Wednesday, February 24, 2016

FBI vs. Apple, Some Observations

·      The FBI is trying to force Apple to write code which will do three things. First, it will eliminate those part of the current operating system which makes the data on the current phone indecipherable after 10 failed password attempt. Second, it will eliminate the increasing time intervals between password attempts at accessing the device. Third, it will allow password attempts be allowed remotely from a computer rather than being entered in by hand.

·      The FBI wants to use “brute force” to discover the correct password to the phone. In other words, a computer will try every possible combination of number and letters until it hits the correct one. If the password is composed only of numbers and has four digits, this can be done very quickly by computer, since there are only 10,000 possible number codes. If it is an alphanumeric code, it takes more time since, rather than only ten possibilities for each position, there are 36. If the password is case sensitive, then there are 62 possibilities. If the password is an alphanumeric code which is case sensitive and has six positions, then it will take even more time. The time to discover the correct password depends on the number of possible combinations of symbols, how fast the computer using the brute force is, and how fast the iPhone can respond. Obviously, adding symbols as well as letters will increase the number of possibilities. How long it would take to break into the particular iPhone in this case is not clear.

·       The FBI is relying on a short, ambiguous 1987 statute, the All Writs Act, to try to compel Apple to write the necessary code. The courts will have to resolve whether the All Writs Act is applicable in this case. If some sort of resolution is not reached between Apple and the government, then it seems likely that this will reach the Supreme Court.

·       Bill Gates entered into this discussion by leaning to the government’s side, but not completely.

·       Gates used an analogy to banks giving up customer transaction information to law enforcement authorities. Gates, though, is understating what banks are required to do. Not only must they respond to subpoenas, they are required to file suspicious activity reports (SARs) to a bureau of the U.S. Treasury Department, the Financial Crimes Enforcement Network (FinCEN). Often these are transactions that could involve money laundering or violation of U.S. international sanctions regulations (which are promulgated by another part of the Treasury, the Office of Foreign Assets Control.) When a particular bank gets into trouble for having lax controls, or actively assists, in money laundering or sanction violations, the volume of SARs increases as other banks start playing it safe. The banks are prohibited from telling their customers about any SARs reports.

·       Supporters of Apple’s position argue that, if Apple is forced to write this computer code, other countries (such as China) may lean on it to use the same method to force entry into the phone of its citizens in order to suppress dissent. These countries could do that now, though Apple’s ability to resist such demands might be weakened if the FBI prevails.

·        It seems unlikely that there is anything of interest on the particular phone in question. The government already has the metadata from the phone and what was backed up to Apple servers. The auto backup function of the phone was disabled a few weeks before the San Bernardino attacks. This is what the government wants.

·       It is pretty clear that the government is using a case involving terrorism to set a precedent. It seems to be winning in the court of public opinion.

·       It is not clear how the courts will resolve this case or whether Congress will be able to pass a law clarifying the government’s ability to force software companies to write code in order to assist its investigations.

·      The technology industry is probably correct in saying that there is no foolproof way to leave a backdoor into a smartphone’s data that can be limited to the government and the manufacturer. Hackers will probably find a way to break in.

·       If U.S. technology companies are prohibited from creating encryption for phones that make them secure from outsiders without some sort of backdoor, others, perhaps companies located abroad, will do so.

·       The issues are not easy, and it is healthy to have a debate. The law is having difficulty keeping up with technology.

