Tuesday, 27 April 2010

Levin vs. Blankfein Faceoff

Some quick observations on the performance of Goldman Sachs' CEO at the roasting before Congress today:

1. Blankfein technically outpointed Senator Levin during the opening exchange, I think -- Levin doesn't have a particularly deep understanding of high finance -- but Goldman's chief lost the big point: how Goldman's actions appear to Main Street. Basically Blankfein condoned the practice of "betting against a product you're selling." That's the damning headline. Here's what it sounds like to Joe Blow: I sell you my car, and meanwhile, I bet with someone on the side that the car will break down within six months. No graceful way to put lipstick on that pig.

2. Notice how often Blankfein used the phrase "market maker" when facing off with Levin? Nice defense except -- Levin wasn't really interested in being tutored on what a market maker does. Levin was too busy cudgeling the head of the investment bank with the "conflict of interest" point. Main Street doesn't understand "market maker." It does, however, understand quite well "conflict of interest."

3. Is the successful beating up on Goldman a sign that the investment banks have been hoisted on the petard of the complexity they nurtured? They produced synthetic CDOs that the rating services couldn't understand and mis-rated; these same synthetic CDOs were so complicated, with so many sliced and diced mortgage-backed securities underlying, that arguably the disclosure standard should have been higher than normal, even for sophisticated investors; "synthetic CDOs" are raising a lot of eyebrows among members of Congress who are wondering -- "What the hell is the point of something that's this damn confusing? There's got to be a rat in this woodpile."

4. Senator McCaskill scored points, along with McCain, by noting that with a synthetic CDO, there's no real there there. It's just a side bet on actual assets that have already been sold, so you're not actually buying anything concrete. McCaskill shook her head in befuddlement before saying, "seems like a hamster in a cage trying to get to compensation." Blankfein defended the product with some mumbo jumbo about managing risk profiles. But what we're left pondering is McCaskill's image of hamsters manically tunneling through the wood chips for dollar bills.

5. Is Blankfein this dumb, or did he have a convenient "idiot" moment: Senator Pryor asked him about structured investment vehicles (actually, Pryor used clumsier wording, and then Blankfein hastily corrected him, knowledgeably saying "structured investment vehicles.") And then Blankfein goes completely ignorant, it seems, when asked why the bank would use an SIV. His reply: "I'm not sure." (Cue laughtrack at home.)

Ah, a little more cathartic financial-crisis theater ...

Monday, 26 April 2010

Financial Reform: Unsung Proposals that I Wish Were on the Table

We will be getting reform, and soon, it appears. Mike over at Rortybomb nicely table-izes six big areas/rules/issues to watch as legislation takes shape.

Maybe I'm just getting jaded, but what's on the table doesn't excite me much.

Transparency in derivatives through exchange trading? Yes, deeply important, but lobbyists will probably carve out small exemptions that Wall Street banks will then funnel as many of their trades through as possible. Too big to fail? Yeah, sure, cut 'em down to size, but Krugman is right on this one. Smaller banks, sufficiently interconnected and freighted with risk, can haul down the system too.

Hard leverage cap? I wholeheartedly support limiting leverage, but remember: leverage is a number. As Repo 105 and the continual perversion of accounting for capital under the Basel Accords show us, annoying numbers can be massaged. So under a hard leverage cap, I predict an explosion in "leverage-friendly financial innovation." Just wait.

So what is there to do? It won't happen during this round -- maybe the system has to seize up again, horribly, in the next few years -- but I wish we would look more at meta-type solutions. Here are some unsung proposals that I wish would get more consideration:

1. Contingent debt. This comes from the Republican side of the aisle, and though I confess to not having studied in great detail how the idea would work, I like the gist of it: banks hold a chunk of bonds that, when they come under duress, automatically convert to equity, boosting their cushion of capital. The percentage of such debt could be adjusted, if need be. The concept is market-oriented, as investors help police the institution's risk-taking. As Greg Mankiw writes:
This contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.
2. Financial transaction tax. I know, I know: to have efficient and liquid markets, you want participants to be able to trade as freely as possible. But I think that, sometime over the last decade or two, the amount of trading vaulted through the point of maximum efficiency and into something else -- something born of supercomputers run amok that just encourages volatility and instability. We need to slow down the financial machine a little. A small tax might encourage the bloated financial sector to shrink a little (a good thing) and raise money for our deficit (also a good thing).

