Via many news wires:
Vice President Joe Biden's son and a close friend of Secretary of State John Kerry's stepson have joined the board of a Ukrainian gas producer controlled by a former top security and energy official for deposed President Viktor Yanukovych.
The move has attracted attention given Messrs. Biden's and Kerry's public roles in diplomacy toward Ukraine, where the U.S. expressed support for pro-Western demonstrators who toppled Mr. Yanukovych's Kremlin-backed government in February. The uprising provoked a pro-Russia backlash that has plunged the post-Soviet republic into conflict and bought it to the brink of civil war.
Hunter Biden, a lawyer by training and the younger of the vice president's two sons, joined the board of directors of Ukrainian gas firm Burisma Holdings Ltd. this month and took on responsibility for the company's legal unit, according to a statement issued by the closely held gas producer.
His appointment came a few weeks after Devon Archer —college roommate of the secretary of state's stepson, H.J. Heinz Co. ketchup heir Christopher Heinz —joined the board to help the gas firm attract U.S. investors, improve its corporate governance and expand its operations. A State Department spokesman declined to comment.
"The fact that I joined the board of directors is largely based on the company's will to grow," Mr. Archer said in an interview with Ukrainian media published on Burisma's website. "Last year alone witnessed a lot of transformations." He vowed to make the company more transparent.
Mr. Biden, 44 years old, and Mr. Archer, 39, work for Rosemont Seneca Partners, a U.S. investment company. It is affiliated with Rosemont Capital, a private-equity firm Mr. Archer co-founded with Mr. Heinz.
Two people familiar with Mr. Heinz's involvement in the firms said he isn't involved with the day-to-day operation of Rosemont Seneca, which is 50%-owned by Rosemont Capital. The people also said there was no financial investment by the firms in Burisma, just board memberships for Messrs. Biden and Archer.
Messages were left for Hunter Biden at his offices in Washington and New York and at offices of a law firm where he is of counsel. A person answering the phone at his office in Washington said Messrs. Biden and Archer were unavailable and promised to pass along a message.
The White House press secretary and the vice president's office described Hunter Biden's activities as those of a private citizen, bearing no endorsement of the U.S. government.
"Hunter Biden is a private citizen and a lawyer," said Kendra Barkoff, a spokeswoman for Joe Biden's office. "The vice president does not endorse any particular company and has no involvement with this company."
I seem to have picked up a running injury (surprise!), though a new one for me. It may be 'runner's knee' or just a quad muscle tear or tendon problem. Directly above my right knee, but at times it moves higher up as well. Picked it up last week, associated with a 18+ mile run on Tu and then again on Th (should have waited till F or Sat?). I didn't run this week at all, except for a 2 mile attempt yesterday. That was fine and the injury wasn't really noticable before or during the run, but it got quite noticable after the run, including today.
So I'm walking, not running. Agh...
One of my failings is not sticking my neck out here when exciting things happen in the world. Like Cyprus over the weekend. What could be more worthy of comment?
So some meandering and delayed thoughts.
First, some (substantive) snark from DeLong:
The 1919-1939 interwar period taught us four lessons:
In order for the world economy to be prosperous, adjustment to macroeconomic disequilibrium needs to be undertaken by both "surplus" and "deficit" economies--not by "deficit" economies alone.
If the world economy is to have any chance of avoiding or limiting crises, an integrated banking system requires an integrated bank regulator and supervisor.
In order for crises to be successfully managed, the lender of last resort must truly be a lender of last resort: it must create whatever asset the market thinks is the safest in the economy, and must be able to do so in whatever quantity the market demands.
In order for any monetary union or fixed exchange rate system larger than an optimum currency area to survive, it must be willing to undertake large-scale fiscal transfers to compensate for the exchange rate movements to rapidly shift inter-regional terms of trade that it prohibits.
I, at least, thought that everybody--or everybody who mattered in governing the world economy--had learned these four lessons that 1919-1939 had so cruelly taught us. Now it turns out that the dukes and duchesses of Eurovia had, in fact, learned none of them. History taught the lesson. But while history was teaching the lesson, the princes and princesses of Eurovia and their advisors were looking out the window.
First, we are seeing a real divergence here between, and it is hard to draw the line correctly, at least for me, the educated German outlook and the educated US outlook, at least most of the educated US outlook (there are exceptions). Why the divergence is as large as it appears to be isn't quite clear to me. Some of it is contextual, with educated thought unable to push the boundary with policies that don't have institutional frameworks to hang them on. The non-existence of a legitimate institutionalized European central power that is supernational means some policies don't have an easy place to to themselves on a menu, and that seems to matter. But I am surprised it matters so much.
Second, it is a bit hard to understand how we can have a banking market equilibrium in which a) there isn't credible deposit insurance, b) there is no largish amount of credibly junior to bank deposits bank bonds outstanding, c) there are bank deposits held in weak banks in weak sovereign countries (i.e. counties that don't have guaranteed access to Euro reserves). If you can't see that your bank is stable by looking at bond spreads in a credible bond market and you don't have credible deposit insurance, why put money in that bank? On the other hand, that seems to be the equilibrium in Europe right now, lots of deposits in weak banks in counties that can't provide deposit insurance if they are not backed up by Germany. So maybe Cyprus is special case, but how can you know? And moving your cash to German banks is cheap.
Another issue is that Cyprus banks, and I would guess other weak banks in weak counties, have basically no bond holders who could take a hit. There's also no bond market to look at to gauge the strength of the banks. Cyprus banks have basically two types of liabilities, basically distributed 50:50, since there is no equity that is worth anything nor any bond holders: deposits and central bank credits (which in the end, however they are structured, are central bank funds from the ECB and strong European central banks). The problem here is that central bank creditors don't behave like regular private sector creditors subject to regulatory and legal constraints about priority in bankruptcy before bankruptcy has occurred. Instead, central bank creditors get treated like post-bankruptcy emergency creditors: they call the shots and are senior to pre-bankruptcy creditors (i.e. depositors). But this creates problems: a) central banks can get away with self-dealing that private sector actors can't engage in, b) depositors can run and are not locked in, so you can't actually make them junior creditors without a run and locking up at least some of the deposits (that's why you use deposits, it's a self-enforcing arrangement that prevents you from being made junior, since that sets off a run).
One perspective is that the ECB and German Central Bank own this mess since they are the residual source of funds for the Cyprus banks who otherwise would have gone belly up a while back and hence have been calling the shots for a while. But there is not state/law/regulator to impose that (which in turn is one reason the ECB extends the credits in the first place, since it knows it can call the shots without these restrictions)...so the question is how it will play out under the pressure of the potential and actual economic consequences.
At least I don't have to worry about my millions in the bank.
