Finance Guy

Is Being an Ideologue a Contributor to Stupidity?

2012-01-20T06:36:00.009-05:00

A gratuitously provocative question?

Maybe not.

Consider the following equation:

TA * TR = TB.

Let's say TB represents some "financial obligation" among a group of people. Further, let's say that at some point in time, the group has a TB of 40. And then, almost 30 years later, TB equals 55.

Now, if you don't know the values of TA and TR, what would be logical to conclude about how they must have changed over that period?

This one is so simple, it couldn't stump an eighth grader who wastes most of math class staring out the window. For TB to increase on the right side of the equation, one of the two variables on the left side of the equation must have increased -- or perhaps both did, in some combination.

But what if you're an ideologue? And what if your ideology leads you to think a "TB" of 40 for this particular group is already high? And what's more, you vehemently insist that TR should be as low as possible, and that a lot of economic problems result from a high TR?

So what happens when you see:

TA * TR = 40

Jump to:

TA * TR = 55

It's clear to you what the problem is. TR! Because TR is always the problem! You don't spend a lot of time mulling over what may be going on here. You fixate on TR, because that's what you always fixate on.

In which case, your name might be Ari Fleischer.

Because this equation is really: "Taxable Amount (taxable income of the top 10% of the population) times the Tax Rate (tax rate of the top 10% of the population) = Tax Burden (the percentage of overall federal taxes paid by the top 10% of the population)".

Fleischer, President Bush's former press secretary, recently tweeted that the "Tax Burden" of the richest 10 percent soared from 40 percent in 1979 to 55 percent in 2007. The implication: the TR (Tax Rate) on this group is already high enough, and this group is carrying more than its fair share of the TB (Tax Burden).

But ideology -- his visceral dislike of taxation, and the welfare state, and wealth redistribution -- has made him too dumb to see how a simple equation works.

Because consider this thought experiment: if in 20 years, the income of the top 10 percent explodes and the other 90 percent of the population become their slaves and earn no income (and meanwhile the Tax Rate doesn't change at all), the top 10 percent will pay 100 percent of taxes (up from 55 percent). But what does that show? That they're being taxed too much?

Of course not. It shows that we've regressed to something akin to a feudal society.

There are two variables on the left side of this equation, TA * TR = TB. If you're an ideologue you tend to miss stuff like that. (See Mark Thoma proving here that, yes, the answer to the mystery of what happened with the Tax Burden does lie with "TA," as the richest scored the biggest income gains over the last three decades.)

But ideologues don't do nuance well. They also abhor cognitive dissonance.

This is why I think Peter Wallison has become a sort of trivial hand puppet for the right, a useless one-note screech owl in his vehemence that it was Fannie and Freddie that caused the financial crisis (and he apportions no blame at all to Wall Street's securitization machine). He can't see beyond his ideological blinders.

P.S. For those of you thinking that Fleischer's "tax burden" is a percent, not a straight-up number like 40, yes, I've simplified. But the argument isn't impaired by this simplification. The ratio just introduces a second layer of complexity. If you understand math, you know what I mean. If you don't, I can write it all out ...

Bill Black Takes on the "Fannie and Freddie Did It" Meme

2011-12-30T07:27:00.003-05:00

I really enjoyed this piece for its knowledgeable, historical analysis. Black doesn't exactly side with the "It Wasn't Fannie and Freddie" crowd, but he's more unsparing in his criticism of ideologue Peter Wallison, whose position "It Was All Fannie and Freddie" is laughable (and Black shows us even more reasons why).

I'm willing to move up Fannie and Freddie on my list of causes of the crisis to, say, number 6 or 7 from number 11. ;)

Black frames the problem well, I think. What caused problems wasn't Fannie and Freddie's mandate to help the poor -- in other words, all those do-good liberals trying to put welfare Moms in houses they couldn't afford. It was, plain and simple, accounting fraud to lavish bonuses on the top echelon of executives -- the same problem found at investment banks that were more direct causes of the crisis.

Joe Nocera Takes on the Big Lie

2011-12-26T06:11:00.004-05:00

I've often thought you could make a case for Fannie Mae's and Freddie Mac's culpability in the financial crisis: a very, very small case.

So, if you started listing reasons for the crisis, they might come in, say, number 11 or thereabouts.

What amazes me is the persistence of the simple-minded Republican narrative that they were the cause of the financial crisis. Not a cause. But the cause. (And the hard-core faithful don't want any other causes entered into the record, as when the four Republicans on the FCIC voted to ban the words "shadow banking" and "deregulation" from the final report!)

This viewpoint is so ignorant and ill-informed, so contrary to "the truth on the ground" that we know from how this crisis developed and what it looked like as it unfolded, that it strains credulity. Is Peter Wallison so ideologically blinkered that he can't even process a set of historical facts in a logical way?

Joe Nocera had a good recent column about this, The Big Lie.

What I enjoyed best though was the second comment that appeared afterward. Excerpts:

I was a mortgage broker during the housing bubble. I can tell you that a "conforming" loan -- one that was run through Fannie or Freddie's "desktop underwriting" software -- always made us nervous. We got rejected for approval regularly whereas if we sold a subprime loan with a higher interest rate we got approved more easily and made much more on the loan ... rather than blame what was in essence a good government program for the housing collapse I say a lot of it deserves to go to the lenders and brokers who hustled these loans.

Once mortgages became securitized and the lenders had no skin in the game the whole system went to hell.

Exactly, and a flaw I noted in the securitization model (and I'm far from the first person to make the observation) almost two years ago.

Earth to Peter Wallison: Are you listening?

Keep an Eye on That Shadow Banking, Folks

2011-12-10T07:05:00.004-05:00

Because it's starting to rear its ugly head again.

Turns out that what may be at the heart of MF Global's gaping hole on its (off) balance sheet: collateral that may have been shifted over to its U.K. unit to permit rehypothecation.

"Rehypothecation" is one of those mouth-filling words that basically says you can repledge the same piece of collateral (a useful trick in the shadow banking world of repo).

In the U.K., the collateral can be endlessly rehypothecated, again and again and again, creating long, unstable, dangerous chains -- and the interesting concomitant, lots of liquidity (which tends to act like a stimulant -- call it cocaine for the financial system -- and we know how hard it is to break a drug habit). Reuter's Christopher Elias:

This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing.

Ladies and gentlemen, this is h-u-g-e. Too few people have wrapped their brains around this. We have central banks that greatly influence money supply/liquidity through their open market operations. Then we have a massive, off-balance sheet system of shadow banking that does the same with no oversight, in complex ways we barely comprehend.

This is a powder keg waiting for a spark.

For more, check out Alphaville's "Shadow Banking and the Seven Collateral Miners."

Europe's Bailout Fund -- Seriously, WTF Is This Thing?

2011-11-30T05:57:00.002-05:00

I tried to figure out the EFSF again (the European Financial Stability Facility) and, once again, my brain exploded.

I can't figure out if this Rube Goldbergian mother of all securitization schemes is:

(a) a way to secretly print a whole bunch of euros behind door #24 while everyone is distracted by the elephant and monkey show in Exhibition Room C.

(b) a clever new way of shunting tail-risk into a vehicle that, when it fails, will send fireworks high into the night sky as the eurozone spectacularly implodes.

(c) a way of handing out 1,000 gold-plated pigs when there are only 10 gold-plated pigs in the warehouse, vague promises of 990 more gold-plated pigs, and a whole lot of securitization in between.

(d) a full-employment act for structured finance professionals on the continent.

(e) some combination of the above.

Or add your own speculation below. Because, in this Brave New World of Structured Finance, we're obviously beyond the point where an entity (say the IMF) simply extends a loan to some country (or countries) in fiscal straits.

Here's some more commentary on this bewildering high-finance thingamabobby:

More European Financial Chicanery

Fed Funnels Money to Banks on the Sly

2011-11-28T06:12:00.003-05:00

Excellent Bloomberg story showing what was largely an open secret (even if the details weren't known), well before the Fed was forced to cough up the paperwork on its bailout of the U.S. financial system:

Secret Fed Loans Gave Banks Undisclosed $13 Billion

This should be required reading for every American.

The hard-hitting article also reinforces the image of Geithner as a complete tool.

The ground left uncovered: that, for this enormous bailout, we the taxpayer got very little. Our financial regulators, our political leaders, failed to effectively reform a banking system that has metastasized out of control.

New Song Charting on YouTube: "Eat a Banker"

2011-11-20T06:54:00.003-05:00

I found this song on YouTube with its timely message for the 99%:

"Eat a Banker"

It has a rather mellow, swaying beat -- not a violent-sounding song at all. I can even imagine it playing softly in the restaurant as some downtrodden poor person is dining on one of those overfed Wall Street bankers. ;)

In Case Anyone Forgets Why "Occupy Wall Street" Exists

2011-11-20T06:23:00.005-05:00

1. Our Congress -- ahem, the best Congress money can buy -- decided that pizza is a vegetable. This decision makes absolutely zero sense from a health and nutritional standpoint (I love pizza -- I had three slices yesterday -- but if what I ate qualifies as a vegetable, I'm a living, breathing zucchini). However, it makes perfect sense from a food industry lobbying standpoint.

2. AIG won't help struggling homeowners. From Bloomberg: "American International Group Inc. (AIG) is holding out as rival mortgage insurers accept policy changes that support the U.S. government push to stoke refinancing among borrowers with little or no home equity."

Reminder: Not only did the U.S. bail out AIG, the U.S. is currently the MAJORITY OWNER OF AIG. If the U.S. government is too weak-spined to compel AIG to get on board with refis (which almost everyone agrees need to take place to right the listing housing market), then it's clear who's really running the show.

3. Corporations are increasingly paying a smaller percentage of their profits as income tax. At the same time, childhood poverty has been on the rise. Those trends aren't likely to change anytime soon as corporations are the kind of "people" who can write big campaign checks, but a child in poverty isn't similarly flush with excess funds to fertilize Senator Gasbag's re-election efforts.

Working on Wall Street Means Never Having to Say You're Sorry

2011-11-06T06:17:00.003-05:00

Felix Salmon waxed indignant about Jon Corzine's peculiar resignation statement, and laugh-out-loud lines such as, "This was a difficult decision, but one that I believe is best for the firm and its stakeholders."

This is as absurd as someone driving a bus off a cliff, killing everyone aboard but himself, then holding a press conference during which he says in a conflicted voice, "It is with a heavy heart that I wish to announce that I have decided to part ways with the company."

Felix comments, "... would it be too much to ask for just a tiny hint of remorse here? A short apology, perhaps, to the thousands of employees and customers who have lost their jobs or their money?"

Remorse? How do you spell that again?

Wall Street doesn't DO remorse, Felix. C'mon, man. You're smarter than that. Throughout the financial crisis and its aftermath, the lack of remorse was painfully striking.

Almost two years ago to the day, I commented on this phenomenon. We taxpayers weren't thanked by the big banks that received bailout funds (as I recall, Citigroup was a notable exception that came rather late). No apology for their securitization meltdown either. But Blankfein did see fit to note that they were all doing God's work.

And AIG's Robert Benmosche memorably threw a hissy fit about not being able to pay his executives more than $500,000 a year.

Is there really any mystery any longer why "Occupy Wall Street" exists?

Saturday Morning Housecleaning

2011-10-29T07:46:00.002-04:00

I went back and cleaned up a bunch of comment spam. Comment spam, I'm finding out, grows geometrically once it takes root. For instance, my most-popular post ever:

Debunking Gary Gorton's Fire Sale Thesis

Was completely lousy with comment spam, with more than 50 comments, and all but six just crap. The spam had overrun the comment section like some kind of kudzu-inspired mold life form.

In cleaning up the spam, I found myself in the ironic position of deleting comments that offered high (but phony, non-specific) praise of my intellectual insights, while leaving a few comments that basically suggested I was a blowhard (but that were real).

Vive l'open society.

So anyway, be forewarned if you're hawking UK dissertation papers, low auto insurance quotes, shutters for sale in Clearwater, Florida -- I'm onto you. Go foul someone else's watering hole.

Well, I Got This One Right at Least

2011-10-28T07:36:00.002-04:00

Every so often, as a blogger, you look back on previous posts to answer the question, "Was I just being shrill and pessimistic or was I onto something?"

A year ago, I wrote "The Foreclosure Mess: 7 Reasons Why It's Much Worse Than You Think."

And I'd say, though the post wasn't wholly original content, that I got this one right as the MERS mess drags on (random observation: MERS and MESS are practically the same word, as the "r" in MERS is only one letter space -- i.e., p-q-r-s -- away from being MESS. Keep those ironies coming, mortgage industry!)

DVA: Accounting Gimmickry That Makes No Sense

2011-10-18T07:04:00.002-04:00

Once again, the banks are booking big profits based on DVA -- debt valuation adjustment -- because their creditworthiness has deteriorated. Once again, this accounting gimmickry makes absolutely no sense.

The rationale for booking DVA gains: the debt you have issued becomes cheaper as your credit risk rises, so theoretically you can buy it back at a lower price, saving money.

This is ridiculous because it ignores the fact, as I explain in this post from two and a half years ago, that it costs more to raise the money to buy back the debt.

The gains don't exist. They're completely illusionary.

The DVA accounting convention is a sham. It shouldn't be allowed. Isn't there an accountant out there bright enough to see the inherent absurdity in it?

Is Occupy Wall Street the Beginning of the Revolution?

2011-10-11T06:06:00.002-04:00

When I returned to my homeland a few years ago, after the financial crisis and a brief period abroad, I was quite dismayed.

It's not that America suddenly had changed. We had been changing for a while. Money had been growing into a monster force in politics. Our Washington politicians were far too quiet on social issues, like poverty and the distribution of wealth, where armies of lobbyists didn't represent entrenched interests.

Our politics were getting uglier in other ways. There was less ability to work together for the common good. It was as if, in an age of drama-seeking reality TV shows, politicians thought they had to vie for airspace by pumping out increasingly ludicrous and confrontational soundbites.

But what angered me the most was how we blew the opportunity to have a soul-searching moment about our financial system and effect real change after the 2008 crisis.

Steve Waldman has a brilliant paragraph over at his interfluidity blog about the unfairness of TARP:

Once you understand that the problem is a fairness issue rather than a dollars-and-cents issue, the policy space grows wider. Holding constant the level of expenditure, one can make bail-outs more or less fair by the degree to which you demand sacrifice from the people you are bailing out. TARP was deeply stupid not because it meant socializing risks and costs created by bankers. TARP was terrible public policy because it socialized risks and costs while demanding almost no sacrifice at all from the people most responsible for those risks. The alternative to TARP was never “let the banks fail, and see how the bankruptcy system deals with it.” The alternative would have been to inject public capital (socialize risks and costs!) while also haircutting creditors, writing-off equityholders, firing management, and aggressively investigating past behavior. It was not the money that made TARP unpopular. It was the unfairness. And the unfairness was not at all necessary to resolve the financial problem.

Make no mistake: Something like TARP was necessary after credit markets seized up. Letting giant, highly interconnected banks collapse right and left was not an option. But, out of the ashes of the crisis, who was the leader of power and conviction who emerged and swore, Never again!, and who acted boldly and with courage to reform a financial sector that had metastasized out of control?

Nobody.

Everyone pretended what we had gone through was just a bad dream. What we got instead was watered-down legislation that the banks are already skillfully plotting how to evade.

I would say to friends at work, "It's amazing to me that there isn't someone agitating for a revolution. This is awful, with so many people unemployed, and the rich getting richer, and Wall Street's most powerful getting bailed out without punishment or consequence -- why isn't there a populist uprising?"

Finally, along came Occupy Wall Street. The movement has spread. Winter will probably kill the mass protests, or at least put them on hiatus until spring.

But at least the disenfranchised and angry are speaking, maybe not with enough coherence for the media, who are fussing over their nut graphs and story structure, but their frustration is 100 percent genuine and runs wide and deep.

They're speaking, and I find that quite heartening.

Unemployment vs. Inflation: Why Do We Worry Too Much About One, Not Enough About the Other?

2011-09-11T14:39:00.004-04:00

Something that's been kicking around my brain for a few months now:

Why do we get so bent out of shape about the threat of inflation? And why don't we get more bent out of shape about the reality of high unemployment?

I find this really, really puzzling. Inflation, it seems to me, is a bookkeeping problem. Unemployment (beyond the minimal frictional level) is a tragedy.

Thought experiment: Prices of all goods and services inflate exactly 10 percent a year, again and again, steady as clockwork. Manufacturers adjust by raising their prices 10 percent annually. Labor demands 10 percent higher wages. Savers and investors build this 10 percent inflation into their "risk-free return" expectations. Social Security checks increase 10 percent a year.

So who gets hurt? Nobody. Psychologically, you may feel dismayed that last year's $2 loaf of bread now costs $2.20, but your wages of $55,000 are $5,000 higher too.

Now try to create a similar thought experiment for 10 percent unemployment. Millions of workers in the labor force are idle. They're frustrated, angry. For every minute they lack jobs, we as a country lose part of our productive capacity. Their power to consume is weakened. They siphon resources through the social safety net, through food stamp and Medicare programs.

This is unquestionably terrible: for our economy, for our country's self-image, for social and political stability. You can't spin high unemployment in a neutral light. It's impossible.

Now, granted, I know inflation can be harmful. Runaway inflation (Zimbabwe) does have real costs. Also high inflation can inject uncertainty into economic forecasting and planning. And it often does produce classes of winners and losers.

But still: it's not net destructive, not like high unemployment. After all (from an illustrated encyclopedia of economics),

Ignoring menu and distortion costs for a moment, inflation is roughly what mathematicians call a zero sum game. For every loser during inflation (someone who must pay more for a given good), there is a winner (someone who receives a greater price for the things sold).

I dare you to find a respectable economist who maintains that high unemployment is a "zero sum game."

So one more time: Why do we care so much about inflation and so little about unemployment?

One (rather depressing) possibility -- look who's affected.

Unemployment tends to hit the more marginal members of the workforce. If they were any good, some of us think, they'd have jobs, wouldn't they? Inflation though tends to be more of a concern among savers, among those on a fixed income, among businesses (who might even like unemployment to be a bit high to keep their labor costs down). All these groups are politically strong and speak with a louder voice (and fling around more campaign cash) than those bitter, disenfranchised unemployed people.

So what do you think? How to explain our lopsided concern, especially with unemployment at 9.1 percent?

After Many Words, a Short Conclusion on Information-Insensitive Debt

2011-08-21T15:01:00.004-04:00

Why six lengthy blog posts on information-insensitive debt? (By the way, they were published all at once because Blogger has been acting screwy lately, barring me from my account for more than a month. In case you want to refer back to them: Part 1, Part 2, Part 3, Part 4, Part 5, Part 6.)

I strongly believe that the shadow banking system was never confronted and dealt with properly after the financial crisis, and that this was a tragic error.

I suspect that the shadow banks will be back, with fresh problems, in the not-too-distant future.

At that time, we may finally be forced to figure out what to do with them. I expect various approaches to be proposed.

To decide wisely how to deal with the shadow banking system, I think we have to possess the right theoretical framework for understanding it. In my opinion, policy based on a flawed theory of “information-insensitive debt" will lead us to create an even more dangerous financial system.

Information-Insensitive Debt and the Strange Case of Haircuts

2011-08-21T14:39:00.003-04:00

Now for part 6 of my rather exhaustive (and exhausting) look at Gary Gorton's theory of information-insensitive debt.

This post is rather granular, to show inside-out how a very dubious assertion at the theory's center leads Gorton to what (I think) is a wrong-headed interpretation of what occurred during the height of the financial crisis.

We start with haircuts -- in the repo market, not at the local barber shop. Anyone who needs a refresher on how repurchase agreements work, go here.

HAIRCUTS FOR DUMMIES

Per Gorton, the haircut is the "percentage by which an asset's market value is reduced for the purpose of calculating the amount of overcollateralization of the repo agreement."

That's very gnarly sounding. Here's an unpack that gets at the gist of the matter.

When you "deposit" say $100 million in a shadow bank through a repurchase agreement, the bank essentially posts collateral (to guarantee your funds in case it defaults). The haircut can be thought of as a way to ensure you get ALL your money back. So you may receive $105 million of securities for that $100 million -- a haircut of 4.8 percent (5/105). If the shadow bank collapses overnight, you're holding $105 million of securities to make you whole on $100 million -- not a bad proposition, it seems.

Haircuts vary with the nature of the collateral debt. During the financial crisis, for AAA corporate debt, they were minor (about 5 percent, according to Gorton). A graph of haircuts on asset-backed securities, on the other hand, resembles a Stairmaster in profile. They climbed from zero percent to about 40 percent when the financial system was in extremis. That deep 40 percent haircut was the shadow banking equivalent of a large amount of money being sucked out of the system -- a bank run, in other words.

WHY A HAIRCUT? HINT: THE ANSWER MAY SURPRISE YOU

Now comes a question that turns out to be more interesting than it first appears. Namely, what are these haircuts based upon? This is where things get curious. You might assume, if you're a common-sensical markets person, that “depositors” demand haircuts because if their counterparty in the repo agreement fails (a la Lehman), they need to be compensated for the fact that the securities may not really be worth what they were told. Or, an alternative explanation could be that they’re afraid the value of the securities might drop while they’re holding them.

Both interpretations, however, would be incorrect, according to Gorton.

Gorton informs us that:

Haircuts are a function of the default probabilities of the two parties to the transaction, as well as of the information-sensitivity of the collateral.

Now, before we analyze that, here's another excerpt you need to read, to get the full picture of where Gorton is coming from (this is also from his paper titled Haircuts, the bold is mine):

Keep in mind that the collateral offered in repo is valued at market prices. If the bonds become riskier, and their prices go down, then they would be valued at these lower prices. Furthermore, if there is more uncertainty about their price in the future, that risk can be addressed with a higher repo rate. Repo rates can and did go up (see Gorton and Metrick (2009)). Why should repo collateral be haircut? And why should these haircuts go up? Our answer, following Dang, Gorton, and Holmström (2010a,b), is that a haircut amounts to a tranching of the collateral to recreate an information-insensitive security so that it is liquid. The risk that is relevant here is different than the risks we usually think about, which are related to the payoff on the security. A haircut addresses the risk that if the holder of the bond in repo, the depositor, has to sell a bond in the market to get the cash bank, he may face a better informed trader resulting in a loss (relative to the true value of the security). This risk is endogenous to the trading process. It is not the risk of loss due to default. Consequently, the price cannot adjust to address this risk.

PAINTING ONESELF IN A CORNER WITH EFFICIENT MARKETS THINKING

The first thing you should have noticed: Gorton very much appears to be some form of EMHer (Efficient Markets Hypothesis, or the belief that market prices are efficient and reflect all existing public information). (As a reformed EMHer, I can spot a member of the species. This is precisely how they talk: "If the bonds become riskier, and their prices go down, then they would be valued at these lower prices." They don't simply make a point; their stating of a proposition has a whiff of the evangelical.)

Being an EMHer, though, paints him in a corner, starting with his explanation of the two factors contributing to haircuts. Because for an efficient markets guy, the "default probabilities of the two parties to the transaction" -- reason #1 for haircuts -- shouldn't matter at all.

After all, if the collateral for your deposit is a security at market price, that's what someone would buy it for at that moment. And you're only holding the security overnight -- or for a few days -- so where's the risk? Of course, the price may change. But Gorton covers that in the longer excerpt above, saying you'll demand a higher repo rate to compensate for that risk. The more detailed excerpt, in fact, appears to conveniently forget about counterparty risk.

So, back to square one: why do you need a haircut?

BETTER INFORMED TRADERS ON THE LOOSE!

This is where the theory starts crumbling around the edges. Remember, the centerpiece is information sensitivity, so that's the Procrustean bed Gorton has to fit his analysis into. Here's how he explains why a shadow banking “depositor” requires a haircut: if forced to sell the debt (my bold again), "he may face a better informed trader resulting in a loss (relative to the true value of the security)."

Ah, so the real problem is a "better informed trader." But what does that phrase mean? And what does it imply? I'm not sure whether Gorton tries to use it in a special way, but let's assume he doesn't. In that case, a "better informed trader" would presumably be a trader who knows the worth of the debt better than you do. And, it appears, you're worried that his information will be negative and push his offer price lower.

So a better informed trader knows something about the value of the security that you don't, so you're afraid that the debt may be mispriced, and that's why you demand a haircut?

No, Gorton would probably demur, it's not quite that. He tells us "This risk is endogenous to the trading process. It is not the risk of loss due to default." See, the market price plus the repo rate has already captured the risk of loss due to default, according to Gorton. But then, what is the nature of the knowledge possessed by a better-informed trader? When the donut cart makes its rounds at corporate headquarters? Because, seriously, when I hold a debt security, I'm concerned mainly with one thing: getting paid what I'm due, when I'm due it (and the probability of that occurring).

(Another thing: what is the "true value" of the security? What relationship does it have to the "market price"? Which should I care about? If the true value is $100 million but the market price is $200 million, why should I mind paying $200 million as long as other traders in the market are willing to pay that, especially if I possess the security for only a day or two?)

The other problem with these "better-informed traders" is that it stretches credulity that they suddenly appear on the horizon, a sagacious glint in their eyes, waiting to take advantage of you. Presumably they were also there the day before. So why weren't they pushing down the "market price" before? And if these better-informed traders are feared, why not find some of the apparently dumb traders of the day before who helped set the "market price" -- and simply sell to them instead, if they're so enamored of the security?

AND SO A THEORY VEERS INTO ABSURDITY

Gorton wants to convince us that the securities were fairly priced (they capture all the risk of loss due to default, remember) and that depositors extracted giant haircuts of 40 percent for fear that, if they got stuck with the debt, the only traders they encounter may possess an "information advantage." He never clarifies why, if this information advantage necessitates such a large haircut, the better informed traders aren't already profiting from their (considerable) advantage by trading in the market.

So Gorton basically says that market prices on asset-backed securities (a key kind of collateral in the shadow banking system) during the financial crisis were accurate. He makes this claim even though there were some 100,000 of them -- sui generis problems abound* -- and trading in particular ones probably got pretty thin and the value of asset-backed securities is often derived from a model (hence "mark to model") and investors were just starting to realize these things had been misrated and were probably lousier than they thought and ... you get the idea.

*(Brief aside: The uniqueness of these assets, and the difficulty accounting for them, was why Paulson scuttled his original plan for TARP, as Hernando de Soto recounted in Businessweek: “When then-Treasury Secretary Henry Paulson initiated his Troubled Asset Relief Program (TARP) in September 2008, I assumed the objective was to restore trust in the market by identifying and weeding out the "troubled assets" held by the world's financial institutions. Three weeks later, when I asked American friends why Paulson had switched strategies and was injecting hundreds of billions of dollars into struggling financial institutions, I was told that there were so many idiosyncratic types of paper scattered around the world that no one had any clear idea of how many there were, where they were, how to value them, or who was holding the risk.”)

ANOTHER WAY OF LOOKING AT THE MELTDOWN IN THE SHADOW BANKING SYSTEM

Is there an alternative explanation of what happened?

Yes, and it might go like this: Before the financial crisis, the haircut was zero on asset-backed securities because it was practically unthinkable that the large investment bank opposite you on the repo transaction would fail. And so, because the counterparty is deemed safe, the asset-backed securities being offered for repo aren't examined too carefully. The "magic pig" phenomenon starts to set in. "Sure, they're worth what we claim," Mr. Investment Banker says. "Would you like to see our math-heavy, extremely complex model or just take our word that you'll get repaid?" And you say: "I'll take your word, no problem."

But then the investment banks start looking shakier, and the asset-backed securities begin looking dodgier as well. You realize too that the banks are frightfully interconnected, boosting risk further. So you begin looking askance at asset-backed securities that you suspect aren't at "market price" at all. Further, you expect you'll have trouble reselling them. This would naturally lead you to demand deep haircuts.

Now you may resist going as deep as 40 percent -- that's pretty severe -- until you get really, really scared. What would scare you the most? If you think that the collateral may be mispriced, the scariest thing would be seeing one of those investment banks go under. Say Lehman Brothers. Until then, if you think the chance of the investment bank failing is remote, you may not extract much of a haircut for the mispriced securities. Who cares what they’re really worth? But once it becomes clear you may get stuck with this collateral -- the game changes totally.

You need a deep discount, and 40 percent would be reasonable. Gorton would have you think that such a discount implies crazy sale prices. This alternative explanation doesn't need to invoke a fire sale to make sense. It would, however, suggest there was a bit of the "magic pig" in those asset-backed securities.

Next: Many words later, a short conclusion: why should anyone care so much about this arcane subject?

Down the Rabbit Hole on Information-Insensitive Debt: Inscrutable Complexity Is a Good Thing!

2011-08-21T14:30:00.004-04:00

Part 5 of a detailed look at Gary Gorton's curious theory of information-insensitive debt in which we ask two key questions.

ONE: IS INFORMATION SENSITIVITY A USEFUL PRISM THROUGH WHICH TO VIEW THE WORLD OF DEBT IN THE FIRST PLACE?

Not really, it seems.

A more useful theoretical construct would steer away from the bi-phase nature of "information insensitive" and "information sensitive" and would at least posit a sliding scale between the two. But an even better theory would ditch information sensitivity completely. Risk is the key to understanding how the world of debt works and how securities are analyzed, not information sensitivity (note: it’s probably no accident, in fact, that certain bloggers have equated Gorton's "information insensitivity" phrasing with the quality of being "risk free" -- but a careful reading of Gorton shows he makes no such equivalence, so he appears to be aware that there's a critical distinction).

A better theory might assert that, with the financial sector's demands for collateral to back derivatives transactions and so on, there will be a need for less-risky securities to fill that role.

TWO: HOW DANGEROUS ARE THE WAYS IN WHICH ASSET-BACKED SECURITIES BECOME INFORMATION INSENSITIVE?

Gorton seems to like asset-backed securities as information-insensitive debt for all the wrong reasons.

He likes them partly because of the senior nature of the debt and the fact that it's backed by a portfolio. He doesn’t recognize that the worth of being senior is firmly attached to credit risk. As an investor, which would you rather hold, if you're anti-risk: the senior debt of Energy Future Holdings (the former TXU that’s freighted with debt after being bought in the biggest LBO in history) or some (not senior) debt of AAA rated Johnson & Johnson?

This isn't a gratuitously needling point, because structured debt likes "yieldy" (read: riskier) assets. Collateralized loan obligations, a type of CDO, are stuffed with leveraged loans -- the high-risk borrowing that private-equity firms take out to make an acquisition. Why? The structuring doesn't make sense using investment-grade debt; you can't wring out enough yield.

So to say a securitization is more "information insensitive" because it may be backed by a portfolio composed of senior debt -- and then to be agnostic about the contents of that portfolio -- is very wrong. And what's more, you should be looking at how correlated the movements within the portfolio are. Junk loans in CLOs will display high correlation if the economy double-dips; that's pretty much a given.

INSCRUTABLE COMPLEXITY IS A GOOD THING? SAY WHAT?

Then there's the really dangerous feature of asset-backed securities that Gorton, bizarrely, is attracted to: complexity. This should be a bug, not a feature, but we've gone down the rabbit hole, folks. Here's his rationale: complexity raises the cost of producing private information. It's too expensive to figure out the debt is mispriced. Ingenious, though the arrant screwiness of this is never acknowledged.

However, here's the catch: that same complexity will, at some point, confer a significant advantage for a dedicated investor (such as a Michael Burry type in the Big Short) to do enough research to determine the extent of the mispricing. This will only occur though, after the mispricing becomes significant enough.

So what you get in the trading of this complex debt is the equivalent of a tectonic shift, violent and jarring, instead of the smooth adjustments that are made by say a U.S. Treasury, which trades largely on public information -- millions of bits of it, clashing and conflicting and impressing various traders in various ways. The asset-backed security, however, manifests itself as stable and information-insensitive -- partly because of its impenetrability -- then, on reaching a certain tipping point of mispricing, lurches into “information sensitivity.” Also, because of its complexity, ratings services will be sluggish to downgrade the debt -- especially after they have been complicit in the initial misrating -- adding to the sudden volatility.

Note, however, that this volatility wouldn't have to be characteristic of a panic or widespread fire sales, as Gorton wants us to believe was the main problem during the financial crisis. This aspect of volatility is inherent in the very nature of complex debt -- a kind of debt that Gorton lauds because it raises the cost of producing private information.

And Gorton sees this as a feature, not a bug. Hmmm.

A BANKING SYSTEM SHOULDN’T BE BASED ON TRADING IN MAGIC PIGS

Information insensitivity is NOT what we need more of in our financial system. Magic pigs are information insensitive, until there is a revelation (the discovery that they are not magic), at which time they become dangerously information sensitive. We DON'T WANT a shadow banking system built on magic pigs (or on securities that want to become magic pig-like).

Next: What’s behind haircuts in the repo market, according to Gorton? (Surprise: It’s not what you think.)

The Worrisome Analogy at the Heart of the Theory on Information-Insensitive Debt

2011-08-21T14:22:00.003-04:00

Now for Part 4 on Gary Gorton's theory about information-insensitive debt, in which we begin by dusting off our SAT analogy skills.

