Tuesday, 30 June 2009

Pray Tell Me, Are Derivatives Good or Are They Bad?

For the past 30 odd years, derivatives have acted as the barometer of popular sentiment toward markets. In good times, they are praised as ingenious inventions that allow companies to save money in their finances. In bad times, they are scorned as the mysterious devices created to game the system. At all times, they are not understood. The level of discussion never goes beyond the derivatives-are-good/derivatives-are-bad platitudes.

This appalling insubstantiality is in full display again in the latest round of talks about the regulation of markets that, naturally, involves derivatives. In its latest research paper, the Bank of International Settlement likens markets to “pharmaceuticals” and argues that more potent drugs – that would be derivatives – should be made available only by prescription. (The analogy cannot be carried any further because that would imply that only very sick companies could use complex derivatives.) Sage of Omaha is on the record with this gem of a thought that derivatives are the “financial weapons of mass destruction”. George Soros thinks that some derivatives are good and some are bad and should be outlawed, exactly the sort of penetrating analysis one would expect from a money manager who wants to be known as an intellectual and a philosopher.

This past Friday, Floyd Norris of the New York Times picked up the subject. “In the world of derivatives, profit for dealers comes from complexity and secrecy.” After that dramatic lead sentence, he went on to assert that “even when derivatives do allow financial risks to be transferred, that is not always a good thing” because, he quoted a finance professor, derivatives in fact “shift risks from those who understand them a little to those who do not understand them at all.” Norris is among the more perceptive of the business reporters.

Speaking of those who do not understand derivatives at all, here is what I wrote in the opening paragraph of the Foreword to Vol. 2 of Speculative Capital:
Derivatives are the functional form that speculative capital assumes in the market. This form is fundamentally a bet. But like the bodies of the damned in Inferno whose deformity corresponds to the sort of sin they have committed, the particular composition of each derivative corresponds to the sort of opportunities that speculative capital intends to exploit. Arbitrage opportunities are many and varied; hence the confusing array of derivatives and the tortuous legal documentation that must accompany each.
I then added:
The subject of risks of derivatives is a virgin territory. That is not due to the dearth of attempts to exploit it. Quite the contrary; the mountain of material on the subject has few rivals in any discipline. But the territory of concern to us is in the realm of theory and thought, into which unthinking material cannot penetrate no matter what its size.
These lines were written over a decade ago. They remain as valid now as they were then.

Meanwhile, the crisis goes on.

Tim Geithner's BIG Gamble

As the Treasury Secretary's toxic-asset plan (PPIP, for acronym lovers) sputters out, soon to wind up on the ash heap of discarded ideas to solve this financial crisis, it's worth pausing to consider what lies in the balance: nothing less than Geithner's own neck.

Consider: the Obama crew takes office in January. What are you going to do about the financial crisis, everyone demands with a hysterical edge. Amid much blaring of trumpets, Geithner promptly appears before Congress with ... no plan, just a lot of artful blather. Hmm. Not good.

But it's still early, he just hasn't had time to craft a detailed plan, and he does return to unveil a real proposal. The trick, he explains, is to remove the toxic legacy assets from the books of the banks; the mounds of crappy loans and securities are weighing them down like an anchor, forcing them into a defensive crouch and causing them to shy away from making loans.

Geithner's plan is for the government (the money) and private investors (the brains) to form partnerships to buy the bad debt. This will set market prices for assets that the banks protest they can't get a fair price for because of too little liquidity. PPIP is widely scrutinized, debated, critiqued, assailed. Meanwhile, the media forget to take a hard look at the plan's key linchpin: the banks themselves. Will they go along? The major banks are strangely silent about Geithner's proposal.

Instead, they arm-wrestle a few accounting changes, post some stunning first-quarter earnings, and then begin to insinuate they don't really need this PPIP idea. And this is Geithner's big moment. This is his gut-check moment of intestinal fortitude. He can either sharply remind the banks that, yes, we just finished bailing you out and preventing the financial sector from imploding and yes, you DO need to play ball with this plan, sorry. Or he can fold like a cheap accordion.

Of course the handwriting is on the wall: Stress tests that no bank can fail. Banks initially handed billions of dollars, no strings attached. A financial lobby that has its tentacles wiggling into every office and closet in political Washington. A history of regulators and Wall Street executives swapping desks back and forth, until you can't tell who's working for whom (or angling to work for whom, someday).

As Obama's team cries "look at the green shoots!" Geithner folds behind a wall of mumbles about how his plan may not be needed any more. Deep down, he probably knows that's untrue. But caving in to Wall Street has become a reflexive gesture for Washington's powerful. So he does.

But the big gamble is this: We're in a quiescent period right now. The stock markets aren't tanking. Worry and panic have abated. But the news still looks bad on a lot of fronts: high unemployment, sagging home prices ... and banks still holding lots and lots of impaired assets.