From Dealbreaker, more at the link. Yes, the 'aw, who could have known' stuff gets pretty annoying. So, yes, I'm on board with this rant.
One thing that would probably be fun would be reading the internal emails sent around at the places that bought terrible RMBS CDOs in the end times of 2006-2007. What did they say? Was it “these mortgages are worth twice what Morgan Stanley is selling them for! We are ripping their faces off”?1 Was it “I looked through a representative sample of the mortgages underlying the collateral in this deal and I think the yield more than justifies the risks”? Was it “my asset-level diligence was light because my macro view is that house prices will go up a lot in the next 18-24 months”? Was it “we have to invest $100mm somewhere and this gets 2bps more yield than other AAA-rated options”? Was it “I don’t know that much about mortgages but I sure am glad we can trust our friends at Morgan Stanley to put us in such a high quality product as this here CDO”? The possibilities are endless and, I think, fascinating: each trade has two sides, and each side has a view, even if that view is sometimes more of a vacant stare.
But the arrow of lawsuits runs only one way so instead we get this:
On March 16, 2007, Morgan Stanley employees working on one of the toxic assets that helped blow up the world economy discussed what to name it. Among the team members’ suggestions: “Subprime Meltdown,” “Hitman,” “Nuclear Holocaust,” “Mike Tyson’s Punchout,” and the simple-yet-direct: “Shitbag.”
The shitbag email chain is part of a collection of internal documents produced in China Development Industrial Bank’s lawsuit against Morgan Stanley over this “Stack 2006-1″ CDO deal that Jesse Eisinger describes today in DealBook and ProPublica. Morgan Stanley has issued the standard “these emails were just a joke and have nothing to do with anything” statement,2 and while normally that is just a meaningless lie that you say after your employees are caught sending around emails saying “this deal is shit, no, I mean it, this deal is composed of actual feces, I am not kidding, come look” – the emails here aren’t that bad. Basically they were like “ugh we gotta name this deal before we print it” and everyone was all “what about Macalester Albermarle Roundtree Paddington Pemberley Structured Finance Limited” and one dope replied with some gallows-humor names. In March 2007. When it was A SUPER DUPER SECRET that subprime mortgages were in trouble:3
Immediately after the shitbag email chain in the documents is Morgan Stanley’s CDO Trading Committee Presentation seeking permission to provide a warehouse for what became the Stack/Shitbag deal. That presentation – which I at least don’t find particularly inflammatory – is dated February 2006.
Look at that chart again. If you worked on the desk that got approval to warehouse subprime in February 2006, and you went and bought some subprime bonds over the course of 2006, and you were selling the resulting deal in March 2007, would you maybe be moved to use harsh words like “meltdown” and “shitbag”? I mean, yeah, the guy buying in March 2007 would end up feeling even worse, but you’d feel plenty bad already.
And oh sure maybe it would occur to you “wow, things could get even worse in subprime, I better dump this shitbag,” but that could occur to anyone, because … well, one, because that is a thing that could always happen and so should always occur to everyone (important Dealbreaker Pro Investor Tip: investments can lose value!), and two, because, like, if a formerly boring par-ish fixed income asset class lost 20-30% of its value in the last couple of months, you really can’t go around thinking “well but it’s a totally safe boring asset class now.”
Matthew Kluger is sentenced to 12 years. Our kids go to school with his kids. Not good for his kids.
Matthew Kluger's father is Richard Kluger, author of the well known (and Pulizter Prize winning) book Simple Justice.
Apparently lots of backstory here, none of which I 'know' about more than 4th hand.
I'm annoyed I can't find any good data. Here is the IMF -- this appears to be the data source or at least methodology for the IMF report I cited a few days ago -- on 'costs' as of, I think, the end of 2009, but this doesn't look to me to be a very good measure of actual costs. Instead, these look like 'accounting' numbers, costs could be both higher or lower than this. I'd like something like 'realized cost', i.e. cost that will not be recovered for sure.
Zero Hedge writes:
I was just marveling how the ten year bund was at 2% last Friday...well today, the next trading day, the ten year bund yield fell 15 basis points to 1.85%. And this is the 2nd day of 15 bp declines in a row.
15 bp is a lot when the yield is at 5%, when the yield is at 2% it is ...words fail me. This is a long-term instrument, not some short-term paper where close to zero rates can arise under reasonable policies. No reasonably policy will ever get you into a setting where a 2% 1.85% yield happens on a 10 year treasury. This is much more worrisome than a 5% decline in the stock market by itself would be (and the stock market decline is in part a reflection of what is going on in the fixed income markets).
I'm glad I'm not trading anymore and I feel sorry for the good optimistic portfolio managers being wiped out here.
Right now, checking the 10 year US treasury, it's yield is 1.925%, down only 6 bp from Friday evening.
Felix Salmon discusses what he claims is BNYMellon's zero interest rate problem. I'm not sure I believe the claim, but you hear this sort of thing and I'm not sure how to analyze the economics correctly. It is clear that being in a low rate environment is messing with lots of business models. Counting assets in custody also allows double counting of underlying assets, though I don't know how much this occurs here.
BNY Mellon makes its money by managing $26.3 trillion in assets under custody. That’s a bigger number, I think, than is humanly possible to comprehend, but here’s a start: it’s about $4,000 per human being on the planet, or $85,000 per American, or $235,000 per US household, or five times the market capitalization of the S&P 500. It’s a truly insane amount of money. These aren’t BNY’s assets, of course — they all belong to someone else. But BNY looks after them, and reliably looking after that quantity of assets is an incredibly important and stressful and difficult and expensive thing to do.
Now if you have $26 trillion in assets under custody, and you can lend them out at a very modest interest rate, you can make a lot of money. But interest rates have been at zero for three years now, and show no sign of rising any time soon — BNY Mellon, and its custodial rival State Street, are among the biggest losers when it comes to the Fed’s zero interest rate policy.
Personally, I've always been annoyed/jealous of the asset holding and transaction data the custodians have and are now using to trade for their own account. The DoJ should get them to disclose it at some level and force them only to trade on the disclosed data (or something functionally equivalent). What custodians are doing now should (but doesn't currently) count as trading on material inside information. Is Dodd-Frank as implemented going to change this? I have no idea, but I suspect not.
Via Bloomberg, today's action in the treasury market. This is a record low, worse than even at the hight of the crisis in late 2008. We need a more expansionary montary policy stance announced as soon as possible (ideally, as of 2008). We last saw 10 year treasury rates under 2% in 1950, one year before the Fed was allowed to stop pegging short term rates as determined by the Treasury (the 1951 Treasury Fed Accord).
