The Amazing Amnesia of Wall Street

 "Why the European debt deal could kill the CDS market," www.globeandmail.com:

But the economic risk is that hedge funds and other investors give up on the CDS market. Not all money mangers treat the CDS market like a casino. Many purchase insurance on their investments to reduce the risk on their balance sheets. As Mr. Tananbaum pointed out at the Economist magazine’s Buttonwood conference in New York on Thursday, that could result in less investing and by extension, less growth.

“If you can’t hedge your position, you shrink your position,” Mr. Tananbaum said.

Ergh.

Maybe you should be reducing your position, rather than relying on insurance as 100 % of your risk management strategy?

Thank you for Banking

I have been watching the Occupy Wall Street (OWS) movement with a mix of resignation and admiration. It is nice to see that people are finally starting to get ticked off with the government and corporations that caused a lot of unneeded pain, while I sit on the sidelines with my surly slacktivism. On the other hand, many of the participants seem hopelessly naive and misinformed about what actually happened, and what might be done to fix our society. And really guys, the finger wiggling stuff, it's ridockulous:  just stop it. Since this blog is my personal soap-box, I figure it is well past the point to document what I saw happening back in 2008, and where I think the problem lies. Politics ain't my forte, but sometimes a man has to vent.

OWS on the left blames the corporations; the Tea Party on the right blames the government, but neither have accuracy pinpointed the problem. The real problem is the incestuous relationship between corporations and government, and how they've bypassed a lot of the mechanisms (checks and balances) that are supposed to make representative democracy fair. So the protesters, in my opinion, are off-base in protesting the banks. They should be addressing the base of the problem, and occupying K-street in Washington, DC, where many lobbyists are based.

I am reminded of the character Nick Nailor in the movie, "Thank You for Smoking." Nailor is the top-dog of the smoking lobby, and his job is to obscure, confuse, and otherwise muddy the waters so that the tobacco companies can continue to do business as usual, without any pesky facts to confuse consumers (or citizens as some of us old-school folks call people). If you haven't seen it, it's a very smart and clever comedy, and one of my favourite films. At the end of the day, I think the point of the film is the glamourize a scumbag.  I.e. the film is lobbying you to admire Nick Nailor, and it is a test to see if you loathe him or not at the end of the movie.

http://www.youtube.com/watch?v=iBELC_vxqhI

However, before I get into the troubles lobbying is wrecking on democracy, let's go back and take a look at what caused the housing crisis. In the most simplistic sense, people were greedy. 

The Housing Bubble

The recent real-estate financial crisis was essentially caused by a failure in risk management, which eventually led to the downfall of many financial corporations, but principally Lehman Brothers and AIG. A whole bunch of home loans were made by many actors to people who didn't have the ability to pay down the principle on the properties they were purchasing. This ran the gamete from 'Sub-prime', to the less risky but actually larger magnitude problem hunk of 'Alt-A' loans, and of course craziness like the NINJA (no-income,no-job,no-assets) loans.

The reason all these questionable loans were made was because the companies making the loans were not holding them in order to make money from the interest. Rather, they were packaging them into securities, called collateralized debt obligations (CDOs), to be sold like bonds to suckers interested customers. Now, no one wants to buy a package of NINJA loans, so each securities was divided into pieces called tranches. The bottom tranche took losses, first, then the next level, and so on, until you got to the best tranche, which only lost value if the entire equity was lost. Those top tranches often had AAA and AA ratings, but as it happens, if the housing market declines by 30 %, you in fact do lose every cent of the equity in a mortgage security and even the supposedly AAA tranches got hosed. The housing bubble was not sustainable in the long-term, to the surprise of only people who were not paying attention.

The key problem with traching things this way is how much equity is leveraged up. Unlike you or me, banks are allowed to lend out typically more than 10 x the amount of reserves they hold. In the high of the housing bubble, this reached 30:1 in many cases, which implies if the overall investment declines by only 3.3 %, the whole starting equity is wiped out. In this case, it's easy to see why the AAA tranches were worthless: the housing market declined by an order of magnitude more than the equity could cover.