Thursday, January 14, 2016

“The Big Short” Movie: My Review

Yesterday, I saw “The Big Short,” a movie based on the book by Michael Lewis. It was announced today that it one of eight films nominated for the “Best Picture” Oscar award. It is an entertaining movie, but I doubt that it will have much, if any, impact on the regulation of financial markets or financial institutions.
The movie focuses, as does the book, on a few, rather strange persons (fictionalized in the movie) who saw that there was a housing bubble of major proportions and that, when it burst, many of the mortgages which had been packaged into mortgage-backed securities and subsequently into collateralized debt obligations (“CDOs”) would end up in foreclosure. They decided to short the market in a big way and were ultimately rewarded.
For those who have not heard of CDOs and credit default swaps, the movie, while both entertaining and in places comedic, is a painless introduction of some of the practices that led to the 2008 financial market meltdown. It is, though, by necessity incomplete and a bit misleading.
In particular, the description of synthetic CDOs, which features Richard Thaler, an economist playing himself, and actress Selena Gomez in a Las Vegas casino is incomplete. Rather than trying to explain that synthetic CDOs were created by putting in them credit default swaps referencing mortgage-backed securities, instead of the securities themselves, the movie’s explanation of this describes the betting that this structure facilitates.  
The reason that this is important is that it was the presence of short sellers that enabled the creation of the credit default swaps that were put into the CDOs. How much this exacerbated the financial crisis has been debated. “Yves Smith” of the blog “Naked Capitalism” is rather caustic on this point.
While the real life characters on whom the movie is based were not that big nor that significant compared to someone like John Paulson, who was also shorting the market, in one instance controversially involved with Goldman Sachs in creating a very bad synthetic CDO (“Abacus”), they were more opportunistic in seeing the trade of a lifetime than heroes. To be fair, the movie does not portray them as unalloyed heroes, but it is clear for whom the audience should be rooting.
Also, while the bailout of the major financial institutions is implicitly criticized, it is left unmentioned that the short sellers benefitted from the bailout, in particular that of AIG, which ended up holding much of the risk that other financial institutions wanted to unload through the use of credit default swaps. If the government had not undertaken through TARP and other measures to bail out the Street, the counterparties to the shorts might not have been able to come up with the money they owed the shorts.
This is all perhaps more complicated than an entertainment movie could put into a story, but it is worth reminding ourselves of what happened. The Street needed the shorts to create the synthetic CDOs. The synthetic CDOs were easier to construct than CDOs with actual mortgage-backed securities, and, moreover, even with the flurry of mortgage lending there was not enough mortgages to meet the demand for CDOs.
The movie implies that it was mainly a few people with somewhat inadequate social skills who saw that there was a housing bubble. Plenty of people saw it; it was just as obvious as the tech stock bubble that preceded it. The failure of the Federal Reserve, and in particular Chairman Greenspan, to see that there was a bubble and to use the Fed’s existing authority to rein in the abusive lending practices in subprime mortgages was a gigantic mistake. There is, though, plenty of blame to pass around. (The Onion had a funny article in July 2008 headlined “Recession-Plagued Nation Demands New Bubble to Invest In.”)
What many did not see, though, was the major financial calamity that would result when the bubble burst. After all, the end of the tech stock bubble, while unpleasant, was manageable. The bursting of the housing bubble and the subsequent financial crisis is still affecting us eight years later.
The shorts were right in realizing that the bursting of the bubble would be calamitous. But they were also lucky. While bubbles of the magnitude of what happened in housing and tech stocks are not hard to see, it is near impossible to predict when the supply of “greater fools” will run out and the whole thing collapses. The movie gets at this by depicting the losses and withdrawals one hedge fund manager had to endure while he waited for the massive defaults he knew were coming. If he had been a bit more off on his timing, he may not have had the financial wherewithal to keep his positions until they paid off.  
At the end, the movie criticizes the failure to break up the big banks and the failure to prosecute the fraud that took place. This may make some moviegoers angry, as it should, but I doubt that this movie will change the political realities.
Nevertheless, the movie is worth seeing. The acting is first rate, it captures the characters and the atmosphere of the mortgage frenzy, and, in places, the movie is quite funny. Also, while the explanations of some of the financial instruments are incomplete, it serves to bring some more clarity in an entertaining fashion to those not familiar with the arcana of the Street about what happened.

Wednesday, January 6, 2016

“Netanyahu at War” Documentary – Some Comments

Last night (January 5, 2016), PBS broadcasted an interesting Frontline documentary, “Netanyahu at War.” The documentary focuses on the troubled relationship Israel has had with the U.S while Benjamin Netanyahu has been Prime Minister.

