Felix Salmon

Sam Mamudi has found a new way to slice mutual-fund data, and the results are very interesting: the flows aren’t just from domestic funds to international funds, as we can see from the monthly ICI data, but also from actively-managed mutual funds to index funds.

Since the end of 2005, actively run U.S. stock funds have seen net outflows every year, totaling $369 billion, while indexed counterparts — not including exchange-traded funds — have seen net inflows of $112 billion, according to fund-industry trade group the Investment Company Institute.

I went one further, and had a look at the ICI’s data on ETF flows. After all, to a first approximation, all ETFs are index funds rather than actively-managed.

Here’s how the numbers break down: total actively-managed mutual funds, both domestic and international, saw a net outflow of $37.7 billion in 2009, and of $24.1 billion in the first seven months of 2010. Meanwhile, passively-managed index funds saw a net inflow of $22.9 billion in 2009, and of $22.4 billion in 2010 so far. But get this: equity ETFs saw net inflows of $69.3 billion in 2009, and another $21.4 billion in 2010 to date.

Those numbers aren’t publicized by the ICI: I had to calculate them using their spreadsheet of monthly ETF data. But if you add it all together, there was a net inflow into equities of $60.5 billion in 2009, and another net inflow of $19.8 billion in the first seven months of 2010. People aren’t pulling their money out of the stock market, they’re just pulling their money out of actively-manged mutual funds in general, and actively-managed domestic mutual funds in particular.

If you look at growth rates, the numbers are even starker. Actively-managed domestic mutual funds saw an outflow of $44 billion in the first seven months of 2010, which was 1.45% of their total value. Equity ETFs, by contrast, saw an inflow of $21.4 billion, which was 3.12% of their total value. If you go back to 2009, the numbers are -2.07% and +10.78%, respectively. Yes, in 2009, the net inflow into equity ETFs (I’m not even including bond or commodity ETFs, here) was greater than 10% of their entire year-end value. Mutual funds, it’s fair to say, never see those kind of net inflows.

This shift is only just beginning. There’s more than $3 trillion invested in actively-managed domestic mutual funds, compared to just over $1 trillion in domestic index funds and domestic equity ETFs combined. On the international side, there’s $1.2 trillion in actively-managed mutual funds, compared to $218 billion in international ETFs, and just $97 billion in international indexed mutual funds.

So in terms of long-term investments, people are still massively overweight actively-managed strategies. But they’re sensibly rotating out of those funds, and into passive ETFs. As that trend continues, and I see no indication of it slowing down at all, one can only expect that correlations between different stocks will continue to rise. And as correlations rise, of course, it becomes increasingly difficult to justify an active strategy.

ICI chief economist Brian Reid says that “considering historical investor patterns for the last 20 years, we are currently seeing weaker investor demand for domestic equity mutual funds than those patterns would lead us to expect.” Too right we are. And there ain’t gonna be no mean-reversion, either. That $3 trillion is going to end up reallocated, sooner or later. And if your business model is based on managing domestic mutual funds and getting a steady flow of new investments, you’re not going to find life easy going forwards.

I wonder whether Chantal Martineau stopped to think about her timing, as she wrote her piece for the Atlantic on a movement pushing for the ability to copyright cocktails. Intellectual-property protection isn’t getting great press this week, as Paul Allen has turned overnight into one of the world’s most gruesome patent trolls.

But ever since the seven-year-old sitting next to you in elementary school put his arm around his paper to stop you from copying his work, humans have felt very protective of their ideas, and very angry at anybody who they think might be copying them. As a result, mixologists are now joining fashion designers in looking for copyright protection for their inventions.

It’s all very silly, not least because the last thing the world needs is bartenders suing each other over copying cocktails. Even Susan Scafidi, the person mostly responsible for pushing the ability to copyright fashion design, realizes that copyright is a pretty narrow and limited protection, and that we shouldn’t try to apply it willy-nilly to anything remotely creative. Here’s what she told me back in 2007, telling critics to look at “legal and social realities”:

Furniture is protected by design patents (overall shape), copyright (surface designs), and trademark — not to mention utility patents (innovative useful elements). One lawyer who represents a number of furniture clients described the process of protecting their designs to me as “triage,” identifying what needs to be protected and sending it to the appropriate government office. Cuisine has a small amount of protection from copyright (recipe collections), and much more from the social norms against copying among creative chefs, particularly when it comes to signature dishes. Since my father is a serious amateur magician (and I confess to having performed a bit myself years ago), magic tricks are my favorite inapposite example. Not only is the literature copyrighted, but many effects are deliberately kept secret by magicians, and unlike fashion can’t be torn apart at the seams by interlopers …

Every industry is unique, and most copyright protection is one-size-fits-all.

Cocktails are clearly closer to recipes — in fact they are recipes — than they are to the kind of things which are normally copyrighted, like books. What’s more, they don’t scale. Fashion designers can sell the same design at many shops and to many different customers around the world, just as publishers can sell the same book through thousands of different outlets. But a bartender can only make cocktails one at a time, and there’s no way that I’m depriving a bartender in DC of any revenue if I order one of her cocktails from a bar in New York. As a result, anybody trying to prove damages is going to face an uphill task.