Retail banking : deposit insurance :: Shadow banking : x

"X" is, of course, the kind of insurance that will save the day when there's another run on the shadow banks, as we saw during the financial crisis. Deposit insurance is a neat innovation that traces back to 1934; it eliminated runs on commercial banks in times of panic. It also made deposits at a bank "information-insensitive" debt -- the value of your $1,000 at Fidelity and Security Trust is secure, even if the CEO absconds to Tahiti with $10 million in a duffel bag.

Before solving for "x" -- or, better, asking whether we should even try to solve for "x" -- let's look at how shadow banking works.

SOME BANKING TAKES PLACE “IN THE SHADOWS”

Retail banking is for you, me, Aunt Edna. Shadow banking is for the giants in the financial system, who have large amounts of cash to park -- typically money market mutual funds, insurers, pension funds. They make “deposits” and “earn” interest through a process that involves something called a repurchase (repo) agreement.

Here's an example of how that works.

A pension fund spends $100 million to "purchase" AAA asset-backed securities from JPMorgan. As part of the deal, JPMorgan agrees to buy back these securities, after a short period of time -- overnight, or maybe a week or two. The pension fund will receive a small amount of interest (a fraction of 1%, as the lending is so short term). If JPMorgan goes insolvent, the pension fund holds those securities as collateral. They can be sold and (theoretically) the pension fund recovers all its money.

Now consider what happens with retail banking with a $100 deposit if the bank becomes insolvent. The FDIC makes the investor whole, paying the $100. Similarly, the pension fund in our example really wants its $100 million returned and doesn't want to deal with those collateral securities, which may not really fetch $100 million on the open market if they happen to be complex products, especially in times of stress.

So what happens in the repo market during a "bank run"? Nervous depositors -- like this pension fund -- demand greater and greater haircuts on securities they “purchase.” In other words, instead of “depositing” $100 million and accepting say $102 million of securities, they may demand much more collateral: $110 million, $120 million. Haircuts on asset-backed securities may go from zero to 40 percent (as they did in the crisis). This has the effect of sucking 40 percent of that $100 million out of the shadow banking market.

Spread this effect around, and the impact is similar to that of a bank run.

SO WHAT WOULD ‘DEPOSIT INSURANCE’ IN THE SHADOW BANKING SYSTEM GUARANTEE?

Here’s a big problem, for those who see insuring shadow banking "deposits" as the obvious solution to bank runs: This kind of banking has a wrinkle that's not found with its retail counterpart. In the shadow system, to guarantee a depositor’s $100 million, you essentially would have to say, “Whatever the actual value of that security you bought in a repo agreement, we’ll buy it back for $100 million.”

Think about this. If you deposit $100 in a commercial bank, the FDIC says you’ll get that $100 back -- which seems fair; you have deposited a fiat currency, and you receive the same amount of that fungible currency in return. But this differs hugely from what the shadow banking system would be guaranteeing: that you would be made whole no matter what the true value of the security that you hold as collateral.

Why is this problematic (other than for the obvious reason that the security, especially if thinly traded and "marked to model," could be mispriced -- and that this tendency to mispricing will be exacerbated because of the very existence of the insurance)?

WHY RETAIL AND SHADOW BANKING ARE WORLDS APART

Well, significant differences exist between retail and shadow banking systems.

"Deposit insurance" for commercial banking means: You're insuring that a depositor of money (common currency) will receive that money back. The bank involved is usually not too risk-loving, not too large, not too interconnected, and not too complex -- plus its commercial banking activities are regulated.

"Deposit insurance" for shadow banking means: You're insuring that a depositor of money (common currency) will receive that money back. The bank involved is usually risk-loving (often an investment bank), large, highly interconnected and complex -- plus its shadow banking activities are unregulated.

Being large and highly interconnected implies that when a bank in the shadow system gets in trouble, others will soon be at risk and the amount of "deposit insurance" ultimately needed may be very high (and the FDIC model won't work, where a team of examiners takes over the bank on Friday and sorts out things so the institution can re-open on Monday -- Lehman, which was enmeshed in the shadow banking system, is still painfully crawling through bankruptcy, almost three years later, even spawning its own periodical: Lehman Brothers Bankruptcy News).

THE CHALLENGE OF PICKING “INFORMATION-INSENSITIVE” DEBT WORTHY OF BEING INSURED

Enormous problems arise when it comes to how securities will be chosen to be insured in the shadow banking system. It's comparatively easy in retail banking. The FDIC insures dollar claims. Dollar claims are in money, or fungible currency.

But in shadow banking, how will securities be selected that will qualify as "information-insensitive" collateral worthy of insuring? Will government regulators be involved in picking and/or rating them? If so, why does anyone think our regulators have the expertise to assess asset-backed securities (one form of information-insensitive debt prevalent in shadow banking) that S&P and Moody's failed miserably to understand properly during the financial crisis?

Who determines how much of this insured information-insensitive debt is appropriate? Who pays for this "insurance" and how? And, if the debt is insured to market value, that will pervert the price at which it trades (Q: What would you pay for a security that is insured for however much you pay for it? A: Potentially, the sky’s the limit.).

And if the debt is insured to market value minus a haircut, who sets the haircut? How is the haircut adjusted if that debt class grows riskier? And, even with a haircut, insurance will tend to push the price higher as traders discover ways to game the system (Here's a scenario: X buys Security C for $100, its true price. Security C, which is classified as "information-insensitive" debt, is insured up to 90 percent of its market value. X sells Security A to Y for $200, who later sells it back to X for $210. Y makes $10 and X now possesses a security that's insured to $189 -- a great game for everyone but the insurer of the debt.)

Also what precautions will be taken to ensure that financial institutions don't start smuggling in junk disguised as quality securities, trying to get them classified as "information-insensitive debt" -- the designation of which will immediately boost the value of the assets?

Next: Is “sensitivity to information” really the way investors analyze debt?

The Theory of Information-Insensitive Debt Prompts Some Head-Scratching Questions

2011-08-21T14:05:00.004-04:00

Here's Part 3 on the magic pigs of high finance, information-insensitive debt (everyone still awake?). Last time we looked at the concept using a common-sense definition of the term. Now let's try to figure out where the theory is unsatisfying on a more granular level, by using Gorton’s own words.

First, to show us what qualifies as information-insensitive debt, he offers examples: high-grade corporate debt, government bonds (presumably U.S. Treasuries, and not Greek 10-year bonds), and AAA rated asset-backed securities.

In different places, he characterizes such debt as (the bold is mine):

[Debt that] "is very liquid because its value rarely changes and so it can be traded without fear that some people have secret information about the value of the debt. If speculators can learn information that is private (only they know it), then they can take advantage of the less informed in trade. This is not a problem if the value of the security is not sensitive to such information."

Also (page 7 of the same document, Slapped In the Face by the Invisible Hand):

"Bank debt is designed to be informationally-insensitive, that is, these bonds are not subject to adverse selection when traded because it is not profitable to produce private information to speculate in these bonds."

These definitions sound impressive, in that arid academic way, but what do they mean when applied to real debt in the wild? For example, the first one doesn't really make sense. He's saying that speculators can't take advantage of the less informed while trading information-insensitive debt, even after learning private information, because "the value of the security is not sensitive to such information."

AND NOW FOR SOME HEAD-SCRATCHING QUESTIONS

What debt could Gorton possibly be thinking of here? Does he really believe that even Treasuries are immune to being profited upon, by someone who possesses private information? If I wiretap the Federal Reserve Board meeting, and learn the Fed is about to announce an operation to purchase $800 billion of Treasuries, he doesn't think that gives me an advantage trading in this market? (Note: the second definition does add "it is not profitable" to produce private information, but this opens a new can of worms, which we’ll soon see.)

Also, U.S. Treasuries are very liquid, but it’s not true that their value rarely changes -- their value changes constantly. Now, do the bonds trade without fear that some people possess secret information about that value? For the most part, yes -- but there may also be certain junk bonds that trade without fear that some people have secret information about them. If so, could these junk bonds qualify?

And what if the junk bonds are "information insensitive" for six years, then the company reveals itself to be tottering near bankruptcy and their price becomes volatile? Do they suddenly become information sensitive, or were they always information sensitive but only seemed information insensitive?

In other words, is this quality of being “information insensitive” only ascertained after empirical evidence of how the security actually behaves? Or is a security considered information insensitive only if we can’t imagine a situation in which someone could profitably produce private information to speculate in the debt? But, honestly, no security exists for which that’s an inherent quality, as the thought experiment for Treasuries shows.

PROFITABLE FOR WHO? YOU, ME? SOME GUY IN BANGLADESH?

And "it is not profitable to produce private information" raises many fresh questions. What's profitable for a trader to do at any given moment depends on many variables that seem as though they should have little to do with information sensitivity.

A trade may be profitable simply because I can lay my hands on large-enough blocks of securities to make chasing a minuscule gain on each one worthwhile. Or, a narrower trading spread may allow me to turn a profit more easily. (Of course more-liquid securities tend to trade with narrower spreads, which leads to a Gortonian paradox, as being liquid is supposed to be a sign of information-insensitivity.) Profitability also hinges on what I pay my workforce -- so does a security become information sensitive simply because I’ve got six traders in Bangladesh who work at one-sixth the salary of their U.S. counterparts? Also how does "private information" factor in? What if it's profitable to ransack Company X's Dumpster for trading information. Does that make its debt information sensitive until the Dumpster is relocated to a more secure place?

Some of the above may sound a bit picayune. But here are the takeaway points: (1) If so many questions can be posed, doesn’t information-insensitive debt sound like a theory that presents a false dichotomy at best? (2) There are so many trades, and so many price movements on securities (especially liquid ones), how do you sort out evidence that proves a security is information insensitive, instead of the opposite?

Next: The troublesome analogy that Gary Gorton’s theory leads to.

Information-Insensitive Debt: An Unnatural Concept, For Starters

2011-08-21T13:56:00.004-04:00

Now for Part 2 on Gary Gorton’s theory of "information-insensitive debt" in which we continue to study the question, "Is it a bad thing or is it a really bad thing?" :)

One big problem: the concept happens to be quite unnatural.

Fiat currency is probably the best example of information-insensitive debt, but it's essentially a trivial, artificial case. Retail banking deposits also qualify as a good example, but they're something different: a special case. Exactly how they're special is important to understand.

WHAT MAKES BANKING DEPOSITS REALLY, REALLY SAFE?

Gorton likes to illustrate the information insensitivity of retail banking deposits by using an example involving a check. Let's say I write a check for a $14 haircut. That piece of paper isn't worth $13.89 or $14.05 to my barber. It's worth exactly $14.

Likewise, if I go directly to my bank instead to withdraw that $14, I can be sure of getting the full amount, even if my bank is Lehman Brothers Savings Inc. and everyone's glumly packing their desk contents into boxes when I arrive. The FDIC insures my deposits up to $250,000. I can breathe easily.

So it doesn't behoove me, or anyone I trade with, to spend time investigating the financial soundness of my bank. No matter what terrible information surfaces about that bank, my deposits are covered.

See a problem already? The debt isn't naturally insensitive to information. It achieves this property by being insured. But the value of anything -- your collection of Pokemon cards or seashells -- can become information insensitive if insured. So, becoming information insensitive this way feels like cheating a bit.

That leaves the tantalizing question: which debt is naturally information insensitive?

None of it, really. On its face, the phrase is oxymoronic, like “jumbo shrimp.” (Note: Gorton parses the term in a special way, which we'll look at later.)

DEBT IN THE WILD IS NATURALLY SENSITIVE TO INFORMATION

Pretty much all debt in its natural state is information sensitive. Markets trade on this information. Some is public. Some is private (e.g., a stock price spikes right before a merger announcement, as the news leaks out). Much information arguably occupies a gray area between public and private. Is private analysis of public data showing that a bond is undervalued private or public information?

Even fear and wild speculation is information of a sort. Say there's a rumor that a neutron bomb will be detonated in Microsoft's main cafeteria tomorrow, based on absolutely nothing. If enough stupid investors believe it (ever hear the phrase "dumb money"?), they may sell their bond holdings in the software giant. Information about this crazy rumor will prompt a smart trader to jump in, scoop up Microsoft debt, and score a neat profit when the price rebounds.

A smart theory would posit that just about all debt is information sensitive. The theory might make an argument that there are varying degrees of sensitivity, and that a particular instance of debt lies on a continuum between very information sensitive and not-that-information sensitive. Okay, fine -- that would at least be nuanced and cautious. But instead, in Gorton's world, we get debt that is either "information insensitive" or "information sensitive" -- and of course debt that lurches from the former to the latter during a financial panic, as if undergoing a change of phase, like ice to water.

SO WHY SHOULD ANYONE CARE ABOUT ANY OF THIS IN THE FIRST PLACE?

Because there’s a shadow banking system in the U.S. that’s larger than the retail banking system. It’s where the financial crisis began in 2008.

Information-insensitive debt plays a key role in shadow banking’s repo market, according to Gorton (later, we’ll look at how repo works). Asset-backed securities, for example, are posted as collateral against repo borrowings. During the financial crisis, the securities suffered huge haircuts once they became "information sensitive" (or once investors discovered they more closely resembled magic pigs than Treasuries). At the same time, Gorton notes, other kinds of debt suffered very minor haircuts.

So here’s something to ponder: If we must have "information-insensitive" debt in our financial system, shouldn't we look to these other types for what it should look like, and not to securitizations that are opaque and become thinly traded with alarming suddenness?

Next: Gorton’s own definition of information-insensitive debt comes up short.

Everything You Always Wanted to Know About Information-Insensitive Debt But Were Afraid to Ask

2011-08-21T13:48:00.002-04:00

Over the last few months, I’ve spent a lot of time studying the idea of "information-insensitive debt" (also known less gracefully as "informationally insensitive debt"). Gary Gorton, a professor at Yale’s graduate business school, appears to be the intellectual progenitor (or one of them) of this concept. In 1990, he wrote an academic paper with George Pennacchi titled "Financial Intermediaries and Liquidity Creation."

My fascination with information-insensitive debt arose from a sneaking suspicion that it was a bad thing (except for a couple of notable exceptions). My keen interest in writing about it, after all this research, arises from a conviction that it is a bad thing, and that the theory itself isn't much good either.

A rough-and-ready definition of information-insensitive debt -- we'll return later to Gorton's own more nuanced and precise definition -- is this, by way of Felix Salmon:

Financial assets which (normally) don’t change in price when new information about them emerges.

Now if you're a markets-oriented person, this very idea should make your skin crawl from the get go. What kind of zombie asset doesn't change in price when new information about it emerges? How weird is that?

MAKING BACON OFF MAGIC PIGS

To begin this series of posts about information-insensitive debt (there’s waaay too much to fit into a single piece, unfortunately), let me introduce you to my magic pigs.

Each magic pig is worth exactly $1 million. Its astonishing value resides in something I call a noumenon. When asked what this noumenon is, which is a thing unseen, I gladly provide a 9,000-word document, with much high-level math and abstruse concepts and economic formulas, to justify its value. I trade a lot in financial markets, and whenever my counterparty demands collateral, I offer bonds entitling him to a number of my magic pigs, should I fail to deliver on whatever I have promised.

So when $10 million of collateral is requested, I hand over certificates for 10 magic pigs. My counterparty doesn't object: the whole market has accepted that these pigs are magic and worth $1 million apiece (after all, I do have documentation and the pigs have been rated top grade by Standard & Poor’s -- ignore for the moment their pro-animal bias, as one of their officials once famously observed, “It could be structured by cows and we would rate it”).

Sometimes I sell a magic pig for $1 million, and the holder of that pig then uses it for collateral, or sells it. Or whatever. Because the value of the pig lies in this complex noumenon, no market participant has any advantage in trying to profit on my pigs (through trading), by first gaining private information. And if a leg falls off a pig, that doesn't matter because its noumenon isn't affected. Even if the pig dies, its noumenon stays intact. So it's still worth $1 million.

The certificates for my magic pigs are truly information insensitive debt -- at least, until I am revealed as a fraud, at which point they very rapidly become information sensitive and start rising and falling in accordance with the market on hog futures.

Next: What do “jumbo shrimp” and “information-insensitive debt” have in common?

S&P Demonstrates Its Utter Hypocrisy

2011-08-06T06:01:00.003-04:00

This morning, I saw S&P had "bravely" downgraded the U.S. to AA+.

What horsecrap.

If nothing else, this shows how irrelevant ratings have become.

Yields on 10-year Treasuries are about 2.5 percent, nearly at historical lows. Every time the market catches a whiff of fear, investors pile into Treasuries. U.S. debt is considered about the safest stuff out there, bar none, as indicated by the yield.

The yield is truth, the market itself speaking.

Meanwhile, S&P is still willing to rate lots of securities AAA -- if you call them CDOs and pay S&P a handsome fee for the rating, even when these securitizations are paying a yield that far exceeds that on U.S. government debt.

What we're seeing today is just rank hypocrisy from a ratings service that has the gall to claim that AAA is AAA, across asset classes.

Tip to Washington: just figure out a way to combine and tranche your Treasuries in some kind of god-awful complex structure -- make it really, really complicated -- then go back and pay S&P a fat fee to rate the mess. You'll get your AAA back. I guarantee it.

Felix Salmon: Quote of the Week

2011-04-16T17:40:00.006-04:00

I was beginning to despair this week. It seemed like the theme was Free Market Idiots Run Amok and someone had forgotten to tell me to put on my Atlas Shrugged underwear.

First, there was Larry Summers saying don't blame financial innovation, but rather, the housing bubble, for the Financial Crisis on Steroids that we went through. Which leaves me wondering: This guy was the president of What-vard? You gotta be kidding.

Larry has nary a disparaging word to utter about any CDO, CLO, CDS, SIV, RMBS, CMBS, REMIC, re-REMIC, structured note. None of those products are bad, fee-gouging, or in any way contributed the teensiest to systemic instability?

Thus, I sentence the estimable Mr. Summers to hereafter receive all his compensation as an income stream from the bottom tier of a synthetic CDO squared.

The second forehead-slapper was Peter Wallison, who at this point isn't even interesting any longer. He's too busy riding his ideological hobbyhorse: Fannie and Freddie are the chief perps in the financial crisis, get the government out of the housing market, private enterprise can do no wrong, blah blah blah. His latest wildly inaccurate piece, on the Bloomberg Web site, was easily shredded by Daily Kos.

Which brings me to Salmon's quote of the week ... the antidote to all the uninformed opinion.

Responding to Gary Gorton's assertion that we need "informationally insensitive financial assets" (debt whose price doesn't change when new information about it emerges), Salmon is quick to respond, "No, we don't."

Informationally-insensitive debt is the best repository the world has ever constructed for housing tail risk in an invisible and impossible-to-measure manner.

That's a great line. Because "informationally insensitive debt" (except when applied to common currency, which is arguably a trivial usage) is a dangerous, oxymoronic twist of phrase. The varieties of "informationally insensitive debt" spawned in the shadow banking system, and used in the repo market before the financial crisis, didn't collapse because of a panic. Rather, the values plunged because investors realized this debt was complex, misrated and overvalued.

Gorton likes to think there was an irrational panic in the shadow banking system. He's right there was a panic, but it was more the sort of panic you experience when you realize the gold bars you're holding are bricks of horse manure spray-painted gold. It wasn't all that irrational. And to prevent that kind of panic, you need assets to be more informationally sensitive, and constantly adjusting for risk -- not less sensitive.

In Case You Were Thinking That Lawsuits Might Reform the Credit Raters ...

2011-03-07T19:37:00.003-05:00

Well, think again.

Time to play connect the dots, with the New York Times getting us started in fine fashion. First, the article linked above notes a disturbing trend taking shape:

... since Dodd-Frank passed, Congress’s noble attempt to protect investors from misconduct by ratings agencies has been thwarted by, of all things, the Securities & Exchange Commission. The S.E.C., which calls itself “the investor’s advocate,” is quietly allowing the raters to escape this accountability.

What accountability? As Gretchen Morgenson tells us:

The Dodd-Frank financial reform law, enacted last year, imposed the same legal liabilities on Moody’s, Standard & Poor’s and other credit raters that have long applied to legal and accounting firms that attest to statements made in securities prospectuses. Investors cheered the legislation, which subjected the ratings agencies to what is known as expert liability under the securities laws.

Why would the SEC do anything that subverts Dodd-Frank so openly? Aren't these our brave regulators, our white knights (yes, with a fondness for porno, but what do you expect in the postmodern age)? Ah, but see, there was a problem when push came to shove on this "expert liability" point.

When Dodd-Frank became law last July, it required that ratings agencies assigning grades to asset-backed securities be subject to expert liability from that moment on. This opened the agencies to lawsuits from investors, a policing mechanism that law firms and accountants have contended with for years. The agencies responded by refusing to allow their ratings to be disclosed in asset-backed securities deals.

So basically, the credit rating services said, "We'll hold our breath until we turn blue."

And the SEC blinked. Actually, double-blinked. Check out this whopping beaut of negligence:

At the time, the S.E.C. said its action (i.e., the agency temporarily removed the "expert liability" threat and said it wouldn't bring enforcement actions against issuers that did not disclose ratings in prospectuses) was intended to give issuers time to adapt to the Dodd-Frank rules and would stay in place for only six months. But on Jan. 24, the S.E.C. extended its nonenforcement stance indefinitely.

Indefinitely. Golly, that has a sort of open-ended ring to it. Hey, let's face it: Like diamonds, indefinitely may be forever.

Okay, now let's do the New York Times one better and finish connecting the dots for them. Because left unanswered is a big question: why the hell are credit rating services so scared of being held responsible for how they grade asset-backed products?

Jeez, I think I know this one -- in fact I think I blogged this one -- twice over! Just go here for a full explanation:

The Ratings Charade Continues: a CLO Investigation, Part I
The Ratings Charade Continues: a CLO Investigation, Part II

You see, the credit rating companies can't afford to be held legally responsible for the grades they assign to asset-backed securities, such as collateralized loan obligations, because they know they would lose in court if these ratings were challenged! The ratings are clearly bogus. I show that above, using nothing more sophisticated than sixth-grade math.

Further, these companies must know their ratings on asset-backed securities are wrong, unless they're incompetent to a mind-blowing degree.

And now the SEC is giving Standard & Poor's and Moody's a free ride on their bogus ratings, aiding and abetting the crime ...

What a great country we live in, eh? Where does the U.S. rank on that global corruption scale again? ;)

The Ratings Charade Continues: A CLO Investigation, Part II

2011-02-05T08:00:00.021-05:00

To bring you up to speed on this exciting melodrama:

Last time I showed you why CLO (collateralized loan obligation) ratings are almost certainly a scam, and why Mr. Ratings Guy from Standard & Poor's should know as much. It was (I hope) a math-lite and entertaining trip through the bowels of high-finance complexity, Wall Street style.

Of course I reached the end of the rather long post with more questions than answers. Why does this ratings scam exist in the first place? Who benefits? Who loses? In today's conclusion, we'll look at the not-so-surprising answers. Center stage in this discussion will be the misrated AAA tranche. It's the largest CLO piece by far, a good 70 percent or so of the overall fund -- and, as you're about to find out, that's no accident.

So why does Mr. Ratings Guy turn a blind eye to ratings that, deep in the pit of his stomach, he knows can't be correct?

Remember Upton Sinclair's little gem of wisdom:

It is difficult to get a man to understand something when his salary depends on his not understanding it.

Structured finance (e.g., CLOs) is very lucrative for ratings agencies. Even if you're the Jim Carrey character in "Dumb and Dumber," you can rate U.S. Treasuries with your eyes closed. Can you say "AAA"? With a bit more work, you can rate investment-grade bonds and loans. But once you dip into junk-rated and structured finance stuff -- ah, that's where it gets complicated. And complicated = higher fees.

So S&P gets paid more to rate CLOs. If the company started to challenge specific CLOs -- if it dared to say, "You know, these ratings don't make sense for this CLO" and began to push back against investment banks, one of two things would happen. (1) The bank, realizing its screwy models had been sussed out, would not structure more CLOs. (2) The irritated bank, which is paying the ratings firm, would simply find another ratings patsy -- Moody's? -- to play along with the bogus rankings for a big fee check.

Either way, it's clear what happens to S&P: It loses a rather fat revenue stream.

Now, why does the investment bank want to structure these things in the first place? This is pretty easy to answer too. Fees, fees, fees, fees. Underwriting fees for CLOs run to 1.75 percent, compared with an average of 0.4 percent for investment-grade bonds, according to Bloomberg News data.

Okay, that explains what's going on on the supply side. But it takes at least two to play in the markets. What's the incentive for the investor to buy misrated CLOs? Is the investor just the naive fool here, hoovering up misrated junk that will later plunge in value, leading him finally to clap a hand against his forehead and exclaim, "Oh, what a terrible mistake I have made!"

Probably not. At least not anymore. Recall that well-worn saying, "Fool me once, shame on you, fool me twice, shame on me."

There was a lot of complex, securitized crapola that cratered during the financial crisis (and has since recovered in value to some degree, but not to the degree that its initial AAA ratings would suggest is proper). So investors got caught playing with the effluvia from the sewer pipe and got burned. Are they really as stupid as they once were?

Nope. In fact, just return to my first post and look at what the tranches of a CLO pay these days. The "AAA" piece that, pre-credit crisis, would have paid 25 basis points plus the Libor rate, now yields 160 to 170 basis points plus Libor. Big, big difference. For those who aren't finance geeks, here's what that means in actual interest rates: three-month Libor is about 0.3 percent, so the CLO buyer who in 2006 would have accepted 0.55 percent as initial interest (assuming today's Libor) now insists on more than three times as much, or as much as 2 percent.

Last time we proved the ratings are an illusion, a clever chimera ... so let's say today's investor, being smarter about these CLOs, knows the game too. What does the 2 percent imply about the true rating? Well, you'd have to skip down S&P's ratings scale a bit to find the "true" rating, based on what investors are willing to pay. And that happens to be about six or seven rungs below the professed rating: much closer to "junk" level than AAA.

This is essentially what the investor is saying to the investment bank selling this stuff: "Sure, I'll take some of that 'AAA.' I know the market is just irrationally frightened of CLOs right now -- (nudge, nudge, wink, wink). I know that I'm getting real AAA at a great price, just because this asset class is out of favor because of the lingering taint from the financial crisis that has unfairly tarred securitized products! (nudge, nudge, wink, wink)."

Inside the investor is thinking: "Yeah, AAA my ass."

Now you may be wondering: What's the incentive for an investor to do this? What's the point of going along with this charade? And this is where things get interesting. There are a number of good reasons to play along with the fake "AAA" ratings:

1. You can use the AAA ratings to burnish your investment results. Say you manage a money market fund that can buy only AAA securities. You can sneak some pseudo AAA into your portfolio and goose your returns. How? Because it's rated AAA, but it pays about 165 basis points more than Libor, or more than three times ordinary AAA. So you'll look like a genius, outperforming your peers, until this junk explodes in your hands (and that could take a while -- remember, it's still probably investment grade, just a good deal lower than AAA).

Update: Ah, the perils of working too quickly! I meant to check out investing requirements for money market managers because I feared -- and I was right -- that my example doesn't work because they can't buy certain AAA products. It turns out money market funds must contain investments with a maximum weighted average maturity of 60 days. (A lot of structuring does spin out tranches with special A-1 or P-1 ratings that are of this shorter, desired maturity, but I don't think any CLOs do.) However, the idea still holds for other AAA-only fund managers: They can use pseudo-AAA from a CLO to burnish their results. A relevant fund for such a strategy might look more like one of these (note: the funds on this Web page invest in "AAA-rated fixed-income products" so I'm not sure if "structured fixed-income products" could qualify for the portfolio, but clearly if they could, the money manager will quickly jump to the head of the class, using pseudo-AAA from a CLO as "performance steroids," if you will.)

2. Certain entities, such as insurance companies and pension funds, have limits on what they can invest in. They can buy only AAA, or a certain percentage of their investments must be rated AAA. So these "AAA" (wink, wink) CLO tranches fit that criterion. This then becomes a neat little way to do an end run around an investing mandate that seems too restrictive to them, especially when they are under pressure to achieve higher returns (pension funds).

3. AAA securities are very useful in the huge "repo" market, where they are used to secure overnight loans, sometimes being rolled over continually. While AAA CLOs may be subject to higher haircuts (or discounts) than say a AAA Treasury, they still may find an important role once again in the repo market.

4. The new Basel III rules are coming, the new Basel III rules are coming! They are intended to make sure that a bank has enough capital to withstand shocks. These rules determine capital adequacy based partly on -- surprise! -- ratings of assets a bank holds. So having a bunch of misrated AAA on its books will help a bank heap on the risk again and plump up profits.

From Minyanville (my bold):

In the afterglow of yesterday’s “hugely oversubscribed” bond issue by the European Financial Stability Facility, (the “EFSF”), EFSF CEO Klaus Regling noted that demand was growing for AAA-rated assets “spurred by Basel III capital rules."

From Bloomberg (my bold):

Three years after collateralized debt obligations (note: a CLO is a type of CDO) helped trigger the worst financial crisis in 70 years, Wall Street’s math wizards are exploring how to use them to deflect rules intended to prevent the next crisis.
Credit Suisse Group AG traders are testing a risk model that may help them reduce capital charges imposed by the Basel Committee on Banking Supervision on derivative products.
Claudio Albanese, a quantitative economist who is advising the lender on the plan, says it could also help banks to limit one of their biggest risks by allowing them to offload through a CDO the risk that one of their trading partners, or counterparties, defaults. Critics say such CDOs could trigger a new crisis.
Albanese’s plan shows how banks are likely to try and mitigate rules that impose higher capital requirements on their operations and threaten profit ...

Okay, a cynic might say after reading up to this point, so what? Investment banks make out like bandits, the ratings firms get their cut, and everyone enjoys goosed returns and higher leverage. Why should I care?

For one, the existence of this ratings scam has the potential to create a distortionary effect in the market. It hasn't yet -- CLO issuance has dropped off a cliff since the glory days of several years ago -- but if the CLO machine cranks up again, suddenly there will be greater investor appetite for the securitizations. Now what's the hamburger that needs to go into the CLO meat grinder to produce these sweet patties of higher-than-normal yield? Leveraged loans. And who takes out leveraged loans? Private-equity firms. And why do they? To engineer sometimes-destabilizing takeovers that load up companies with debt.

So we encourage distortionary economic activity, higher leverage, more debt ... though in the short run, all this will give us a little meth-type boost in prices of stocks and other assets, and investors will feel a little richer, and we'll buy a few more big-screen TVs, and take a few more Acapulco vacations, and exult about how it's great we survived that bad ol' financial crisis ...

Now for the $64,000 question, the one that really matters.

Who's on the hook when all this collapses?

When CLOs go belly up, and massive wealth is destroyed, and credit freezes, and money market funds are about to break the buck once more, and we gnash our teeth and scream, "How can this be happening again?!?" and Jamie Dimon tells us not to worry because we go through financial crises every five years or so, so just take a pill and chill and stop standing on his bonus check?

That would be you. And me. That's right. Joe Taxpayers. A bailout will be orchestrated, overt or covert, and we'll all shoulder the burden.

Perhaps Ben Bernanke will do a slow-bleed of seniors and savers by infusing liquidity, rescuing the large and foolish banks (and other too-big-to-fail pieces of the financial infrastructure).

Just remember: It all starts with a misratings scam your Congress, snugly in the pockets of the banking lobby, never bothered to fix ... ;)

The Ratings Charade Continues: A CLO Investigation, Part I

2011-01-30T15:35:00.004-05:00

The role of the ratings agencies in the financial crisis went largely unexamined by the powers that be. That's a crying shame. Because the game hasn't changed: Investment banks fork over big fees for ratings agencies to sign off on phony ratings for complicated products.

Today I'm going to prove it, step by step. I'm not going to show all my work (I don't want this expanding to the length of a Scribd academic paper), but I can separately (in the comments section or in a separate post) for anyone who's interested.

We start with one of Wall Street's darlings of complexity, called a collateralized loan obligation.

If you're going to hang with me here, you have to grasp the basics of how one works. It's like this: An investment bank bundles together say 30 leveraged loans (this is the risky debt that companies take on in leveraged buyouts). Now, recognizing that different investors have different risk appetites, the bank creates "tranches" of securities that receive payments in a "waterfall" structure, which is the complicated heart of the CLO.

Okay, that sounds confusing. But there's a simple way to look at it. Each of these 30 leveraged loans makes periodic payments (of interest, or interest and principal). Once you strap all the loans together, individually they still make the same payments on the same schedule. But how the money is distributed becomes a bit more complex.

That "pot of yield" generated by the 30 loans is divided as follows. The investors in the top, or safest tranche, get paid first. This tranche is generally ranked AAA. Investors in the next tranche down, which we'll say is AA rated, get paid after that. Then the A rated tranche holders receive their money, or "water." And so it goes, right down to the bottom layer of this structure, sometimes called equity (though it's not technically equity, for you finance nerds -- and there's often also something called an "overcollateralization" feature in a CLO, but we don't need to get into that here.)

When times are good, with all the leveraged loans paying on schedule, the waterfall is bountiful and everyone gets "wet" (i.e. paid). When some of the loans default, and the gushing waterfall of yield slows to something more akin to a trickle, there won't be enough money to go around. But you always start paying off investors at the top (AAA), then move down the structure. If the loans start to sour, the AAA guys are supposed to have an ample cushion before they feel any pain.