See the Bank of International Settlements report summed in this recent FT article:
The report was particularly scathing in its assessment of governments’ attempts to clean up their banks. “The reluctance of officials to quickly clean up the banks, many of which are now owned in large part by governments, may well delay recovery,” it said, adding that government interventions had ingrained the belief that some banks were too big or too interconnected to fail.
Geithner has chosen to lay low and pray the banks can work out their problems on their own. But if this crisis blows up again, as I predict it will, he will be in a very difficult spot. When he tries to roll out a new plan, an understandably angry public will protest, "Wait a minute. Plan number one was hold on a minute, I'm working on it. Plan number two was a public-private partnership that vanished into thin air. Why the hell should we trust you at all at this point? You either don't have the gumption to stand up to the country's banks or you don't have the perseverance to see your own plans through."

At that point, I think Geithner will probably get sacrificed. There is widespread popular anger simmering below the surface, ready to explode when things slide downward again. And they will. Banks know they have a backlog of crap on their books. You can put a TARP over a big pile of manure, but it's still there, and it's still stinking.

Monday, 29 June 2009

PPIP Deathwatch Intensifies

Ah, the WSJ is finally coming around.

Check out this June 29 story: "Wary Banks Hobble Toxic-Asset Plan."

Of course if you were reading this blog (ahem), you would have known this was coming on March 25: "5 Reasons U.S. Banks Are Secretly Terrified of Geithner's Plan."

And if you wanted a blueprint of how the banks were going to hobble the toxic-asset plan, I did explain a plausible scenario in this April 16 entry: "JPMorgan Flips Geithner the Bird."

Or, if you want to just sit around and wait for a while, the Wall Street Journal will get around to figuring all this out by the end of June (hee hee).

Upchuck Story of the Morning

GE: We're not just about lightbulbs anymore. We're also the biggest lender you never knew about.

Plug your nose. Open your mouth. Stick your finger down your throat. Think emetic thoughts. This lead from the Washington Post says it all:
General Electric, the world's largest industrial company, has quietly become the biggest beneficiary of one of the government's key rescue programs for banks.

Ugh. I've got a new sport for the 2012 Olympics: loophole diving. And I predict America will take the gold, silver and bronze.

Saturday, 27 June 2009

Matt Taibbi Goes for the Gold(man)

The Rolling Stones writer takes his usual inimitable, no-holds-barred, no-venom-spared approach to his subject, in this case Goldman Sachs, in this very provocative (and long) piece. On the fringes, Taibbi may sound a little rabid and conspiratorial-minded, but he has marshaled a very impressive body of evidence that deserves a good, long ponder.

He ties Goldman to major bubbles that go all the way back to the Great Depression. I noticed that a few comments about the article accuse him of anti-Semitism. I don't buy it -- not at all. There is undoubtedly anti-Goldman sentiment out there that really is thinly veiled anti-Semitism. But Taibbi's piece is too full of hard facts (maybe stretched a bit too far in places) to be dismissed as simply anti-Jewish frothing. Just look at the sheer number of ex-Goldmanites that Taibbi identifies in high political office. After a while he more or less gives up trying to count them all. It's rather sobering.

Read it, read it, read it. And form your own opinion. Even if you discount Taibbi by 50 percent, he's still telling a pretty scary story. What dismays me the most is that Americans aren't more furious about what has occurred in this financial crisis. There is a sort of dumb complacency that has settled over the land, like we are under the influence of a thinly scattered fairy dust that has sent us all into a kind of stupor. If you don't have a job, or you're fairly bright and aware, you're probably somewhat angry. But for millions and millions of others, "Jon and Kate Plus Eight" is about to come on and they really don't have the time.

Sunday, 21 June 2009

An Excerpt from Vol. 4: A Primer on Bond Mathematics (2 of 2)

In its original form, the equation FV = PV (1 + i) assumes nothing. It merely takes the facts of the transaction – $100 lent at 4% for one year, in our example – and calculates how much money is due to the end of the term. Of course, the lender, like all lenders, assumed that he would be paid back in full, otherwise he would not grant the loan. But that is the lender’s assumption and does not affect the equation. Even if the borrower defaults, the validity of the relation would stand, as it only calculates what should be due to the lender.

Things change when we solve the equation for the present value, PV:

PV = FV/(1 + i)

Mathematically, all we did here was to rearrange the equation, a simple operation familiar to 6th graders. But that technical operation shifted the focus to the present value.

This emphasis and the name “present value” would confuse our borrower and lender. “What do you mean by the ‘present value’ of the loan?,” they would demand to know.

– “The present value is the current value of the loan: how much it is worth today.”

– “What do you mean by the ‘worth’ of the loan”?

–“That is how much the loan is worth! How can we say it? How much it cost the lender to finance the loan”

–“That is $100. It is the loan’s principal. Why do you call it the present value?”

But the present value is not the same as the principal. The new vocabulary is telling us that we are no longer in the private world of borrowing and lending between two individuals. Rather, we have entered the world of securities and markets. The relation PV = FV/(1+ i) expresses relations in the markets and presupposes them. Only then the concept of present value becomes meaningful.

