Monday, 24 November 2008

The View Through the Bushian Looking Glass

GM got a stern dressing down when it showed up in Washington with Detroit's other suffering automakers, hat in hand, seeking a bailout. Would you rescue an outfit with these characteristics:

The company is on shaky financial footing, perhaps insolvent. It is guilty of overpaying workers (blue-collar employees got generous union contracts that provided unsustainable benefits). Its core business suffered from stunningly bad decisions (not developing enough good high-mileage or green vehicles, for example, leaving the company with unpopular products it has trouble selling).

The verdict: Let it perish! But what about the following supplicant:

The company is on shaky financial footing, perhaps insolvent. It is guilty of overpaying workers (white-collar executives got outrageous bonuses and salaries that didn't reflect the long-term viability of the operations they oversaw). Its core business suffered from stunningly bad decisions (taking on too much leverage and acquiring risky, complex securities, leaving the company with unpopular products it has trouble selling).

The verdict: Save it at any cost!

Of course this second example is Citigroup. The financial giant not only received a bailout, but the terms were astonishingly generous. First Citigroup gets a $20 billion loan. Then the federal government agrees to backstop its losses on $306 billion of potentially crappy mortgage-backed securities. That's billion with a “b.” Worst-case scenario, taxpayers would be on the hook for roughly $250 billion on the backstop provision alone. That's more than ten times how much the embattled Big Three automakers sought to borrow, only to be rebuffed.

To be clear: GM shouldn't get a rescue package, not without a tough shakedown. But what about Citigroup? I know it's large. I know letting it fail would be akin to letting die the guy in the science-fiction film whose body is teeming with highly virulent viruses that, if he expires, will explode into the air and perhaps wipe out civilization.

But can’t the Bush team knuckle down and drive a hard bargain with at least one of these financial companies, especially since they’re bargaining from a position of weakness? It’s really baffling.

Monday, 17 November 2008

The Consequences of Efficiency (in practice)

Back in September I wrote about the flip side of “efficiency” in capital markets, singling out sec lending as a culprit.

Last month, A.I.G. asked for additional $38 billion in financing on top of the $85 billion it has already received, raising questions, according to the New York Times, “about how a company claiming to be solvent in September could have developed such a big hole by October.”

Here is a crucial part of the answer:
While about $7 billion of its quarterly losses … were connected with the insurance coverage ... a bigger share of the losses, about $18 billion, were incurred because the assets in A.I.G.’s investment portfolio had fallen in value. Of that total amount, losses of a little less than $12 billion were on investments made under A.I.G.’s securities lending program.
To understand what is taking place in the financial markets, on top of the theory, one must also know the nitty-gritty of the ways money is made. Only then theory could be deployed to connect the dots. Theorizing alone would not do.

Saturday, 15 November 2008

Give Me a Lever Long Enough and I'll Buy the World

When the definitive history of this financial crisis is written, the role of leverage should get a hard look. In the ailing credit markets, leverage turned what should have been chest pains into a full-blown heart attack. The “seize up" metaphor became especially apt.

Those following the storyline closely will know that leverage at Wall Street investment banks soared from levels of 12-1 to 30-1 in about four years. But what does that mean? To the average guy on Main Street, leverage is a rather abstract, foreign concept. However it's critical to grasp the destabilizing power of leverage to understand the mess we're in.

The standard definition of leverage compares money borrowed to equity. So if you take out a $3 million loan and your only equity is a $300,000 house, you’re leveraged at 10-1. But there's another way to look at this idea that illustrates the vulnerability created.

Let's say you buy a stock option (that financial engineers have dreamed up) that behaves this way: it costs $3.33 and captures the return on a $100 share of stock. That's leverage at 30-1. The upside is wonderfully lucrative. If that stock gains a bit more than 3 percent, you double your investment. Beautiful, you may be thinking. The only problem is that when it drops the same amount, you find yourself wiped out. So leverage magnifies risk.