So, in a nutshell, an investment bank has taken 30 leveraged loans, tied to 30 companies that have 30 different stories, and roped them all together into a securitization that pours forth a stream of money that satisfies investors in the manner described above. If you're Standard & Poor's, it's a walk in the park to rate any one of those 30 loans compared with rating the slices of this Rube Goldberg-ian CLO. Which is probably why banks helpfully "suggest" the ratings to the ratings agencies and provide models to demonstrate their reasoning behind those "suggestions."

Now let's say you're Mr. Ratings Guy at Standard & Poors, in charge of signing off on CLO ratings. Your bull***t detector ought to be pinging pretty hard when something with these proposed ratings lands smack dab in the middle of your desk (I've condensed this from a Jan. 13 Bloomberg story):

Citigroup Inc. has revised the proposed interest rates on a collateralized loan obligation to be managed by WCAS Fraser Sullivan Investment Management LLC, according to people familiar with the terms.
A $15 million piece rated BBB by Standard & Poor's will pay lenders 400 basis points (note: there are 100 basis points in one percentage point) to 450 basis points more than the London interbank offered rate, while a $19 million slice, graded BB, will pay lenders 600 basis points more than the benchmark...
A $273 million piece rated AAA will pay lenders 160 basis points to 170 basis points more than Libor and a $13.5 million portion graded AA will pay lenders 250 basis points more than the benchmark, the people said. There is also a $31.1 million piece with an A rating and a $51.075 million slice of subordinated notes, the people said.

Why? Remember how our CLO was constructed: out of 30 leveraged loans. These loans pay a certain floating interest rate over Libor (the London interbank offered rate, or what banks charge when they lend to each other). And that's it. You can't wring out any more yield. So the size of our "waterfall" is constrained by what those underlying loans pay. Let's say it's 10% overall right now (not a bad assumption: a CCC and lower bond index right now is at 9.97%).

Now structuring isn't free. Citigroup isn't creating this CLO out of altruism. Here are some categories of CLO expenses: 1. The cost to structure the CLO and earn a profit. 2. The yearly costs to manage the CLO (for example, there's a reinvestment period, during which the manager must replace loans in the portfolio that pay down) 3. All other expenses, including paying the ratings agency.

Let's fill in some blanks. Let's say management fees average 51 basis points, or about half of 1% (source: 2009 report from PF2 Securities Evaluations). Let's say structuring fees run about 1.75 percent (this is according to a Bloomberg story). And, finally, let's say the life of the CLO will be six to eight years. Even though the management fee must be paid yearly, the structuring is a one-time expense, and can be averaged over the life of the securitization.

Do a little math and you get about 76 basis points as the yearly cost that has to be extracted from that 10% pot of yield you're getting every year. Now the size of that pot has been whittled down to 9.24% effectively.

So, as Mr. Ratings Guy at S&P, you should be getting a little suspicious at this point, even before you look at the proposed ratings: Citigroup claims to be able to strap these loans together and, through some bit of diversification/alchemy, just sort of poof! -- extract 76 basis points a year. If these loans, after being structured, were somehow "de-structured" but with all the fees still intact, you'd be left with the original 30 loans, but paying 76 basis points less apiece, which is a pretty significant gap in bond land.

That should make you go "hmmm." But once you look at the actual numbers for the proposed ratings, your reaction should be something like, "no way."

Just look at the generous yields on the tranches of the CLO! The AAA slice is 160 to 170 basis points over Libor. That's a super-juiced AAA yield. A AAA corporate bond -- once you make a few tweaks (for the fixed-to-floating swap rate, the difference in Libor vs. Treasury -- I won't show my work now but can later for anyone interested) has a comparable yield of about 54 basis points. How can this be, at a time when the credit markets are relatively calm, when even junk debt is selling like hotcakes? This isn't a period of high market stress and irrationality.

(Brief aside: Some readers may object: "Well, a AAA bond doesn't imply the same risk profile as a AAA slice from a securitization." If you think that, you may want to look at S&P's own writing on the issue from January 2010: "In developing our updated corporate CDO criteria (note: a CLO is a type of CDO), we collaborated with Standard & Poor's corporate and government ratings group to promote comparability of CDO ratings with ratings in corporate, municipal and sovereign, as well as other areas of structured finance. When we assign the same rating level to debt instruments in varying sectors, we are expressing the opinion that they have comparable credit risk.")

Back to our unfolding narrative! This is what Citigroup is essentially saying to you, Mr. Ratings Guy: "Hey, ya know, we just structured it and all, and found this great big pot of yield left over! Son of a bitch, funny huh? I mean, there was so much yield we shook out of this thing, thanks to our genius in structuring, that we could pay the structuring fees, pay the annual manager fees, pay all other fees, PLUS hand out extra yield like candy canes right up and down the waterfall structure!"

Because here's what you have: AAA is getting 111 basis points (1.11 percentage points) more than comparable corporate bonds. AA is raking in an extra 149.5 basis points, BBB an extra 229.5, BB an extra 218.5 ... (the spread for the A rated isn't given, but it's got to be consistent with the others because this grade lies between AA and BBB, so I extrapolated that one.)

That gives us another 116 basis points of yield a year, over the size of the entire CLO, that the structuring genies claim to have conjured from somewhere, for a total of 1.92%.

Think about that. These individual loans pay 10% overall. That was presumably their fair value. Somehow Citigroup is claiming, through the miracle of structuring, that it has been able to shave almost 2 percentage points -- one whole fifth -- of that risk away.

This structure makes no sense, right on the ground floor. You can't extract a bunch of fees, pay a bunch of rich yields, and have the math work out, considering there's finite money being paid out by the underlying loans. Structuring, in and of itself, can't produce such enormous savings. If it could, everything in the corporate debt universe would be immediately structured for huge and immediate gains.

Now, Mr. Ratings Guy, you should be saying, "Something smells really fishy here." And if you were thinking like this, you would reach an obvious conclusion:

These ratings have to be bull***t. The AAA tranche of this CLO, for example, deserves a grade closer to junk than to AAA.

Yet Mr. Ratings Guy still signs off on the ratings. Why? Hmmmm...

Stay tuned for Part II in which we answer: Why does Mr. Ratings Guy sign off on ratings he knows can't be correct and why does this farce exist at all? Is what's going on a benign "nobody gets hurt" kind of transgression? And who gets burned if these ratings blow up down the line?

Update: One objection that's been raised: S&P doesn't actually see the pricing when these ratings are proposed. It doesn't see that the AAA tranche, for example, would pay 160 basis points over Libor. Okay, that's somewhat exonerating for S&P, but it doesn't change the math. And what's more, Mr. Ratings Guy isn't that stupid. He can figure out what's going on.

He can easily find out what AAA rated debt pays for other asset classes. Even if he doesn't have the CLO pricing in front of him, he'll discover the same problem I outlined above. This structure supports a tremendous amount of what should be low-yield AAA, and even after you add in yields for the other stuff, there's an awful lot of leftover yield to go around (some of which is used to pay structuring and management fees). All of which leads back to the same questions: How does that act of structuring manage to create so much extra yield? How can these CLO ratings be accurate?

Update, Part II: I wanted to sneak in a second update for those readers who will say -- rightly -- wait a moment, don't loans amortize? So aren't you really receiving the interest rate on the loan plus a certain chunk of principal each year? That's typically correct, and I reference that up high in the post. But just to make clear: I am keeping this example simple with a focus on the interest rate portion only, because the yield is the sexy part. That's what you make over and above your initial investment -- the return of principal is just making you whole. If anyone has further questions/comments, put 'em below and I'll tackle them. The bottom line is the math doesn't really change.

A Roundup: The FCIC Republicans and an Intellectually Fraudulent Take on the Financial Crisis

2010-12-19T06:51:00.009-05:00

Alas, I'm late to this story, but it was so mind-boggling I had to weigh in with something. The four Republicans on the Financial Crisis Inquiry Commission went rogue and issued their own (slim, fact-lite) report on their findings about what caused the crisis ... beating the publication date for the actual report. Sadly their analysis of the crime scene looks something like this, for the comprehension impaired:

FANNIEFREDDIEGOVERNMENTGOVERNMENTFANNIEFREDDIE

Most disturbing was the report (on Huffington Post -- nice job, guys) that the four Republicans voted to ban the following phrases from the official FCIC report: "Wall Street," "shadow banking," "interconnection" and "deregulation." Which is sort of like writing the history of apartheid in South Africa and not being allowed to use the words "race," "white," "black" and "prejudice."

Anyway, my best contribution at this point isn't opining but stepping back and rounding up the financial blogosphere reaction. So much good has been said that it deserves aggregation and linking (please click through and read each!) without any further commentary from me. So here you go:

Yves Smith, naked capitalism:

How can you talk coherently about the crisis and NOT talk about the shadow banking system, which grew to be at least as large as the official banking system and was the primary object of the various government rescue operations? It’s like trying to talk about AIDS and pretend there is no such thing as intercourse. Similarly, excessive interconnectedness, or as Richard Bookstaber vividly called it, “tight coupling” was another critical driver. AND HOW CAN YOU NOT TALK ABOUT DEREGULATION?!? What is there left to talk about once that is excised? Sunspots?

Barry Ritholtz, The Big Picture:

They released a silly analysis that could have been written by wingnut think tanks like the AEI or others BEFORE the crisis even occurred (and indeed, there are many examples of this findable via the wayback machines of the intertubes). ... The Gang-o-four absolves Wall Street and the banks, blames the government — for everything — and ignores the data that conclusively demonstrate otherwise.

Joe Nocera, New York Times:

To fix a problem ... it helps to know what the problem is. The F.C.I.C., with all those witnesses and documents, could have really helped here. But the paper released by the commission’s Republicans this week reads as if they couldn’t be bothered. It simply reiterates longstanding Republican dogma that could have been written without a $6 million investigation.

Mike Konczal, Rortybomb:

I have to hand it to them. They decided to take one for the team and release this report that implies markets can never fail, only governments. No sources, no numbers, no new info, not even 10 pages, but they put it out there so reporters have the option to go “well, on the other hand the Republicans said this.” That’s how seriously the conservative movement takes ideological warfare.

Paul Krugman, New York Times:

We should have realized that the modern Republican Party is utterly dedicated to the Reaganite slogan that government is always the problem, never the solution. And, therefore, we should have realized that party loyalists, confronted with facts that don’t fit the slogan, would adjust the facts.

Alain Sherter, BNet:

The document is a wholly expurgated version of events that omits key facts while twisting others to fit certain ideological preconceptions.

Nick Baumann, Mother Jones:

In this story, Wall Street, shadow banking, and deregulation had nothing to do with the meltdown. Republicans have been pushing this fairy tale for years.

Dave Ribar, Applied Rationality:

A report on the financial crisis that omits the words, "Wall Street," "fraud," "underwriting," "collusion," and "derivatives" and that overlooks Wall Street's view of most clients as "suckers" isn't worth the paper it's written on.

Ezra Klein, Washington Post:

I'm puzzled by the decision the panel's Republicans made to break away, declare certain words off-limits and release a nine-page report that reads like a long op-ed from a generic Republican politician.

Cardiff Garcia, ft.com/alphaville: (on the Republican vote to ban "deregulation" etc. from the FCIC report)

Depending on your point of view, this is either sad, funny, weird, pathetic, or just idiotic.

Revolving Whores, Dec. 15 Edition

2010-12-15T20:58:00.002-05:00

That didn't take long!

After launching my "Revolving Whores" feature a few days ago, I've already got a second installment as Wall Street greases the palm of another public official, according to Bloomberg:

Theo Lubke, who headed the Federal Reserve Bank of New York’s efforts to reform the private derivatives market, joined Goldman Sachs Group Inc. to help Wall Street’s most profitable firm navigate the looming overhaul of financial regulations.

Ka-ching! Mr. Lubke, your bathtub full of caviar awaits ...

Too Big to Fail, the Book, and Inside Job, the Movie

2010-12-11T08:52:00.002-05:00

I just finished reading/watching both of these (okay, I know I'm way late on "Too Big to Fail;" it's been a busy year). Some quick takeaways:

"Too Big to Fail" -- here's what particularly struck me in this fascinating fly-on-the-wall account (in fact, I've never read a more "fly on the wall" book than this one) of the events immediately leading up to the financial crisis in the fall of 2008:

* Christopher Cox, former SEC head: Inept. Clueless. Ineffectual. Stupid. It's truly mind-boggling just how bad this guy was.

* Speed dating, capitalism style: It was amazing how many mergers people were trying to engineer behind the scenes at the fever pitch of the crisis. Goldman buying Wachovia? Bank of America buying Lehman? And the Jewish mothers arranging the hookups were usually Hank Paulson and Tim Geithner (some banking executives even started calling Geithner eHarmony).

* The U.S. could have saved Lehman. Sure, you can parse all the differences between the Bear Stearns situation and Lehman's mess and make a lot of rationalizations for why the two were different -- but once Sorkin shows you how creative and frantic and ad hoc things were behind the scenes, you realize that grounds could have been concocted to save Lehman. The government just decided to draw a line in the sand and see what happened.

"Inside Job":

* If you've read a lot about the financial crisis, much of this film will be like "Sing Along with Mitch." You know the words, the characters, the plot, the outrage that's on slow simmer ...

* "Inside Job" is still a great film because, for my money, it makes its argument about what happened with the most coherence and the least distracting shrillness/gimmickry (plus, where else are you going to hear that old Ace Frehley classic "New York Groove" dusted off?)

* The film's original contribution is the spearing of the academic economists. Watching Glenn Hubbard's facade of reasonableness degenerate to hostility is revealing, as Ferguson pressures him about his connections to the financial industry. Even more unnerving though is watching Marty Feldstein, who seems amusedly detached and really doesn't appear to give a shit about all the havoc that ensued from flawed theories about economics and deregulation.

Revolving Whores

2010-12-11T08:29:00.003-05:00

The debut of my new acerbic feature, "Revolving Whores: An Attempt to Shame the Shameless and Expose How Broken Our Damn Government Is." (I'm channeling my inner Denninger today, with some spicy zero hedge-type attitude on the side.)

Today's featured personality: Peter Orszag. (I meant to blog about this earlier in the week, but now Mike K. has alertly jumped on the story; he has some good observations about Orszag's latest career zig).

Reuters lead:

Citigroup Inc. named U.S. President Barack Obama's former budget director as a senior global banking adviser on Thursday, strengthening its ties to high-profile former officials the same week the bailed-out bank finished shrugging off U.S. government ownership.

So a bank that was, not long ago, the largest in the world in assets, the quintessence of "Too Big to Fail," has now paid a (presumably) big contract to free agent Peter Orszag, who will help Citi hit a few dingers out of the park using his special knowledge of all recent things White House.

America, cleanse thyself.

L'Arrogance: The High-Finance Scent That Never Goes Out of Fashion

2010-11-21T06:32:00.003-05:00

By now, unless you've been under one of those proverbial rocks, you've heard about the massive, pending insider-trading charges, a story apparently broken by the Wall Street Journal:

Federal authorities, capping a three-year investigation, are preparing insider-trading charges that could ensnare consultants, investment bankers, hedge-fund and mutual-fund traders and analysts across the nation, according to people familiar with the matter.

The criminal and civil probes, which authorities say could eclipse the impact on the financial industry of any previous such investigation, are examining whether multiple insider-trading rings reaped illegal profits totaling tens of millions of dollars, the people say. Some charges could be brought before year-end, they say.

Admittedly, I'm a guy sometimes entranced by small detail, so I found this bit of the article most curious, an e-mail sent by a John Kinnucan, a principal (or analyst) at a firm called Broadband Research LLC (and former portfolio manager at Crabbe Huson Special Fund, so his high-finance bona fides are legit):

Today two fresh faced eager beavers from the FBI showed up unannounced (obviously) on my doorstep thoroughly convinced that my clients have been trading on copious inside information," the email said. "(They obviously have been recording my cell phone conversations for quite some time, with what motivation I have no idea.) We obviously beg to differ, so have therefore declined the young gentleman's gracious offer to wear a wire and therefore ensnare you in their devious web.

My first reaction was: Wow. You could build a whole psychology class around the tone of this e-mail. If you were enterprising, you could even bottle it into a scent to be sold to financiers.

"Obviously," the first thing you notice is how effortlessly the writer captures a breezy arrogance. There's a strong grace note of condescension, as if a visit from a couple of FBI agents is to be treated with the same disdain as the appearance on one's doorstep of a pair of vacuum cleaner salesmen. A sniggering-up-the-sleeve quality ("ah yes, these bumbling little investigator types!"). Self-importance. High-brow sarcasm. Haughty disdain for the rule of law. Megalomania.

Where have we seen this before?

Oh yeah. Throughout the whole damn financial crisis.

Banks ungrateful for being bailed out (remember it made headlines when a few bailed-out CEOs actually managed to say "Thank you, America," in testimony a good year after the meltdown). Banks riding the Bernanke liquidity wave to enormous profits and, with little sense of irony, declaring themselves master surfers and paying out lavish bonuses for their "skill." Indignant workers at AIG Financial Products who couldn't believe anyone would try to reduce their fat bonuses even though their division cratered the damn company. Lord Blankfein telling us that Goldman Sachs is doing "God's work."

Plus ca change, plus c'est la meme chose.

The Foreclosure Mess: 7 Reasons Why It's Much Worse Than You Think

2010-10-12T09:08:00.004-04:00

We're in a big, big mess with home foreclosures in the U.S. (foreclosuregate, if you will). I'm not sure many people understand the awful magnitude of this train wreck. So here is my look at seven reasons why it's much worse than you think. Below I partly synthesize much of the fine analysis being done elsewhere (Mike Konczal has been absolutely superb on this issue, as has Yves Smith).

Quick background: In 1996, a private company was formed called Mortgage Electronic Registration Systems, or MERS for short. Why should you care? Chances are better than 50-50 that, if you own a home, MERS officially recorded the mortgage -- probably unknown to you. MERS is headed by R.K. Arnold, a former U.S. Army Ranger with a law degree from Oklahoma City University, ranked #104 in the nation this year by the Association of American Law Schools.

Now you may be worried that Arnold, a guy who apparently doesn't exactly have a stellar legal pedigree, is the CEO of this giant institution that registers millions of mortgages from Big Sur to Beacon Hill. Don't be. Because MERS doesn't have any real employees. It's kind of a shell. MERS Treasurer William C. Hultman revealed as much during a deposition in Bank of New York v. Ukpe:

Q I thought, sir, there’s a company that was
formed January 1, 1999 [sic], Mortgage Electronic Registration
Systems, Inc. Does it have paid employees?
A No, it does not.

Q Does it have employees?
A No.

Q Does MERS have any employees?
A Did they ever have any? I couldn’t hear you.

Q Does MERS have any employees currently?
A No.

Q In the last five years has MERS had any
employees?
A No.

Why the heck would you form a company, then not hire anyone? Well, what's the purpose of your company? If you're making widgets, you need widget inspectors, widget engineers, widget fabricators etc. But MERS was created for mortgage banks to dodge paying local recording fees (and doing the associated paperwork, one assumes) when mortgages were re-assigned. So let's say Wall Street wants to bundle a bunch of mortgages into a security, which then is cut up into teeny pieces to go into another security, which is diced once more to go into another security ... thanks to MERS, you can do all this with a minimum of hassles/expense.

Cool beans, until it all starts to come apart at the seams, and you realize that the companies making the original loans were extending credit to people who could barely fog a mirror in the midst of a huge housing bubble and you've got to foreclose and where's all that paperwork you're going to need dammit?

So, without further ado, here are seven reasons we're in the middle of a really epic mess right now:

1. MERS may be a fraudulent company at its very core.

This becomes obvious in the answer to a simple question: How does a company with no employees foreclose on millions of homes across the U.S.? Easy. Apparently it "simply farms out the MERS Inc. identity to employees of mortgage servicers, originators, debt collectors, and foreclosure law firms." MERS even sells its corporate seal for $25 on its Web page. This corporate structure "is so unorthodox as to arguably be considered fraudulent," says Christopher Peterson, a law professor at the University of Utah.

Exacerbating this problem: no state legislature or appellate court ever gave its stamp of approval to MERS in the first place, so it has no acknowledged legitimacy.

2. Widespread fraud may be taking place to cover up the lapses of MERS.

Mike at Rortybomb does a great job explaining how your mortgage consists of two parts, a promissory note (you promise to repay the lender X dollars, and under what conditions, and with what penalties for missing payments) and a mortgage, known in some states as a deed of trust. Mike reduces all this nicely: "The note is the IOU, it’s the borrower’s promise to pay. The mortgage, or the lien, is just the enforcement right to take the property if the note goes unpaid." Common sense dictates that both parts are necessary to move to foreclose. You can't apply the enforcement without knowing the terms of the note and how much remains unpaid.

But as Yves Smith alarmingly details at naked capitalism, the banks apparently got impatient with the messiness of paper notes in an electronic age. Again, without anyone's approval to do this (no courts signed off, no legislatures gave authority), it looks like they converted physical notes on a massive scale to electronic documents -- safer, cheaper, easier to store etc. ... and destroyed or misplaced a lot of those original notes.

The trouble is when the homeowner being foreclosed on demands that the note be produced. The ensuing document scramble has led to fraudulently created replacements. It's hard to say on what scale this is occurring, but Yves included a chilling quote that she says came from the CEO of a big subprime lender, who defended the practice of transfers lacking paper notes, then had a nervous moment of doubt: “Well, if you’re right [that it's a problem], we’re f**ked. We never transferred the paper. No one in the industry transferred the paper.”

3. This mess is greatly complicated by long, complex chains of securitization.

Mike at Rortybomb provides a good diagram. Start with Joe Homeowner, whose mortgage is originated by say Easy Mortgages 'R Us. Easy Mortgages 'R Us passes the note to the next link in the chain, a sponsor for the security being created (say it's Bank of America, which will scoop up a thousand mortgages, including Joe Homeowner's, and turn them into a product called a residential mortgage-backed security). Then there's a depositor that stands between Bank of America and the trust itself for the mortgage-backed security.

Phew. That's plenty complex. But Mike gave readers only the short form. The residential mortgage-backed security can itself be bundled with other similar securities into a creature called a collateralized debt obligation, or CDO (that should sound familiar from Congressional hearings). And then the CDO can be sliced up and bundled with other strips of CDOs into something known as a CDO squared. Now do it one more time and you get a CDO cubed.

Now remember that old saying: a chain is only as strong as its weakest link. Now here are the many links we've just created for Joe Homeowner's mortgage:

Joe Homeowner --> Mortage Originator --> Sponsor --> Depositor --> Trust for RMBS --> CDO --> CDO squared --> CDO cubed. Moreover, I've probably left out a few entities on the CDO level; I'm sure they use similar intermediary units as the RMBS to create their securities.

Exacerbating this problem: The chains were created too quickly, during what turned out to be unstable times (a bad real estate bubble being inflated). So they're not even relatively robust chains.

4. Ladies and gentlemen, I present: Lawsuit-palooza.

Mike delves into this. Foreclosuregate is a full employment act for lawyers. You could have lawsuits anywhere up and down that chain of document transfer. Investors in the mortgage-backed securities will sue servicers. Homeowners will sue on being foreclosed on, demanding to see the note (with the number of suits increasing exponentially as there are more victories, creating a crushing backlog of cases in our legal system). Investors in the securities will jostle for position and battle with each other, the junior debtholders aligned against the senior. The RMBS trust will go after the sponsor for dumping mortgages on it that lacked the proper paperwork.

5. This will be resistant to fixes, for one, because the mortgage-servicer system for the securities is badly set up, with all the wrong incentives.

Mike nails this one too. The smart way to fix these problems would involve lenders working with homeowners to pare down the loan principal for deeply underwater homes. This approach has been shown consistently to work out better for all parties than foreclosing. At the same time, the lender could take the opportunity to remedy the defective paperwork.

But the mortgage servicer, the one who controls what happens with the mortgages that are now embedded in a security (or maybe multiple securities -- remember those CDOs squared?), doesn't have an incentive to do this. His incentives are narrowly structured: he gets fees, on a certain schedule, for foreclosing. He doesn't get paid for the time-consuming process of working out a solution that would ultimately benefit the investor in the security and the homeowner as well.

In fact, as Mike notes, securitizations must be passive entities to win a bunch of tax breaks. As such, they can't do much hunting down of notes or anything else, it seems, without risking losing their tax-exempt status. A really miserable setup, which is going to be an obstacle to resolving this mess.

6. This will also be resistant to fixes because it's going to be hard to wave a magic wand on the federal level and make the problems disappear.

This situation is playing out locally, not federally -- county by county, state by state. And as the political heat builds on the big, bad banks -- much of America already hates them for their oversized bonuses, for their lack of repentance after driving the economy into the ditch, for the bailouts that saved their asses while leaving double-digit unemployment in its wake -- it's going to be hard for Congress, operating under the klieg lights, to ram through the kind of legislation that could straighten things out. Congress is already perceived as being snugly in the pockets of Wall Street. One thing is for certain: NOTHING will happen before the election. This is a live third rail right now.

7. MERS owns more than 60 percent of U.S. mortgages.

I haven't seen anyone sort through the implications of this, but I've seen in the comment sections of blogs, some people sniffing about, sensing the implications. Namely: I make regular mortgage payments, I have great credit, but what if I ask to see my note? What if they can't produce it? Does that then make me foreclosure proof? This will add an interesting element to valuing more than 60% of the mortgages in this country. How much will Joe Investor pay for the right to payments from a mortgage that may be "foreclosure proof"?

So there you have it. Seven reasons why we really need to be paying attention to the mortgage mess. It's hard to overstate how serious it is.

Verdicts on TARP: What I Wish I'd Said

2010-10-12T07:16:00.003-04:00

When the authority of TARP recently expired, a predictable flurry of opinions made cases for and against the largest bank bailout Western civilization has ever known. I could weigh in too, but I found someone who expressed my sentiments so well, I'd just like to quote her for a few short paragraphs.

Alice Schroeder was writing in Businessweek about Charlie Munger, Warren Buffett's right-hand man, who rather scornfully told an audience of Michigan college students that we "shouldn't be bitching about a little bailout" of the banks. Munger also said, in a curious application of the second-person pronoun (is he secretly from another civilization? or planet?), that the bailouts were "required to save your civilization." (The phrasing carries the whiff of the moral harangue from the elder who knows best; one imagines gramps pulling his cracked leather belt from his trouser loops and announcing to the youngster about to get a good strappin', "I'm doing this for your own good.")

And this is Schroeder's very intelligent response (my bold):

... the problem is the false dichotomy it presents. The choice wasn't between the bailout or no bailout. It was between the bailout we financed, which didn't resemble capitalism in any known form, and a bailout more intelligently executed.

No one made us bail out shareholders along with the banks' bondholders. We didn't have to preserve institutions that are still too big to fail in any meaningful sense of the term. We could have propped them up temporarily, then recapitalized them as smaller, more manageable entities, with former equity holders assuming the cost of the risk they assumed.

We missed the chance to reduce systemic risk by comprehensively rewriting regulation for the financial-services industry. Instead of withdrawing government guarantees, we increased them. So there are plenty of reasons to complain about the bailouts.

Yup.

What I Don't Get About the Opposition to Elizabeth Warren

2010-09-16T11:39:00.004-04:00

Okay, so Obama just appointed Elizabeth Warren to set up the new Consumer Financial Protection Bureau, which makes her the interim head of the agency, or something ... it's all still kind of confusing. She really deserves to be named to the job outright. What's the hold up? King Richard III had a lame leg and didn't do this much foot-dragging.

Ah, she may not be confirmable by the Senate, says Chris Dodd, head of the Senate Banking Committee. Why not? This too is a bit hazy; Senators can be maddeningly elusive when they don't want to discuss something. But the case against Warren seems to boil down to:

1. Lack of experience/qualifications.

This line of argument quickly falls apart though. She hasn't been knitting doilies in Dubuque and teaching night classes in creative writing for the last decade. She is (1) a bankruptcy law professor at Harvard who has "written several books over the years focusing on how debt, predatory lending and bankruptcy affect average middle-class Americans" (Bloomberg News) (2) the head of the TARP oversight committee, who in that position became intimately familiar with the mechanics of the massive bailout of the financial sector and the shenanigans that led to the financial crisis (3) (and here's the kicker) the person who argued in a 2007 article for the creation of an agency just like the Consumer Financial Protection Bureau.

2. Lack of objectiveness/not friendly enough to banks

This seems to be the real line of argument. Just listen to Senator Shelby of Alabama, from the Bloomberg story quoted above:

Shelby said he “would like to see a more objective person in that job. Elizabeth Warren, obviously, is not an objective person when it comes to the consumer issues.”

So Warren is perceived as too aggressive an advocate for consumers. She's not "bank-friendly" enough. (The banking sector has vigorously lobbied against her.)

Now think hard about this second point. Because it's the main reason the Senate would shoot down her candidacy, it's the point the Republicans are preparing to rally around, it's what has Dodd quaking with fear apparently ... and it's COMPLETE BULLSHIT. I'll show you why:

Say we're going to create a Dog Protection Bureau. Because, it so happens, there's a class of people who aren't always nice to dogs. These are rich, powerful people. They can afford to hire high-priced lobbyists to represent their interests in Congress (unlike the dogs). Sometimes, they abuse dogs in some reprehensible fashion and get away with it.

Now I'm not saying all these people are always horribly bad to dogs. Some of them may just steal a few milk bones here and there, or maybe they're making dog toys out of substances that aren't carcinogenic exactly, but that still cause mouth sores and runny eyes and nuisance stuff.

So we need to appoint someone to head the Dog Protection Bureau. We find a person who's an excellent, unquestioned advocate for dogs, float her candidacy, and the U.S. Senate says, "Eh, I don't think she's confirmable. She's not objective enough. She's too pro-dog."

To which a sane, logical person might respond: So what the hell are you creating the Dog Protection Bureau for? To be an impartial judicial arbiter on all matters dog, trying to see both viewpoints: the need to protect dogs and the need to abuse them/kick them around a little, for whatever reason? And if so, why are you calling it the Dog Protection Bureau? Why not call it the Dog Issues Administrative Court or something?

But if you are trying to protect dogs, you should welcome a strong advocate for dogs.

And if you are trying to protect consumers, you should welcome a strong advocate for consumers.

What am I missing here? Senate Republicans and Democrats, can you fill me in?

Is Diversification Really a Free Lunch?

2010-09-11T14:58:00.006-04:00

Scooting around the Net today, I found myself checking out what Greg Mankiw has been up to (besides relentlessly plugging the half dozen textbooks he's written). I drop by his blog from time to time, even though he doesn't allow comments on his posts, which I find a bit strange. Dropping by feels like the equivalent of paying a visit to someone but only being allowed to peer in the house windows: You can watch what they're doing, and eavesdrop to your heart's content, but no talking please.

So I came across this New York Times column by the good Harvard professor, brimming with advice for the college bound. I nodded enthusiastically at his scold that high schools spend too much time on Euclidean geometry and trigonometry (when was the last time someone stopped you in the street and asked if you knew the cosine of the angle of the shadow being thrown by the lamp post on the corner?) and not enough on probability and statistics.

Amen, brother!

In fact, I found myself pretty much onboard with the whole piece -- until I reached this paragraph and started scratching my noggin a little:

The evidence of financial naïveté shows up every time some company goes belly up. Whether it is Enron or Lehman Brothers, many company employees are often caught with a large fraction of their wealth in a single stock. They fail to heed the most basic lesson of finance — that diversification provides a free lunch. It reduces risk without lowering expected return.

Okay, let's think about this. Note that, first of all, the good professor has provided a lopsided universe of examples. Yes, Enron and Lehman Brothers flamed out, spectacularly, and punched a saucer-plate sized hole through plenty of their employees' 401(k)'s. Very true. But how many Microsoft and Google millionaires have we also heard about, ordinary secretaries or maybe even guys who changed the water in the fish tank on weekends and scrubbed the toilets, who got a glory ride to early retirement on their company stock? Had they properly diversified, they might have made only enough to buy a used Vespa.

So am I anti-diversification? A heretic in the investing community? Diversification, after all, is one of the ten commandments of smart investing.

Nope. Not at all. I believe in a diversified portfolio (I personally own a mix of U.S. stocks, bonds, emerging market equities, Japanese shares -- ugh, cash-like instruments and cash itself).

The problem is, I think Mankiw's only half-right in his last two sentences.

I agree with: Diversification reduces risk without lowering (or increasing -- he neglects the corollary on the upside) expected return.

Simplification: You work at an S&P 500 company. Let's say the average yearly gain on the S&P is 8 percent. You invest in only your company's stock. For any given year, it may rise 8 percent -- or it may surge 22 percent, or conversely, fall 15 percent. Lesson: an individual stock can be quite volatile. But say you buy shares in 30 S&P companies instead. Some may go up, negating the declines of others, and at the end of the day, you'll probably have a smoother ride -- less volatility.

I strongly disagree with: Diversification provides a free lunch.

What you just witnessed in the example above isn't a free lunch. It's a smoother ride (to mix metaphors). To wit: there's a greater chance, in any year, your company's stock will soar 40 percent or plunge 40 percent than a basket of 30 stocks will do the same. By diversifying, you tamp down volatility. But for the basket, while the losses may be bounded at say 25 percent, the gains won't be as high either (let's say 25 percent to keep it simple).

