its operations at a greater rate and increasing its debt load by 60% over the next four years, would you consider this management to be responsible and the company to be a highly attractive investment?  Yet our government considers this to be “A New Era of Responsibility.”

My advise to you would be to pay NO ATTENTION to the words.  Follow the numbers instead and let them narrate the true story.  At least you will be in a position to decide whether you like the story or not.

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