Archive for October, 2008
Scary Thoughts on the Lack of Size and Humor
Disparate issues linked by their overwhelming smallness.
It’s been a few of weeks since our last post, and such a long gap is highly unusual as we’re rarely at a shortage for words. We’ve been busy, but more importantly, we didn’t feel compelled to write about our normal topics of interest; despite the market volatility, little has changed in the intervening days.
In addition, the accumulated effect of seeing so many behave in such small ways over large matters was and is rather sad and depressing. No, we’re not talking about the election campaigns, which, by the grace of God do have a definite endings – if only for a year or so until the next ones begins.
The Smallness of Our Leaders: in the financial crisis, few individuals took right, reasoned, and principled courses of action or bothered to think before they spoke. While we expect such fallen behavior on a day-to-day basis, we do hope that our elected and appointed officials are able to rise to the occasion. Their failures to do so – their panic and expediency – remain sources of disappointment. Here is a very, very, very small example that has stuck with us for nearly a month and was likely unnoticed by most.
In the days between the two Congressional votes on the bailout, we saw a Congressman from Tennessee rant about mark-to-market accounting. He knew no more about accounting issue than he did about anything else, except talking perhaps, but that didn’t stop him.
While we listened to his diatribe against it, we thought, hmmm, not a single specific reference to the underlying issues of relevancy, reliability, economic efficiency, etc. Replace “mark-to-market accounting” in his otherwise generic spiel, “we have to something about mark-to-market accounting before it…,” and he had a ready-made speech for all that is evil du jour: AIDs in Africa, the lack of clean water in villages, illegal drugs, legal drugs, drunk driving, international piracy, child labor, greed, foreign car manufacturers, cancer, diabetes, Wall Street executives, oil prices, etc., and no other words would have changed. He had a handy demonization template, and that made actual contemplation superfluous; so, he had changed his mind and would vote for the bailout.
A the time, we thought, unfortunately, there are no literacy or poll tests for voting in Congress. Or was it another example of voter fraud.
As we mentioned, it is a very small example, but it suffices for small men and their lack of depth, and it also relates to the main purpose of this post.
A Few Words on Financial Markets: By the way, on those market and incentive topics – our normal blog fodder – we stand by everything that we’ve written and continue to believe the bailout was and is a mistake. Even if it does mitigate the liquidity crisis – and we’re not sure that it has – we ask, at what cost to our economy and our freedom?
For example, we’ve been musing that many government officials have been able to quite inadvertently meet their election year promise of substantially reducing energy costs – even before the election. But at what cost? They can rightly argue that their actions – whether planned or not – have saved billions for the American people as oil has moved from its peak of $147 dollars per barrel to its current range in the mid-60s. Unfortunately, it has been at the cost of trillions of dollars of wealth.
On that topic, in April, we predicted (wildly guessed) that oil could be at $40 per barrel by year end. We could actually see it quite lower – even in the $25 per barrel range. Our rationale: the cohesion of OPEC and its partners, particularly Russia, will likely failure, and we expect large investment funds – like CALPERS – to continue to liquidate their commodity holdings since equity values have plummeted.
We’ll have more to say about economic issues in the next few days, particularly with respect to the recent change in tax policies that provide a benefit – the absorption and use of loss carryforwards – that the IRS is permitting acquiring banks to take in the recent mergers.
That policy change, while far less graceful and efficient, is not much different than our idea to solve the mortgage crisis – but not the liquidity crisis; so, provides a small bit of hope. (Search the archives or read just about anything we wrote in September and early October. We’ll still not sure that officials realize that these two crises are distinct._ It is not nearly as clean or as precise as our approach, but that’s not why we are writing.
Sarah Palin: as we wrote almost two months ago, we continue to be amazed at the senseless vitriol and sheer hatred spewed towards Mrs. Palin, particularly among Hollywood and New York celebrities, who put forth as much thought as the above-referenced Congressman from Tennessee. As we wrote in our initial post, they hated her before they knew her, and they could hate her with such ease because of who she is – someone very similar to many people we know, like, and love: conservative, pro-family, pro-life, middle-aged, religious and gun-totin’.
But, we must add, we’re not surprised that so many thoughtless and dull folks dismiss her small town mayoral experience and her small population gubernatorial experience. It says more about them and their lack of experience and intellectual empathy than it does about her.
We spent ten years in academia, but it didn’t take that nearly long to appreciate the validity of Henry Kissinger’s quote that – and we paraphrase – the fighting in academia is so vicious precisely because the stakes are so small.
What’s true in universities it is also true in small towns and most other organizations as well, including the staff departments of large corporations.
Regardless of all the many ways that one can describe functions of governments, at a minimum it involves resource allocation and gathering (funding). In other words, who gets what the government has and who has to give for the government to have.
Does the reader think that resource allocation decisions are easier in a small town than in the naiton’s capital? One’s purchase decisions in a small town may aid or bankrupt a neighbor, an acquaintance or a former classmate who walks or drives by your home everyday or attends the same church or shops at the same stores or eats in the same restaurants. Consider that as opposed to doing this or that to a nebulous and abstract groups like “small businessmen” or “big corporations?” in a locale where almost everyone – mostly strangers – are representing something or someone else: rather than directly feeling the pain of actions and decisions.