Interestingly, the documentary indicates that Netanyahu has failed to understand U.S. politics even though, of all Israeli leaders, he has the best background to understand this country. He and his family moved to the U.S. when he was seven, and he went to U.S. schools from that time on (including high school). He earned two degrees at MIT and was studying for a doctorate in political science at Harvard but returned to Israel after his older brother was killed in the Entebbe raid. He also was an official at the Israeli embassy in Washington in the early 80s and subsequently served as the Israeli ambassador to the U.S.

This documentary, which is almost two hours long, is well worth watching. The end of the program focuses on the nuclear negotiations with Iran and the dismal professional and personal relationship between Netanyahu and President Obama. Netanyahu’s decision to address Congress in order to urge them to scuttle the deal was clearly a mistake. Since he lost, his actions in defiance of a U.S. President showed that the supposedly invincible Israeli lobby could be beaten. His attempt to convince American Jewish voters of the rightness of his cause also did not succeed. The vast majority of Jews voted for Obama both times he ran. Throwing his hat in with the Republicans, when most Jews are Democrats, was a mistake by Netanyahu that Israel will have to correct. It is possible that Netanyahu mistook his conversations with rich, conservative American Jews as representing general American Jewish opinion. According to Jeffrey Goldberg, who is interviewed in the documentary, Netanyahu and his entourage were sure that Mitt Romney would win the 2012 presidential election, and were like Fox News “bitter enders” before admitting to themselves that Obama had won. (The Israelis would have had better intelligence if they had read Nate Silver’s 538 blog, then hosted by the New York Times.)

There is a lot more to the documentary, including arguments concerning whether Netanyahu’s actions and speeches in 1995 helped create the atmosphere contributing to the assassination of Prime Minister Yitzhak Rabin. Netanyahu was an implacable opponent of the Oslo peace process to which Rabin had subcribed. The treatment of this subject gives both sides their say.

Nevertheless, I have a few quibbles. The first is stylistic. I dislike Will Lyman’s voice of god narration for the Frontline programs, which seems to be a cheap way to stack the deck in favor of whatever point Frontline is making. (How could you possible disagree with that authoritative voice? But I have.)

Also, the program did not indicate the background and positions of some of the interviewees. For example, while correctly identifying Ron Dermer as Israel’s current ambassador to the U.S., there is no mention of his professional ties to the Republican Party as an American citizen and his role in arranging Netanyahu’s speech to Congress with Speaker John Boehner. However, Ron Dermer does not come off all that well in the show unless you totally agree with him. He sounds like many political operatives who show up on cable political shows who do not depart from their talking points.

Also, Ari Shavit, who wrote an interesting book on Israel (my review is here) makes the main point of the documentary at the end that, if things turn out badly, the years 2009 to 2015 will be viewed as a sad chapter in history and a failure of the Americans and the Israeli governments to work together. What is not mentioned is that, while Ari Shavit, who work for the liberal Israeli newspaper, Haaretz, is in some ways a liberal in Israeli politics, he agreed with Netanyahu’s reasons for opposing  the nuclear deal with Iran. This is probably what he was talking about in his interview, but the editing takes away some of the context. (Shavit though did not agree with Netanyahu’s tactics of opposing the American President on this. See “An Israeli Triumph Over Obama on Iran Could Be Disastrous.”)

Nevertheless, I recommend the program for those interested in Israel and the Middle East in general. Now that we see the total breakdown of relations between Saudi Arabia and Iran, the Israeli situation underlines how complicated the politics of the region are. For the U.S., there is no obvious optimal Middle East foreign policy, but the current and subsequent American presidents will have to navigate this difficult terrain as best they can. It is way too easy to get things wrong. One can only hope that they avoid some of the disastrous decisions of some of their predecessors.