So by diversifying, you lose your chance to become a Google millionaire, but you also won't have to eat cat food and sleep under the freeway overpass during your golden years.

Ah, but if only "diversification provides a free lunch" were only wrong ... no, it's worse than that. It's very dangerous, as the financial crisis attests to.

Consider that a collateralized debt obligation, or CDO, is the poster child of diversification. It's stuffed with mortgages from all across the country, and once you get into the strange beast known as the CDO squared, it's more bewilderingly complex (and more diversified). Investors obviously thought that, through diversification, they were getting a free lunch by buying up CDO tranches.

Why do I say that? Somehow they came to accept that a CDO could be worth more than the sum of its parts. They must have by definition, because the assembler of the CDO must be paid to put together and market the thing (and extract a profit). So if the mortgages contained within it collectively yield say 6.4 percent on average, the CDO genie will do his magic and transform them into tranches that collectively pay 6.1 percent on average (or whatever the typical spread is for these products).

So where did the 0.3 percent go, which was being paid for assuming a certain amount of extra risk? That's your diversification "free lunch" (arrived at by manipulating correlation numbers foolishly, as it turned out, through the Gaussian copula). Actually it gets even better: investors thought they were getting free dessert too! Because, remember, through the copula wizardy, the slices of the CDO earned high ratings while paying more than similar-rated debt! (A free eclair with that sandwich, sir?)

The "free lunch" was later revealed to be a "fraud lunch" when CDO prices cratered and the ratings turned out to be ridiculously inflated. However, here's what the illusion of the free lunch did: it spawned a long line of hungry investors, who couldn't get enough of these amazing CDOs, which created further demand for dicey mortgages, which got sausaged into more CDOs, until finally the whole sham famously exploded.

So beware of savants, even Harvard professors, touting "free lunches" in the investment world.

Dick Fuld: Crazy Like a Fox?

2010-09-01T20:29:00.004-04:00

Dick Fuld appeared before the Financial Crisis Inquiry Commission today and, some would say, showed himself as completely untethered from reality. The former Lehman Brothers CEO wasn't about to mince words; at the outset of his prepared remarks he asserted:

Lehman’s demise was caused by uncontrollable market forces and the incorrect perception and accompanying rumors that Lehman did not have sufficient capital to support its investments.

"Say WHAT?" was more or less the reaction over at naked capitalism. For how could any man be in such denial?

For my part, I think Fuld may be playing a role on a stage. Consider that a large Wall Street investment bank doesn't just go gently into the night. Lehman wiped out a lot of wealth on its way down. And note that phrase that keeps recurring in Anton Valukas' very, very thorough report on Lehman's demise: "colorable" claims. In other words, plenty of hungry lawyers may have sufficient grounds to sue Fuld's butt ten ways to Tuesday.

Also lots of prosecutors would love to put him behind bars for a long while. Let's not forget that Sarbanes-Oxley requires that a CEO sign off on financial statements as true and accurate, and in doing so, takes responsibility for their content.

Now, if you're Fuld, and you're sweating and conniving a way out of this mess, you know you can't really plead insanity. As bizarre as some in the current crop of U.S. CEOs are, they hardly qualify as insane. Yet there is another option that looks a bit like insanity, a sort of blind and resentful denial of any responsibility. Don't even try to be reasonable.

So if we could rig Fuld up to a lie detector, it would be interesting to find out if he really believes what he's saying right now -- if his public face concords with his private thoughts.

In other words, is Dick Fuld crazy? Or just crazy like a fox?

The Cause of the Financial Crisis in Two Words

2010-08-08T15:25:00.005-04:00

The other day I was thinking: ask any knowledgeable observer what caused this financial crisis, and you'll probably get a long, rambling explanation with anywhere from four to ten villains, their identities largely depending on the speaker's ideological/philosophical bent.

But what if that person was allowed only a word or two to capture the essence of the problem? What would the best word(s) be?

Some might say "greed." But that's no good. Greed's a given on Wall Street. If anything, greed is the grease that makes the wheels move over there. The greedy may have become greedier, but this still doesn't supply a satisfying explanation for the whole mess that paralyzed our financial system.

My two words (you're welcome to suggest your own), which provide a prism through which I think most of this crisis can be understood, are simple:

Mispriced risk.

Now for the walk through. First, the obvious stuff. Peel off the outer layer of any CDO and you'll find plenty of mispriced risk. What about that super senior tranche rated AAA, while it rests on mezzanine slices of crappy mortgage securities? Way mispriced.

The infamous Gaussian copula that aided the creation of AAA gold from subprime dross? That's a handmaiden to mispricing. And the credit raters: they're right at the center of the rampant mispricing, slapping AAA labels on stuff they didn't understand as they grubbed around for rating fees.

How did the credit crisis get so large? Mispriced risk. If a AAA corporate bond yields say 3.2 percent, and a AAA chunk of a CDO yields 3.5 percent, what are you going to buy (assuming you trust the ratings, and AAA implies the same level of risk, no matter the security). So money will start pouring into the new AAA category that promises the same low risk but a higher return.

What about credit default swaps? Consider a big issue there: many were sold much too cheaply, considering the dangers they were insuring.

Again: mispriced risk.

What was at the heart of the seize-up in the credit markets in 2008? Remember, the shadow banking system froze up. Counterparties to repo transactions wanted much bigger haircuts on collateral they were taking for overnight lending. Why? Fear of mispriced risk on the collateral. In other words, that collateral purported to be AAA might actually be some variant of C.

You could even argue that excessive leverage ties back to mispriced risk. Why is a bank willing to take on so much leverage? Because it thinks its overall risk is actually fairly small. Just look at the "value at risk" metric, and its widespread adoption, and how it lulls Wall Street into a false sense of security.

For their part, regulators failed to do a number of things that would have helped correct the epidemic of mispriced risk. They failed to insist on greater transparency that would have flushed some of this risk out into the open. They failed -- actually, didn't even attempt -- to reduce the complexity of financial instruments that artfully conceal risk. They simply abdicated their duty to police the financial system as instruments that mispriced risk created a vacuum, sucking in huge piles of cash because investors were enticed by the prospect of a free lunch.

The financial crisis, explained, two words: mispriced risk.

Taleb With a Telling Anecdote on the Regulatory Mess

2010-08-05T06:31:00.006-04:00

Nassim Nicholas Taleb weighs in on the regulatory mess in our financial system through a curious tale of being approached while at Davos with the following (legal) proposal to avoid FDIC regulations:

[He] tried to sell me a peculiar investment product. It allowed the high net-worth investor to go around the regulations limiting deposit insurance (at the time, $100,000) and benefit from coverage for near unlimited amounts. The investor would deposit funds in any amount and [the] company would break it up in smaller accounts and invest in banks, thus escaping the limit; it would look like a single account but would be insured in full. In other words, it would allow the super-rich to scam taxpayers by getting free government sponsored insurance. Yes, scam taxpayers. Legally. With the help of former civil servants who have an insider edge.

Got it? I left out the name of the salesman for this scheme for shock value, because it was none other than ... Alan Blinder, a former Vice Chairman of the Federal Reserve Bank of the United States.

So, in case anyone was left wondering, government officials apparently don't feel any regret/guilt/sense of impropriety about crossing over to the other side -- going from regulator to regulatee -- and profiting off the knowledge/connections gained while enforcing financial rules.

But Taleb makes one other must-ponder point dear to my heart:

... the more complicated the regulation, the more prone to arbitrages by insiders. So 2,300 pages of regulation [i.e., the current financial reform bill] will be a gold mine for former regulators. The incentive of a regulator is to have complex regulation.

Second, the difference between letter and spirit of regulation is harder to detect in a complex system. The point is technical, but complex environments with nonlinearities are easier to game than linear ones with a small number of variables. The same applies to the gap between legal and ethical.

I've repeatedly said on this blog that the answer to our financial system's regulatory woes is not a rules-based approach of trying to anticipate every situation, of trying to plug every hole, of trying to cover every contingency in this or any other possible world. It's impossible to do. We need to look at more flexible solutions, such as principle-based regulation with teeth. We're foolish to head back down this path of growing a new regulatory bureaucracy that is doomed to fail as smart financiers parse out endless loopholes.

So How Should We Respond to Regulatory Failure?

2010-06-14T07:19:00.004-04:00

Mark Thoma poses the question on his blog. Specifically, he notes:

I keep reading arguments that start with the fact that regulators have been imperfect in the past and use it to argue that we should eliminate (or substantially reduce) the amount of regulation that is imposed. However, just because regulators missed things in the past like Bernie Madoff, the financial meltdown, and the risks that BP was taking does not imply that regulation ought to be reduced or eliminated.

Agreed. And the conservatives beating the anti-regulation drum are getting tiresome. Let's do a 30-second review of regulatory failure and the financial crisis.

There were structural reasons for the failure:

1. We have a confusing hodgepodge of regulators (OTS, OFHEO, FDIC, SEC, OCC, Fed, etc.). Is it any surprise that regulatory issues fall through the cracks between their respective walled fiefdoms? Or that their regulatees go "regulator shopping," trying to find a sympathetic ear, with such a plethora of choices? Our Balkanized regulatory system is defeating us. What if the Food and Drug Administration, an acclaimed regulator, were broken up into the Vegetable Administration, the Fruit Administration, the Meat Administration etc. Is there anyone who thinks that would be more effective?

2. What needed to be regulated wasn't regulated. The huge shadow banking system wasn't on anyone's watch list. That needs to change by, say, yesterday. By rights the Fed is the best equipped to oversee shadow banking. But the Fed, we're learning, is an academic-minded, banker-sympathetic institution that enjoys gazing at its theoretical navel. These guys have no appetite for bare-knuckles regulation. So we'll have to figure out another way to do it, unless we can graft a pair of cojones onto this gelding.

There were cultural causes of failure:

1. Regulators didn't believe in their mission. Christopher Cox. SEC. Need I say more? And that's just one example. Under Bush, too many foxes were assigned to head The Association for the Safety of Chickens.

2. Regulators who didn't believe in their mission were, not surprisingly, uninformed about the latest innovations/questionable activities going on. Why spend your afternoon learning about credit default swaps/CDOs/some other complicated thing when your boss doesn't really care anyway and some really racy porno on the office computer is only a few mouse clicks away?

The single most important part of the solution, besides fixing the above:

Disable or at least severely crimp Wall Street's loophole-diving, rule-evading capability. Wall Street will always be a step ahead of the regulators in "innovating" cool new products that avoid tax payments and arbitrage capital regulations. We can shrug and meekly accept regulatory impotence. Or we can have a deeper conversation and realize it's time we started thinking outside of the box.

What about saying to the lords of high finance: any new product, whether intended for institutional or retail consumption, is illegal unless it has been approved by a new "Financial Products Safety Commission." Sure, Wall Street would howl. And such a requirement would quash some innovation. But, as we've seen, in this Brave New World of high finance, a lot of innovation is ultimately destabilizing and incredibly complex to no good purpose.

Or what about getting radical on accounting? Currently we let Goldman, Morgan Stanley et al do the limbo in a thousand creative ways to avoid capital constraints and make themselves appear more robust than they are. What if we told them the game has changed? That they are liable for criminal/civil penalties for using any accounting treatment that later is found not to accord with the spirit of existing regulations, as judged by say a "reasonable corporate accountant" or some such? Will this be chilling and cause more conservative accounting? Sure. But isn't that what we need after the free-for-all of the last decade?

It's fun to dream, though I'm not optimistic that any of my ideas will be adopted. We need big thinkers, big thoughts, ambitious men (and women!) to pull off meaningful change. And that's not what we have right now in Washington.

Was the Top Kill "Chance of Success" a Made-for-TV Number?

2010-05-28T20:21:00.007-04:00

I'm always curious about how people use and abuse the tools of probability and statistics. In structured finance, slices of CDOs failed at a rate completely inconsistent with their high-level ratings. Okay, that's bad. But even worse is that when strips of CDOs started being packaged in other CDOs, not only did the level of complexity rise in the new products (the "CDOs squared"), but sensitivity to initial misrating -- and the implied low probability of default -- exploded. (The explanation of why this is so is a bit technical, but is worth checking out at Marginal Revolution's The Dark Magic of Structured Finance.)

Now Top Kill has failed.

Failed to plug the spewing oil pipe a mile below the water's surface in the Gulf of Mexico.

Failed to stop the environmental carnage taking place in the ocean and along Louisiana's shores.

Top Kill came with its own simple, straightforward probability: a 60 to 70 percent chance of success. The number gave us comfort -- BP was doing the right thing, because it had better than even odds of stopping the oil belching into the seawater -- but not too much comfort, because, obviously, the flip side of that rate of success is a 30 to 40 percent chance of failure.

I thought for a while about BP's public stance on the likely effectiveness of Top Kill, and thought some more, and finally concluded: Whether BP planned it this way or not, they came up with the perfect public relations probability of success. If Top Kill's chance of success was exhaustively and scientifically studied then ascertained to be a number anywhere between 10 percent to 90 percent, and BP came to me, and I was a seasoned PR professional, my advice would be:

"Say publicly that Top Kill has a 60 to 70 percent chance of success."

Why? Well, imagine it actually has a 10 percent chance of success. And BP admits that. What's going to happen? The public, media, elected officials -- everyone will turn on BP and excoriate the oil giant for not coming up with a plan that has reasonable odds of working. Then when Top Kill fails, everyone will roll their eyes and say, "Of course it was going to fail. It was a lousy plan with only a 10 percent chance of success."

Now imagine the converse: there is actually a 90 percent chance that Top Kill will achieve its objective. And BP announces that. If the operation then succeeds, there will be a sigh of relief, but also a sort of collective shrug. What did you expect? After all, a 90 percent chance is the equivalent of an uncontested layup in the game of basketball. But if Top Kill failed, reaction would be furious: how could they screw up something with a 90 percent chance of working?

Now where's the sweet spot? It's a percentage that aligns with "cautiously optimistic." It's a percentage a little north of 50 percent -- but not too far north. It's a percentage that, if you fail, you can say, "Well, we knew from the beginning there was a large chance we weren't going to be able to do this," but if you succeed, you can say, "This was far from a sure thing, but we pulled it off, and congratulations to the great team at BP blah blah blah." That sweet spot, quantified: 60 to 70 percent.

Who knows what the actual chances of success were? I'm not an engineer, but once I learned a bit about Top Kill, it sounded fairly dubious. It sounded more like an operation with a 25 percent chance of working -- if that.

What if we wanted to find out what BP's top executives, in their heart of hearts, really thought were the odds of pulling off Top Kill?

Here's one way: the top 50 BP executives could've been forced to stake half of their wealth to a "futures" market on whether or not Top Kill would work. Sort of like betting on a prize fight. They would be allowed to trade in and out of odds that would fluctuate (much as is done for a heavyweight championship fight) depending on which position the money is favoring, and by how much ... and eventually, we'd get something resembling what BP really thought were its chances of plugging the leak. So, for instance, one guy would be betting half his wealth that Top Kill had a 65 percent chance of working (and would collect 35 percent if he won) and another executive at BP would be wagering it had a 35 percent chance of working (and would collect 65 percent if he won).

A little fanciful, and you may wonder -- well, who cares if BP lied to us (note: I have no idea if they did, but wouldn't be surprised) on the odds? Actually we should care because when the odds are 10 percent, not 60 to 70 percent, there's much more pressure to develop a "Plan B" -- and "Plan C" and "Plan D" as well. And I kind of wonder if the odds were at say 65 percent of Top Kill being a success -- and BP executives could take that position, but it would cost half of their wealth to play -- how many would've gamely said, "I'm in on that bet!" My guess: very, very few.

So Why Did the Stock Markets Do a Bungee Jump on May 6?

2010-05-15T12:05:00.006-04:00

What I find interesting about this story (and if you think bungee jump is hyperbole, you haven't looked at the intraday Dow chart) is there's a decent analogy: Imagine that murder victims start turning up in some small, idyllic U.S. city. Throats slashed, bodies mangled. Residents grow fearful. They start locking their doors all the time, glancing over their shoulders, going out less. The pressure mounts for police to find the killer, to calm a jittery city.

Now imagine a hit-and-run of sorts in the financial markets. Stocks make a sudden, vertiginous plunge, only to rapidly recover. Billions of dollars of wealth evaporate, then reappear. But how did this happen? Who caused it? Who profited from it? Could they do it again, and what if the next time the markets don't bounce back? And so investors grow fearful. They wonder: Should I continue to put more funds into volatile stock markets? Can they be trusted?

And the search begins, among the financial forensic teams, to find a culprit for the turbulence on May 6.

Except -- here's where our serial killer analogy breaks down -- was it really a lone actor? We'd like to think that; it fits into a more comforting narrative, with justice to be meted out if we find wrongdoing, and if we don't, we at least know where to take measures to fortify the system. Could it be Mr. Fat Finger Trader? The clumsy oaf who pressed "b" for "billion" on his keyboard when he meant "m" for "million"? Or here's the latest suspect, according to cbsnews.com:

Shares of money manager Waddell & Reed Financial Inc. fell Friday as it was identified as the stock trader that sold off a large number of index futures contracts during last Thursday's market collapse ...

Waddell's sale of 75,000 e-mini futures contracts in a 20-minute span on May 6 drew the attention of regulators, Thomson Reuters reported.

These "minis" are tied to the S&P. A futures contract is a way to bet on which way you think a market, stock or commodity is going to move; narrowly defined it's an agreement to buy or sell something at a set price on a set day in the future.

Now that 75,000 number does seem impressive. Well, at first. Wealthtrader.net tells us:

The current average daily implied volume for the E-mini is over $150 billion making it the most liquid trading derivative in the world.

What was the implied volume (I'm assuming "implied" refers to the contract's notional amount) for the 75,000-unit trade? Start with the notional value of an e-mini: $50 times the price of the S&P index. The high for the S&P that day was 2,407.8, so this trade was probably executed at somewhere south of that. Let's say the e-mini "dump" amounted to less than $9 billion of implied volume on May 6.

In other words, less than 6 percent of the typical daily volume came from this sale. Was this a big trade? Sure. Was it a little hard for the market to digest? Probably. Was it the real villain that we're seeking? I doubt it.

It's a media-ready story though. The storyline is simple. The government also surely realizes that finding a lone actor will make its job so much easier.

Unfortunately, a more sophisticated analysis of possibly the real culprit on May 6 has emerged, an analysis that is not so comforting. It suggests that our stock markets have a deep, systemic flaw. Paul Kedrosky at Infectious Greed nicely, and succinctly, laid out the argument in "The Run on the Shadow Liquidity System."

His view: good old-fashioned liquidity in the stock markets has been transformed in the age of supercomputers and high-frequency trading and algorithm-driven strategies:

... traditional providers of liquidity, market-makers and other participants, are not standing so ready to make the other side of the market. There are fewer traders prepared to make a market for the sake of market health. This is ... mostly because of what has happened with high-frequency trading, algorithms, and the like, which increasingly jump into the trading queue in front of and around orders, creating some liquidity, but also peeling pennies for themselves, frustrating market participants and heretofore liquidity providers...

The result:

... all of this changes market microstructure in insidiously destabilizing ways. For the first time we have large providers of this shadow liquidity, algorithms and high-frequency sorts, that individually account for large percentages of daily trading activity, and, at the same time, that can be turned off with a switch, or at an algorithmic whim.

Certainly we need to find what went wrong on May 6. We need to, to reassure the investing public that our stock markets are safe, fair, reliable -- places where you can feel comfortable putting a large chunk of your retirement nest egg. But, in the rush to judgment, we should be on guard against trying to largely pin the events on a lone actor, just to avoid a truth that is both complex and inconvenient.

Update: Actually, the fingerpointing at Waddell & Reed appears even more misguided than I thought ... you can blow up those calculations I made above; they were for a normal trading day. Turns out that during the 20-minute freefall on May 6, 842,514 e-mini contracts swapped hands (says Reuters). 75,000 is less than 9 percent of that number (and is probably only a few percent of the total for the day) ... again, it's sizable, but remove Waddell & Reed, and you still have a heavy, heavy volume.

Levin vs. Blankfein Faceoff

2010-04-27T18:45:00.004-04:00

Some quick observations on the performance of Goldman Sachs' CEO at the roasting before Congress today:

1. Blankfein technically outpointed Senator Levin during the opening exchange, I think -- Levin doesn't have a particularly deep understanding of high finance -- but Goldman's chief lost the big point: how Goldman's actions appear to Main Street. Basically Blankfein condoned the practice of "betting against a product you're selling." That's the damning headline. Here's what it sounds like to Joe Blow: I sell you my car, and meanwhile, I bet with someone on the side that the car will break down within six months. No graceful way to put lipstick on that pig.

2. Notice how often Blankfein used the phrase "market maker" when facing off with Levin? Nice defense except -- Levin wasn't really interested in being tutored on what a market maker does. Levin was too busy cudgeling the head of the investment bank with the "conflict of interest" point. Main Street doesn't understand "market maker." It does, however, understand quite well "conflict of interest."

3. Is the successful beating up on Goldman a sign that the investment banks have been hoisted on the petard of the complexity they nurtured? They produced synthetic CDOs that the rating services couldn't understand and mis-rated; these same synthetic CDOs were so complicated, with so many sliced and diced mortgage-backed securities underlying, that arguably the disclosure standard should have been higher than normal, even for sophisticated investors; "synthetic CDOs" are raising a lot of eyebrows among members of Congress who are wondering -- "What the hell is the point of something that's this damn confusing? There's got to be a rat in this woodpile."

4. Senator McCaskill scored points, along with McCain, by noting that with a synthetic CDO, there's no real there there. It's just a side bet on actual assets that have already been sold, so you're not actually buying anything concrete. McCaskill shook her head in befuddlement before saying, "seems like a hamster in a cage trying to get to compensation." Blankfein defended the product with some mumbo jumbo about managing risk profiles. But what we're left pondering is McCaskill's image of hamsters manically tunneling through the wood chips for dollar bills.

5. Is Blankfein this dumb, or did he have a convenient "idiot" moment: Senator Pryor asked him about structured investment vehicles (actually, Pryor used clumsier wording, and then Blankfein hastily corrected him, knowledgeably saying "structured investment vehicles.") And then Blankfein goes completely ignorant, it seems, when asked why the bank would use an SIV. His reply: "I'm not sure." (Cue laughtrack at home.)

Ah, a little more cathartic financial-crisis theater ...

Financial Reform: Unsung Proposals that I Wish Were on the Table

2010-04-26T07:43:00.003-04:00

We will be getting reform, and soon, it appears. Mike over at Rortybomb nicely table-izes six big areas/rules/issues to watch as legislation takes shape.

Maybe I'm just getting jaded, but what's on the table doesn't excite me much.

Transparency in derivatives through exchange trading? Yes, deeply important, but lobbyists will probably carve out small exemptions that Wall Street banks will then funnel as many of their trades through as possible. Too big to fail? Yeah, sure, cut 'em down to size, but Krugman is right on this one. Smaller banks, sufficiently interconnected and freighted with risk, can haul down the system too.

Hard leverage cap? I wholeheartedly support limiting leverage, but remember: leverage is a number. As Repo 105 and the continual perversion of accounting for capital under the Basel Accords show us, annoying numbers can be massaged. So under a hard leverage cap, I predict an explosion in "leverage-friendly financial innovation." Just wait.

So what is there to do? It won't happen during this round -- maybe the system has to seize up again, horribly, in the next few years -- but I wish we would look more at meta-type solutions. Here are some unsung proposals that I wish would get more consideration:

1. Contingent debt. This comes from the Republican side of the aisle, and though I confess to not having studied in great detail how the idea would work, I like the gist of it: banks hold a chunk of bonds that, when they come under duress, automatically convert to equity, boosting their cushion of capital. The percentage of such debt could be adjusted, if need be. The concept is market-oriented, as investors help police the institution's risk-taking. As Greg Mankiw writes:

This contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.

2. Financial transaction tax. I know, I know: to have efficient and liquid markets, you want participants to be able to trade as freely as possible. But I think that, sometime over the last decade or two, the amount of trading vaulted through the point of maximum efficiency and into something else -- something born of supercomputers run amok that just encourages volatility and instability. We need to slow down the financial machine a little. A small tax might encourage the bloated financial sector to shrink a little (a good thing) and raise money for our deficit (also a good thing).

3. "Deep clawback." Misaligned incentives are clearly an issue. And there'll be some feeble attempts to better align pay with long-term performance, but little will probably change. What we need is a way to get deeper into the pockets of bank executives and directors who allow their companies, through negligence or a desire for risky growth, to spin out of control, endangering the financial system. It sounds radical, but let's consider putting their personal houses and cars on the line -- or at least make them easier to prosecute criminally. Then behavior will change. If bankers hate "deep clawback," there's an alternative: Regulate the financial industry like a utility.

4. Move away from a rules-based to a principle-based system. This would be tremendously useful. With a squadron of lawyers and accountants in tow, every major Wall Street bank knows how to game and evade and twist every single rule that's been thrown at them. They will ALWAYS beat a rules-based system. But what if, in certain places in our laws, we used the language "what a reasonable accountant would ..." or something similar? This would stop them dead in their tracks. Because then they can't simply say in defense, "Well, you don't explicitly prohibit what I'm doing, so it must be okay."

So those are some of my favorite ideas that aren't seriously part of the discussion, unfortunately. We will get reform. It may not be that impressive. But if the financial system blows up again -- and relatively soon -- someone in Congress may get the idea that what we really need is more meta-reform -- and less tinkering around the edges.

The Goldman vs. SEC Story That No One Has Written ...

2010-04-17T09:53:00.006-04:00

When I saw that the SEC had finally decided to go after Goldman Sachs, I immediately rejoiced: Yes. At last. What the hell took you so long?

Then, when I started sifting through the strange case of Abacus 2007-AC1 (fairly trips right off the tongue eh?), I had a "pullback" moment, especially after seeing Goldman's defense (see the bottom of the page).

First, I have no love for Goldman. Far from it. I think it's rather creepy the way they release their ideological spores throughout our political system by practicing "civic responsibility" and occasionally shipping a handful of executives off to the Treasury Department, to keep the U.S. approach to the financial system appropriately capitalist at all times. But this Abacus case -- ah well, it doesn't make sense, unfortunately. I think the SEC will lose unless Goldman wants to pay up to make the bad publicity go away.

Here's why.

Read the SEC complaint. Read Goldman's denial. Observe the Venn diagram point where the two fact sets overlap in a significant way.

From Goldman: ACA had the largest exposure to the transaction, investing $951 million.

From the SEC: On or about May 31, 2007, ACA Capital sold protection or “wrapped” the $909 million super senior tranche of ABACUS 2007-AC1, meaning that it assumed the credit risk associated with that portion of the capital structure via a CDS in exchange for premium payments of approximately 50 basis points per year.

Think about that for a second. Whether it's $909 million, $951 million or $927.33311 million -- ACA, both sides agree, had a huge exposure to this deal. This was a $2 billion synthetic CDO. The German bank IBK, the other banner investor, only had $150 million of exposure (though to riskier tranches, true).

So ponder this a bit: why would ACA, whose duty was "portfolio selection agent," allow itself to be duped into stuffing the CDO sausage with the RMBS equivalent of rat tails and nose parts, if it was so hugely on the hook for the losses? Because consider this (all part of the SEC's own fact set in its complaint):

1. Paulson was a known short on subprime mortgages at this point. In 2007, the synthetic CDO was set up. Here's what happened a year earlier, according to the SEC:

Beginning in 2006, Paulson created two funds, known as the Paulson Credit Opportunity Funds, which took a bearish view on subprime mortgage loans by buying protection through CDS on various debt securities.

2. ACA wasn't some newbie from Canoobie when it came to setting up CDOs. The SEC tells us:

ACA previously had constructed and managed numerous CDOs for a fee. As of December 31, 2006, ACA had closed on 22 CDO transactions with underlying portfolios consisting of $15.7 billion of assets.

And, what's more, ACA knew that Paulson was heavily involved in helping pick the securities for Abacus. Again, the SEC:

On February 5, 2007, an internal ACA email asked, “Attached is the revised portfolio that Paulson would like us to commit to – all names are at the Baa2 level. The final portfolio will have between 80 and these 92 names. Are ‘we’ ok to say yes on this portfolio?”

So get a load of this: You're ACA. You're among the best at structuring CDOs. You should be able to evaluate the mortgage bonds being assembled for the security pretty well. You should know how the risks work. You should also know what's going on in the larger market: who's bullish on these things, who's bearish (Paulson, Paulson, Paulson).

And you swallow risk on about half of a synthetic CDO that you let Paulson fill with, um, crap?

I think there's more to this story than meets the eye. My guess is that ACA is much more guilty (of stupidity or something else) than anyone is suggesting. I think (1) they got caught being idiots, essentially making a longish bet on residential mortgages by insuring the super-senior tranche of the CDO (this is the last one to take losses, when the defaults start to mount) (2) they may have been making a cynical play, on the bottom part of the synthetic CDO, letting Paulson pick some crap, thinking that the super-senior tranche would be amply protected if the housing market deflated a little OR they were simply grossly negligent and unbelievably stupid by not reviewing the bonds that a known subprime-mortgage short was stuffing into a CDO they were insuring almost half of.

So I'm doubtful the SEC will win this one, unless there's something big I'm missing. But I think the SEC's case will be the perfect stalking horse for achieving the financial system reform that we do need pretty badly -- so maybe it's not so bad to put Goldman on the rack for a year or two.

Must-Read Story of the Morning

2010-04-10T06:57:00.004-04:00

I've grown a little numb to the shocking revelations of this financial crisis, but every so often, a story will drop my jaw and make me go "wow."

Today's candidate: Pro Publica's The Magnetar Trade.

One of the authors, Jesse Eisinger, you may remember from the Wall Street Journal. I admired his stuff during his tenure there. He impressed me as a smart guy who liked to dig -- and then dig some more.

The "Magnetar trade" Yves Smith apparently has written about at some length in her new book Econned. She has mentioned Magnetar a few times on her blog, without going into too much detail (I'm sure her book does, and I'm dying to read it. Where's my review copy, dammit? :))

Right now, Magnetar looks like the scariest enabler of this subprime bubble I've seen so far. Of course Michael Lewis looked at the enabling role the shorts played in his The Big Short. But the players he interviews were small. And they were only indirectly feeding the subprime lunacy.

To wit: as long as there was appetite for products packed with questionable home mortgages (the securities known as CDOs, or collateralized debt obligations), his shorts would happily take the other side of the trade. But, as far as I can tell, they weren't actively instigating the creation of these crap-congested things.

Magnetar apparently had a more clever, and dangerous, approach. It offered to buy the lousiest portions of the CDOs (the so-called "equity tranches" -- they're not technically equity, but tend to behave like equity, thus the name). For a high risk investment, the equity tranche is like the canary in the coal mine, an early-warning signal of trouble ahead. Or, to mix animal metaphors: A fish rots from the head down. A CDO rots from the equity tranche up.

So the equity tranche can be hard to place, especially for a shaky investment. And if you can't place it, then the CDO just doesn't get created. So was Magnetar crazy?

Crazy like a fox, it turns out. Because the hedge fund turned around and shorted the entire CDO.

How it made money initially puzzled me, but as far as I could tell (Eisinger keeps it sketchy, presumably because he's writing for a general readership), Magnetar's equity investment was a rather small piece of the CDO, and since the hedge fund was going short on the entire security, it stood to gain more than it would lose. The disturbing brilliance of this strategy: while the CDO is "in the clover," making money, the income thrown off by Magnetar's equity tranche funds its short bet on the CDO. So the fund solved the classic short problem of "how long can I afford to hold out if this thing doesn't blow up soon?"

Read the story. I have a feeling that "Magnetar," before this a name that's been largely under the radar, is about to start attracting a little (unwanted) attention.

Update: My further reading leads me to believe that Magnetar was buying credit-default swaps against other slices of the CDO (larger slices than what it owned certainly), though not the entire CDO.

"So, My Friends, What is This ... 'Financial Innovation' You Speak Of?"

2010-04-02T08:00:00.008-04:00

I've sometimes wondered what would happen if aliens teleported in to Washington and -- since they're aliens, of course, and naturally inquisitive -- began asking questions about anything and everything ("You peel it before you eat it? Ah yes, fascinating. So this Seinfeld, he is like a king to you?"). Eventually they'd get around to the financial crisis and how we plan to prevent such a disaster in the future. And our "wise men" (Geithner, Summers, with some bespectacled lackeys in tow) would patiently explain how we have to restrain bad behavior in the system, while not discouraging financial innovation.

At which point I imagine the lead alien, Zrigfryx, would scratch his ample, hairless dome and say:

"So, my friends, what is this ... 'financial innovation' you speak of?"

And if I were sitting in the back row of the small assembly -- lucky enough to have snagged one of the lottery tickets for the the limited seats available to the public -- I'd thrust my hand high in the air and say, "Oh, I know. I know. Let me answer that one."

Because I'm really starting to understand what this "financial innovation" is that the industry is so hellbent on preserving.

Just the other day, I happened to come across this Bloomberg story about how the investment bank Macquarie Group hired a guy by the name of Christopher Hogg. What particularly caught my eye was Hogg's signature accomplishment: "a developer of one of the most popular financing tools of the 1990s."