Does the reader think that taxing decisions are easier in small towns than within the federal government? Raise property assessments and earn the wrath of those same neighbors, acquaintances, and former friends.
[Where is one more likely to receive the immediate feedback from uncomfortable conversations and cold stares? In Washington or Wasilla? Where is one more likely to receive negative feedback filtered and diluted through a staff of gutless, careerist sycophants? Washington or Wasilla? Yeah, the questions really do answer themselves. (Our hypothesis: local politicians find more dog waste in their front yards than average citizens do.)
In one of our own volunteer activities, we allocate a precious, scarce, and first-class resource among a group of individuals who do not pay for its use. Such a setting is, of course, a recipe for excessive demand. Based upon that experience we’d certainly argue in Mrs. Palin’s favor over someone whose main private sector experience seemed to be organizing begging efforts directed towards the federal government. (In our case, we joke that the best evidence of fair treatment is when every user is annoyed with us so try to ensure it.)
Of course, the contentious reader might always argue that such small towns are so corrupt that there is no notion of taking actions that annoy friends and acquaintances, i.e., the whole objective is to enrich them (and oneself) while in town hall. In that case we’d then argue that it, indeed, provides excellent training for work in the nation’s capital. But, that’s not really why we’re writing, either.
Our point is much smaller though it is related to Mrs. Palin.
Mr. Letterman’s Persistent Lack of Humor: we were too involved in our work to change the channel when David Letterman’s show began last night. We don’t recall any of the monologue bits, but they were as lame as usual. (No one, in good conscience, could call his lines jokes.)
What we do recall was a skit where one of the child actors wore an over-sized version of Sarah Palin’s passport as a Halloween costume. It was stamped Mexico and Canada (and the USA) and nowhere else, and that was it. That was the whole “joke.”
The cardinal that flies into and bangs its head on the family room windows hundreds of times each morning exhibits about the same level of wit.
I guess the point of the passport costume was to show that Mrs. Palin hasn’t traveled much outside of Alaska or the US. Presumably, such travel is now a qualification for Vice President because…well, who knows why. It must be something that only someone as sophisticated and learned and cultured as our Ball State grad, Mr. Letterman, could appreciate. Personally, we’ll take someone willing to kill a moose. It takes more skill and courage.
Now, maybe we’re slow or just don’t pay enough attention, but that’s when it finally hit us.
Mr. Letterman has been unfunny for years; that’s not news, we and many others have written about that, and it seems to be true since at least the Reagan administration.
No, what we’ve concluded is last night was not only is Mr. Letterman inherently unfunny, but to do that night-after-night, year-after-year, requires a staff. He can’t be doing the very little that he does alone. It is very likely that he has a very large and equally untalented staff of writers excreting such material like elephants with dysentery five nights a week.
As we see it, it would take a substantial number of insecure and untalented individuals to generate the group think required to permit such crap to air. Why, at its essence, it almost seems like government work.
If it were only a few writers, it seems that they would be more likely that they would be able (1) to maintain their self-respect and dignity and judgment, which would then permit killing such lame ideas when they were initially discussed or (2) to have the discretion not to mention them to others in the first place.
Of course, we must consider all possibilities, and it could be the case that Mr. Letterman only hires degraded individuals willing to do anything for money or noxious household chemicals. (In that case, he might be a bit more efficient than we suspect and is able to generate his (albeit low-quality) output with only a few comrades.)
So, why does he get the big money? Well, this is one time when we must propose a labor theory of value as the answer. Perhaps, the personal effort and sacrifice required to associate with Paul Shaffer for an hour a day justifies the compensation. Better he than we.
Happy Halloween, and don’t worry, it gets worse before it gets better. The election is next week.
TARP? Garp? Is There a Difference?
We must admit, this is our first post that is truly in bad taste, but it seems so appropriate that we just could not help ourselves. TARP. TARP.
We’re trying to write seriously about the government’s – the Treasury Department’s – latest expediencies and tactics to … well, we’re not sure of the objective… presumably, to make it all go away so that Mr. Bush and his appointees can enjoy their last Autumn and Christmas in D.C. (Why would anyone want to ruin Mr. Bush’s last Christmas in the White House by causing the possible financial ruin of much of the world. People can be so mean and selfish sometimes! Can’t we just use the taxpayers’ money to pay them to go away!)
So here is our personal problem. Every time we think of TARP we are reminded of Garp as in John Irving’s The World According to Garp. It has been a long time since we’ve read it; so, the details are slightly hazy, but we think we’ve remembered enough to draw the correct analogy.
We’re not actually reminded of Garp himself, so much, but more of his father T.S. Garp, the critically-wounded, WWII soldier, who spends his last days bedridden and senseless in a stateside army hospital. As we recall, he had been a ball-turret gunner on perhaps the underside of a B17 or B24, who took shrapnel to the head during a bombing raid over Germany.
