DC’s New Mayor Should Say No to Taxi Medallions

I love taxi medallions.

As an example for my microeconomics students, not as policy.

Just last week, I used New York City’s medallion system to show how an entry barrier — the requirement that each yellow taxi have one of a limited number of medallions — could create profits in an otherwise viciously competitive industry.

How much profit? Well, according to the most recent data from the city’s Taxi and Limousine Commission medallions for independent cab drivers traded at between $610,000 and $620,000 in October. If you figure 8% as a reasonable rate of return of this asset, that translates into almost $50,000 in pure profit each year from driving a cab, thanks to the entry barrier.

Good exam question: Who gets that profit? Hint: It isn’t the cab driver, who either has to lay out $600,000+ for a medallion or lease one at perhaps $50,000 per year.

Of course that profit comes at the expense of taxi riders, who face a double whammy: they pay more for the cab rides they can get, and they end up taking fewer cab rides (the latter effect is known as a deadweight loss – society loses the benefit of the cab rides that would have happened without the medallion system).

Given that background, I was horrified to learn from Matt Yglesias that taxi drivers in Washington DC are lobbying Vincent Gray, the city’s new mayor, to introduce a medallion system. Yglesias quotes Alan Suderman of the Washington City Paper thusly:

Derje Mamo, a taxi driver who helped run transportation for the mayor-elect’s campaign, said cabdrivers already are pushing Gray to reshape the Taxicab Commission and allow for the creation of a medallion system. A medallion or certification system would limit the number of cabs operating in the city. Proponents of such a system argue that too many taxis are flooding D.C. streets. ‘He’s got one year, that’s it,’ Mamo said.”

As Yglesias notes, this is a really bad idea. There’s no reason to believe that there are too many cabs on DC streets (except, of course, from the view of cab drivers who hate the competition), and in some neighborhoods there may well be too few. A more plausible concern, as some commenters on his blog note (but I can’t link to because of some glitch), is that current taxi fares might be a bit too low. Taxi fares are still a new thing in DC–until 2008 the city had a zone system that many passengers, myself included, found bewildering–and it may be that the initial levels weren’t set exactly right. If Mayor Gray wants to do something for the cabdrivers, he should ask the Taxicab Commission to ponder whether some upward tweaks to fares might induce some extra supply that passengers would value.

Update: For further discussion, please see this later post.

Positive Feedback and the Flash Crash

The CFTC and SEC staffs are out with their analysis of the May 6 “flash crash.”

Short version: A large trader (identified by the media as Waddell & Reed) initiated a large sell order to be executed based on volume, not time or price. The initial selling boosted trading volumes which prompted the algorithm to sell even faster. That positive feedback then spawned the short-lived crash.

The whole report is worth a skim for the details about market functioning, but if you are pressed for time here’s the key part of the Executive Summary (with my emphasis added and footnotes deleted):

At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader (a mutual fund complex]) initiated a sell program to sell a total of 75,000 E-Mini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.

This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.

The execution of this sell program resulted in the largest net change in daily position of any trader in the E-Mini since the beginning of the year (from January 1, 2010 through May 6, 2010). Only two single-day sell programs of equal or larger size – one of which was by the same large fundamental trader – were executed in the E-Mini in the 12 months prior to May 6. When executing the previous sell program, this large fundamental trader utilized a combination of manual trading entered over the course of a day and several automated execution algorithms which took into account price, time, and volume. On that occasion it took more than 5 hours for this large trader to execute the first 75,000 contracts of a large sell program.

However, on May 6, when markets were already under stress, the Sell Algorithm chosen by the large trader to only target trading volume, and neither price nor time, executed the sell program extremely rapidly in just 20 minutes.

This sell pressure was initially absorbed by:

• high frequency traders (“HFTs”) and other intermediaries in the futures market;

• fundamental buyers in the futures market; and

• cross-market arbitrageurs who transferred this sell pressure to the equities markets by opportunistically buying E-Mini contracts and simultaneously selling products like SPY, or selling individual equities in the S&P 500 Index.

HFTs and intermediaries were the likely buyers of the initial batch of orders submitted by the Sell Algorithm, and, as a result, these buyers built up temporary long positions. Specifically, HFTs accumulated a net long position of about 3,300 contracts. However, between 2:41 p.m. and 2:44 p.m., HFTs aggressively sold about 2,000 E-Mini contracts in order to reduce their temporary long positions. At the same time, HFTs traded nearly 140,000 E-Mini contracts or over 33% of the total trading volume. This is consistent with the HFTs’ typical practice of trading a very large number of contracts, but not accumulating an aggregate inventory beyond three to four thousand contracts in either direction.

