Tag: speculation

It Was those Bad Speculators That Drove the Housing Bubble….

A recent report from the Federal Reserve Bank of New York examines the role of speculators in driving the housing bubble. Setting aside the fact that almost everyone who bought a house was “speculating” to some degree, the researchers focus on those who were buying homes they did not intend to live in.

Some have already tried to paint this study as proving the government had little to do with the housing crisis. To their credit, the study’s authors do not go that far. Others, Mark Thoma for instance, show no such constraint:

“This is pretty far away from the (false) story that Republicans tell about the crisis being caused by the government forcing banks to make loans to unqualified borrowers.”

Of course, I’m sure that even Thoma knows that he’s set up a straw-man. Does anyone really believe that the Community Reinvestment Act and the Government Sponsored Enterprises housing goals were the only factors behind the crisis? Perhaps if the New York Fed really wanted to understand the crisis, it should look in the mirror.  It would seem reasonable to me that three years of a negative real federal funds rate might have had some impact on the housing market, particularly in encouraging speculators. After all, the Fed was basically paying people to take money.

None of this takes away from the role that Fannie and Freddie played in the housing market. For mortgages they purchased directly, Freddie’s investor share increased from three percent in 2003 to seven percent in 2007. And this ignores the massive volume of private label mortgage backed securities purchased by Fannie and Freddie. I think its reasonable to believe some of those were investor loans. In addition, the FBI has reported that the most frequent form of mortgage fraud has been borrowers stating the loan was for a primary residence when it was not.  But then it would be impolite of me to suggest we actually prosecute borrowers who committed fraud.

As I argued over two years ago, the relatively high percentage of foreclosures that are driven by pure speculators should make us question the many efforts to slow or stop the foreclosure process. If so many of these foreclosures are speculators, then why do we continue to protect them from losing the homes? They gambled, they lost. It’s time to move on and let the markets continue to adjust.

Now, one can continue to blame private sector actors for following the perverse incentives created by government. After all, the banks didn’t have to make the loans and the borrowers didn’t have to take the money. But it should be the primary objective of public policy to get the incentives correct. It should by now be crystal clear that all of the massive speculation in the housing market didn’t “just happen”—it was the result of massive government distortions in our housing and financial markets.

 

Gas Prices, Speculation, and the Price of Tea in China

With gasoline in the United States moving toward (and in some places, above) $4 a gallon and motorists understandably unhappy, there is a growing desire to blame someone for the high prices.

Previous gas price spikes in 2006 and 2008 brought blame on ”Big Oil” (meaning firms like Exxon-Mobil, BP, Royal Dutch/Shell, et al., which really are just mid-sized oil — but whatever), the Bush administration and Republicans, environmentalists, and the federal government. But 2011 offers a new leader in the blame game: speculators. From Capitol Hill lawmakers, to business columnists, to activist websites, to letters to the editor and hyper-forwarded emails, people are calling out trading in the oil and gasoline futures markets, aka ”speculation,” and demanding that government do something about it.

The problem is, I haven’t seen any of these folks offer a coherent explanation for how speculation drives up the price at the pump. And I doubt any is forthcoming.

The speculation-blamers’ story is simple enough: Investors sign futures contracts in oil and gasoline — traditionally, agreeing to a price today for oil or gas that will be delivered weeks or months in the future (and that probably has yet to be pumped out of the ground or refined). But, speculation-blamers say, the investors are running amok, paying outrageous prices for the futures. Those prices then affect oil and gasoline sales today, driving up prices at the pump.

Worse, they say, many of the futures are just paper transactions: the traders don’t have oil or gas to sell, nor do they intend to take delivery of it. Instead, when the future closes (that is, reaches its end-date), then one of the two counterparties will simply pay the other the difference between the agreement’s price and the actual market price on the closing day. For instance, if Smith Investments and Jones Investments signed a six-month future for one barrel of oil at $100, with Smith taking the “short” position (believing that oil’s price will be less than $100 six months from now) and Jones taking the “long” position (believing the price will be above $100), and six months from now oil is selling for $80, then Jones will pay Smith $20. Vice-versa if oil’s price is $120. (In fact, most futures today are settled in cash, even if one of the counterparties is somehow involved in oil production or use.)

On first blush, the speculation-blamers’ story makes sense: Surely, the price for future delivery of oil or gasoline will affect the price for present-day delivery. And all the paper-transaction stuff just seems devious and dangerous — shrewd Wall Street investors are hosing Main Street again!

But think more carefully about the story, and it begins to unravel.

Futures prices for some commodity like oil or gasoline can affect current prices — but if and only if those futures cause producers, consumers, or stockpilers (i.e., people who buy and hold commodities for future sale, aka speculators) to change their behavior in some way that would affect supply and demand today. For instance, if the federal government were to announce that it’s going to buy a lot of gold in six months at a price much higher than what it sells at now, stockpilers would likely respond by buying and storing gold today in anticipation of selling it to Uncle Sam later, at a profit. This would push up prices today.

However, commodities that are costly to store are less likely to experience this because speculators will have to factor in the storage cost, which could make the strategy risky and unprofitable. For instance, roses are inexpensive most of the year, but are very expensive around Valentine’s Day. The reason for this (in part) is that roses harvested in August can’t be stored cheaply and sold on Valentine’s Day. A “rose future” signed in August but closing in February won’t have much effect on August rose prices.

Interestingly, oil and gasoline are more like roses than gold. Oil and gas don’t spoil (at least, not to the extent roses do), but they’re expensive to store — petroleum is heavy, dirty, emits fumes, and is combustible. For that reason, not a lot of oil or gasoline is stockpiled for the long term (beyond the Strategic Petroleum Reserve). With that said, there has been some building of oil stockpiles in recent weeks, but it’s not dramatically higher than the stockpiling usually seen prior to the summer driving season – and gasoline stocks have been declining.

What about the devious-seeming paper transactions? One prominent speculation-blamer, The Street contributor Dan Dicker, derisively compares this investing to gambling. OK, but what does that have to do with the price of gasoline at the pump? If you and I were to bet on the Capitals-Rangers series, our bet wouldn’t affect the outcome of the series. Likewise, I don’t see how a bet on the future price of oil between two investors would affect the price of oil today (or in the future for that matter) because their paper transaction would not affect the supply or demand for oil today.

So what is driving the gasoline price spike? It seems far more likely that it is the result of a combination of the following:

  1. Uprisings in the Middle East could spread to mega-exporters Saudi Arabia and Iran, which has resulted in an implicit risk premium on oil and oil products.
  2. Japanese recovery efforts from the March 11 earthquake and tsunami are drawing heavily on petroleum.
  3. China and India are using more energy as their economies recover from the global recession.

All of this exacerbates the underlying problem: World demand for oil is very strong at most any price, but supply can’t be ramped up quickly in response to demand (because it takes about a decade to bring a new oil field online). In economic parlance, this means that both supply and demand are “price-inelastic,” which in turn means that even little problems can have a big effect on price (fortunately, in either direction). To understand this better, see this short paper.

Now, I admit, I’m no Wall Street wizard, and perhaps the Dan Dickers of the world know something that I don’t. But, so far, I haven’t seen them present a sound explanation for their claim that speculation is to blame for high gas prices. When I read their comments, I think of the old retort, “What’s that got to do with the price of tea in China?” So the next time one of these folks starts in, we need to get him to clearly explain how “speculation” affects the price at the pump.