Friday, 31 July 2009

AIG: New Sources of Possible Rot

Okay, we all knew AIG's financial products division was a rogue, out-of-control actor that ended up bringing the giant to its knees. But at least, in the heart of the insurer's operations, everything was just splendid, solid as a rock.

Oops. Make that a sand hill.

The New York Times says:
State regulatory filings ... show that A.I.G.’s individual insurance companies have been doing an unusual volume of business with each other for many years — investing in each other’s stocks; borrowing from each other’s investment portfolios; and guaranteeing each other’s insurance policies, even when they have lacked the means to make good. Insurance examiners working for the states have occasionally flagged these activities, to little effect.
More ominously, many of A.I.G.’s insurance companies have reduced their own exposure by sending their risks to other companies, often under the same A.I.G. umbrella.

Ah, Jeez. Here we go again. Two interesting elements that emerge from this article: (1) State insurance regulators were impotently flagging concerns but couldn't get their arms around the magnitude of the problem so we might ask ... where the hell is a federal regulator for AIG? Can't we at least get one of those up and running while we're dithering on health care reform and waiting for the stimulus package to kick in all the way? (2) AIG is making cooing noises of unconcern ... where have we heard that before? Oh yeah: a certain employee, a Joe Cassano, said that the chances of his financial products division losing even a nickel were practically zero. Guess how that turned out?

So who owns this mega-turd called AIG? Umm, that would be ... the ... U.S. taxpayer! Wow. We really are suckers. This is the metaphor I keep thinking of for the U.S. government: He's a fat kid. A rich kid. You recognize him on the playground immediately and run over to him. Why? Because he's such a great guy? No, because change is always spilling out of his pockets. Or he's buying something ridiculous and you just can't believe it. "He paid Jim $40 for that dead cricket? He bought ten boogers off Lester for $10? I wonder what he'll give me for this dirty candy bar wrapper?"

I think Obama made a big misjudgment on this financial crisis. I think he thought he could skate through, not shake too many trees and not upset too many people, and thus be well-fortified politcally to deal with other pet issues, such as health care reform. I think he made a big mistake by not clearing the decks and taking this first year of his term just to sort out the many, many problems of this financial crisis and help sculpt a much more robust system going forward.

Wednesday, 29 July 2009

High-Frequency Trading: MUST READ!

Congrats to Mike, who is using his considerable economics training to good ends now over at the Atlantic's business blog section. He has an introduction to high-frequency trading that may be a bit of a slog for the novice, but it is a VERY IMPORTANT read for any stock market investor.

I've been watching the attention focused on high-frequency trading bloom rapidly over the last month or two -- sort of like a slow-motion explosion -- from Zero Hedge's initial ominous entries on the subject, to a New York Times piece that followed surprisingly quickly, to Mike now ... and I think this will be the next scandal in the stock markets, assuming enough people are bright enough to understand what's going on. They certainly should care.

What's happening: there is the market for the big boys with the high-powered computer algorithms, the Goldman Sachses and all ... and there is the market for the rest of us. My naked assessment so far, based on admittedly limited information: the rest of us are getting screwed. Or should I say, any little guy who trades stocks, is invested in a retirement fund that trades in and out of stocks, or has a 401(k) that's making buys and sells, is getting screwed.

It seems that ultra-fast computers can do a number of bad, manipulative things to stock prices. They can scrape a few pennies, or fractions of pennies, off lots of trades (those pennies are coming out of your, or your mutual fund's, pocket). Pretty soon we're talking real money.

But please, read what Mike has to say. He has a very smart, incisive, well-reasoned posting on this. He shreds the argument that the computers are simply providing liquidity. He also highlights the real issue, beyond the fact that we're getting ripped off: this is distorting how the market is supposed to work. Prices on stocks are supposed to move based on perceptions of the underlying value of the company, not because of smokes and mirrors and rotten ruses.

I gotta be honest. For a long time I used to preach that the smartest investment was the stock market, where you just put your money in an index fund and left it alone. No hassle! Returns were, what, ten percent on average a year? But I've really soured on the market. Stocks have performed absymally over the last 10 years. I've personally lost thousands of dollars.

Now someone might argue: Well, just stick with it. They'll bounce back. But I'm starting to smell rot in the system itself. Companies juice immediate profits to pad bonus checks. The historical returns ain't looking so hot either: what are they now, about 8 percent? Hell, you can get a good 5 percent in a safe bond fund. And now we have this high-frequency trading revelation: if the stock market didn't resemble a casino before, it sure as hell does now. And the guy next to you at the table, whether you know it or not, may have an edge at the game of chance -- at your expense.

I'm very discouraged about fairness in markets right now. I'm starting to edge toward the belief that the United States is a deeply corrupt country. I use the word "deeply" not in the sense of arrant corruption -- I don't believe that is the case. Rather, I think we have a system that is profoundly corrupt in that it appears to be democratic and free, but is increasingly controlled by special interests and powerful entities that do their worst behind the cloak of a free market ideology.