That wasn't the worst part, however. The worst part was how risk management for those low-hanging tranches that no one wanted was handled. Risk management is generally composed of five different aspects:

1. Retention
2. Reduction
3. Avoidance
4. Transference through Insurance
5. Transference through Participant Assumption

Retention is simply acceptance of risk; this is actually how we deal with the majority of risk.  Reduction and avoidance are obvious, although in this case reduction (by not loaning money to people who are unlikely to pay it back) and avoidance ("too big to fail") were not really respected. Assumption of risk is things like waivers, it assumes that the participants are informed of what's happening and the people in charge aren't committing fraud (::cough:: ::cough::).

For the housing bubble and mortgage securities,insurance was the risk management tool of choice.  In this particular case, they used instruments known as Credit Default Swaps (CDSs). Basically, they're contracts that say if someone defaults on our debt, you pay for it. One can argue back and forth as to whether securitizing mortgages is a problem or not, since if the originator of the mortgage doesn't hold onto it, they lack incentive to ensure the lendee pays it back. However, the financial fobbles came mostly from the idiocy of the tranching at super-high leverage ratios and the cargo cult of finance that insurance through CDSs constitutes sufficient risk management. 

The reality is that, for the most part, insurance and assumption of risk don't actually prevent bad things from happening. However, everyone in the financial industry was assuming that their insurance would protect them, not realizing that they were all insuring each other. Insurance only works when the many repay the few that suffer loss.  When everyone's a loser, everyone's still a loser even if they're insured. Or in this case, AIG was the bag-holder for too many of the default contracts, and couldn't pay them, so the taxpayers had to do it instead.

Corporations as Artificial Persons

In economics, an externality (or transaction spillover) is a cost or benefit, not transmitted through prices,^[1] incurred by a party who did not agree to the action causing the cost or benefit. A benefit in this case is called a positive externality or external benefit, while a cost is called a negative externality or external cost.

In these cases in a competitive market, prices do not reflect the full costs or benefits of producing or consuming a product or service. Producers and consumers may either not bear all of the costs or not reap all of the benefits of the economic activity, and too much or too little of the good will be produced or consumed in terms of overall costs and benefits to society. [...] (http://en.wikipedia.org/wiki/Externalities).

Corporations have many legal rights, in many cases equivalent to a citizen (see legal personality for some background). This is essentially a requirement for corporations to operate within the legal system. However, there's an accountability problem with how corporations currently legally operate. If a corporation is responsible for negligent manslaughter, does the corporation go to jail?

I think the problem isn't with government or corporations or other large groups of people per sae, but more so a conflict between ethics and morals. We are pretty cooperative, altruistic, and egalitarian animals so a lot of our morals as individuals are hard-wired. A lot of enforcement of this behaviour from the tribe comes from shaming and guilt, but our society has become so huge than individuals have a lot of anonymity. So when a government or corporation does something we would find objectionable from an individual stand-point, the bad behaviour can be rationalized by the participants as, "it's the company doing it."

This comes back to the idea of externalities, and in particular negative externalities and moral hazard.  The banking industry took on a bunch of risk, risk they thought they fire-walled themselves away from by purchasing credit default swaps. When the housing bubble burst, their risk management policies failed, and the government had to step in because they were, "too big to fail." As a current, egregious example, consider this: last week, Bank of America was busted for moving derivatives (in the trillions) from an uninsured investment subsidary into a taxpayer insured, deposit subsidy  (Bloomberg News). Derivatives aren't real money per sae, but this does show exactly how risk is being off-loaded from financial corporations onto the rest of the world.

Where were the consequences to the individuals working in the FIRE industry burning down the remainder of the (productive) economy? Anyone? So here is where the anger of both the Tea Party and OWS comes from: the financiers have received a multitude of benefits for screwing up, and there was no reciprocation when the collapse occurred. Yes, many middle/upper-class real estate agents and mortgage originators lost their jobs, but most of Wall Street got their bailout money and were left untouched.