3. "Deep clawback." Misaligned incentives are clearly an issue. And there'll be some feeble attempts to better align pay with long-term performance, but little will probably change. What we need is a way to get deeper into the pockets of bank executives and directors who allow their companies, through negligence or a desire for risky growth, to spin out of control, endangering the financial system. It sounds radical, but let's consider putting their personal houses and cars on the line -- or at least make them easier to prosecute criminally. Then behavior will change. If bankers hate "deep clawback," there's an alternative: Regulate the financial industry like a utility.

4. Move away from a rules-based to a principle-based system. This would be tremendously useful. With a squadron of lawyers and accountants in tow, every major Wall Street bank knows how to game and evade and twist every single rule that's been thrown at them. They will ALWAYS beat a rules-based system. But what if, in certain places in our laws, we used the language "what a reasonable accountant would ..." or something similar? This would stop them dead in their tracks. Because then they can't simply say in defense, "Well, you don't explicitly prohibit what I'm doing, so it must be okay."

So those are some of my favorite ideas that aren't seriously part of the discussion, unfortunately. We will get reform. It may not be that impressive. But if the financial system blows up again -- and relatively soon -- someone in Congress may get the idea that what we really need is more meta-reform -- and less tinkering around the edges.

Sunday, 18 April 2010

A Gathering of Donkeys at the “Genteel Surroundings of the Great Hall of Kings College”

Last week, the inaugural meeting of the Institute for New Economic Thinking was held in Cambridge University.

Gillian Tett attended the meeting and covered it for the readers of the Financial Times:
In the genteel surroundings of the Great Hall of Kings College, Cambridge, dozens of the world’s leading economists conducted an earnest conference on the future for economics, partly funded by Soros’ $50m largesse. One of the central conclusions of the day was that economists and market traders alike needed to devote far more time to human psychology, rather than just the raw economic numbers beloved by so many policy wonks.
So, the aim of the seminar, with George Soros as its sugar daddy, was to promote the “behavioral economics” that has been making the rounds in the past decade – the word “new” in the title of the gathering notwithstanding.

The meeting produced some original and high quality thoughts.

Jeremy Siegel of Wharton compared the years prior to 2007 with the years prior to 1929 and noticed a similarity: In both cases the “risk premium” went down. This, he concluded, only makes sense if investors “convince themselves that the economy is stable”.

George Akerlof, a behavioral economist, said: “In good times, people trust. But in bad times, confidence disappears and that cannot be restored.”

Adair Turner of FSA said: “We need to recognise that humans are partly rational and partly instinctive.” Half angel, half devil, he might have added.

George Soros summarized them all: “Economic phenomena have thinking participants, natural phenomena do not ... [but] participants’ thinking does not accurately represent reality.”

Hmmmm. Participants’ thinking does not accurately represent reality.

I don’t suppose Soros meant that people involved with markets are mad; that would be embarrassing. He must have meant, rather, that the reality “in itself” is something different from what we comprehend; we cannot know the reality, he wanted to say. This is more than saying that the reality is unknown. It is saying that reality is unknowable. America's own European sophisticate skipped over 200 years of the development of philosophical thought in the West to reach the beliefs of the medieval monks, which he suggests should be the starting point of a new way of thinking about economics and finance.


A while back I wrote about the Walking Man and pointed out that Giacometti is depicting a man at the instant of stopping in reaction to something he has seen.

The key to understanding the work is the Walking Man's face, which is void of any expression . At the instant that we see him, he has not yet had time to analyze, contemplate, recognize or otherwise form an opinion about the object before him. These stages of mental engagement will come later – an instant, an hour, or a year later. Our Walking Man, as we see him, is not a Thinking Man. He has not stopped because he remembered or realized or thought of something. He has stopped because he saw something in the outside world.

What will come next?

If he recognizes the object – a river, an animal, a group of men running towards him – he would do so from experience, either his own or that of his fellow men.

If he does not recognize the object, he would have to “investigate”; thinking alone will not do.

Through observation and thinking, the Walking Man would learn only the immediate, outward properties of the object. But no amount of staring at the object and thinking about it will reveal anything about its essence. He has to get closer to the object and examine it.

The connotations of “investigate” and “examine” are clear: our Walking Man will have to take action . He could, for example, run an experiment: change the natural state of the object and force it to react to new conditions and relations, in consequence of which it will reveal new properties. There are other methods of cognizance available to our man. The point is that the conscious, purposeful interaction with the outside world is the beginning and condition of the knowledge.