Monday, 27 July 2009

A Short Break

I want to work on Vol. 4, but they pull me back!

So, the woman who made the 911 call which led to the arrest of Skip Gates – this is the neighbor at Harvard Magazine I wrote about – is denying she is a racist on account of her color. Her lawyer – no doubt retained to negotiate a book deal or a TV appearance – says that “the fact is, she’s olive-skinned and of Portuguese descent”. That is the same as being “tobacco colored”, in the less neutral phrasing of another American of Portuguese descent. “You wouldn’t look at her and say, necessarily, ‘Oh, there’s a white woman’. You might think she was Hispanic,” says the lawyer.

Personally, whenever I see a white woman pass by, I say to myself: ‘Oh, there’s a white woman.’ I also say, ‘Oh, there’s a black woman’, when I see a black woman pass by. Until recently, I also said to myself, ‘Oh, there’s a Chinese woman’ whenever I thought I saw a Chinese woman. But sometimes I got confused or had second thoughts: ‘Oh, maybe that was not a Chinese woman. Maybe that was a Korean woman.’ So now I lump together Chinese, Korean and Japanese women, together with Malaysian, Singaporean, Thai, Filipino, Burmese and Vietnamese women and throw in Sri Lankan and even Indian women for good measure and just say to myself, ‘Oh, there’s an Asian woman.’ That is what I do in post race America when I walk down 5th Avenue.

The caller’s lawyer categorically rejected that her client ever spoke to the arresting Officer Crowley, although that is precisely what Officer Crowley has written in his report. “She went on to tell me that she observed what appeared to be two black males with backpacks on the porch of Ware Street,” his report says.

So of the two main characters involved in Gates arrest, at least one is a liar. Or all three, if you count the lawyer. Of course, this is no Rashomon. We see through these characters as if looking at a glass menagerie.

Finally, the caller’s lawyer finishes with this gem: “All she reported was behavior, not the skin color.”

MLK’s dream is coming close to realization. Blacks are judged not by the color of their skin but the nature of their activities on their front porch. Now that is not the same as the “content of their character”, but patience.

At times like these, I pity the poor souls who do not live in the U.S.; to think how much entertainment – incessant, polymorphous and free entertainment – they miss.

Now I really must get back to work.

Sunday, 26 July 2009

The Way Markets Work (in the age of speculative capital)

This past Friday, the New York Times had a front page article on “high frequency trading”. Under the heading “Stock Traders Find Speed Pays, In Milliseconds”, it said that “powerful computers, some housed next to the machines that drive marketplaces like New York Stock Exchange, enable high frequency traders to transmit millions of orders at lightning speed and, their detractors contend, reap billions at everyone else’s expense.”

The paper went on to explain how high frequency trading works. You can read the full article here. But you don’t have to. In high frequency trading, large orders by the institutional traders are shown – “flashed” – to equally large trading houses a few milliseconds before they are made public. The trading houses then exploit this information by getting ahead of the market.

Flash trades are available to anyone for a fee, in the same manner that live price quotes are available to anyone for a fee. The rest have to live with the “delayed” prices. So pompous posturing of Schumer notwithstanding, there is nothing unusual or unethical about it, certainly not with the prevailing standards in capital markets. In fact, the concept is the evolution of the “day trading” that attracted quite a following in the early 1990s.

The destruction of capital that took place in the recent crisis eliminated the possibility of creating “equivalent positions”, so speculative capital has had to return to its roots of buying and selling the same security. That is what day traders did in the early 1990s, only now the size of capital must be much larger. Gone forever are the days where a few street smart kids with $50,000 in capital and their “level II” machines could earn a living. It is this wholesale nature of the markets that creates perception of “unfairness”. The real unfairness though, lies in the fact that some folks have money, others don’t.

The Times had the good sense to focus on buying. Intercepting a sell order from an institutional investor is trickier because it might – and probably would – run afoul of rules designed to prevent short sales. But I am sure no institution that has allocated billion of dollars to trading and has placed its machines next to NYSE computers – to minimize the distance traveled by electrical signals – would contemplate any improper conduct.

High frequency trading is the “natural” way markets operate in the age of speculative capital. Whether you have a problem with it or not, I suggest you get used to it.

One Thing I Know About the Systemic Rot

If you are not familiar with Jean Luc Godard and his approach to film making, chances are that you will not “get” his movies. Godard believes that the “bourgeois society”, as he calls it, is so corrupt that no matter how serious and worthy a message may be, it will be corrupted by the fact of its transmission in, and to, a corrupt environment. (A Far Side cartoon had a group of clowns throwing pies in one another’s face and one of them saying, ‘But seriously, folks!’)

