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.

Wednesday, March 4, 2009

Madoff learned tricks from Social Security

A Ponzi scheme is a "swindle in which a quick return, made up of money from new investors, on an initial investment lures the victim into much bigger risks." Social Security collects money from almost all U.S. workers and pays out retirees more than they contributed while they were working. Your FICA taxes don't go into some special savings account. First, the proceeds pay that years benefits then the rest gets spent by the Federal government. The Social Security trust gets a government note (an IOU) for the difference. It's as if all the workers paying FICA are lending the government money until they retire. What rate of return do we get? In good times, politicians of both stripes kicked around the idea of throwing some of it in the stock market but thankfully it's just stayed in plain vanilla government bonds. You would think that today's retirees, as a group, would be getting paid out what they collectively put in plus the appreciation from investing in government debt. That's not the case. Not even close. The first benefactor of Social Security paid in $24 over 3 years. She lived to be 100 and collected nearly $23,000; kind of like winning the lottery. The problem is not everyone can win the lottery. If they say it's possible it's a Ponzi scheme. Haven't we learned that we can't promise to pay out more than we take in? Isn't that one of the reasons we're so screwed? That's what we're doing with Social Security. We promise retirees a monthly benefit based on what they made while they were contributing. It's calculated by considering the average wage while they worked and inflation and has two brackets that makes it progressive. Sounds pretty reasonable but each retiree, on average, gets the equivalent of a $55,000 check on their 65th birthday. That adds up quick. This whole time we should have promised them what they put in plus interest. I'm not saying the benefits can't be paid out progressively, i.e. the lower earners get a larger share than the higher earners, just that we can't pay more than is there. Just ask Bernie Madoff, you can't keep paying the old investors a phantom return with the new investors money. You can only pay out real profits. Here's a link to a spreadsheet with raw data and the current benefits and the calculation rules to get them compared with what their payments are worth today. This doesn't even address the myriad exceptions that in every case increase benefits. Enough talk about fairness and preserving the economy for our children. The facts are retirees did not pay in as much as they're taking out and that can't continue indefinitely no matter what the AARP says.

Our Eyes are still closed

It took a lot of people keeping their eyes closed for a long time to get to today. It's not like we could go back in time T2 style and kidnap the Quant who came up with VaR and make everything alright. The market demanded something like it and it was supplied. The trading firms wanted a brainiac to give them peace of mind. It's natural to want to feel secure even if you're not. Money managers seek out the appearance of security all the time. The suckers who got burned by LTCM in '98 felt secure because they invested with a bunch of Nobel laureates (beware Nobel winners with can't lose ideas); Bernie Madoff played on his resume, religion, and aura of exclusiveness to convince investors that he was "T bill safe"; and IAG sold bogus security to banks by the billions. It seems to me we should be able to recover some of the losses from the Madoff (where does $50 billion go?), IAG, Lehman, Countrywide, et al debacles by going after bonuses paid on earnings that didn't really exist. Restate the financials and the bonuses disappear. What's really worrisome going forward is that we're all involved in a huge Ponzi scheme but we won't talk about it. It's just too upsetting to face the facts that Social Security, or any defined benefit pension plan, is unsustainable.

Sunday, March 1, 2009

Value at Risk- Thank you Quants

Greed was the driving force behind the credit collapse but Greed couldn't have done much without a whole Batman's utility belt full of tools. One of the best was the Value at Risk model. VaR was developed at J.P. Morgan in the mid 90's to meet a demand by portfolio managers. More and more banks were deeper into trading and more and more trading involved hard to price derivitives (it didn't help that another quants invention, Black-Scholes, was being used to price these). VaR puts a dollar amount on the risk of any portfolio, no matter how hard to price. As it turns out that dollar amount is as useful as Rain Man's estimates on what things cost. (remember- "about a $100") It became industry norm to quote the 1% VaR number which is supposed to be the most a portfolio can lose 99% of the time. Compensation became tied to this number. As a trader or portfolio manager you aimed to have high profit numbers relative to your VaR. In theory this compared the risk you were taking to the profits you were making. The problem was the system was easily gamed. If a trade (a bet really) has very little likelihood of losing money but has a less than 1% chance of exploding in your face then it shows up as 0 risk on 1% VaR. It didn't take long for traders looking to make big bonuses to figure this out and start getting short wings in trader parlance. Those wings became cheap-- way cheaper than they would have been if VaR did not exist. If something went wrong they would quickly increase in price as one short after another tried to cover his position. Guess what? Something went wrong.

What got us here?

Citing greed as the reason our economy blew up is like blaming gravity when you fall off a ladder. It's true but it's not going away so to avoid another fall you should figure out why you lost your balance. In the world economic crisis' case, we basically had a bad base for our ladder, slippery shoes, a windy day, and a drunk helper holding the ladder. It wasn't a matter of if we were going to fall but when, how far, and how much it would hurt when we hit the ground.

Every politician, every Wall Street exec, every Fed economist and almost every journalist has an axe to grind when describing what caused this disaster. There are a lot of asses to cover. The politicians in D.C. grill the executives and blame their greed as the cause but that's to keep the journalists busy so they don't look at why that greed wasn't regulated. The Wall Streeters have been beaten up so bad that they're silent now but not so long ago they blamed the short sellers and the press for their woes. I remember Angelo Mozillo saying on CNBC that Countrywide's mortgages were as sound as ever and the stock would rebound; meanwhile he was selling as many shares as he could. The current and former Fed geniuses won't admit to much blame lest they get thrown off the Fed-Goldman-PIMCO-Administration-Ivy League President merry-go-round that keeps them fat in both financial and reputation capital. CNBC acted as a financial cheerleader for years, an apologist for Wall Street for a few months before regressing to televised talk radio since the inauguration. They are to Jamie Dimon what Katic Couric is to Barrack Obama. Did our free press fail us at all? The problems at AIG, the time-bomb models used to measure risk, the compensation programs that lead to risking the whole firm for one group's bonus pool, regulators set up to look the other way, lenders pressured to approve more and more questionable loans-- these tools of destruction, and others, went uncovered until it was too late. Let's figure out what got us here and what we can do differently going forward.