Wednesday, July 29, 2009

Rise of the Machines

In the Terminator series, machines rise up to replace humans. On Wall Street, fiction now appears to be reality, as complex algorithms and super-fast computers conspire to wrest control of market liquidity.

Recently, the New York Times brought attention to the ins-and-outs of high frequency trading, or HFT. (Read here.) And with Goldman Sachs producing eye-popping trading results, many observers – looking to identify the next weapon of mass destruction – are crying foul. (Read here, Goldman's profits in HFT.)

Sen. Charles Schumer (D-NY), pushing to ban components of HFT, is increasing visibility even more.

HFT, basically, is rapid-fire buying and selling of securities, in milliseconds. Proprietary trading desks and hedge funds orchestrate it for own-account gains, trading for pennies or less literally in the blink of an eye. By constantly churning, these funds' trading activity often constitutes the market for many different securities. (Read explanatory diagram here.)

Here's where problems arise. When a mutual fund submits a buy order with a limit price, HFT funds can buy-and-sell the difference between the current price and the limit price. If, for example, a dealer looks to execute a buy-order with a $25 limit and the price is $24.90, HFT funds could theoretically profit from the entire 10c difference.

As the mutual fund portfolio manager, you worry that your best price should have been something less than $25. You know that pennies on millions of shares represent a material cost, and that your shareholders bear this.

In this case, the market isn't achieving true price discovery for the security in relation to its liquidity. A substantial amount of liquidity is addressing price movement alone (irrespective of the security), while only a portion is takng into account the security's actual value.

HFT is controversial because it potentially creates information asymmetry and false liquidity. Its proponents argue, however, that barriers to entry are low (once you get past the set up costs), so pricing is actually transparent; and some liquidity (albeit low quality) is better than no liquidity.

As with derivatives, the problem – if we want to call it that – in HFT isn't the product itself, but the typical inefficiencies of a marketplace that can never be completely uniform. Some folks are just really clever at exploiting those inefficiencies, and market functions take time to keep pace.

Whatever response lawmakers and regulators take, as long as there's money to be made, the folks who brought you CDOs and HFT will spawn something new and different.

That is, until the machines actually do rise up, and all humanity is finally gone.

Related reading:

Hurrying Into the Next Panic? (NYT)

How to Understand High Frequency Trading (Atlantic Online)

High-frequency Trading (Marginal Revolution)

Saturday, July 25, 2009

The Art of Medicine and Variance in Care

How much of medicine is art? How much is science? And how should this affect the health care reform debate?

Consider this in terms of variance in care.

Experts, no matter their point of view, roundly reference the Dartmouth Atlas Project more than any other study as proof positive that care delivery varies widely across the United States, and contributes directly to massive inefficiency across the system.

These experts frequently cite two related statistics:

1. 30% of health spending doesn't yield healthy outcomes, and
2. $700 billion is the total cost of this system-wide inefficiency per year.

Lawmakers have responded by emphasizing medical guidelines and protocols in their various bills, in an attempt to narrow variance – some might say an effort to standardize care delivery. CMS and commercial health plans, by the way, have long supported these measures in their reimbursement practices.

Recently, the Wall Street Journal published an editorial that raises the issue of medicine as an art. "By 'medicine' I mean that ancient art and science with origins before Hippocrates, that discipline that has the patient at its center," the author writes. "I'm talking about the 'medicine' that deans across the country will invoke in a few weeks as they exhort first-year medical students to embrace the ideals and values of the noble profession." (Read here.)

As a science, medicine is continuously evolving. Best practice today may not be best practice tomorrow. A physician's ability to respond to a patient's individual needs allows this process to take shape.

While stepped-up centralized control might reduce intervention risk on the downside, it's also likely to limit intervention risk on the upside (treatment that produces healthy outcomes). The result could be more automated patient–provider interaction, and less opportunity for medicine as an art.

If medicine is, in fact, partly an art, then any reform approach that targets more centralized control would immediately contradict this characteristic, by definition.

The best way to eliminate variance and protect the art–science balance is to enable a system that's fully transparent to all components of the health value chain, from consumer on down.

Best practice would be more clearly understood than it is today, and the art that produces healthier outcomes more easily recognized.

