Politics, Economics and other Stuff

Late Payments and FICO

A 30 day late payment is almost as costly as foreclosure to you credit score (as known as FICO).   I had no idea --- I had wondered about this and I now have a professional reason to care so I might take a look...seems weird.    This would explain some of the extreme white-black credit score differences -- the underlying behavior may not be as different as I though it had to be.  I reminder never to be 30 days late (i.e. not paying with in a few weeks of getting a 2nd notice).  (Yahoo via Volokh) 

Cioffi and Tannin found not guilty on all counts

Bloomberg reports:

Prosecutors missed the mark so widely in the fraud trial of Bear Stearns Cos. hedge fund managers Ralph Cioffi and Matthew Tannin that a juror said after their acquittal she would invest with them if she had the money.

The panel of eight women and four men who spent the past month hearing testimony in the case took only nine hours to find them not guilty on all six counts. During interviews after the verdict today, several jurors said the government failed to prove the defendants defrauded investors who lost $1.6 billion in the two hedge funds run by the men -- both of which were mostly made up of subprime mortgage-backed securities.

The funds collapsed in 2007, as did Bear Stearns itself less than a year later. The defendants, according to juror Serphaine Stimpson, were made “scapegoats for Wall Street.”

Cioffi, 53, the portfolio manager for the two funds, and Tannin, 48, their chief operating officer, went on trial Oct. 13 in federal court in Brooklyn, New York, on charges of conspiracy, securities and wire fraud. Each faced as many as 20 years in prison if convicted. 

Back in the Summer of 2008 when Cioffi and Tannin got charged I read the indictment as 'pretty thin gruel'. On the other hand, what they did was, on a technical reading of the law of the type done by lawyers (but not useful for regulating business via the criminal justice system), potentially illegal.  So this is a case were getting a jury trial mattered. 

What caused the recession?

I don't have a short or very confident answer.  It is hard to evaluate the relative contributions of different factors as well as the importance of their interactions with each other and existing institutions and policies. 

This is a placeholder post to make sure I put something up on this question.

Some brief suggestions of causes that tend to get neglected:

1. Inability to take collective action in the government and private financial sector.  Governance in the public and large corporate finance sector gets deadlocked and requires lots of backing and forthing and incrementalism, mostly in the face of daily demands for change.  Worrying about potential future disasters and getting others to take actions to prevent them is pretty hopeless and hence just doesn't get on the very limited agenda for change.  This applies in the private financial sector as well. Cleaning up past messes is much easier and has gets more support from the political environment. 
2. The need to learn form realizations as opposed form thinking about what might happen in the future, especially if collective action is called for (see point #1).  But learning need not improve things in 2nd best economies -- instead learning may create more problems for social collaboration. 
3. Oil.  Don't forget oil and the energy crisis...
4. Inflation and interest rates where too low to before the crisis started, opening up the possibility of a nominal spending collapse.  We've already had this in Japan and we had a deflation scare in 2002/03, so there was warning on the need to raise the long-term inflation target.  
5. Dumb final savers and their demand for supposedly safe high return assets impacted all the way through the financial asset production chain. If the final consumer demands AAA rate high yield products somebody is going the produce them.  Regulation can shut down dumb buyers getting these products, but its harder to do than you think, especially if people who know what they are doing make lots of money buying high yield AAA products and there is a track record to point to that allows the producers of these assets to try to sell them to a wider audience. 

The Galleon Insider Trading Charges

Pragmatic Capitalist writes:

Reader DanH was nice enough to forward us a recent copy of Galleon Groups performance going back to 1992.  It turns out that the fund was Madoff-like in its performance.  These guys just couldn’t lose.  Whether the market was up or down they cranked out 25% returns like they were printing money.  It makes you wonder just how long these guys were trading on insider information?

I have run the risk adjusted returns on hundreds if not thousands of portfolios throughout my career and I have never seen numbers like these.  NEVER.  There is virtually ZERO downside volatility in these figures.  Their largest one month drawdown was -6.19%!  That is simply unheard of for a portfolio with such high returns.  Gauging from the returns I would be willing to bet the insider trading was going on for most of Galleon’s existence and was likely much more rampant than currently reported:

Note though that these are only returns through 2008.  Returns don't look that crazy to me, just terribly good for these types of strategies.  

The US dollar shortage in global banking 2008/2009

I should give this BIS paper a good read: Patrick McGuire and Götz von Peter, The US dollar shortage in global banking and the international policy.  Sorry, no good summary yet.  Not actually clear what the right story here is, though people like to talk about it. 

The analysis shows that between 2000 and mid-2007, the major European banking systems built up long US dollar positions vis-à-vis non-banks and funded them by interbank borrowing, borrowing from central banks and FX swaps. We argue that this greater transformation across counterparties in fact reflected greater maturity transformation across these banks’ balance sheets, exposing them to considerable funding risk. When heightened credit risk compromised sources of short-term funding during the crisis, the chronic US dollar funding needs became acute, particularly in the wake of the Lehman Brothers bankruptcy.

In contrast to many previous international financial crises, it was banks’ international exposures to other industrialised countries that deteriorated, and the global interbank and FX swap funding structure which seized up.  ...

[T]hese estimates suggest that European banks’ US dollar investments in nonbanks were subject to considerable funding risk at the onset of the crisis. The net US dollar book, aggregated across the major European banking systems, is portrayed in Figure 5 (bottom left panel), with the non-bank component tracked by the green line. By this measure, the major European banks’ US dollar funding gap had reached $1.0–1.2 trillion by mid-2007. Until the onset of the crisis, European banks had met this need by tapping the interbank market ($432 billion) and by borrowing from central banks ($386 billion),21 and used FX swaps ($315 billion) to convert (primarily) domestic currency funding into dollars.22 If we assume that these banks’ liabilities to money market funds (roughly $1 trillion, Baba et al (2009)) are also short-term liabilities, then the estimate of their US dollar funding gap in mid-2007 would be $2.0–2.2 trillion. Were all liabilities to non-banks treated as short-term funding, the upper-bound estimate would be $6.5 trillion.

The implied maturity transformation in Figure 5 became unsustainable as banks’ major sources of short-term funding turned out to be less stable than expected. Beginning in August 2007, heightened counterparty risk and liquidity concerns compromised short-term interbank funding (Taylor and Williams (2009)), visible in the rise of the blue line in the lower left panel. The related dislocations in FX swap markets made it even more expensive to obtain US dollars via currency swaps (Baba and Packer (2009a)), as European banks’ US dollar funding requirements exceeded other entities’ funding needs in other currencies. European banks’ funding difficulties were compounded by instability in the non-bank sources of funds as well. Money market funds, facing large redemptions following the failure of 17 Lehman Brothers, withdrew from bank-issued paper, threatening a wholesale run on banks (Baba et al (2009)). Less abruptly, a portion of the US dollar foreign exchange reserves that central banks had placed with commercial banks was withdrawn during the course of the crisis.24 In particular, some monetary authorities in emerging markets reportedly withdrew placements in support of their own banking systems in need of US dollars. Market conditions during the crisis have made it difficult for banks to respond to these funding pressures by reducing their US dollar assets. While European banks held a sizeable share of their net US dollar investments as (liquid) US government securities (Figure 5, bottom right panel), other claims on non-bank entities – such as structured finance products – have been harder to sell into illiquid markets without realising large losses.

Other factors also hampered deleveraging of US dollar assets: banks brought off-balance sheet vehicles back onto their balance sheets and prearranged credit commitments were drawn.25 Indeed, as shown in Figure 5 (top right panel), the estimated outstanding stock of European banks’ US dollar claims actually rose slightly (by $248 billion or 3%) between Q2 2007 and Q3 2008.26 It was not until the fourth quarter of 2008 that signs of deleveraging emerged.27 The frequency of rollovers required to support European banks’ US dollar investments in non-banks became difficult to maintain as suppliers of funds withdrew from the market. Banks were thus forced to come up with US dollars, given their reliance on wholesale funding and short-term FX swaps. Essentially, the effective holding period of assets lengthened just as the maturity of funding shortened. This endogenous rise in maturity mismatch, difficult to hedge ex ante, generated the US dollar shortage. Banks reacted to the dollar shortage in various ways, supported by actions taken by central banks to alleviate the funding pressures.28 Prior to the collapse of Lehman Brothers (up to end-Q2 2008), European banks tapped funds in the United States; their local US dollar liabilities booked by their US offices, which included their borrowing from Federal Reserve facilities,29 grew by $329 billion (13%) between Q2 2007 and Q3 2008, while their local assets remained largely unchanged (Figure 6, left panel). This allowed European banks to channel funds out of the United States via inter-office transfers (right panel), presumably to help their head offices replace US dollar funding previously obtained from the market. 