“T.S.” were not his first two initials, but represented his rank, Technical Sergeant, which is about all of the background his mother, an attending hospital nurse in the same ward, knew of his father.
As we recall, despite his diminished state, T.S. Garp had one compulsion, which he seemed to be able to do unconsciously and definitely not self-consciously. During these compulsive episodes, he would repeat his name, “Garp, Garp.…” As his condition worsened, his mantra changed to “Arp, Arp…” and finally, just before his death to “Ar, Ar…”
In our mind, many of the Treasury’s recent tactics don’t seem that different than T.S. Garp’s last efforts. However, within a shorter period of time – less than two weeks – they seemed to have gone from “TARP, TARP…” to “RP, RP.…”
The injection of capital to “save the banks” seems to be nothing more than a Relief Program. Corporate welfare and cronyism at its self-indulgent best.
So did yesterday’s tough talk go like this? “We’re forcing you to take this money, which no one else will lend to you, and you won’t lend to each other. Furthermore, to show you we mean business, we’re going to guarantee your debt for a fraction of the true, underlying, insurance premium, and finally, before you say anything, know that we’re going to insure your deposits, too. That should teach you to get into a mess like this, again.” Maybe Mr. Paulson should read John Rosemond, rather than contacting his former employees and his friends for advice on how to save themselves.
Once again, shame on them.
As they spend our money–all of our money–the cruelty of those two near-homonyms, sense and cents – all 70 trillion of the latter – becomes brutally clear.
It’s Time!
As the IMF, the G7 and the President “endeavor to persevere,” we have of own recommendation to end the global financial crisis.
We’re Not Socialists or Statists:
We very much believe in freedom and personal responsibility; strongly prefer private enterprise to government services and bureaucracy; prefer democracy – well, republican democracy, at least – to centralization and authoritarianism (except in matters of religion); and prefer free markets and capitalism to any of their failed alternatives. We’re not libertarian, but on economic issues, we’re not that far away.
We’re certainly not leftists.
We’ll hold our nose and vote for McCain despite his recent, wrong-headed plan to buy bad mortgages at face value; despite McCain-Feingold, and despite his views on global-warming. As we wrote in Well, This Is a Fine Mess You’ve Gotten Us into…. if only Mr. McCain would retain a semblance of humility that we have seen in the past. (It must be quite easy to recommend buying over-priced crap when it is not your own money, per Mr. McCain, Mr. Hubbard, et. al.)
Morover, we don’t view the unprecedented decreases in global equity markets as a market failure, nor – despite the lack of trading – we do not view the near shutdown of intra-bank credit markets as a market failure. We view both as evidence that markets work and that in both cases they inform about the true underlying failure: the weakness of our financial intermediaries.
We Face Two Problems:
Neither the current financial crisis nor the mortgage crisis that preceded it was caused by exogenous variables or factors. The mortgage crisis did not result from an earthquake or volcano or tsunami or influenza or wildfire or any other natural cause. It did not result from the destruction of war or any non-financial, man-made action. It resulted from the actions of finance industry employees, elected representatives, and government bureaucrats. In Saturday’s The Wall Street Journal, on page A13, immediately below Peggy Noonan’s excellent scolding, there is a good summary: The Government is Contributing to the Panic.
Before continuing, please notice that we separate the mortgage crisis from the current, global crisis.
Despite our government’s obtuseness, these crises are indeed separate issues. By that we mean that if the mortgage crisis were solved, the banks would still face deep, deep suspicions and face funding problems. We think that lack of confidence would be sufficient to sustain the global crisis, which at its root is a deep distrust of major financial intermediaries. (See Even A Perfect Bailout Will Fail for example.) Conversely, if that suspicion were eliminated, there would still be a need to deal with the epidemic of bad loans, particularly in the Sunbelt. (See our proposal: A Better Solution (than a government takeover).)
The Global Problem: The mortgage crisis has informed investors, the populace, and banking industry cohorts – everyone presumably except Messrs. Paulson and Bernanke – that the global crisis stems from a lack of confidence in many of the nation’s largest, most prestigious banks.
It seems that no one has confidence in the banks’ business judgment, financial acumen, viability, or creditworthiness, including their ability to repay an overnight loan, especially other banks. (See Financial Projection in a Crisis or most of what we’ve written recently.)
The Mortgage Problem: We’ve written extensively about the mortgage crisis and produced a simple, implementable, tax-based, private-enterprise solution to THAT problem: A Better Solution (than a government takeover). That crisis was not inevitable, but it was the result of bad luck combined with ridiculously flawed government policies and very poor corporate oversight that turned bad luck into horribly bad luck via incredibly fast feedback loops – among both borrowers and lenders – in the housing and mortgage markets. That’s as close as we’ve come to a wildfire or any other contagious catastrophe. (We wrote about that, too.)
