Archive for June, 2008

Optimization creates inflexibility

Friday, June 27th, 2008

Programmers know this, but I’m not talking about code.

In any field, it seems, optimization creates inflexibility. This is because optimization (maximization of performance) generally requires assumptions about the continuity of conditions.

In computer programming, you gain great speed benefits by writing graphics software in assembly language, rather than a compiled language such as C. But assembly is purpose-designed for a single microprocessor family. Change families, and all your work must be thrown away. So this optimization require one big assumption about future use of your software.

In investing, you can gain higher returns with leverage. But the greater the leverage, the more central your assumption of price stability or continuity, the greater your reliance on avoiding one really bad day, and its associated margin call.

In advertising, you can maximize conversion rates by having each CPC ad click through to a specific landing page designed for that ad. But the amount of work required to make a campaign-wide change increases by an order of magnitude.

Maximizing international trade optimizes economic output but greatly increases exposure to common-factor economic collapse, such as a discontinuity in the oil supply.

Thus optimization increases performance (narrowly measured), but also exposure to Black Swans.

Gas prices vs home prices

Wednesday, June 25th, 2008

A recent Wall Street Journal article’s claim that gas prices will make Riverside real estate worthless is exciting but exaggerated.

Paraphrasing the argument: imagine you are the canonical Riverside resident, commuting to LA in a flag-draped SUV. That’s 12mpg, $4.80 per premium gallon, 120 miles per day, 210 days per year: over $10,000 per year in gas, requiring at least $12,000 in pretax earnings or 20% of the median family income. (The WSJ article concludes about $14k after tax, using different assumptions.)

Accurate so far. But then the article quotes a Deutsche Bank analyst claiming such homes could become “effectively worthless” because of the cost of sustained higher gas prices.

Obviously ridiculous. 30mpg regular-gas used cars are readily available for $5,000. The return on investment of changing from SUV to high-mileage beater is over 100%. So even if people don’t behave rationally in the short run, eventually the cost per mile will drift down, using the existing stock of technology and vehicles.

So WSJ and Mr. Deutsche Bank are wrong. Yet these houses may still become nearly worthless, because overbuilding during the bubble was concentrated in marginal locations. Gas prices are not the only thing going the wrong way for Riverside county.

Unlike tradable securities, homes have a fixed location. The cost/benefit assessment of buying in a given neighborhood includes not just gas prices, but taxes, commute time, weather, crime rates, etc.

Comparatively, Riverside County is not a nice place to live. It is the smoggiest location in the nation, brutally hot in summer, yet also expensive, crime-ridden, far from economic centers, and with poor access to good schools.

As a result, when housing supply far exceeds demand, this is logically one of the first places to be abandoned. Gas prices are only one reason.

For historical precedent, consider the Antelope Valley northeast of Los Angeles, which includes the cities of Lancaster and Palmdale. The area lies within Los Angeles County, but is geographically part of the Mojave Desert: baking heat, high winds, dust storms, etc.

The Antelope Valley was marginal to begin with, held together by a local postwar aerospace industry. When that declined, the area was decimated. A double-digit percentage of homes there were abandoned, and Palmdale Airport closed for decades. It can happen.

Riverside is a huge county, stretching from the Arizona border to within 30 miles of the Pacific Ocean. Parts of it (e.g. Corona) are not far from LA, and may recover quickly. But I sure wouldn’t want to own a 4,000-square-foot home in, say, Indio right now.

Share repurchases and the Great Deleveraging

Sunday, June 22nd, 2008

The Economist writes in “From buy-backs to sell-backs” that the slowdown or reversal of share repurchases is an ominous harbinger for stock markets.

The article seems to miss the central reason for the change: the cost of risky debt was historically, monumentally low before August 2007, leading everyone (corporations, individuals and governments) to increase their debt/equity ratio.

The academic model cited in the article, with tax effects, argues for a 100% debt, zero equity structure. In the real world, this is usually moderated by a nonlinear increase in the cost of debt as the debt/equity ratio increases: lenders simply won’t go that high. But just how high they may be willing to go is a moving target. Before last summer, lenders were eager, so many public companies dutifully issued debt and bought back stock, increasing firm value by increasing debt/equity ratio, as in the academic model.

Suddenly in August, the price of risky debt skyrocketed, dramatically reducing the optimal debt/equity ratio. Companies are frantically trying to delever in response.

The best CFOs recognized all along that the cost of risky debt, and the cash flow available to service it, change through time. As a result, the true optimal debt level was much lower than implied by the prevailing cost of capital during the go-go years of 2005-2007.

The article also mentions rights issues by banks. These are a related matter, but not in the way implied. Banks were on the other side of the leverage table before 2007, providing the aforementioned monumentally cheap risky loans. The results of this are well known, and banks need to rescue their now impaired balance sheets. Few will lend to them, so one of their only financing options is to issue stock. A rights issue is the least expensive way to do so.

The really ominous harbinger for stock markets is neither the slowdown in buybacks, nor the increase in rights issues, but rather the underlying reason for both: inability to borrow. This cannot be resolved until the root cause of the credit crunch — a crisis of confidence in credit rating agencies — is corrected. This problem lays outside the realm of monetary policy, and thus cannot be fixed by the central banks.

Wrong Business Model

Friday, June 20th, 2008

T-Mobile, which has supplied Wi-Fi service for years at Starbucks shops, is now suing the coffee chain over its plan to let AT&T Wireless deliver competing Wi-Fi service for free. T-Mobile alleges harm to its “substantial investment” in its Wi-Fi network.

Let’s stand back a moment and consider the economics of charging money for Wi-Fi access.

Every Starbucks already has a broadband line in the back room. Adding a Wi-Fi hub costs $80 in hardware, plus 30 minutes of installation time by a high school graduate, say another $20, for a total of $100 per store.

So, to provide unsupported free Wi-Fi at 7,000 Starbucks stores would cost a non-recurring onetime $700,000, or less than 0.1% of the operating income of either Starbucks or Deutsche Telekom (the owner of T-Mobile). After that initial expenditure, such a network would be essentially free to operate.

Obviously, then, T-Mobile’s “substantial investment” is not in the actual Wi-Fi service infrastructure. Instead, essentially all effort and expense goes into guarding the gates: building and maintaining a billing infrastructure to charge for, and control access to, all those Wi-Fi hubs from a central location.

A controlled-access Wi-Fi infrastructure of this scale likely costs 100 times more to build, and thousands of times more to operate, than the free version. If over 99% of the recurring operating cost is in guarding the gates, the whole enterprise is perilously exposed to a free competitor. As Wi-Fi becomes ubiquitous, you’ll always be able to poach a connection from the store across the street.

In short, this is a bad bet. Wi-Fi access is not a business, it’s a feature. Uncontrolled access, possibly with advertising, is the most likely outcome.

Stagflation makes you thinner?

Tuesday, June 17th, 2008

Restaurant chain TGI Friday’s now advertises “right-sized” (i.e. small) entrees for $5.99.

But this happy development is a causative flyspeck alongside the implications of the exploding price of corn syrup, exacerbated by the midwest floods. If the price of a Big Gulp doubles, America may save more money on health care than it spends on food.

Not so helpful to the truly poor, of course.