The German 10 year bund is doing pretty much the same thing. I thought the German bund would have a significantly lower yield, but it is only a few basis points below the treasury (it looks like it has a higher yield here, but you need to compare the yields at the same time of day).
via the FT, today's action on the 30 Year Treasury -- now that's vol, biggest move since 1987. I never traded 30 year instruments, since they are weird...the ten year treasury is much better behaved (still, the 10 Year Treasury did 16 bps today, so this looks like it isn't a 30 year technical).
Totally crazy. What is the Fed doing?
Update #1 (Aug. 9, 6:30 pm): make that a yield of 2.2% on the 10 year Treasury.
To make clear: this is a sign of monetary policy that has been far too tight. The TIPS implied real return on 10 year Tresasuries right now is, just coincidently, 0.00%, with negative real yields at shorter maturities.
We need a signal from the Fed that rates will stay low even during a rebound in spending and the price level. That we don't have this even now is crazy.
Update #2: Doug comments:
Do you think the problem is that monetary policy is too tight? Or that with the real economy so weak there is zero actual return on capital?
The simple theory here would be 'too tight money -> low demand -> low real activity -> low real returns on capital -> low real rates.' Don't think of the real return on capital as exogenous but as driven by the utilization of capital. The bigger problem in interpreting this data along these lines is that treasuries don't have a tight (or even very loose?) relationship to 'return on capital'.
Update #3: as far as I know, there is surprisingly little research on this channel of monetary policy, though it seems like it ought to be a major transmission mechanism. One of the issues I have thought about looking into, thought it has all the usual macroeconomic modeling pitfalls.
It's well-known that there's a backfill and survivorship bias to many Hedge Fund indices. As most indices promote their product, this is understandible. Yet just as with the equity risk premium, the hedge fund bias usually neglects the adverse timing bias: that market inflows and outflows make the raw time series returns overestimate the return to an average investor. Thus, many funds with $100MM in assets have great return their first year, of say 50%, and then get on the cover of a big magazine, get $1B, and lose %20. Is the return on such a fund the average--geometric or arithmetic--of the 50% and -20% return, or should it weight the 20% loss more, reflecting the performance of the average investor in that fund? ...
Ilia Dichev has a new paper out (with Gwen Yu) in the JFE documenting this bias is around 3-7% for hedge funds, just as he found this bias was around 3% for equity indices:
We use dollar-weighted returns (a form of IRR) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our main finding is that annualized dollar-weighted returns are on the magnitude of 3 to 7 percent lower than corresponding buy-and-hold fund returns. Using factor models of risk and the estimated dollar-weighted performance gap, we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the S&P 500 index, and are only marginally higher than the risk-free rate as of the end of 2008. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.
Felix Salmon notices (left hand axis is basis points, i.e. 1/100 % units):
Thanks to Mohamed El-Erian for pointing this out in his latest Secular Outlook: the market risk spread on advanced economies now exceeds that on emerging economies. ...
This is a very big deal, because the names in the EM.15 index are not exactly paragons of creditworthiness. Here’s the list: it starts with Argentina and Venezuela, and goes on from there, including countries like Panama, Russia, and Ukraine.
Meanwhile, the SovX G7 list is short and powerful: Germany, France, Japan, Italy, UK, and USA.
A large part of the story is the natural resource sovereigns are doing very well? Still, quite impressive.
Andrew Ross Sorkin writes in yesterday's NYT:
Ever since, politicians, pundits and professors have been calling him a liar. Goldman Sachs, his critics contend, escaped relatively unscathed largely because the bank saw the apocalypse coming and moved to profit from it.
This narrative might feel like well-trodden territory. But the sometimes mind-numbing 650-page report on the financial crisis published last week by the Senate Permanent Subcommittee on Investigations offers a stark conclusion: Goldman Sachs executives did not tell the whole truth.
Senator Carl Levin, a Democrat from Michigan, is so convinced that Mr. Blankfein and his colleagues “misled” Congress that he wants to refer the matter to the Justice Department to figure out whether Goldman executives broke the law.
While prosecutors will have to determine the potential legal implications, the evidence amassed by the Congressional subcommittee increasingly shows that Goldman bet against the mortgage market — and did so successfully. It wasn’t just a “hedge.”
Why then has Goldman tried to spin it into a different story?
“I cannot figure out why they keep denying it,” said William D. Cohan, the author of the new book, “Money and Power: How Goldman Sachs Came to Rule the World,” and a columnist for NYTimes.com. His best explanation is that “given the political dynamics that we’re living in the moment, they’d rather be perceived as being as dumb as everybody else.”...
The findings of the Congressional report are straightforward and damning.
The Senate subcommittee said it found the phrase “net short” some 3,400 times in documents from Goldman related to the mortgage market. For example, the company wrote in a letter to the Securities and Exchange Commission that “during most of 2007, we maintained a net short subprime position and therefore stood to benefit from declining prices in the mortgage market.” In September 2007, Goldman told employees that “we were overall net short the mortgage market and thus had very strong results.”
Now, compare that to a statement from the bank in 2010: “Goldman Sachs did not take a large directional ‘bet’ against the U.S. housing market.”
Reading those quotes back-to-back is the equivalent of hearing someone declaring it is raining when it is a sunny day with clear blue skies. It just doesn’t make sense.
The confusion continues today.
“The testimony we gave was truthful and accurate and this is confirmed by the subcommittee’s own report,” Goldman said in a recent statement. “We did not have a massive net short position because our short positions were largely offset by our long positions, and our financial results clearly demonstrate this point.”
To defend its stance, the bank notes that in 2007 it was short the mortgage market $3.8 billion and long $3.3 billion. In Goldman’s mind, those positions were simply hedges — and the outcome could have gone either way.
But whether through brilliant bets or dumb luck, Goldman Sachs made $500 million from that short. In this case, Goldman was not just offsetting its risk. It was profiting from those bets, and quite a lot.
For Goldman to suggest otherwise — as it has — is almost silly.
Having studied Goldman’s statements closely, it appears the firm decided to take a Clintonian approach to parsing its words. Notice that Goldman and Mr. Blankfein always qualify their denials of the firm’s short bets by saying they were not “massive” or “large” or “consistent.”
Such descriptions may be accurate. What’s large, or even massive, may be in the eye of the beholder.
To Goldman, a $500 million net short position may seem tiny relative to the rest of the firm’s positions. But $500 million is still a lot of money; to the rest of the world it might even seem “large” and “massive.”
Goldman’s other qualifier — about its positions not being consistent — is also true. There were times that Goldman was not net short and there times when the firm tried to reduce its short positions.
But semantics should not be the issue. Goldman should be proud of its prescient call about housing.
It was better for its shareholders, and frankly better for the taxpayers, that the firm was smart enough to short the mortgage market. After all, Goldman didn’t require a big bailout like Citigroup or the American International Group.
As Josh Birnbaum, a former star trader at Goldman who pushed that short position, told Mr. Cohan, “The net result of the mortgage department in 2007 was a record year. Think about that statement: making a record amount in a year when everyone else was losing their shirts.”