Godard’s way of fighting this condition is willfully corrupting the message, so that the extremity of the illogic would shock the audience and awaken them to what takes place around them.

I can see his point. Every one can see his point; just turn on the TV! There have been many studies about the control of media by a handful of organizations and the impact of such concentrations. A recent study on the influence of the Internet found that while blogs play an important role in the dissipation of the news, the agenda, what blogs discuss and write about, is set by the major news organizations. Viacom, Walt Disney, Bertelsmann, Time Warner, Vivendi and Murdach's News Corp decide virtually everything that you hear and read. After the agenda is thus set and the boundaries of discussion delineated, bloggers are left to yap to their heart’s content – within the already set boundaries. Yes, Godard does have a point.

But his response is nihilistic. It is the adult’s version of throwing a tantrum, which ultimately becomes a cop out. Frankly, I have no problem with the control of the news by a few. The reason for my insouciance? I know that no matter how partially and one-sidedly the agenda is set and how tightly the wording and the narrative of a text is controlled, a reader who is paying attention will always be able to see through the issues. That is because, to strip the matter into its elemental formulation, it is impossible to say something without revealing something about the objective reality outside us. That follows from the nature of words and discourse and is true even when there is a conscious effort to misrepresent. Hence Kissinger’s comment that no one could lie completely, and the philosopher’s observation that he learned politeness from the rude people. That was also the premise of the Hollywood movie The Usual Suspects .

So I comfortably, confidently and conveniently rely on the mainstream media for information. Needless to say, I do not stop there. Read, for example, the Destruction of Fannie Mae and Freddie Mac, which was 100 percent based on the mainstream media reports but showed something that no media outlet had ever mentioned – or ever will.

What, then, is my take on the main story of the past week about the arrest of Henry Louis Gates Jr. at his home by a uniformed member of the Cambridge Police Dept?

Let us set aside what we know about the role of authority, the kind of people who are drawn to it, the makeup of the police department in major cities of the U.S., the role that movies and TV cop shows play in shaping the conduct of police officers and the conditioning of citizens to accept that conduct, the right of citizens to live peacefully at their home (to the point of defending it with deadly force!), et, etc.

Why was Officer Crowley at Gates’ doorsteps?

Answer: Because someone had called reporting a possible break-in, no doubt by “two black men.” (The other man was the limo driver helping Gates to open the jammed lock.)

Q: Who was the caller?

A: A neighbor.

Q: Professor Gates’ house is Harvard property, given to Harvard employees only. Is it safe to assume that the neighbor was also a Harvard employee?

A: Yes, she was.

Q: The house given to Professor Gates must have been in an upscale neighborhood on account of his high position. Is it safe to assume that the neighbor had an equally high position? Surely, she could not have been a low ranking clerk, right?

A: No, she is not a low ranking clerk. In fact, she works at Harvard Magazine.

A neighbor who works at Harvard Magazine.

There you have it. Henry Louis Gates Jr.’s neighbor who works at Harvard Magazine – I would not be surprised if she had a PhD in social relations – does not recognize him in the broad daylight of a July afternoon. Never mind that she does not stop to say hello or chat or inquire about his trip to China, from which he had just returned after a grueling 16 hr flight. She absolutely does not recognize him. Consequently, naturally, the solid citizen that she is, she picks up the phone and reports a break-in.

That no one mentioned this point means that it was not considered worthy of mention by virtue of its ordinariness.

It is from this population that the arresting officer Crowley is recruited.

Everything you need to know about the significance of the story and the social background against which it took place is now at hand. From day one, then, you could have surmised – called, really – everything that unfolded, including the officer’s self-righteous rage for being criticized, the predictable defense of his act by police chiefs and radio talk shows, and even the President’s foray into the “controversy” and his subsequent backing off.

Had the event taken place in some Mississippi backwater town, the case would be dismissed as a stupid act of a county sheriff and the ignorance of the local populace. In short, it would have been the “bad apples” defense.

I never believed that Southern hillbillies are more ignorant than Massachusetts intellectuals. Furthermore, facts are not isolated events. What is real is rational. This problem certainly transcends locality, which is another way of saying that it is universal, i.e., system-wide.

By a long detour we have finally arrived at this blog’s main focus!

The most critical attribute of a systemic flaw – whether a systemic risk or a systemic rot – is its ordinariness which, by virtue of being ingrained within the “system”, renders it invisible to those inside the system. There is no uber regulator that can detect, much less prevent, a systemic collapse of the financial markets because the collapse is the end point of markets’ normal operations. That is a terrible fact, but that is the way things are, which is why despite constant urgings, I am not in a hurry to get out Vol. 4 to “capitalize” on the current crisis. We are merely in the beginning.

One question remains: How can one learn politeness from rude people without having a frame of reference, without knowing what is rude and what is polite? How would you detect the true part in the narrative of someone who is bent on telling complete lies?