Wednesday, July 22, 2009

Public Opinion and Goldman Sachs

Hate 'em, hate 'em, hate 'em. From the left, right and center, the attacks are flying, and polticos have been quick to jump on the bandwagen. As David Reilly notes in Bloomberg News, "Weathering the aftermath of the financial crisis may prove tougher than surviving the storm." (Read here.)

But let's not forget. In September 2008, the system had to be saved. And though in hindsight we may disparage the choices Messrs Paulson, Bernanke and Geithner made, they've worked – at least for now. AIG bailout or no AIG bailout, Goldman adroitly swerved around the chasms that obliterated others. In fact, as we've noted recently, it pressed its accelerator, increasing its value-at-risk throughout the worst of the descent.

If Wall Street is to restore itself, then risk-takers have to come back into the market. While taxpayer subsidies may have aided Goldman's resurgence, the bank did take calculated risks where others didn't, or couldn't.

And so it should reap its reward.

Longer-term, a healthy Wall Street is a vital contributor to wealth creation on Main Street. This begins with a balanced risk-reward equation. Distortions still exist, and we're not there yet.

Goldman's success, we hope, is a step in the right direction.

And now politicos may be letting emotional short-sightedness blind them into creating new distortions.

In a healthy market, others will share Goldman's smarts, and a host of others, extending well into Main Street, its opportunity for success.

Monday, July 20, 2009

A Sudden Appetite for Web-based Computers

Is the computer business model fundamentally changing? The explosive growth of netbooks – low cost, high performance PCs – suggests that it's already underway.

Priced at between $200 and $500, netbooks function mostly as web browser tools (offering the same performance in this regard as traditional PCs), but feature only limited storage (which means big cost savings). Experts see them as gateways to Internet-based computer services, or cloud computing.

The category’s sales are surging. According to industry trackers, global netbook shipments will reach 33 million units in 2009. That’s 100% year-on-year growth for an already substantial category, which only began a few years ago.

(No doubt, Microsoft and Intel, netbooks' primary software and microprocessor suppliers, welcome the category's growth. Desktop and traditional notebook sales, meanwhile, are languishing.)

Geographically, EMEA (13.3 million units), North America (8.8 million units) and greater China (3.9 million units) are expected to be the three largest purchasers. Growth rates, though, will be highest in emerging markets.

The Gateway LT2000 Series is a one-inch thick netbook with a 10.1-inch display. The mini-notebook weighs 2.62 pounds and includes features common among netbooks, such as an Intel Atom processor, Windows XP, a built-in Webcam and microphone and Wi-Fi support. Price: $300.

The recession has certainly aided netbooks' gains. But the consumer's expanding use of web-based applications could also signify a market shift away from traditional desktop computing. For phone companies, netbooks are the next significant growth opportunity after smart phones. Verizon, for example, gives them away for free, recouping its investment in high-speed Internet access fees.

Because the category is so new and growing so quickly, industry people haven't fully defined it. For now, it just covers slimmed-down notebooks. Perhaps, one day, it could evolve to encompass smart phones and other devises. Future generations of Apple's iPhone, already more a computer than a phone, could resemble netbooks, and vice versa, as user functionality advances.

Another product that might fall into this category is Amazon's hugely successful Kindle, the upmarket electronic book reader, and pure web-based tool. Besides clearing space in travelbags, the Kindle is also familiarizing its users, mostly high-end consumers, with the ease and convenience of a web access-only devise.

Let's not forget, too, all the mobile devices targeting the health care industry. The federal government has earmarked billions of dollars for health IT. Hardware will need to evolve to support docs on the hoof, mostly in the form of tablets and handhelds. This entire system and its various components are likely to utilize web-based architecture.

Computing in the business world, generally, could transform, as processing and applications shift in the same fashion, from the desktop to a central server, or a virtualized desktop. What's left is a simple access terminal, or thin client.

The netbook category is also attracting high-caliber software developers. Just recently, Google announced the development of Chrome OS, an open source, lightweight operating system, which will address the netbook market specifically: "people who live on the web — searching for information, checking email, catching up on the news, shopping or just staying in touch with friends".