The fact is that the current cocktail renaissance is coming about because, rather than despite, the fact that cocktail recipes are easily shared and remixed, and because the rise of blogs is making doing so easier than ever, helping drive a surge in demand for well-made, well-mixed drinks.

Mixologists like Eben Freeman who want copyright protection seem to me a bit like the small neighborhood coffee shops who got scared when a Starbucks opened up across the street — only to find that demand for their own good coffee went up, rather than down, as a result. The more people copy your cocktail, the more demand there will be for your cocktail, and the happier everybody will be. Embrace it, don’t fight it.

Ricardo Caballero has an interesting idea:

The economy is barely muddling through. While some of this is unavoidable given the magnitude of the financial shock that is slowly working its way out of the system, macro-policy still has an important role to play in preventing a relapse. Unfortunately, the Federal Reserve has the resources but not the instruments, while the US Treasury has the policy instruments but not the resources. It stands to reason that what we need is a transfer from the Fed to the Treasury.

Caballero doesn’t give an indication of how big this transfer should be. But presumably he thinks the transfer should be substantially larger than the sums that the Fed is already remitting to Treasury.

And remittances are pretty large, and they’ve been growing sharply since the Fed started expanding its balance sheet. Remittances from the Fed to Treasury ranged from $19 billion to $34 billion between fiscal 2000 and fiscal 2008. In fiscal 2009, they were $34 billion — that’s the amount of money the Fed sent to Treasury between October 2008 and November 2009, about $2.8 billion a month. But if you look at calendar 2009, the Fed ended up remitting $46 billion to Treasury — that’s a rate of $3.8 billion a month. And in fiscal 2010, the CBO projects that total remittances will reach a whopping $77 billion — that’s $6.4 billion a month.

(The historical CBO data comes from this CBO report; the projections come from this one.)

The CBO, back in January, took the Fed at its word and projected that remittances would start falling after fiscal 2010, to $74 billion in fiscal 2011, $52 billion in fiscal 2012, and a low point of $41 billion in fiscal 2013 before they started rising again. But remittances are largely a function of the size of the Fed’s balance sheet, and given that the Fed is dipping back into its QE arsenal, the chances are they’ll be higher than that in actuality.

Put it all together, and the present value of the Fed’s remittances to Treasury is surely well over $1 trillion. I’m sure there’s some way that the Fed could front-load its remittances, paying out a few hundred billion dollars now, and paying less in future. That way Treasury wouldn’t need to “commit to transfer resources back to the Fed once the economy returns to full employment”, as Caballero suggests — it would just get lower remittances going forwards.

Treasury would still need to spend that money, though, and I do wonder whether it might need some kind of Congressional approval to do so. Anybody care to weigh in on the constitutional implications of this idea?

On Friday, Dan Loeb released his second-quarter investor letter, which was immediately published by Dealbreaker. It’s a very political document, kicking off with a full page of quotations from various presidents (and, for some reason, Chinese general Liu Yazhou). It’s easy to see why Andrew Ross Sorkin uses it as the jumping-off point for his column today, headlined “Why Wall St Is Deserting Obama.” And as ever, the column is reposted at Sorkin’s Dealbook blog.

Now Sorkin and Dealbook are the exemplars, at the NYT, when it comes to the journalistic virtue of putting primary documents online. Their Scribd account has over 100,000 subscribers and has had over 2 million visits; it’s much more active than the parallel documents.nytimes.com format used by much of the rest of the paper.

But anybody reading Sorkin’s column today simply has to take him at his word when he says that Loeb’s letter “sounded as if he were preparing to join Glenn Beck in Washington over the weekend.”

If I wanted, I could paint I different picture of the letter. I could point out that there are no fewer than three quotes from Barack Obama on its first page, talking about the importance of helping others and spreading wealth across the whole American population. I could note that Loeb is just as harsh on capitalists as he is on the government.

Many people see the collapse of the sub-prime markets, along with the failure and subsequent rescue of many banks, as failures of capitalism rather than a result of a vile stew of inept management, unaccountable boards of directors, and overmatched regulators not just asleep, but comatose, at the proverbial switch.

And he also sees new government rules being helpful on this front:

Many of the boards we have come across are populated by individuals who rely on the stipends they receive from numerous corporate boards and thus appear motivated primarily to ensure continuing board fees, first-class air travel and accommodations, and a steady diet of free corned beef sandwiches until they reach their mandatory retirement age. We are therefore encouraged by the recently finalized proxy rules, which will ease the nomination and election of directors by shareholders.

He’s even pulling with the government when it comes to cracking down on sleazy for-profit colleges:

Our perspective on the government’s increased willingness to use its regulatory muscle enhanced our short positions in the for-profit education space. Indeed, this summer certain government actions taken regarding these companies served to accelerate the unfolding of our thesis on these names.

So, who has the more accurate view of Loeb’s letter, me or Sorkin? The answer is Sorkin: I’ve been quoting very selectively. But in one crucial respect I’m being much more open and transparent about the letter than he is: I’m linking to it. He’s not.