Yale Endowment Update

The results for the 2008/09 fiscal year are in.  Important since the large university endowments are widely emulated 'best practices' organizations:

The final results are in: Yale's endowment lost 24.6 percent of its value between July 1, 2008, and June 30.

The endowment's value plummeted to $16.3 billion, from $22.9 billion, in that period, the University announced Tuesday. But Yale said the return "falls in the range of expected outcomes" in a year when equity markets across the globe fell by some 30 percent.

"If a portfolio produces returns of 41 percent (as Yale’s did in fiscal 2000) and 28 percent (as Yale’s did in fiscal 2007), then there exists the possibility that the portfolio might produce a substantial double-digit decline," the University said in a statement.

In the aggregate, Yale's marketable assets declined by just 13.1 percent. But private equity holdings lost 24.3 percent of their value, and real assets, the largest part of the University's endowment, posted a decline of 33.9 percent.

Not clear what those 'real assets' are -- the traditional lumber and commercial real estate? 

Harvard was down 27.3%, real assets down 37.7%.  

Sun Capital

A funny rant about private equity firm Sun Capital over at Zero Hedge.  Scroll down a bit less than one page for the start of the rant. 

Incentives and Behavior of Mortgage Servicers

The NYT has an article on incentives and the behavior of mortgage servicers which reminds me that I ought to know more about this topic.  One question is where the existing contracting arrangements come from and how they can be modified or renegotiated. 

Even when borrowers stop paying, mortgage companies that service the loans collect fees out of the proceeds when homes are ultimately sold in foreclosure. So the longer borrowers remain delinquent, the greater the opportunities for these mortgage companies to extract revenue — fees for insurance, appraisals, title searches and legal services.

“It frustrates me when I see the government looking to the servicer for the solution, because it will never ever happen,” said Margery Golant, a Florida lawyer who defends homeowners against foreclosure and who worked in the law department of a major mortgage company, Ocwen Financial. “I don’t think they’re motivated to do modifications at all. They keep hitting the loan all the way through for junk fees. It’s a license to do whatever they want.”  ....

Legal experts say the opportunities for additional revenue in delinquency are considerable, confronting mortgage companies with a conflict between their own financial interest in collecting fees and their responsibility to recoup money for investors who own most mortgages.

“The rules by which servicers are reimbursed for expenses may provide a perverse incentive to foreclose rather than modify,” concluded a recent paper published by the Federal Reserve Bank of Boston. ....

When borrowers fall behind, mortgage companies typically collect late fees reaching 6 percent of the monthly payments.

“For many subprime servicers, late fees alone constitute a significant fraction of their total income and profit,” said Diane E. Thompson, a lawyer for the National Consumer Law Center, in testimony to the Senate Banking Committee this month. “Servicers thus have an incentive to push homeowners into late payments and keep them there: if the loan pays late, the servicer is more likely to profit.”  ...

Mortgage companies not only gain this extra business through their subsidiaries, but also collect reimbursement for the payments when the houses are sold.

The investors who own bad mortgages accept whatever is left. Investors typically do not notice how much they give up to the servicers, because fees are embedded in complex sales.

“It’s under the radar,” Ms. Golant said.

Ultimately, the benefits of delinquency erode incentives for mortgage companies to dispose of troubled loans quickly, say experts, allowing distressed houses to decay and fall in value — a fact of little interest to the servicer.

“At the end of the day, it doesn’t matter what the house sells for, because they don’t take that loss,” said Ms. Golant. “Meanwhile, they are collecting all these fees.”

Infectious Leverage

I've been looking for papers on leverage externalities and not finding too many.  I suspect some are being written though.  Here is one I did find:

Goel, Song, Thakor, Infectious Leverage

This paper develops a theory of "infectious leverage" in financial markets in which the lender's payoff depends heavily on the value of the collateral backing the loan. There are two main results. First, leverage is an "infectious" phenomenon in that high leverage among borrowers also leads to high leverage among lenders. There is thus a multiplicative effect of leverage on the fragility of the financial system. Second, there is an externality in bank leverage in that a bank's exposure to credit risk depends on the leverage decisions of other banks and banks choose privately-optimal leverage ratios that are higher than what is socially optimal. The model has an overlapping generations setting in which banks make one-period mortgage loans in the first period that are secured by collateral, and the analysis solves for the equilibrium in the housing market, so the current house price and the distribution of future house prices are both endogenous. The prices of houses and hence the second-period values of collateral depend on the supply of loans in the second period, which then determines the ability of second-generation borrowers to raise financing to purchase houses in the second period. Thus, if banks are hit with second-period liquidity shocks that diminish aggregate credit availability in the second period, collateral values fall, thereby increasing the bank's credit risk. This creates an interesting interaction between credit and liquidity risks for lenders. Moreover, it leads to the result that an idiosyncratic shock suffered by a subset of banks can become a systematic shock for the whole banking system, and the likelihood of this increases with banks' leverage choices. Although the model is developed in the context of the housing market, we argue that it is applicable in any borrower-lender setting in which collateral values depend on the aggregate availability of credit, and credit risk in turn depends significantly on collateral values. Empirical and policy implications of the analysis are drawn out.

'Betting on black swans' or 'People pay for hope'

Falkenstein has a nice rant about Nassim Taleb's investment advice and hedge fund strategies:

[A]s funds affiliated with Taleb are becoming popular I think it would be helpful to address those specific strategies. The basic premise is that financial economists, and investors, systematically neglect improbable events. The result is that out-of-the-money options, especially qualitative analogues like unconventional investment ideas picked up at cocktail parties, offer the best reward-to-risk ratio. Let's consider these.

You can invest in a Black Swan fund that buys out-of-the-money options such as Universa Investments run by his former partner Mark Spitznagel. Taleb, and Spitznagel, would argue their implementation is much more sophisticated than merely buying out-of-the-money options in that it also takes advantage of 'behavioral biases'. Now, as 'prospect theory' implies people ignore, or overweight, improbable events, such 'behavioral biases' allow a strategy a great deal of latitude. In practice simple ideas, such as the underpricing of out-of-the-money options is too simple to sell, so the vendor feels compelled to confabulate a pretentious but useless tweak.  ...

Empirica Kurtosis, his earlier hedge fund, also started out with a widely reported 60% return in 2000, but then folded quietly in 2004. I earlier said I would donate $10k USD to his favorite charity if he sends me audited financials showing the cumulative Sharpe ratio of Empirica Kurtosis LLP over its lifetime was greater than 0.5 (which is a poor hedge fund return, consistent with exit), and the offer still stands. Thus, over the long run, not a sequence of 2008s, this is a crappy strategy. ...

Another claim by Taleb is that 'wild' risks from cocktail party chatter is especially useful. At some level this is like saying things that can't be quantified are really important, which has the nice property of being tautologically untestable, but in practice we understand what this means: funky investments outside of stocks, bonds, bank deposits, etc. Llama farms, gold medallions, and no-money-down real estate, are all unconventional, and all scams. Sure, the people pitching them show someone who got rich doing this, the same way Amway lines up its multilevel marketing operation, it is an appealing idea—why not me? Airport Holiday Inn conference rooms are always full of conferences on how to become rich following their 3-point plan, which invariably involves trading through them, or buying their $100 instruction manual. They have a horrible average return, because 'fraudulent scam' is not rare in this space, rather de rigueur.  ...

[P]eople tend to pay for hope, and nothing offers hope better than the lottery-like returns available in potential Black Swans. Hope is a good thing, and motivates a lot of hard work and creativity. But it would be foolish to think that the more improbable, the more speculative, the more derided by economists, the better the risk-adjusted return merely because of this. This tendency to buy into lottery ticket leads to all sorts of really bad investments:

• Higher volatility stocks have lower return than low volatility stocks
• Higher beta stocks have lower returns than low beta stocks
• out-of-the-money options have lower returns--and higher betas--than in-the-money-options
• higher leveraged firms have lower returns than lower leveraged firms
• firms is greater financial distress have lower returns than firms with low financial distress
• Junk bond mutual fund returns are lower than investment grade mutual fund return over the past 22 years
• sports longshots such as 50-1 odds horses, have lower returns than favorites
• lotteries with the highest payouts have the lowest expected returns
• IPOs have lower-than-average stock returns

[This is in my book, and also summarized on an SSRN paper I wrote here.] Notice a pattern? The more volatile, more uncertain, the lower the return. People pay a premium (accept a lower return) for 'Black Swans', because in one fell swoop, they can get rich and prove they were RIGHT! Instant satisfaction.  ...