Knowledge is the reflection of the outside world in human consciousness. But such reflection is not passive or mechanical, a mere “mirroring”. It is “active” because it is interplay of the outside world and the man’s faculty of reasoning, interplay between the material world and subjective thought which arises from the purposeful and practical transformation of the real world by men.

But how could our Walking Man be sure that his subjective thought process accurately reflects the essence of the object, the thing “as is”, or “as God sees it”? After all, his thinking takes place through abstract, a priori notions such as cause and effect and time and space that do not seem to depend on experience. If his thinking depends on these subjective constructs, what assurance is there that he will be able to understand the true essence of the black cube, that Thing-In-Itself?

Thinking is subjective. And it does take place through a prior notions. But these notions, far from being independent of experience, are the controlling forms of experience as reflected in the human mind. They are the framework through which humans perceive the world.

It is precisely the interaction of the material world and subjective mind that is knowledge, or the search for Truth. There are not two sets of knowledge, one, “true” nature of the world, the Thing-In-Itself and the other, its reflection in human mind, the Thing-For-Us. Knowledge, rather, is the dialectical unity of these opposites. Truth is the process of interaction between the material world and the subjective mind. It is the truth of this relation, the Identity of Thinking and Being.

Truth, then, is absolutely relative because it is a process of becoming. It constantly evolves towards a higher stage, as we discover more interconnectedness. At the same time, it is relatively absolute in the sense that, with respect to a given set of conditions, it describes persistent and stable relations. The Newtonian mechanics is absolutely true within the confines of Newtonian mechanics. So are the relations of quantum mechanics within its confines. But neither is, considered abstractly, absolutely absolute.

At each stage, within the given bounds, we verify the absolute truth of the relation objectively: by our ability to reproduce, exploit and recreate the objects under definite conditions. When we know all the qualities of a thing and the synthetic unity of its parts, we know its “essence”; there is nothing more left to know except that the object is outside us.


Everything I wrote above is a part of the Western philosophical canon.

(Eastern, too, as I will show in Vol. 5. For now, here is Rumi, with an impossible brevity, in 14 words in Farsi, and an impossible beauty and poetry that cannot be translated: You hold the pen in your hand and the entire universe is a view in front of you. Some attributes of that view you create [by drawing]; some you take in [by being there]. Let the Western philosophers struggle to explain the interaction of mind and matter and the transformation of the material world by man!)

Yet, setting aside the enticement of the “research” dollars offered by Soros, none of the donkeys gathered in the Great Hall of Kings College knew anything about it. This is clear from the agenda of the conference and the utterances of its participants: In good times, investors “convince” themselves that the economy is stable. In bad times, they convince themselves otherwise. Just like that.

We say nothing by saying that man is the cause of what takes place in the world. That statement is self-evident enough. It is akin to saying that the “cause” of airplane crashes is gravity.

Man is the ultimate economic agent, it is true. But he does not act in a vacuum. He reacts to the objective conditions in the outside world.

I began this blog with a 10-part series on the current crisis. In Part 1, I wrote:
The events leading to this seizure have been covered in detail from many perspectives but always within the same prescribed framework: the crisis as the culmination of a series of unfortunate events set in motion by (choose your emphasis) greedy traders, irresponsible lenders, foolish borrowers, sleeping-at-the-switch rating agencies and feeble regulators.

The focus on the human element makes for good storytelling and has an evangelically uplifting bent that is appealing: If only the bad guys were to be replaced with good guys – something definitely in the realm of possible – the wrongs will be set right. The fault, dear Brutus, is not in our stars, but in ourselves!

Such takes on the crisis are not inaccurate; they are irrelevant. The subject matter of finance is not people; it is capital in circulation. It is silly to point out that “ultimately”, things happen in markets because people take actions; capital as a thing cannot trade or structure deals. People, however, do not act in a vacuum. They act on the basis of what they see and perceive in the market, which is another way of saying that their actions are shaped by the dynamics of capital – the form and pattern of its movement in the market. This movement takes place according to the objective laws that rise and operate independent of the actions of individual agents. To the extent that these individual actions also affect the markets, such effect is secondary.
This theme is present in many of the posts on this blog, most recently here and here.

I will have more to say on the subject on Vols 4 and 5.