Wednesday, November 18, 2015

Shaky Ground: The Strange Saga of the U.S. Mortgage Giants by Bethany McLean

Bethany McLean’s new book, Shaky Ground: The Strange Saga of the U.S. Mortgage Giants, is short (about 150 pages) but filled with useful information and analysis concerning the two biggest government-sponsored enterprises (“GSEs”), Fannie Mae and Freddie Mac. I recommend this book for anyone wondering about these entities and why they are still in conservatorship.

I should point out at the outset that I spent most of my career in the Domestic Finance section of Treasury, and the Treasury, no matter the political complexion of the Administration, took a dim view of Fannie and Freddie. The career Treasury official I worked for in the first half of the 1980s summed up the attitude succinctly by remarking that Fannie Mae and Freddie Mac officials paid themselves private sector salaries without taking private sector risks. While Treasury would take every opportunity to say that GSE debt was not guaranteed by the U.S. government, the market assumed, rightly as it turned out, that if the GSEs ever got into trouble, the U.S. government would make good on the debt. In other words, Treasury was correct as a legal matter in saying that the debt was not guaranteed, but most, if not all, Treasury officials knew that the Treasury would have to do something if they got into financial trouble because of the implicit government guarantee. The shock to the financial system of a Fannie or Freddie default would be too great.

In fact, it was the implicit government guarantee that effectively saved Fannie Mae in the 1980s. Fannie Mae was then faced with the same problem as the savings and loans in a rising interest rate environment. Both Fannie and the S&Ls were financing long-term assets (home mortgages) with shorter term financing. When the cost of financing became much higher than the return on their assets, this proved to be a big problem. Fannie solved this by resorting to issuing mortgage-backed securities, on which Fannie bore credit but not interest rate risk, and by changing its financing strategy so that the duration of its liabilities more nearly matched the duration of its assets, thus reducing its interest rate risk. (I am using the term “duration” in its technical sense, which is related to but not the same as maturity, but you can probably follow what I am saying even if you do not how to calculate duration.) Fannie would not have been able to do this and effectively grow out of its problem without the implicit government guarantee that afforded it continued access to the credit market. Real private companies would have faced downgrades on their debt and eventual failure.

Another reason for Treasury resentment of the GSEs is that, when it came to policy issues that affected them, the GSEs would either argue as if they were  private corporations or as if they were government entities, depending on the particular issue. Fannie Mae, in its publicity, stated that this mixture of public and private worked for the benefit of housing and the U.S. economy. From the Treasury perspective, Fannie and Freddie did just enough for low income housing in order to form a formidable political coalition including the housing finance industry, real estate brokers, and advocates for low income housing.

Further, Treasury was keenly aware that Fannie and Freddie were thinly capitalized. Officials from both companies would argue that they had a good handle on their risk, and that the only thing that could bring them down was a housing bust all over the United States, rather than in  particular regions. Treasury was resigned to appreciating that nothing really could be done about them unless they got into real trouble. In the event, there was a housing bust, and the U.S. government took them over.

Nevertheless, I do not subscribe to the view that the activities of Fannie and Freddie were major causes of the financial crisis. The person most associated with pushing this view is Peter Wallison, a former General Counsel of the Treasury Department during the Reagan Administration and currently co-director of financial policy studies at the American Enterprise Institute, a conservative think tank in Washington, D.C. He was also a member of the Financial Crisis Inquiry Commission and wrote a dissent from the Commission’s report. In his dissent, he argued that a prime cause of the crisis was the affordable housing goals of Fannie and Freddie. This was too much for his fellow Republican commissioners, and they jointly filed a different dissent, which, as I have previously commented, made reasonable arguments.