Basically one would be better off not chasing dreams via Black Swans, and stick to boring investments. ...Black Swan investing is a sucker's game, endemic in markets, a perennial loser, and highlights asset classes to avoid, not pursue.

The Risk-Adjusted Cost of Financial Distress

Almeida and Philippon, The Risk-Adjusted Cost of Financial Distress, J Finance 2007

Financial distress is more likely to happen in bad times. The present value of distress costs therefore depends on risk premia. We estimate this value using risk-adjusted default probabilities derived from corporate bond spreads. For a BBB-rated firm, our benchmark calculations show that the NPV of distress is 4.5% of predistress value. In contrast, a valuation that ignores risk premia generates an NPV of 1.4%.We show that marginal distress costs can be as large as the marginal tax benefits of debt derived by Graham (2000). Thus, distress risk premia can help explain why firms appear to use debt conservatively.

Risks of High Wealth

via Zero Hedge, I see the news that

Jean-Pierre Aguilar, co-founder and CEO of France’s largest hedge fund, died in a gliding accident over the weekend.

Capital Fund Management, which Aguilar helped set up 18 years ago, broke the tragic news to its investors in a letter yesterday. Aguilar, a passionate glider, was killed during a flying contest in the south of France sponsored by CFM. The accident occurred during the final flight of the six-day event, and also took the life of his co-pilot, the head of the Gliding Club of Barcelonnette, France.

Aguilar died “while competing in a sport he loved and where he had tremendous experience,” CFM told investors. The 49-year-old is survived by a wife and three children.

CFM moved to quickly to reassure investors that the US$2.7 billion firm would survive its leader’s untimely death.

Trusting Mortgage Brokers

Mark J. Garmaise, After the Honeymoon: Relationship Dynamics Between Mortgage Brokers and Banks

This paper provides new micro-level evidence describing how the dynamics of mortgage broker-bank relationships contributed to the current residential loan crisis. In a theoretical analysis, I demonstrate that brokers have an incentive to present mortgages to the bank that are of decreasing quality over time. Empirically, I find strong evidence of this behavior in the data; I show that 22% of the delinquencies in my data are attributable to the increasing unobservable risk of mortgages originated by a given broker over the course of his relationship with a bank, controlling for month-of-origination vintage effects.

AIG Financial Products Update

Felix Salmon quotes Michael Lewis writing about AIG FP:

[AIG] FP literally had no idea what it was doing. He tells the story of Gene Park, who examined FP’s business at the end of 2005 and found that it was insuring deals which were 95% subprime:

Park then conducted a little survey, asking the people around AIG FP most directly involved in insuring them how much subprime was in them. He asked Gary Gorton, a Yale professor who had helped build the model Cassano used to price the credit-default swaps. Gorton guessed the piles were no more than 10 percent subprime. He asked a risk analyst in London, who guessed 20 percent. He asked Al Frost [FP's main liaison to Wall Street], who had no clue.

Cassano simply trusted the models (which were built with a lot of Gorton’s help), even when the models weren’t designed for subprime in particular, or even really for mortgages.

One more twist in the Madoff Saga...

Just when the Madoff saga had calmed down I run across a report that flabbergasts me again.  ProPublica (via Clusterstock) reports that Madoff Client Jeffry Picower Netted $5 Billion—Likely More Than Madoff Himself:

It now appears that the biggest winner in Madoff's scheme may not have been Madoff at all, but a secretive businessman named Jeffry Picower. 

Between December 1995 and December 2008, Picower and his family withdrew from their various Madoff accounts $5.1 billion more than they invested with the self-confessed swindler, according to a lawsuit filed by the trustee who is trying to recover money for those Madoff defrauded.  [View the complaint.] ...

The complaint states that the Picowers were beneficiaries of the Ponzi scheme for more than 20 years. The withdrawals listed between 1995 and 2008 reveal a pattern of large quarterly disbursements, transferred to Picower-controlled accounts by check or sometimes wire, that peak in 2003. Three years later something happens that causes the amount to drop precipitously. It recovers slightly the following year, but the highest-flying days are over for good.   ...

Picower, 67, began his career as an accountant and lawyer in New York but seems to have made much of his fortune as an investor in the medical industry. He has avoided media interviews and, with a few notable exceptions, succeeded in keeping a low profile. If the Picowers were recognized at all, prior to their Madoff notoriety, it was through praise for their philanthropy. Yet even here, their ties to Madoff loomed large. The growth of their largest foundation was attributed to their Madoff investments. Madoff himself served as a trustee on another Picower foundation.  

The court-appointed trustee makes a powerful, albeit still largely circumstantial, case in court filings that Picower knew Madoff's fund was illegitimate. Although Madoff ostensibly produced eerily consistent 10-12 percent annual returns for his clients, the returns he provided Picower were other worldly:

• In 14 instances between 1996 and 2007, a group of Picower trading accounts experienced annual returns of more than 100 percent. On 25 occasions, the annual return exceeded 50 percent. During this same period, the biggest annual gain in either the Dow Jones Industrial Average or the S&P 500 was 31 percent, for the S&P in 1997. The S&P 500's annual average for that period was slightly under 9 percent.
• The annual rate of return for two of Picower's regular trading accounts in the four years between 1996 and 1999 ranged from about 120 percent to more than 550 percent annually.
• In 1999, one account earned 950 percent.

According to the Madoff trustee's court filings, "the account reflected little trading activity and relatively few holdings," yet Picower took hundreds of millions out of it. At the time of Madoff's arrest, the account had a reported negative net cash balance of more than $6 billion.

At the beginning of each quarter, the Picowers received sums that grew from an annual total of $330 million in 1996 to $1 billion in 2003. These withdrawals were divided into odd numbers spread over various accounts. Added together, they usually equaled large even sums. For example, on January 2, 2003, Picower withdrew $1,378,852 from his account Jln Partnership. Yet when withdrawals across all accounts were totaled for that day, they amounted to precisely $250 million.

Picower's quarterly withdrawals reached their zenith in 2003 and then decreased by half the next year, eventually dropping to their lowest point in 2006. For some reason, the quarterly withdrawals totaled an uneven $16,975,422 in 2006, only to rebound to exactly $40 million in 2007.

Picower's extraordinary gains do not appear to have been achieved at random. The trustee's complaint details how Picower, often acting through a subordinate, ordered up "returns" which Madoff's office then delivered. In some cases, Picower is alleged to have requested backdated returns for trades or sales of securities.

• On April 18, 2006, Picower wired $125 million to Madoff to open a new account. Madoff's office began "purchasing" securities in the account, but "it backdated the vast majority of these purported transactions to January 2006" when the stock market was at its lowest for the period, according to the complaint. Twelve days later, the net equity value of the account was $164 million, a gain of $39 million – or more than 30 percent – in less than two weeks.
• The complaint details conversations between Picower associate April Freilich and Madoff's office beginning around May 14, 2007, when Freilich stated that the Picower Foundation needed gains during January and February of 2006, a year earlier.
• On May 18, Freilich specified that the foundation needed "$20 mil in gains" and "want[ed] 18% for year[] 08 appreciation" for January and February of that year. Five days later, Freilich changed the amount to $12.3 million. Subsequent statements reflected gains of $12.6 million.
• On December 22, 2005, Picower or Freilich allegedly faxed a letter to Madoff dated December 1, directing him to sell specific holdings. The statement for that month reflects that the sales were finalized on December 2, a process that typically takes three days. The clues that the letter was back-dated: A fax with the tell-tale December 22 date and an attached portfolio appraisal dated December 16 that included the positions that were supposedly "sold."
• On or around December 29, 2005, Freilich allegedly faxed a letter to Madoff asking for $50 million in gains across certain accounts. Subsequent statements generated by Madoff for the accounts show stock sales, presumably to satisfy the request, that were supposedly recorded around December 8 and 9, 2005, approximately three weeks prior to Freilich's letter. ....