Saturday, 17 April 2010

The Goldman vs. SEC Story That No One Has Written ...

When I saw that the SEC had finally decided to go after Goldman Sachs, I immediately rejoiced: Yes. At last. What the hell took you so long?

Then, when I started sifting through the strange case of Abacus 2007-AC1 (fairly trips right off the tongue eh?), I had a "pullback" moment, especially after seeing Goldman's defense (see the bottom of the page).

First, I have no love for Goldman. Far from it. I think it's rather creepy the way they release their ideological spores throughout our political system by practicing "civic responsibility" and occasionally shipping a handful of executives off to the Treasury Department, to keep the U.S. approach to the financial system appropriately capitalist at all times. But this Abacus case -- ah well, it doesn't make sense, unfortunately. I think the SEC will lose unless Goldman wants to pay up to make the bad publicity go away.

Here's why.

Read the SEC complaint. Read Goldman's denial. Observe the Venn diagram point where the two fact sets overlap in a significant way.

From Goldman: ACA had the largest exposure to the transaction, investing $951 million.

From the SEC: On or about May 31, 2007, ACA Capital sold protection or “wrapped” the $909 million super senior tranche of ABACUS 2007-AC1, meaning that it assumed the credit risk associated with that portion of the capital structure via a CDS in exchange for premium payments of approximately 50 basis points per year.

Think about that for a second. Whether it's $909 million, $951 million or $927.33311 million -- ACA, both sides agree, had a huge exposure to this deal. This was a $2 billion synthetic CDO. The German bank IBK, the other banner investor, only had $150 million of exposure (though to riskier tranches, true).

So ponder this a bit: why would ACA, whose duty was "portfolio selection agent," allow itself to be duped into stuffing the CDO sausage with the RMBS equivalent of rat tails and nose parts, if it was so hugely on the hook for the losses? Because consider this (all part of the SEC's own fact set in its complaint):

1. Paulson was a known short on subprime mortgages at this point. In 2007, the synthetic CDO was set up. Here's what happened a year earlier, according to the SEC:
Beginning in 2006, Paulson created two funds, known as the Paulson Credit Opportunity Funds, which took a bearish view on subprime mortgage loans by buying protection through CDS on various debt securities.
2. ACA wasn't some newbie from Canoobie when it came to setting up CDOs. The SEC tells us:
ACA previously had constructed and managed numerous CDOs for a fee. As of December 31, 2006, ACA had closed on 22 CDO transactions with underlying portfolios consisting of $15.7 billion of assets.
And, what's more, ACA knew that Paulson was heavily involved in helping pick the securities for Abacus. Again, the SEC:
On February 5, 2007, an internal ACA email asked, “Attached is the revised portfolio that Paulson would like us to commit to – all names are at the Baa2 level. The final portfolio will have between 80 and these 92 names. Are ‘we’ ok to say yes on this portfolio?”
So get a load of this: You're ACA. You're among the best at structuring CDOs. You should be able to evaluate the mortgage bonds being assembled for the security pretty well. You should know how the risks work. You should also know what's going on in the larger market: who's bullish on these things, who's bearish (Paulson, Paulson, Paulson).

And you swallow risk on about half of a synthetic CDO that you let Paulson fill with, um, crap?

I think there's more to this story than meets the eye. My guess is that ACA is much more guilty (of stupidity or something else) than anyone is suggesting. I think (1) they got caught being idiots, essentially making a longish bet on residential mortgages by insuring the super-senior tranche of the CDO (this is the last one to take losses, when the defaults start to mount) (2) they may have been making a cynical play, on the bottom part of the synthetic CDO, letting Paulson pick some crap, thinking that the super-senior tranche would be amply protected if the housing market deflated a little OR they were simply grossly negligent and unbelievably stupid by not reviewing the bonds that a known subprime-mortgage short was stuffing into a CDO they were insuring almost half of.

So I'm doubtful the SEC will win this one, unless there's something big I'm missing. But I think the SEC's case will be the perfect stalking horse for achieving the financial system reform that we do need pretty badly -- so maybe it's not so bad to put Goldman on the rack for a year or two.

Saturday, 10 April 2010

Must-Read Story of the Morning

I've grown a little numb to the shocking revelations of this financial crisis, but every so often, a story will drop my jaw and make me go "wow."

Today's candidate: Pro Publica's The Magnetar Trade.