To presuppose markets is to presuppose buyers and sellers. The new form of Eq. (1) assumes that when the creditor takes his IOU to markets, he will find Moneybag waiting for him, ready to buy the note at its “fair value”.

What happens if there are no buyers?

To answer that question, we must ask why and under what conditions would there be no buyers?

There could be two reasons; one particular, the other, general.

The particular reason has to do with the perceived “credit risk” of the individual security, credit risk being the risk that the borrower will fail to pay back the loan and interest on the due date. If there are concerns about our borrower’s ability to pay back the loan, Moneybag, like other potential buyers, will stay away. No one comes to market to suffer a loss, and with many securities to choose from, there is no reason to risk one’s capital on a risky bet.

Our creditor would react to this situation the only way sellers all over the world react when the demand for what they are selling softens: by discounting the price. Instead of asking $100, which is the note’s original “fair price”, he marks it down and offers it at say, $98.

In itself, this act of discounting is unremarkable. But something interesting happens on the technical side, when we substitute the new price in the PV equation. With the future value unchanged at $104 – it is the defining characteristic of the bond and cannot be altered – the one variable that must change is the rate i:

PV = FV/(1 +i)

98 = 104/(1+i), or:

i = 6.1%

Technically, this was expected. In equation FV = PV (1 + i), the bond price (PV) and interest rate i are inversely related. If rate increases, the price will decrease. Changing the order, it stands to reason that if price decreases, the rate will increase. This is no different than saying that if the area of the rectangle remains constant and its length decreases, then its width must increase.

Meanwhile, we have said nothing about interest rates in general. That is another way of saying that we assumed they remained unchanged. The increase in rate is therefore something specific to our particular security. That something is the borrower’s potentially deteriorating finances.

What is this rate? That is, what does 6.1% a year correspond to, or represent?

In the nomenclature of modern finance it means that if the borrower were to ask for additional loans, he would not be able to secure it at 4% and would have to pay 6.1%.

This conclusion is counter intuitive. Even primitive societies treat their vulnerable members with extra care. Certainly in the liberal democratic societies we are expected to see senior citizens, for example, on account of their reduced income, receive special discounts for a wide range of social and private services from transportation to movies. “Give me a break” is the cry of the hurt and vulnerable that demands a more lenient treatment. Obama administration’s Helping Families Save Their Homes Act fell squarely into this category before it was gutted out by the lobbyists.

In the case of the financially vulnerable, though, the fundamental relation of the bond mathematics dictates the opposite: if a borrower has trouble meeting his obligation, then interest rates on him must rise.

Such a “remedy” at once reveals the viewpoint of Eq. (1), which is that of finance capital. Far from being an abstract, neutral relation expressing a general truth, Eq. (1) expresses the power relation in a social structure in which finance capital dominates.

Under these conditions, the well being or survival of individual borrowers is not of concern – not because finance capital has “no heart” but because such matters are irrelevant. “So says the bond,” finance capital’s spokesman, Shylock, declares, further demanding that the judge second his view: “Doth it not, noble judge?” And when the judge asks him to bring a surgeon to attend Antonio's wounds lest he bleed to death in consequence of giving a pound of flesh, Shylock inquires: “Is it so nominated in the bond?” Therein lies the basis of the contract law which is the centerpiece of the Anglo-Saxon jurisprudence. All the learned erudition the law scholars at Yale and Harvard and the pompous musings of the U.S. Supreme Court judges on the subject of contract law never go beyond the self-serving utterances of this usurer.

As finance capital tightens its grip on the economy, its viewpoint is presented as a universal truth: the less credit-worthy the borrower, the higher the interest rate he must pay. Michael Milken’s junk bond operation in the 1980s was based on this idea. A straight line connects him to the recent sub-prime mortgage fiasco.

(A reader in the comment section asked whether interest rate is always positive. That, too, is the question that finance capital floats. Setting aside some technical exceptions such as when a security “goes special” in the repo market, the interest rate is always positive in the sense that the lender will always charge the borrower; a negative interest rate means that a lender will pay you interest to borrow his money. This is prima facie absurd. However, if the rate is 4% and inflation is running at 5%, the lender presumably loses 1% when lending. It is in that sense that the interest rate for him is negative. That, needless to say, is also the viewpoint of finance capital.)

The subject of the borrower’s deteriorating finances has been extensively researched in finance. The borrower’s probability of default (PD) and the lender’s exposure at default (EAD) and his loss given default (LGD) are extensively studied. Google these terms to see what I mean.

But then there is the general case of why there might not be any buyers in the market. In the aftermath of the Lehman bankruptcy in September 2008, the commercial paper market completely shut down.

Under this condition, no security, regardless of the financial health of the issuer or borrower, would find a buyer. The creditors holding the IOUs would cry in frustration: “But this security of mine is absolutely guaranteed to pay back $104 at maturity.” To which the market would reply by quoting the oft quoted line from The Godfather: It’s not personal Sonny!