I have to agree with Goldman here: a $500 million net short position is tiny for Goldman, nothing at all close to material. It's not like there is any clean 'net housing' derivative out there, it's all model based and getting anything within $500 million is pretty much a fractional model error. The important thing here is that they were not, like for instance Lehman, ~$70 billion or more net long housing. The NYT could always be getting the numbers wrong here, but to me this looks like Goldman got out of the market in time and that's it -- a major achievement for the firm and the Goldman Sach's statements above are not false or even misleading.
For comparision, Goldman's shareholder equity at the end of 2010 was $77 billion, operating income in 2010 was $12 billion. Total balance sheet size $977 billion. A $500 million position isn't much here or there, less than 1% of firm equity and less than 0.1% of the balance sheet. Being net $500 million short or long on the size of Goldman's positions isn't anything even accountants get excited about, the real issue is if the valuation model these numbers are based on is crazy or not.
Robert A. Jarrow and Philip Protter have nice paper out: A Dysfunctional Role of High Frequency Trading in Electronic Markets
This paper shows that high frequency trading may play a dysfunctional role in financial markets. Contrary to arbitrageurs who make financial markets more efficient by taking advantage of and thereby eliminating mispricings, high frequency traders can create a mispricing that they unknowingly exploit to the disadvantage of ordinary investors. This mispricing is generated by the collective and independent actions of high frequency traders, coordinated via the observation of a common signal.
A big topic with lots of ill conceived opinion out there...I'm not sure that this is a real world problem, but it looks like a nice conceptual paper. The bigger issue here is that HFT may be driving up the liquidity costs of informed fundamental traders, making it less profitable to aquire fundamental information. Not clear to me that this is actually true though, given the time horizons fundamental traders should be trading on and given how unclear it is that we need more informed fundamental traders. But both could be true.
The Economist's Free Exchange writes about Basel III's bank capital rules:
[T]he new regulatory scheme could fail in several ways. The most serious failure in Basel III is that it doesn't address the principal contribution of Basel II to the last financial crisis, namely, the calculation of risk-weights. One of the key components of Basel II was to increase the amount of capital banks had to hold against riskier assets. Extremely low-risk assets, meanwhile, could be held with very little or even no capital. Risk, moreover, was calculated primarily by reference to the rating assigned by one of the recognised ratings agencies. The consequence of this Basel II reform was to discourage banks from lending to risky enterprises, and to encourage the accumulation of apparently risk-free assets. This was a primary contributor to the structured finance craze, as securitisation was a way to "manufacture" apparently risk-free assets out of risky pools. What brought banks like Citigroup and Bank of America to their knees wasn't direct exposure to sub-prime loans, but exposure to triple-A-rated debt backed by pools of such loans, debt which turned out not to be risk-free at all.
Since it did not change this risk-weighting, Basel III effectively doubles down on Basel II. Banks will need to hold more common equity than ever—against their risk-weighted assets. That massively increases the incentive to find low-risk-weight assets with some return, since these assets can be leveraged much more highly than risky assets. Unless I've missed something, lending to AA-rated sovereigns still carries a risk-weight of zero. So one result of Basel III could be to encourage banks to increase their lending to sovereigns at the margins of zero-risk-weight status.
Pension Pulse writes:
Tyler Durden of Zero Hedge posted an excellent comment, Illinois Teachers' Retirement System Enters The Death Spiral: AIG Wannabe's Go-For-Broke Strategy Fails As Pension Fund Begins Liquidations.
I quote the concluding remarks, but it's worth reading the entire comment:Alas, at this point it is too late: for TRS, and likely for many, many other comparable pension funds, which had hoped that the Fed would by now inflate the economy, and fix their massively incorrect investment exposure, the jig may be up. As liquidations have already commenced, the fund is beyond the point where it can "extend and pretend", and absent the market staging a dramatic rally, government bonds plunging, and risk spreads on CDS collapsing, the fund is likely doomed to a slow at first, then ever faster death.
Then one day, Goldman's risk officers will call the TRS back office, and advise them that due to its "suddenly riskier profile" established in no small part courtesy of Goldman's investment allocation advice, the collateral requirements have gone up by 50%. The next step is either Maiden Lane 4... or not. For the sake of the 355,000 full-time, part-time and substitute public school teachers and administrators working outside the city of Chicago, we hope that the TRS has now been inducted into the hall of the Too Big To Fail, as otherwise roughly $34 billion in (underfunded) pensions are about to disappear.
You can read the Bloomberg article, Illinois Pension May Sell $3 Billion of Assets to Pay Benefits as well as the Chicago Tribune article. ....
While pensions are finally getting the attention they deserve, I'm worried that they're the next AIG (but much, much bigger). The Fed is going to do what it can to bail out pensions, but I have serious doubts that even they are fully aware of the magnitude of the pension Ponzi and how it could easily topple the global financial system (ever quantified pension leverage and counterparty risk?) .
On the other hand, I've been worried about underfunded state and local pension plans since 1988 or so. But that doesn't mean we may not see some serious defaults here soon.
Better monetary policy would help.
This is getting %&*$# ridiculous...10 bp on the 10 year bond, 15 bp on the 30 year bond today. A sign that the Fed isn't doing its job. Not quite the record lows for the long dated bonds from Dec. 2008, but we're getting close for the 10 year bond (and we are past the Dec. 2008 records for the 2 year bond, but that's less worrisome).
|Date||1 mo||3 mo||6 mo||1 yr||2 yr||3 yr||5 yr||7 yr||10 yr||20 yr||30 yr|
I'm getting the sense that audit effort is often directed at the wrong targets.
Here is today's example, the indictment of
Lee Bentley Farkas of Taylor, Bean & Whitaker [for] committing a $1.9 billion fraud against investors and the federal government that led to the demise of his firm and one of the nation's largest regional banks, Colonial Bank in Alabama.
If you look at the indictment, the fraud isn't what you'd naively expect, the misrepresentation of loan documents and loan quality control efforts. Instead, you have straightforward misstatements of cash flow and assignment of assets -- i.e. things that any decent auditing system should detect. As a result this sort of failure, auditors now will get double up their efforts to audit the harmless and drive up their fee income and stymie business rationalization and process improvements. I want audits of the auditors, maybe some random fraud tossed into the accounts to see if they can detect it. We need some quality testing for auditors, with some decent reporting of audit quality -- not the Sox process monstrosity we have now which drives up costs and ties up business processes for nothing.