Bethany McLean easily demolishes Wallison’s argument by pointing out, among other things, that the mortgages Fannie and Freddie bought or securitized were not as risky as Wallison claimed and the two institutions were latecomers to the subprime party. As for the more sophisticated argument that Fannie and Freddie took all the good loans, leaving only bad loans for the private sector, McLean writes that “this leaves a lot of other factors unexplained. Among them: Why was there so much money, for a period of time, to be made on these fringes? Why didn’t the private sector do what it was supposed to do best, namely manage risk?” (p. 55)

It is unclear why Wallison has been obsessed with Fannie and Freddie. He may be trying to make a political case that stricter regulation of the private financial sector is unnecessary because the financial crisis, in his view, is the result of government policies. As I have indicated, I am not a fan of these companies and their activities were part of the myriad of causes for the financial crisis, but focusing on these companies and leaving out other actors, which had much more to do with the crisis, is a mistake. There is plenty of reason to question whether initially privatizing Fannie and Freddie (their respective histories, incidentally, are different) were good ideas, and, as McLean points out, the political process has not produced any consensus about what to do with these entities.

Fannie and Freddie are currently profitable, but the profits are flowing to the U.S. government, which I suppose should please deficit hawks. For example, in calendar year 2014, Fannie paid the Treasury $20.1 billion in dividends and Freddie paid $19.6 billion. However, when the government put the two GSEs into conservatorship, it left 20.1% of the common stock in private hands in order not to include the two companies’ debts on the U.S. balance sheet. Now the holders of the common stock and preferred stock have gone to court because they believe that they have a right to some of the profits the GSEs are generating. Whether or not they do has not been finally decided by the courts.

Fannie and Freddie are providing significant financial support to the housing market. Left undecided is what role the government should play in housing. The 30-year fixed rate mortgage is possible because of Fannie and Freddie, and U.S. homebuyers have become accustomed to the availability of this type of loan. On the other hand, government subsidies to housing – and Fannie and Freddie are only part of that – arguably distort markets and encourages more resources to be devoted to housing at the expense of other sectors of the economy and encourages families and individuals to buy larger houses than they really need or would otherwise buy. Since there is no consensus on what to do with the GSEs, they continue in conservatorship and, at least until the courts have finally spoken, providing their profits to the U.S. government, which also effectively bears the risks from their operations.

There is much more to the book, including discussion of Ed DeMarco, who was acting head of the regulator of  Fannie and Freddie, defying enormous pressure to have them provide relief to borrowers. There are also some errors and oversights in the book, though none are critical. I will single out two here. The author uses the term government-sponsored enterprise to refer to only Fannie and Freddie. In fact, there are other GSEs, such as the problematical Farm Credit System. (The GSE that has been successfully spun off from the government is Sallie Mae, which is active in the student loan market.)

Also, the author quotes former Treasury Secretary Tim Geithner saying “how little authority we had over Fannie and Freddie” without mentioning that Treasury had the authority to approve (or disapprove) their debt issuances. Treasury had used that authority mainly as a traffic cop, that is, to make sure that the Treasury and the GSEs were not all issuing debt at the same time. Treasury stopped acting as a traffic cop during the Clinton Administration. However, in the early 1980s, Treasury used the authority to stop Fannie Mae from issuing debt in a manner motivated by questionable tax strategies. In one instance, it stopped Fannie from setting up a Netherlands Antilles financial subsidiary as a way to issue bonds in Europe without imposing a 30% foreign withholding tax. (Tax law regarding the 30% foreign withholding tax was subsequently changed to exempt “portfolio interest income.”) The Treasury could likely have been more aggressive in using the debt approval authority, as Fannie and Freddie grew their mortgage portfolios, on which they bore both interest and credit risk, in the decade leading up to the financial crisis, but shied away from doing that.
Fannie and Freddie have long been absent from the headlines, but what ultimately to do about them is important. They should not be in conservatorship forever. Despite my quibbles, I recommend this book is for those interested in the subject, whether or not they are previously familiar with these two companies.

Thursday, October 15, 2015

Treasury Auction Manipulation Investigations and Litigation – Some Comments

There have been allegations of manipulation by major dealers of the auctions for U.S. Treasury securities. Apparently, at least twenty-five lawsuits have been filed, and the U.S. Justice Department and the New York Department of Financial Services are investigating. The back story to these lawsuits and investigations is not public, and the Treasury does not seem to be commenting.