What stops (or limits) its growth? Economic recovery could do so short-term – depending on how long it sustains. Replacement cycles and wealth effects will likely favor traditional categories, especially if the recovery is deep and long-lasting. (Four times as many notebooks are expected to ship this year, making it a much bigger category in the way that practitioners currently define it.)

Longer-term, consumers could see data control as a severely limiting factor. The reality of Google or Microsoft storing personal data in one of its vast server farms might unnerve folks enough that they'll want to keep the old, reliable desktop close at hand.

Then again, consumers unveil themselves constantly, whether in social networks or in their online search results. De-sensitization to personal information might be high enough that people don't really care.

If consumers continue migrating to Web-based services, and computers merely provide access, then netbooks will accelerate industry transformation (anticipated by some), though not without other Web-access devices also contributing.

In this environment, product design and ease of use are still likely to determine pricing differences as before, except now the hard drive plays an inconsequential role, if any at all.

(Skeptics, on the other hand, will point to the deep-rooted market inertia that constantly bogs down the computer industry, and protects the incumbent business model.)

Now and then, economic conditions and technology do conspire to create major inflection points.

This looks to be one such occasion.

Friday, July 17, 2009

How Much is Preventive Care Worth?

Zero, according to the Congressional Budget Office. In fact, the CBO views preventive care only in terms of the dollars lawmakers intend to spend on it – that is, as an expense item.

“CBO’s scoring is a little bit wacky,” Sen. Charles Schumer (D-NY) said in an interview today. “They are not quite fair because they don’t measure the cost savings down the road, just the immediate spending.”

But how else should the CBO view preventive care? Conceptually, the idea of prevention makes perfect sense: Lead a healthier lifestyle, and pay less in medical expenses. Unfortunately, there's little precedent for its success, and nothing for a nationwide program that would cover the scale of the United States. (Read about preventive care in the New England Journal of Medicine here.)

Whatever savings number a politician ascribes to it, it's immediately contestable. You say, '$200 billion.' I say, '$400 billion.' What about $250 billion or $100 billion? Why not $600 billion? Then again, why not $5 billion, or $5 million?

Also, gains in prevention occur on an individual basis, and aren't always the result of provider intervention. (Medication adherence statistics, anyone? One third of all drug prescriptions aren't filled.)

And can we ever agree on what motivates someone to change his lifestyle? For some, the trigger can be financial; for others, peer pressure; for others still, getting out of bed on the wrong side. Sometimes these factors work in combination. Sometimes they don't.

The point is, there's no tried and true formula. As in behavioral economics, we might try to build a system that "nudges" people, but how do we measure this? What happens when the parameters change, or become obsolete? Just as quickly as our home and work environments evolve, so does the study of medicine – faster than government-derived rules could ever adjust.

Intuitively, we know prevention is a good idea. We also know that, for it to succeed, we have to realize its merits ourselves, individually.

Its worth, then, is the personal value we take from it, not what a national system imposes on us collectively.

It's really just a matter of respecting who we are.

Wednesday, July 15, 2009

Price Discovery's Back, But Wall Street's a Long Way from Recovery

Is Wall Street better off than a few months ago? Yes, but uncertainty still clouds its future. In fact, the risk is growing that it will suffer a persistent, structural imbalance, skewed towards trading and own-account price discovery functions.

Take, for example, Goldman Sachs' second quarter earnings report. It bristles all over with the dominance of trading: $9.3 billion in revenue, six and a half times what investment bankers produced and nearly ten times what asset managers yielded.

In terms of total revenue, Goldman's trading operations now stand at 80%, sixteen percentage points higher than a year ago. Investment banking and asset management, meanwhile, muster about half the impact that they used to (12% and 8% of total down from 21% and 15%, respectively).

We see this best illustrated in the firm's risk measurement tool, value-at-risk (VaR). The following chart shows this for the 12 month period ending in March 2009 (the most recent reading). The next two charts feature the VIX index and TED spread over the corresponding period, to illustrate the market backdrop.

Even as capital markets wilted, Goldman never stepped off of its accelerator, revving harder in the worst of the meltdown.