From the TB&W indictment:
13. Beginning in or about early 2002, TBW began to experience significant cash flow problems and was unable to cover adequately, among other things, its operating expenses. In an effort to cover the shortfalls, FARKAS and co-conspirators devised a scheme to misappropriate funds from Colonial Bank, Ocala Funding accounts, and eventually the United States government. The scheme evolved over the years as FARKAS and co-conspirators sought to misappropriate more money and to hide the misappropriations from, among others, certain Colonial Bank and Colonial BancGroup management, Freddie Mac, Ginnie Mae, the FDIC, financial institution investors in Ocala Funding, auditors, regulators, and shareholders. The scheme ultimately led to the misappropriation of more than $1 billion.
14. Initially, the scheme involved TBW and Colonial Bank co-conspirators hiding millions of dollars of TBW overdrafts in its primary bank account at Colonial Bank, which arose from TBW's operating deficits, through frequent transfers of funds back and forth between that account and another. After the overdrafts reached into the tens of millions of dollars, however, FARKAS and co-conspirators revised the scheme and misappropriated hundreds of millions of dollars more by selling Colonial Bank what amounted to fictitious assets. To do this, FARKAS and co-conspirators engaged in sales to Colonial Bank of mortgage loans that did not exist, that TBW already had sold to others, or that had significantly impaired value. As a result, FARKAS and co-conspirators caused Colonial Bank to falsely report the value of mortgage loans in its accounting records. ....
A. Overdrafts in TBW's Master Account at Colonial Bank - The Sweeping Scheme
16. In or about early 2002, TBW began running overdrafts in its master bank account at Colonial Bank due to TBW's inability to meet its operating expenses, such as mortgage loan servicing payments owed to investors in Freddie Mac and Ginnie Mae securities, payroll, and other obligations. Conspirators at TBW and Colonial Bank covered up the overdrafts by transferring, or "sweeping," overnight money from another TBW account with excess funds into the master account to avoid the master account falling into an overdrawn status. This sweeping of funds gave the false appearance to other Colonial Bank employees that TBW's master account was not overdrawn. The day after sweeping funds, the conspirators would cause the money to be returned to the other account, only to have to sweep funds back into the master account later that day to hide the deficit again.
17. By in or about December 2003, the size of the deficit due to overdrafts had grown to tens of millions of dollars. In response, FARKAS and co-conspirators devised a plan to disguise the deficit as payments for mortgage loan assets purchased by Colonial Bank.
B. Plan B/COLB
18. In or about December 2003, FARKAS and co-conspirators caused the deficit in TBW's master account at Colonial Bank to be transferred to "COLB"—a mortgage loan purchase facility at MWLD. Through the COLB facility, Colonial Bank purchased interests in individual residential mortgage loans from TBW pending resale of the loans to third-party investors. The purpose of the COLB facility was to provide mortgage companies, like TBW, with liquidity to generate new mortgage loans pending the resale of the existing mortgage loans to investors. The COLB facility was designed such that Colonial Bank would recoup its outlay only after TBW resold a mortgage loan to a third-party investor, which generally was supposed to take place within 90 days after being placed on the COLB facility.
19. In this part of the scheme, which the conspirators called "Plan B," the conspirators sought to disguise the tens of millions of dollars of overdrafts as payments related to Colonial Bank's purchase through the COLB facility of legitimate TBW mortgage loans. FARKAS and co-conspirators accomplished this by causing TBW to provide false mortgage loan data to Colonial Bank under the pretense that it was selling the bank interests in mortgage loans. As FARKAS and co-conspirators knew, however, the Plan B data included data for loans that TBW had already committed or sold to other third-party investors or that did not exist. As a result, these loans were not, in fact, available for sale to Colonial Bank.
20. As TBW continued to experience operating losses, FARKAS and co-conspirators engaged in additional sales of Plan B loans to Colonial Bank, causing Colonial Bank to advance to TBW tens of millions of additional dollars from the COLB facility. In reality, the Plan B loans could not be resold to recoup Colonial Bank's outlay for its interests in the loans. As a result, FARKAS and co-conspirators sold tens of millions of dollars worth of what amounted to fake assets to Colonial Bank and caused Colonial Bank to falsely record the value of these assets in its accounting records.
C. Recycling Plan B Loans
21. To avoid scrutiny from regulators, auditors, and Colonial Bank management of Plan B loans sold to Colonial Bank, FARKAS and co-conspirators devised a plan that gave the false appearance that TBW was periodically selling the Plan B loans off of the COLB facility. The conspirators referred to this aspect of the scheme as, among other things, "recycling," and the method for recycling evolved over time. One way FARKAS and co-conspirators effectuated a recycle was that they caused new Plan B data to be sent to Colonial Bank to replace old Plan B data. By doing so, FARKAS and co-conspirators created a document trail that gave the false appearance that mortgage loans had been sold to investors and that Colonial Bank, in turn, had purchased interests in new mortgage loans in their place.
D. Fictitious AOT Trades
22. In or about mid-2005, FARKAS and co-conspirators caused the deficit created by Plan B to be moved from the COLB facility to MWLD's Assignment of Trade (AOT) facility. The AOT facility was designed for the purchase of interests in pools of loans, which were referred to as "Trades," that were in the process of being securitized and/or sold to third-party investors. The conspirators moved the deficit to the AOT facility in part because, unlike the COLB facility, Colonial Bank generally did not track in its accounting records loan-level data for the Trades held on the AOT facility, thus making detection of the scheme by regulators, auditors, Colonial Bank management, and others less likely.
Ke Tang and Wei Xiong, Index Investing and the Financialization of Commodities (2010)
This paper examines the financialization process of commodities precipitated by the rapid growth of index investment to the commodities markets since the early 2000s. We find that concurrent with the increasing presence of index investors, commodity prices have become increasingly correlated with the world equity index and US dollar exchange rate, and with each other. In particular, this trend is more pronounced for commodities in the two popular commodity indices, the GSCI and DJ-UBS indices. As a result of the financialization process, the spillover effects of the recent financial crisis contributed substantially to the large increase in commodity price volatility in 2008. Our study thus highlights the increasingly important interaction between commodities markets and financial markets.
I've been puzzled by how to think about the recent financialization of commodities, going back in this form maybe ten years or the late 1990s. What in particular puzzles me is how the increased shifting of pricing risk to outside investors can change return patterns -- what happens in the spot markets and to storage and production decisions? The information content of prices and their relationship to real factors has changed a lot, via mechanisms that are not at all clear. People, even traders, like to talk about financialization as if it were some well understood process, while all stories I've seen don't hang together from a theoretical perspective.