The Picowers gave to a host of worthy causes from the Children's Aid Society to the New York City Ballet, but Jeffry Picower's passion centered on health issues, particularly funding for medical research. On December 1, 2005, the couple made a rare public appearance at a ceremony at the Massachusetts Institute of Technology to dedicate a new center to study the brain, the Picower Institute for Learning and Memory. The Picowers' gift of $50 million, spread over five years, was the single largest in the school's history. In a video of the ceremony, Nobel Prize winning Japanese scientist Susumu Tonegawa told the crowd that without the Picowers there would be no institute. The Picowers stood by silently as Tonegawa unveiled a portrait of the couple to conclude the ceremony. ...

Picower's legal and regulatory history was outlined in an article by Forbes Magazine. The 2002 article, which didn't mention Picower's activities with Madoff, said Picower was "worth at least $300 million." That same year, the trustee reports, Picower's quarterly withdrawals from Madoff totaled $895 million. 

This is the stuff conspiracy theories are made of...

Update #1: the Picower house in Palm Beach.  Pretty scary neighborhood if you look around (click through to the 'bird's eye' view). Also his house in Fairfield, CT (or his neighbor's larger house, hard to tell...).   

Update #2: the thing that surprises me is that none of the prime suspects has disappeared yet.  With that much cunning, money and time to prepare I would have expected a few more disappearances. 

High Frequency Trading Shops

One group of trading shops that is hiring throughout the downturn are the high frequency guys, something I don't do.  The WSJ reports:

The majority of stock trades now originate with fully automated “high frequency” funds, a phenomenon that has accelerated during the market turbulence of recent years because of the relative success of the strategy.

These funds employ no traders in the conventional sense. They employ no economists or chart trackers. Rather, programmers at funds such as those operated by Citadel Investment Group and Renaissance Technologies outfit computers with strategies based on obscure mathematical correlations. Then the machines trade in and out of stocks at light speed without human intervention, a departure from the “fundamental” investing model that dominated trading for the last century.

Five years ago, less than one-quarter of U.S. stock-trading volume was generated by “high-frequency” traders, and few considered the funds more than a niche strategy, according to Matthew Rothman, an analyst of quantitative funds for Barclays Capital.

That percentage has since more than doubled even as overall volumes increased, with some estimating as much as two-thirds of daily volume now stems from these funds. The niche’s role now overshadows that of mainstream brokers, mutual funds and hedge funds.

With the rise of these automated funds, the stock market is more prone than ever to large intraday moves with little or no fundamental catalyst. Computers don’t analyze the news (although some strategies use headlines as triggers) or seek to justify their buying and selling. Even in the relative quiet of the last three months, investors have often watched individual stocks or sectors move by 10% or more without explanation.

Major hedge funds have put other strategies on ice are now opening new funds devoted to high-frequency strategies and hiring the mathematicians and computer programmers that run them. Some of the fastest-growing market makers, such as Global Electronic Trading Company, or Getco, also use the automated strategies.

Bill Cronin, head of electronic sales for Knight Capital Group, said the popularity of these funds started to take off about the time the recent bear market started. Since then, their success has drawn more capital into these model-makers, extending their reach just as other money managers lost assets and reduced trading.

According to Hedge Fund Research, high frequency trading strategies total assets under management were $141 billion as of the first quarter, down about 21% from their high. By comparison, the overall hedge fund industry peaked at $1.93 trillion in 2007 and was recently down 31% off that peak.

With the surge in high frequency, traditional money managers face the increased likelihood of seeing orders “gamed,” or deliberately gouged. Some conventional brokers such as Joseph Saluzzi, a founder of boutique trading house Themis Trading, consider the high-frequency funds troublesome “locusts … feeding off the equity market,” saying the current market structure makes it too easy for a high-speed computer to expose a large order before it’s fully executed.

Not a stable business model nor, in any direct manner, very socially useful (though things are complicated).  Mostly about about driving up execution costs and the market impact for other traders.  

Update #1: well, it seems that Renaissance's two public funds are continuing to have a really really bad year. 

Financial Reform

Clusterstock writes:

Buried in Obama's financial reform plan is a requirement to make stockbrokers act in the best interests of their clients ("fiduciary responsibility"). 

This would replace the current conduct standard, which merely requires brokers not to stuff their clients accounts full of products they would be crazy to buy ("suitability").

Most money managers and independent financial advisors have long been held to the fiduciary standard, which makes vastly more sense. ...

The WSJ elaborates:

But requiring brokers to operate under a fiduciary standard could force them to offer products that are less costly and more tax-efficient. They will have to disclose any potential conflicts of interest, such as any fees they may get for favoring one product over another. That could mean clients will be offered fewer proprietary products if the broker can find a lower-cost option elsewhere.

For example, a broker couldn't put you in a mutual fund with higher fees -- or one he gets a bigger commission for selling -- if he could get a comparable fund with lower fees elsewhere, says Tamar Frankel, an expert on fiduciary law at Boston University School of Law.

The proposal addresses a long-simmering debate over how brokers and investment advisers, who have traditionally offered more financial-planning advice, are regulated.

For years, investment advisers -- regulated by the Securities and Exchange Commission as part of the Investment Advisers Act of 1940 -- have been held to a fiduciary standard, meaning that in serving the clients, they have to put their clients' interests first. Brokers were excluded from that definition of investment advisers as long as they didn't get paid special compensation for that advice, and gave it as "solely incidental" to their brokerage services.

But over the years, that distinction became more blurred as brokers held themselves out as financial planners, even as they continued to operate under the more lenient standards. Making matters more confusing is the fact that some brokers became dually registered, operating under a suitability standard when they are selling products, but under a fiduciary standard when doling out investment advice.

Which raises the question of why stock brokers now operate under the 'suitability' standard. 

Efficient Bank Recapitalization

Thomas Philippon and Philipp Schnabl have a paper I ought to read: Efficient Recapitalization.  I've been surprised by the lack of papers so far that try to lay out what the actual economic problem bank recapitalization schemes are trying to solve.  The abstract:

We analyze public interventions to alleviate debt overhang among private firms when the government has limited information and limited resources. We first compare the efficiency of buying equity, buying risky assets, and providing debt guarantees. With compulsory participation, all the interventions are equivalent. With endogenous participation, buying equity dominates the two other interventions. We extend our results to deposit insurance, debt covenants, and heterogeneity across assets. Finally, we propose a constrained-efficient mechanism where the government makes a subordinated loan in exchange for call options on equity.

This results seems unsurprising for a simple model...so the issue is what a more complex (and realistic) model would show.  So far I don't know how to reverse engineer a model that would point towards the sort of policy we're seeing now. 

Millennium Partners gets charged with Insider Trading Again

Zero Hedge points out that

In a watershed case, the SEC has launched its first CDS insider trading case implicating Millennium Partners portfolio manager Renato Negrin and Deutsche Bank CDS trader Jon Paul Rorech. According to the SEC, Negrin and Rorech engaged in illegal activity in the CDS of VNU N.V., a Dutch holding company that owns Nielsen Media, and made a $1.2 million profit. ...

In addition to cutting the careers of Negrin and Rorech short, this could be a huge blow to Millennium Partners itself, which has had some serious brushes with the SEC previously, most notably in the mutual fund market timing scandal which ended up costing Millennium a $121.4 million settlement in disgorgement and Izzy a $30 million penalty, as well as prohibiting Izzy from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter for a period of three years;

In addition the SEC stipulated in that case that Millennium must "cease and desist from committing or causing any violations and any future violations of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder" and "comply with certain undertakings, including the retention of an Independent Compliance Consultant to review its compliance program and the establishment of a Compliance, Legal, and Ethics Oversight Committee to ensure that Millennium's illegal conduct does not recur." Unforunately, it would seem that this Commttee might have failed just a little bit in its oversight of illegal conduct at the $10 billion hedge fund if the SEC's allegations are proven to be true.

Full SEC complaint at Zero Hedge. 

The first Administration Scandal with (political, not legal) Legs?

Bronte Capital reviews the problems Vice President Joe Biden's family business may have created.  Seems worth following.  Feeder funds run by celebrity marketers with shamefully insufficient due diligence are on my, and many other people's, current shit list, so this may have legs.  It would be consistent with my understanding of how the world works and who Joe Biden is (not that this is evidence).    The FT summary is pretty good as well. 