There’s no legal or journalistic reason why Sorkin shouldn’t link prominently to the letter. When I spoke to Richard Samson, the NYT’s top lawyer on such matters, he was clear that although there are copyright reasons why the NYT might not post the letter itself, there’s absolutely nothing to stop the paper from linking to where the letter is posted elsewhere. And in general, Sorkin’s Dealbook blog is pretty good when it comes to external links.

I see a few possible reasons why Sorkin might not link to the letter, none of them good.

First, he might be moving Dealbook away from the blog concept (and it was always more of an email newsletter than a blog to begin with) to something much more self-contained. Dealbook has been hiring aggressively, and is clearly setting itself up in opposition to, and in competition with, other online sources of financial news. Maybe that makes Sorkin more hesitant to link out than he was in the past.

Alternatively, maybe Sorkin is happy to link out in theory, but he has problems linking specifically to the relatively juvenile and tabloid Dealbreaker. I don’t think that’s true: Dealbook does link to Deabreaker on a semi-regular basis.

There’s a couple of other possibilities, too, which are more worrying. Perhaps Sorkin got the letter directly from Loeb himself, on the condition that he not publish it, and he felt that linking to it would violate the spirit of that agreement. Or maybe there was no formal agreement at all, but Sorkin just felt that linking to the letter would annoy Loeb, and therefore decided not to do so in order to help maintain his relations with a source.

Or maybe it was just an oversight, further evidence that linking to primary sources simply isn’t very important at the NYT.

My hope, as Dealbook beefs up, is that it’s going to become more, rather than less, bloggish — that it’s going to spend as much effort on aggregating and curating news and information from around the web as it is on breaking that news itself. Indeed, one would expect Dealbook to have linked to Loeb’s letter before Sorkin’s column appeared.

Of course, the coming NYT paywall is going to make such bloggishness difficult, but difficult need not mean impossible. Let’s hope Sorkin hasn’t given up on many of the possibilities of the online medium before he’s even really got going.

An Impressive New Feature Makes Gmail’s Inbox Smarter — GigaOm

Wherein a billionaire does enormous real-estate deals without having a clue what he’s doing — Curbed

Susanne Craig leaving WSJ for the NYT — CJR

My lesson from reading Amy Wallace on libel suits: make sure that, unlike Simon Singh, you’re US-based — Reporting on Health

The number of vacant houses in the U.S. is now roughly 2x the entire Canadian housing stock — Kedrosky

Very excited about the MFAA’s upcoming El Anatsui show, in its shiny new space — MFAA

For the first time since at least 1997, less than 29% of stock ratings worldwide are “buys” — Bloomberg

“The majority of students committed to earlier deadlines, resulting in higher grades” — Ariely

The “efficient relationship paradox”: a company’s current customers experience its worst service — TNY

55% employees say workers wearing casual attire are more productive. But 64% say managers should dress up — Plan Sponsor

Federal Taxation of Labour Income in Canada is Regressive: A truly excellent blog post — Worthwhile Canadian Initiative

A Question for the Kansas City Fed — Economist’s View

“One-bedrooms, which measure about 1,000 square feet, will cost $10,000 a month” — NYT

44% would pick being richer, 21% thinner, 14% smarter, 12% younger. 9% would stay the same — NYP

I haven’t laughed so much reading a blog entry in ages — Language Log

Never mind the stimulus vs austerity debate: here’s something that both sides should be able to get behind. It’s a simple legislative fix which increases tax revenues without raising taxes; which increases the demand for housing; which increases the economy’s productive capacity; and which boosts wages for American workers. It’s about as Pareto-optimal as legislation gets. So let’s open the borders, and encourage much more immigration into the US!

The SF Fed’s Giovanni Peri has the latest research on the subject:

Statistical analysis of state-level data shows that immigrants expand the economy’s productive capacity by stimulating investment and promoting specialization. This produces efficiency gains and boosts income per worker. At the same time, evidence is scant that immigrants diminish the employment opportunities of U.S.-born workers.

The effects of immigration on US wages are large, positive, and significant:

Over the long run, a net inflow of immigrants equal to 1% of employment increases income per worker by 0.6% to 0.9%. This implies that total immigration to the United States from 1990 to 2007 was associated with a 6.6% to 9.9% increase in real income per worker. That equals an increase of about $5,100 in the yearly income of the average U.S. worker in constant 2005 dollars. Such a gain equals 20% to 25% of the total real increase in average yearly income per worker registered in the United States between 1990 and 2007.

It’ll be interesting to see how much debate this paper receives. Anti-immigration forces are more likely to ignore it than attack it, I think, if they don’t like what it says. And George Borjas seems to have stopped blogging over a year ago, which is a shame, because he would be the perfect foil for Peri.

Is there any chance of significantly liberalizing America’s immigration regime? I doubt it, not while unemployment is over 9%. No matter how convinced economists are that immigration creates jobs, voters aren’t going to believe them. And so politicians aren’t going to vote for it. Talk about ignoring the low-hanging fruit.

Update: Cardiff Garcia provides background here.