One of the authors, Jesse Eisinger, you may remember from the Wall Street Journal. I admired his stuff during his tenure there. He impressed me as a smart guy who liked to dig -- and then dig some more.

The "Magnetar trade" Yves Smith apparently has written about at some length in her new book Econned. She has mentioned Magnetar a few times on her blog, without going into too much detail (I'm sure her book does, and I'm dying to read it. Where's my review copy, dammit? :))

Right now, Magnetar looks like the scariest enabler of this subprime bubble I've seen so far. Of course Michael Lewis looked at the enabling role the shorts played in his The Big Short. But the players he interviews were small. And they were only indirectly feeding the subprime lunacy.

To wit: as long as there was appetite for products packed with questionable home mortgages (the securities known as CDOs, or collateralized debt obligations), his shorts would happily take the other side of the trade. But, as far as I can tell, they weren't actively instigating the creation of these crap-congested things.

Magnetar apparently had a more clever, and dangerous, approach. It offered to buy the lousiest portions of the CDOs (the so-called "equity tranches" -- they're not technically equity, but tend to behave like equity, thus the name). For a high risk investment, the equity tranche is like the canary in the coal mine, an early-warning signal of trouble ahead. Or, to mix animal metaphors: A fish rots from the head down. A CDO rots from the equity tranche up.

So the equity tranche can be hard to place, especially for a shaky investment. And if you can't place it, then the CDO just doesn't get created. So was Magnetar crazy?

Crazy like a fox, it turns out. Because the hedge fund turned around and shorted the entire CDO.

How it made money initially puzzled me, but as far as I could tell (Eisinger keeps it sketchy, presumably because he's writing for a general readership), Magnetar's equity investment was a rather small piece of the CDO, and since the hedge fund was going short on the entire security, it stood to gain more than it would lose. The disturbing brilliance of this strategy: while the CDO is "in the clover," making money, the income thrown off by Magnetar's equity tranche funds its short bet on the CDO. So the fund solved the classic short problem of "how long can I afford to hold out if this thing doesn't blow up soon?"

Read the story. I have a feeling that "Magnetar," before this a name that's been largely under the radar, is about to start attracting a little (unwanted) attention.

Update: My further reading leads me to believe that Magnetar was buying credit-default swaps against other slices of the CDO (larger slices than what it owned certainly), though not the entire CDO.

Sunday, 4 April 2010

A Sad Justice

“What really for me marks a conservative judge is one who doesn’t decide more than he has to in order to do his own job. Our job is to decide cases and resolve controversies. It’s not to write broad rules that may answer society’s questions at large.”
Thus spake Justice John Paul Stevens of the U.S. Supreme Court on the eve of his retirement from the bench.

What a fool. What a waste. What an ass.

A few pages later, under the heading “School Law Clinics Face a Backlash”, the same New York Times reported how, after these clinics “go after powerful interests, lawmakers get involved”:
Law school students nationwide are facing growing attacks in the courts and legislature as legal clinics at the school increasingly take on powerful interests that few other nonprofit groups have the resources to challenge.

On Friday, lawmakers [in Maryland] debated a measure to cut money for the University of Maryland's law clinic if it does not provide details to the legislature about its clients, finances and cases.

The measure, which is likely to be sent to the governor this week, comes in response to a suit filed in March by students accusing one of the state’s largest employers, Perdue, of environmental violations.
Yet, the man who sat on the bench of the Supreme Court for 35 years, deciding matters of life and death – of individuals, communities, societies, customs and habits – sees his role as that of a clerk and a referee, of merely “resolving controversies” and not “writing broad rules that may answer society’s questions at large”.

Another simpleton who scorns “social engineering”.

I am the clerk. I am the scribe, not understanding what I hear, not knowing what I write.

What explains this mentality – this limiting quality, really?

The answer is the absence of self-criticism, that not “watching oneself”. “To the extent that I look back at earlier situations,” the judge told the Times, “I really don’t think I’ve changed all that much.”

John Berger, in his masterful novel on the exposition of art, A Painter of Our Time, writes:
[A]genius ... watches himself. That is the largest part of his technique, and it is what separates him from others. We all forget continually. The genius, because he watches himself, remembers. He naively remembers his dreams, he ruthlessly remembers his real experiences, and gradually, very gradually, he learns to remember the exact nature of his mistakes and successes as a man applying paint to a flat surface. And so he recognizes what others have felt but never known. Technique and genius are nothing more nor less than that recognitions.
The point here is not to criticize an old clerk; merely to emphasize the importance of being continually self-critical. Such vigilance gradually brings about a broader comprehension of events; we see how they all are connected.