The Sell Algorithm used by the large trader responded to the increased volume by increasing the rate at which it was feeding the orders into the market, even though orders that it already sent to the market were arguably not yet fully absorbed by fundamental buyers or cross-market arbitrageurs. In fact, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.

What happened next is best described in terms of two liquidity crises – one at the broad index level in the E-Mini, the other with respect to individual stocks.

For more, click on over to the report.

What To Do With Fannie and Freddie?

The Economist asked several experts to recommend options for resolving Fannie Mae and Freddie Mac, the two failed mortgage giants.

In addition to comments, the magazine’s web site allows users to recommend responses they like. It’s hardly scientific, but since the rankings (as of 9:15pm eastern time) work to my favor, let me rank them in declining order of recommendations:

My co-author Phill Swagel (a whopping 13 recommendations) describes our joint proposal for fully private GSEs that purchase an explicit backstop from the government for their mortgage-backed securities. Pros: The relationship is explicit and transparent, taxpayers are compensated for bearing risk, the portfolios are eliminated, the government backstop will soften severe mortgage meltdowns, and competition can discipline the Fannie and Freddie duopoly. Cons: There are still risks from the remaining government role.

Larry Kotlikoff (11 recs) outlines another proposal to restructure the companies into more sensible private entities. His model: mortgage mutual fund companies.

John Makin (7 recs) wins the award for brevity, arguing that they should be liquidated over 5 years.

Mark Thoma (4 recs) suggests a continued role for the firms, as long as they face much tighter regulation.

Tom Gallagher (4 recs) proposes putting them back on the federal budget as real agencies. This avoids some potential pitfalls of having them run as private companies.

P.S. As an anonymous commenter helpfully points out, the entries over at the Economist have these newfangled things called “dates” associated with them. Not sure how I missed that. The two highest scorers are also the oldest. Also, I must confess that I clicked the recommend button on Phill’s piece, lifting it to 14 votes. Because of some weird interaction between Safari and the Economist site, however, that resulted in it believing that I recommended all five pieces. Ah the perils of technology.

The End of Cap and Trade?

No, not for carbon. For sulfur dioxide.

As noted by Mark Peters at the Wall Street Journal:

The original U.S. cap-and-trade market, which succeeded in slashing the power-plant emissions that cause acid rain, is in disarray following the issuance of new federal pollution rules.

The collapse in the pioneering market where power producers trade permits that allow them to emit sulfur dioxide and other pollutants that cause acid rain comes as policy makers seek to establish a similar market to curb the emissions of carbon, a cause of climate change.

The SO2 market has been one of the great successes of economic engineering, using market forces to drive down the cost of cleaning the environment. After almost twenty years of trading, however, the market ran into what may be an insurmountable hurdle: increased regulatory concern about the location of SO2 emissions.

The SO2 marketplace is national in scope, which has been great for establishing liquid trading and allowing emitters to find the cheapest way of reducing emissions. But it also meant that some SO2 emissions would end up in particularly unwelcome spots, e.g., upwind of cities, states, or entire regions that are having trouble meeting air quality standards.

Over the past couple of years, court rulings and new regulatory efforts by the Environmental Protection Agency have increased the emphasis of the location of emissions. And that means that the national market may be coming to an end.

That’s certainly what it looks like in the allowance marketplace, where prices have fallen from more than $600 per ton in mid-2007 to $5 or less today:

The price decline has been particularly sharp because utilities had been polluting less than allowed in recent years. That allowed them to build up an inventory of allowances to use in the future. With prices so low today, however, utilities have essentially no incentive to avoid sulfur emissions and no incentive to hold allowance inventories. As Gabriel Nelson puts it over at the New York Times:

With SO2 allowances trading at about $5 per ton, and little prospect of carrying over the permits into the new program, utilities have little incentive to bank allowances or add emissions controls for the time being, traders say. Because those controls have upkeep costs beyond the original investment, some plants might even find it more cost-effective to use allowances than to turn on scrubbers that have already been installed, traders said.

Fannie & Freddie Reform Gets a Boost from the Washington Post

Sunday’s Washington Post has an encouraging editorial about the Fannie Mae and Freddie Mac reform proposal that Phill Swagel and I recently put forward. An excerpt:

[Their plan would] abolish the most toxic features of the old “government-sponsored enterprise” model. In particular, the plan would get Fannie and Freddie out of the business of directly purchasing mortgage-backed securities, which was highly profitable to them in large part because their implicit government guarantee enabled them to fund a large portfolio at artificially low rates. Their existing $5 trillion pile of securities and guarantees would be wound down or sold off to the private sector.