So what did he innovate? A way to finance infrastructure projects in poor countries, expanding GDP and turning generous profits at the same time, a real win-win? A more efficient pipeline for getting capital to struggling small U.S. businesses that deserve it?

Nope ... and nope. Hogg came up with "Mips." Cute name. Sounds like a Christmas stocking stuffer that turns into a runaway bestseller. Mips are actually "monthly income preferred securities." They're described as "a type of preferred stock that resembles debt." Now you may wonder, "Why the heck do we need these things? What greater purpose do they serve?"

Well, it's sort of like this: You look at "Mips" through your right eye and you see an equity, like a preferred share of stock. But you look at "Mips" through your left eye and you see a bond -- or debt. Mips involve special purpose vehicles (what doesn't these days, eh?) and an appropriate amount of complexity that I'll skip over here.

The bottom line is, after all the innovating, here's the payoff:

The shares provide benefits of stock because they’re considered equity by debt-rating companies while offering tax advantages of bonds because companies can deduct the dividend payments from income they report on their tax returns.

Got that? Basically Mips are a tax dodge. It's not that Mips have found a way to provide capital more efficiently or smartly ... in fact, in a world with an ideal tax code, Mips probably contribute to the less-efficient allocation of capital. Remember those CLO "innovations" that appeared to offer higher returns for the same risk as other similarly rated products? And how they started inefficiently sucking in capital and no one bothered to ask, "Hey, is the risk just being mispriced here or is there really a free lunch sitting out there on the sidewalk?"

Of course with Mips the rejoinder might be: the U.S. doesn't have an ideal tax code. To which one might reasonably reply: Okay, so which option is better (1) Try to fix the tax code (2) Let people exploit whatever loopholes they can find and the hell with it; happy Easter egg hunt!

Mips are hardly a rare example of loophole-seeking "innovation." Just this week in Dealbook, Andrew Ross Sorkin nailed another one: dividend payments that are embedded in derivatives so investors can avoid paying any taxes on the income. Nice huh? While you and I are faithfully mailing off checks to the IRS for our dividend taxes every year, certain wealthy people, helped along by "innovators," aren't playing by the same rules (note: this loophole is being closed, thank God).

I imagine that after I finish explaining all this to Zrigfryx, and he extends a spindly forefinger to scratch his dome again in puzzlement, he might say something like:

"So why is preserving all this financial innovation so important to you Americans?"

And I guess I'd say:

"Larry? Tim? You want to take that one?"

Were There Widespread Fire Sales of Assets During the Financial Crisis?

2010-03-27T05:57:00.009-04:00

Last week I argued that Gary Gorton failed to prove there were fire sales of assets during the financial crisis. Of course he chose a bad indicator, and so set himself up for a formidable challenge, sort of like trying to hit a home run with a plastic whiffle bat. He looked at spreads of investment-grade corporate bonds -- specifically, at periods during the crisis when, inexplicably, investors demanded higher yields for AAA corporates than for AA. But, alas, the inexplicable proved all too explicable on closer examination.

Still, that's a narrow example. What about those big U.S. banks that refused to sell securities, citing "fire sale" prices they were being offered. Was that accurate at least?

This is worthwhile to ponder because the Treasury and the Fed completely bought into the "fire sale" story. They fashioned a response to the crisis appropriate to a situation where the biggest problem was not bad assets, but investors with bad (irrational) thoughts about assets that were good ... or at least not all that bad. Remember these words from the Treasury rollout of PPIP?

The ... need by investors and banks to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales. As prices declined, many traditional investors exited these markets, causing declines in market liquidity.

For starters, it's worth disentangling some self-interest here. The banks had a huge vested interest in having us believe the "fire sale" thesis. Because, if we did, that meant: (1) They could justifiably refuse to sell the assets at the "fire sale" price and not confront the fact that they might be insolvent. (2) They not only could keep the asset on their books, but also they could justify fudging the price -- after all, if a market isn't rational, shouldn't you inject your own rationality? (3) If the problem lay not in the asset, but in the broader market, they could slough off blame for having made a bad investment. (5) Not only could they shed blame, but they also could make a play for sympathy: "vultures" who prey on the distressed by seeking "fire sale" prices aren't very sympathetic figures. (6) They could wait for a bailout that they could already see coming on the horizon.

So the "fire sales" thesis was a very, very powerful one, in many ways, for the big banks.

But again: to what degree was it true?

I thought about this for a while and came up with a back-to-basics approach to understanding where the truth lies. It starts with a typical "fire sale" example from real life.

Joe, in Detroit let's say, just lost his job Friday. It's Saturday. He needs to make rent Monday. He's on the front lawn next to a large hand-lettered sign that says, "Yard Sale." All around him: the armoire, his old Spider-Man comics, a few boxes of hand tools, and other odds and ends marked really cheap. Consider the armoire alone. Say its "true" price, secondhand, should be $100, but Joe's selling it for $20.

80% off! A real "fire sale" price.

But what is meant by its "true" secondhand price? "True" in this context is a slippery word. So let's define further -- okay, a bit arbitrarily, but some benchmark of value must be established. Let's stipulate the "true" price represents what a used-furniture dealer in the middle of Detroit would typically get for the item within a one-month time frame, were it offered for sale in his showroom.

This example allows three important factors to be isolated, in determining whether something is being subject to a "fire sale" price:

1. Time urgency -- The quicker something needs to be sold, the more "fire sale" pressure on the price, all else being equal. If Joe had more than two days to sell the armoire (the furniture dealer typically counts on a month), chances are good he could get a better price.

2. Breadth of universe of buyers -- Joe is counting on finding a buyer among the people who happen to drive by his house, and who at the same time happen to be looking for an armoire. The furniture store, on the other hand, has more relevant buyers by virtue of the fact that there's a regular flow of clients that cross the threshold expressly looking for pieces such as what Joe is selling.

3. The "money like" nature of the asset -- The less "money like" the asset, the more likely it will be subject to "fire sale" pricing pressure. Joe's armoire is very "un-money like." But if Joe was selling a $100 savings bond coming due in six months (and, to keep the example simple, we assume a zero interest and inflation environment over that time), he should receive close to $100 for it.

Now consider a residential mortgage-backed security in the fall of 2008. A big U.S. bank holding the asset says it's worth 90 cents on the dollar. A buyer says it's worth 40 cents. So is that a "fire sale" price? How does the above criteria apply here?

1. Time urgency: Does the asset need to be sold immediately? Small hedge funds and thinly capitalized speculators did have to dump assets at stress points during the crisis, trying to meet margin requirements or cover large withdrawals. But the big banks didn't appear to be in dire straits. They freely turned away buyers. So there really wasn't time urgency that the buyer could leverage for advantage.

2. Breadth of universe of buyers: Markets these days are increasingly global. U.S. subprime dreck, after all, found a home in insurance company portfolios in Taiwan. Likewise, if there really was a liquidity crunch in the U.S., the big bank's assets could have been offered up around the world. The Chinese have huge dollar reserves. Well before 2008, they complained publicly about having to hold so many Treasuries. If the "fire sale" assets were really woefully underpriced by investors in the U.S. and a surefire bet to offer reasonable returns at 90 cents on the dollar, China's state investment vehicle could have snatched them up.

3. The "money like" nature of the asset: The RMBS is a bond backed by streams of payments from mortgage holders. So it's fairly "money like." Granted, you do need to crank through calculations of expected defaults etc. But that all translates into a degree or risk, for which you demand a premium. At the end of the day, you still get compensated with money.

So what happened? How can you get so fast from 90 cents on the dollar to 40 cents without a fire sale? There must be some irrationality wrapped up in that low price, right?

Maybe not much. Consider that a buyer of the asset will demand some discounts, for sensible (not "fire sale") reasons:

1. The underlying assets, as home prices plunged, were starting to rot out, even if homeowners were at that moment current in their payments. Negative equity loomed.

2. The assets were further suspect because it was becoming obvious that the ratings agencies had improperly bestowed AAA ratings on many of them when they shouldn't even have been rated investment grade.

3. The buyer would have to do a certain amount of due diligence on a complex asset to become comfortable with the risk contained in the thousands of underlying home mortgages, and would naturally need to be compensated for this information gathering.

4. The broader RMBS asset class was tainted and so the asset was no longer as valuable for use in the huge repo market (just as, in the repo market, a bond that becomes "special" becomes more valuable in a quantifiable way, so the reverse is true -- when it becomes "stinky special" it's worth less for repo transactions and so a bond that's heavily repo'ed -- as AAA securities were -- should drop in price).

5. The very complexity of the asset, and its reputational damage, would impair the ability of the buyer to resell it, so the perceived illiquidity would impair value.

6. The complicated nature of the asset created possible minefields for the buyer, minefields that would most likely start blowing up if the asset were to deteriorate further, so taking on the risk related to complexity demanded some discounting.

7. There was significant systemic risk in the world at large, and this led to risk profiles being adjusted upwards for even apparently safe tranches of dicey securities.

So of the 50 percentage point gap, what can be attributed to "fire sale" pressure? Of course it's impossible to say without a concrete example. But I think if you went through these assets for the big banks, one by one, the "fire sale" factor would generally account for a small to very small part of the discount.

If you want another take on this issue -- basically agreeing with me, but using a capital asset pricing model where equity and credit markets are compared (and using a lot of formulas) -- check out The Pricing of Investment Grade Credit Risk during the Financial Crisis. Its conclusion:

Many analysts appear to be looking at large recent price changes and concluding that we must be witnessing distressed pricing and widespread market failure. This conclusion is based on intuition that fails to appreciate the extreme nonlinearity in the risks of credit securities, especially those manufactured by securitization (i.e. CDO tranches). Our analysis suggests that the dramatic recent widening of credit spreads is highly consistent with the decline in the equity market, the increase in its volatility, and an improved investor appreciation of the risks embedded in these securities. From this perspective, policies that attempt to prevent a widespread mark-down in the value of credit-sensitive assets are likely to only delay -- and perhaps even worsen -- the day of reckoning.

Now, after having expressed all this skepticism, I'm going to do a bit of a pivot here and move in the other direction: I do think that "fire sale" risk is a growing danger going forward.

If the first of the three stress points for "fire sales" is time urgency, that means when everyone beelines for the exits simultaneously, you're in deep trouble. Now the way the modern financial system has been evolving -- quants who seem to be copying each other's homework and modeling the same assumptions, super-computers that trade at blistering speeds, a global system where money flows easily across borders, interconnected networks of growing complexity -- it's becoming easier to imagine a situation where everyone does try to cash out all at once, and that causes the system to lock up. And a systemic regulator should be looking hard at this issue.

But in late 2008 and early 2009, I don't think the "fire sales" thesis explains the huge pricing gaps for securitized assets such as RMBS the big banks were trying to sell, especially considering the Fed's activist role during this period. Rather, this was simply a clever decoy that the banks used to redirect attention away from the truth. It's what they want you to believe happened because it lets them off the hook ... and helps create the rationale for the Great Hidden Bailout of 2009 that we'll all be paying for, in ways large and small, for years to come.

Debunking Gary Gorton's "Fire Sale" Thesis

2010-03-20T13:24:00.003-04:00

A few weeks ago I looked at Gary Gorton's Somewhat Flawed Take on Shadow Banking. One big problem I had with his paper (which now has been enshrined as part of the public record at the Financial Crisis and Inquiry Commission) is his analysis of a very curious phenomenon during the first half-year of the worst part of the crisis. Namely, at several points, AAA rated corporate bonds paid bigger yields than AA rated. This is a real "upside down topsy turvy" kind of thing. Bonds that achieve a triple AAA rating -- the highest possible -- are supposed to be really safe, almost U.S. Treasury safe. AA, the next ranking down, denotes a bit more risk. And a bit more risk means that investors demand a higher yield.

But over two periods -- one in the fall of 2008 and the other early in 2009 -- investors were getting a dramatically lower yield (well, dramatic in the bond world) for AA than AAA. That's Alice in Wonderland stuff, it seems.

Gorton explains the market weirdness on page 13 of his paper to the commission. (First, here's background you need: just before the excerpt below, he was discussing the sudden withdrawals of funds from the shadow banking system, withdrawals that took the form of repo haircuts on structured debt -- if you're lost by that last sentence, see my earlier post on Gorton's paper, linked above):

Faced with the task of raising money to meet the withdrawals, firms had to sell assets. They were no investors willing to make sufficiently large new investments, on the order of $2 trillion. In order to minimize losses firms chose to sell bonds that they thought would not drop in price a great deal, bonds that were not securitized bonds, and bonds that were highly rated. For example, they sold Aaa‐rated corporate bonds.

These kinds of forced sales are called “fire sales” – sales that must be made to raise money, even if the sale causes to price to fall because so much is offered for sale, and the seller has no choice but to take the low price. The low price reflects to distressed, forced, sale, not the underlying fundamentals. There is evidence of this. Here is one example. Normally, Aaa‐rated corporate bonds would trade at higher prices (lower spreads) than, say, Aa‐rated bonds. In other words, these bonds would fetch the most money when sold. However, when all firms reason this way, it doesn’t turn out so nicely.

The figure below shows the spread between Aa‐rated corporate bonds and Aaa‐rated corporate bonds, both with five year maturities. This spread should always be positive, unless so many Aaa‐rated corporate bonds are sold that the spread must rise to attract buyers. That is exactly what happened!!

When I read this, his "fire sales" thesis didn't smell right. Before we see how it falls apart -- I chose to look at a puzzling period in March 2009 when it appears that the worst outbreak of "fire sales" occurred, according to his own graphic -- let's make a couple of stops.

Why does this matter anyway? This "fire sale" section is buried on page 14 of his presentation.

Because -- and this is very important -- there are two dominant views of this financial crisis. They are so critical to shaping perception, they are practically worldviews. Depending on which you hold, you're likely to propose a different set of policies to revive the financial system. They are:

At the heart of this crisis was a liquidity crunch. The banks peddled this line furiously. Credit markets seized up and poor bankers were innocent bystanders, stuck with valuable assets they could only sell at ... here it comes ... fire-sale prices. The market was valuing their assets, worth 90 cents on the dollar, at 40 or 50 cents! If you believe this: you probably thought that Geithner's PPIP proposal made sense and was going to work, and that the big banks just needed a little breathing room and an infusion of liquidity (which the Fed happily provided in spades) and they'd get back on their feet and start lending normally again.

At the heart of this crisis were plain ol' crappy, overvalued assets. Their values had become inflated by a combination of loose money spurred by too-low Fed interest rates, rating-agency complicity, opaque markets (RMBS, CMBS), and maybe a dash of housing-bubble mania. If you believe this: you probably thought that tougher measures needed to be taken with the big banks, that these crappy assets had to be honestly accounted for and cleared at market prices, and that large swaths of the banking system were insolvent.

Notice most smart observers would assign some truth to both; they are not mutually exclusive concepts. However, people tend to align themselves with either the first or second idea. I am in the second camp, firmly, and Gorton seems to be more in the first.

Okay then: why doesn't Gorton's explanation smell right in the first place?

This is sort of interesting. Let's go meta-finance for a moment.

There are many classes of assets. And there is money, the ultimate liquid asset, extremely flexible and wonderfully fungible. One way of looking at assets is to see how "money like" they are (I'm not precisely talking about liquidity here, so I'm going to stick with "money like"). By "money like" I mean how much "objective value" (as expressed in a unit of money, say dollars) the asset contains. So if we all were guaranteed $2 for any loaf of bread (that met certain criteria of course, pertaining to such attributes as dimensions), and the bread could be redeemed at "bread banks" (a groaner, I know), loaves of bread would be very "money like."

Okay, let's take Beanie Babies. Gong! Not very "money like" at all. At the height of the fad, you might receive $50 for a rare stuffed penguin that might not fetch 15 cents a year later. Let's slide quickly down the asset scale. House -- more "money like." Share of stock: even more "money like." A plain-vanilla corporate bond: very "money like."

For what is an ordinary "bullet" corporate bond? A series of interest payments, usually semi-annual, and then a lump sum spit out at the end of its lifespan of maybe 5, 10, 20, or even 30 years. And these payments are all made in ... money. Bonds don't pay you in Toblerones, iPads, or dental floss. It's all money, money, money.

Now what's a simple way to think about a bond's coupon? Say IBM's 5-year plain-vanilla bond pays 4 percent interest and is rated AA. Part of that coupon -- let's say 2.5 percent -- reflects interest rate and inflation risk over the five-year life of the bond. The remainder -- and this is where it gets interesting -- is for credit risk. Since IBM is perceived as really safe, it pays out 1.5 percent interest for credit risk. If it were Johnson & Johnson, let's say, and rated AAA, and perceived as really, really safe, it might pay only 1.3 percent.

Now which of these bonds would you, Joe Investor, buy? You might think the IBM at 4 percent instead of the Johnson & Johnson at 3.8 percent. The IBM pays more, right? But that company also stands a higher chance of defaulting on its debt. There's no free lunch. You take more risk; you get more money.

But what if the Johnson & Johnson, with its AAA rating, paid 4 percent, and IBM, a whole grade lower, paid only 3.8 percent. That's a no brainer. Bonds are very "money like," remember? You don't "like" a bond more because it's prettier, has a dormer window on the third floor, or would look good on a pendant. You like it for its money-ness. So you'd snap up Johnson & Johnson at 4 percent and marvel at your wonderful luck.

Which brings us to our main subject ...

Why did yields on AAA corporates balloon out over AAs if that doesn't make any sense? Was it indeed a "fire sale" as Gorton claims, a mass rush to the exits, with perfectly good AAAs being chucked overboard at whatever price the market would offer?

I did some research. I did so knowing that Gorton's thesis would stand under three conditions: (1) the AAA corporates were "true" AAAs and not lower grades masquerading as AAAs (2) the universe of AAAs was reasonably diverse in nature (as in, not skewed to one particular industry) (3) there was a reasonably large number of AAA corporates trading (as in, you might have a diverse selection of bonds, but if there are only six of them, that's too few and the volatility of small numbers could explain the strange inversion between AAA and AA yields.)

I could have looked at the period in late 2008, but instead I chose an even more dramatic one, where an even larger inversion occurred (even more "fire sales"!). If you look at Gorton's graphic on page 14, you'll see the icicle-shaped spike in early March of 2009. Briefly, AAA corporate bonds paid more than 2 percentage points more than AAs! That's a huge spread. Gorton would have us think that investors were just dumping truckloads of perfectly good AAAs and the market, facing a glut of the bonds, irrationally pushed their prices way down (and their yields up).

So I looked behind the curtain, using a handy Bloomberg machine. And what I found was nothing like what he suggested was going on.

First, using Merrill Lynch indexes, I saw evidence of the inversion easily enough. The components of Merrill Lynch's AAA index may not exactly match what Gorton looked at, but the curves seem pretty close, so I think we're on fairly solid ground (as you'll soon see, there aren't a lot of AAAs in the first place, so I'm confident there's large overlap in both our data sets; I may graph my numbers later and drop in that visual here). Also I focused on AAAs because that's where the real story is: while AA yields did creep higher during that period, the AAAs zoomed past them and were mainly responsible for creating the gap.

And what a gap it became: AAA pulled ahead of AA by 11 basis points on March 2. That spread widened out to 191 on March 4, hit a high on March 5 of 195, then subsided to 135 on March 10 and fell to 74 on March 13. (Note: there are 100 basis points in 1 percent, so 195 basis points is 1.95% -- which may not seem like much, but in bondland, between investment-rating grades, it's huge.)

Then the meat of the investigation began. Who was in the AAA corporate index at that time? A diverse, large number of companies?

Nope. Not by a long shot. Not many companies win a AAA rating, understandably, only the best of the best. I went through a half-dozen screens of the bonds in the Merrill Lynch index as of March 6, 2009 (the screens show a company name, and the specific bond that belongs to the index). And guess what? To call it an index at that time was pretty much a misnomer. It was General Electric.

General Electric bonds (or those of its financing arms) accounted for 71.5 percent of the index weighting. Berkshire came in second at 8.9 percent. That leaves less than one-fifth for everyone else (and there weren't a lot of others, though it hardly mattered because they made up so little of the overall weighting anyway).

(Note: a careful reader of Gorton will see that he looks at only 5-year bonds. Even so, it turns out that when I filtered for that criterion, it mattered little: GE's weighting drops a little, but only to 68 percent, and Berkshire's rises a little, and everyone else is about 20 percent again.)

So the story of AAAs in March 2009 is not really a market story about AAAs ... it's a story about GE. Still, to be fair to Gorton -- it could be that investors were irrationally chucking their solid GE bonds, desperating trying to raise cash, even though GE was a top-tier company. So what was the GE story right about March 5, 2009? A great AAA corporation with the wind at its back, sailing toward a sparkling future? Let's concede that the early part of that year was turbulent, and markets were down, so one might expect a ding or two in the giant's armor.

It turns out GE's armor was more than lightly dinged:
1. Its stock had plunged 61 percent from Jan. 1 to the end of the day March 5, almost three times the drop of the S&P 500.
2. Its credit default swaps were trading sky-high, meaning investors saw GE as a poor credit risk. The swaps were 1,037 basis points on March 5, compared with JPMorgan's 219 -- and JPMorgan was rated only AA! So let's mull that: JPMorgan at the time was considered almost five times safer than GE, even though GE was a higher-rated company.

And, if you're still not convinced, a March 5 Bloomberg story quotes Marilyn Cohen of Envision Capital Management on GE: "It's a leper right now."

A AAA rated leper? Sounds like an oxymoron. What were investors so bent out of shape about? Bloomberg's article says:

Investors are punishing the shares on a presumption, which the company disputes, that GE Capital will need more outside funding to cover potential writedowns and losses in real estate, consumer credit cards and leasing.

There was a fear that GE's finance arm would need to post $12 billion in collateral if its long-term ratings were cut to single A. Whence this downgrade fear? Well, Moody's said on Jan. 27, just a month earlier, that it was looking at lowering GE's rating. And in fact, if you look at the same AAA Merrill Lynch index on April 15, 2009 -- about a month later -- neither GE nor Berkshire are there; they've dropped off.

So did AAA corporates irrationally leap above AAs during this tumultuous period in March, when the greatest spread inversion of the financial crisis occurred? Absolutely not.

There were no "fire sales," as Gorton would have us believe. This wasn't a story about investors in hard times selling grandma's fine china at big discounts so they could afford a little soup for dinner. This is a story of ratings lagging behind reality, legitimate investor concerns, and GE's peculiar circumstances. So next time you hear the "fire sale" argument advanced, approach with full skepticism.

What Does Repo 105 Tell Us About This Crisis?

2010-03-13T07:07:00.009-05:00

Now that a couple of news cycles have washed over us since the revelation of the Lehman Brothers accounting scheme known as "Repo 105" (cute street drug name that suggests quick-hit crack for financiers), I thought it was worth trying to distill the takeaways from this news.

First, if you need to get up to speed: Lehman was very heavily massaging its books so as to hide its high leverage from shareholders and other outsiders (such as the credit-rating agencies). It was using "repo" transactions to shift large sums off the balance sheet temporarily at quarter's end. The program was known as "Repo 105" because Lehman would get $1 for each $1.05 of securities that it temporarily parked with any of seven counterparties (Mizuho, Barclays, UBS, Deutsche, etc.).

If you want more on Repo 105:
The original (gasp!) 2,200+ page report by examiner Anton Valukas
Here's Zero Hedge as one of the first to weigh in
Karl Denninger waxes indignant (and justifiably so)
My favorite Repo 105 blog headline

Okay, so what does the unfolding Repo 105 scandal tell us about this financial crisis?

1. That shadow banking is a big issue that must be addressed.

Most Americans know of the word "repo" only as it pertains to some guy who shows up to take your car after you miss half a dozen payments. But a different "repo" lies at the heart of the shadow banking system. It's short for a "repurchase agreement," originally designed for rock-solid government securities "sold" to investors, usually overnight to be bought back the next day, in this way generating short-term financing for the seller. The repo market gradually broadened out to other seemingly rock-solid products rated triple AAA, such as what turned out to be dodgy securitizations. The repo market is opaque and unstable ... and HUGE ... and needs to be much better regulated on these grounds alone. But now we find out that it can be used for playing accounting games too.

2. That regulators were really, really asleep at the switch. Catatonic perhaps.

It just keeps getting worse and worse. I thought the serial bungling at the SEC on the Madoff case was mind-boggling, but Denninger quotes a section of the Valukas report that will make your jaw drop and hit the kitchen table with an audible thud. Get this: the SEC and Federal Reserve Bank of New York began onsite daily monitoring of Lehman in March 2008. Worried whether the firm could survive a bank run, the New York Fed devised two stress tests. And Lehman failed both. Then the New York Fed came up with a third test. And Lehman failed that too. So you'd expect the Fed to lower the boom, right? Demand Lehman raise capital or at least ... do something for chrissakes. No, instead Lehman is allowed to create its own test that the firm ... passes. Is there any planet on which this makes any sense at all? Head of NY Fed at the time: one Timothy Geithner. And oh yeah, so much for confidence in those "stress tests" the banks underwent last year.

3. That, faced with a banking culture of gold-medalist loophole divers, we must adopt much more principle-based accounting.

How can you "sell" securities with an agreement to "buy" them back a week later, solely to skirt a true accounting of your assets and liabilities, and this isn't considered fraud? The answer: because you found a nifty loophole (Lehman's had to go to England to get it) that ratifies the highly dubious transaction as a "true sale" and it sounds like this:

If two parties intend to exchange assets for cash, and then later the party receiving the assets decides to hand back “equivalent assets (such as securities of the same series and nominal value) rather than the very assets that were originally delivered,” that amounts to a sale.

4. That effective financial regulation demands global cooperation.

Lehman couldn't get a U.S. law firm to sign off on Repo 105, so it looked overseas and got the approval and justification from London-based Linklaters. Also Lehman shuffled the Repo 105 sales through its European arm, Lehman Brothers International (Europe). So in an age of easy global money transfers, and of financial companies adept at arbitraging regulatory regimes, we need to find ways to make sure bad behavior doesn't simply hop over a body of water and wreck our financial system from afar.

5. That our biggest failing in the U.S. may be that we have not seen fit to prosecute a single top executive from a major financial institution for their role in helping precipitate the crisis, a year and a half after it erupted, a failure that has badly corroded faith in our government.

Why can't we summon the courage to do the right thing? Sure, many executives just made bad bets -- greedy and stupid though they were. But others, as we clearly see in Lehman's case, purposefully misled the world. Why is this any less serious than Enron? The government's gross failure only gives ammunition to the critics that say that the Wall Street titans have a choke chain on our leaders in Washington.

Felix Salmon: Your Dyed-in-the-Wool Credit Default Swaps Enthusiast

2010-03-07T12:20:00.009-05:00

Every smart guy has to have a blind spot.

Felix Salmon -- whom I usually find myself nodding vigorously in agreement with -- is an ardent credit default swaps supporter. In a recent post, he uses Greece's recent successful bond sale as a way to trot out his favorite hobbyhorse. Why did the 10-year issue go off so well? Wait for it ... credit default swaps! His take:

A liquid CDS market is a great way of enabling countries to access the primary markets even when the secondary markets are full of uncertainty and turmoil.

The commenters below his short post are understandably angry and baffled, as Salmon doesn't quite explain how the CDS market played savior to beleaguered Greece. So I'll take a stab here: (1) Greece was beset by uncertainty and turmoil. (2) There wasn't enough trading in its existing bonds to give potential investors confidence about what the "correct" credit-risk spread should be for the bonds it was selling, thus threatening to push up yields demanded on the debt. (3) Enter the more active, or liquid, CDS market to save the day -- it stood in as a gauge of credit risk. (Geeky bond talk: offered rates on bonds comprise expectations of future interest rates + inflation along with credit risk; a credit-default swap is pure credit risk, and so isolates that piece of the puzzle for investors wondering what rate they should require on hardly-risk-free Greek debt.)

First, to back up the truck for a second: credit default swaps are reaching the point where they are sometimes unfairly demonized. For example, some European leaders had started to beat up on CDS speculators, saying they were driving up the cost for Greece to issue debt.

Ummm ... don't think so.

Check out Citigroup's rebuttal in this paper: You Can't Blame the Mirror for Your Ugly Face. It happens to be an apt metaphor. Sure, it was becoming more expensive to insure Greek debt against default. But that wasn't because of mischievous hedge funds scheming in smoke-filled rooms; it was because Greece was dithering and making mousy squeaking noises about taming its out-of-control budget deficit.

So let's concede the demonizing-is-occurring-sometimes point up front.

But I think Salmon all too often misses the forest for the trees on credit default swaps. He extols them for supplying liquidity, and that has informational value for the larger bond market and contributes to efficiency in pricing. But, at least in my reading of him, he doesn't step back and look at the big picture. Namely, if financial bust-and-boom cycles are inevitable (and yes, they are), then it behooves us to look at what exacerbates and ameliorates them. And there is good evidence, from this last crisis, that a huge CDS market (that's now shrunk to $25 trillion notional from $50 to $60 trillion), changes a garden-variety financial crisis to a financial crisis on steroids.

Think of what happens in a financial crisis: credit tends to freeze or contract, making liquidity scarce. Now think of what happens right at the same time in the CDS market: there's a large hoovering up of liquidity. You have CDS writers scrambling to post collateral or make good on their bets on the debt of failed companies. They need money and tap available cash and sell assets, just when the economy needs more liquidity. Credit swaps are cyclical enhancers, in a bad way.

And there's more: default swaps are highly leveraged and become highly volatile in times of economic distress. So a CDS on Bank of America trades at 80 basis points, nice and steady, for four or five years, then boom -- all of a sudden Bank of America takes a huge writedown and the swap is zooming back and forth between 600 and 900 basis points. Multiply this by a handful of companies -- you can be assured in a downturn that others will be revealed to be on thin ice -- and now you've got large amounts of money sloshing back and forth, even before a default has been declared, as swap writers try to meet collateral obligations.

All this volatility is not what the distressed financial system needs at this time, but that's what swaps contribute. As they add to systemic volatility, they can feedback-loop in an unpleasant way -- the posters of collateral, if they are not well hedged, can begin adding strains of their own in unexpected places.

And then, because our modern financial system is so interconnected, at some point the very interlaced network of swap sellers and buyers will expose a weak point. AIG was a big weak point last time -- and it was engaged in an undeniably stupid activity. But next time there will be another weak point, probably more subtle. We're not dumb enough, hopefully, to let another AIG write swap protection ad nauseum until the house burns down. But when the markets grow more volatile, and money is shifting back and forth to cover the multi-trillion-dollar exposures on credit default swaps, you can bet that there will be a weak point again -- it could be a hedge fund, a small one that goes down, that leads to cascading failures and, at some point, another giant bailout.

So all that -- the macro, systemic stuff -- is what I'm surprised Salmon doesn't spend more time thinking about because he's a really smart guy.

The suggestion right now is to put credit default swaps on exchanges for trading, to increase transparency and make exchanges the backstop for failure (and who backstops the exchanges? Three guesses and one hint: it rhymes with "shmaxpayers.") It may be worth trying that. But I think we also should look hard at the alternative: even though credit swaps do some micro-good for the market (pricing efficiency on little-traded bonds) they may do too much macro-bad to be allowed to exist.

Why Barney Frank Tied His Tongue In Knots Over Fannie and Freddie

2010-03-06T06:00:00.010-05:00

Barney Frank got caught in an interesting bit of backpedaling and sidestepping this week on mortgage giants Fannie Mae and Freddie Mac after he suggested that, as the Washington Post worded it, "investors who have lent money to the two firms or bought their mortgage-backed securities could one day suffer losses."

In other words, he tried to make the case that Fannie and Freddie don't enjoy implicit U.S. government support, as investors have been assuming for a long time.

This created predictable consternation. Later Frank executed a cute little spin move and sought to clarify: His position, he said, "does not prevent the Treasury from treating the debt of Fannie and Freddie in the manner that it believes best supports the important goal of stabilizing the financial system." So Congress won't try to interfere with the folks at Treasury as they infuse billions of dollars ($100 billion so far, the Post tells us) into the tottering agencies.

Got that? Here's what he's saying: "No, we don't stand behind Fannie and Freddie, but yes we do stand behind Fannie and Freddie."

What's going on and why would Frank even start down this loser of a path in the first place?

Here's the important background: Fannie and Freddie are frauds. Easy to remember: all three words begin with the letter "f." They're accounting frauds. They're not "government-sponsored entities;" they're off-balance sheet vehicles of the U.S. government.

For decades people have suspected as much ... the difference now is, this financial crisis finally presented us with the irrefutable proof. Fannie and Freddie started to tank, and before you could blink an eye, the U.S. government rushed in to rescue them in early September of 2008. Then came the Christmas Eve surprise a few months ago. The Obama administration sprang a biggie on us while we were trilling fa-la-la-la-la's and getting groggy on the eggnog, pledging unlimited financial assistance to Fannie and Freddie.

Now think about that word. Unlimited. What else does the government support in an unlimited way? Oh, maybe the Defense Department. Medicare. Social Security.

Things that are part of the government.