Modern finance has nothing to offer on this topic. You will sooner find Taleban mullahs writing about distilling single malt whiskey than finance scholars of the Western liberal democracies writing about this subject – and for a good reason. The main pillar of modern finance, Equation (1), does not lend itself to even considering the question of the absence of buyers. Why there would be no buyers, i.e., why markets would break down, is something completely outside the realm of its consideration. In fact, the entire theoretical edifice of modern finance and economics is based on the assumption that every seller brings his own buyer to the market, a preposterous assumption that is refuted thousands of times a day every time a commercial is aired, an advertisement is posted, a sales call is made and a price is discounted. So in the aftermath of Lehman bankruptcy, when the CP market shut down, all the best and the brightest of finance in business and academia could offer was that buyers had “gone on strike”!

Why and under what condition buyers would disappear en masse from a market is the subject of Vol. 4 of Speculative Capital. The condition is the prerequisite for the realization of systemic risk, its trigger point.

It is under these conditions that the role and activities of the Federal Reserve call for a brief comment.

For the past several months, the Fed has been trying to reduce the interest rates and particularly, the mortgage rates. To that end, it has been buying Treasuries – that is called “quantitative easing” – and the agencies, the latter being the IOUs of Fannie Mae and Freddie Mac. The logic is that buying the securities would increase the demand for them and thus, their price. (Remember supply and demand! If the price of IOUs increases, “their” interest rates would decrease.) The understanding of the members of the Board of Governors of the Federal Reserve of the nature and role of interest rate in the country – and hundreds of analysts, economists, policy makers, ex-banker, MBAs and quants that they employ – boils down to this embarrassingly crude logic. Therefore, in the face of rates behaving in the most unexpected manner, they have nothing to say. “Learned helplessness” has become de rigeur.

The Fed, at the same time, is being assigned the role of supervising the financial system with the purpose of preventing a systemic collapse. But with its mechanical view of how markets work, it would not know why buyers might suddenly vanish. The subject of finance is not the psychology of buyers and sellers but the laws of movement of finance capital. This subject is not simply within the Fed’s theoretical ken.

The setup reminds me of an Iranian poem on the eve of the Mongolian attack on Iran. The poet wrote:

The king is drunk, the world is in chaos and the enemies are front and back;

It is well too obvious what will come out of this.

Saturday, 20 June 2009

In Memory of the Passing of a Great American

This morning brought a bit of sad news: the inventor of the "Magic Fingers Vibrating Bed" passed on to the Great Beyond at the ripe age of 92.

I found this story, as with so many things Americana, on the Huffington Post blog. The story included a photo of the inventor: a mild-looking elderly man wearing old-guy couture and glasses thick enough to fry an ant. It's a candid shot -- it looks like his grandkids were taking him to the park that day for a walk or something.

In other words, a perfectly appropriate, informal image. Who would expect the obiturary photo of the inventor of the vibrating bed to show him wearing a tie and preppy sports jacket and an aristocratic sneer? No, John Joseph Houghtaling was one of us, an everyday Joe. He belonged to a peculiarly American tradition: guys who invent stuff that no one really needs but that everyone wants to try at least once.

For one shiny quarter, his vibrating bed promised 15 minutes of "tingling relaxation and ease" to weary travelers. The heyday of the coin-operated bed was the late 1960s and 1970s.

I came to know my first "Magic Fingers Vibrating Bed" many years ago. My high school shop teacher, a rather small, densely bearded man, had offered me a job during spring break, helping him clean and service a bunch of ice cube machines he owned.

I'm not sure why he chose me. Perhaps because I was a good student who seemed hard-working, honest and trustworthy. Or perhaps because I seemed like the sort of person who wouldn't laugh at a middle-aged man who, over the course of his life, had managed to acquire an empire no more significant than a chain of ice cube machines outside of motels in rural northern Maine.

I don't recall much about the actual job. Drive through the woods for a while, come to a motel with an ice machine, stop. As I remember, I would then go about putting a shine on the ice machines while he went inside and chatted with the motel owners. Were they selling much ice? Were they pleased with their ice machines? Did the customers find the ice satisfactory?

At the end of the day, he would pick a motel for the night. One had a "Magic Fingers Vibrating Bed." I figured, what the hell, and dropped in a quarter.

The bed rather aggressively kicked into life, like something in a Stephen King short story. I expected a sort of gentle, soothing hum. This bed sounded more like a piece of industrial equipment, lying in wait for me. I lay down on it. The bed buzzed away and trembled. The sensation didn't much resemble fingers, unless they belonged to some stick-fingered person with bad tremors.

It was a bust, but I don't remember feeling cheated. It was more like a feeling of awe that I lived in a country that could produce men who could invent such things as "X-Ray Spectacles" and "joy buzzers" and "Magic Fingers Vibrating Beds" and could actually make a fortune doing so.

Monday, 15 June 2009

More Games People Play with Credit Default Swaps

Willem Buiter lays out the latest manipulations engineered in the credit default swap market. I was aware of various squeezes that the holders of CDS (those who are insured against default, in other words) would try to orchestrate, to send a company pitching into bankruptcy so they could collect on their bets. But, in a delicious irony, they're not the only ones who can play games in the CDS markets where, remember, you don't have to have any interest in the underlying asset (bond, security, whatever) to take a bet.