In brief the allegation is that major dealers collude in keeping the yield up (or price down) in Treasury auctions. The complaints compare the auction results to trading in the when-issued market for the same security and contend that statistical analysis shows that there must be collusion.

It is certainly possible, but, after having read two of the complaints (State-Boston Retirement System v Bank of Nova Scotia et al, U.S. District Court, Southern District of New York, No. 15-05794 and Cleveland Bakers and Teamsters Pension Fund et al v. Bank of Nova Scotia, New York Agency et al), I do not think the issue is that clear. The statistical evidence in these complaints is badly presented, and the authors, while assuming the pose of experts on the government securities market, seem to have studied up on this market fairly recently. For example, their knowledge of bond math is limited.

One problem with their argument, as “Yves Smith” on her naked capitalism blog points out, bidders in Treasury auctions may effectively demand a concession in price to act effectively as underwriters for a sizeable chunk of securities.  She thinks, though, that the plaintiffs will avoid a summary judgment against them and will proceed to discovery. If there is evidence of collusion, such as emails or chat room discussions, then there will be a case to be made.

While this is interesting, what the commentary I have read misses is that prior to changes that happened in the government securities market, by government actions, market developments, and technology, the information advantage that primary dealers enjoyed was much more significant. For example, in the 1970s and 80s, primary dealers were the only ones allowed to trade at the major interdealer brokers, with the exception of Cantor Fitzgerald, which operated a government securities trading facility. Consequently, the primary dealers had access to an inside market which was not transparent to anyone outside the club. One firm, which was not a primary dealer, Lazard Frères, complained loudly about this state of affairs, but got no support from Treasury and made no headway in its complaint.

When it came to the auctions, at the time Treasury auctions were multiple price, that is, Treasury accepted bids at the highest prices (or lowest yields) until the amount offered was sold. Competitive bidders had to pay the price that they bid, even if that was higher than the average price. This type of auction poses the problem of the “winner’s curse” for participants; in other words, they run the risk of paying too high a price for the securities. Large investors, therefore, bid through the primary dealers, because they knew that the primary dealers were better able to know the real prices in the market. The primary dealers provided this service for free, because the amounts their customers were bidding for provided them useful information about the underlying demand for the securities. This system worked for the Treasury, but it undeniably gave the primary dealers an advantage and could be criticized as unfair.

Since then, the interdealer market has changed, and prices are much more freely available (though some firms, such as Bloomberg, charge a considerable amount for the use of their terminals). Also, the primary dealer advantage in the auction has been eroded, since Treasury now auctions its securities in single-price auctions. The best bids are still the ones accepted, but all successful bidders pay the lowest price accepted, thus doing away with the winner’s curse problem. (The argument from a cost perspective for Treasury is that the amount of money that Treasury “leaves on the table” is made up for or more than made up for by the higher prices bidders offer in this type of auction. In other word, bidders are not tempted to shade their bids but are more willing to bid based on their true demand curve in this type of auction, since they know that they will not overpay for the securities.)

In single-price auctions, there is less reason for investors to go through a primary dealer, and the amount of direct bids by investors has increased. This seems to be a fairer system for Treasury auctions. However, one can easily see that single-price auctions do leave room for collusion, and perhaps game theorists should study whether the opportunities and temptations to collude are greater in single-price or multiple-price auctions.

In any case, it will be interesting to see if the government investigations or the private class action lawsuits develop any hard evidence beyond the statistical analysis. One interesting point is that the statistical evidence for collusion apparently end after the Libor manipulation investigations become public.