As we have mentioned frequently, the mortgage-related losses were indeed concentrated in the financial industry because of its lax management, poorly-structured incentives and the resultant excessive and concentrated risk-taking. In our opinion, anyone who states otherwise is either a liar or a fool. One cannot see the egregiously bad mortgages made to the undocumented and the uncreditworthy and based on the hopes of extrapolated past price increases onto future house values and view it as anything except wild bets gone bad – bets permitted by lax management and poorly-designed incentives resulting in excessive and concentrated risk-taking.
So where does that leave us?
The initial government bailout was never designed to deal with this larger problem of lost confidence. If it was, then it is a further indictment of the Treasury Secretary and the Fed Chairman. In fact, per many of our criticisms and yesterday’s WSJ editorial, Government Fear Itself, it doesn’t seem to have been designed for any purpose at all, which of course should make everyone suspicious of Mr. Paulson’s abilities. (We obviously don’t agree with the Journal’s view against nationalization, but we think they’re missing the bigger point of not decoupling the problems.)
Guaranteeing all deposits? How does that help provide overnight funding or mitigate moral hazard or instill confidence in the decision-making ability of these (not all) bankers? We’d argue that at least a few depositors would remove their money just for the principle of it. (Yeah, some people still have those things.) More importantly, it does not seem to solve any of the intra-bank lending problems.
Guarantee all bank borrowing? How does that permit efficient asset allocation in the economy? Moreover, it also leaves the persons who made the problem still in charge and subsidizes those actors and firms at the expense of everyone else. So, it seems neither efficient nor just. (It is expedient, which was probably why it was recommended.) In our view the guarantee would need to be interminate, or the problem would reappear when the guarantee expired.
We’d imagine that based upon the magnitude of gains on many derivative trades, especially for buyers of credit derivatives and other spread andbasis products, the government would face substantial calls for cash as those guarantees would likely quickly turn into such calls – not quite the same, but not that different than AI. – especially as those instruments matured and settled.
No, if the government is responsible for all claims on those banks, then it (we taxpayers)) should directly control (own) the assets. So, we say:
Fire, Close, Nationalize, Fire, Reorganize, Sell
It’s not a 12-step program, only six, but it does require the President to accept the nature of the crisis like most 12-step programs: “God grant us the serenity to accept the things we cannot change, courage to change the things we can, and wisdom to know the difference.”
Fire: Mr. Paulson and Mr. Bernanke were out-of-their-element in the mortgage crisis, let alone in this larger, more serious problem. The Wall Street Journal editorial staff, proponents of the $700 billion bailout, admit that Mr. Paulson had no plan once that money was his to control. On Saturday morning we lamented Where Have All the Grownups Gone? But we’ve complained frequently about the lack of thought and analysis regarding the current problems and proposed solutions. (See: Principles Lost and More or Friday’s The Unexamined Crisis.)
So, Mr. Bush, please stop cluelessly talking about endeavoring to persevere and please fire Mr. Paulson and force Mr. Bernanke to resign.* (We don’t recall everything from our Money & Banking class, but we believe that you do not have the authority to directly fire him.)
Close: Next, shut the equity markets for one week. After 9/11, the equity markets were closed that Tuesday and the rest of the week, and this current crisis is at least as serious to the nation’s economic health as 9⁄11. (We know there were facility issues, too.) While this may seem extreme, it is necessary to give investors, creditors, and bank customers the time needed understand the nature of true problem and to internalize our next recommendation and what it means to them, i.e., renewed stability and restored faith in financial intermediaries.
Nationalize: Mr. Bush and the United States should nationalize the worst banks. By “worst” we mean ones that have, say, the lowest combination of (1) equity market value to total assets, (2) estimated unrealized losses to regulatory capital, and (3) the complement of Fed borrowing to total assets, but we’re willing to take suggestions from others on the exact nature of this metric.
As we have mentioned, we do not view the current crisis as a failure of the markets. We view it as a failure of government policies and government-regulated institutions, including the government sponsored entities, and heavily-regulated banks. So our government solution is not designed to mitigate a market problem but instead to reverse problems created by other government errors or government-induced errors.
In that regard, we recommend that the government take 100% ownership subject to one caveat. Permit non-executive, employee-owners who possess restricted shares to maintain their a stake in the entity. (Overall, it seems unlikely that other small shareholders would suffer as much, particularly if the when the equity markets rebound as they regain confidence in financial intermediaries.)
Also note, we are not recommending the nationalization of the entire industry – only the weakest, least trusted banks. For example, at this point, we see no reason for the government to consider nationalizing firms like Wells Fargo, PNC, or USB among others.
Fire: Dismantle the boards of directors and fire senior managements. We recommend this for two reasons. First, it is the just thing to do. We base that statement on our interpretation of the Parable of the Faithful and Unfaithful Servant, which describes moral hazard issues. Second, it provides a severe warning to surviving institutions to get their firms’ affairs in order and instill more rigorous oversight of potentially risky activities. So, we view it as efficient, too. One of the best ways to solve moral hazard problems is through the implementation of severe penalties for undesirable outcomes. (We know it is an information argument based upon likelihoods, but we’re being informal here.)