Annastiina Silvennoinen and Susan Thorp, Financialization, crisis and commodity correlation dynamics (2009)
We study bi-variate conditional volatility and correlation dynamics for individual commodity futures and nancial assets from May1990-July 2009 using DSTCC- GARCH (Silvennoinen and Teräsvirta 2009). These models allow correlation to vary smoothly between extreme states via transition functions driven by indicators of market conditions. Expected stock volatility and money manager open interest in futures markets are relevant transition variables. Results point to increasing integration between commodities and nancial markets. Higher commodity returns volatility is predicted by lower interest rates and corporate bond spreads, US dollar depreciations, higher expected stock volatility and nancial traders open positions. We observe higher and more variable correlation, particularly from mid-sample, often predicted by higher expected stock volatility. For many pairings, we observe a structural break in the conditional correlation processes from the late 1990s.
Erkko Etula, Broker-Dealer Risk Appetite and Commodity Returns (2010)
This paper shows that the risk-bearing capacity of U.S. securities brokers and dealers is a strong determinant of risk premia in commodity markets. Commodity derivatives are the principal instrument used by producers and consumers of commodities to hedge against commodity price risk. Broker-dealers play an important role in this hedging process because commodity derivatives are traded primarily over the counter. I capture the limits of arbitrage in this market in a simple asset-pricing model where producers and consumers of commodities share risk with broker-dealers who are subject to funding constraints. In equilibrium, the price of aggregate commodity risk decreases in the relative leverage of the broker-dealer sector. I estimate the model in the cross-section of commodities and find strong empirical support for its predictions. Fluctuations in riskbearing capacity have particularly strong forecasting power for energy returns, both in sample and out of sample.
Hard to tell...the NYT claims that:
IT’S a $2.6 trillion mystery.
That’s the amount that foreign banks and other financial companies have lent to public and private institutions in Greece, Spain and Portugal, three countries so mired in economic troubles that analysts and investors assume that a significant portion of that mountain of debt may never be repaid.
The problem is, alas, that no one — not investors, not regulators, not even bankers themselves — knows exactly which banks are sitting on the biggest stockpiles of rotting loans within that pile. And doubt, as it always does during economic crises, has made Europe’s already vulnerable financial system occasionally appear to seize up. Early last month, in an indication of just how dangerous the situation had become, European banks — which appear to hold more than half of that $2.6 trillion in debt — nearly stopped lending money to one another.
Now, with government resources strained and confidence in European economies eroding, some analysts say the Continent’s banks have to come clean with a transparent and rigorous accounting of their woes. Until then, they say, nobody will be able to wrestle effectively with Europe’s mounting problems. ...
Limited disclosure and possibly spotty accounting have been long-voiced concerns of analysts who follow European banks. Though most large publicly listed banks have offered information about their exposure — Deutsche Bank in Frankfurt says it holds 500 million euros in Greek government bonds and no Spanish or Portuguese sovereign debt — there has been little disclosure from the hundreds of smaller mortgage lenders, state-owned banks and thrift institutions that dominate banking in countries like Germany and Spain. ...
Analysts at the Royal Bank of Scotland estimate that of the 2.2 trillion euros that European banks and other institutions outside Greece, Spain and Portugal may have lent to those countries, about 567 billion euros is government debt, about 534 billion euros are loans to nonbanking companies in the private sector, and about 1 trillion euros are loans to other banks. While the crisis originated in Greece, much more was borrowed by Spain and its private sector — 1.5 trillion euros, compared with Greece’s 338 billion.
2.2 trillion euros is a lot...
Nikkei is down 3.6% right now, the usual size for a big downturn. And European policy seems frightfully deflationary, even more so than US policy...how are people supposed to service their debt in this environment? [Not that I think inflation isn't going to pick up in the long-run....I just believe that short run deflation and excess default is going to contribute to longer run inflation.]
Friday's 10 year treasury move was 3.39% to 3.2%, putting it in the top 10 daily treasury rallies since 1990 in terms of % yield change and larger than any pre-2008 rally since 1990. Also the biggest treasury rally since March 2009, the end of the last immediate crisis by most counts. (Data here)
BTW, the 17 largest 10 year treasury daily swings since 1990 have all been since 2008. In terms of vol we're back in crisis territory and it may end worse than before...or not...that's why it's a crisis.
Update #1: S&P 500 went down 1.35% on Monday, treasuries didn't move much. I didn't have time to follow the action, but it seemed like a normal day.
My bank in Spain has recently been unusually friendly and generous. Normally, they are happy to pay me 0% interest for the balances I keep. Now, as I was asking for a routine transfer to my other account in Germany, I got a phone call - and a bit of a surprise. How about, said the friendly branch manager, 4% if you keep it here? No? How about 4.5%? No? Did the Germans offer more? What can we do to keep it? Shall we meet in person? Wow. I am so friendly with my local branch, I have actually never met my branch manager. So this was starting to sound a bit funny. I don't keep balances the withdrawal of which will threaten the survival of this bank (or any other) single-handedly, so this particular, keen advisor got me worried... but checking a bit, it seems to be a general thing. Spanish banks are effectively finding it very hard to borrow in wholesale markets; private banking clients are pulling their money out bigtime, and putting it into stable core countries; and every bank and caja is now offering 4% term deposits, which is a pretty amazing rate given that Euribor is just a touch over 1%. Now Moody's has published a small note on contagion risk from the Greek crisis for Spanish and Portuguese banks. Given that they are rapidly becoming real estate investment trusts with a banking business attached, trying to sell millions of repossessed homes, there were plenty of fundamental problems to worry about. Now, we have something similar to a bank run in the bond issuance building up. Actually, while I have no particularly insight into how the balance sheets of Spanish banks look, I think I'd rather be safe than sorry, and send a bit more dough back home...
John Hempton writes:
Japanese bonds – yielding close enough to zero – have been a fantastic investment for about twenty years.
After all seven year JGBs were yielding above 1 when I was (unfortunately) short them. Nominal prices were dropping more than three percent per year.
So the return on owning JGBs was over 4 percent real per year. Tax only applied to the nominal part of the return – so the post tax return was above 4 percent per year REAL.
Now how long did you need to hold stocks to get a 4 percent post-tax real return? Mrs Watanabe with her large JGB holding has seemingly done OK.
I've been getting 4% real after tax in my junk bond centric IRA/401k, but that' not going to hold up. And it's been much less steady...I need to rethink where I'm putting my money. But this might suggest that US long-term treasuries are still not overvalued, even though I've been waiting for a US government bond market slaughter for two decades now. 1994 and 1999 don't count...And yes, I did think about fully getting out of junk bonds early 2008, but I didn't consider my balances high enough to worry about it, so just some rebalancing into cash ...
I do have to admit I told a friend not to buy Apple shortly after the iPad came out. Still, this feels like to top: at an all time high late last month, 266 at today's close, market cap of $240 billion. $43 billion in sales in 2009, $12 billion profits. Things cannot get any better than this for Apple.
Just a gut felling call from me.
