Wednesday, March 24, 2010

The Big Short

Micheal Lewis' "Big Short" is out and, as expected, it's a great read. He tells the story of a few traders that saw the insanity of the mortgage bond and CDO markets. Here's a short synopsis before I get to my point, but this book should be mandatory reading for every American, so I don't want to give away too much.
Around 2005, a one-eyed social misfit managing a fund out of Cupertino starts examining the details of mortgage bond issues down to the nitty gritty. He finds that the credit worthiness of the homeowners is so poor in some of these bonds that many of them are certain to default when the 2 year teaser rate expires. He wants to get short so he helps Wall Street adapt credit default swaps, formerly used only on corporate debt, to mortgage backed securities. Some others eventually place the same bet and, of course, they all score when the CMBS market begins to implode in the summer of '07.
Now, to my point. There has been nothing done and nothing is proposed that will stop this from happening again. A lot of people want to ban derivatives. Some want to separate the trading operations from the banking operations. Others think compensation limits will work. None of these will work because loop holes will continue to exist. The disaster occurred because the market was not transparent. Asymetries of information allowed Goldman Sachs to sell a product to one customer for 20 times what it was paying to another customer. That's good for Goldman but bad for their customer and bad for us when we have to bail that customer out. It sucks that Goldman and others (but especially Goldman) have tried to replace brokerage revenues that disappeared from that great information equalizer, the internet, with "trading" profits made from customers intentionally kept in the dark. That's not really trading, it's stealing. In the Chicago exchanges, a meeting of the minds is required for a trade to take place. The market participants don't all have the same information but they do know what prices are trading. The same thing can't trade for 12 cents and $2.50 at the same time, no matter how it's packaged. In negotiating financial reform, Wall Street is extremely focused and financially incentivized to fight efforts at greater transparency and price discovery as opposed to the American taxpayer whose financial incentive, while as great or greater as a whole, is dispersed among millions. Congress needs regulations that moves Wall Street derivative trading onto exchanges. The self regulation from the International Swaps and Derivatives Association is a joke. They don't require margin. They don't settle instruments daily based on quoted, tradable prices. They don't provide common clearing which eliminates third party credit risk and they don't publish intraday prices that lead to market transparency. Any one of these measures would have prevented the growth of CDO's and the CDS' written on them. We probably still would have had a real estate correction but the leverage created by Wall Street would have been much smaller and backed by sufficient capital.

Wednesday, December 9, 2009

Pelosi Math

The proponents of the transaction tax claim it will raise $150 billion dollars based on their math. Of course, if their proposal could be retroactively applied, the firm of Sullivan Crouth Trading, a proverbial "flea on the elephants ass" of U.S. trading, would owe the Feds $125 billion for the last 10 years. Wait a second while I get my checkbook-- I usually sign the checks on the dashboard. I think that makes three things clear; the proposal is absolutely ridiculous, the politicians who back it are either brain dead or liars, and Pelosi and that guy from Oregon could not care less about creating jobs.

Thursday, December 3, 2009

The .25% Transaction Tax (or Let's Create Jobs by Chasing 50,000 Great Ones Away))