Sunday, September 20, 2015

Update on VW Diesel Emission Investigation

After I posted my last entry on this blog, “Volkswagen, Diesel Emissions, and Regulatory Failure,” Bloomberg published an article on its website, “VW's Emissions Cheating Found by Curious Clean-Air Group,” which explains how the VW diesel emission issue was discovered.
Briefly, according to the article, the International Council on Clean Transportation (“ICCT”), a non-governmental organization headquartered in Washington, DC with other offices in San Francisco and Berlin, decided to test certain American versions of diesel cars in order to demonstrate that U.S. stricter emission standards could be met. In Europe, there were questions about the lab test for emissions of the European versions of these cars. In other words, the researchers were not initially suspicious of Volkswagen.
The researchers asked for help from West Virginia University’s Center for Alternative Fuels, Engines and Emissions since it had the right equipment to measure emissions while a car is being driven. The testing demonstrated the excess emission of nitrogen oxides from the VW cars. This was not the case with a BMW, which was also tested.
ICCT’s press release on this matter can be found here.      
Meanwhile, press reports (here and here) indicate that VW has told its U.S. dealers to halt sales of 2015 model year diesel cars and the 2016 diesel cars have not yet been certified by the EPA for sale. VW dealers must be fuming.                                                                                                                                    

Saturday, September 19, 2015

Volkswagen, Diesel Emissions, and Regulatory Failure

Yesterday came the news out of the blue that the Environmental Protection Agency and the California Air Resources Board are charging Volkswagen with incorporating software in 2009-2015 diesel cars that enabled cheating on emission tests, particularly the emission of nitrogen oxides. According to the EPA, VW has admitted the use of a so-called “defeat device” in these cars. The EPA letter to VW states: “It became clear that CARB and the EPA would not approve certificates of conformity for VW's 2016 model year diesel vehicles until VW could adequately explain the anomalous emissions and ensure the agencies that the 2016 model year vehicles would not have similar issues. Only then did VW admit it had designed and installed a defeat device in these vehicles in the form of a sophisticated software algorithm that detected when a vehicle was undergoing emissions testing.”
The defeat device software was designed to sense when a car was being tested for emissions and would reduce emissions in order to pass the test. However, the degree of emission control used during the test is not applied when the car is being driven, and emissions are then significantly higher for nitrogen oxides and not in conformity with EPA or California requirements.

Though this is not spelled out by the agencies, presumably turning off some of the emission controls enables better performance and better fuel mileage. Approximately half-a-million cars may have this defeat device and will have to be recalled for a fix yet to be devised. (Disclosure: I own one of these cars.) There may be some reluctance among some owners to bring their car into a dealer for the fix, if the fix for the emission issue results in less power and worse fuel mileage. How the cars will be affected is not clear at this point. VW is under orders to devise a fix, but has not yet done so.

The EPA has the power to fine VW; press reports indicate that VW’s potential fine could be up to $18 billion, but most observers think it will be substantially less than that. Meanwhile, while the EPA and the CARB continue to investigate, the Justice Department is also investigating. Justice is presumably investigating whether any criminal charges should be brought.

West Virginia University and International Council on Clean Transportation (“ICCT”) researchers initially discovered the discrepancy between emissions in real-world driving and test results. (Update: More information has since appeared about this, which I summarize in the next post. The ICCT was not initially suspicious of VW, but was looking at the differences in the emissions between European and U.S. versions of the same cars because of questions that had arisen about the emissions of these cars in Europe.)
The West Virginia researchers may not have looked at the responsible software code. An interesting article by Alex Davies on the Wired website, “The EPA Opposes Rules That Could’ve Exposed VW’s Cheating,” explains that this likely would have violated the 1998 Digital Millennium Copyright Act, which is administered by the Copyright Office of the Library of Congress. According to the article, in December 2014, the Copyright Office was asked to grant exemptions from certain provisions of the Act for software used in cars, trucks, and agricultural machinery. The article states: “Having access to car controls would allow for ‘good-faith testing, identifying, disclosing, and fixing of malfunctions, security flaws, or vulnerabilities,’ [the exemption proponents] argued, according to comments they submitted to the Federal Register.”