Felix Salmon points to a need for regulatory reform:

If you’re confused by the scandal surrounding the Ponta Negra hedge fund and its Biden landlords, don’t blame yourself: it’s really confusing stuff. If you have the patience for it, just read John Hempton[Bronte Capital]’s archives: start here, and then run through this, this, this, this, and this. (Don’t worry, there’s more to come, but we’re up to something over 6,000 words already.) Alternatively, Alphaville is running its own series, of which the first two parts are now up: 1,700 words on 650 Fifth Avenue, and 1,250 words on the Biden connection. The Alphaville posts are quite hard to follow, partly because the FT lawyers have stripped them of links, and partly because this whole thing is just very opaque and complex.

The one thing which is abundantly clear is that Jeffry Schneider (always mistrust people who can’t spell their own name) is a very shady character indeed, who was fired from various financial-sector jobs before ending up selling fraudulent hedge funds and seemingly working out of the Bidens’ hedge-fund hotel. Schneider was a “marketer” for hedge funds, including Ponta Negra — which means he sold them to rich individuals, and took a commission for so doing. How did he find the rich individuals? Lots of ways, but one was that he paid upwards of $10,000 a month for access to lists of people who were rich enough to qualify as hedge-fund investors.

This is the bucket-shop end of the hedge-fund world: small and sleazy and shadowy. But here’s the thing: if you’re a rich individual who’s phoned up by Jeffry Schneider and told about some fabulous new hedge fund you should put lots of money into, he has a pretty good explanation for why it’s so difficult  to get any information on him and his company: under the laws banning the advertising of hedge funds, he’s not allowed to give out much in the way of information.

As part of the forthcoming regulation of hedge funds I think there should be a lot of efforts to make them more transparent, rather than allowing them to use SEC regulations to justify their opacity. At the moment, simply giving out information about certain investments is considered to be advertising: I used to run into this problem the whole time when I was in New York, covering 144a bond issues which could only be sold to big institutional investors, and being told that therefore I couldn’t get any information on them. We need to move instead to a world where information is allowed to be free, even if the public at large still isn’t allowed to invest in the funds or securities in question.

Once we get there, it should become much easier for bloggers to uncover Ponzis — which is certainly a good thing. Hempton has a big advantage in that he’s part of that world himself, and has access to information which isn’t freely available online. Why can’t we all have that access?

Setting up a New GSE

Brad Delong writes:

There comes a point when the right thing to do will be to set up a Maggie Sue--a manufacturing, transportation, services, and other business loan-guarantee authority owned by the government, a financial GSE alongside Fannie, Freddie, and Ginnie--to guarantee "conforming" loans to operating companies, and let the major banks wither.

Taxes and Credit as alternative methods of identifying Ability to Pay

More later...

Counterparty valuation adjustments

I've wondered about this issue before, not clear to me how to think about it, though I'm pretty sure there are are one or more correct ways (see for instance here).  CVA is credit value adjustment, i.e. an adjustment due to the estimate that the counterparty (or you yourself in this case) will not pay.  See also Holding to Account. 

Krugman writes:

So the accounting rules say that a decline in the market value of a bank’s debt thanks to increased credit default swap spreads — that is, because investors think you’re more likely to fail — counts as a a profit. On the other hand, if your bank looks stronger, the spreads fall, and you book a loss.

FT Alphaville has the story. Citigroup reported

A net $2.5 billion positive CVA on derivative positions, excluding monolines, mainly due to the widening of Citi’s CDS spreads

while Morgan Stanley reported

Morgan Stanley would have been profitable this quarter if not for the dramatic improvement in our credit spreads - which is a significant positive development, but had a near-term negative impact on our revenues.

So Citigroup is profitable because investors think it’s failing, while Morgan Stanley is losing money because investors think it will survive. I am not making this up.

The NYT also reports:

One of the maneuvers, widely used since the financial crisis erupted last spring, involves the way Citigroup accounted for a decline in the value of its own debt, a move known as a credit value adjustment. The strategy added $2.7 billion to the company’s bottom line during the quarter, a figure that dwarfed Citigroup’s reported net income. Here is how it worked:

Citigroup’s debt has lost value in the bond market because of concerns about the company’s financial health. But under accounting rules, Citigroup was allowed to book a one-time gain approximately equivalent to that decline because, in theory, it could buy back its debt cheaply in the open market. Citigroup did not actually do that, however.

“It’s junk income,” said Jack T. Ciesielski, the publisher of an accounting advisory service. “They are making more money from being a lousy credit than from extending loans to good credits.”

Edward J. Kelly, Citigroup’s financial chief, defended the practice of valuing its bonds at market prices, since it values other investments the same way. The number fluctuates from quarter to quarter. For instance, Citigroup recorded a big loss in the fourth quarter of last year, when the prices of its bonds bounced back.

“I think it is unfair to focus on it in isolation rather than considering it with all the factors,” Mr. Kelly said.

Other banks have taken a similar approach. Bear Stearns, now absorbed into JPMorgan Chase, and Lehman Brothers, which plunged into bankruptcy last autumn, took advantage of credit value adjustments as their bonds lost value last year, as did Goldman Sachs.

JPMorgan, which reported strong results on Thursday, added $638 million to its first-quarter profit by availing itself of this adjustment. Bank of America and other large financial companies are expected to take similar steps when they report their results.

A similar issue shows up when mortgage write-downs are counted as mortgagor income for tax purposes.  Cannot pay your $400K mortgage and it gets written down to $300K?  You need to pay income tax on that $100K.    Which is a very sensible rule in most cases, though currently waived, since everybody would otherwise get paid tax free in loans that later get written down.  The big issue here seems to be, besides consistency with other accounting practices, what the timing of the income is: can you could non-payment as income before the non-payment occurs, i.e. does the change in the value of the anticipated non-payment count as current income? 

Update #1: well, thinking about this issue while driving my kids around, it seems that the problem here is that the accounting rules are remarking liabilities but not the change in asset value that is driving the change in liability value.  For example, assume a company with a project worth 200 has 100 bonds outstanding and 100 equities, both at par.  Then the project is reassessed by the market to be worth 200 with probability 0.5 and 50 with probability 50.  In that case, equity only gets paid 100 with probability 0.5 and is worth 50, and debt gets paid 100 with prob. 0.5 and 50 with prob. 0.5, for a value of 75.  With CVA the firm is making 25 in profit due to the lower value of its debt, due to defaulting on its debt with prob. 0.5.  Which is fine as far as it goes, but note that the accounting doesn't pick up the firms loss of 75 on the project, which is shared between debt, with a loss of 25,  and equity, with a loss of 50.  True profits by equity are -75 (from the project loss) and 25 (from the transfer from debt), for a total of -50 (exactly the loss in equity value). 

So the problematic feature here is marking the liability side to market but not marking the asset side to market, even though larger movements in asset side values are driving the liability side valuation adjustments. 

Risk Management

Rortybomb writes:

One of the reasons risk management is frustrating is because this exchange occurs all the time:

Risk Manager: So if we do that, the tail risk in the 1% region expands exponentially.
Other Dude: I know. And if we end up there, it’s going to be Mad Max. We are all screwed. There won’t even be a company left.
Risk Manager: Exactly. So if we gamma-hedge dynamically we can shift…
Other Dude: What? Let’s go ahead. If the worst case happens, we are screwed anyway.
Risk Manager: Hmmm.

The other issue is that the exchange above generalizes to a prisoner’s dilemma incredibly fast. “Well, the desk down the hall is doing this, and if the worst case scenario happens, we don’t get bonus points when our business goes bankrupt. And if it works and we didn’t do it, second place is no bonus. Third place is you’re Fired.” Replace “desk down the hall” with “bank across the street”, or “shady mortgage lender across the neighborhood”, and I think you get a lot of what went wrong the past 8 years

There are more than a few posts and papers that ought to be written on this topic (with good models and, hopefully, some evidence).  Not a new idea, but something that nevertheless needs elaboration, especially in terms of what countervailing arrangements can be put in place by people who can design them and implement them and have the incentives to do so well. 

Art Loan Write-Downs

The WSJ writes:

Of all the crazy loans handed out by banks in the past decade, perhaps the most ill-considered were art loans.

Associated Press

A photo of a 1981 artwork entitled “Dollar Sign,” by artist Andy Warhol. (AP Photo/Martin Lawrence Galleries)

As art exploded in price, both banks and owners wanted to tap into the value. Paintings were used in the same way as people used their homes — as giant ATMs spitting out cash as long as the market went up.

But there are two problems with art: It is especially hard to value, and it can disappear –suddenly.

Evidence of the first problem became apparent last week when the Swiss banking giant UBS shuttered its “art banking” practice. The bank had an 11 person team devoted solely to advising and financing client art purchases. It also sponsored Art Basel.