Reorganize: Implement our market-based solution to the mortgage crisis. We’ve linked to it twice already in this post; so, won’t do so again, but it is based upon permitting either investment tax credits or cash-basis accounting (extreme accelerated depreciation) for prospective purchasers of troubled mortgages, MBS, and mortgage-related CDOs. That reduces the initial cost and provides a cushion for mispricing. We’d also recommend low tax rates on subsequent resales or cash flow realizations.
It would also seem that a government takeover of several of the weakest banks would make it much easier to sort and cancel out margin calls and overnight loans, etc., and to offer promissory notes rather than asset pledges or cash for deep-out-of-money trades (in-the-money for the other party).
Sell: Offer the reformulated banks as IPOs as soon as possible – hopefully by next summer. We greatly prefer IPOs to forcing mergers and creating ever larger banks. We believe that such mergers create over-concentration of otherwise idiosyncratic risk; they made the idiosyncratic systematic so-to-speak. We wrote about that on several occasions, too. (See, for example, Forced Mergers? Bigger Is Not Necessarily Better!, Bigger Is Not Necessarily Better or Idiosyncratic and Concentration Risk, Again.)
We realize that we could offer more details, but we’re a small organization with limited time. Moreover, there are far more specifics here than in the Treasury’s initial bailout plan, and we’re not asking for $700 billion.
We’d be happy to receive your comments and feedback on our proposal. Are we missing something? Have we ignored crucial weaknesses? If so, let us know. If not, we say, “it’s time.”
As always, we’ll update and revise this in the coming days as we clarify our thoughts and rework our sentence structures and eliminate typos.
Copyright © 2008 Spero Consulting.
*Yeah, that’s our allusion to Chief Dan George’s character, Lone Watie, in The Outlaw Josey Wales. Get dressed up in civilized clothes, go to Washington to meet the President, and pledge to be united. How exactly does that help?
Eliminate Proprietary Trading at Insured Institutions
Today, October 11, we’ve been organizing our thoughts about the ongoing financial crisis. We’ll have more to say about ways to remedy the immediate crisis, but this post contains a specific recommendation for when the crisis ends, which today may seem to be far, far off. We’re sure that – whether justified or not – many laws and regulations will be revised and toughened, and this should be one of them.
We make this recommendation because from our experience and from the inferences that we’ve made about firms throughout this crisis, it seems that neither many senior managers nor regulators fully understand many prop trading activities although, of course, neither set of individuals would ever admit as much.
With government support comes obligations, including the commitment not to take outsized risks or ones that are particularly difficult to measure or approximate, and that seems reasonable to us.
In that regard, it seems very likely that the federal government will continue to provide higher levels of deposit insurance above the past limit of $100,000. Already that limit has been increased to $250,000, and there is talk of, at least temporarily, guaranteeing all deposits. (The guarantee of all deposits is stupid and counterproductive, and if it goes into effect, it will eliminate a useful disciplining and warning mechanism. Having large, uninsured depositors flee risky financial institutions warns managements to change and informs regulators of impending problems. We plan a separate post on that topic in the near future.)
Now, however, along with the indemnity that insurance provides should come the obligations of the insured – a quid pro quo if you will. It seems that the government has done a very poor job of setting risk-sharing mechanisms, i.e., the equivalent of deductibles, i.e., inflicting financial pain on the senior management when a bank fails – beyond the loss of share value.
We won’t comment on that aspect today; instead, we propose a limitation on insured-institution trading activities. Insured banks should not be permitted to have proprietary trading desks in their capital markets departments.
Note that this will not stop banks from harming themselves by (1) lending or (2) making bad investments or trades in their treasury departments or (3) mismanaging customer trading desks.
It will however, allow regulators to focus their attention on where the major risks are taken within the firms. Without going into details, we realize that their is a certain fungibility between treasury trades and prop trades in capital markets departments and to a certain degree between prop desks and customer desks in said departments, but it would seem to be more difficult to justify certain trades and strategies if the desks were within typical, bank-related business activities. (When could write much about this but it likely wouldn’t change minds; so, we defer.)
We’re completely for the free-market–more so than most bank managers – but until such institutions forsake their government insurance, we’ll insist that they have an obligation to the citizenry – through the government – to behave in a responsible, low risk manner. If that generates lower returns for them on average, then so be it. That’s the nature of the risk-return spectrum and their legal and fiduciary responsibilities.
By the way, if an all-in, full-accounting were ever performed, we’d be doubtful that such prop trading operations were profitable or value-creating, especially at the commercial banks. From what we’ve observed, trading PnL (profit and loss) is considered and sometimes trading-related PnL is considered for performance evaluation, but rarely an all-in accounting is performed. The marginal overhead costs risk-management, back-office operations, auditing, accounting, etc., associated with such activities are often ignored. Moreover, on a risk-adjusted basis, it is substantially less likely that overall, net returns are positive.
Finally, we actually think that many senior managers of commercial banks would welcome the ban. We suspect that many of them are suspicious of such activities but don’t feel qualified to evaluate and eliminate them. We think it is true of most regulators, too. They don’t object because they don’t want to seem unsophisticated; pride goeth before the fall.