Check out his case study of Amherst Holdings. It turns out the writer of CDS policies can (legally) screw the holders. And so Amherst did.

So, to add to the list of offenses committed by the CDS market:

#77 -- high potential for unethical game playing (manipulating, screwing the other guy through a big-money muscle play, whatever you want to call it).

All of which reminds me: I talked to a former Morgan Stanley guy over the weekend. Quite bright, articulate. He passionately defended credit default swaps. He defended them on a level of granularity that I wasn't always able to follow. But again I noticed that CDS true believers tend to stake out a micro bit of turf. They tend to miss the forest for the trees. He was talking mostly about pricing information (as if there was no way to discover this before the advent of the credit default swap).

The big stuff he didn't go near: the high levels of leverage that CDS create, the fact that the swaps suck hard on spare liquidity in a crisis when credit is tight, the fact that CDS create the illusion of risk vanishing under a film of fairy dust (if the U.S. government had not bailed out AIG and thus its writing of CDS lottery tickets, a lot of banks that thought they had their butts covered on risky asset-backed securities would be in a world of hurt) ... and now, it looks like a large amount of game-playing is possible when you can take out multiple insurance policies, willy nilly, without having any interest in the underlying asset.

The credit default swap market needs to be brought to heel. Really really soon.

Sunday, 14 June 2009

An Excerpt from Vol. 4: A Primer on Bond Mathematics (1 of 2)

I am busy with Vol. 4 of Speculative Capital. Its subject keeps expanding because I digress. Each digression then proves to be the main subject. Here is a short excerpt on “bond mathematics” from the manuscript, with only minor editing for the blog, so you would see what I mean.


Consider a borrower who borrows $100 at the going rate of 4% a year for one year. As the evidence of his obligation to pay, he gives the creditor an IOU, a promissory note saying that, at the end of the year, he, the borrower, will pay back the original sum plus the accrued interest, for a total of $104. The calculus of the note is as follows:

100 + 100 x .04 = $104, or:

100 (1 + .04) = $104

The amount presently borrowed, $100, is the present value of the loan. The amount to be paid back in one year, $104, is its future value. If we designate these values by PV and FV, respectively, and let i stand for interest rate, we can generalize this relation as Eq. (1):

PV (1 + i) = FV

Eq. (1) is the fundamental relation of fixed income mathematics. It contains three parameters that uniquely define a debt instrument: principal, interest and maturity. In any lending and borrowing, you have to know how much you are lending or borrowing (principal), at what rate (interest) and for how long (maturity). (Maturity is hidden in Eq. (1) because we assumed it to be one year. This assumption has no bearing on our discussion.)

If, after lending the money, the creditor has a change of heart or suddenly needs $100, he cannot go to the borrower and demand the money. The term of the loan is one year. The borrower will not return it before the designated maturity date, before he had the full use of it, as contractually agreed. So the creditor’s $100 is “locked”, meaning that he has to wait one year before he could get back the principal and interest of his investment. His note, in financial jargon, must be “held to maturity”.

Thanks to the existence of capital markets, though, there is a way out for our creditor. He could sell his note there. What takes place in capital markets is the conversion of securities form of finance capital into money form. But these abstract concepts have as yet no meaning for us. For the time, simple buying and selling would do. So the creditor takes his IOU to market and presents it to a potential buyer, Moneybag.

– “How much are you asking for your note?”, asks Moneybag.

– “Well, the total amount due is $104”.

– “You have to stop trying to put one over us, my boy,” says Moneybag. “We the bond people are math savvy. Your note promises $104 1 year from now. Now is not "one year from now", if you know what I mean! You are selling your note today. The question before us is how much is the note worth today.”

We already know the answer. We only need to solve Eq. (1) for PV:

PV = FV/ (1+ i)

Substituting FV = $104 and i = .04, the PV of the promissory note is $100:

PV = $104/(1 + .04) = $100

We were expecting this result. In the absence of any change in the future cash flow, the term or the interest rate, the present value of the loan had to be what the creditor originally lent to the borrower.

Now, if Moneybag buys the note for $100, he would in fact be paying back the creditor and replacing him as the lender. The borrower need not even be aware of this change in his note's ownership. That is the critical function of financial and capital markets. They are the central pooling places for finance capital. In that regard, they provide capital at a scale beyond the reach of any single individual.

Note also the role of interest rate. If the rates rise to 5%, the creditor will not be able to get $100 for his note. Moneybag would pointedly remind him that he, Moneybag, could lend $100 with 5%, so he would be a fool to replace the creditor in a loan that only pays 4%. Under the new conditions, then, the creditor would have to accept less than $100 for his note. (Eq. 1) gives us the exact amount. We only have to remember that the future payment, $104, remains unchanged as that is all the borrower has agreed to pay. The overall rate, however, is now 5%. Substituting these into Eq. (1), we get:

PV = $104/(1 + .05) = $99.05

If the rates increase by 1%, the creditor will lose about 95 cents.