Surprise! Nancy Pelosi has convinced Tim Geithner that ending the U.S. co-leadership in financial markets is good for the economy. In a related story, Geithner is looking for someone to remove his horse's decapitated head from his bed. I don't think this bill will ever see the committee but the idea of it is so offensive to anyone who thinks actions have consequences that I have to call the hacks in Congress out. Financial markets require liquidity. Of course this tax would chase liquidity providers (like me and 4,500 other Chicagoans) overseas (or more accurately, the jobs would go overseas. We'd still be here.), but it also would tax long term investors. An investor is going to be less likely to invest in the U.S. knowing that the secondary market is less liquid. This affects every American. The tax would not raise the revenues Pelosi claims, as trading volumes would fall drastically,but more importantly, what right does she have to shut down a legal industry? Our government is for the people by the people. When it turns its power against the people, as it has done more and more frequently for the last 9 years, it loses it's legitimacy. The backers of this tax have more or less said it's purpose is to get back some of the bailout funds given to Wall Street but that begs 2 questions: Why did you, Congress, approve the bailout of Wall Street when the majority of Americans opposed it? (if they hadn't given them our money they wouldn't have to take it back) and second, Is Congress so clueless that they don't realize this is a tax on the American people and it may make Goldman et al more profitable by eliminating their less deep pocketed competition? When smaller market making operations disappear, with some moving offshore, Goldman and friends wider markets for securities will not have the competition that leads to efficient price discovery that benefits the American investor and, indirectly, the American pensioner. I'm at a loss.
The Nobel Prize winning New Keynesian, cheerleader of government intervention, Paul Krugman, wrote in 2002, "To fight this recession, the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble." ... WTF! What kind of an economist thinks it's a good idea for the Fed Chairman to create any kind of financial bubble? And why isn't he now telling the real story of how the bubble was created? Human frailties such as greed were really just symptoms, or maybe manifestations, of the disease. The disease was easy monetary policy by the Fed that fueled malinvestment in real estate. Furthermore, when an inhouse economist from a firm that stands to make hundreds of millions from said bubble calls for one, most journalists would be skeptical. Paul Krugman is not most journalists. This man just doesn't get it. If you subsidize something you will get too much of it. That means less investment will go to other areas. Now he calls for massive government intervention in health care and job creations. What will that do? Well, I don't have any Nobels laying around but I think we can expect health care to inflate more rapidly than it would otherwise and we'll see businesses encouraged to invest in labor at the expense of R&D. Since R&D expenditures correlate positively with increased production and productivity determines wages, the American worker should expect to be poorer. So as Krugman ramps up his cheerleading for another stimulus package from the Benevolent One, I'd like to say on behalf of the American worker, Thank you.

Monday, November 23, 2009

A Case Study of Government Interference in the Housing Market

Congress, the Fed, and both the Bush and Obama administrations all blamed the housing bubble and accompanying financial meltdown on failings in the free market and have called for more regulations and expanded lending facilities for the Fed to control the money supply. Is there any truth to the claim that it was a failing of capitalism? Was the mispricing of real estate really a free market caught in a frenzy, like the dot com bubble or the original tulip mania? The facts don't support that claim.
After the dot com bubble burst, money managers were sitting on loads of cash, looking for returns. Meanwhile, the Greenspan Fed kept interest rates artificially low for an extended period. With the low cost of capital, investments were made that would not have been if rates were higher. That's what happens when money is cheap. When it's market priced, investments compete with each other for capital. The winners get funding. In commercial real estate it worked this way. 1)Fund eyes property, say a downtown mixed use skyscraper, calculates expected returns based on projected rents and compares with cost of capital. The deal looks good. 2)They obtain financing from, say, J.P. Morgan. JPM makes money on the transaction... and wants to do it again and again so 3) they arrange to sell the debt obligation, freeing them to lend the same money again. 4) Rinse and repeat. They're allowed to do this because they've convinced regulators that if the loan is sold, it should not adversely affect capital requirements. Of course the buyer of the debt obligation only puts a fraction down with JPM financing the rest... for a fee, of course. As more money poored into commercial r.e., prices increased significantly relative to rents. That's inflation. This poor government regulation and monetary policy was going to lead to a bubble but at least it's damage would be contained to professionals. NOT. The private housing sector had another blender in the bowl to really whip up prices. The quasi governmental entity FNMA (Fannie) became the number 1 purchaser of mortgages in the secondary market. Lenders like Countrywide and WaMu were able to write many more mortgages than they would have without government interference in the market. They made bad mortgages and sold them to Fannie. The government also lowered loan requirements and forced banks to make loans in poorer neighborhoods. Housing prices shot up. Economically responsible people were either priced out of the market or compromised their principles and joined the game. The point is, these well intentioned progressive programs were essential to the bubble and did tremendous damage to the American poor and middle class in the long run. It wasn't Dems or Reps alone that did this. Neither one has made any effort to constrain the federal government's growth and influence in markets. When the federal government subsidizes an industry or behavior, capital flows into that industry leading to bad investments and inflation. The solution to the ensuing disaster is more government interference, currently socialism for the rich bankers at the expense of the rest of the country. If market forces had been allowed to determine the price of money (interest rates) instead of by Fed fiat, we would not have had the housing bubble and we would not be in recession.