The Alliance of Automobile Manufacturers opposed granting the exemptions, and the EPA opposed all the requested exemptions, but one, on which it did not take a position. The EPA was concerned that granting exemptions from prohibitions from examining the computer code would enable consumers to change the code in order to boost performance of their vehicles at the expense of higher emissions. The Copyright Office has not yet made a decision. The Wired article concludes:
The irony of the EPA’s concern over owners altering their vehicle code in a way that would violate the Clean Air Act is that VW was allegedly using its surreptitious algorithm to do exactly this—that is, to favor performance over fuel economy in a way that violated the Clean Air Act. And legalizing public access to the software used in the 482,000 VW cars now being recalled could possibly have revealed the alleged “defeat device” code earlier. As noted on Twitter by Thomas Dullien, a prominent security researcher and reverse engineer who goes by the handle Halvar Flake: “The VW case is an example why we need more liberal reverse engineering regulation. In a world controlled by code, RE creates transparency.”
Meanwhile, in Europe, where about half the cars are diesel, there has been concern that lab testing of automobile emissions is not providing accurate results. The European Commission plans to impose real-world emission testing requirements in 2017. There is some skepticism about whether the new testing regime will close the gap enough between test results and emissions produced by cars on the road.  

EU requirements for nitrogen oxides emissions are not as stringent as those in the U.S. Nevertheless, according to a February article in The Guardian, there are suspicions that auto manufacturers may be using “tricks” to pass the emission tests. The article does not address whether any of these suspected “tricks” are violations of law. At least some of them may be permitted loopholes. Regarding the current emission tests, the article states:
But the current ‘New European Drive Cycle’ laboratory test for measuring these emissions is a quarter of a century old, and has been outpaced by technological developments in the car industry. Studies have shown that lab techniques to measure car emissions can easily be gamed with techniques such as taping up doors and windows to minimise air resistance, driving on unrealistically smooth roads, and testing at improbably high temperatures.
Campaigners say that car makers also use tricks such as programming vehicles to go into a low emissions mode when their front wheels are spinning and their back wheels are stationary, as happens in such lab experiments.
Note that the programing trick the article refers to is similar to what VW has been accused of and admitted to doing in the U.S.  

The concern in Europe has recently been increased by a recent report claiming that only ten percent of new diesel cars meet current requirements. The concern in Europe about the health hazards of diesel cars has been building for some time. There are proposals to ban diesel cars in Paris in 2020, and the French government wants to phase out diesel cars. London is also considering restricting diesel cars, and Mayor Boris Johnson plans to impose a surcharge in addition to the congestion charge on diesel cars in 2020.
Clearly, there have been policy and regulatory failures with respect to diesel cars on both sides of the Atlantic. Europeans are reconsidering their move to diesel cars, and, in the U.S., I would think that the tax credits for diesel cars that were in place for a while to encourage diesel as an alternative automotive fuel will be viewed as a mistake. (I benefitted from that tax credit.)

Opponents of government regulation will no doubt jump at this experience to demonstrate how the government, with even the best of intentions, manages to do the wrong thing. That government policy was not well thought out in this area is clear. (I posted a comment in 2012 about how volume illusion was exaggerating the greater efficiency of diesel engines. A given volume of diesel weighs more than an equal volume of gasoline.) The inadequacy of testing and VW and perhaps other car companies apparently manipulation of test results are real failures of both the public and private sector. However, I don’t think that one can make an argument that without government regulation, automobile emissions would be less than they are now. They almost certainly would have been worse.
What VW has apparently done is appalling and that it took U.S. regulators this long – the cars in question date back to the 2009 model year – is not encouraging. VW of course will pay a price. Its dreams of becoming a major player in the U.S. market would seem to be shattered, and its bet on diesel cars is in question. It is not clear, though, whether other technologies than that used in the VW cars that are likely to be recalled and that are in use in some diesel cars in the U.S. are adequately reducing emissions. It is also possible that new cheaper and effective technologies can be developed without too much sacrifice.

Note: This post was updated in light of new information about the ICCT and West Virginia University research into this issue, which is discussed in the next post.