If the rate drops to 3%, the promissory note will be more valuable, as it pays 4% interest where others could only get 3%. The creditor will demand more for what, under the new circumstances, is a more profitable investment. The “extra” profit is 97 cents that we can calculate using Eq. (1):

PV = $104 /(1 + .03) = $100.97

This relation holds generally: Interest rates up, bond prices down, and vice versa. We see it in Eq. (1) as well. As interest rate i in the denominator of Eq. (1) increases, the present value of all promissory notes would decrease, and vice versa.

Eq. (1) is the fundamental relation of fixed-income mathematics, “fixed-income” being the universe of all the bills, notes, bonds, swaps, mortgages, accounts receivable, annuities – in short, any stream of future cash flows. The “mathematics” part is finding their present value , which should be the price at which the fixed income instruments is bought and sold.

You can take Eq. (1) and run amok. You could, for example, observe that a 1% increase in rates resulted in 95 cents fall in price while 1% decrease in rates resulted in 97 cents rise in price. So the price change of notes in response to a change in interest rates is not symmetric. You could spent a few years of your life studying the non-linearity of price-yield relations in bonds and then branch out and focus on the “convexity” issue, which is a second-derivative of sorts, dealing with the sensitivity of the sensitivity of price-yield relations in bonds.

Or, you could try to determine what happens if the borrower’s finances deteriorate. That, presumably, will increase the likelihood of the borrower's default, which should adversely affect the bond price.

Or, you could consider what would happen if the borrower could pay back his debt early. This “option” should obviously impact the bond price. That is a promising area of research worth a few hundred PhD dissertations on the subject of options adjusted bonds spreads/prices.

If you could do one or all these things, you would become a “quant”, a “rocket scientist”, a math wizard responsible for creating complex new products that would spearhead the globalization of finance. You could become a respected professor of finance at an Ivy League school of your choice. With a little luck, you might even receive a Nobel Prize in economics or become a policy maker at the Federal Reserve Board.

In short, in the realm of “mathematical finance”, you could be all you can be, and still understand absolutely nothing about finance, including its most fundamental relation in Eq. (1).

Let us look at it closely.

Eq. (1) belongs to a large class of physical, social and natural relations in the form of A = mB. These relations, without exceptions, have limits beyond which they are not valid. That is another way of saying that they are based on certain assumptions that limit their applicability. There is no ultimate equation of everything that is unconditionally valid across time and space.

Take, for example, Newton’s relation between force (F), mass (m) and acceleration (a), that is arguably the most profound relation in the universe. It states that

F = ma

The relation applies to all forces – gravity, electro-magnetic and weak and strong nuclear forces – and to all masses. In focusing on the seeming multiplicity of forces in nature and relating them to mass (matter), the equation defines the very discipline of physics which seeks to determine how the natural forces are related to one another and what is the nature of the matter. The equation is valid across the known universe, and helps plot the trajectory of satellites even outside the solar system.

Yet, it has limits. If force (F) increases, the acceleration (a) and, with it, the speed, will increase. But that is true only within “ordinary” speeds. As the speed approaches the speed of light, the mass also increases, countering the acceleration. At 300,000km/s, the relation is no longer valid. A different kind of physics governs.

What is the limit of PV = FV/ (1 + i)? That is, what are the assumptions and suppositions behind it?

First and foremost, this relation expresses a social relation, as evidenced by the presence of interest, i. That limits the applicability of the relation. Charging interest, for example, is forbidden in Islam. So in the Taleban controlled areas of Afghanistan and Pakistan, for example, Eq. (1) is not valid. If you try to enforce it, you would jeopardize your long term business prospects. Short term business prospects, too.

Shylock of The Merchant of Venice, by contrast, insists on interest. He lives by it. That is how relation (1) is a social relation, a product of historical development.

“That is an interesting observation, Mr. Saber. Very intellectual! But surely you realize that we do not live under the Taleban rule. We are citizens of Western liberal democracies where markets rule – the recent black eye they have gotten notwithstanding. So let us please focus on practical matters and leave the intellectual parts of finance to ivory tower academics.”

What else does Eq. (1) presuppose?

Wednesday, 10 June 2009

Squishy Values Stuff, But Very Important

Check this out, at Mark Thoma's site, on "Financial Community Norms."

I think Thoma has latched onto something that has escaped the notice of a lot of other commentators during this crisis. Namely, that the rot in our system may go pretty deep and must be addressed at that level. We need to take a second look at attitudes and values and norms. It sounds like squishy stuff, but we ignore it at our own risk. We've produced a financial culture now that accepts that crass self-enrichment and naked ambition and the relentless pursuit of loopholes (meet the letter of the law, but not its spirit) are one hundred percent okay. You get yours, I get mine, and who cares who gets hurt. Capitalism is a rough game that's not for sissies.

I'm not sure what the answer to the narrow-mindedness and greed is. Good luck trying to embed a moral compass in every MBA's butt. Unfortunately, the U.S. government's craven approach to the big banks, and its failure to knock them down to size, probably ensures that very few cultural changes will take place.