The problem, in my opinion, comes from the fact that corporations, as artificial persons, do not vote but have an inordinately large influence onto government because of their ability to hire paid lobbyists. Lobbying is essentially an ethically acceptable form of corruption. I might say that it's analogous to how paraphrasing is an ethically acceptable form plagiarism: we find it vaguely disquieting, but we can't really find enough dirt to call you out on it either. In the end though, lobbying is influence peddling, contains a ton of moral hazard and that makes it wrong.

It's fair and reasonable for other governments (whether they be foreign or domestic) to lobby government officials, and individuals. The problem comes when corporations do it, and in a corrupt fashion. Many lobbyists are former public servants who are then hired to help game the bureaucracy by the corporations they were previously regulating. This is a form of quid pro quo, "do what we want and we'll hire you after you retire," that I think would be considered amoral by most people, but yet it is pretty much the norm, especially in the defence and financial sectors. It is a major disruption of the checks and balances that were originally built into democracies: we need a large bureaucracy to administer our governments, and elected officials are very dependant on the technocrats to execute legislation. So when an international corporation gets its fingers into the pie, we end up with democracy pie with a distinctive oligarchy-filling.

The Race to the Bottom
The last decade has been punctuated by two significant recessions, the dot-com crash and then the housing bubble. Aside from those events, growth has been quite impressive. However, it has also been quite uneven, with a lot of people being left behind.

What is perhaps less obvious is that social dislocation may also follow periods of rapid growth, since the benefits of growth are very seldom evenly distributed.  Indeed, it may be precisely the minority of winners in an upswing who are targeted for retribution in a subsequent downswing. (Niall Ferguson, The War of the World, p.lxii)

In the above quote, Ferguson is talking about how Jews benefited from the increasing urbanization of Europe following the great depressions of the 1870s and 1890s, and how this made them a target on the basis of tribalization, following the great depression of the 1930s. It is pretty apropos for our current mess too.

The growth starting after the dot-com crash up to the housing market crash of 2008 was largely a mirage. In a lot of ways, it was a jobless recovery. Productivity increased, wealth increased, but in general many people were left behind. The employment index gives a much fairer impression of the scale of the problem than any unemployment rate ever could. 

The proportion of employed persons in the USA (from Calculated Risk). Note the y-axis does not originate at zero.

Roughly 5 % of the jobs in the USA have simply disappeared over the past ten years and is at the same level seen in the 1970s. That means that 1 in 20 people have permanently left the workforce. At that level, everyone will know someone who's no longer working, and badly effected demographics will know many people. I cannot believe that conservative pundits are are not screaming bloody murder about having so many people out of the workforce since all of them have to be supported by the working population.

This brings me to the notion of the race to the bottom. That is, he idea that you need to attract businesses by making regulations that protect the environment, workers, and offering tax breaks and subsidies. This to me sort of says, we think our local industry is incompetent, and we need to bring in a multinational to provide jobs rather than build our own economy. I.e. it's lazy governing. The main winners in the deregulation sweepstakes of the finance industry were the USA, Ireland, and Iceland. How well did that work out for you guys? I think the dichotomy that we have to allow bad actor corporations to operate in our boarders to keep people employed is a false one: why cannot the elimination of a naughty corporation allow space for a nice corporation to win market share?

Bad actor corporations are just that, and they tend to be a net-negative on the economy.  Just as an example, look at high-frequency trading. What is the economic benefit to high-frequency trading?  To my eye, it seems the more sophisticated complicated financial instruments become, the less benefit they provide to the rest of society as legitimate instruments of providing credit to the rest of the economy. The Keep It Simple, Stupid (KISS) should rule our laws surrounding finance.

Try to think of capitalism as a sandbox experiment in evolution.  The initial conditions and rules that govern our little experiment will determine what sort of corporate mileau that pops out the other end. If we have rules that allows negative externalities to be produced without any negative consequences, of course the end result will favour the corporate animals that produce a lot of them.  If we want to get more altruistic companies in our countries, we need to make sure the sandbox favours them.  If you want more Enrons, deregulate and race to the bottom.