Goldman Sachs daily value-at-risk (first quarter Form 10-Q, May 6, 2009)

VIX index, Historical Volatility (Equity Risk)

TED spread (Credit Risk)

One by one, Goldman's competitors imploded, and it sped that much faster, to where, now, it exposes itself to 35% more risk than the same period 12 months ago ($245 million versus $184 million, per day).

If anything, Goldman's success validates the aggressive trading/hedge fund model. But while the price discovery process in the public markets might be back in place, all's not well with other capital market components, including the private equity and venture capital industries, and the flow of funds from institution to corporation.

"In the first half of 2009, M&A volume fell 35% globally to $1.14 trillion and IPO issuance was just $12.7 billion – earning just $406 million for underwriters. This year could go down as one of the worst for both businesses, according to Dealogic. There's not much to suggest it will be any different in the coming months," notes David Weidner in Market Watch.

As The New York Times
recently reported, "Many in the [venture capital] industry predict that a third to a half of the 882 active venture capital firms could disappear, if only because poor returns will force underperforming firms to shut down. It is already happening: Investment in venture capital funds shrank to $4.3 billion in the first quarter, from $7.1 billion in the same quarter a year ago...

"The source of concern is lower returns brought on in part by a dearth of public stock offerings. Five-year returns in the venture capital industry, which reached 48% in 2000 at the height of the dot-com bubble, were just 6% through 2008, according to the National Venture Capital Association."

Although Wall Street's recovery is moving forward, the throttle's nowhere near open. As a pricing mechanism, it's functioning, but, insofar as Goldman's explosive success is more or less unique, Wall Street runs an increasing risk of concentrating capital, a contributing factor to the credit crunch. (Goldman also appears to have benefited from extreme, short-term market inefficiency.)

As an investment channel supporting business innovation and economic advancement, the markets remain comatose. Wall Street's relationship–or agency–side continues to falter. Even Goldman's vaunted investment banking franchise lost 15% year-on-year, despite having gained a more dominant position.

Two factors overhang the recovery:

  1. Uncertainty over financial market regulation, and its impact on banks' business models.

  2. Uncertainty over cost of capital, namely the impact of higher taxes and administrative burdens.

Once these issues clarify, markets will adjust, whether the outcomes are negative or positive. It's how regulators and policymakers resolve these issues that will determine not only the recovery's trajectory, but also (longer-term) what sort of role Wall Street will play in the broader economy.

Until then, expect others to emulate Goldman's trading-driven approach.

What other choice do they have?

Monday, July 13, 2009

Spotlight on Goldman

Here we are once again, on the eve of another record earnings report by Goldman Sachs. Are we back to the old days, or on to something new and different?

We can safely agree that the banking crisis is officially over, as this writer and others have recently argued. Whatever we may draw from the Treasury Department and Federal Reserve's methods, they've worked. Confidence is restored, at least enough to allow market-savvy traders to place the kind of aggressive bets that can reap windfalls for bank profits.

What's in store long-term is still a matter for debate, and as financial market regulation nears, no one's holding back on opinion. We just hope to measure the solution in more accountable transparency and more transparent accountability, and an opportunity for a more competitive marketplace in information and capital.

Different tomorrow will be the degree to which Goldman separates itself from the pack. Whatever huge numbers it posts, no competitor – what's left of them – is likely to come close. In the old days, Lehman would lead off with the usual better-than-expected earnings report. Goldman came next, then Bear, Morgan and finally Merrill Lynch. The language was always the same: "We've done a good job in managing risk", or "Our results once again demonstrate the diversity and financial strength of our group".

This go-around, of the big five, just Goldman and Morgan will report – and this time not as investment banks, but as bank holding companies. No one believes that Morgan will come anywhere close to Goldman, certainly not as it may have in the past.

But a new and completely different risk factor overhangs Goldman's once and future success: public opinion. The perpetual leader, Goldman appears to have navigated the crisis so brilliantly that it faces certain questions, many relating to the prowess of its trading operations.

If it's too good to be true, then it can't be. That's the difference between then and now. After Madoff, skepticism runs too deep for anyone achieving outlier success to wade through unchecked. The contrasting pain on imminent double-digit unemployment is too acute.

How far regulators and lawmakers ride this potential public inquisition will also reflect any shifts in the country's political leaning. We'll be able measure our tilt by how long these questions linger on the front pages of the popular press and in the blogosphere.