Where Have All the Grownups Gone?
When will they ever learn?
Peggy Noonan has another excellent opinion column in today’s The Wall Street Journal. It is entitled, Playing Frisbee on a Precipice. The title and the column’s blurb say it all: “Our political class lacks the seriousness this moment demands.” Clearly, her essay is about the smallness of our present day politicians and their advisers.
She has perfected the ability to lament, yet simultaneously expect, the fallen nature of man.
We’ve written about our admiration for Ms. Noonan on a number of occasions, and once again she strikes the metaphorical nail directly on the head. There is an overwhelming smallness of the current political class where everything, regardless of the crisis, is attempted to be used for short-term political gain. What small, small people in both parties.
It’s obvious from her title that she uses the metaphor of playing Frisbee on a cliff to show their utter lack of seriousness, primarily within the two Presidential campaigns and with candidates. Perhaps deep down inside, our political actors realize that they are not up to the task and therefore continue to play games as the fellow citizens lose trillions of dollars.
In that sense our politicians are like young siblings or friends making outrageous claims against each other knowing full well that their parents would step-in and never permit such events to transpire. Unfortunately, the grownups are gone, and the noise downstairs isn’t an older sibling trying to scare via a the equivalent of a Halloween prank.
It’s worth mentioning that a month ago we used somewhat similar imagery to Ms. Noonan’s about the mortgage crisis in Our Poster Boy for the Credit Crisis.
In that post we compared many Wall Street firms to our hungriest Basenji, Boots. As the photo shows, Bootsy had his head buried so far in the food bag that he had no idea where he was. To his good fortune he was in the kitchen, and not near the basement steps as he pushed on.
Due to lax management, poorly designed incentives, and the resulting excessive risk-taking, Wall Street’s metaphoric head was buried just as far in the food bag seeking ever smaller and smaller morsels as it pushed closer and closer to the precipice of the Grand Canyon – located in to housing bust of the Southwest, no less.
We still prefer our graphic to the one in her column:

By the way, Ms. Noonan and Sarah Palin share that trait that seems to be feminine but which Ronald Reagan also possessed. It permits a severe scolding but in a gentle, humorous way.
We don’t know of Mrs. Palin well enough to include her, but we’d argue that it worked for Mr. Reagan and works for Ms. Noonan because their central core was/is so permanent, solid, and robust that one knows exactly their position before they speak. That inner sense of completeness, combined with the confidence that naturally follows from such maturity, means that listener or the reader knows the words are from the heart, the essence, the core and not just cheap rhetoric. That depth of conviction permits the humor and irony to be appreciated for what it is, and also what it is not: it is not meanness or cheap tactic.
Enough about people bigger than us. Out of our own smallness, we couldn’t help linking the failed leadership of the nation’s oldest babyboomers, who are now in charge of many government functions and large corporations, to one of their favorite, Pete Seeger protest songs from the sixties. It was about government missteps, too. “When will they ever learn? When will they ever learn?”
The Unexamined Crisis
Update (October 14): Dennis Berman has a nice article about last week’s panel discussion, Street’s Demands May Stir Public Wrath, in The Wall Street Journal. It is very similar to this post from Friday. While we lament the lack of intellectual curiosity – or any type of curiousity or self-examination or self-criticism – in our entry, Mr. Berman mentions the possible implications of such obtuseness. Being self-absorbed and self-involved makes it difficult to know when the hoi polloi and politicians have turned against oneself. We like Mr. Berman’s seemingly nonplussed resignation and matter-of-fact statements to that effect.
“The unexamined life is not worth living.”
–Socrates (via Plato in The Apology)
Please read: Stewards of Capital Gather at NYSE. What Happens Next? Who Knows? at The Wall Street Journal’s blog, Deal Journal, which reports on a panel discussion involving several finance industry executives.
Then, consider the above Socrates quote as it pertains – or more precisely does not pertain – to our leading financial executives. Is there an iota of marginal, new insight in anything that they said during the session?
Perhaps they have deep insights, but they are unwilling to share them with the competition. Or perhaps their insights would induce further panic in the markets, and so they keep them them deeply hidden? Perhaps.
We ask: was there anything said beyond mere platitude or personality, e.g., “they did it right” (at the Treasury), or more than a mere ad hoc statement?
No, we’re not that naïve. We have no such expectations, but such reports are disappointing nonetheless.
We’re always searching for that one, rare individual who will stop and think during such a crisis. Unfortunately, this time around corporate and government leaders remind us of a middle-school, girls basketball team in full, “hot potatoes” panic. The biggest difference is the girls do understand their shortcomings and limitations. At what point after high school does that leave us?
Well, This Is a Fine Mess You’ve Gotten Us into.…
Messrs Paulson, Bernanke, Bush, Reid, and Mrs. Pelosi.
(Edited and slightly revised on 10−11−08)
We’re always deeply suspicious when a politician tells us how he or she is going to “fix the economy.” The best they can do is get out of the way, but unfortunately they rarely do. That’s the sinful, human problem created by that all-too-common combination of hubris and ignorance.