Dizzying amounts of leverage contributed to the demise of Long Term Capital Management in 1998. When it began to implode, the firm had $4.9 billion of capital supporting a towering, Seussian edifice of $1.25 trillion of positions not reflected on its balance sheet. LTCM effectively had no cushion to fall back on when setbacks in the market began eating up its capital.

When LTCM began crumbling, the Federal Reserve had to intervene to ensure an orderly dismantling of the company. LTCM had become too big to let it simply collapse. Sound familiar? One takeaway lesson should have been that financial regulators need to closely monitor levels of leverage in the system. But somehow we lost sight of that.

Tuesday, 11 November 2008

Lehman On My Mind

Speaking of politics, those who track polls say that McCain’s fate was sealed on Friday, October 10. That is the day the Dow Jones opened 750 points down and McCain said that the U.S. economy was fundamentally sound. Almost immediately, his poll numbers which had been consistently close to Obama’s, sank and never recovered.

If so, blame the Lehman bankruptcy for at least contributing to McCain’s loss, with all the implications that follow. October 10, you recall, was the settlement date for the credit default swaps on Lehman. The dreadful opening of the markets in the U.S. was in anticipation of multi-billion dollar losses by Lehman CDS writers that was estimated to be in the order of $400 billion. It turned out that, thanks to netting, the ultimate payable amount was less than $6 billion. On that news, the Dow Jones recovered, but not McCain’s poll ratings.

The Lehman bankruptcy established a high water mark for the dislocated rates and prices and, in that regard, has become a de facto reference point for the crisis. All market rates and indices have a pre-Lehman and post-Lehman level, with the latter being drastically, at times almost unbelievably, different from the former. The Baltic Dry Index, for example, that measure the cost of shipping goods (as opposed to liquids such as oil and gas) dropped 76% in one month, from about 5,000 to 1150 post-Lehman.

I was away on the week of September 15, with little access to markets. Still, I wrote that Lehman bankruptcy would be an event to remember. I focused on the inability of the Fed to take action because it had reached the limit of its authority, something that Treasury secretary Paulson confirmed and emphasized in a recent interview. But there is more twist to the story. There always is

Why was Lehman allowed to fail? And under what general heading should we classify/archive the event?

I have a few thoughts on the subject. In coming weeks, I will share them with you.

Thursday, 6 November 2008

Wall Street’s Deafening Silence

Throughout the long dark days of this financial crisis, one thing that has struck me is the silence of Wall Street’s public relations machines. I keep waiting for one bank, any bank, to give us their best-spin version of what went wrong, or why they aren’t as bad as all those others – or to say something. Surely they must see how vilified they have become. Shareholder activist Nell Minow even quipped that the Street is one bonus away from having the villagers descend with torches.

But when “60 Minutes” did its exposé on the financial crisis early on, none of the major Wall Street banks would comment, apparently in any form. None of them even sent what I call the “coward’s note” – that carefully crafted defense/statement that is read on air at the end of the broadcast segment. Later, when the bank CEOs went to Washington to sign off on billion-dollar bailouts, they left the meeting with Treasury Secretary Paulson and fled to their limousines. They adroitly dodged the press corps waiting outside. None of them did so much as issue a short statement of thanks or say that the money would help them extend more loans to unfreeze the credit markets.

How to explain this total silence? Partly it may stem from a “duck and cover your ass” mentality: anyone who raises his head to defend himself at this unsettled time may just draw more incoming fire. Also the more you say, the more ammunition you supply prosecutors and lawyers busy cobbling together investigations and lawsuits related to the financial meltdown. But the biggest reason may be simply that Wall Street’s largest banks realize how badly they screwed up.

When you think you’re an innocent man, you want to shout your message to the world. When you think you’re innocent to some degree, you seek ways to disseminate your version of events. When you think you’re guilty as hell, you shut up and pray for an earthquake or something that will bump news of your misdeeds off the front page.