I will take up these topics in Vols. 4 and 5 of Speculative Capital.

Tuesday, 21 July 2009

A Sad Day in Blogland

Mike, creator of the Rortybomb blog, is no longer anonymous ... on July 20, 2009, he came out, revealing his true name to be ... Percy Fraddlehapper ... no, no, his real name is actually ...

Mike. That's right. He was already halfway out of the blogger's closet of Hidden Identity anyway. His full name: Mike Konczal.

What's more, it looks like he just turned 30 and we forgot to send the virtual cake with the electronic candles. Drat. Anyway, Mike has been on a tear lately, churning out some top-notch content and raising his profile in a lot of places.

And now, like the character in the Jim Croce song, Mike can croon, "I Got a Name."

That leaves a dwindling number of us Resolutely Anonymous Bloggers. There's Cassandra does Tokyo (does anyone else get a little tired of the witty but de trop prose style?) and George Washington's Blog (now, in the great tradition of rebranding for knowing simplicity, titled just "Washington's Blog") ... and me.

Not to worry: I'm not coming out anytime soon. When you suggest that hungry and unemployed Americans fill their empty bellies by eating Goldman Sachs bankers, you really do have to stay in the shadows.

Friday, 17 July 2009

Annals of Cluelessness, Hank Paulson Edition

Is it just me or is anyone else thinking: How totally clueless was Hank Paulson?

I mean, Paulson now reveals that the Bush administration was discussing how to feed U.S. citizens in the event of a breakdown in law and order, had commerce and banking collapsed during the financial panic last fall. This, from the Independent:
Making his first appearance on Capitol Hill since leaving office, the former Treasury secretary Hank Paulson said it was important at the time not to reveal the extent of officials' concerns, for fear it would "terrify the American people and lead to an even bigger problem."
Four months before the Lehman implosion/AIG meltdown/freakout sirens started wailing, Paulson was saying this: "In my judgment, we are closer to the end of the market turmoil than the beginning." (May 16, 2008) Two months later, he's still blissfully optimistic: "It's a safe banking system, a sound banking system. Our regulators are on top of it. This is a very manageable situation." (July 20, 2008)

Okay, that last quote is from July ... a month passes ... two months ... and then everything goes tits up and suddenly he and other top Bush officials are huddled in a secret meeting room, talking about how to feed 300 million Americans once the wide-scale looting begins.

To me, that reveals a staggering degree of cluelessness. Bear Stearns craps out in mid-May, the nation is sitting on a teetering pile of dicey lending, and Paulson just blithely goes about his business, until things get really bad, and then he shifts from "What, me worry?" to "Holy s***, the sky is falling and how are we going to feed all of America when outlaws overrun the country?"

If Webster's is looking for an illustrative margin photo for the word "clueless" for their next dictionary, I've got a suggestion ...

Thursday, 16 July 2009

I Smell Something ... Anti-Goldman ... In the Air

Even Lucifer himself, endowed with powers to shake the heavens and earth, couldn't counter the amount of bad publicity that the entity some perceive to be the financial anti-Christ (and that others simply call Goldman Sachs) has been getting lately. Recently Bloomberg TV commentators were taking potshots at Wall Street's most gilded survivor of Meltdown 2008, asking a very reasonable and quite pointed question: What the hell was Goldman doing with computer programs capable of manipulating markets (which an employee allegedly stole, prompting swift FBI action)?

But wait, there's more. Sure Matt Taibbi may be prone to working himself into an overwrought state about Goldman, with his "vampire squid" and "blood funnel" metaphors, but now Janet Takolivi has an opinion piece at CNN where she blasts Goldman's bloated earnings quarter and drops in a colorful bit of imagery that we'll probably see again in days to come.
Wall Street's "financial meth labs," including Goldman's, massively pumped out bad bonds and credit derivatives that have melted down savings accounts, pension funds, the municipal bond market and the American economy.
So it's not just Taibbi who's swinging a sharp sword. If you're Goldman, you have look out on all sides ... including your backside. The Wall Street Journal, a newspaper fond of capitalism draped with muscle, adorned with sashes of gold, goes after the giant investment bank too, amazingly enough. Here's the money paragraph:
Goldman will surely deny that its risk-taking is subsidized by the taxpayer -- but then so did Fannie Mae and Freddie Mac, right up to the bitter end. An implicit government guarantee is only free until it's not, and when the bill comes due it tends to be huge. So for the moment, Goldman Sachs -- or should we say Goldie Mac? -- enjoys the best of both worlds: outsize profits for its traders and shareholders and a taxpayer backstop should anything go wrong.
Wow. Sentiment is really starting to swing, in a big way, against Goldman Sachs.