First, the USA has to figure out what direction it wants to take its economy in because too many people have been left without a livelihood. Exporting imperialism, sustainability, high-tech manufacturing, whatever...  Right now 20 - 25 % of the US economy is in the FIRE (financial, insurance, and real estate) sector and sorry but that's silly.  You cannot produce wealth by shuffling around pieces of paper (or more likely, bits in computer memory). The FIRE sector is essential, but also essentially parasitic on the rest of the economy.  It's the only sector that has become more bloated and less efficient with the massive gains in information technology over the past half-century, and that indicates to me that something is wrong with the laws and regulations that govern it.

We need to recognize that there's a need for a balanced economy, because honestly you cannot have everyone doing research and development, developing new ideas and products.  I'm barely smart enough to do research myself, in my own tiny little highly specialized field. Germany does it; Japan does it.

Second, occupy K-street. Wall Street seems to be doing too good of a job of populating the US Treasury Department and Financial Reserve with their own people.  Laws and regulations are not a bad thing, but there is a tendency due to excessive political partisanship for these to not be flexible, living rules. I think it is fair to say that in the USA, the blame for excessive partisanship should largely lie on the GOP and their righteous, doctrinaire approach to governance.  Regardless, the rules surrounding political lobbying and the various forms of, well, bribery that are allowed to go on need to be tightened up immensely. 

Third, the Euro needs to go. I haven't talked about the Eurozone at all, but I think it's fair to say, sovereign governments not being in charge of their own currency has caused 'issues.' It was a technocratic solution imposed from the top without a plurality of support.

I wouldn't want to come across as histrionic, the system actually works pretty well, but it does need to be reformed to deal with the reality of international corporations being artificial persons with little to no accountability to anyone. Most people in the West are fabulously wealthy by any historical standard, and technology continues to march on, but clearly things could be better as change has outstripped some of the rules our culture lives by. Corruption is never a positive thing and we should always try to stamp it out whenever we can.So no violent revolution please, just real reforms, and end the race to the bottom, because we don't want to be at the bottom.

Fusion Power, Steampunk-style

Harnessing the power of fusing hydrogen isotopes together has long been a staple of science fiction, a means of achieving otherwise unachievable power densities, so as to make so many gee-whiz devices within the realm of the possible.  In reality, fusion design concepts are generally massive, cantankerous, and incredibly expensive (see magnetic confinement fusion and internal confinement fusion).  Fusion has been practical for awhile now, but it generally requires more energy input than it outputs, and the prototypes have been ludicrously expensive. The joke is with fusion, with research that's been ongoing for fifty years, is that it's always and always will be, "twenty years away." 

In order to make hydrogen fuse, the first step is to get it hot enough that it ionizes, such that the electrons are no longer attached to a nucleus, forming the forth-form of matter, a plasma.  Generally, the aim is to bring together a Deuterium (proton+neutron) ion and a Tritium (proton+2 neutrons) ion close enough together that the strong nuclear force affects the fusion of the two ions.  However, the electrostatic charge on the ions is a longer range force, and it tends to mess up collision trajectories, such that only very high energy ions on a direct collision course could ever fuse.  So the temperatures required are quite massive.

The magnetic confinement tokamak design that most people will be familiar with due to its widespread coverage in popular science magazines, tries to achieve more or less steady-state fusion power.  Steady-state fusion tends to be plagued by energy losses, particularly turbulence in the plasma, that bleeds off power. In comparison, pulsed concepts like internal confinement are easier to initiate, but the natural tendency of an extremely hot gas is to expand rapidly, so fusion rapidly slows and stops, limiting the overall efficiency of the process.

Ok, enough background: enter General Fusion, a company based in British Columbia, that is angling to build a fusion power generator that, well, seems like it would fit right into a Steampunk science fiction novel! It's the one fusion concept that I've seen that one could conceivable build using relatively low-technology components: pistons, microwave ovens, that sort of thing.  It's something MacGyver might build. 

Magnetized Target Fusion (MTF) is a hybrid concept that is supposed to be low-cost.  It was first proposed in 1976 as the LINUS concept, and it relies on first forming a small ball of  deuterium and tritium plasma, called a plasmoid (or sometimes a spheromak).  The plasmoid is given some angular momentum, such that it's actually a vortex, so that it has an inherent magnetic field that holds the plasmoid together for a brief moment.  The plasmoid, which is already pretty warm, is then compressed so that a pulse of fusion occurs.