Tuesday, 4 November 2008

Election Night Musings on Why We Fail to “Get It”

Vols. 1 and 2 of Speculative Capital were published by the Financial Times in 1999. Vol. 1 came out in March and was FT’s “Book of the Month”. It got a respectable review and relatively strong sales which increased over time.

Vol. 2 followed in June and, as far the options discovery was concerned, was an instant dud. No one reacted to it.

The silence surprised me. There were large and active equity, fixed income, commodities and FX markets with tens of thousands of users and traders. Option valuation was, and remains, a mandatory subject in all business school programs. Surely the proof that options were not what everyone had thought they were had to be newsworthy.

After a few months, the comments began to trickle in and they were uniformly critical. The 100-plus page proof, that an option is not a right to buy or sell but a right to default, somehow had failed to make its mark; even a few who praised it had not understood it. There was, furthermore, this weird reciprocity, as I did not understand what the critics were saying. “What do you mean by right to default?”, “Where is the default?”, “Who defaults in an option?”, the readers were asking, and I thought I had answered these questions clearly and unequivocally. So the disconnect was real. It certainly went beyond careless reading of the text.

It is said that authors are always complicit in misunderstandings of their work. With that in mind, I began the work on The Enigma of Options in late 2000. I resolved to answer all the questions from the “ground up” and explain the default aspect of options to everyone’s satisfaction. The “old” Vol. 3 which I had planned as the final volume of the Speculative Capital on systemic risk had to wait.

The Enigma of Options was published in 2004. In terms of sales, it did marginally better than its predecessor, but the baffling comments about the impossibility of options being a right to default still kept coming in. One reviewer for a hedge fund newsletter said the whole theory was wrong because it was as a Marxist interpretation of option valuation. You can read an abbreviated version of it here that was posted on the Amazon site for the Enigma.

One property of dialectics is intelligibility. The method must explain not only itself but the alternative views as well. The Enigma of Options follows the dialectical method. It shows how the standard option valuation is incorrect. It also shows why it is incorrect and how and why the model’s authors went astray.

I wondered why a plain-for-everyone-to-see mathematical argument appears as Marxist interpretation. Then noticed that I had given the answer in the Enigma, when I wrote that “the inability to take the next logical step – at times almost willful, as if one were afraid of consequences – demands an explanation”.

Our critic reads the Enigma and realizes that it is like nothing he has read or heard before – in style, argument and most important of all, in the progression of though from one point to the next. He looks around. He is surrounded by family members, friends, neighbors, strangers, enemies, none of whom talk or write in that particular way. The critic knows as surely as night follows day that he is an all American man, living in America and surrounded by the Americans (friends, family members, strangers, enemies). So if what he is reading is like nothing he has ever read or heard, it follows that the text must have come from some Other. What could the Other be? Islamic/terrorist is one possibility, but those folks do not write about options. The only other Other are Marxists, as our critic vaguely “knows” that Marx had something to do with economics – in the same vain that he knows Jesus was a good man. So he concludes accordingly.

That is the reason behind Palin and McCain’s reference to “real America” and “real Americans”. Prior to the publication of Speculative Capital, I, too, would have dismissed them as demagogues and hate mongers. But what they say is what they genuinely believe. They and their supporters listen to Obama and his supporters and immediately know that that is not how their families, friends and enemies talk. They know they are real, true, Americans. That makes anyone not speaking the same way not American – pardon the double negative, but you know what I mean. In all events, the feelings and beliefs are genuine.

But what about a character like Greenspan? How is it that he is “accepted” despite big words and a seemingly impenetrable argot?

The answer is that listeners know what he says is drivel. They like to hear big words from his mouth, a weakness that Mencken noticed more than seventy years ago. But they like them precisely because they know that the words are harmless.

The problem with the The Enigma of Options is that when our critic reads it, he can follow it. More, he understands it. And therein lies the question, the dilemma: how and whether to accept something logical even thought it negates our beliefs, our standing, our achievements? That dialectical question is the very essence of ethics and morality.