Goldman Sachs, Easter Egg Hunt

Identifying the former Goldman Sachs employees working for the U.S. government is frankly like an Easter egg hunt. "Hey, look, I found one over here in the West Wing! Four for me! How many do you have so far?" From time to time, the media helpfully provides a map of sorts. Here's the latest I found, from the Huffington Post. Also note the revolving-door game, which is a bit more troubling (Former SEC head Arthur Levitt to Goldman -- argh, the white knight to the dark side, woe is us).

Goldman of course touts the Goldman-to-Washington-Halls-of-Power conveyor belt as a commitment to public service. Right. Which is why so many Goldman alums start soup kitchens for the homeless and found Goodwill used-clothing depositories. Not quite. Let's get real here. Any organization has its own DNA of sorts that defines itself and that ensures its survival. Anytime you can spread your DNA beyond the narrow confines of your business environment, into the larger political arena, where the big decisions are made that affect your industry (and many others), you stand a better evolutionary chance of long-term survival. This is what Goldman is doing. I bet the Goldman organism understands this too, on some level.

E.O. Wilson would just stand back and marvel.

Tuesday, 9 June 2009

It's a Small, Small (Goldman Sachs) World

I'm starting to understand where the Goldman Sachs-is-everywhere paranoia comes from. It's because ... Goldman Sachs IS everywhere, sort of like a ubiquitous Lucifer with a money clip. Is Goldman Sachs Satan? I know this guy thinks so. Anyway, they're not just hogging all the top spots in the Treasury Department anymore. They've also got a desk at your favorite newspaper!

Check this out: At the Wall Street Journal, staffer Evan Newmark included in his online blog this gag-worthy line: "Hank Paulson is a national hero." I know, my reaction was the same: "Come again? What planet are you living on? Earth? My Earth? And this is Hank Paulson, former Treasury Secretary, bald guy, hangdog face? Same guy who as head of Goldman successfully lobbied Washington to let Goldman and four other investment banks escape capital requirements in 2004, letting them pump up their leverage crazy-high, leading to failures (Bear Stearns, Lehman) and a full-blown financial crisis that later blindsided him when he was Treas Sec, and then after he got up and dusted himself off he promptly went about trying to funnel billions in absolute secrecy to all his banking buddies on Wall Street? That freakin' Hank Paulson?"

So you may be thinking, "Wow, you'd have to be really ignorant and delusional to call Paulson a national hero. Or you'd have to be a former employee of Goldman Sachs."

Yeah. That's it. The second one.

Newmark apparently once worked for Goldman Sachs. Wouldja think the Wall Street Journal might see fit to disclose that? Nah.

Anyway, there is justice in the universe. If you haven't read it yet, Matt Taibbi (he of Rolling Stone fame), does an excellent takedown -- nay, slamdown -- of Newmark's limp-brained nomination of Paulson as savior of the nation. I'd say we're not going to see HP on a postage stamp anytime soon, if enough people read Taibbi's withering, expletive-laced criticism.

My favorite part, in which Taibbi addresses Newmark directly (my bold):
If anyone besides Paulson had been running Goldman Sachs earlier in this decade — if a person with a serious brain injury had been in his place, for instance, or a horse, or a head of lettuce — we’d all be better off today, because there wouldn’t be so many toxic Goldman-underwritten mortgage-backed CDOs on the market. We, all of us, are paying the freight for assholes like Paulson, and like you, for that matter.

Saturday, 6 June 2009

My Best Jon Stewart Impersonation

Okay, sure, we already knew this: Bank Profits from Accounting Rules Masking Looming Loan Losses. First-quarter bank profits were nothing but a chimera, the finance industry's version of a griffin that vanishes with heavy wingstroke over a nearby rainbow.

Now for my Jon Stewart impersonation. Ahem.

So let me get this straight: Citigroup and friends can kick sand in the face of 98-lb. government weenie Tim Geithner -- hey, we don't need your plan to buy our crappy assets! -- because they're healthier now, and if you don't believe that, hey just look at their first-quarter profits -- which, uh, by the way, were all make-believe, like your two-year-old daughter's imaginary friend in the sandbox. Oh yeah. I've got LOTS of confidence this is going to turn out well.

Prediction: There will be a nasty double dip in this recession; the green shoots are brown shoots that have been spray-painted. We will face the bank problem once more. And everyone will moan and gnash their teeth and say, "But I thought they were getting better!" And the banks will trot out a lame line in the vein of, "It's not our fault; we didn't foresee things would get this bad."

Roger Ehrenberg nailed it here. The government is closing its eyes, taking the path of least resistance, instead of taking the hard road that would lead to a faster and fairer resolution of the financial industry's problems.

Friday, 5 June 2009

The Best Government Money Can Buy

Sometimes the big U.S. banks make me laugh until the tears start flowing down my cheeks, then I realize I can't tell if I'm laughing or crying.