So what prompted Frank's initial comments was that some on Capitol Hill want Fannie and Freddie's finances to be incorporated into the federal budget. That would be honest accounting. If Aunt Fannie and Uncle Fred are living in your attic, you may tell Tom living next door that you're not responsible for them even though Tom suspects otherwise. Then, once you decide to guarantee them unlimited assistance, that game should be over. You can't pretend any longer. Aunt Fannie and Uncle Fred belong in your household budget somewhere.

The problem: Frank knows that if Fannie and Freddie are on the books, the budget blows up -- the deficit would soar. Then we'd really look like Greece. So Frank tries the conflicted damsel pose. He thrusts out one arm, protesting that Fannie and Freddie bondholders are mistaken to think the U.S. will automatically bail them out (see? the government doesn't support the mortgage companies after all!), then when the investors get nervous, he gives them a sly wink and beckons them a little closer (see? the government does support the mortgage companies after all!).

Well, it's time to stop jerking everyone around. Either Fannie and Freddie are U.S.-backed and they belong on the government's books or they're private entities and caveat investor. It's bad enough that Wall Street plays these off-balance sheet games; the U.S. government shouldn't be given a free pass to do so as well.

Gary Gorton's Somewhat Flawed Take on Shadow Banking

2010-02-28T13:51:00.010-05:00

When I saw this Feb. 20 .pdf on shadow banking, prepared for the U.S. Financial Crisis Inquiry Commission, I got kind of excited. Reading material for my one-hour stationary bike workout! And shadow banking no less, my latest pet obsession! Ah, Sunday morning nirvana for a finance wonk.

Then I started perusing the piece and, after turning over the bike pedals oh about 1,100 times (I try to spin at 90 rpm, and when I get involved in my reading, I'll hit the mid-90s), I grew a bit disenchanted.

Read it for yourself of course. If you want a better treatment of the material, Gorton is essentially cribbing off himself from an earlier paper -- "Slapped In the Face by the Invisible Hand" from May 9, 2009 -- which is a bit smarter, dares to be prescriptive and explores the subject in more depth. My nose de-wrinkled a little after reading "Slapped."

But please start with the crisis inquiry presentation because the writing is more accessible for people who aren't finance nerds. He does a few things that I really liked:

1. History: He presents some of the historical sweep of bank panics over the last couple of centuries.

2. Prime mover: He zeroes in on the real nexus where the financial system failed in our current crisis. In case you weren't aware, basically there was a bank run -- but it wasn't retail (i.e., little investors like you and me and Grandma Jones). It was wholesale, the big institutions that make up the "deposit" base of the shadow banking system.

3. Wild haircuts: he shows nicely how the "banking run" of 2008 took place, through the haircuts on repo'ed collateral that, by increasing from negligible levels, effectively "withdrew" money from the system. I know that line is a bit abstruse, so read his explanation on page 12.

But I think Gorton misses enough stuff that his paper ultimately disappoints. Here are four points he makes that left me shaking my head:

Holding loans on the balance sheets of banks is not profitable. This is a fundamental point. This is why the parallel or shadow banking system developed.

He's a bit intellectually sloppy here -- too busy to show his work or cite the evidence? If you read what he says about securitization (shadow banking's backbone and sine qua non) in his earlier "Slapped," you'll see that he is a bit more revealing, and subtle, there.

Why did securitization arise? We do not know for sure. One possibility, discussed further below, is that it was a response to bank capital requirements, which created a cost without a countervailing benefit. Banks, being private institutions, can exit the industry if it is not profitable. Another possibility is that the demand for collateral made securitization profitable, and this could not be accomplished on-balance sheet because deposit insurance was limited.

So there was a huge need for collateral (that $600 trillion worldwide derivatives market perches atop a mound of supposedly rock-solid collateral that, though relatively tiny by comparison, has grown enormously over the last two decades). And banks were chafing under capital rules.

Okay, I'll buy that. But that's a long way from a convincing argument that hold-the-loan-to-maturity banking is inherently unprofitable in the modern age. He rather disingenously overlooks a big point: it's partly not profitable because of shadow banking which has (1) no capital requirements (2) no FDIC insurance to pay (3) no other regulatory burdens. So the shadow banks can operate more cheaply and pay more for funds, squeezing banks cleaving to a traditional model.

Point two where we don't quite see eye to eye:

In securitization, the bank is still at risk because the bank keeps the residual or equity portion of the securitized loans and earns fees for servicing these loans. Moreover, banks support their securitizations when there are problems. No one has produced evidence of any problems with securitizations generally ...

My reaction to this: ??????? No problems with securitization generally? That seems rather boldly dismissive. If banks support their securitizations when there are problems, why are they allowed to push the risk off balance sheet? That seems to be a legitimate issue. And the way that risk is imperfectly understood and shuffled down the line via securitizations -- a loan originator puts crap in the soon-to-be-securitized ground beef for the RMBS that's leaving his hands in a week and ultimately winds up in a hamburger patty served up to an investor in Singapore who can't make heads or tails of what he's buying and just relies on a AAA stamp bestowed by a team at Moody's that couldn't really understand what the hell they were rating either -- well, some would call that a legitimate issue too.

Another point where I think he's off base:

Why would dealer banks be growing their balance sheets if there was not some profitable reason for this? My answer is that the new depository business using repo was also growing ... Now, of course there is the alternative hypothesis, that the broker-dealer banks were just irresponsible risk-takers.

I'm not really going into this one -- this blog entry is getting too long already -- only to say this appears to be what they call a "false dichotomy" in debating circles. After all, dealer banks could have been pursuing irresponsible risk-taking that had a profitable reason behind it. That's pretty much self-evident if you read the entire section here.

Now, on to one last point, where he contends that AAA rated securities were marked too far down because of fire sales and cites, as proof, the fact that AA rated corporate bonds at certain times paid more than AAA corporate bonds. That's because so many AAA's were being dumped that the spread flipped, he says.

Okay, first, I'll confess I don't have the data set on that graphic he provides. But I'd sure like to explore it in more depth. Because, honestly, it makes no sense.

Quick bond primer: One piece of the yield attached to any bond represents credit risk. Credit risk is the chance that say IBM goes belly up and you're standing in line with other creditors, trying to get back money that you "lent" to IBM by buying its bond. If you assume more credit risk, you are compensated more. For example: if IBM bonds have a small chance of defaulting, but Wal-Mart bonds have a smaller chance, then IBM's bonds (of a given maturity) will be rated say AA and pay 6 percent and Wal-Mart will be rated say AAA and pay 5.4 percent.

Now bond buyers aren't stupid. Aunt Flo isn't a big player in this market; these are institutions and hedge funds and a lot of sophisticated money managers ... take a look at some bond-pricing formulas, study a little duration, and get back to me in the morning if you doubt what I'm saying.

The point I'm making is this: if these yields flipped, there's a good chance that the "fire sale" explanation is probably the weakest one to make. Because look: even if you're a fire sale buyer, scared as hell of what's going on in the financial markets, your IQ doesn't instantly fly out the window. Relatively speaking, you still prefer AAA over AA. If my fire sale price for AAA is 90 cents on the dollar, my fire sale price for AA isn't going to be 93 cents on the dollar. Because that's leaving free money on the table. That's your first lesson in Bonds 101. No one does that.

So how to explain what happened? Here are a couple of hypotheses that I think are probably more believable: (1) There was a lot of mis-rated AAA crap that really deserved to be graded A or below, and for some reason, the AA securities tended to be rated more accurately, or maybe they were mispriced somewhat too, but it took longer for the problems to be evident. (2) Something else -- maybe even fraudulent -- is going on here. Look at his chart and see how nonsensical it is -- in early March of last year, a good four months after the peak of the crisis, AA's were paying about 2.25 percentage points more than AAA's! By way of comparison, that's more than double the amount that AAA's ever exceeded AA's between January of 2007 and November of 2009.

So this is what Gorton asks us to believe: four months after the "panic button" phase of the financial crisis, there was a sudden move to massively offload AAA's at any price -- sellers were willing to get scorched on the asking price and buyers didn't recognize the value that they were getting compared to AA's and never pushed the spread back together. I mean, 2.25 percentage points?!?! That makes no sense to me.

I'm willing to bet there's something else going on there and I'm surprised that Gorton didn't sniff harder to try to find it.

So while I'm glad that Gorton's writing about shadow banking -- we all need to understand its role better -- he comes up a bit short by my yardstick.

Where the Courage to Reform is Lacking

2010-02-24T06:29:00.003-05:00

The "hey we're missing the shadow banking market in all these reforms" meme is spreading. I like that, after my Jan. 24 post where I bemoaned the lack of attention to the 900-lb. gorilla in the room (or however much that mythical gorilla weighs). Marginal Revolution weighs in here. Mike Konczal at Rortybomb did his usual excellent calmly reasoned and thorough analysis here. And we got a superb Venn diagram by Raj Date (never thought you'd see one of them again after eighth grade -- guess again; check out page 3!) that reveals shadow banking to be the poop that's left unscooped in the proposed financial reforms.

So where is the courage to reform lacking?

Simply: we don't like pain (our politicians, our mirror images of the worst of ourselves, have all along taken the pain-avoidance steps in dealing with the financial crisis). Shadow banking is a means of leveraging up the financial system. Leverage provides the palliative of easy money (along with that extra risk). I'm betting Washington will leave the shadow banking/leverage mess untouched; who wants to prescribe two tablets of austerity for a hungover economy, even if it's good for overall future stability? We're a "now" people, impatient to have what we want, and cranky when we don't get it quickly.

Ah ...

Imaginary Dialogue with a Fed-Secrecy Defender

2010-02-14T10:49:00.005-05:00

The make-believe dialogue that follows was inspired by this New York Times story that recaps the events leading up to, and the arguments surrounding, Bloomberg LP vs. Board of Governors of the Federal Reserve. That's Bloomberg's court battle to get the details on a bank bailout that has reached a staggering $2 trillion (according to the Times and, depending on how you count, may be actually a trillion or two higher). Much of the bailout has been cleverly orchestrated by the Fed behind the scenes, so Americans know little of who got what. Bloomberg wants to pierce the veil of secrecy to find out which banks received money, how much, in exchange for what collateral, under what terms.

And the Fed is stonewalling like crazy, fighting this tooth and nail through the court system.

So here's my imaginary dialogue with a Fed-secrecy defender (abbreviated below as "FD"). The parts in bold are taken right from the Times article; other secrecy arguments I have extrapolated on somewhat, in keeping with what I have read so far is the Fed's position.

Me: $2 trillion ... wow. That's a lot of Subway sandwiches. The mother of all bailouts. Seriously, what's the problem with revealing who got what through this hidden bailout?

FD: It's a terrible idea. Such disclosures could stigmatize financial institutions by suggesting they were desperately in need of government money and, therefore, weak.

Me: Hmm. That's an interesting line of defense. Let's make it more concrete. So you're saying disclosure of significant weakness is a bad idea. Sort of like if someone forced you to reveal you just took $3.4 billion of losses. That certainly might give the market the idea you were pretty weak and ripe for a boost from good ol' Uncle Sam.

FD: Right.

Me: Well, take a look at this. This is Citigroup admitting to investors in its 10Q regulatory filing from the second quarter of 2008 that it wrote down $3.4 billion of subprime mortgages. In fact, this entire filing seems to be full of stigmatizing disclosures of various types.

FD: That's different.

Me: Besides, such a "stigma" may be a good thing.

FD: How do you mean?

Me: We keep talking about "moral hazard" in this crisis, as in an actor tends to be more reckless when he knows somebody else will pick up the tab for his mistakes. So maybe a little "stigma" is a way to reduce moral hazard? Banks, realizing the stigma attached to being a recipient of a federal bailout program, will be more cautious and take on less risk next time.

FD: It's not that simple though. The banks, if perceived as weak, could be subject to 1930s-style bank runs.

Me: Oh really? So you'd say we're as vulnerable to bank runs now as we were in the 1930s. Ok, let's take a look. Most of these bank runs you're referring to were from 1929 to 1933. Do you want to guess what happened on Jan. 1, 1934?

FD: I'm not sure.

Me: Insurance of bank deposits took effect through the Temporary Federal Deposit Insurance Fund. Today most Americans know their bank deposits are FDIC-insured up to a generous limit ($250,000 currently). So bank runs are much less of an issue nowadays. And if you recall, all during this financial crisis, the government has thrown its weight behind the financial industry, further soothing anyone who panics easily. Remember the "Stress Tests" for the banks? Team Obama made it clear upfront that no one would be allowed to fail. So the idea of bank runs seems rather far-fetched.

FD: Listen, releasing this information would be a bad idea for other reasons too. Think of the future impact, if there were another crisis and the Fed had to rescue the financial system again! Even strong banks that were considering taking money might instead retreat in trepidation.

Me: Whoa, hold on a second. I'm a little confused. Why are we bailing out strong banks?

FD: Well, you have to be fair and account for the fact that, in the midst of such a crisis, a strong bank may need more capital than it originally set aside.

Me: Then shouldn't it turn to the capital markets?

FD: It may be too expensive to raise the needed funds in the capital markets. It's a credit crisis!

Me: I hate to sound heartless but maybe the "strong bank" just bites the bullet and raises the money the expensive way. Next time it prepares better for a rainy day huh? Or if it really can't raise the funds at all without being in danger of going under, I would question your premise that it's a "strong" bank. Maybe it's only a "strong" bank when the economy is roaring along. And if we rescue this "strong" bank, what signals are we sending to a more conservative bank that is smaller and less profitable only because it avoided taking the risks of the "strong" bank during the boom times?

FD: Nevertheless, I don't think you realize what damage would be caused, making public the specific, detailed information Bloomberg seeks. It would cause serious competitive harm.

Me: And I hate to sound like a broken record but -- one way a bank could avoid that "harm" is not to tap the government's aid programs. Plan better next time, take less risk, and you won't have to grab hold of the Fed lifeline -- and be exposed for doing so.

FD: That's easy to say, but the fact remains, we have to deal with the hand we're dealt.

Me: Okay, then, tell me what's this "serious competitive harm" exactly? Especially when most of the big banks are already drawing assistance from the panoply of Fed programs. How seriously is Citigroup harmed if we learn it's 85 percent on the government teat and Bank of America, its big competitor, is only 79 percent? Say we find out that JPMorgan has $200 million of collateral parked at Fed Loan Facility X. You think JPMorgan is suddenly going to go out of business as investors panic?

FD: You have a naive understanding of markets. We're not talking about just public perception. Savvy traders could quickly get their hands on such data in the future and use it to their advantage even as the government was trying to stabilize the markets.

Me: Okay. Let me ask you something. Have you ever wondered why a company's share price makes a few suspicious-looking spikes in the days running up to an announced merger in which it will be acquired at a premium?

FD: Obviously someone has gotten wind of the deal and is buying the shares to profit from that knowledge.

Me: Exactly. Markets are notoriously leaky. Savvy traders are already hearing things about Fed aid, and figuring out things, and acting on rumors, when it comes to the bets they're making on these banks. But what you have now is imperfect leakage: investors are punishing some banks that shouldn't be punished, others are being punished to an imperfect degree, and yet others are going scot-free when they should be punished.

FD: Well, still, disclosure has the potential to whipsaw the market at a very volatile and sensitive time.

Me: February of 2010? When Bernanke is saying the economy has recovered well enough that we ought to think more seriously about raising interest rates?

FD: No, I'm talking about the height of the crisis naturally.

Me: But the documents would be released now, and this isn't the height of the crisis. And, if the Fed fears timing is an issue going forward -- if it needs to be able to make decisions during times of stress without the immediate scrutiny of the market -- why not work out a time frame that allows a 60-day or 90-day period before disclosures?

FD: You have to admit that if this information were to come to light all at once, it would be terribly disruptive to the markets.

Me: I agree it could be. But why? Because the Fed has sat on so much information, in the dark, for so long -- almost a year and a half. If the Fed had a timetable for periodically releasing details of what it's doing, and with whom, the market would be better able to assimilate the revelations. So when do you advocate that the Fed come clean? Never, right?

FD: Well, you don't understand the Fed's culture. It has a longstanding policy against disclosure.

Me: So that makes it right? Do you support slavery?

FD: Of course not.

Me: Someone in the year 1850 could have argued that the U.S. Constitution had a longstanding "policy" of condoning slavery. The law of the land at the time said that escaped slaves had to be returned to their rightful owners.

FD: Obviously our Founding Fathers got that one wrong. But you don't understand that the Fed needs to be insulated from public opinion to do its job effectively.

Me: Actually I do and I think we need to be sensitive to that issue. But there are other issues too. Such as who watches the Fed? What if a malevolent personality were to be installed as Fed chairman, and the place became a sinkhole of graft and corruption. It seems ridiculous now, but it's certainly not beyond the pale. What body can effectively rein in the Fed? Shouldn't we be a little worried about an agency that engineers a covert $2 trillion bailout, the details of which we know very little about? It seems that the Fed, in return for the latitude that we give it to make decisions about monetary policy, should reward our trust with more transparency.

FD: Well, rant all you will -- you won't win this one. You'll see.

Me: You know something? That's finally something we agree on. I have little faith the Supreme Court will do the right thing. But "won't win" isn't the same as "shouldn't win."

5 Reasons Not to Expect the U.S. to Rein in Shadow Banking (or Pass Much Financial Reform)

2010-02-06T17:12:00.005-05:00

When I was living in Hong Kong, I once saw a photo of the Chinese leadership that left a strong impression. China's political elite were having their annual conclave. The International Herald Tribune ran a photo of nine of the most powerful men in the country: all with hair dyed black, dark blue suits, red neckties -- except for one man wearing a blue one.

So, Sesame Street redux, one of these things was not like the others -- but the subtext was clear: not by a heck of a lot. Maybe he didn't get the "Red Necktie Memo." Or maybe he felt a little ornery that morning.

In the aftermath of the financial crisis, the U.S. government is the equivalent of the guy in the red necktie. He's different from those he regulates -- but not by much. That's a big reason the needle isn't likely to move much on financial regulation.

Just look at what was at the heart of the crisis: overly complex and leveraged products that sought to evade sensible (but inconvenient) accounting standards; that were blessed by ratings agencies with overt conflicts of interest; that were held at (a fiction of) arm's length through off-balance sheet vehicles (SIVs); and that supported a shadow banking system through such activities as repos and reverse repos.

Why would the government crack down on any of this since it's been captured, cognitively, by the financiers? In effect, the government is now doing all this stuff that caused our problems. Let's look:

1. overly complex and leveraged products: When Treasury Secretary Geithner was given the job of coming up with a proposal to rid the big banks of toxic debt, he created a complicated monstrosity that could've emerged from the Goldman Sachs war room (and for all we know, it did). Known as PPIP, the plan proposed pairing private money with public to buy distressed debt through auctions; private investors would use taxpayer funds to leverage up as high as six to one. Geithner suggested this after it was clear that too much leverage had helped spark the original disaster. All this led one to wonder: Did he sleep through the crisis? PPIP's most redeeming feature: it flopped.

2. sought to evade sensible (but inconvenient) accounting standards: Financial Accounting Standards Board shenanigans anyone? Under government pressure apparently, the standards board ditched mark-to-market accounting for certain bank assets in April last year, making it easier to pretend the shlock on your books was actually gold -- well, tarnished gold at the moment, but it would look better in a year or two, you could argue. So transparency wasn't a priority for Team Obama, it seems.

3. that were blessed by ratings agencies with overt conflicts of interest: The ratings agencies midwifed a lot of ugly babies that they pronounced beauty queens: crap securities that received AAA ratings. And what has Washington done to shake up the agencies, or reform the ratings system? As far as I can tell, approximately nothing. Why? Is it because the government may have an interest of its own in manipulated ratings, for the panoply of Fed lending facilities that require assets graded AAA? Geithner and Co. want to recapitalize the banking system on the sly -- without another ugly headline number like "$700 billion for TARP" -- and maybe the brain trust has decided to lay off the credit raters to ensure there's no avalanche of downgrades that, should it occur, would prevent shovelling that low-cost Fed money out the back door for suspect "AAA" collateral.

4. that were held at (a fiction of) arm's length through off-balance sheet vehicles (SIVs): This one's easy unfortunately. Fannie Mae and Freddie Mac are really the original off-balance sheet vehicles. It's no secret that Fannie Mae was moved off the government's balance sheet in the late 1960s because it was turning into a budget buster. Now it enjoys a funny quasi-public status: a "private" company that will get bailed out again and again (just like the SIVs of the big banks). Oh, and if you need another example, here's the government trying to spin a special-purpose vehicle off from TARP. Yup, they learned well from their Wall Street masters.

5. that supported a shadow banking system through such activities as repos and reverse repos: The Fed isn't so eager after all to shut down the repo market (in a repo, you sell a security to someone at a "haircut" price (that could be 10, 20, 30 percent off, depending on the security) with the promise to repurchase it shortly thereafter, say a day later). Turns out that the Fed plans to sop up extra liquidity through reverse repos of Treasuries. So since the reverse repo is a big part of its strategy, is it such a leap of the imagination to think that in the end the White House economic team will just advocate hands off most/all repos and reverse repos?

There you have it. The government has borrowed Wall Street's playbook. So why is anyone out there surprised we're not seeing reform?

Why Structured Finance?

2010-01-30T15:50:00.013-05:00

It's a provocative meta-question that has preoccupied me a lot lately. My question is meant to be a loaded one, as in, "What is the value of structured finance?"

To start out, Wikipedia does a serviceable job of getting us going, definition-wise:

Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk using complex legal and corporate entities. This risk transfer as applied to securitization of various financial assets (e.g. mortgages, credit card receivables, auto loans, etc.) has helped to open up new sources of financing to consumers. However, it arguably contributed to the degradation in underwriting standards for these financial assets, which helped give rise to both the credit bubble of the mid-2000s and the credit crash and financial crisis of 2007-2009.

Okay, let's start by looking at securitization: specifically, securitization of mortgages. That's a hot topic. We'll pay a visit to a site I found called Derivative Dribble, written by Charles Davi. He's the self-described resident derivatives wonk at the Atlantic Business Web site. He aims for lucidity when he writes -- kinda like me actually. Here's how he begins his explanation (the bold is mine):

We will explain how securitization works by first exploring the most basic motivation for isolating assets: access to cheaper financing. Assume B is a local bank that focuses primarily on taking deposits and earning money through very low risk investments of those deposits. Further, assume that B is a stable and solvent bank, but that it lacks the credit quality of some of the larger national banks and as such it has a higher cost of financing. This higher cost of financing means that it can’t lend at the same low rates as national banks. B’s local community is one in which home values are high and stable, and as a result the rate of default on mortgages is extremely low. As such, B would like to be able to compete in the local mortgage market, but is struggling to do so because its rates are higher than the national banks. What B would really like to do is borrow money for the limited purpose of issuing mortgages in its local community. That is, B wants to separate its credit quality from the credit quality of the mortgages it issues in its community. Securitization is the process that facilitates this isolation.

So what do we have in Bank B? A stable, solvent bank that makes low-risk investments. Hmm. I know what you're thinking -- if only we had a few more of those around! So if you cleave to one view of finance -- that your friendly neighborhood bank should be making low-risk investments and not doing anything too dangerous -- then you're probably ready to give up on securitization already. But let's keep going.

Bank B wants to grab some market share in its community, where home prices are high and stable. (Ah, did you catch that? High and stable ... so we're postulating a community rather like Lake Wobegon, where all the women are strong, all the men are good-looking, all the kids are above average -- and all the home prices are high and stable. So you may wonder -- what happens when Bank B tries this same strategy, but home prices are low and volatile, or only appear high and stable but are actually poised for a crash?)

Moving on: "B wants to separate its credit quality from the credit quality of the mortgages it issues in its community." B wants to enjoy the same solid credit profile of a large national bank and save a few basis points on the cost of its funds. Sounds like a win-win, right? Consumer gets a cheaper loan, B gets access to cheaper financing, so what's not to like?

Well, why does B have lower credit quality and access only to more expensive financing? Sure, it could be simply due to B's smaller size. But what if it isn't, not completely? What if one reason B's credit quality lags is that, even though it appears to be a stable institution, its loan agents aren't the sharpest saws in the shed. Not by much -- I mean not enough to get it into trouble really -- but should it really be allowed to simply pass its credit risk, even if small, down the chain?

Or here's another thought: Let's even say Bank B is perfectly responsible, but once it gets into this securitization business all of a sudden something happens. Its incentive structure changes. It's skimming a fee off these loans and not holding them anymore, so who's to worry about the borrower defaulting? All of a sudden Bank B basically starts flinging beef into the securitization machine to be turned into tranche patties of mortgage securities.

Now here's the next step Davi outlines:

We know that so long as B owns the mortgages, B’s creditors will still consider B’s credit as an institution when lending to it, even if that lending is for the limited purpose of issuing local mortgages. The solution to that problem is simple: B sells the mortgages off shortly after issuing them. But to whom? Well, common sense tells us that investors are not going to be too excited about buying mortgages piecemeal. So, B will wait until it has issued a pool of mortgages large enough to attract the attention of investors. Then, it will set up a special purpose vehicle (SPV) where that SPV’s special purpose is to buy the mortgages from B.

So B is out of the picture now. Phew. Or is it? Look over news stories from the past two years and count up all the banks that tractor beam-ed in their structured investment vehicles after these entities began to flounder financially. And who invented the SIV back in 1988? A bank that right now isn't exactly a shining beacon of financial stability and good sense: Citigroup.

Time to skip right to his conclusion:

Thus, the rate paid on the notes issued by the SPV will be determined by examining the credit quality of the mortgages themselves, with no reference to B. Since the rate on the notes is determined only by the quality of the mortgages, the rate on any individual mortgage will be determined by the quality of that mortgage.

Now let's think hard about this. These mortgages are being sold on to investors. All the securities will have to be rated by a big-name rating agency, say S&P. Now how many S&P analysts do you think live in our imaginary Lake Wobegon? No, they're in their New York City bunker. They're not going to know anything about the local steel mill rumored to be in danger of closing, about the series in the newspaper suggesting a toxic underground plume of chemicals may be spreading near the neighborhood of homes whose mortgages they're rating, about the fact half these places are in a neighborhood starting to go to seed. Instead they'll just look at the area's default rates, sales prices, then crunch numbers in some model.

Of course the best people to judge what's going to happen to these mortgages probably sit right in the headquarters of Bank B. They're doing banking for the community's needs. The bankers drive through these neighborhoods all the time. They see fresh construction projects on the east side, they see acts of vandalism on the north side, they know which business are doing well, and where, and have some sense of the community's future.

Okay, that went much longer than I expected! Enough for today. But I've got many more thoughts (and much more material) for future installments of this look at structured finance.

What's to Become of Shadow Banking?

2010-01-24T12:19:00.003-05:00

I listened to Obama's new, tougher stance on the banks (limit their size, eliminate proprietary trading) with a bit of skepticism. One, I don't quite trust him the way I did, say, three days after his election, when I thought that maybe -- just maybe -- the soaring rhetoric would be matched by an iron will and an incorruptible character. I'm no longer convinced he's on the side of the average American, though he displays a masterful populist oratory at times. Is he just a political elite who swaps in and out of roles, like a skillful actor?

In this case though, there's a bigger reason for my skepticism.

Obama is missing a huge part of the problem. To be blunt, what happens to shadow banking? It has revived in impressively scary fashion since seizing up completely in the aftermath of the Lehman bankruptcy. This is a world of repos (repurchase agreements), asset-backed securities, "haircuts" and off-balance sheet vehicles. This is a world that Washington needs to understand much, much better. The Fed (and other regulators) really need to think out a few things -- what implications does shadow banking activity have for effective money supply, for financial system leverage, for systemic fragility, for the efficacy of regulatory agencies. What does it mean to have a large, and thriving, shadow banking system that has no oversight and no liquidity backstop?

What good is it to remove proprietary trading from commercial banks, if we end up shoving volatile market activities into a dark corner, where they threaten again someday to haul down the entire financial system? What firewalls are we building between the regular banking system and the shadow one? What size do we want the shadow banking system to be? What role do we want it to have? What kinds of companies do we want operating in this "darkness"? What do we want them doing? Not want them doing?

I'm surprised that this subject isn't being more intensely debated. This is a biggie, folks.

Support Your Local Bank!

2010-01-24T12:07:00.004-05:00

Sometime in December, I had a stunningly obvious epiphany: If Obama wasn't going to do anything about the banking behemoths, and Congress wasn't either because our representatives were in thrall to the lobbyists paid for by the special interests funding Congressional campaigns, I -- and millions of fellow Americans -- could act. We could vote our anger with our deposits.

And so when I recently relocated to New York, I found a nice cozy little neighborhood bank to put my money in. This bank pays a decent rate of interest on my savings. On Saturdays there's no line at the teller's window. The loan officer/manager/Kleenex box changer is usually sitting at his desk near the lobby, gazing idly out the window, ready to serve you. The place has a relaxed, down-home feel.

I figured: These are guys who played it safe, and conservative, and didn't throw buckets of money into risky securities before the financial crisis. Shouldn't they be rewarded? Shouldn't we -- the American people (forget about the corrupt power structure) -- feed the good banks, the community lenders and the credit unions, and try to starve the Citigroups and Bank of Americas that screwed up so egregiously?

I'm happy that my epiphany wasn't a sole flash of insight in the darkness. After I resolved to place my money in a community bank, I saw on the Huffington Post site that Arianna was urging others to do the same. I don't know how much of an impact this campaign will have, but at last I feel as if I'm doing something good, and not just complaining.

Up and Running Again, Finally

2010-01-24T11:59:00.003-05:00

New York is a major international city? Really? Out here in Forest Hills (that's Queens, New York City, for those who haven't been sucked into the metropolis), it took me five weeks to get Internet access. Time Warner wanted everything but a tissue sample from me to prove my identity, apparently because the last tenant in this apartment absconded with some of their equipment (I imagine it was the little modem that's now blinking at me that's about the size of three stacked slices of bread -- yup, that's gotta be really valuable). Okay, frustrated rant over. Back to the blog.

That Giant Sucking Sound ...

2009-12-17T17:19:00.002-05:00

is New York City inhaling another finance blogger. That's right, first it was Mike over at Rortybomb, and now I've got a semi-full U-Haul truck parked in the frigid cold, waiting for the trip tomorrow morning. All day I've been playing that moving game of Tetris, slotting in boxes, furniture and odds and ends (guitars, keyboard, studio photography light poles) in available spaces in a cavernous truck.

For my readership of 10 to 15 -- you know who you are -- my blogging may be a bit less frequent after I start this new job. It's not that I lack ideas; the rub is simply that blogs suck up time. Maybe I'll try blogging shorter (a la Greg Mankiw, who sometimes just links to stuff he finds interesting, with no comment). I dunno; that's not really my style. But ...

I really, really wanted to do a long entry this week on the maddening futility of regulating banks using capital ratios. The problem is that Basel-type thinking (capital weightings for certain classes of assets) is just so, I don't know, 19th century. Modern financiers will always be a step ahead, using new products to innovate around the rules, so that you have to wonder, "Is this just a failed approach?"

But what in its place? Do we just let banks gamble recklessly, with even less supervision? That seems foolish since the fact that regulators were asleep at the switch during this financial crisis was a huge problem.

I think there may be a better way. I would consider ditching capital ratio requirements altogether (radical idea), but in return, make it easier to prosecute and strip of their wealth Wall Street CEOs and traders who end up running an institution into the ground. What if there were no capital requirements, but someone said, "You bankrupt this company through reckless behavior or negligent oversight and we'll take every penny you have, possibly throw you in jail, cut off your pinky and thumb (okay, I'm exaggerating to make the point), and ensure you never work in the finance industry ever again."

How high do you think the capital ratios would be in that scenario? Say 15, 20 percent, as opposed to the current 8 percent minimum today? Hard to say, but when there are aggressive clawbacks and serious prosecutions, I'm not sure you need a lot of rules about needing this much capital for this kind of asset and this much for the other. What we have now unfortunately is a broken system -- a dense framework of rules that encourages the banks to go diving for loopholes, following the advice of a platoon of securities lawyers.

Dimon, in the Giving Xmas Spirit, Gives Obama the Bird?

2009-12-15T09:14:00.003-05:00

Just had to link to this naked capitalism post by Tim Duncan:
Bankers Support Regulation? Au Contraire?

Only hours after Obama met with Wall Street "fat cat" CEO bankers (about half of whom opted to be patched in by conference call -- how's that for signaling?), JPMorgan put out this media release on its Web site.

The JPMorgan statement of Dec. 14 appears to be guarded support for financial regulation. In other words "yes, let's have some of course, but slowly, slowly ... carefully, carefully."

The details matter, and the stakes are simply too high and the consequences too far-reaching to do this hastily and poorly. While we agree with many of the proposals, we share concerns with others that some regulatory proposals could restrict lending by banks, which will hinder economic growth and job creation.

Duncan's analysis:

This press release so quickly after the meeting at the White House today would seem to have no apparent purpose other than to make it clear to the other bankers and lobbyists that nothing has changed with regard to the industry’s passive-aggressive battle against the CFPA. It also appears to be a rather harsh metaphoric middle-finger to the White House given that it is posted less than 24 hours after the President personally asked for Mr. Dimon’s support.

Why did I find this amusing? Well, because of my April blog post, JPMorgan Flips Geithner the Bird. At that time, Dimon was saying basically, "Hell no, we're not going to offer up any assets for PPIP (Geithner's plan to relieve banks of toxic assets)."