But Mr. Marron and Mr. Swagel would keep a government role in Fannie and Freddie’s other business: securitizing conventional, moderately sized “conforming loans,” which is both necessary to mortgage liquidity and relatively less risky. And instead of a non-transparent, implicit government guarantee, the new securities would carry an explicit one, for which the securitizers would pay a fee. Accumulated fees, in turn, would cover losses, thus shielding taxpayers. To promote innovation and competition, this business would be open not only to Fannie and Freddie but to any other well-capitalized financial institution capable of taking it on.

What Should We Do with Fannie and Freddie?

The past few years have demonstrated that Fannie Mae and Freddie Mac, the two mortgage giants, were built on a flawed business model. One that paired private profit in good times with taxpayer burdens in bad times; created systemic risks to the world financial system; concealed the degree of federal involvement in mortgage markets; and directed many of the benefits of government assistance to shareholders and management, rather than homeowners.

The folks at e21 asked Phill Swagel and me to ponder how Fannie and Freddie ought to be restructured when they emerge from government conservatorship.

Our proposal, “Whither Fannie and Freddie: A Proposal for Reforming the Housing GSEs” has just been released.

Here’s the gist:

The two firms would become private companies that buy conforming mortgages and bundle them into securities that are eligible for government backing. The reformed firms would not have the investment portfolios that were the main source of risk under their previous structure. The federal government would offer a guarantee on mortgage-backed securities composed of conforming loans. This guarantee would be explicit, backed by the full faith and credit of the United States. To compensate taxpayers for taking on housing risk, Fannie and Freddie would pay an actuarially fair fee to the government in return for the guarantee, and the shareholders of the firms would take losses before the government guarantee kicks in. Other private firms such as bank subsidiaries would be allowed to compete by securitizing conforming loans and purchasing the government guarantee. Over time, entry into these activities would help ensure that the benefits of the government support are passed through to homeowners and would reduce the risk that the failure of any one firm would pose a threat to the housing market or the overall economy.

Our proposal would also free Fannie and Freddie from regulatory requirements that promote affordable housing. As worthy as those efforts can be, we believe they should not be run through these reformed organizations with their narrower missions (and no investment portfolios). If policymakers think that the conforming mortgage market should help finance those efforts, that can be done through a tax on the MBS guarantees, above-and-beyond the actuarially-fair fee for the government insurance. The resulting revenue can then be directed to affordable housing programs through usual budget channels.

How did we come to this proposal? Well, we were trying to fix what we see as the major flaws of the old model (lack of transparency, uncompensated taxpayer risk, misalignment of incentives), while maintaining its benefits (e.g., that mortgage credit kept flowing for conforming loans even during the depths of the crisis and that government-insured MBS are a useful asset class when the Fed wants to do quantitative /credit  easing). In addition, we felt that some backstop role for the government is inevitable as a matter of political economics and that it ought to be explicit at the outset.

P.S. For a nice overview of the Fannie & Freddie situation, see this article by Nick Timiraos in the Wall Street Journal; it includes a brief mention of our plan.

Disclosure: I do not have any positions, long or short, in any Fannie or Freddie securities. Also, a close relative once served as a board member of one of the companies, but that ended several years ago.

A Useful Primer on Derivatives Regulation

Bob Litan of the Brookings Institution recently penned an excellent overview of the issues surrounding derivatives regulation, with a particular focus on credit default swaps (CDS). “The Derivative Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, and Other Interested Parties,” is really two pieces in one: a primer on derivatives policy and a warning about the power that a few firms now exercise over CDS markets.

Bob’s recommendations for reform (which I have numbered for convenience) are:

1. Induce or require “standardized” derivatives to be “cleared” on central clearinghouses rather than handled by dealers, acting on behalf of each of the parties (the buyer and seller) to these contracts.

2. Establish the conditions that will induce derivatives that are centrally cleared to be traded on exchanges or an equivalent transparent platform, as is now the case generally with stocks and futures contracts.

3. Ensure that adequate reserves – in the form of capital or margin – are held against all trades that are not centrally cleared.

4. Require the margin or collateral backing derivatives positions to be held either in segregated accounts or by third parties (such as a central clearinghouse) so that these funds cannot be co-mingled with other assets of dealers.

5. For derivatives that are both centrally cleared and traded on exchanges, regulators should ensure that the transaction prices and volumes of derivatives transactions are posted promptly on the equivalent of a “ticker” (post-trade transparency), while also ensuring that the prices at which buyers are willing to trade (the “bids”) and sellers willing to sell (the “asks”) are made public so that all parties, not just the dealers, know the state of the market at any given time (pre-trade transparency). I believe that a price ticker, or something close to it, should be in place even without central clearing and/or exchange trading.

Of course, much of the heavy lifting will be deciding which derivatives are “standardized.”