No doubt, Goldman's leaders will speak cautiously. Everyone knows its numbers will be stellar, so we don't suppose management would desire anything better. Best to be as matter-of-fact as possible.

Perhaps, though, public opinion will see its own success in Goldman's success: a vibrant green-shoot of Wall Street back from the dead.

Maybe opinion will make the connection between a healthy Wall Street and a healthy economy.

We hope that, however Goldman does it, other financial institutions won't necessarily see trading-led profits – betting with Other People's Money, in other words – as the sole route to success.

Thursday, July 9, 2009

Marking Real Change in Health Care


Changing something familiar can be a huge gamble, especially in policy making. The odds that lawmakers will actually reform the health care system are poor at best. Whatever legislation does emerge won't achieve more than a few tweaks and modifications of what we know so well. No lawmaker is willing to accept the political risk in addressing the underlying problems, no matter how severe they might be – at least not yet.

Myriad cost, quality and access issues mean different things to different people. Hospitals, physicians, benefit managers, health plans, drugmakers, and patients each hold different views on how the system should change, none of which align with each other.

Physicians, for example, follow certain guidelines designed by health plans (the folks who pay them), whose interests often conflict with patients (the folks who don't pay them). A pricing mechanism simply doesn't exist to establish uniform measures of quality among these different stakeholders.

Stephen Hyde's excellent book Cured! The Insider's Handbook for Health Care Reform offers both a refreshing examination of health care's perverse economics and an important framework for putting the system into working order. Cured! is not only relevant to today's reform debate, but will also serve as an important reference document for years to come.

Book Details
By Stephen S. S. Hyde
HobNob Publishing, 490 pages, $19.99

In 1976, Mr. Hyde, an actuary, became the federal government's first chief financial regulator of the nascent HMO industry. He later founded Peak Health Care, which he merged with United Health in 1986 to become the market leader in managed care. Since then he has founded companies functioning in the medical and pharmacy spaces, and serves as an industry consultant and a board member of numerous health care companies. This is his second book, and follows Prescription Drugs for Half Price or Less.

Cured! cuts through political veneers to expose the health care system for what it is: "a balkanized system of private and government programs that lack a comprehensive focus on meeting the medical needs of America's consumers in an economically sustainable fashion".

Health care's market failure begins and ends with the insurance markets, and their method of reimbursement. Not until patients actually purchase medical services themselves, with the protection of catastrophic insurance, can health care ever reform. The litmus test is the consumer's ability to answer two basic questions:
  1. Who are the best doctors and hospitals for my medical needs?
  2. Which of them are the least expensive?
Coverage, the delivery system and funding requirements will each improve substantially to satisfy all political persuasions, once policymakers correct the market failure.

Perhaps Mr. Hyde's best work occurs in his book's detailed background sections. He dedicates over 250 pages to analyzing misconceptions and truths about the bloated $2.3 trillion industry, revealing the dark undersides of complex topics (such as the market positioning of the managed care and pharmacy benefit management industries) so that the man on the street can understand the issues as well as any academic or industry expert.

"One might think of forced health insurance enrollment as a mandatory license to breathe," he writes, in discussing health care as an obligation. "Indeed, once you see the price, sharp inhalations may be unavoidable. The glib but irrelevant argument-by-analogy is 'you must have health insurance, just as car owners must have auto insurance.' But driving has long been viewed as a privilege subject to numerous regulations to protect the public safety. The requirement also includes the right to abstain from driving, and indeed there are almost 100 million non-driving Americans. Also, the purpose of mandatory car accident liability insurance is to protect the victims of the insured drivers' mistakes, not the drivers themselves. Car insurance is not relevant to health insurance."

Mr. Hyde's upfront, concise approach makes Cured! a compelling read. He has written this book for the consumer. But in making it readable, he neither condescends as a 40-year veteran of his stature might, nor circumvents the complex workings of his concepts, whether addressing adverse selection, hybrid managed care models, or philosophical questions about health care as a right.

His readers could – and should –include health care's most seasoned insiders, from corporate CEOs to physician practitioners.

