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take advantage of this crisis, not by cloning the French economy, but by rebuilding the parts of our economy that are outdated.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.