As we mentioned in a previous post, the most honest moment of the current Presidential campaign was an ad in which McCain admits that he doesn’t know much about economics, and it was an Obama, Anti–McCain ad.
If only, if only, McCain would act in the humble spirit of that ad. Instead he announces a new bailout plan for those who can’t pay their mortgages. It is an admirable sentiment. Unfortunately, it is likely to be very unwise (given the way such programs are implemented).
We ask: if you’re close to defaulting on your mortgage, why struggle? Why liquidate retirement accounts, why take a second job, cut entertainment costs or pare down vacation budgets? Why not default dear reader and let the government pickup the difference? We haven’t looked at the specifics of his plan, but we would be very, very surprised if it didn’t introduce such dysfunctional incentives for those struggling to make their monthly payments.
But Mr. McCain’s latest misstep isn’t why we’re writing.
This evening, (Thursday, October 9) we saw this headline on The Wall Street Journal’s web site: Treasury Weighs Next Step to Stem Crisis.
Isn’t it obvious? Isn’t it time for Mr. Paulson to go? And Mr. Bernanke, too, over at the Fed? (Except for next three plus months with Mr. Bush, we seem to be stuck with others – kind of like our shoulder bursitis or chronic disc problems.)
Do you think the markets would react negatively to those resignations? We doubt it. Would you? Would they?
They’ve made any number of mistakes since 2007, and below we try to categorize the collective errors into as few groups as possible. In our opinion:
- The gang misspecified the initial problem. This might have been due to the fact that Paulson and Bernanke may have been too close to the situation and much of it involved their friends, former colleagues, acquaintances, and probably their neihbors. The rest the gang missed it because they seem inherently clueless.
- They had/have no viable solution to the misspecified problem, let alone the real problem. We’ve written extensively about why the bailout would fail and, in fact, how it would lengthen and deepen the crisis. Try this link or just go to the blog; many of our recent posts have talked about these issues. The real problem is no one trusts the banks.
- They overstated and (generally) overreacted to the initial problems. It was like screaming that a flaming wolf was falling with the sky in a crowded theater of sheep and chickens. Well, we’re seriously mixing our metaphors but their cries of “wolf” and “the sky is falling” were like shouting fire in a theater, whether or not it is true. They were wrong, yet created fear nonetheless. Quite a feat to be sure.
- They had no understanding of the implications of their overstatements. It seems that their initial overstatements were mere rhetoric designed to get their misguided bailout bill passed into law, but words have implications, too. Those words weren’t very confidence-inspiring. In fact, at the time and in retrospect, those words seem(ed) to be panic-inducing because the solution seemed (seems) very hokey to many but investors remembered the words of fear, especially in the context of a doubtful plan. In other words, investors seemed to believe that there was a problem but didn’t seem to believe the existing bailout or its federal overseers could solve the real one. Ergo, the unprecedented equity losses.
We believe the group’s collective actions and statements showed that our government officials were and are fearful, scared, and especially clueless about true underlying problem. In fact, they seem to have made the situation worse by offering a solution that didn’t fit the problem and by forcing large banks to merge and. (See Bigger Is Not Necessarily Better for a discussion of the forced mega-mergers and the future problems that might cause.)
As we wrote Tuesday in Even A Perfect Bailout Will Fail, the problem isn’t the bad mortgages or technical defaults or mark-to-market accounting. The massive mortgages losses were the vehicle that conveyed negative information about the banks. The problem is that many banks bought the bad mortgages at very high prices (and rather recently, too) and those mortgages aren’t worth much today. The market’s judgment is that the banks should have known better.
Those mortgage-related purchases show the banks to be far less competent and far less trustworthy and far less creditworthy than almost anyone imagined just a short time ago.
It wasn’t just bad luck. It was incompetence on a grand scale. That’s what turned bad luck with possibly a small number of mortgages into a global crisis. We don’t believe that either the mortgage crisis or the larger financial crisis were inevitable, but we do believe that it is quite possible for a little bad luck, so-to-speak, to turn very ugly, very fast. (Good fortune would have prevented the problem and few would have realized the potential for it existed. That makes us wondered: how many times in the past have we been lucky, i.e., “there but by the grace of God go I?”
Given the lax (yet very common) lending standards used more many mortgages, it was easy to generate a domino-effect where a concentrated but small number of defaults (and resulting house devaluations) could have generate unbelievably-fast, feedback loops that quickly (and negatively) affect local and regional housing values, and the national (and global) economies. It appears that these feedback loops could jump across regions, say, from California to Charlotte, as we mentioned in Wachovia, the Hold-up Problem, and Feedback Loops.
It seems that no firm’s analytical models included this contagion phenomena and none of their analyses captured these neighborhood, town, and regional dependencies and interpdependencies. (See our Trading, Incentives and Organizational Structure and Risk Management from the Spring.)
Only a very small number of geographically close (neighborhood) defaults, can be treated as independent trials, like separate, unrelated coin flips.