It is unclear how many art loans are underperforming. As it is shutting the operation down, after $50 billion of bank write-downs, it is safe to assume the unit wasn’t a money-maker. THESE WRITE-DOWNS ARE TIED TO ART FINANCING?

“Art banking does not belong to our core activities, so we will discontinue the operation,” a spokeswoman said, raising the obvious question of why they built it in the first place.

The more serious problem is that art can vanish. Sure, cars, boats and planes can vanish, but not as easily as a painting. J.P. Morgan last week sued Dutch businessman Louis Reijtenbagh for secreting his Rembrands, Picassos and other paintings out of the country. The artwork was collateral for more than $23 million in unpaid loans.

The suit says the art was supposed to be safeguarded at an apartment in Manhattan, at Trump Tower, that is owned by Reijtenbagh’s sons, Jacob and Edgar. Oops. A list of the art that is now gone includes works by Rembrandt, Picasso, Claude Monet, Edgar Degas, Pierre Bonnard, Rene Magritte and others.

Stocks in the Long-Run

via the NYT, I see Pastor and Stambaugh have a new draft of their paper Are Stocks Really Less Volatile in the Long Run? out.

Conventional wisdom views stocks as less volatile over long horizons than over short horizons due to mean reversion induced by return predictability. In contrast, we find stocks are substantially more volatile over long horizons from an investor’s perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. We decompose return variance into five components, which include mean reversion and various uncertainties faced by the investor. Although mean reversion makes a strong negative contribution to long-horizon variance, it is more than offset by the other components. Using a predictive system, we estimate annualized 30-year variance to be nearly 1.5 times the 1-year variance.

Which doesn't necessarily that the relative risk of stocks relative to bonds rises with horizon --- bond may also have increased long horizon risk, maybe more so than stocks.  It would be good to know.  And I've not looked at the paper long enought to know what sort of structure Pastor and Stambaugh allow for and what sort of structure Pastor they exclude.  For instance, how does the paper handle the time-varying possibility of really bad outcomes, with very occasional regime shifts, some potentially never observed historically?  

Simon Johnson on the Crisis

Simon Johnson writes in The Atlantic, blurbed as:

The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.

Well, I'd first have need to read the article to have an opinion....

Insurance Guarantee Associations

I've never heard of insurance guarantee associations, but then again there haven't been that many recent insurance company failures in the US.  The system appears to be about what one would expect given other programs like the FDIC or unemployment benefits, except that an AIG failure might (?) overwhelm the tax base here, insurance premia written in the relevant state. A high tax on this tax base would be inefficient in any case. 

“AIG subsidiaries are likely in worse shape than appeared at first blush,” Lehrer explained. So far, AIG has sold only one of its 72 subsidiaries that sell insurance in the U.S.

Past collapses have not been a big deal because they have been small; but an AIG collapse would not be small. “In the past, when insurers have collapsed, it has meant that people in a few states have seen surcharges of a few dollars on their insurance policies—annoying, but not a big deal,” said Lehrer. “A bailout of AIG’s insurance businesses could mean enormous new taxes for just about everyone. Some people might see a very unwelcome surprise in their insurance bill.”

Lehrer compared the situation to another famous corporate collapse. “On the surface, this looks a lot like Enron,” said Lehrer. “A lot of the underlying business may have had serious problems.”

The consequences for the collapse of any one of AIG’s sizeable insurance subsidiaries would result in significant taxes—called “assessments” —on homeowners, automobile, life insurance, and other policies. These assessments would be decided at the state level.

In almost all cases, legislatures do not need to approve assessments before they are levied to bail out insurance companies. All insurers participate in “guarantee associations,” and in most states, these associations are nominally private, but state law mandates that all insurers writing ordinary insurance policies participate in them. With the exception of New York state, the associations have few hard assets and instead depend on nearly unlimited taxing authority.

“Congress needs to be ready to deal with this problem,” Lehrer concluded.

The $300,000 dollar cap on life insurance benefits covered is a small fraction of my total life insurance, even a small fraction of my life insurance with American General Life, an AIG subsidiary. I did diversify away from AIG even though they were the cheapest carrier with when I upped my life insurance by 50% when kid #3 showed up, since AIG did look terribly opaque with a big potential downside even in 2004. 

Update #1: interesting, it seems that for most states the assessment looks like this, with different assessment rates, all pretty low:

Two percent (2%) of the average premiums in state for policies covered by the account during the three calendar years preceeding the impairment or insolvency.

Which means that the assessment is on policy holders of the insolvent insurance company only (or is it all companies in the jurisdiction?), and that it isn't that high, at most one or maybe two months of premiums.  Not clear if this can cover the obligations of a defaulting AIG subsidiary or what happens if it doesn't. 

Stocks vs. Treasury Bonds

A nice graph in the FT, showing the cumulative return difference between stocks and the 20 year T-bond.  Note that T-bonds (not even investment grade corporate bonds) beat stocks 1803-71 and since...hm, I cannot tell from the graph, sometime in the mid 1990s. Time to turn anti-Treasury bond. Note that these are the periods where stocks are under the stock vs. bond high water mark, not the shorter periods in which stocks underperform the bond.   Still, holding stocks vs. holding the 20 year Treasury bond (in a tax free account -- stocks are still tax advantaged compared to Treasury bonds in taxable accounts) gives the same returns since 1969. 

'Wall Street's Flight back to Partnership'

Larry Ribstein writes:

Wall Street's Flight back to Partnership

As I’ve been saying, the uncorporation (partnerships, LLCs, limited partnerships) is set to rise out of the ashes of Wall Street’s moribund corporate model. Wall Street investment firms, incorporated in the 1990s, lost control of risk and ended up as banks. The nail in their coffin is government money, with its baggage of heavy scrutiny, even if the firms manage to avoid confiscatory taxes on compensation.

Yesterday brought this Bloomberg story (HT Carney) about the emergence of Wall Street trading boutiques snapping up refugees from the big firms:

Broadpoint, whose shares have outperformed Citigroup Inc.’s by almost 51 percentage points this year, has added more than 240 people since September 2007. They include traders from Bear Stearns Cos., Lehman Brothers Holdings Inc. and Merrill Lynch & Co., which either collapsed or were absorbed by bigger banks * * * Cantor Fitzgerald LP, the closely held securities firm, has hired 100 people in the past six months from banks, including UBS and Bear Stearns.

* * *“The talent is streaming out of the doors of the big firms,” Bruce Foerster, a former Lehman Brothers managing director and now president of South Beach Capital Markets in Miami said. “As the best and the brightest leave, they will tip their hat to Senator Christopher Dodd. Bright people won’t want to be at places where the government is.”

The Plan Update II

This is going to be blog post I'd usually not write, since I'm going to put out a view that is terribly unnuanced and which deserves much more nuance than I can give it now. 

One aspect of the plan is that it appears -- yes, a weasel word, I'm not going to do the research necessary to back this up -- to be structured so that the Administration does not need to go to Congress, something Administration officials seem to have told Ezra Klein on background: 

Virtually no one thinks that Congress is willing to quickly offer either the legislation authorizing such an action nor the massiveupfront money that receivership would require. Will Ben nelson and George Voinovich vote to take control of the banks? And what happens to the market while Congress is debating? And to Congress if the market dives?

MY also notices this:

One aspect of the Geithner plan that I think people aren’t focusing enough attention on is that unlike the other main alternative approaches, it can be executed without further congressional approval. The reason is that there are federal agencies with a standing authority to make loans [for purposes and in a context never contemplated by the authorizing legislation...Stefan]. And though the plan does have a potentially giveaway structure, technically what’s being offered aren’t subsidies but no recourse loans. Or to put it another way, the subsidies are in the form of no recourse loans rather than direct appropriations, so the government has the authority to move forward under existing TARP legislation and other laws. That, I think, clearly explains the somewhat byzantine structure of the plan’s operations and is also, if you’re sitting in the West Wing, a considerable advantage over a nationalization plan that would require large additional appropriations to cover the debts of nationalized institutions.

John Carney:

If we were more cynical, we’d say that the entire point of this complexity was to promote public ignorance. Complexity is an ally of bureaucracy because anything that the public cannot figure out is effectively autonomous and removed from public scrutiny. But let’s not jump to the conclusion that the regulators have set out to confuse us.

Instead, it seems more likely that this is a budget dodge by the Obama administration. Politicians love guarantees because they don’t require current expenditures. In fact, they often pretend a guarantee or a loan is free money—as if a guarantee something that probably won’t ever have to be paid off and all loans from the government will get paid back. As we’ve learned throughout this crisis, that’s a dangerous fiction.