Everybody knows that the biggest winners from default and foreclosure are always the lawyers. But did you know that default fees on foreclosed properties alone are now being racked up at a rate of $2 billion a year? That’s the kind of money which attracts a lot of interest:

In the past five years, many of the default industry’s largest law firms have leveraged their mushrooming volume — courtesy of their status with the GSEs — into private equity investments, not to mention a large cash payday for their firm’s partners. Unlike many other areas of law, foreclosure processing typically involves a significant amount of paper pushing, and many law firms have set up operating subsidiaries to their legal operations to manage this aspect of their businesses. It’s these paper-pushing subsidiaries that have been purchased by private equity and hedge fund investors in recent years, looking to find a profitable investment during the economic downturn.

The interesting thing about this market is that it has sprung up in the shadow of Fannie and Freddie, which are being very strict about what is and isn’t allowed in this market:

Beyond determining the legal fee schedule for much of the multi-billion dollar default services market, the GSEs also largely determine who gets their own foreclosure work. Both Fannie and Freddie maintain networks of law firms called “designated counsel” or “approved counsel” in key states marked with significant foreclosure volume — and they either strongly suggest or require that any servicers managing a Fannie or Freddie loan in foreclosure refer any needed legal work to their approved legal counsel.

Each state will have numerous designated counsel — sometimes as many as five law firms — but in practice, attorneys say, two to three firms end up with the lion’s share of each state’s foreclosure work. In states hit hard by the housing downturn and foreclosure surge, like Florida, the amount of work can be substantial…

Freddie Mac sent out a memorandum last week to its designated counsel stating that its law firms could not agree to a blanket cut in foreclosure and bankruptcy fees involving Freddie Mac loans without the GSE’s approval first…

“It won’t be long until we have a federally-regulated foreclosure industry, where Congress sets allowable fees,” opined one of the attorneys I spoke with.

I can see the attraction, from Frannie’s point of view, of keeping the foreclosure business in a small number of foreclosure mills which behave in a predictable and affordable manner. If they’re going to do that, however, they should have strict oversight over those law firms, some of which look very sleazy indeed. Federal regulation, in this context, doesn’t look like such a bad thing at all. Because you can be quite sure that those private equity and hedge fund investors have no particular interest in being scrupulously fair when foreclosing on a delinquent borrower.

The apple, it seems, doesn’t fall far from the tree:

Litton Loan Servicing received more consumer complaints than any other loan servicer in the three years through June 2010, according to the Better Business Bureau. The 794 complaints against Goldman Sachs’ Litton led Morgan Stanley’s Saxon Mortgage at 631 complaints, American Home Mortgage at 597, Ocwen at 521 and Barclay’s HomEq at 161. The BBB gave Chase, Litton and Ocwen “F” grades due to the volume of complaints filed, their failure to respond and the seriousness of many complaints. Facing a BBB investigation in 2005 prompted by excessive complaints, the BBB voted to revoke Litton’s membership, but Litton promptly resigned. “They were arrogant,” said Dan Parsons, president of the BBB’s Houston chapter. “It was all about how much money they could make.”

I’m sure that Goldman has often regretted buying Litton, but I also get the feeling that it’s kind of their painting in the attic — the place where the dark Goldman id gets its fullest and most honest expression. Lloyd Blankfein was famously passed over for a job at Goldman before getting a job as a commodities trader at its J Aron subsidiary and rising stratospherically through the ranks; I wonder whether some dark genius at Litton will similarly manage to vault up to become senior Goldman management. After all, subprime mortgage servicing is just about the only part of the financial markets which is even more arrogant than commodities trading.

Mark Gimein uncovers some statistical legerdemain at the Harlem Village Academies, a pair of middle schools in New York. Let’s see how good you are at middle school math, by seeing whether you can answer this question correctly.

A middle school runs from 5th grade to 8th grade. In the 2006-7 year, it had 66 students in its fifth-grade class. In the 2009-10 year, 100% of its eighth-graders were proficient in math. If all the eighth-graders who passed their math test were members of the fifth grade in 2006-7, how many eighth-graders passed their math test this year?

If you said 66, you get an F. If you said “I don’t know, probably a few of those fifth-graders moved away, maybe 60?” you get a D. If you said 19, you get an A.

Of course, the public announcements from the Academies are all about that 100% math-proficiency rate, and make no mention of the fact that clearly you’re only allowed to even enter eighth grade in the first place if you’re going to pass that test.

Gimein puts his finger on the broader syndrome:

Steve Koss, a former math teacher at Manhattan’s Lab School, paints the city’s relationship with stats as an example of Campbell’s Law at work. Named for sociologist Donald T. Campbell, the precept holds, essentially, that the more that numbers are used for political purposes, the more they will be manipulated—and distort the decisions they were supposed to inform.

So whenever you see a politician citing some datapoint you never much heard about before, be very suspicious. And the same goes double when money’s on the line: if inflation-linked or GDP-linked bonds ever become a large part of a government’s liabilities, expect shenanigans surrounding the official inflation and GDP figures. Statistics can be useful, but only if nobody much cares about them. In that sense, they’re a bit like headline corporate earnings.

Since I’m interested in the value of a guaranteed real income, this sentence jumped out at me from Arnold Schwarzenegger’s recent WSJ op-ed:

Few Californians in the private sector have $1 million in savings, but that’s effectively the retirement account they guarantee to public employees who opt to retire at age 55 and are entitled to a monthly, inflation-protected check of $3,000 for the rest of their lives.