The main advantage of forming a plasmoid first, over the plain inertial design, is efficiency in transferring energy from electricity into the plasma.  Lasers, plain and simple, aren't efficient at converting electricity to coherent light — I don't know what the lasing efficiency is at the National Ignition Facility, but commercial solid-state lasers are usually in the single digits. In comparison, a plasmoid can be formed with basically a high-tech microwave, using radio-frequency radiation, and the conversion efficiency is very very high.

Of course, the next question is, how to compress the plasmoid?  A plasmoid has a lifetime of approximately 100 μs according to General Fusion, so compression has to occur on that timescale. The proposed solution is to use over two-hundred pistons driven by compressed air to smash into the 'pot' holding the plasmoid, inducing a converging acoustical wave. As the wave converges, its strength increases and it collapses the plasmoid to very high pressures, ~1 Megabar and results in a enormously high magnetic field within the collapsed plasmoid, on the order of 1000 Telsa.  Effectively, it's like an artificial implosion nuclear bomb, using a very small amount of material. By using pneumatically-driven pistons instead of say, lasers, to achieve compression General Fusion is again gaining major efficiencies in terms of their energy input to output ratio (aka 'gain' in the fusion world).  Air can be compressed relatively efficiently up to thermodynamic limits, so the whole concept doesn't have massively lossy steps that crush the overall system efficiency.

Since the pistons are basically flat, the shock wave will actually not be perfectly spherical.  Also, it's pratically impossible to get all the pistons to hit the sphere at the exact same time — General Fusion claims they have accurate control of the impact time down to 5 μs which is 'good enough.'  Since there will always be some error in the impact timing, the shock wave will imperfectly compress the plasmoid and one can expect a lot of cavitation and other hypervelocity fluid dynamical effects.  The cavitation is similar to shaped-charge explosives, in that very high-speed jets are formed.  I am not very clear on the physics of these plasma jets, but I would guess that they are basically the source of the ultra-high temperatures that make fusion possible with this concept. So cavitation early in the compression of the plasmoid is bad, because it bleeds off energy and reduces the ultimate compression achieved.  However, a certain amount is probably desirable once the pressure reaches its ultimate limit.

Figure 1: General Fusion's pneumatic fusion reactor concept (http://www.generalfusion.com/generator_design.html). Plasmoids are formed in the plasma injectors (cones on the top and bottom) and then injected into the 'pot' of liquid lead and lithium. The two plasmoids collide in the middle and are metastable for a brief instant.  The pot is surrounded by 220 pneumatically driven pistons which hammer the side of the pot, creating an imploding acoustical wave that compresses the plasmoid, causing a pulse of nuclear fusion.

The pot itself is actually full of a mixture of liquid lead and lithium metals, as there's a need for an 'aether' to transmit the acoustical energy.  The lead acts as a neutron/thermal heat sink, absorbing the energy from neutrons produced by the fusion event both to recover it in the form of heat but also to protect the rest of the machine from high-energy neutron radiation.  The lead-lithium mixture carries the heat produced by the fusion pulse to some working fluid (i.e. water) which can then produce electrical power.

The lithium is a slow neutron absorber, but it also undergoes fission to hydrogen and helium isotopes (via n + ⁶Li → T + ⁴He and n + ⁷Li → T + ⁴He + n), thus acting as a source of tritium, which is very expensive, radioactive, has a tendancy to leak through solid materials, and dangerous, since it can be used to make hydrogen bombs.  Hence the reactor is designed to have a high breeding ratio (claimed at 1.6:1), so that once a little tritanium is given as a starter, more comes out.

Flowing the lead-liquid mixture in and out of the pot is likely a little tricky because the mixture has to spin in the pot, so as to setup favourable conditions for the plasmoid collision.