And Edward Harrison Gets It As Well

The blogger behind Credit Writedowns wrote, in a post about Wells Fargo selling distressed assets for 35 cents on the dollar (and that was twice what most hedge funds were offering!):
To me, this explains very well why the PPIP program was a failure: if banks can sell distressed assets quietly over time to private bidders, they might be able to delay taking writedowns. But, the price discovery involved in the PPIP program would be a blood bath for banks already capital-constrained. This is why the program has failed.
Yup. As I wrote on March 23, in "Five Reasons Why U.S. Banks are Secretly Terrified of Geithner's Plan":
2. Your game of vastly over-marking assets grinds to a halt.

Once your impaired bank assets are put in pools for private investors to bid upon, and real market bids result, you will be under enormous pressure to revalue huge swaths of your holdings. You can maintain that fictive price of $80 only if you keep the assets cloistered away, locked in a high tower away from judgmental eyes. Once you invite bids, you invite price discovery that, even if you reject the sale, will force you into what could be a crippling re-evaluation of how financially sound you are.

Wednesday, 15 July 2009

The New York Times Figures It Out Too

This NYT editorial pretty well sums up what I've been saying for a while about the dying quail that is Geithner's plan to buy up toxic banking assets:
The Obama administration has largely shelved, for now, its plan to finance the purchase of banks’ toxic assets, ostensibly because of the banks’ recent success in raising capital. An alternative explanation is that the banks won’t sell. Recent accounting changes make it less painful for them to keep bad assets on their books. Why admit to losses if you don’t have to?
Exactly. What I love about this bit of succinct truth-telling in the NYT is that it's not muddied by a lot of other pseudo-reasons, such as "investors don't want to partner with the government, fearful of being demonized or having the rules changed on them in midstream." Let's face it: that's just a smokescreen. If there's a big fat pile of money up for grabs in the middle of the floor, Wall Street will jump on it, damn the bad P.R. But if the banks don't offer up any assets, there is no big fat pile of money and Geithner's plan just ... dies.

Monday, 13 July 2009

On the Destruction of Capital

The European Commission’s recently issued report on member states says that “the crisis is the equivalent of capital destruction, reducing – at least for a time –the productive potential of the economy.”

Capital is a social thing. It has no equivalent any more than art or religion has equivalents. Its destruction, likewise, is a very particular phenomenon. So it is nonsense to speak of the “equivalent of capital destruction”. What we have in this crisis is the destruction of capital, period.

Why did the authors of the report insert the word equivalent where it does not belong?

The answer is that it tones down what is being said. To the delicate ears (or eyes) of bureaucrats in Brussels, “destruction” would be too strong, so their minions diluted the word the best they could.

But surely these authors must know what capital destruction is, otherwise it would be impossible to speak of something “equivalent” to it.

The truth is that they do not. They merely have an inkling about it, the way Bernanke has an inkling about systemic risk. If pushed to explain exactly how capital is destroyed or what the “system” is in systemic risk, they would have nothing to add except reguritating what they have already said.

The pussyfooting and hesitant writing is the by-product of unclarity of thought. At the same time, it works to maintain the unclarity and, in doing so, creates a going concern of ignorance.

I have written about the destruction that is going on around us. See, for example, here and here and here.

When capital is destroyed, its various forms shrink. Speculative capital is hit particularly hard because of its reliance on leverage. Arbitrage opportunities turn exoskeletal and cannot be exploited quickly – or at all. That is the story behind the closing of Meriwether’s “relative value” fund. The man is no doubt a good trader but like all traders understands nothing about the real theory of finance.

How exactly is capital destroyed? What are the mechanics and dynamics of the destruction – and its consequences?

These are the main questions tackled in Vol. 4 of Speculative Capital. If you are interested in the subject, stay tuned.

Friday, 10 July 2009

Hungry? Eat a Goldman Sachs Banker

You've lost your job. The kids are staring at you from the next room with those gaunt faces and soulful eyes. The unspoken question on their lips: after paying the utility bills and hospital expenses for Timmy's chemotherapy, can we afford to eat?

My answer: of course you can! Just stroll on down to Wall Street, find yourself a Goldman Sachs banker, get a roasting spit at Wal-Mart, squirt some lighter fluid on a bed of backyard briquets, and voila! Goldman Sachs bankers have plenty of fat on their bones -- it's hard to vouch for their nutritional value beyond that, but a nice, filling high-fat meal (the corpulent bankers might last a week and the funky leftover pieces can be turned into soup stock) can go a long way toward dispelling those recession blues.

How do I know they have fat on their bones? Check this out: the average Goldman employee is making almost $700,000 a year (and that includes the mailroom guys and the bubble-cracking receptionists, so you know the bankers are making a LOT more). So if you've been reduced to eating Saltines with a thin smear of butter, you can bet they're getting something much better, like Melba crackers slathered with sturgeon roe.