The problem is, I can’t make the math work. You can argue until you’re blue in the face about proper discount rates, but at the very least any pension plan should be able to invest its money to keep up with inflation. But let’s see what happens with a 0% real discount rate, not least because it makes the math easier.

California’s life expectancy is 77.9 years, so let’s say the average retiree lives for 23 years after retiring at 55*. If they earn $36,000 a year in real terms for 23 years, that sums to $828,000. And the minute you start assuming even the most modest of real investment returns, the less realistic Schwarzenegger’s number becomes: if you invest $1,000,000 at a 5% yield while paying out $3,000 a month with 2% annual inflation, that’ll support payments for 682 months, or about 57 years, taking our hypothetical retiree to the plump old age of 112.

To put it another way, I’m sure that any life insurer in the world would happily take Schwarzenegger’s bargain and accept $1 million of public funds in return for the obligation to pay a 55-year-old California retiree $3,000 a month, in real terms, for life.

The rest of the op-ed is misleading, too: see Paul Kedrosky’s elegant fisking of Schwarzenegger’s chart. But as ever in California, political rhetoric always tends to trump economic reality. California’s finances are indeed pretty gruesome, and it’s true that the state has been making pension promises it can’t afford for decades. But given how bad reality is, there’s no need to exaggerate it for the sake of politics.

Update: Many thanks to all my commenters. First, as many of them pointed out, life expectancy at age 55 is actually somewhere in the 25-28 year range, not 23 years. And especially thanks to DanHess, who actually found a private-sector quote:

I got some quotes for how much a million dollars will buy for a fifty-five year old in terms of a fixed annuity starting presently and going for life. They were generally in the range of about $5000 per month, some a bit more, some a bit less.

I just got off the phone with the Vanguard annuity sales department, where I was told that for a 55-year-old, inflation adjustment knocks off approximately 30% to 35% off the payout of the annuity.

$5,000 minus 1/3 for inflation adjustment brings you down to around $3330 per month. But I’m not convinced that the inflation adjustment should be so expensive these days, given that any life insurer should be able to hedge the inflation risk very cheaply right now.

Finally, there’s the question of survivor benefits, which I admit I hadn’t considered. I don’t know exactly how California pensions work, but if they essentially end up being paid until both of two spouses have died, rather than until the recipient has died, then that obviously increases their value significantly.

Joe Nocera addresses the question of who might buy houses to rent them out:

It’s even become nearly impossible for well-heeled investors to buy rental properties. This is no small matter. At the peak of the bubble, the rate of homeownership approached 70 percent. Now it is falling toward 65 percent — which is more or less where it was before all the housing madness of the last decade. That means that millions of Americans who were briefly homeowners need to become renters again. They need a place to rent.

But somebody has to buy the homes they are leaving behind and turn them into rental properties. The most likely buyer is a professional investor who purchases rental properties for a living. Yet, absurdly, government rules have made it exceedingly difficult to make loans to investors who want to buy up rental properties. This only adds to the shadow inventory.

I wish the online version of his column had a hyperlink in there somewhere, so that I could work out what government rules he’s talking about. As far as I can tell, the most recent change to government rules took place in February 2009, when Fannie Mae amended its rules on loans to investors. The changes made it easier for professional and semi-professional investors to buy houses, but a bit harder for someone wanting to get their toe in the door; they were understood at the time to be an easing of Fannie Mae policy.

The new rules allowed investors to have Fannie-backed mortgages on up to ten different mortgages; the previous maximum was four. At the same time, however, Fannie Mae closed a few loopholes which allowed people buying an investment home to have liquid reserves of less than six months’ worth of payments on the new home. And the definition of what was considered to be a monthly payment, for such purposes, was expanded beyond just mortgage costs and taxes to include things like ground rent and owners’ association dues.

This seems like sensible underwriting to me. The days of lending only against home values are long gone; we have to move back to a world where lenders look at borrowers’ wealth and income too.

That said, it’s worth remembering, in this context, that mortgages in most of the US are, to all intents and purposes, non-recourse. Some states, including California, have no-recourse laws, while in others it’s simply vanishingly rare for a mortgage lender to go after a borrower personally for funds they haven’t been repaid. And I’d assume that individual landlords lie somewhere between homeowners and businesses on the spectrum of how likely they are to simply return a property to the bank if it falls into negative equity.

As a result, even Nocera’s “well-heeled investors” can be bad credits, if they don’t put down a substantial downpayment which gives them real skin in the game. Does that make it “nearly impossible” for them to buy rental properties? Maybe it does, if they don’t want a lot of equity. In which case it might be worth trying to construct a parallel mortgage system which gives bank a bit more recourse than they have at the moment, at least for investment properties.

Nocera’s bigger point stands, though: it’s in everybody’s interest for landlords to be able to buy up properties without silly obstacles being thrown in their way. If such obstacles exist, let’s try to find a way to remove them.

Just after I went on holiday in July, the Boston Fed released a 57-page paper quantifying the subsidy from poor to rich that is the result of credit-card interchange fees. It was picked up by the likes of the NYT and the WSJ, and now Tim Chen, the CEO of NerdWallet, has decided to push back on the findings.