That stage of comprehension is the material basis of a theory that is no longer an intellectual pursuit or a parlor game but a weapon.

When the Fed People Act Responsibly

Dialectics is the investigation of the relation between the whole and the part. In the past couple of times that I wrote about the illegality of the Fed’s actions, I put them in the context of a larger development of social decay.

But there are also the parts. Like the individual lines in a painting or sentences in a story, they shape our comprehension of the big picture.

On Thursday, under pressure from Congress, the Federal Reserve Bank of New York released more information about its holdings. I am quoting a few passages from a related Wall Street Journal article, followed by my comments in blue.

  • The Federal Reserve Bank of New York lifted a veil of secrecy on the troubled mortgage assets it purchased as part of the 2008 rescue of Bear Stearns Cos. and American International Group Inc.
That’s very good. We’re all for transparency. What did the newly released data show?

  • The data show the government is now in the same situation as many U.S. banks: dealing with a portfolio of loans and property that have lost their value, and which borrowers are struggling to pay off.
No surprise there. Unloading junk unto the Federal Reserve is like throwing garbage in the ocean. The garbage might not be in front of your eyes, but it is there in the environment and will be returned to you in due time.

  • For months, the regional Fed bank has been under pressure from lawmakers to make public details of the assets in three special-purpose companies that were created to take on roughly $80 billion in troubled mortgage positions previously held by Bear Stearns and AIG ... As of the end of 2009, the New York Fed was owed about $62 billion by three Maiden Lane vehicles.
The New York Fed has invested $80 billion in troubled “positions”; the paper cannot bring itself to call them securities. Now if you invest $80 billion in fixed income securities, you should be “owed” $80 billion. But the New York Fed is owed “about” $62 billion. The missing $18 billion must have been straight write down, money down the rat hole, as explained next.

  • One loan controlled by the government is $12.75 million in financing Bear Stearns provided to the owner of the 167-room Radisson Hotel in Jacksonville, Fla. The hotel is owned by a venture controlled by Philadelphia real-estate investment company AMC Delancy Group Inc. Kenneth Balin, AMC chairman and chief executive, said he believed Bear provided the loan with plans to include it in a debt pool known as a securitization. But that never happened, leaving Bear, and now the government, with the note.
Bear Stearns provided the loan with plans to include it in a debt pool known as securitization.

In case you don’t follow the technical jargon, Bear Stearns lent $12.75 million to AMC Delancy group without, no doubt, much of any review or analysis. Why? Because it was planning to bundle the loan with other equally shaky loans, say one for $12.25 million and another for $25 million, and sell the pool, now a “callateralized debt obligation or CDO” for more than its par value of $50 million, to say, $55 million. That is what Countrywide also did. And Citi. And Washington Mutual. You get the idea. That is what drove the “boom” that preceded the crash.

Alas, all the good things must come to an end. Bear went under before it could sell the junk to the public.

  • Mr. Balin said that loan was used to refinance debt borrowed in 2004, when it bought and renovated the hotel property.
This is the confirmation, if any was needed, that the current “note” is a junk bond that replaced another junk bond. The interesting thing is that the Journal does not say when the refinancing took place. My guess would be sometime in 2006.

  • Mr. Baling said that, so far, he gives top marks to those overseeing the loan on behalf of the U.S. taxpayer. “The people that are handling this note are behaving responsibly,” Mr. Balin said.
Here, the Journal abdicates its responsibility of honestly reporting the event by not telling us the Mr. Balin winked. In fact, it adds a wink of its own by bringing in the U.S. taxpayers.

Nasser, but you were not there. How do you know that he winked?

The man must have winked because he is mocking us.

He has a $12.75 million loan that he cannot repay. But the original lender is gone and the loan has somehow ended up on the books of the Federal Reserve Bank of New York, which “oversees” it. And what a marvelously accurate word that is, the “oversee”, the ultimate mot juste.

You see, the New York Fed cannot foreclose the loan, else it would be in possession of a Florida hotel. No one would buy the loan because it is junk. So, what other option is there if Mr. Balin is not paying, which he is not? The answer is, Nothing. The bank has to oversee the loan, the way a loyal agent would oversee an estate, until such time that Florida real estate market recovers. Then Mr. Balin would approach the Fed with an offer that the bank cannot refuse. He will buy his note at some deep discount and the New York Fed would announce another step towards the anxiously awaited goal of reducing its balance sheet.