Yves Smith writes:
The real risk here is to Eurobanks. They ran with even higher leverage ratios than US banks, they are believed to have recognized less of the losses thus far on their books than their US peers. Even worse, readers report that the major dealers (and the Eurobanks were part of this cohort) are carrying toxic assets at prices that are vastly above likely long-term value. Eurobank exposure to Greece is over $190 billion, and total periphery country exposure is roughly $900 billion.
So the whole idea that the financial crisis was over is being called into doubt. Recall that the Great Depression nadir was the sovereign debt default phase. And the EU’s erratic responses (obvious hesitancy followed by finesses rather than decisive responses) is going to prove even more detrimental as the Club Med crisis grinds on.
I'm trying to figure out how the European payment system could freeze up and how one would unfreeze it. Lots of the banking system could end up on the ECB balance sheet... which would be fine if done correctly.
And from Wolfgang Münchau at the Financial Times: Greece is Europe’s very own subprime crisisThis is going to be the most important week in the 11-year history of Europe’s monetary union. By the end of it we will know whether the Greek fiscal crisis can be contained or whether it will metastasise to other parts of the eurozone.
Münchau suggests three things to watch: 1) to see if Greece presents a credible plan (Münchau says what he has heard is "deeply discouraging"), 2) that the loan package has to be substantially more than €45bn (Münchau says €80bn) and 3) the situation in Germany (Angela Merkel is still struggling for support).
Meanwhile the FAZ writes, underestimating -- though I'd need to do more research -- the problems a Greece poses for European banks:
Die Lasten aus der Griechenland-Krise sollten nicht die Steuerzahler tragen, sondern die Gläubiger. Sie sind Schuld an laxer Kreditvergabe. Die Vorstellung, als Folge von Abschreibungen drohe der Zusammenbruch des Finanzsystems, ist abwegig. Griechenland ist dafür zu klein.
Part of the issue here is that what happens in Greece is a trial run for Portugal, but also for Spain and Italy, maybe also parts of Eastern Europe and Austria. Or in the famed words of Bernanke March 2007 way of putting it:
the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.
Update #1: Ambrose Evans-Pritchard writes:
Chancellor Angela Merkel continues to equivocate, demanding "very strict conditions". Dissent is growing louder in her coalition ranks. Both Free Democrats and Bavarian Social Christians have said it is time to break the taboo and ask whether Greece should "step outside" EMU. Werner Langen, the leader of Christian Democrat MEPs, said the bail-out appears to breach Germany's constitution.
If so, we will find out soon. Four professors will launch a legal challenge in early May at the Verfassungsgericht (high court). Should they secure an injunction, EMU may fly apart.
The Court ruled in 1993 that Maastricht was constitutional only as long as EMU remains an area of monetary order. "A 'transfer union' is a bottomless pit and is bound to threaten currency stability. That is what we are going file," said Tübingen Professor Joachim Starbatty.
When accused of consigning Greece to ruin, he told the Frankfurter Allgemeine that EMU exit and default is Greece's only salvation. "The truth has to come out into the open. Greece is in no position to pay it debts," he said.
The EU-IMF "therapy" of deflation for Greece repeats the catastrophic errors of Chancellor Heinrich Bruning in the early 1930s and must lead to a depression, he said.
Yet that is what IMF chief Dominique Strauss-Kahn is preparing for Greece, against the better judgment of his own experts. "Greek citizens shouldn't fear the IMF; we are there to try to help them," he said over the weekend. Yet a week ago he told Greece that devaluation and default are non-starters. "The only effective remedy that remains is deflation. That will be painful. That means falling wages, and falling prices. There is no other way."
Actually, the IMF pursues other ways often, last year in Jamaica. What Mr Strauss-Kahn means is that the EU will not tolerate any other way. The Greek people must be sacrificed for the Project and to hold the EMU line, like the Spartans of Thermopylae who perished to gain time for the Alliance.
They are to squeeze fiscal policy by 6pc of GDP this year in a slump – a "death spiral", warns George Soros. They are to do this without the IMF's devaluation cure. If they do stabilise the debt – to hit 130pc of GDP this year after Eurostat's revelations – they will be left paying 6pc to 8pc of GDP to foreign creditors for ever. Will Greeks comply meekly, or turn their Spartan blades on Europe?
No country in Western Europe has defaulted since the Second World War. More than €7 trillion has been lent to Club Med states, banks and homeowners in the belief that it cannot happen. EMU shut the warning signals, disguising risk. What investors overlooked is that currency risk mutates into default risk in a monetary union.
It makes default more likely, not less. The bond markets have suddenly twigged.
In barely two weeks, the City mood has shifted from ruling out a Greek default as absurd, to accepting that it could happen, to now fearing that restructuring is highly likely.
A country such as Portugal with total debt of 300pc of GDP, a current account deficit of 11.2pc, and a budget deficit of 9.4pc should not think it has the luxury to trim spending at a leisurely pace. Portugal has an ugly choice. If it tightens hard to soothe bond markets, it too risks depression. EMU's Faustian Pact is closing in.
I'm wondering what's going to happen to the quality of the debt collateral if the Club Med goes through a severe and extended recession.
I've not been writing on Greece and its implications for all of us...partly for lack of research...but today's moves, on very low liquidity, are impressive:
Data just taken from Reuters show 2-year government bond yields rising from 7.8 per cent yesterday to 10.38 per cent today, a jump of 2.55 percentage points. (FT)
Get the default done, and put the relevant European banks on support (i.e. either nationalization and recapitalization, bail outs, or taking over Greek debt to prevent this). Not clear how kicking the problem down the road without principal reduction for Greece will help.
Okay, I should write more...lots of nice debt structuring issues here, both for Greek debt and the financial structure of the institutions that are Greece's creditors.
Also put me in the more pessimistic than the market about the US and German economy column. Lots of hard painful adjustment still to come, and that could be mishandled by monetary authorities and credit markets.
I've not been posting on the Goldman Sachs fracas...since, well, I'm not sure how to analyze the case at the level of precision I aspire to...as far as I can tell everybody was playing their assigned roles. The Abacus deal doesn't look like Repo 105 to me, which strikes me as far more serious, though Repo 105 participants may have been much deeper in the hole to start with (and may have been blessed by the Fed?). So I'm more sympathetic to beating up on Ernst & Young than on Goldman Sachs, but that in part that just reflects my local perspective.
On the related Magnetar trade, I like this Felix Salmon post, though I may feel differently once I sleep on it (for instance, gaming the dumb rating agency models was pretty much standard, not a Litowitz insight):
The story begins in 2005, when Greg Lippmann of Deutsche Bank gets ISDA to create some standardized language for credit default swaps on subprime mortgages. That was the spark that lit the fire — and one of the first people to realize the enormity of the potential conflagration was Alec Litowitz of Magnetar. Lots of hedge funds had the bright idea of shorting mortgages: you can read Michael Lewis’s book on many of them, or Greg Zuckerman’s on the biggest one of all, Paulson & Co.