The numbers in the Boston Fed paper, says Chen, don’t pass the smell test:

The popular press had a field day with the idea that card-using households are earning $1,482 annually from cash users. But if we assume that the reward rate is 0.75% on rewards credit cards, as they mention on page 15, then the average card-carrying American has to spend $197,600 on credit card purchases each year. Even if we assume that card users receive the full 2% merchant fee, which is ridiculous, we’re talking about $74,100 in credit card spending. Keep in mind that this isn’t the number for “rich” card-carrying Americans; this is the average, and it doesn’t include any cash that these households might be spending, so something smells fishy.

This does a really good job of misrepresenting the Boston Fed paper. For one thing, the rich don’t just spend more money on credit cards, they spend more cash, too. So a lot of the cross-subsidy on this axis takes place from Americans to themselves: they take the money they overspend when they pay in cash, and get it back in terms of credit card rewards when they pay with plastic. The real cross-subsidy takes place between rich and poor:

On average, and after accounting for rewards paid to households by banks, when all households are divided into two income groups, each low-income household pays $9 to high-income households and each high-income household receives $434 from low-income households every year. The magnitude of this transfer is even greater when household income is divided into seven categories: on average, the lowest-income household (< $20,000 annually) pays a transfer of $23 and the highest-income household (≥ $150,000 annually) receives a subsidy of $756 every year.

Still, Chen’s calculation is mathematically correct: even if they’re getting the subsidy from themselves, card-using households are still getting a gross benefit of $1,482 per year, on average. That number seems high, and it’s derived from the same data used to generate the poor-to-rich cross-subsidy data. So is Chen right? Is the data flawed?

In fact, the paper says, on page 8, that the average household spends $1,190 a month on credit cards — that’s $14,280 a year. How can that level of expenditure generate such benefits of $1,482 a year? The answer is that the $1,482 number has nothing to do with the amount of money that credit-card users spend on credit cards, and it emphatically is not, as Chen implies, an estimate of the total value that card-users get back in the form of rewards: that’s just one part of the total calculation.

The real reason why the $1,482 figure is so large is that credit-card transactions account for only 17% of total expenditures, but raise prices for everyone. Everybody pays the same price, which is higher than it otherwise would be because merchants have to pay interchange fees to card companies. People using credit cards get some benefit from that, but people paying in cash just end up paying more than they otherwise would have to.

The numbers and formulas can be found on pages 17-18 of the paper, and they’re not easy to follow. But boil them down, and it comes to this: total merchant costs are $54 billion per year. Of that, $24 billion is accounted for by credit-card transactions, and $30 billion by cash transactions (which includes debit cards, in this paper, for the sake of keeping things simple). Cardholders also get $8.5 billion back in the form of rewards.

So people paying in cash end up paying 83% of the merchant costs, despite accounting for only 55% of merchant expenses. Meanwhile, people paying with credit cards pay only 17% of the merchant costs, despite accounting for 45% of merchant expenses, and they get $8.5 billion in credit card rewards back on top of that.

The Boston Fed study assumes that it would be fair if cash payers and credit-card payers paid for merchant expenses in proportion to the degree that they caused those expenses. The cost to cash payers is essentially the degree to which they help pay merchants’ credit-card expenses. And the benefit to credit-card holders is the degree to which merchants’ credit-card expenses are paid by cash payers, plus that $8.5 billion in rewards.

Chen has other problems with the Boston Fed study. He complains, for instance, that it includes housing and automobile expenses in the total expenditures split between cash and credit cards, despite the fact that precious few people use credit cards for either one. That’s a fair complaint. He also says that the poor and the rich shop at different places: if you assume that all poor people shop only at dollar stores and only pay cash, while all rich people shop only at Bergdorf’s and only pay with credit cards, then there’s no cross-subsidy at all. The Boston Fed study, it’s true, makes no allowance for the phenomenon of rich people shopping at rich-people shops.

Finally, Chen complains that the Boston Fed survey ignores a lot of fixed costs involved in handling cash, and then parades a long list of cash-related expenses, like the cost of incorrect change and the cost of returned checks, which he considers to be fixed costs rather than marginal costs. But the fact is that the paper does assume $30 billion in marginal costs of dealing with cash payments, and that number is big enough to encompass a lot of what Chen considers fixed costs. As the paper’s authors note, “the data do not distinguish well between fixed and marginal costs”.

Chen concludes that the paper’s numbers might well be “absurd”, and that if they took into account his quibbles, the cross-subsidies might disappear entirely. I’m far from convinced. Yes, the paper makes a number of simplifying assumptions. But for every assumption which might serve to ratchet up the size of the cross-subsidy, there’s another which serves to ratchet it down. Here’s the paper:

We have omitted from the benchmark transfer calculations two very important features of credit card markets—redistribution of bank profits and business credit card use — that most likely would increase the transfer estimates and by much more than the reductions reported in Table 12. In other words, we are confident that we have most likely understated the transfers rather than overstated them.

Redistribution of bank profits is basically a function of the fact that credit cards are a profit center for banks, and banks are owned by the rich, not by the poor. So when banks make money from their credit-card operations, that money ultimately benefits rich people with credit cards, rather than poor people who pay cash.