And if lowly  bloggers aren't good enough, Rogoff -- former IMF chief economist and Harvard international macro guy -- agrees as well:

The whole administration strategy seems to involve shoveling money to the financial system in the most opaque way possible. It's sort of an end-around Congress--both through plans such as this and also the Fed initiatives. The Fed initiatives involve all sorts of loan guarantees and various kinds of subsidies, and the Fed does not mark-to-market the way they're telling everyone else to. So, it's hard to know.

This does create a bit of a problem for people how might be tempted to take democratic theory seriously or who in the recent past have used (sloppy?) versions of democratic theory to criticize the Bush Administration's view of executive power.  On the other hand, this is the way the game is played in the American political system -- the Bush Administration was not an aberration. And is some ways this is a brazen subversion of Congress's power of the purse by making loans that are highly likely to go bad without seeking Congressional approval for this spending, since the legislation authorizing the authority to make these loans does not contemplate -- again a weasel word that needs a lot more nuance -- this sort of leverage structure or risk taking. 

It might still might be a good plan, given the circumstances.  But it is still hard to tell. 

Now for the nuance...

Update #1: well, it does look like Congress will get to vote on the second tranche of TARP funds.  So there will be a Congressional vote on a small fraction of the funds. 

The Plan Update

One of the big issues with the Plan is who can participate.  The main participation qualifications appear to be

• Capacity to raise $500 million of private capital.
• Experience managing eligible assets.
• A minimum of $10 billion worth of eligible assets under management.
• Headquarters in the U.S.

This seems like a bit of a narrow range of entities, both by size and by prior experience.  For instance, why can't employees with previous experience with these assets go out and raise their own money and start a small fund?  Say raise $50 million and start a $250 million fund (which is going to take a few months to get up to -- no new fund is going to start out with $10 billion of eligible assets under management)?  That would assure a lot more competition between fund managers.  Limiting this plan to maybe a dozen known entities who cannot be encroached upon by new firms seems like a bad stance to take.   

On the other hand, having competitive entry might just blow up the plan, since the plan may leave money ($100 billions?)  on the table for fund mangers and there would be infinite entry under the proposed rules if the plan allows for free entry by fund mangers.  Which suggests the plan isn't optimally designed (we're trying to help out banks with legacy assets, not fund managers). 

Or even if there isn't infinite entry with free entry, free entry might make sure the winner's curse hits the auction with full force and we have a close to 100% default default probability for the funds.  Which still might be fine, if it allowed for some rational price setting, but a near certain default would undermine the incentives fund managers have do the work to price rationally. 

Also, at the moment it seems that the banks get to pick which bad assets they sell, subject to the FDIC signing off on the ones the banks pick.  But why would the banks pick the ones we want them to sell? We need to know what the incentives here are to sell which assets. Which is the same problem the previous post points to. 

Update #1: John Hempton agrees:

The biggest problem with the Geithner plan is that the banks chose which assets to sell to the fund.

It allows selective price discovery on assets where the company taking the test selects the questions.

That doesn't prove anything except that banks taking self assessed exams for which the penalty is death tend to pass.

Too Big to Fail

Cheap Talk writes:

Suppose a bank is “too big to fail”. It’s got some bad assets that the government wants to buy so the bank becomes liquid again and people are willing to lend to it. But the assets come in different qualities and the government  would like to buy them at different prices to minimize the loss to the taxpayer.  It might want to pay a low price for the really bad stuff and a medium price for the medium bad stuff etc.  If it knew the quality of the assets , no problem - you can just pay different prices for different qualities.  But if the bank knows the quality it would try to palm off bad asset as a medium quality asset to get the better price.  The standard solution to this is to use inefficiency to “screen” different types of assets.  For example, the government says it is willing to buy a lot at the low price but less at the high price.

You have to set the quantity traded carefully so there is no incentive to sell the bad assets at the medium price as the amount the government would buy is too small to make it worth it.

All well and good it seems but remember this bank is “too big to fail”.  So, here’s what can happen: The bank sells bad assets to the government pretending they are medium assets.  It keeps the bad assets the government does not buy.  If they tank, guess what, as it’s too big to fail, the bank can dump the assets on the government anyway.  So, in the end, this scheme does not work, the government ends up buying medium and bad assets at the medium asset price.

I haven’t worked this out, but it seems to be what when banks are too big to fail this is what’s going to happen whatever you try to do: you end up paying high prices for bad stuff and there’s nothing you can do about it.  (Morally speaking, I’m replicating an old argument of Dewatripont and Maskin’s on the “soft budget constraint.”) The banks are happy as they get lots of surplus and the taxpayers pay a high price for liquidity.  The fact that the government has a social motive, saving the financial system, makes it impossible to eliminate adverse selection.

One thing that ought to happen in the aftermath of this is crisis is a move to make sure everybody can fail, either by being small enough to fail or by having credible and effective nationalization plans in place. 

The Geithner Public-Private-Partnership plan seems to mitigate this problem but not eliminate it.  Having a good model of how underwater banks and publicly financed funds would trade different types of assets would be helpful. 

AIG Bonus Mess Update

Thinking about the confiscatory -- and no, this is really confiscatory, not the pretend confiscatory taxes Republicans like to complain about -- surtax on large TARP recipient bonuses, it strikes me as very bad policy.   This sort of thing is going to make any top management very very reluctant to have their firms participate in any credit support programs.  Any reasonable CEO would rather shrink his company quite a bit rather than be hit after the fact by tight and way under the market limits on what he can pay employees, limits that will take take companies apart very effectively.  And even if this mess is eventually cleared up and no crazy legislation passes, it will still be a significant deterrent for entering into credit support programs, since now there is no up front assurance something like this isn't going to happen again in the future. 

Update #1: on the other hand, how about some retroactive clawbacks for the Board of Directors of AIG?

Forgetting the obvious political embarrassment, the fact that [Obama administration special envoyto Pakistan and Afghanistan] Richard Holbrooke served on AIG's board of directors from 2001-2008 just shows what a farce Wall Street had become. Richard Holbrooke is rather learned about brokering peace in Yugoslavia. But he knows very little about overseeing managers charged with overseeing traders charged with gaming the credit default swap market.

What he would know a lot about, conversely, is the phone numbers of powerful politicians you might want to call if you were worried about this or that regulatory matter coming before the Congress. Which is presumably how he earned his $800,000 in compensation.  

I have no problem with clawbacks for income over say $2 million a year on average for people in the AIGFP group or tasked with supervising this group for say 2001-2008.  But going after people earning less money --- i.e. people who never had the power to change anything and were being paid for their work -- or people not involved with AIGFP is just silly. Or telling people who are trying to clean up this mess that you won't pay them reasonable bonuses is crazy.  And doing this via the tax code in this manner is crazy and is going to induce all sorts of suboptimal tax planning.  We're dealing with a very small number of guilty people here in AIG, 20 or 30 at most, probably fewer than that, and even then it isn't clear they are really at fault and not the regulatory system and the Congress and Administrations and Courts who set it up that way. 

Altogether, this episode is making me revise my view of the functional nature of the US political system downward. 

There is the question how much of this is pretense or Washington Kabuki: this bill is written in order to fail.  This way you can be for a bill that will never pass.  But there's still the question of who will step up and take the heat for the Representatives who passed this mess. 

Time for traders to obtain offshore tax status?  Maybe Canada could make a play for disgruntled US citizens. This episode does underline the sad need for expensive tax and estate planning and diversifying one's asset holdings offshore.  Finally, the now more rational fear of confiscatory and irrational tax policies makes creating a global financial regulatory structure with the power to prevent or mitigate AIG like problems harder. Hm, that seems like a point worth elaborating...how does this work? 

Forgetting the obvious political embarrassment, the fact that [Obama administration special envoyto Pakistan and Afghanistan] Richard Holbrooke served on AIG's board of directors from 2001-2008 just shows what a farce Wall Street had become. Richard Holbrooke is rather learned about brokering peace in Yugoslavia. But he knows very little about overseeing managers charged with overseeing traders charged with gaming the credit default swap market.

What he would know a lot about, conversely, is the phone numbers of powerful politicians you might want to call if you were worried about this or that regulatory matter coming before the Congress. Which is presumably how he earned his $800,000 in compensation.  