For the test-bed unit, which is smaller than an industrial scale reactor would likely be due to efficiencies of scale, about 100 Megajoules of mechanical energy is required as an input and about 600 MJ of thermal energy is produced.  The heat can then be used to make steam, just like any other thermal power plant, and recovered at around a 33 % efficiency, so that 200 MJ of electrical energy is produced per shot.  Hence the net would be 100 MJ per shot, and the target goal is 1 shot per second, thus producing 100 MW of power.

There are of course a variety of problems with the concept.  One of the biggest is getting the two plasmoids to collide and combine in the desired manner to form a little vortex of plasma in the centre of the pot. This is a hard thing to test without two working plasma injectors and a pot of liquid lead-lithium.  Currently they are relying on simulations, and there is plans for an explosive-based compression test to see if their plasma injector is working as desired.  The disadvantage of the explosive-based method is that it's destructive, so they can only get one test per boom-boom.  This makes iterating the design expensive and manpower intensive, but they are planning a shot in the fall of 2012 without Tritium.

Another problem is that material from the pot or the plasma injector nozzles (called spalling in the tokamak field) will be absorbed into the lead-lithium liquid, and that these impurities will radically increase the rate at which the plasmoids dissapate.

Irradiation of the machine itself is also a problem.  The lead-lithium matrix will absorb 99.9999 % of the neutrons but the walls of the vessel will still become too radioactive after about six months of use. Fortunately neutron embrittlement should not be a problem because the neutrons should be moving at relatively low velocities by the time they get to the shell of the pot.

Lifetime of the shell and pistons is also a concern, due to the thermal and shock stress caused by the impacts. This is actually something that improves as the machine gets bigger, because the pistons can move slower in order to achieve the same overall compression ratio. 

When I describe this concept as being steampunk-themed, I am exaggerating a bit.  In fact, this concept requires exquisite timing to control all the pneumatically driven pistons, and to form and inject the plasmoids into the liquid lithium-lead chamber, and that means lots of fibre-optics and other high-speed network devices unavailable 20-30 years ago. It is definitely the hipster of fusion power schemes, however. 

The bottom line: I remain skeptical that nuclear fusion can be more economical than either photovoltaics, which will eventually be the cheapest source of power on the planet, or advanced fission reactors.  Fusion is one of those gee-whiz things that sounds really exciting, until you start getting into the details and wonder how it will be economical, and the radiation waste aspect isn't really any better than fission (there's no worry about products decaying into Radon, which is a radioactive gas, but they do have to worry about Tritium contamination of the reactor, and it's a gas that can flow in-between the molecules of solid metal). The company has raised about $40 million thus far, and they probably need more than double that to finish their prototype in 2013/14, so it will be interesting to see if they find it. On the other hand, this concept is ripe for science-fiction fodder.

The Corporation (2003) movie

I recently found out that old but interesting documentary has been released on a 'free' shareware basis


http://www.archive.org/details/The_Corporation_

The Corporation is not an even-handed documentary.  It basically lays the claim that the corporate entity, which carries many of the legal rights of a person, has the personality of a psychopath/sociopath. 

The basis of this claim is basically two-fold:

1. The legal definition of a corporation essentially requires it to maximize its growth, its profits, as its primary responsibility to its owners. 
2. Corporations essentially trade on dumping externalizations onto others, i.e. tragedy of the commons. 

I don't really agree that corporations are inherently evil, anymore than someone might argue that civil government is inherently evil. Both are organizational constructs that are governed by the laws of the land, and the morals of the people that serve in them.  Both can do truly atrocious things, or they can be very beneficial to society as a whole. 

I think this documentary is actually pretty topical right now with the 'Occupy Wall Street' movement on the left, and the 'Tea Party' on the right-side of the political spectrum.  Both groups object basically to the concentration of power in the hands of unaccountable individuals and institutions. I reference this post on the similarities between the two movements, be sure to check out the Venn diagram:

http://howconservativesdrovemeaway.blogspot.com/2011/10/occupy-wall-street-vs-tea-party.html

 Large corporations lobby for the government to have more power, and in return the government enacts laws and regulations favourable to large corporations. 

Corporatism isn't capitalism.