And the Boston Fed study looks only at individual credit card use, ignoring the huge market in corporate credit cards. Many rich people put a lot of their personal spending on corporate or business cards; I myself use a business card for nearly all my credit-card purchases, which dates back to my days as a self-employed freelance journalist. I’m therefore one of the lucky recipients of the cross-subsidy here, but I’m ignored in this study.

Overall, I’m much more persuaded by the Boston Fed study than I am by Chen’s attempted fisking of it. The numbers aren’t completely accurate — they can’t be. But the true cost of interchange fees is clearly paid by the many, with the bulk of the benefits going to the few, and therefore there’s bound to be a cross-subsidy there. And I don’t think that Chen is being intellectually honest: he’s looking only for aspects of the report which might overstate the subsidies, while ignoring everything which might understate them.

Finally, Daniel Indiviglio looked at the study, and concluded that although the costs are real, they’re worth paying:

Ultimately, the question comes down to whether the cost of placing an additional burden on the poor is worth the economic benefit that robust credit card usage provides. Unfortunately, due to the nature of the industry, it’s not clear that there’s a way to have both. In order to encourage more credit card use, the poor end up stuck with the bill.

I don’t agree with this. Of course you can have both: you can mandate lower interchange fees, for one thing. US interchange fees are the highest in the world, for no good reason. And you can pass a law allowing merchants to slap on a surcharge for credit-card transactions. Credit-card usage might decline, at the margin, if you did that, but it would still be “robust” — it just wouldn’t be excessive. And the poor wouldn’t end up paying billions of dollars for benefits which accrue overwhelmingly to the rich.

Update: Tim Chen responds in the comments. He makes some conciliatory noises: “I don’t necessarily disagree that interchange fees should be regulated,” he writes, adding that “cash users do bear the brunt” of the price increases that merchants slap on to be able to pay interchange fees. But overall he sticks to his guns as far as the numbers in the paper are concerned.

One of the biggest problems I have with the paper is the $1,482 benefit. I’m going to stick to this number for simplicity, even though it doesn’t account for income differences or cross-subsidies.

I think this is a silly stance to take, because the $1,482 benefit is entirely theoretical. It’s a benefit accruing to card holders which ultimately comes from those who pay cash — but in the real world, most of us do both. The authors aren’t saying that the average person with a credit card receives benefits which net out to $1,482 a year. If you want to see how the math works for individual people, then you have to look at the way that the authors slice the population according to income. The $1,482 number, rather, includes a lot of benefits that people essentially pay to themselves.

Let’s say I pay in cash with my left hand, and use my credit card with my right hand. Then the paper’s saying that if I’m an average American, my left hand is paying more than its fair share, while my right hand is paying less than its fair share. And the real problem isn’t so much that my right hand is getting benefits from my left hand — rather it’s that poor people are much more left-handed than rich people. And so they end up sending money from their left hands to rich people’s right hands.

The $1,482 number comes from looking at the money flowing unfairly from all left-handed spending, which ends up helping out all right-handed spending. It shouldn’t be confused with the average amount of right-handed spending that the average American engages in. Chen writes:

If I’m a card user spending $15,000/yr, how is it even mathematically possible for me to receive a benefit of $1,500, or 10%? Card companies are siphoning 2-4% off of every card transaction, so shouldn’t this serve as an upper bound on any benefit I can possibly receive?

But the point is that we’re talking about money which left-handed spenders are spending that they shouldn’t be. And that isn’t really a function of how much right-handed spending is going on. Indeed, if the share and amount of right-handed spending dropped from 17% to 10%, then the average benefit to right-handed spenders would go up, not down, because the left-handed spenders would be overpaying even more, to the benefit of ever fewer right-handed spenders.

Chen has another problem with the methodology:

Saying that a reduced burden on the part of the card users is the same thing as a benefit seems to me like double-counting. On one hand the authors are saying that cash payers are giving up $151, and on the other hand they are saying that this added burden is a benefit to card users. This seems logically inconsistent to me. If anything, the amount of rewards should be reduced by the premium that card users have to pay to derive their benefit, no?

But in fact the authors of the paper do just that. The amount of rewards is calculated as the difference between what card-holders should pay and what they do pay. It is reduced by the amount they’re paying to derive their benefit — but even after that reduction, the result is still large and positive.

Chen tries another tack:

Another way to look at it is that if all merchants started passing that fee entirely onto me, then I am receiving 0.75% in rewards and paying 2% in fees. In this case, wouldn’t the paper state that I’m theoretically still receiving a benefit from these rewards, even though I’m losing money in practice?

The paper is entirely consistent with a world where cardholders are “losing money in practice”. It just says that if they’re losing money, they’re losing less money than they should be. And people paying cash are losing more money than they should be.

Finally, Chen writes:

The only other thing I would point out is that the Durbin Amendment did give merchants the legal right to offer discounts to cash users, which is the same things as applying a surcharge to card purchases. And even the Boston Fed’s paper states that many merchant agreements allowed this practice beforehand as well. So I’ve always wondered, why don’t more merchants take advantage of it?