Okay, some of you are probably thinking: Wait a minute, won't Goldman protest if enough Americans take to heart this eat-a-Goldman-banker advice, thus depleting their ranks? You would think that, but Goldman has a famously civic sense of responsibility. They're so interested in helping America that they're practically running the U.S. government! Of course the company doesn't mind if you eat some of their bankers. (Just keep it within reason: I'm sure you're all aware of the concept of "overfishing;" we do need to allow time for the stock to replenish.)

Now you may be puzzled when you get to Goldman's headquarters on Broad Street, ask to see a banker, and he's relatively thin with a vulpine stare and a well-toned body. This is not one of the ones you'll want to eat! He's into his Stairmaster, Pilates, or some such. Don't leave with this guy. Get one of the soft, scrumptious, fleshy ones, and believe me, you should have plenty to choose from.

Now you're probably thinking: Hold on. Some Goldman banker isn't going to just walk out of the building with me, climb into a waiting vehicle, and let me conk him on the head. After all, they're known for being the smartest guys on Wall Street. And this is very true. So you need to have a strategy. First, you must blend in. If you're hunting deer, you don't head into the woods dressed like Disco Stu! So you need to put on a fairly sharp, well-tailored dark suit. Make a good impression on your prey.

Okay, then how do you lure a Goldman employee out of his lair? Let's take a tip from Matt Taibbi, who did a close-up study of these creatures for the latest issue of National Geographic, er, Rolling Stone. Here's what the great financial zoologist observed: "The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money."

Got that? I know it sounds scary: "vampire squid," "blood funnel." But just remember, the average Goldman banker is busily trying to smell money. He won't jam that blood funnel down your throat; your esophagus or stomach lining doesn't interest him in the least. But your money does, so keep your wallet in your pants AT ALL TIMES or this could end badly!

Once you've located a portly Goldman banker, you can take advantage of your knowledge about his feeding habits to lure him away. The Goldman culture is a bit secretive, so you should lower your head and start mumbling something like, "Synthetic CDOs ... single-name credit default swaps ... millions in profits ... my house." The "millions in profits" will probably activate and possibly engorge the blood funnel. This is a good sign! You've got the banker where you want him, thirsting for a good feed. Get him into a taxi, keep mumbling to keep him interested, get him home, and ker-pow! I don't think I need to go into a long lecture about how to prepare meat.

NOTE: For all those who are easily offended, this is meant to be satire. For all those who are cannibals, when your court date comes up, I don't know you.

Tuesday, 7 July 2009

A Curious Statement (worth pursuing further)

It was the main business news of the day that “Ex-Worker Said to Steal Goldman Code”, as the New York Times put it.

The story involved one Sergey Aleynikov, an ex-Goldman employee, who allegedly downloaded the firm’s proprietary trading software to his computer before leaving for greener pastures.

The story was jazzed up for maximum effect, with code words such as “sophisticated high-speed trading”, “a server based in Germany”, “a memory device” and, of course, “Sergey”! But it had too many holes in it and I didn’t buy it for a second. Apparently, neither did the judge, who released the said individual on a $750,000 bond.

If Sergey Aleynikov did what he is alleged to have done, he must have been a geek who learned nothing about finance while at Goldman. The superiority and, therefore, the value, of Goldman’s trading software does not come from some special insight into how markets work. It is, rather, due to the firm’s capital; Goldman could throw hundreds of millions of dollars into the market in order to create, and simultaneously profit, from an arbitrage position. The arbitrage opportunities are available at the wholesale level only. There is no opportunity in these markets for poverty-stricken geniuses. Fools with money will trump them every time.

What grabbed my attention, though, was the argument of the assistant United States attorney handling the case who told the federal judge that “Mr Aleynikov’s supposed theft posed a risk to United States financial markets”. He went on to add that “the bank” – that would be Goldman – “raised the possibility that there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways.”

That is a very curious statement. Now, if I were a systemic risk regulator, of the kind the Federal Reserve is soon to become under Obama administration’s proposals, I would approach Goldman and insist on getting answers to the following questions:

1. How and in what way could this program pose a danger to the U.S. financial markets?

2. How and when did you become aware of this potential danger of the program – at the planning stage, after it was coded, after it was put into use?

3. When and what were the circumstances in which you became aware of the potential danger of the software to the financial system?

4. What actions were taken after the potential danger to the financial markets was discovered? Who was the highest ranking officer to be informed of the potential threat?

5. What department was responsible for developing the program?

6. What department is responsible for maintaining the program?

7. Who wrote the technical specifications (the “specs”) for the program?

8. How long has the program been in use?

9. Who has used the program since it was put in production?

10. Is there a flag in the program that alerts the user to a “red line” beyond which the normal use would turn into a danger to the financial systems?

11. If Yes, explain how. What would happen if the red flag were ignored?

12. If No, how would the user know that he/she was crossing a red line?

13. Provide a detailed history of how Goldman used the program since it was installed.

14. Provide a detailed “what if” scenario of how someone bent on harming financial markets would have used the program since it was installed.