Since the Geithner Plan was rolled out with all due fanfare, and awaited with baited breath, the Dimon comment was actually pretty explosive, though it got scant coverage. The subtext of Dimon's remarks was clear: "Screw you. Take your PPIP and stick it up your nether regions." And PPIP has been dying a slow death all year long, as other banks decided to shy away from the program as well.

So has JPMorgan (or Dimon, more specifically) now metaphorically flipped off Geithner and Obama too? If so, that would be arrogance seasoned with plenty of chutzpah.

Joe Lieberman, Mighty Force of Nature

2009-12-15T08:59:00.002-05:00

It looks like uber-nebbish Joe Lieberman gets to exact his will on the nation on health-care reform. Amazing. So this is democracy. One guy can hold hostage the most important health care legislation in decades.

I was listening to Lieberman on TV last night. He sounds like a Jewish Steven Wright. I keep waiting for the punchline. ("I'd kill for a Nobel Peace Prize ... but seriously folks, about health care ...") Lieberman has a flat, uninflected, depressive aspect that apparently the people of Connecticut find irresistible.

Hell hath no fury like a former Democrat scorned.

Is the SIV Accounting Fraud Nearing an End?

2009-12-12T08:22:00.004-05:00

Anyone who's read this blog for a while will know that one thing I absolutely can't wrap my head around is the Great SIV Loophole, and why it was never addressed until the "structured investment vehicles" exploded messily.

Here's how everything worked before the financial crisis/meltdown/blowup: A bank -- let's call it "Smitigroup" -- creates an off-balance sheet vehicle; let's give it a sexy name like "Xena." Here's what lil ol' Xena does: it borrows money by issuing short-term securities, then in effect lends money by buying longer-term securities. Now, if you're a Joe Blow reader who's wondering, "Exactly why does, ahem, Smitigroup, want to do this?," let's look at what's going on.

You make the short-term borrowing at say 2.8 percent, then you buy longer-term products at say 3.5 percent. Notice the "spread" between the two. Borrow a million for $28,000, buy a longer-dated asset (like, say, a security backed by mortgages from some fast-appreciating neighborhood of homes in south Florida) that pays $35,000 a year, and you're pocketing a cool $7,000 annually from the difference.

Rinse. Wash. Repeat. (As they say.)

Now, if you're financially savvy, you may be thinking, "Hey, that sounds kind of like what my bank does." And bingo -- you'd be right. Your bank basically "borrows" short term from its depositors (paying them a small amount for their funds) then lends long term (home and business loans). But there is a difference: the structured investment vehicle is more like an invisible bank; it doesn't show up on regulatory radar.

So let's return to that riveting question: Why does Smitigroup want to create an SIV? Well, one reason obviously: the potential profit. But why create the SIV off-balance sheet?

Yes, why oh why? Because Smitigroup operates under capital constraints and other regulations. It must have a certain amount of underlying capital to be able to expand its traditional banking operations. But here's the neat thing about its SIV: Smitigroup waves a magic wand and Xena takes shape and starts operating at arm's length from its creator, so that the business doesn't eat into Smitigroup's capital base. Meanwhile Xena funnels profits back to Smitigroup.

Hey! What's not to like?

But then, you have a liquidity seize up -- those long-term assets Xena is holding become worth less, no one wants to buy its short-term securities, and Xena begins to circle the bathtub drain at an increasingly frenetic clip. So, no problem for Smitigroup right? Smiti won't be on the hook.

Wrong. Suddenly you see the tractor beams appear. Smiti hoovers up Xena, moving the vehicle's operations onto its own books. So much for the fiction that Xena was "independent"!

This is the absurd crap -- sorry, crap is the most polite term I can think of -- that was allowed to persist in the financial industry. Now though, that may be changing, Floyd Norris of the NYT reports in a meandering column:

The issue is a couple of new accounting rules that are forcing banks to put back on their balance sheets some strange creations that bad accounting rules had allowed them to shunt aside in the past.

Strange creations indeed! But as weird as these SIVs were, there was an even odder beast out there:

Bank holding companies have been allowed to issue something called “trust preferred securities.” The beauty of those securities was that they were really debt that the holding companies could call capital. Having that “capital” meant the bank could take on more debt. A system that lets a bank borrow more money because it has already borrowed money — rather than because it has sold stock — is hardly a wise one.

Got that? As a bank, I'm supposed to hold capital against my assets (mostly loans). The more loans I make, the more the capital ratio shrinks toward my regulatory minimum. But a "trust preferred security" turns that equation upside down. As I make more loans, my capital ratio grows. Ain't bank accounting grand!

Broadly, such tricks fall under the rubric of "capital arbitrage." Ah, if only we could have seen these capital arbitrage tricks at the time. But zee banks, zey are so clever! It would take a man of almost unimaginable perspicacity and intelligence, a man possessing perhaps clairvoyance even, to divine the gravity of the game that was afoot ...

Or maybe not:

In Spain, some smaller banks are in trouble from real estate loans, but the big banks seem to have emerged in good shape. One reason is that Spanish regulators were not fooled by things like SIVs, and insisted that if any bank wanted to create one, it could, but would have to hold reserves anyway. Since there was no business reason — other than capital arbitrage — for a SIV, those banks shied away.

Oh well. But at least the Financial Accounting Standards Board is finally getting around to sewing this loophole shut:

The FASB, in an attempt to save face and a degree of integrity, has pushed back on Wall Street by passing FAS 166 and 167 which would require investments in off-balance sheet vehicles to be brought on-balance sheet. The implementation of FAS 166 and 167 is imminent and would require financial institutions to set aside increased capital against selected assets.

This seems like a no brainer, a slam dunk. But the banks are squealing, predictably, because they have been hiding operations off balance sheet for a while and are worried about the impact of bringing them back onto the books.

The fact that we're even having this discussion is ridiculous. We need a better regulatory regime. I think capital-based requirements in a rule-based system (See Basel, incarnations I and II, e.g.) may be an obsolete approach, especially in an information-rich age of high-speed computers and financial innovation galore. The banks, with an army of lawyers in tow, will always twist and limbo their way around the requirements.

There is a better way. I'll look at that later this week.

Matt Taibbi's Latest Must-Read: Obama's Big Sellout

2009-12-11T09:45:00.007-05:00

The Rolling Stone writer takes on President Obama in his latest Wall Street slamdown. Everyone should read it, whether or not you agree with him, or care for his freewheeling, expletive-heavy, cynical style. I think Taibbi does channel well the pissed-off liberal-intellectual zeitgeist of disgust with Wall Street excesses.

His main points are:

1. Everyone who's senior level on Obama's economic/Treasury team once worked for Robert Rubin, came from Citigroup, came from Goldman Sachs, or some combination of all three. It's rather sobering as he ticks off the names, one by one -- and ties them back to Rubin/Citi/Goldman. And we wonder why we get so much Samethink out of this White House on economic issues?

2. Banking lobbyists right now are busily gutting legislation that would add consumer protections for financial products and force stricter regulation and transparency for derivatives trading. They are of course abetted by our "elected" representatives, who probably should be required to wear logo-plastered jumpsuits, a la racecar drivers, to show which special interests (which major insurers, banks etc.) they really take their marching orders from.

3. Americans on the whole are too dumb to care that the financial sector is hardly being reformed at all, despite the fact financier misdeeds brought us last fall to the brink of Credit Armageddon.

What disappointed me about Taibbi's article was that he catalogs a familiar litany of crimes but doesn't try to answer the underlying question of his piece: Why did Obama sell out? What happened to "Change We Can Believe In?" Is Obama really just another empty suit politician? Did we, American voters, just get duped again?

Here are the possible explanations I have for why Obama sold out. Pick the one, or ones, you like or feel free to add your own in the comments section:

Obama really was a fraud, just like so many other politicians, willing to say whatever he had to to get elected. He has no principles.

Obama talks a good game -- he is a master rhetorician -- but his cojones are about the size of sesame seeds. He does believe in change, but in practice, he all too quickly defaults to dull compromise.

Obama remains very aware of his "blackness," and is so worried about seeming radical to White America that he tacked hard the other way, to the safety of the Wall Street moguls.

Obama to this day doesn't really understand how badly his team screwed up and how much they gave away to the banking interests; economics is his weak suit and he simply isn't very interested in it, preferring on that long flight to Pakistan to read the Urdu poets instead. And he really thinks that, over the long view of history, his team will be lauded for its courage and wisdom in how it tackled the financial mess, and not disparaged for failing to deal directly with so many problems that caused it.

The banking lobby basically does own our capital: they own the Senate, the House, and the White House too. Of course that includes owning Obama, who felt the sting when Wall Street moneybaggers began to tighten their pocketbooks and said they weren't going to donate as much funds to Democrats because of his constant bashing of their industry.

More Proof that "IBG" Thinking Motivated Bankers

2009-12-09T09:55:00.002-05:00

Well, the electronic ink was barely dry on my previous entry when I noticed, somewhat belatedly, this piece by Lucian Bebchuk et al in the Financial Times: Bankers Had Cashed in Before the Music Stopped.

Yesterday I blogged that OPM ("Other People's Money") and IBG ("I'll Be Gone") were meta-reasons for the financial crisis. Of course that didn't quite square with part of the accepted storyline of the collapse: namely, as Bebchuk notes, "according to the standard narrative, the meltdown of Bear Stearns and Lehman Brothers largely wiped out the wealth of their top executives."

In which case, IBG thinking ("I'll Be Gone when this stinker of a product/strategy blows sky high") would have afflicted the junior traders, but not the senior leaders, it would appear. And, accordingly, one would expect a furious flurry of pay reform taking place now as angry CEOs, their wallets and their stock portfolios scorched once, vow to never let such an orgy of risk-taking ever occur again.

Except ... except ... the top brass apparently made out like bandits too. They were IBG beneficiaries, if not quite direct practitioners. From Bebchuk:

In 2000-07, the top five executives at Bear and Lehman pocketed cash bonuses exceeding $300m and $150m respectively (adjusted to 2009 dollars). Although the financial results on which bonus payments were based were sharply reversed in 2008, pay arrangements allowed executives to keep past bonuses.

So you have those traders practicing IBG, and those supervising them who are incentivized to turn a blind eye to IBG.

Which leads us to the number of the day.

Chances of Wall Street spontaneously reforming compensation practices: approximately 0.

The Two Abbreviations that Explain the Financial Collapse

2009-12-08T09:45:00.005-05:00

I was traveling this weekend -- back! -- and last night it occurred to me that if you want to understand why this financial crisis occurred, you can look hard at two often bandied-about abbreviations. Forget about low interest rates, regulatory lapses, securitizations, risky derivatives etc. etc. Those are reasons, but these are meta-reasons. These are the reasons that create the environment for the reasons. These abbreviations are easy to understand, but have deep, wide-ranging implications.

1. OPM ("Other People's Money)
What does it mean to make bets with other people's money? I think the answer is obvious. When I'm betting my house on an outcome, you can be assured that my thinking moves down a different decision tree than when I'm betting your house.

How was Wall Street betting with "Other People's Money"? Largely, this came about because of a shift in ownership models. The old wingtipped investment bankers worked at firms owned by partners. The oft-repeated joke about partners is that they live poor, but die rich. Their wealth is tied up in the worth of the firm. Under this type of model, you can bet that Wall Street CEOs over the past decade would have known exactly what types of risky wagers their traders were making each day. But they didn't.

Because they were using "Other People's Money."

"Other People's Money" is what you get from the new ownership model: becoming a public company. You sell shares to a vast swathe of investors, everyone from Aunt Edna to Fireman Joe's Pension Fund, to raise capital. And so when your company starts trading for itself in credit default swaps or liquidity puts, you as CEO don't risk losing your house if the bets go bad. You risk losing Aunt Edna's house. (Note: even with CEO "incentives" that try to align your pay with performance, you still tend to capture the upside of your company's gains and escape most of the pain of the losses.)

Big difference. And a slew of Wall Street banks went public in the 1980s and 1990s (Goldman was late to the party, making the jump in 1999).

Yves Smith at naked capitalism and the always incisive (and often acerbic) business journalist Michael Lewis have noted repeatedly the significance of changed ownership models, re: this financial crisis. And they're right: This constitutes a huge meta-reason for the meltdown. On top of all this, once you really start to leverage up other people's money, the danger of excessive risk-taking compounds fast.

2. IBG (I'll Be Gone)
If you were to use this in a sentence, it would sound something like: "IBG (I'll Be Gone) by the time that trading strategy blows up." The prevalence of short-term thinking -- trying to make the numbers for quarterly earnings reports to satisfy investors and analysts (that's a consequence of playing with "OPM;" you're always performing for the stockholders), trying to hit yearly targets for that fat bonus -- it all tends to focus the mind on the end of the money-seeking nose, and not much farther out.

"I'll Be Gone" actually represents the convergence of two bad trends: one, this short-term thinking that reflects in part the stunting of our attention spans, and two, the abdication of personal responsibility ("Hey, my trades went south? So they went south ... that's life, seeya.").

So think about it: if you've got a financial industry with a belief system centered around "get mine, get out, and use other people's money to do it" ... well, why are you surprised that a lot of big reckless bets were made and everyone got out with their bags of gold and no one's being prosecuted?

The Fed: Ivory Tower Economists or Just Clueless Bagholders?

2009-12-01T21:51:00.005-05:00

The Fed as bagholder ... it hadn't occurred to me until I read this piece on naked capitalism called "The Fed, Treasury and AIG" (the title has the disarming ring of a child's nursery rhyme). Author: Richard Alford, former Fed economist. He defends the Fed's behavior related to the AIG rescue -- he sounds a bit querulous at times, but it's a thankless mission he's on -- and then he hooks a sharp left turn toward the end of his essay and launches a flurry of pointed and interesting questions:

Why didn’t Treasury announce a more detailed proposal including a Fed role limited to bridge financing? Why didn’t the Fed require it as a condition for supplying “liquidity” to the capital-impaired AIG? Why didn’t the Fed require a commitment from Treasury to assume AIG assets it acquired subject to legislation being enacted? Why didn’t the Fed leave the responsibility for management of AIG with Treasury? Why did the Fed permit itself to be used as an off-balance sheet slush fund by Treasury? Why did the Fed permit itself to be put in a position wherein it would have to pay out public monies on behalf of a capital impaired-institution? Why did the Fed turn itself in to a political punching bag?

Indeed. Why, why, why? Perhaps Bernanke's a leading academic economist, but he certainly lacks a Phd. in "cover your ass"-ology. He's the Gomer you get to sign all the room service bills during one of those crazy guys-go-wild weekends at some luxury hotel. He's the kid you hand the freshly lit stink bomb to, then say, "Listen, Ben, we have to duck outside for just a minute, but you just hold this thing, don't let it go, and we'll be right back. Promise." And earnest Ben says, "Sure, Hank. Sure, Tim."

Yup, Ben Bernanke's confirmation as Fed chairman is now in danger because it looks like he got played as a patsy. Bernanke let the Fed be drawn outside of its proper sphere of influence. It appears he got pushed and he didn't bother to push back.

If there's a lesson to be abstracted from this I'd say: any agency clueless enough to be duped by a bunch of Treasury bureaucrats, who were in turn duped by the Wall Street pros, shouldn't be christened "super regulator" of our entire financial system.

Obama's Two Biggest Blunders: What do They Have in Common?

2009-11-30T20:02:00.004-05:00

I'll go out on a limb -- actually, I don't think I have to go very far out -- and wager that wise historians of the future will chronicle two big blunders of President Obama's first year in office. They will be:

1. His kid-glove handling of the banks that caused the financial crisis. There was too much "please" and "if you don't mind" and mucho foot-dragging on reforming a broken system and rooting out wrongdoers. The president expressed a little outrage, maybe once or twice, then drew back into his shell. Meanwhile the government has handed over billions to the banking industry, very few strings attached, as unemployment soars. The perception on Main Street: the Obama administration is beholden to a plutocracy that really runs the U.S. of A.

There is much anger about the bailouts that's on a steady simmer right below the surface, I think. It will cripple Obama's future ability to be effective. Paul Krugman really nailed it with his recent op-ed piece pointing out the great tragedy in how the White House played patty cake with the bankers: our leaders have blown a load of credibility with the American public. Obama an agent for change? Yeah, right.

2. His ramping up of the war in Afghanistan. Public sentiment is already turning hard against this war. We're tired of wars in distant lands that half of us can't locate on a globe; we're tired of the burden they place on our groaning budget deficits; we're tired of the open-endedness of these conflicts.

Obama will buck popular opinion, it appears, by sending 30,000 more troops to Afghanistan. And we should all recognize that poker play: I call you and raise you 30,000 troops. This puts him 30,000 soldiers farther from extricating America from what will probably turn into a quagmire. I think it's a very dumb move from a very smart man. His decision puts me in mind of Hannah Arendt's wonderful book, "The March of Folly." Why do wise men persist in hopeless courses of action?

Anyway, before I get sidetracked too much, the central point: What do both of these blunders share? What's the common element? What weakness do they expose of Barack Obama -- by all accounts a highly intelligent man of a reflective nature, someone who can appreciate nuance, who has the native smarts to master any issue out there, no matter its complexity?

I would submit it's this: Obama has a weakness when it comes to bucking the system. He eagerly seeks compromise, tends to be conflict averse, and falls short on courage of conviction. With Wall Street, he didn't dare face down the banking industry. He expressed a little indignation and backed off. With the war in Afghanistan, he didn't dare to face down the military brass, who have sold him a bill of goods on what's achievable over there. He didn't want to be the guy who lost Afghanistan.

Someone might rebut: Well, what about health care? Someone who's wedded to the status quo wouldn't be trying to overhaul the health care system. That's true, and I think Obama dreams big. But look at how he's behaved with health care: He's introduced reform and made the soaring rhetorical speeches, then backed off to let Congress thrash out the actual bills. Public option? No public option? He's easy. Whatever.

Lyndon Johnson, by all accounts, was an arm twister. Barack Obama appears to be more a speechmaker -- and the words are starting to ring hollow.

PPIP Deathwatch, November Edition

2009-11-28T10:16:00.003-05:00

The Geithner plan (PPIP), for public-private partnerships to buy up toxic assets saddling banks in the U.S. financial system, has been roundly attacked from the start. For my part, early on, I predicted PPIP would fail for a simple reason: the banks wouldn't offer up any toxic assets for sale (for fear of revealing themselves insolvent) and the U.S. government wouldn't have the stomach (or balls) to compel them to.

So I offer up this article in US Banker (a little late, but it's been a hectic month): PPIP Finally Ready, But Who's Selling?

For me, the impact paragraph comes at the very end (bold mine):

Ron Glancz, a partner at Venable LLP who has clients with toxic assets, agreed. "It's not created a lot of stir," he says. "We have banks that have a lot of toxic assets, and they are not selling to PPIP. It doesn't deal with the fundamental problem that banks can't book these losses, because that's a depletion of capital."

The official storyline is something rather different though. The Treasury Department claims that PPIP is no longer needed, as the economy has improved and major banks have been posting profits. But what's the truth? Here's a quick and dirty rundown:

1. Bank profitability: Well, duh. Banks were given much greater leeway in valuing their assets, back in April. If you can claim multiple pieces of junk worth 40 cents on the dollar are actually worth 80, that's going to boost profits considerably. That, and if you're a major bank, you get to borrow super-cheap from the Fed through an alphabet soup of lending facilities.

2. The economy has improved: The meaningful indicators, such as the rates for unemployment and foreclosures, as well as gauges of consumer sentiment, still look pretty grim. A less meaningful indicator -- the stock market -- of course shows an impressive little runup. Quarterly GDP made an expansionary spurt, but how much of that is temporary stimulus (Cash for Clunkers etc.)?

Which brings us to ...

3. Have the Fed's "cash for trash" emergency backstop programs sopped up a lot of the toxic securities: To me this is a really intriguing question. We know that "Helicopter Ben" is eager to flood the financial system with easy money. The Fed takes collateral from the major banks, and in exchange hands out good ol' dollar bills, usable anywhere. Talk about a jolt of liquidity!

Of course the Fed won't take any ol' piece of crap as collateral. It has to be rated AAA. But ... oops ... weren't Moody's et al rating practically everything AAA, even if it stunk to high heaven? Well, yeah. So one might wonder: how much "AAA" collateral is at the Federal Reserve, and what kind of assets does it represent, and who is it from? The answer: we don't know. The reason: the Fed refuses to tell us. We know that because Bloomberg is chasing the agency through the U.S. court system right now, seeking some details. And the Fed is stonewalling like crazy.

But here's an interesting question: How does the bank that has posted collateral at the Fed account for the value of that security on its books? Because, when you come right down to it, if "A" (the value of that security, as parked at the Fed and exchanged for good hard cash) exceeds "B" (what the bank can get for that security through a PPIP auction, even assuming there will be a little overpaying by the PPIP buyer), the bank will prefer to stick the money with the Fed. And PPIP will fail.

Of course the irony -- which one can spot from a good ways off -- is that the Fed, eager to restore liquidity and restart markets, is actually hampering the necessary clearing activity and proper restarting of the securities markets for dodgy assets, thanks to all its meddling. But then again, what's a good financial crisis without an abundance of irony?

Update: To be fair, I should note that lesser quality securities (below AAA) can be submitted for the PPIP auctions. So, obviously, a bank holding these lower-rated assets can't weigh "what is their value as collateral through the Fed vs. what is their value sold through PPIP"? The Fed, after all, only takes triple A (well, for what that's worth, and it would be interesting to know how much AAA the Fed has scooped up that has then been downgraded). But dodgier securities may not be great candidates for PPIP either, because they can be harder to value, and a bank may want to exploit this uncertainty by carrying them at inflated prices on its books (and conversely, because of the problem of adverse selection, PPIP bidders may penalize such securities, so it's a lose-lose for the bank). That may convince the bank to hold onto these assets and not risk having to do a writedown.

Phew! Just Flew Back from China and Boy My Arms Are Tired

2009-11-26T15:08:00.004-05:00

Or however that joke goes. Right now I'm de-jetlagging after a seemingly endless flight from Hong Kong and trying to catch up on what I missed. I spent a week in China. For today, just a short odds-and-ends entry...

(1) When did passengers turn into "customers"? I noticed this on the Continental flights I took. Had it been only one flight, I would have just written off the incident as someone on the flight crew remembering some half-digested bit of marketing political correctness. But this practice was apparently part of some memo because the "customers" references came up on different legs of my journey. "Customers, please be seated." "We thank our customers for flying with us." That sort of thing.

One thing you gotta understand about me: I love the English language. I love it on a number of levels, right down to the sound of words knocking together. Further, I believe in simple, direct, effective communication. I grit my teeth when corporate America keeps trying to put lip gloss on the fact that they're terminating workers. We have gone from "firings" to "layoffs" to "downsizing" to -- a particularly odiously bland term -- "rightsizing."

Who the hell came up with "rightsizing"? It sounds so laudable. As in: "We were wrongsized before, and when we realized this, we rightsized, and now as a company we feel soooo much better." Compare that to: "We just fired 200 workers." The trouble is, "rightsize," besides having that fuzzy feel-goodness of Newspeak, is maddeningly imprecise. "Rightsize" could mean that you added 200 workers, if your company felt it was too small. Or it could mean you opened another plant, or acquired a rival. I think there should be Useless Euphemism jars, like swear jars, for awful euphemisms. Every time a flack tells you his company "rightsized," he should have to put a buck in the Useless Euphemism jar.

But back to the customers sitting on the airplane, waiting an hour on the tarmac twice on delayed Continental flights (whoops, wrong peeve) ... why not just ditch the marketing PC and call us what we are, most accurately, in our current role? Maybe when we're buying the ticket at the counter, we deserve to be referred to as "customers." But once we're on the plane, we become passengers. There's no shame in that. And the word best reflects our role at that moment.

Say the plane smacks into the side of the mountain, killing 230 people aboard. When Continental holds a media conference on the disaster, are they going to say, "We lost 6 members of the flight crew and 224 customers."

Of course not.

(2) China, tear down this wall! By "this wall," I am referring to the Chinese firewall of censorship on the Internet. While on vacation, I looked forward to keeping current on my favorite blogs only to find the large blogging communities -- WordPress, blogger -- blocked.

Why? Because China, despite its emergence as a global power to be reckoned with, is still a politically immature country, its leaders fearful of independent thought, criticism and debate. As far as they are concerned, the state news service (Xinhua) tells its citizens what they need to know, with an appropriate viewpoint. "Question Authority" is not a fashionable slogan over there.

I'm not trying to China-bash here. Often the Chinese look at Westerners and protest, "You don't understand our country." And I respect that point of view. There is much that we don't understand. I think the U.S. makes its worst blunders abroad when it assumes that the yearnings in the hearts of our citizens are exactly the yearnings of men and women everywhere, and that what is good for our country must be good for any country. It is hubris bordering on madness to think that we can neatly and simply transplant a Jeffersonian democracy to the harsh sands of Iraq for example or to the desolate strife-torn mountainous region of Afghanistan. America would do better with a little more humility.

Yet -- yet -- at some kind of baseline, there should be principles that reasonable men can agree on that make for a better society. One is the open, independent, vigorous sharing of ideas and opinions, I strongly believe. In America, I think we have open and independent sharing, though its vigor has somewhat been sapped by a culture narcotized by entertainment. In China, they have none of the above. I wonder sometimes if they realize the cost.

There is a real cost in lost innovation, across so many spheres: not only economic, but social and cultural too. There is a cost as well in human development of one's citizens (I am sometimes surprised at the number of very smart Chinese I have met who are not particularly nuanced thinkers or debaters; they have never been taught to question and examine things). Then there is the most ludicrous of costs -- the tangible cost of repression: of maintaining the spy networks, of paying the censors' salaries, of having to constantly screen what is acceptable and not -- a cost akin to buying the bullet that you then use to shoot yourself in the foot.

I think China contains the seeds of greatness, but first must have the courage to let a thousand flowers bloom ... from within.

Tin Ear of the Year Nominee: AIG's CEO

2009-11-11T09:20:00.003-05:00

Man, this guy is -- how to put this gently? -- aw, the hell with it -- the very embodiment of chutzpah. Early in this financial crisis, I noted the curious lack of contrition on the part of Wall Street bankers. There was nothing in the way of an apology, just a lot of hustling out the back door with the bags of TARP money. There wasn't even that mumbled, eyes downcast, insincere "I'm sorry" that you get from your four-year-old who was caught smearing peanut butter on his sister's ponytail. At the time I wondered about the deafening silence of Wall Street's public relations machines.

Lately, Wall Street's head honchos have opened up a bit more, even going on "charm" offensives. And now, you understand why they were silent before. Because these guys radiate arrogance, even when they think they're striking a humble pose. You have Lord Blankfein over at Goldman Sachs, telling us the firm is doing God's work (shades of noblesse oblige) and that a certain amount of income inequality just has to be tolerated.

And then you have AIG's Robert Benmosche, who's threatening to walk off the job after only three months. I love the brutal Huffington Post headline and subhead:
AIG Chief Threatening to Jump Yacht
New CEO Benmosche Spent First Two Weeks on Job Vacationing on the Adriatic ... Now Claims He's Done, Angry About Pay Restrictions

(Note: the pictured yacht is not his, I suspect -- it appears far too small.)

Okay, Benmosche -- who I have yet to see a photograph of, but I imagine most images portray him with foot lodged firmly in mouth, as that's where it appears to have been since his hiring -- is fuming about pay restrictions on AIG executives. Remember, AIG was on the brink of self-immolation last fall when the U.S. government discovered that the company was actually a hedge fund grafted atop a sedate-looking insurer, and was about to go up in flames in a very messy way. And so the government (using our taxpayer dollars) interceded.

So now the U.S. government has the audacity to make rules about how the top executives are compensated, which has a funny sort of logic about it because we own the damn company. AIG is a ward of the state: we purchased four-fifths of this wrong-way bet colossus. Of course we have a say. Don't sell me a hair-covered lollipop then tell me I can't clean it up.

And the top 25 executives at AIG are being forced to work at starvation wages. Anyone want to guess what their annual salary is capped at? $100,000 a year? Well, no -- not that starvation. Any self-respecting AIG top executive is still going to have golf club dues and such. We can't airbrush all that away. Okay, then $200,000 a year? Nah, not that bad. $300,000 a year? Oops, not that low. Not even what the U.S. president makes: $400,000 a year.

Here's the answer: Benmosche is bitching because he can't pay them more than $500,000. By the way, how rich are you if you make a cool half a million? Check this out: you happen to be the richest 107,565th person on the planet. No, actually, you're even richer than that, because the Global Rich List calculator tops out at 107,565 at $201,000 of income. So let's just say you're pretty stinkin' well off.

Benmosche, by throwing a hissy fit about the inability to lavishly compensate his key executives, is displaying a level of Tin Ear-edness that may just win him top honors this year. Since he has no clue about how to run a company without a fat-salaried caste of big bosses, I hereby offer up a few bits of advice (free, because I know he's on a, ahem, budget these days).

1. Grow your own executives, dammit. Surely there are people -- strivers; check the backs of their co-workers for claw marks -- within the relevant divisions, at lower levels, who dream of running the world someday. They're probably not happy with their pittance salaries of $250,000 to $300,000. $500,000 would be a big salary bump. Find them. Mentor them. Put them in place.

2. Split job responsibilities. Okay, if you can't find one guy to run your fire insurance or whatever division for $500,000, find two guys. Better yet, find two women. And a couple of minorities to boot. Use this as an opportunity to introduce a few new faces and spread duties a bit more widely. Checks and balances, right? Maybe, next time, Betty will say to Financial Products co-head Flo Bassano, "Hey, do you really think we ought to be loaded up with so many of these darn CDS things? They look sort of volatile."

In short, be creative. And for God's sake, talk to your PR department. They may, in so many words, tell you what the rest of the world wants to: Stop yer bitchin'.

Blankfein Makes the Argument for Heavily Regulating Banks

2009-11-10T08:09:00.006-05:00

Imagine a world in which the air that we breathe -- that's right, that air all around you -- wasn't freely available. Let's say it's held in "air reservoirs" and pumped into our airtight houses. Whenever we go outside, we have to take compressed air in tanks because the normal atmosphere can't support life. And we all get used to living this way -- okay, it's a bit inconvenient, but everyone gradually adjusts and life goes on.

How do you think, in such a world, air would be "regulated"? With the same light hand we would use for regulating the sale of frivolous items, such as lawn gnomes and chia pets? Ah, dumb question. Of course not. Air would be the most regulated commodity mankind has ever known. There would be frequent quality checks for air contamination, strict rules about pipes that carried the critical air supply, regulations about every aspect of the portable air tanks that we depended on.

Why? Simple. Without air, we die. This is a life and death matter.

Abstractable principle: the amount of regulation appropriate for an activity (or commodity, or whatever) should be in some direct proportion to how vital it is. Without breathable air, the entire human race perishes. So clearly, there will arise a lot of rules surrounding the proper reserves of air, how it will be supplied to the population at large, what quality is acceptable, and so on.

By this same argument, Goldman Sachs CEO Lloyd Blankfein believes that the financial industry should be heavily regulated. Because, well, it is the vital lifeblood for our economy. Credit is the "air" that businesses, large and small, need to survive. If you don't believe me, here he is, hotly telling a reporter that you can't compare bonus-seeking bankers to coal miners striking for better wages in the 1970s. Because the bankers happen to be involved in something much, much more important:

"I’ve got news for you," he shoots back, eyes narrowing. "If the financial system goes down, our business is going down and, trust me, yours and everyone else’s is going down, too."

Sounds pretty grim. Sounds like an industry that's really, really vital to our economic health. Sounds like a pretty convincing argument for a new, much more intrusive, regulatory regime. U.S. Congress, all you guys have to do is connect the dots for Mr. Blankfein now. He's made the argument for you.

Must Read of the Day: Kill Credit Default Swaps

2009-11-07T09:10:00.006-05:00

At first, my leading "must read" candidate was Roger Ehrenberg's Barking up the Wrong Tree. Roger identifies an ongoing problem with Washington's attempt to knuckle down on the financial industry: legislators get distracted by pander-ready sideshows. Example: dark pools and high-frequency trading in the stock market (note: I'm not saying either is necessarily harmless, but I agree that they're not doing the harm of the big elephants in the room -- unregulated derivatives trading and corrupted credit-rating agencies). Why is this? As Ehrenberg observes, plenty of little investors are in the stock market, so Congress takes on related issues with a lusty sense of outrage. But derivatives and credit raters are willfully ignored because the subjects aren't as sexy and grandma doesn't spend any time checking out, say, how Moody's grades "SocGen CMBS Non-Conforming Pool XII."

Still, that blog entry dropped to second place on my "must read" list after I found this, over at naked capitalism: First, Let's Kill all the Credit Default Swaps. Yves Smith, who has gotten pretty smart about CDS products while researching and writing her soon-to-be-released book related to the financial crisis, says:

Credit default swaps have no redeeming social value. They are a fee machine for Wall Street and their supposed value is considerably overstated (the world pre credit default swaps functioned perfectly well) and their costs, which are considerable, are not given the attention they warrant.