But that was a simple trade. Someone like Michael Burry or John Paulson or Andrew Lahde would go up to Deutsche Bank or Goldman Sachs, and say “hi, I want to buy credit protection on the BBB-rated tranches of subprime RMBS”. And then those banks would have to find someone else willing to take the other side of the trade, which wasn’t always very easy. And the market never really got very big or important.
But then Litowitz hit on the idea of a mezzanine subprime hybrid CDO — and that was a real game-changer.
First it’s worth explaining exactly what such a strange beast is. A CDO is just a collection of fixed-income instruments, aggregated and tranched. In this animal, all the instruments are “mezzanine” — which means they carried the very lowest investment-grade rating, triple-B. They were also all subprime. And “hybrid” means that the CDO was a mixture of cash bonds and artificial credit default swaps, normally in a ratio of roughly 4 CDSs for every bond.
There were subprime synthetic CDOs before Litowitz came along — Greg Lippmann had created some — but they were generally linked to the broad ABX index, which meant that you couldn’t construct them with anything like the level of specificity and granularity that Litowitz was looking for. And Litowitz’s insight was that the ratings agencies’ models didn’t look at loan-level data on the contents of CDOs, they just looked at the ratings of the contents of CDOs. So you could fill a CDO up with all manner of subprime NINJA nuclear waste, and it would look to the ratings agencies exactly the same as if it held much safer BBB tranches of prime fixed-rate mortgages.
This looks interesting, though with the usual provisio that these papers often sound much better in the abstract than in the implementation (via Delong):
KRISTOFFER P. NIMARK, SPECULATIVE DYNAMICS IN THE TERM STRUCTURE OF INTEREST RATES
If long maturity bonds are traded frequently and traders have non-nested information sets, speculative behavior in the sense of Harrison and Kreps (1978) arises. Using a term structure model displaying such speculative behavior, this paper proposes an empirically plausible re-interpretation of predictable excess returns that is not based on the value traders attach to a marginal increase of wealth in different states of the world. It is demonstrated that (i) dispersion of expectations about future short rates is suffcient for individual traders to systematically predict excess returns even in a model with constant risk premia and (ii) the new term structure dynamics driven by speculative trade is orthogonal to public information in real time. The model is estimated using monthly data on US short to medium term Treasuries from 1964 to 2007 and it provides a very good t of the data. Speculative dynamics are found to be quantitatively important, accounting for a substantial fraction of the variation of bond yields and is more important at long maturities. We also show that a three factor no-arbitrage factor model would nd overwhelming but misleading evidence in favor of time varying risk premia if the world is characterized by the modelpresented here.
The introduction is more informative:
If long bonds are traded before they mature, the price an individual trader will be willing to pay for a bond depends on how much he thinks other traders will be willing to pay for it in the future. If traders have access to different information, this price may dier from what an individual trader would be willing to pay for the bond if he had to hold it until it matures and \speculative behavior" in the sense of Harrison and Kreps (1978) arises. That is, the possibility of reselling a bond changes its equilibrium price as traders exploit what they perceive to be market misperceptions about future short rates.
In this paper we present a term structure model populated with rational traders that engage in the type of speculative behavior described above. We use this model to argue that relaxing the assumption that all traders have access to the same information introduces empirically relevant new dynamics to the term structure of interest rates. More specically, we apply the properties of orthogonal projections to show that if traders' information sets are non-nested, (i) individual traders can systematically predict excess returns (dened as the dierence in return on holding an n period bond until it matures and holding a sequence of short bonds for n periods) even in a model with constant risk premia. (ii) Individual traders can predict and take advantage of other traders' prediction errors even though no trader on average is better informed than other traders and (iii) that the speculative dynamics introduced by non-nested information sets are orthogonal to public information.
Despite the fact that the speculative dynamics are orthogonal to public information, we can both quantify their importance as well as back out an estimated historical time series of their evolution in the past. This is possible since we as econometricians have access to the full sample of data and the speculative term is orthogonal only to public information available to traders in real time. That is, we can use public information available in period t+s : s > 0 to back out an estimate of the speculative term in period t. The estimated model suggest that speculative dynamics are quantitatively important and explains a substantial fraction of the variation in observed US bond yields.
Mark Roe, one of my favorite law professors, has a new paper out on the special treatment of derivatives counterparties of firms in Chapter 11:
Chapter 11 bars bankrupts from immediately repaying their creditors, so that the court can reorganize the debtor without creditors shredding the bankrupt firm’s business. Not so for the bankrupt’s derivatives counterparties, who can seize and liquidate collateral, net out gains and losses, terminate their contracts with the bankrupt, and keep both preferential eve-of-bankruptcy payments and fraudulent conveyances they obtained from the debtor in ways that favor them over other creditors. Their right to jump to the head of the bankruptcy repayment line, ahead of even ordinary secured creditors, warps their pre-bankruptcy incentives both to monitor the pre-bankruptcy debtor and to adjust their investments to better account for counterparty risk, since they do well in any resulting bankruptcy. If they bear less risk, other creditors bear more risk and have more incentives to monitor the debtor or to assure themselves that the debtor is a safe bet. But the other creditors — such as the United States of America — are poorly positioned to provide that monitoring. Moreover, the policy justification for the super-priorities — reducing financial contagion risk — is difficult to maintain today: contagion is as likely to be propagated by the priorities as it is to be stifled, the priorities did not prevent contagion in the 2007-2008 financial melt-down and may have spread it, and we use alternate resolution mechanisms anyway for systemically vital failing financial institutions. Bankruptcy policy was made in the erroneous belief that it could contain contagion and that there was no other way to do so. The best regulatory reaction to these monitoring and regulatory disconnects is for Congress to cut back the extensive de facto priorities embedded now in chapter 11 for these derivatives counterparties. Repeal would induce the derivatives market to better recognize the risks of counterparty financial failure, which in turn should dampen the possibility of another AIG/Bear/Lehman financial melt-down, thereby helping to maintain financial stability. Yet the major financial reform packages now in Congress do not contemplate the needed cutbacks.
Well, it looks like I had no blog post on politics at all in January.
And no posts on the sovereign debt crisis in the EU.
Update #1: interestingly, the Greek crisis is only one of several top stories in the German news, I'd say behind the current Afghanistan hearings and the top story of the week the BVG court ruling on welfare payments. So that's good crisis management, keeping the leaks to the press under control.
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)
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.
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:
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 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.
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%.
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.
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.
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.”
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
Falkenstein has a nice rant about Nassim Taleb's investment advice and hedge fund strategies:
Almeida and Philippon, The Risk-Adjusted Cost of Financial Distress, J Finance 2007
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.