  • Noting guest-satisfaction surveys, Mr. Baling added: “It’s a beautiful hotel”
I told you, the man is mocking us.

One critical item that I do not understand is how this note ended up on the balance sheet of the New York Fed. I thought that Bear Stearns was taken over by JPMorganChase, so this security should have been on the bank’s balance sheet.

But that is not entirely accurate. Come to think of it, I actually do understand.

Friday, 2 April 2010

"So, My Friends, What is This ... 'Financial Innovation' You Speak Of?"

I've sometimes wondered what would happen if aliens teleported in to Washington and -- since they're aliens, of course, and naturally inquisitive -- began asking questions about anything and everything ("You peel it before you eat it? Ah yes, fascinating. So this Seinfeld, he is like a king to you?"). Eventually they'd get around to the financial crisis and how we plan to prevent such a disaster in the future. And our "wise men" (Geithner, Summers, with some bespectacled lackeys in tow) would patiently explain how we have to restrain bad behavior in the system, while not discouraging financial innovation.

At which point I imagine the lead alien, Zrigfryx, would scratch his ample, hairless dome and say:

"So, my friends, what is this ... 'financial innovation' you speak of?"

And if I were sitting in the back row of the small assembly -- lucky enough to have snagged one of the lottery tickets for the the limited seats available to the public -- I'd thrust my hand high in the air and say, "Oh, I know. I know. Let me answer that one."

Because I'm really starting to understand what this "financial innovation" is that the industry is so hellbent on preserving.

Just the other day, I happened to come across this Bloomberg story about how the investment bank Macquarie Group hired a guy by the name of Christopher Hogg. What particularly caught my eye was Hogg's signature accomplishment: "a developer of one of the most popular financing tools of the 1990s."

So what did he innovate? A way to finance infrastructure projects in poor countries, expanding GDP and turning generous profits at the same time, a real win-win? A more efficient pipeline for getting capital to struggling small U.S. businesses that deserve it?

Nope ... and nope. Hogg came up with "Mips." Cute name. Sounds like a Christmas stocking stuffer that turns into a runaway bestseller. Mips are actually "monthly income preferred securities." They're described as "a type of preferred stock that resembles debt." Now you may wonder, "Why the heck do we need these things? What greater purpose do they serve?"

Well, it's sort of like this: You look at "Mips" through your right eye and you see an equity, like a preferred share of stock. But you look at "Mips" through your left eye and you see a bond -- or debt. Mips involve special purpose vehicles (what doesn't these days, eh?) and an appropriate amount of complexity that I'll skip over here.

The bottom line is, after all the innovating, here's the payoff:
The shares provide benefits of stock because they’re considered equity by debt-rating companies while offering tax advantages of bonds because companies can deduct the dividend payments from income they report on their tax returns.
Got that? Basically Mips are a tax dodge. It's not that Mips have found a way to provide capital more efficiently or smartly ... in fact, in a world with an ideal tax code, Mips probably contribute to the less-efficient allocation of capital. Remember those CLO "innovations" that appeared to offer higher returns for the same risk as other similarly rated products? And how they started inefficiently sucking in capital and no one bothered to ask, "Hey, is the risk just being mispriced here or is there really a free lunch sitting out there on the sidewalk?"

Of course with Mips the rejoinder might be: the U.S. doesn't have an ideal tax code. To which one might reasonably reply: Okay, so which option is better (1) Try to fix the tax code (2) Let people exploit whatever loopholes they can find and the hell with it; happy Easter egg hunt!

Mips are hardly a rare example of loophole-seeking "innovation." Just this week in Dealbook, Andrew Ross Sorkin nailed another one: dividend payments that are embedded in derivatives so investors can avoid paying any taxes on the income. Nice huh? While you and I are faithfully mailing off checks to the IRS for our dividend taxes every year, certain wealthy people, helped along by "innovators," aren't playing by the same rules (note: this loophole is being closed, thank God).

I imagine that after I finish explaining all this to Zrigfryx, and he extends a spindly forefinger to scratch his dome again in puzzlement, he might say something like:

"So why is preserving all this financial innovation so important to you Americans?"

And I guess I'd say:

"Larry? Tim? You want to take that one?"