The final third of Cured! features Mr Hyde's solution: the American Choice Health Plan ("ACHP"), a congressionally established regulatory mechanism. He proposes seven basic rules to meet eight goals that he introduces in the first pages and details throughout the entire work: universal insurance access, sustainable value and affordability, free rider prevention, voluntary participation, financial protection, choice of insurance and providers, portability, and personal responsibility for prevention.

ACHP's seven rules enable a self-sustaining regulated market for health insurance to take root. These rules are universal annual open enrollment, competitive and regulated insurance market, conversion from defined benefit to defined contribution, voluntary individual participation, enrollment limitations, health funding account, and BAGLE premium pricing. BAGLE refers to premium adjustments for behavior, age, gender, location, and employment/extracurricular risks. His proposal opens premium pricing to the markets, expunging it from the purview of regulators.

Fundamentally, ACHP removes government and employers from the business of insurance, and exposes providers and health plans to a market-based determination of value. It transforms the current group-based insurance model into a fully individual one, so that insurance can be, well, insurance.

Most important, ACHP's fully transparent, patient-centered structure would satisfy the most aggressive coverage and care delivery goals, and achieve 50 percent cost savings at the same time.

"Like the farmer and the cowman in the musical Oklahoma, insurers and policyholders need to turn in their adversarial relationships to become, if not friends, then co-conspirators. Their common goal? High-quality, low-cost health care. American Choice will deliver that."

To be sure, Mr. Hyde faces a considerable challenge in the degree of reform he proposes. As oppressively inefficient as health care might be today, it's not so terrible that policymakers are willing to consider actually changing the system. Proposals working their way through Congress are half measures that more-or-less emphasize the current system. Large employers will still self-insure, Medicare will still force cost shifting, and individuals will still have no clue about the value of care they receive.

But even if policymakers aren't ready for Cured!, consumers could be. Confusion over what health care reform means provides the perfect opportunity for Mr. Hyde to publish this book. And the more consumers know about what they could have, the more likely they'll demand a new system.

Unfortunately, it may take a complete system failure either financial or in delivery of care for ACHP to receive the attention it deserves.

Let's hope we never reach that point, and that we see its fair hearing well ahead of time.

Friday, July 3, 2009

Medical Rationing and the Most Appropriate Health Care System

Health care as an economic good occurs in limited supply.  Providers contribute a finite number of units of service, and payers are supposed to determine what these units are worth.

Rationing as an issue is incontrovertible, argues the health economist Uwe Reinhardt. It would occur both in a single payer system and one that’s fully market-based.  The reform debate should, therefore, address the value of dollars spent.

"As I read it,” he notes, “the main thrust of the health care reforms espoused by President Obama and his allies in Congress is first of all to reduce rationing on the basis of price and ability to pay in our health system.  An important allied goal is to seek greater value for the dollar in health care, through comparative effectiveness analysis and payment reform."

Better value should lead to better outcomes.  

But which mechanism is best at determining that value?  A centralized, top-down system, or one that's bottom-up and consumer-driven? 

The current system is already highly centralized. Its private sector elements cannot compete under the same market rules as other industries.  Insurance laws, for example, prohibit interstate competition.  In 2008, economists from the University of Minnesota published a study indicating that allowing people to buy insurance across state lines would reduce the uninsured population by 12 million.

And consumers can only make value-based decisions on a limited basis, and without much consequence.  High-deductible health plans are an attempt at this.  Market penetration, though, is low, and high-volume health care users, such as the elderly, utilize Medicare and other traditional forms of insurance.

So, if rationing occurs regardless of the system, then Prof. Reinhardt is correct: Rationing, by itself, is an irrational point of contention.  He's also correct in that the debate should instead address value. 

But insofar as the conversation is about the most appropriate system, aren't we already debating value?  Arguments about rationing stem from perceptions of what sort of value the system produces.

Whether that system is top down or bottom up, price will always factor into its decision-making process.  Rationing is a byproduct of price.

Wouldn't true reform be a concession that the centralized approach has failed?

Maybe the economics aren't quite bad enough that lawmakers would accept this. 

Or, maybe the debate hasn’t yet progressed to address how the competing systems would function in detail.  If that’s the case, we’re a long way from thinking of what value means.