I have no problem with clawbacks for income over say $2 million a year on average for people in the AIGFP group or tasked with supervising this group for say 2001-2008.  But going after people earning less money --- i.e. people who never had the power to change anything and were being paid for their work -- or people not involved with AIGFP is just silly. Or telling people who are trying to clean up this mess that you won't pay them reasonable bonuses is crazy.  And doing this via the tax code in this manner is crazy and is going to induce all sorts of suboptimal tax planning.  We're dealing with a very small number of guilty people here in AIG, 20 or 30 at most, probably fewer than that, and even then it isn't clear they are really at fault and not the regulatory system and the Congress and Administrations and Courts who set it up that way. 

Altogether, this episode is making me revise my view of the functional nature of the US political system downward. 

There is the question how much of this is pretense or Washington Kabuki: this bill is written in order to fail.  This way you can be for a bill that will never pass.  But there's still the question of who will step up and take the heat for the Representatives who passed this mess. 

Time for traders to obtain offshore tax status?  Maybe Canada could make a play for disgruntled US citizens. This episode does underline the sad need for expensive tax and estate planning and diversifying one's asset holdings offshore.  Finally, the now more rational fear of confiscatory and irrational tax policies makes creating a global financial regulatory structure with the power to prevent or mitigate AIG like problems harder. Hm, that seems like a point worth elaborating...how does this work? 

Die Ticketmater Die

The WSJ reports on what seems like very dishonest and tendacious [sic?] accounting by that all so loved and respected company Ticketmaster:

Citing declining ticket sales, costs associated with layoffs and a massive impairment charge, Ticketmaster Entertainment Inc. swung to a loss of $1.07 billion on revenue of $384 million in the last three months of 2008, the company reported Thursday.

The results could bolster the West Hollywood, Calif., ticketing company's contention that adverse economic conditions are part of what is forcing it to merge with concert promoter Live Nation Inc. Ticketmaster shares closed at $4.09 in 4 p.m. Nasdaq Stock Market trading, down less than 1% but significantly below a 52-week high of $27.

The loss compares with net income of $51.1 million in the fourth quarter of 2007. Excluding the impairment charge, net income for the latest quarter fell 81% to $9.9 million, or 16 cents a share; FactSet Research Systems Inc. had expected earnings of 29 cents a share. For the year, net income excluding the impairment charge declined 56% to $74.7 million.

In a conference call discussing the results, Chairman Barry Diller lashed out at politicians and others who have raised questions about the company's proposed merger. Mr. Diller singled out New York Sen. Charles Schumer for engaging in what the executive called "always-to-be-expected shameless grandstanding."

Sen. Schumer aggressively questioned Ticketmaster's chief executive, Irving Azoff, during a hearing last month on the merger. The deal would create an unprecedented music-industry powerhouse, dominant in ticket sales, concert promotion, venue operation and artist management. That has created a controversy, with competitors and others in the business complaining that the company would have too much power.

On Thursday, a spokesman for Sen. Schumer, Brian Fallon, said "concertgoers would be better off if Mr. Diller provided cheap seats instead of cheap shots."

The bulk of Ticketmaster's loss was because of a $1.1 billion charge the company took because of a precipitous decline in its share price since being spun off from IAC/InterActiveCorp last year. The fourth-quarter revenue represented an increase of 9.4% from the year-earlier period, mainly because of acquisitions, the company said.

The company incurred a loss of $18.82 a share, compared with income of 91 cents a share in the fourth quarter of 2007.

For the full year, Ticketmaster reported revenue of nearly $1.5 billion, a 17% increase from 2007, thanks to its acquisitions of Front Line Management, resale service TicketsNow and Paciolan, a college-sports ticketing company. The company said its revenue from ticketing amounted to about $1.4 billion, for 141.9 million tickets sold -- an average of 3% more per ticket than it reaped in 2007. The company posted a net loss of $954 million for the year, thanks to the impairment charge.

The merger is one of several controversies currently facing the company. Mr. Diller also addressed the company's attempts to capitalize on the so-called secondary market in tickets, which has been controversial, because it has appeared to serve as a way for artists to charge more than face value for their concert tickets while pretending they are actually being resold by fans. Mr. Diller apologized for the flap. "We are in the early stage of our efforts and we're learning all the time," Mr. Diller said. "While we've certainly made our mistakes, they've been of omission, not commission."

How do you take an impairment like this?  Seems very fishy.  Time to look at the quarterly report...ah, here it is

Goodwill Impairment
During the fourth quarter of 2008, the Company recognized a non-cash, pre-tax charge of $1.1 billion related to the impairment of goodwill in its Ticketing segment. The impairment, which was indicated by our 2008 annual impairment testing of goodwill, reflected the decline in the Company’s share price since its spin-off from IAC in August 2008 and the recent uncertainty of economic conditions. No impairment charge was recorded in the prior year.

Wow, you even get to do this pre-tax. But it isn't clear to me how it plays out taxwise, since

For the year ended December 31, 2008, the Company recorded a tax provision of $25.6 million on pre-tax book loss of $984.2 million. This represents an effective tax rate of -3%, which is different from the statutory rate of 35% principally due to the impairment of goodwill that is not deductible for tax purposes. Excluding the impairment charges recorded in the fourth quarter of 2008, the Company’s effective tax rate would have been 42%. This rate is higher than the statutory rate of 35% principally due to losses not benefited in foreign jurisdictions and state taxes, partially offset by foreign income taxed at lower rates and foreign tax credits. For the year ended December 31, 2007, the Company recorded a tax provision of $89.0 million, which represented an effective tax rate of 35%. This rate approximates the statutory rate of 35% principally due to state taxes offset by foreign income taxed at lower rates.

So it looks like various loophole clawbacks made them pay $25.6 million in taxes. 

Citi Short Squeeze

Well, the news of the day, beyond the fact that the Fed now deems to announce some of its policy in advance to increase policy effectiveness, is that there is big short squeeze on for Citi stock.  Not clear why and the extent to which this is a Treasury move.  Lots of blood in the street it seems. 

Not understanding Black-Scholes Option Pricing

Seeking Alpha writes in an unsigned article:

In his recent report to the shareholders of Berkshire Hathaway (BRK.A, BRK.B), Warren Buffett explains why he’s buying and selling the very derivative securities he notoriously lambastes as weapons of financial mass destruction. It’s simple really. He thinks the Black Scholes model is wrong, and lots of these derivatives are mispriced as a result.

The guy’s got a point. Under the Black Scholes Model, the longer the time to exercise, the higher the price of the option. That makes some sense in the short term, but suppose you are trying to price a 100 year put option on the S&P 500? The Black Scholes Model would tell you that put option is vastly expensive, which is silly because it’s really, really unlikely that the S&P500 is going to be lower in 100 years.  ...

There’s another problem with the original Black Scholes Model, which is that since it doesn’t account for average returns on equity prices, it can’t account for the law of averages. For example, we can expect SPY to return 7.5% a year on average, but in any given month or year, it’s not going to necessarily do that. In fact, the shorter the time frame we’re looking at SPY, the less likely it is to return 7.5%. But, the law of averages provides that longer the time frame we look at SPY, the likelier it gets that 7.5% is going to be the actual rate of return.

Ahm, there may be problems with Black-Scholes option pricing, but these are not the problems, as any first year finance course is going to teach you.  Black-Scholes explicitly deals with both these (closely related) issues.  Saying that Black-Scholes overvalues long-horizon put options is the same things as saying the S&P 500 is currently undervalued, since Black-Scholes values options via (frictionless) trading arbitrage under the assumption of constant log volatility.  Expected drift in the price of the underlying asset doesn't matter for option prices and this isn't changed by more complecated models.   Buffet, who isn't going to make this sort of mistake, is simply making the bet here that vol is going to fall more than the vol implied in these long-horizon options.  Buying and selling options is a bet on vol movements (and the conditional vol surface), not on the direction of the market that could not be done by buying the market itself.  [Some vague comments about transaction cost issues here....]

As to

the longer the time to exercise, the higher the price of the option. That makes some sense in the short term, but suppose you are trying to price a 100 year put option on the S&P 500? The Black Scholes Model would tell you that put option is vastly expensive, which is silly because it’s really, really unlikely that the S&P500 is going to be lower in 100 years. 

Yes, but Black Scholes realizes that unlikely isn't the same thing as impossible and assigns a really really high relative price to cash flows in these states of the world, which is the same state pricing that values the S&P500 today and leads to expected S&P500 appreciation as these state of the world become less likey as time passes.