No, it isn’t the same thing at all. My business American express card comes with whopping great interchange fees — much more than my free Citibank Mastercard. If surcharges were legal, then a store could happily charge me more if I paid with my Amex than if I paid with my Mastercard. And that would be fair. But you can’t do that with cash discounts. The point about surcharges is that they would and should be used to discourage people from using the cards with the highest interchange fees. Merchants are perfectly happy to accept credit cards with very low interchange fees. And in order to be able to make the distinction, a cash discount isn’t good enough: you can’t offer me a cash discount for not using my Amex, if I don’t get a cash discount for not using my Mastercard. That’s why we need merchants to be able to impose surcharges, rather than just discounts.

“More frequent use of swear words indicates deception” — Farnham St

Frannie acquitted of causing the financial crisis. Karl Smith has a good summary — Modeled Behavior

Auto-tune Bob Rubin! — YouTube

The patents behind Paul Allen’s suit — WSJ

Ask 6 economists what the top marginal rate of tax should be. Get 9 different answers — Time

Factbox: What ammunition does the Fed have left? — Reuters

IndyMac Grants Church a Reprieve — Shame the Banks

I’m not entirely clear why Matt Yglesias has suddenly come over all bah-humbug at the presence of Mohamed El-Erian on the Washington Post op-ed page:

If there’s a clash between what policies would be good for PIMCO’s investment positions and what policies would be good for the global economy, El-Erian has a responsibility to push for policies that would be good for PIMCO’s investment positions. Is there such a clash? Well, readers of The Washington Post op-ed page have no way of knowing. So what’s the point of publishing it?

The oversimple answer to the question is that El-Erian controls over $1 trillion in assets: if you wanted to put a face to the famous bond vigilantes, it would probably feature that famous moustache. If you care what the bond vigilantes might be thinking, then you can probably get a pretty good sense of it by reading El-Erian’s frequent op-eds.

A better answer is that there simply isn’t a clash between what’s good for the global economy and what’s good for Pimco, which is overwhelmingly a long-only investment house. Pimco’s long-term health is a function of there being a strong global economy which generates lots of savings for Pimco to manage. If you’re running a few million or even a few billion dollars, then you can significantly grow your assets under management by taking bold bets which pay off. If you’re running a trillion dollars, that’s no longer the case. At that point, your assets under management are much more a function of the global savings rate than they are of your own expertise as a fund manager.

The best answer, however, is that it doesn’t really matter who wrote the op-ed: it should stand or fall on its own merits. El-Erian makes the case that we’ve lost the global cooperation and determination to change our ways that we saw 18 months ago: essentially, we’ve wasted our crisis.

An already polarized political environment is becoming even more fractured by real and far less substantive issues. There is virtually no political center that can anchor consensus and enable sustained implementation of policy. Meanwhile, as anti-Washington sentiments rise, interest in a national agenda is increasingly giving way to the election cycle. Internationally, the impressive degree of cross-border coordination seen during the global financial crisis has been reduced to inconsistent — and at times contradictory — national responses.

This worrisome trio of increasingly ineffective national and global policy stances, intense political polarization and growing social pressures speaks to the risk that the economy’s recent soft patch will evolve into something even more troublesome and sinister.

El-Erian has a global perspective, and from that point of view it’s pretty clear that another one-off stimulus package, even if it’s a big one, isn’t going to achieve very much. Instead, the former IMF technocrat is looking for something much more coordinated and strategic, where the G8 construct a vision of where they want to be, and then work out how on earth they’re collectively going to get there from here.

It’s not like El-Erian’s prescriptions are those of a fiscal cheapskate. Quite the opposite: this kind of shopping list comes extremely expensive.

Specific measures would include pro-growth tax reform, housing finance reform, increased infrastructure investments, greater support for education and research, job retraining programs, removal of outdated interstate competition barriers and stronger social safety nets.

The point is rather that when Republicans can’t agree with Democrats, and Germans can’t agree with Americans, on any of this, the prospects for the global economy dim. And when the world is sick, the US can’t thrive. That’s not a function of who El-Erian is, or whether he’s conflicted. It’s just international geopolitical reality.

HAMP might not have helped lots of homeowners stay in their houses over the long term, but it did push back the point at which they got foreclosed on. To now. Here’s a graph from the latest report from Lender Processing Services:

What you’re seeing here isn’t subprime dreck: it’s sensibly-underwritten conforming loans which were bought by Fannie and Freddie. Through 2009 and the first half of 2010, the rate at which those loans entered foreclosure proceedings was pretty steady. But as we enter the second half of 2010, there’s a huge spike, especially in the loans which have been delinquent for more than six months.

That spike is loans which entered the HAMP modification process, but then got kicked out, for reasons good or bad. Without a successful permanent HAMP modification, foreclosure comes soon enough.

As homes move out of HAMP and into foreclosure, the amount of distressed real-estate sales will rise, and home prices will of course fall in the effected areas, pushing ever more homeowners into the negative-equity status which is very highly correlated with default risk. And so the vicious cycle continues.

We should break that cycle, by forcing loan servicers to allow homeowners to stay in their houses at a market rent. HAMP did its job in terms of pushing off foreclosures for 2009. But now it’s causing more harm than good. And pretty soon, if they continue to rise at this rate, foreclosures are going to be a big political issue again. Some inventive replacement is desperately needed. Ideally one which isn’t cruel and bound to fail.