These are questions I would ask Goldman if I were a systemic risk regulator.

Monday, 6 July 2009

A Rather Egregious Case of Confusing Cause and Effect

You have heard all the talk about correlation not being causation. About the perils of research: researchers finding what they (unconsciously) planted in the evidence; about being factually accurate about the observations and yet totally wrong on the conclusion; about the epistemology of science. Etc.

All those abstract issues were beautifully rendered in a real life and easily comprehensible example thanks to the research of Professor Mark Garmaise of UCLA’s business school. The Financial Times reported the results of the professor’s iconoclastic research in which he showed that “before crisis, US mortgage brokers fed loans of deteriorating quality to the banks they did most business with.” This, the professor concluded, proved that brokers abused the trust of the banks and in doing so, planted the seeds of the crisis which, everyone remembers, began in the subprime mortgage area:
”At the beginning of a relationship, the bank’s natural intuition is to avoid fly-by-night brokers they barely know,” said Professor Garmaise, who likened bank-broker dynamics to a marriage. “The broker knows this, so they are on their best behavior, but over time the broker gains credibility and each additional mortgage matters less.”

Such breached of trust accounted for a staggering 22 per cent of late mortgage payments and 28 per cent of foreclosures in the nearly five years covered by the study.
That brokers initiated progressively lower quality mortgages is a matter of record. Very little by way of research is needed to confirm this well-documented race to the bottom. But just about everything else in the research is wrong. Far from being hapless victims, banks were the instigators of the problem. They pressured the brokers to keep the mortgage supply chain going no matter what the quality.

In the two-part series on the destruction of Fannie Mae and Freddie Mac I documented this pressure and explained the reasons for it. In Part 2, I quoted the following telling passage from a New York Times story:
[William D. Dallas, the founder of a mortgage brokerage] recalls being asked to make more “stated income” loans, in which lender do not verify the information provided by borrowers and brokers with tax returns, pay stubs or other documentations. The message, he said, was simple: You are leaving money on the table – do more of them.
Rewriting history is a favorite sport among the powerful who stand exposed by the light of the past. (A Soviet era politician once quipped that “nothing is more unpredictable than the past.”)

That is where the role of true scholarship, i.e., disinterested scholarship, comes in: to filter the noise injected into past events by the self-serving spin of interested parties.

But there are no disinterested scholars in the U.S. universities. A finance professor in a major business school simply cannot function without constantly bringing in grant money. And when you take the king’s shilling, you play his tune. More: you dance to his tune.

This is the academic cadre that is expected to find a way out of the crisis.

Saturday, 4 July 2009

Always Taking the Path of Least Resistance

That could be the motto of Washington for its interventions into the financial markets. If you can either (a) Solve a crisis by directly confronting insolvent banks and taking measures that will cause some short-term pain but ensure a better future or (b) Roll the currency printing presses all night and flood the system with money and hope that that eventually works, over say five years or a decade or whatever ...

What do you do? (b) of course. (b) doesn't rile up the banking lobby, get any Congressional noses out of joint, threaten to anger any populist groups. (b) isn't leadership either, but leadership is a quaint notion these days. Let's face it: it's not that America is pain-averse. It's worse: we're discomfort-averse.

So, continuing our multiple choice test, if you can either try to resolve the housing foreclosure problem by either (a) Knuckling down on the banks and persuading them (through legislation, if need be) to renegotiate mortgages so that both the homeowner and the bank take a hit, but at least the homeowner has an incentive to start paying the bill again or (b) Flood the system with cheap money and hope the problem goes away ...

What do you do? (b) of course. It's the path of least resistance.

But now comes evidence that this approach, while convenient and non-controversial, unfortunately has a little drawback: it doesn't work. Check out this commentary by economics professor Stan Liebowitz in the WSJ:
What is really behind the mushrooming rate of mortgage foreclosures since 2007? The evidence from a huge national database containing millions of individual loans strongly suggests that the single most important factor is whether the homeowner has negative equity in a house -- that is, the balance of the mortgage is greater than the value of the house. This means that most government policies being discussed to remedy woes in the housing market are misdirected.

More specifically:
The Obama administration's "Making Homes Affordable" plan focuses on having the government help lower obligation ratios (the share of income devoted to house payments) down to 31% from levels somewhat above 38%. But my analysis finds that mortgages having such obligation ratios at closing did not later experience high foreclosure rates. This suggests that reducing these ratios is not likely to significantly improve the foreclosure problem.

So here's what this means, and it's very common sensical: Your biggest asset is a house. You're paying on it for another 10, 20 years. If you owe say $200,000 on it, but it's worth $250,000, you'll want to keep paying off your mortgage. But if you owe $250,000 and it's worth $200,000, you're more likely to say, "Bleh. I'm staring at a $50,000 loss. Sayonara house."