Wednesday, April 1, 2009

Goldman Sachs Projected to Have Every Dollar by 2016

Treasury's solution to the gridlock caused by deregulation of the giant financial companies is to let the giant financial companies write the new rules. The Obama Administration met with the CEOs of the biggest banks and brokerage houses (Goldman Sachs and his best buddies) to come up with a plan to create a fluid market for the CDOs that are weighing down our banks' balance sheets. Conveniently for the biggest brokerage houses, the way to get that deep, transparent market is to have Goldman and 3 or 4 other thieves make the market for those assets. We were told that private money would have a chance to trade this boondoggle. That's true as long as you already have at least $10 BILLION worth of shitty CDOs already on your books. Otherwise, you can find someone who does to manage your money for the low, low rate of 2% plus 20% of the profits. Of course, there are only a handful of firms that meet this counter-intuitive requirement of being qualified to appraise what is shit because they are knee deep in shit. Surprise! One of those is Goldman Sachs. Even the WSJ is pissed off about it. I personally know of at least 2 qualified traders/ assayers-of-risk who were beating the drums to create a fund to trade these distressed assets. Having thousands of these funds participating would guarantee that the taxpayer get the best price possible. Unfortunately, they haven't proven they're qualified by blowing up the planet's banking system. Instead, we'll just have to trust G.S. and friends not to collude. To quote Merryl Streep as that nun, "I have doubt, so much doubt."

Friday, March 6, 2009

Don't just "Change"; "Adapt"

The world economy has changed but our government's regulation of it has not adapted. The world has become so interwoven that what used to be a regional issue quickly becomes an international crisis. History says WWI started because some archduke and his wife got capped in the Balkans. I'm guessing that if the shooter missed, something else would have been the catalyst. The world had become a dangerous place. After that war there were half-assed efforts to organize the international community to avoid another world war. After that didn't work and the world got a glimpse of how World War III would be fought, there was finally consensus to form a body that could help to avoid repeating history again in another 20 years (I'd say the U.N. was a 3 quarters -assed effort). That's where we are financially. The old system doesn't work and the U.S. needs to lead the way to a new, safer system. The states regulate insurance. The Feds have at least a half dozen agencies that have some regulatory responsibility. The regulated determine who regulates them through loopholes (who knew AIG was actually a thrift?) and lobbying efforts. Some avoid regulation altogether. The regulating chain is only as strong as it's weakest link, and, as it turns out, that was every link. When one financial behemoth metaphorically gets capped, the whole world economy is threatened. This is a pre WWII system getting drubbed by 21st century innovations. The solution is to take advantage of this crisis, not by cloning the French economy, but by rebuilding the parts of our economy that are outdated. We need a regulatory system that works to prevent the next crisis. Risk management does not mean coming up with a model that calculates a likelihood of a position blowing up. Effective risk management models identify the risk of blowout and prescribe a hedge to avoid it. It is possible to know absolutely that a position will not sink the whole firm, let alone the whole economy. This means lowering leverage and, therefore, paper profits. But as we've found out, those profits were never real anyway. Deferred bonuses are also a good idea, disincentivizing burying long term risk for the sake of short term paper profits. Special interest groups will fight this regulation but the taxpayers, as the insurer of last resort, have earned the right to control risks that affect the whole world. As Warren Buffett said, "derivatives are financial weapons of mass destruction." Like military w.m.d.s, they cannot be uninvented. We need a system that guarantees they never go off again.