Here they are, in the New York Times, putting the campaign contribution nozzle in the gas tanks of our favorite Congresspeople. Because, you may not realize it, but Congresspeople need a very special fuel to run, and that fuel is green (but sadly not Soylent Green, so we can't just mash up surplus poor people).

Sometimes I despair of this country ever being able to heal itself. We are so firmly in the grip of moneyed interests. We have met the enemy, and he is wearing a rep tie and a member of the American League of Lobbyists.

Thursday, 4 June 2009

Hate to Say I Told You So, But ...

When Geithner whisked the veil off his bank rescue plan (to set up public-private partnerships to buy toxic bank assets through auctions), everyone immediately began crawling over it with a magnifying glass, looking for flaws. The informed commentariat was screaming about the taxpayer being ripped off, about huge subsidies for overpayment on crappy assets, and on and on. At first blush, it looked like the banks were playing us for fools again.

I proposed a counter-theory early on, on March 25 (and was one of the rare few to throw my weight behind this particular viewpoint, as far as I can tell; Roger Ehrenberg was another):

The major banks, weighed down with toxic debt, weren't celebrating Geithner's auction plan; rather, they hated it. Huge overpaying on the part of the buyers (investors paired with the government) wasn't baked in at all. Unless the system could be gamed, which seemed unlikely, overpayment would be relatively small. Once the banks took a good hard look at PPIP, they swallowed hard and said: "Damn. We are in a LOT of trouble if we have to be part of this. We'll have to stop pretending our crappy assets are worth so much. We'll be exposed as insolvent for the world to see. We need to find a way to deep six this PPIP."

The banks aren't stupid though. If they had attacked PPIP out of the gate, they would have seemed obstructionist, ungrateful and even mendacious (they kept complaining they couldn't obtain a "market price" for selling their assets; now Geithner's program offered buyers of the assets cheap money, on great terms -- so if they still couldn't get a "market price," what was their excuse going to be?). So they laid back, waited and maneuvered behind the scenes.

The tottering banks realized they needed to reject the Geithner plan from a position of strength. Their strategy became evident by mid-April, as I noted on April 16 in "JPMorgan Flips Geithner the Bird."

The moribund institutions took a three-step approach:
1. Get strong enough to lean forward.
2. Get strong enough to sit all the way up.
3. Spit hard in Geithner's face, aiming for the eyes, if possible.

Of course the banks didn't actually achieve #1 and #2. This being a crisis of illusory profits, illusory values and such, they instead activated the banks-getting-up-and-looking-healthy hologram, for us all to behold. In other words, they accomplished #1 and #2 by getting accounting rules bent for no good reason (except to allow them to more easily overstate the value of bad assets) and reporting glowing first-quarter earnings that, when examined close up, either made no sense at all or benefited totally from massive government intervention to prop up the banks.

Then one of them had to hawk a loogey in Geithner's pretty white-boy face and see how everybody (Washington officials, news columnists, commenters far and wide) reacted. Jamie Dimon of JPMorgan got the honor (after all, he's got the best cred in the White House, having been on the short list for the Treasury Secretary position). So Dimon came out and said, "JPMorgan isn't going to participate in PPIP; forget it."

The other banks waited, peering anxiously through spread-fingered hands, to see if there would be a huge outcry of protest ... but Dimon didn't get his hand slapped, and the blogosphere pretty much ignored his statement.

So that brings us predictably to now, where half of PPIP (the legacy loan component) is being postponed (read: dead) and believe me, the second half (the auctions for the securities) should be headed into the grave too. Just wait.

Here's the lead on the New York Times story:
The Federal Deposit Insurance Commission indefinitely postponed a central element of the Obama administration’s bank rescue plan on Wednesday, acknowledging that it could not persuade enough banks to sell off their bad assets.
The reason given, quite bluntly:
Many banks have refused to sell their loans, in part because doing so would force them to mark down the value of those loans and book big losses. Even though the government was prepared to prop up prices by offering cheap financing to investors, the prices that banks were demanding have remained far higher than the prices that investors were willing to pay.
And why were a bunch of sick, ailing banks allowed to get away with this? Well, because they outsmarted Washington, sucking hard at the federal teat and muscling accounting rule changes, until they could appear healthier than they really are:
F.D.I.C. officials portrayed the change as a sign that banks were returning to health on their own.
Again, hate to say I told you so, but ...

Wednesday, 3 June 2009

PPIP Deathwatch, June 3 Edition

There's a saying: If they're going to run you out of town, get out in front and make it look like a parade.

Well, Timothy Geithner by now must be reading the handwriting on the wall. The major banks don't like his public-private partnership plan to buy their lousy assets through auctions. They ain't gonna play. Putting their assets up for sale for anything resembling market value would expose the parlous state of their books. And Geithner knows he has a weak hand: he doesn't want to push the big banks into doing anything they don't want to; he's not an auto industry regulator after all.

So Geithner begins to slowly back away from PPIP, talking about it in a sort of detached way:
"As confidence has improved a little bit, we may see less interest -- both on the selling side and the buying side," Geithner said. "It's hard to tell, though, how much interest you're going to see. There's still some concerns, too, about the rules of the game."