It's abundantly obvious what should be done. Washington needs to find a way to facilitate the renegotiation of mortgages for homeowners who are underwater. Or, of course, it can take the path of least resistance: throw a few trillion at the problem and hope it goes away.


Friday, 3 July 2009

Isn't Revisionism Fun? The Geithner Plan Revisited

The New Republic's Noam Scheiber catches up with a "Deep Throat" from the Treasury Department as the Geithner plan, or PPIP, begins to spiral downwards faster, heading toward a near-certain death. You'll see a flurry of reasons tossed about for its demise, but if you get right down to brass tacks, there's only one that really matters: the banks don't want to play. They don't want to accept low auction prices for their bad assets. They want to pretend those holdings are worth more, for as long as possible, and postpone the day of financial reckoning.

As we all know, success has many fathers, but failure is an orphan. So does that mean the Geithner plan, which would have paired public and private investment to buy toxic assets, is an about-to-be orphaned failure? Au contraire, Mr. Nameless Insider insists:
If you had asked--I don’t want to speak for the secretary--what’s problem number one? I think he (Geithner) would say capital. Problem two? Capital. Problem three? Capital. Everything was in the service of that view. The legacy loans program was meant to help clean balance sheets. It was not an independent good in itself. It was seen as friendly to equity raising. Now people say the legacy loans thing is not gaining as much traction, so is that a failure? But because we had a good outcome in terms of raising equity, they [the banks] were able to raise equity without shedding assets ... you should be okay with that.
Ah. So PPIP was really all about the ability of banks to raise capital, and now that they seem to have solved that on their own, PPIP becomes expendable. Hmmm. Very interesting. But it does leave some unanswered questions.

1. If PPIP was all about (1) capital, (2) capital and (3) capital, why wasn't it sold to us that way?

Here's the Treasury Department's own summary paragraph on the Geithner plan from March 23:
Despite these efforts, the financial system is still working against economic recovery. One major reason is the problem of "legacy assets" – both real estate loans held directly on the books of banks ("legacy loans") and securities backed by loan portfolios ("legacy securities"). These assets create uncertainty around the balance sheets of these financial institutions, compromising their ability to raise capital and their willingness to increase lending.
Okay, Treasury does mention capital, but it also mentions lending, and look at the larger context. These assets create uncertainty around the balance sheets. And that has changed how? The assets are still creating unwanted uncertainty around balance sheets. Further, the Treasury had this to add at the time about its plan:
This approach is superior to the alternatives of either hoping for banks to gradually work these assets off their books or of the government purchasing the assets directly. Simply hoping for banks to work legacy assets off over time risks prolonging a financial crisis, as in the case of the Japanese experience.
Now the Treasury wants to pretend that the pile of dreck in the back room doesn't really matter after all.

2. If PPIP assumed capital was the problem, why was it structured in such a way that assumed liquidity was the problem?

PPIP is an awfully queer way to solve a capital problem. PPIP essentially would have pumped in a lot of cheap money to give private investors enough funds to buy the banks' toxic assets. PPIP made sense in a world where liquidity is scarce and investors need a little help from their friends (the U.S. government) because of the onerous cost of borrowing on the open market.

PPIP basically bought into the bankers' mythology: They couldn't sell their impaired assets at a fair price because of tight credit; no one could get money because the lending markets had seized up. Of course this was a lie, but Treasury went ahead and diligently built a whole plan (PPIP) around the lie. Now if PPIP had worked, then Treasury and the banks would have been correct: it was just a liquidity crisis. But now that PPIP is floundering badly, instead of admitting defeat, Treasury decides it's time for revisionist theater.

3. What happens to those banks that supposedly no longer need PPIP when the government jerks away the various crutches for the financial markets?

The major banks are still sitting on tens of billions of dollars of bad "legacy" assets. They are able to raise capital, but not because they're any healthier or smarter. Consider: (1) The banks were handed billions of dollars under TARP. (2) The government has made cheap funds available to them through an alphabet soup of lending facilities. (3) The government has said none of the 19 stress-tested banks would be allowed to fail. (4) The banks were allowed to twist accounting rules to their advantage, starting in April, to enable them to look healthier even if they're not.

Is it any surprise then that they are capable of raising capital? Investments don't get much juicier than this. The government will backstop losses, while the banks keep the profits. Hey, I'd lend ten bucks to a junkie who was getting $1,000 weekly welfare checks. But what happens when the government tries to fold up the Bailout Nation Tent? Also, Mark Thoma makes an interesting point: what if investments were made in the banks on the assumption that they would be getting rid of their toxic assets when they're not? Does that constitute a federally sanctioned double cross?

A few things to ponder. I think the summer will be full of PPIP revisionism as the Geithner Team tries to make excuses for the plan's failure.