She lists their sins, including their "anti-social" nature. A credit default swap, remember, is basically insurance in case bad stuff happens to a company and renders its bonds worthless or impaired. When you buy this protection though, the only way to cash in is for the bad stuff (a so-called "credit event") to occur. So, like cash-strapped homeowners who have a tendency to play with flames around heavily insured items, a holder of say an IBM credit default swap might prefer that the computer maker declare bankruptcy (a triggering credit event) rather than restructure its debt -- even if restructuring the debt is a smarter move for the company that in the end does more economic good.

Yves also notes that simply moving credit default swaps onto an exchange may simply create a "too big to fail" exchange -- and not extricate us from this mess at all. It's a good point and indicates that the CDS may be too neutron-bomblike to allow in the financial arsenal of weapons.

A casual observer might wonder about this. After all, a CDS is basically insurance, and we have well-capitalized insurers that do just fine. Well, first the insurance industry is well-regulated, unlike the CDS market, but even if the swaps were highly regulated they differ from standard insurance in two big, troubling ways:

1. Unlike with, say, home insurance, you can buy a CDS repeatedly for the same bond. This would be the equivalent of being able to insure someone's house, say, 50 times over -- or even more. Further, you don't have to have any underlying ownership interest whatsoever in the insured bond. So this is a perfect tool for highly leveraged, out-of-control speculation.

2. You can set aside a stockpile of reserves for insurance more effectively, because correlations are weaker. A national insurer may suffer losses from a hurricane in Florida, but chances are good that its claims elsewhere in the country will run at about the same pace as usual (the probabilities of damage events occurring at separate locations, over a wide enough area, are uncorrelated). That makes it easier to absorb the loss from the hurricane. Unfortunately, when the economy tanks, bankruptcies rise in all sectors. It's like a hurricane that sweeps the length and breadth of the U.S. What's worse, with a credit default swap, the hurricane can strengthen off its own destruction, like some evil black hole that becomes more powerful as it draws in more matter. Namely: as we saw in this last crisis, collateral requirements against credit default swaps start to suck liquidity out of the system as the credit markets spiral downward, which in turn exacerbates the plunge.

I don't think our lawmakers are brave enough to try to get rid of credit default swaps, but I find it interesting that a fair number of smart people who know how these products work, in an intricate way, are suggesting such a thing.

How Much Crappy Collateral is the Fed Warehousing?

2009-11-05T11:47:00.005-05:00

The possibly scary answer to this question periodically gets my stomach churning. When the definitive works are written on this financial crisis, in another decade or so, I think the authors will pass judgment not so much on the overt bailout -- TARP is small potatoes, folks -- but on the "invisible bailout" that no one ever voted on, but that the Fed orchestrated behind the scenes. We can't write these definitive books yet, because the outcome of the invisible bailout isn't clear.

What put me in mind of this subject: this paper over at Zero Hedge, allegedly by a "Nathan Jerome Burchfield," that claims the Fed may have accepted crappy CMBS (commercial mortgage-backed security) collateral against loans it made. This occurred through the TALF, or the Term Asset-Backed Securities Facility. And then, after the Fed accepted this stuff as top notch collateral (AAA rated, creme de la creme), the ratings agencies -- interestingly enough -- turned around and downgraded the products.

I'll get to that oddity in a second, but first, let's pause for a moment to look at where we are in this financial mess. Ostensibly, things are going pretty well -- the troubled credit markets seem to have taken a magic calming pill -- but if you whisk back the curtain (which few Americans are inclined to do), you are treated to a crutch-like monstrosity of money-rigged supports that brings to mind that old poster "Building a Rainbow." It's hard to tell what asset prices for securities are really worth, because the Fed is swallowing them up at an astonishing rate, as long as they're bearing a AAA rating from one or two of our not-very-trustworthy credit raters. The securities (most likely generously graded) are accepted by the Fed as collateral, giving them value that they ordinarily would not have. So you give the Fed these "AAA" securities, it gives you dollar bills in exchange -- yee hah! -- then sits on your collateral.

But what's this collateral really worth? And what happens when the Fed takes collateral that then is downgraded to something less desirable -- to a rating that the Fed wouldn't have accepted in the first place?

If the Fed were smart, like say Goldman Sachs -- believe you me, it would start hoovering up more collateral, or insist on $x dollars to compensate for the downgrade. But remember: the Fed's agenda is less about protecting the taxpayer than about invisibly bailing out Wall Street. In fact, a critic might even wonder if the Fed, the credit agencies and the holders of the CMBS have in some way colluded so that the ratings hit occurs only AFTER the Fed accepts the securities. That way, the CMBS owner has already got his cash -- bye bye, so long sucker.

Certainly, at the very least, the Fed seems like the "mark" in the "market" these days. Consider: the Fed announces that, starting in July, it will accept CMBS as collateral ... meanwhile, everyone has been predicting all year that commercial real estate will be the next market to fall flat on its face. So the Fed has accumulated billions in CMBS collateral -- I think the latest figure is $6 billion -- in a sector that's prime for collapse. Dumb or really dumb?

A true-blue capitalist might argue that this is precisely the kind of sector the Fed should avoid -- let the upheaval come, the prices drop, the readjustment occur. Let the free market sort out things. But the Fed, gently intervening through its invisible bailout, helps keep asset prices artificially high.

Outraged about this example? Save some outrage. The Fed is rife with lending programs like TALF. The organization's balance sheet has become an alphabet soup of crutch-supports. And these programs have gotten pretty darn fat. Anyone recall this Yves Smith blog entry, Term Auction Facility: Confirmation of Financial Stress?, from Feb. 19, 2008 (the bold is mine)? God, seems like a lifetime ago huh?

To give a quick overview of the TAF: it was launched December 17, with two $20 billion actions, one for 28 days (the one conducted on the 17th) and a second for the 20th for 35 days. The reason for the program was that the gap between the Fed funds rate and interbank rates had become very large, suggesting that banks were reluctant to lend to each other. That was even more acute in December, since banks customarily curtail their short term lending then so they can tidy up their books for year end.
We’ve called the TAF a discount window without stigma (and in fact, the Fed implemented the TAF because banks weren’t using the discount window even when they should have). Banks can post a wide range of collateral, borrow on a non-disclosed basis, and can hold on to the cash for a while (by contrast, the discount window is overnight)

And what would you expect when you allow "a wide range of collateral"? Probably a rapidly expanding program, as banks shovel in all sorts of junk and get dollars in return. And sure enough:

The Financial Times today raises some concerns, noting that banks are indeed using the TAF to use crappy collateral for borrowing.
And note that, with no announcement I can recall, the facility has been increased to $50 billion even though the year end crunch has passed. That too is not a good sign.

So whatever happened to good 'ol TAF? By the end of June of this year, the Fed said that the value of collateral pledged through TAF was $1,570 billion (edit: actually, to be fair, only $899 billion of that was against current loans). Big, bad and bloated.

And so, the larger questions: where does all this massive intervention end? Does the Fed really think there's an easy way to just quietly and painlessly withdraw such huge levels of support? And what if that collateral turns out to be worth not very much? Who's stuck with the tab?

Settling the "Was it Lehman?" Dust-up

2009-11-01T09:09:00.011-05:00

Was the U.S. government's decision to let Lehman Brothers tumble into bankruptcy last fall a fatal miscalculation? By letting Lehman go, did we precipitate the brutal freeze-up in the credit markets?

Answering that question has become a hot niche topic for debate. The latest contribution by William Sterling is here: Looking Back at Lehman. It's a rather tedious read, so I'll just cut to the chase:

In contrast to the analysis of Lehman skeptics such as John Taylor (2008, 2009) and John Cochrane and Luigi Zingales (2009), the evidence we present supports the view of many practitioners that the decision not to rescue Lehman represented an immediate and massive shock to the financial system that was larger by an order of magnitude than anything seen over nearly two decades.

First, if you examine the day-by-day, blow-by-blow data, I think it's obvious that the Lehman bankruptcy did matter hugely. But if you look at the larger picture, I don't think Lehman mattered much at all. The long historical view: we were poised on the tip of a teetering Seussian-type credit edifice, creaking with hidden risk and towering with high leverage. It was bound to collapse in an ugly way sooner or later.

The "micro" analyses that focus on how the credit markets reacted in the immediate aftermath of Lehman's collapse largely miss the point. Which is: Lehman's failure revealed the Seussian-type credit edifice in all its terrifying precariousness for the first time. There were at least two big problems that came to the forefront with Lehman:

1. The shadow banking system was shown to be extremely fragile.

First, check out this primer on shadow banking; it's what I consider a great introduction to the subject. It's an interview between Mike Konczal (the creator of the always-smart Rortybomb blog) and a Barnard College professor, Perry Mehrling.

Shadow banking was (still is, I imagine) HUGE. This MarketWatch story claims that the shadow banking system had $10 TRILLION in assets in early 2007, making it the same size as the traditional banking system. Just ponder that for a second. That's a tremendous amount of money sloshing about that's meeting demand for funds in the economy, while doing so outside of the reach of regulators.

Big brokers such as -- ta da -- Lehman Brothers were supposedly the largest players in the shadow bank network. How does shadow banking work? An investment bank such as Lehman arranges to sell some securities to what we'll call a "pseudo-bank", then buy them back say a day later for more money (that extra bit of money providing an interest rate on funds, if you will, for the lender). James Kwak at Baseline Scenario breaks it down well here.

Those securities may be AAA-rated, making them appear pretty safe. That's important because the pseudo-bank has to juggle two risks here: (1) That it will get stuck with the securities (2) That, if it is stuck with them, it will have to make enough money selling them to be made whole. Who are the pseudo-banks? Largely, it appears, money market mutual funds swimming in cash, looking for better yields.

So Lehman gets to de facto borrow against high-rated securities (that serve as collateral). Once this collateral looks suspect, or Lehman begins to falter financially, the mutual fund may refuse to "roll over" the buy-resell contract. Then, since these are very short-term agreements, Lehman can very quickly find itself pretty much screwed, unable to raise money that it desperately needs.

Which is what happened when Lehman stumbled. Its financial footing was rapidly whisked away and, because this is a "shadow" banking system, there was nowhere to turn for emergency liquidity (see Mike at Rortybomb for a longer discussion of this gaping weakness).

Now, if you're a pseudo-bank providing funds to this shadow banking system, and you observe Lehman staggering about, badly wounded, what do you think? It's not, "Well, that must be a problem isolated to Lehman." No, it's more like, "Holy crap, almost any of these investment banks could be in similarly rough shape, and how do I know these 'AAA' securities are really worth as much as anyone says."

Meanwhile, the U.S. government begins to realize that it can't let all the investment banks go belly up, en masse, because the Lehmans and Morgan Stanleys have got a million tentacles reaching into many corners of the global financial system, such as through their derivative operations. These guys have been at ground zero in the efforts to launder risk.

So Lehman's failure was about more than Lehman. I think we could've rushed in and bailed out Lehman, sure, but eventually the sprawling, frail shadow banking system would have blown up somewhere else.

2. Lehman was shown to be worth a lot less than it claimed, further scaring the hell out of everyone. Everyone starts to wonder, "How solid are the counterparties I'm doing business with?"; nervousness sets in; credit flow ices over.

September 15, Lehman Brothers Holdings says it will file for bankruptcy. It cites bank debt of $613 billion, $155 billion in bond debt, and assets worth $639 billion. Doesn't sound too bad huh? Assets of $639 billion, liabilities of $768 billion?

Now take a guess how much Lehman's bondholders recovered on the dollar. 50 cents? 40 cents?

Recovery rates for defaulted bonds have declined in the U.S., true. Moody's said they fell, on average, from 61.8 percent on senior unsecured bonds in 2007 to 33 percent in 2008. But Lehman bonds crapped out spectacularly. They fetched less than 10 cents on the dollar. That's pretty awful.

So there you have it.

Here's my takeaway point: Lehman's bankruptcy was a proximate cause of the credit freeze, but that doesn't necessarily mean rescuing Lehman would have been the wise thing to do. Perhaps if we had saved Lehman, that would have only delayed the breakdown of the financial markets to the fall of 2009, and it would have been twice as bad.

I worry about the "No More Lehmans" crowd because they're the ideological heirs of "Bailout Nation," the hopeless model of propping up Too Big To Fail banks. And I'm concerned they don't even seem to realize it.

Selected Readings for a Thursday Morning

2009-10-29T09:29:00.005-04:00

1. Under Attack, Credit Raters Turn to the First Amendment

First, a disclaimer on my recommendation for this Huffington Post investigation: a version of this story has been done before; it's not exactly anything new. To wit: Moody's and friends like to scurry behind the First Amendment when outraged investors seek recompense for losses after believing their inflated ratings.

I know the argument the credit raters are trying to make, but it always has offended me somewhat. You think of the great figures of American history who have invoked the First Amendment, and how it has been this core, unassailable principle that makes our democracy so powerful. And then Moody's ... well, subverts it to this end. I suppose my reaction is akin to the reaction you'd expect from a Fox commentator who discovered footage of a beatnik casually wiping his butt with the American flag.

For now the lesson we must learn is to treat the credit-rating agencies as untrustworthy, unfortunately, as they consider their ratings to be basically on par with an opinion column in a NAMBLA newsletter. It's all just free speech, right? But remember what motivates their "free speech." They can in effect "sell" good ratings, as they are paid by the company that issues the product they're rating.

Even if prostitution is deemed legal (as it is in some places), a whore is a whore is a whore. To some degree, credit-rating agencies will continue to be whores (or have pronounced whore-like tendencies, at the least) as long as they are paid by the people whose products they're judging. So investors, caveat emptor.

2. Naming Systemically Dangerous Firms

This guest post by David Moss at The Baseline Scenario left me clutching my head and moaning. Apparently the systemic risk legislation for the financial industry that's beginning to wend its way through Congress would identify "Too Big to Fail" institutions and then NOT make their names public. The stated reason: identifying them would encourage "moral hazard."

No. No. No. No. No. (Draw picture of me here, repeatedly banging my head against a brick wall.)

Sometimes I wonder what kind of chowderheads we have drafting laws in this country (actually, I should know by now: they're not the men and women we elected; they're the lobbyists that paid for their campaigns). Assuming that we decide to allow "Too Big to Fail" institutions to exist (believe me, there are many Americans who question the wisdom of this), why the hell should we keep their identities in the closet? Remember, one big pillar on which regulatory reform needs to be built:

Transparency.

One more time:

TRANSPARENCY.

The truth is, there will be enough leaking of this "Too Big to Fail" list that plenty of people will know who's on it. The market will make adjustments; you'll get your damn moral hazard anyway. What you may not get is the open and vigorous debate that we need about the TBTF's that appear on the list. Any bank that merits a Too Big to Fail should be regulated within an inch of its life, like a common utility. And it should be watched really, really closely, because when it blows up, it can blow a gaping hole in the side of the good ship the U.S. Economy.

And for all of us to be super-vigilant about these Too Big to Fails, we all need to know who they are.

"Too Big to Fail" shouldn't be some neat little merit badge you get at a moonlit ceremony in the heart of the dark woods. It needs to be a stamp, hopefully more akin to a scarlet letter, that gets planted on your forehead in full view of the public (which has to pay for your Too Big to Fail-ness, if you do screw up, so believe me, there's plenty of justice here).

Nobody Rides for Free? Think again, Jackson Browne

2009-10-28T08:44:00.006-04:00

Lately I've been thinking about the "free rider" problem in economics, partly because free riders are so easy to find once you start looking for them. It's an unbelievably easy Easter egg hunt.

The free rider of course is someone who partakes of a benefit but doesn't help pay the associated cost. If you live in a village of 1,000 people, and there's one dirt road in, absent a local government structure someone might try to collect funds to have the road paved. If 999 people contribute $1,000, but you don't deem the project worthy and decline to pay anything, then you "free ride" on that nice smooth road when it's finally covered with a shiny black layer of pavement.

This winter, I may be a swine flu free rider. How? I'm leaning against getting a protective shot. Part of my reasoning is: Because of the general feeling of panic, and the constant media drumbeat about the dangers of swine flu, millions will get vaccinated. They will help form a protective buffer around me, damping the spread of the flu. Thus, I benefit from the precautions they take.

You can also appreciate this on a mathematical level. Possible infection rates for swine flu have been predicted to be around 30 percent (which strikes me as very high -- but as a free rider, that's okay, because it just means that this figure will scare more people into getting vaccinations, and so give me an even better free ride). But the more people who get the vaccine, the lower that infection rate will be. Now, if 299,999,999 people out of a population of 300 million get a swine flu shot (or nasal injection), and I'm the only one who doesn't, then my chances of getting the virus are practically zero. Because, obviously, where am I going to get it from? An airborne petri dish?

If you feel annoyed at me for free riding, don't be. Everyone's free riding somewhere. Just look around.

Take Afghanistan. It's a justifiable war, I think, unlike Iraq. Yet it still looks like a hopeless quagmire. The legitimacy of the Afghan government has been hollowed out by incompetence and corruption. I would find a way to get troops out of there, fast. This conflict will only end badly. General McChrystal is right: he does need more troops, but even then he may only be able to fight the enemy to a standstill.

But back to the free rider part: There are apparently plenty of other nations that want the U.S. to stay in Afghanistan, to try to sort out this opium-growing and strife-torn mess of a country that is an all-too-convenient hatching ground for future terrorists. The whole world reaps the benefits of fewer Al Qaeda cells operating within Afghanistan's mountainous borders. But other countries are reluctant to commit their troops or their funds to support our combat operation. They would rather sit back and free ride. And so the U.S., still thinking it's the superpower with the mostest, takes this burden on its shoulders.

One more free rider example to complete the set of three today:

I'm about to move to New York City. I was doing comparisons to see how a given salary stacks up in different metro areas. Zounds! New York is frightfully expensive (as if I really needed to be told that, but once you see the numbers in black and white, it is pretty sobering).

I'll be forking over a big chunk of my paycheck to the federal government for taxes. In fact, New Yorkers most certainly contribute a big slice of the federal taxes collected in this country. The irony is that the people who complain the most bitterly about taxes and big government live in the conservative red states, in the heart of America, where salaries are lower. So they get to gripe while free-riding, to some degree, off the liberals.

Example (go here for the cost-of-living calculator): $100,000 in Manhattan salary would buy the same as $40,384 in wages in that reddest of red capitals (and believe me, I know, having lived there once), Oklahoma City. So here's the picture: Oklahoma residents are fuming about government being too large, taxes too high, and meanwhile the typical worker in the state capital probably pays a good deal less to support our troops abroad than the liberal president of the Sierra Club in New York City.

(For those who say it all balances out, because New Yorkers get proportionately higher salaries, two things: (1) If you're making $40,384 in Oklahoma City, good luck transplanting to Manhattan and getting $100,000 just because, you know, you deserve more because of the cost-of-living differential. (2) Our income tax scale is progressive, so $100,000 puts you in a much steeper tax bracket than $40,384.)

Nobody rides for free, Jackson? Au contraire ...

The Inanity of the Home Buyer Tax Credit Laid Bare

2009-10-27T20:50:00.006-04:00

For anyone who missed it, Nemo at self-evident had a good post on why the tax credit for newbie home buyers is a really dumb idea (The First-time Home Buyer Tax Credit is Idiotic; he doesn't mince a lot of words). He had a follow-up here to explain it all in (brace yourself) the economic parlance of supply and demand curves.

I'll just cherry-pick a few reasons why the tax credit is stupid:
1. It forestalls the setttling out of home prices at their natural bottom, which is what we desperately need before the U.S. housing market can begin a sustained recovery.
2. It encourages first-time homebuyers to leverage up too much to buy a home (and what's more, they won't be buying at the natural bottom -- see point #1 -- so they stand a greater chance of winding up underwater on their mortgage).
3. Once you start shifting around the supply and demand curves, you find that the tax credit, if anything, induces developers to boost the supply of homes in the market. But the housing market, if anything, is suffering from a glut of units right now.

So why do we have an idiotic tax credit gumming things up? To throw a crutch under the housing market to help the banks and beleaguered homeowners, even though we could do more with the money by just writing everyone a bunch of checks and save all the paperwork and economic distortion? Yeah, that's part of it.

The other part is what Washington has become: a giant pork pull. Politicians know that their policies don't need to make any economic sense as long as they're shoveling enough free money out the door to keep enough Joe Averages in the constituency happy enough to re-elect them.

Health Care Reform? I'm Busy Counting My Gold, You Dark-skinned Whippersnapper!

2009-10-27T11:13:00.003-04:00

The title says it all:
U.S. Health Care Reform Mainly Opposed by Rich Old White Men

That Time of Year: WSJ Op-Ed Defends Insider Trading

2009-10-25T10:00:00.012-04:00

I say "that time of year" because periodically (okay, maybe not every year, but as sure as the swallows land at Capistrano), the WSJ runs an op-ed piece that defends the practice of insider trading.

This year's version is written by Donald J. Boudreaux and, owing to its sort of porky length, I am betting that it appears only online and not in the print Journal. Boudreaux makes enough sense that, if you want to see the real fright gallery for this Halloween-timed piece, check out the comments section afterwards. You'll find a lot of people -- they smell like traders to me; they have that sort of smart knowingness about the markets on a very micro level -- cheering him on. Clearly Boudreaux managed to quickly assemble his own amen corner.

So what is wrong with insider trading? Boudreaux offers many reasons why it's actually a good thing. But does his exuberant defense capture the whole picture?

First, what is insider trading? It's pretty much what it sounds like: insiders buying and selling stocks of publicly traded companies based on knowledge that they have that others don't. Obvious example: You know, as a director on the board of Cisco, that the company will be bought out by the Chinese at a 30 percent premium. The formal announcement will come in two weeks. So in the meantime you buy every share you can lay your hands on. When Cisco pops say $15 a share, you cash in.

That's illegal. In Boudreaux's world, it wouldn't be (though, as he proposes, Cisco would be left to define its own narrow or broad version of "insider trading" -- for example, it could mandate that no insiders can trade on information related to takeovers/mergers. The company then would be free to sue any violators itself; federal regulators wouldn't get involved).

Let's look at what Boudreaux is saying, bit by bit. First, he points out that regulating insider trading is a messy, imperfect business to begin with. The application of the enforcement rules is unavoidably biased. Here he makes an interesting (and valid) point:

These prohibitions are meant to prevent all insiders with non-public information from profiting from the use of such information before it becomes public. It follows that unbiased application of these prohibitions should target not only traders whose inside information prompts them to actively buy or sell assets, but also traders whose inside information prompts them not to make asset purchases or sales that they would have made were it not for their inside information.

Okay, here's what he's saying, in easier-to-parse English: Insider trading catches only sins of commission, not sins of omission. It catches people who are buying and selling (they leave a paper trail, alas), but not those who would have bought and sold, if not for their privileged information.

So picture Fred, who's working for King Kazoo. He's a mid-level manager who happens to glimpse a copy of King Kazoo's sales for August, on the desk of his boss. At lunch, Fred was planning to place an order to sell 5,000 shares of King Kazoo. But he sees kazoo sales rocketed higher in August. The stock is going to soar. Fred thinks to himself, "Ah, maybe better not call my broker after all." And when the stock subsequently jumps 20 percent, Fred is sitting pretty.

That's not insider trading. Fred never made a trade. But it is insider knowledge that leads to a profitable advantage. And it's undetectable. We can't hook up Thought Monitors to everyone who works at, or deals with, a public company to see what they would have done had they not seen Document X or heard Y.

It's a problem for sure. But I think it's a problem of a different order of magnitude that we might just have to swallow hard and live with. It's a different order of magnitude because out-of-the-blue or less-motivated decisions to buy or sell stock (as with Fred above) are going to be smaller than motivated decisions to buy or sell based on a clear advantage. Okay, that's confusing, so here's what I mean more plainly: Fred was going to sell 5,000 shares and decides not to, seeing the great August sales figures. Now if insider trading were allowed and Fred was thus encouraged to profit off any information he had, he'd certainly be motivated to go out and buy a bunch of shares. But I think he would try to buy a much larger chunk of shares -- maybe 50,000 -- knowing he can make a bucketload of money.

So here's the contrast: the action he doesn't take is more likely based on a weak-motivation decision (he's going to sell the shares to generate a little cash, he has a vague feeling the stock will drop, he had a bad burrito last night and just doesn't feel like owning as much stock). But the action he does take -- buying or selling -- is based on a strong-motivation decision (he's almost certain the shares are heading higher). And when he acts on strong motivation, many more shares are likely to be involved.

The upshot is that I don't think the "sins of omission" are excusable, just that they tend to be less bad, so it's not worth getting too overexercised on that point.

Moving on: the core of Boudreaux's argument would warm the cockles of the heart of any efficient market theorist. Remember, that theory holds that the price of any stock, in an efficient manner, adjusts to reflect all relevant, available information. So, in this ideal world, the price of Kazoo stock is exactly what it should be.

But, of course, this overlooks something (actually a big something, in that it doesn't account for bubbles, momentum movements and the myriad irrationalities of human nature, but we'll let that part go for now). Kazoo stock can't be perfectly priced (even disregarding the irrational stuff), because the market doesn't have all the relevant information. Insiders do possess much of this information. And so, by allowing them to add their "information" to the market's understanding of the stock, this gives us a better approximation of its true value. And this is good, Boudreaux points out, for many reasons:

Suppose that unscrupulous management drives Acme Inc. to the verge of bankruptcy. Being unscrupulous, Acme's managers succeed for a time in hiding its perilous financial condition from the public. During this lying time, Acme's share price will be too high. Investors will buy Acme shares at prices that conceal the company's imminent doom. Creditors will extend financing to Acme on terms that do not compensate those creditors for the true risks that they are unknowingly undertaking. Perhaps some of Acme's employees will turn down good job offers at other firms in order to remain at what they are misled to believe is a financially solid Acme Inc.

In economist speak, capital (human and otherwise), is being misallocated in this scenario. Acme may receive too much credit, on too generous terms, because its stock price shows a healthy company that does not indeed exist. Talented managers at Acme -- who could be launching profitable startups or using their expertise to propel other firms to greatness -- are instead pouring their valuable time into a black hole of a company that's about to declare bankruptcy.

The argument appears compelling. Where does it break down? I think it's on the shareholder side, with the help of a feedback loop. Because while I think Boudreaux is on the cusp of a valid point with his "economic inefficiency argument," I think he misses badly on the share-price analysis, and this flaw then turns around and undercuts his efficiency point.

So let's look at this more closely, using the Acme example that Boudreaux himself has provided. Imagine Acme is a paragon of insider trading -- by this I mean that everybody has free rein to trade on whatever insider information they can obtain. A Boudreaux-ian would say, "Great, the stock price is really accurate and very efficient. The markets must love that!"

But do they? What are the two bedrock principles most often cited when discussing ideal markets? Free and fair. Certainly the Boudreaux world qualifies on number one. But it falls far short on number two. So what are the implications?

Let's go back to what a fluidly functioning market is all about. There are buyers. There are sellers. Shares change hands, and a moment later the stock ticks higher or lower. For that transaction, at that instant in time, there is a winner. And there is a loser. I personally think this is a more useful paradigm for understanding stock trades, especially shorter term, than that of "mispricing."

So let's imagine there are two investors in Boudreaux's world, Joe Insider and Ted Outsider. Acme is at $30 a share. Joe Insider sees evidence of the company's shakiness. Ted is unfortunately oblivious. Joe starts to sell. Ted sees a buying opportunity and scoops up cheap shares of Acme. Meanwhile Acme falls all the way to $10 a share.

Now, you can argue that a certain amount of mispricing was eliminated during this process. Acme now trades at a "truer" price. But let's examine what happened in the market. Ted realizes he's been had. He took the wrong side of the trade; Joe took the right side because he knew what was really going on.

Okay, Acme now trades at $10. That's good because the price is now more accurate, right? So now Ted should feel more comfortable about buying up more Acme shares because it's settled at this fair $10 price. So he snatches up Acme at $10 each. At the same time, Joe sees inside evidence that the price is going to drop even further. He dumps his holdings, does some short-selling, and makes a profit when the stock hits $3. Ted, meanwhile, takes a bath again.

Now Ted is irked. He's still got some shares, which slowly climb back to $10. At this price, he figures, "That's it. I'm out of this turkey." But at the same time, on the inside Joe sees that Acme is on the verge of acquiring a patent that will turn the company around. And so Joe grabs a whole bunch of shares, Ted divests his, and Acme has a super run up to $20 a share.

What does it mean when you have a situation like this? Ted, who is an active trader and contributing to making the market more liquid, is probably going to steer away from companies with heavy levels of insider trading. Why? This one doesn't take a rocket scientist folks: for every trade, there's a winner and a loser, and going up against insiders on his trades more often than not, Ted's going to turn out to be the loser.

Acme's stock then becomes more illiquid. Not good.

Boudreaux does claim that firms such as Acme will enjoy a lower cost of capital because their stock prices reflect a truer value of the company. But is that really so? Could their cost of capital actually be higher?

How so? On the equity side, the broader investment community will be more reluctant to put money in a company where insiders have the advantage in stock trades, by virtue of the information only they possess. More and more investors may take a pass in trading these shares, as it becomes clear that in any trade, you are increasingly likely to be across from an insider who has an edge. The stock price will naturally fall when a smaller pool of investment dollars is chasing a given set of shares. And so the company may, paradoxically, appear to be weaker than it actually is.

This is the feedback loop part.

What else will happen at Acme, if it becomes a haven for insider trading? Well, other unpleasant possibilities: there could be information hoarding, because information is clearly money, and if you have it and others don't, then that money is all yours to make. Also, insiders at Acme might form links to big money hedge funds, selling them information (which would appear to be legal in this brave new world -- if you can profit on insider information, why can't you then take partners or sell that information for others to profit on), as these large funds would be able to leverage the insiders' information more effectively.

Is this really the world we want? Insider trading occurs unfortunately all too frequently right now. It is hard to police; that's undeniably true. But once you take the "fair" out of "fair" market, what do you have left?

Are the American People Really the American Sheeple?

2009-10-22T10:17:00.005-04:00

Have we turned into a nation of sheep? Are we really so tractable and fleece-able as an outsider might think, considering the rather feeble response of the average American to the outrages of the financial crisis?

Everyone basically agrees on where we are now, one year after last fall's implosion. The Too Big to Fail banks are even bigger than before (and thus even more immune to failure). Wall Street bonuses and pay are rocketing higher again, even as 500 desperate people (including a master's degree holder and a seasoned business analyst) compete for a single lousy admin spot at a trucking school that barely pays $27,000 a year. The financial industry is battling the small elements of reform tooth and nail; God knows what resistance we'll get when we try to introduce big, meaningful reform.

What prompts my musing is this story in the Huffington Post showing the large, yawning gap -- chasm really, if you will -- that has opened up between Wall Street bonuses and the average American's yearly paycheck. Once again, to be clear: this isn't a straight-up comparison of salaries; this is a comparison of dessert (bonus) to meat and potatoes (living wage). And, to continue with the metaphor, Wall Street is not just getting a much better main course than the rest of us, their dessert alone makes our meat and potatoes look like scraps of rat tails and moldy French fries.

The gap has been widening for years. And yet -- even now, after the Wall Street's whole edifice of debt and derivatives just about toppled a year ago -- we seem to be uttering a collective "baaaaaaa" and going about our grass-grazing with nary an eyeblink. What explains such quiescence? That's what really puzzles me. Here are some of the theories, though I'm not saying I completely agree with all of them. Pick the one you like.

1. Americans are just too fat and content to be bothered: we are the expected products of an affluent society that offers up lots of cheap, high-fat food, easy-to-digest entertainment -- and not enough to chew on when it comes to intellectual stimulation. Despite the high unemployment, even now we find enough ways to get by. As long as we can scrape up the funds to pay the cable bill, don't go looking for a revolution. We get mad, then we realize that The Amazing Raze is on in ten minutes, and pretty soon we've forgotton why we were so pissed in the first place.

2. Americans are, on the whole, just not that smart, and the financial mess requires the ability to understand very complex topics. Ask an American to locate Afghanistan on a world globe, and chances are decent his finger will land somewhere east of Tibet or south of Sumatra. And even the smarter among us are much challenged to understand this complicated financial engineering that creates "credit default swaps" and "synthetic CDOs," and how everything interrelates.

3. Americans tend to have a simple worldview and are easily led astray by clever charlatans who twist our fundamental ideological beliefs. What American would oppose the noble principle of freedom? So then why would anyone oppose free markets? Isn't that the bedrock of our capitalist system? If something goes wrong, it can't be the fault of free markets; the meddling hand of government regulators must be involved. This theme has emerged on the right (and to be fair, there is an element of truth, because regulation has distorted markets). And so then the clever demagogue sells the great themes of America -- freedom! innovation! the self-made man! -- back to the wage slaves who might be jealous of Wall Street. And, cowed, they slink back into the herd of sheeple.

4. Maybe we really aren't sheeple; we just haven't reached a critical mass of fury yet. A cynicism about the big bank bailouts and the White House's kid glove treatment of Wall Street is deepening across the land, hollowing out the legitimacy of our public institutions. There actually is a lot of anger, even among those who complain nothing can be done. These people aren't marching in the streets yet, but they're getting closer to. And if politicians continue to be tone deaf to the masses, the sheeple will cast off their woolly-headed subservience and make their voices heard, in a big way.