Once a (low) threshold is met, however, it seems that everyone in the neighborhood is (negatively) affected. Such a phenomenon is often called as a tipping-point.
A few foreclosures on a street can be attributed to idiosyncratic factors, e.g., divorce, relocation, gambling, etc. However, after a critical, but still small, number is of defaults is reached, the value of many or all of the homes on the street or in neighborhood is diminished and possibly destroyed. Depending upon the fragility of borrowers’ creditworthiness, including the percentage of the value financed, these losses on a street can roll up and induce losses within subdivisions, then towns, and then regions, and then even across regions.
We’ve mentioned repeatedly that these mortgage-related losses seem to be especially concentrated among banks this time, and despite the recent massive losses in the equity markets, that still seems true. We believe this was due to lax management, including poorly-structured incentives, which led to excessive–risk taking of both well-understood products (mortgages) and poorly understood ones (MBS and CDOs). See this post, for example: Idiosyncratic and Concentration Risk, Again.
At present, it seems that few outsiders trust the banks. Worse yet, it seems that no insiders – other banks – trust each other. A few days ago, we attributed that suspicion to the equivalent of psychological projection in Financial Projection in a Crisis. Each bank projects its own diminished viability onto the others. Unfortunately, it seems many of them are making the correct inference and drawing the right conclusion. (Note: we don’t mean all banks as many, particularly the smaller ones, seem to be avoiding the current mortgage mess.)
This lack of trust among banks has led to many collateral calls, and it is why AIG, the writer (insurer) of many credit default swaps (CDS) has eaten through over $120 billion in a few weeks. (That’s seems to have been another misjudgment by the Fed.)
Certain commentators have called for establishing clearinghouses for other-the-counter (OTC) derivatives like CDS. We doubt that it could be done quickly enough to instill confidence. Moreover, that doesn’t solve the existing problem of not being able to meet margin calls today.
We’re beginning to believe that the government must act immediately to nationalize certain large banks. At a minimum, it would solve issues related to margin calls and collateral problems and eliminate the need to take other silly actions.
We’re almost an economic Libertarian, so it gives us pause to contemplate nationalizing certain institutions, but we consider such a plan to be a remedy to past government mistakes, including almost everything our government officials have done in the last month or so, and including the misguided “bailout.” (By the way, we know that government helped create the mess, and we don’t trust them to do a great job, but by definition, no one can nationalize.)
We write it partially to convince ourself, but there seems to be little left to do but nationalize those banks with the biggest reputation problems and the lowest percentage of capital to assets.
If that happens, the government needs to do it swiftly and by surprise. It needs to take 100% of their equity thereby wiping out existing shareholders. All boards and senior managers must go, too. Certain trading desks with capital markets’ departments and – where necessary – treasury departments would need to be quickly split (to the extent possible) from general bank operations. Once stabilized, the new entities would need to be sold as soon as possible.
Separately, we believe that our proposed, private solution to the mortgage crisis, i.e., A Better Solution (than a government takeover), would solve that problem, which is now a minor aspect of the bigger problem. A mere symptom of the financial industry’s bigger problem, and neither our very clever plan nor the government silly bailout will solve that bigger problem: a complete lack of confidence in many of our largest financial institutions.
The economy requires financial intermediaries that can be trusted, and the reputations of many of the current ones have been shattered; so, it seems that something big has to change: possibly they need to be taken over and then resold them. We’re not sure that we completely believe it, yet, but it is something to contemplate.
We don’t see the current crisis as a failure of markets. It was a failure of government intervention and policies at many different times and stages, with the latest ones being the most visible.
So, ossibly, a government solution is required to reverse the damage it caused?
Mr. Paulson and Mr. Bernanke must leave before that can occur, regardless of the proposed mechanism to fix the problem. They are doing nothing to mitigate the problem, and in fact seem to unintentionally exacerbate it.
We need to think more about it, but as scary as it is to write, the quick nationalization of the worst banks MAY be the cheapest and best solution.
We’ll likely continue to revise this post as we clarify our thoughts.
10−09−08: The Expiration of the Short-Selling Ban
We’re not sure whether to start this post on a sarcastic tone or not. The sarcastic start is “it’s too bad the short-selling ban expired, could the dear reader imagine how far stocks would have fallen without it?” But, the market did tank again today.
Instead, we’ll note that when such a ban is arbitrarily imposed during a seemingly negative event, most participants infer/conclude that the event is worse or much worse than they would have otherwise thought or were led to believe – possibly worse than anyone ever imagined. (By arbitrarily, we mean spur-of-the-moment and not due to a mechanical, precommitment to impose such a ban when, say, a market variable hits a pre-established barrier.)
Such inferences tend to make investors and other individuals nervous, possibly panicky, and much more likely to sell their holdings thereby negatively affecting prices and bringing about a result opposite of the initial desire affect.
Now, such a conclusion seems obvious even to someone as unsophisticated as we; so, that makes it seem that government official are so extremely nervous, panicky, and out-of-their-element that they are at or pass the point of senselessness. They remind us of middle-schoolers playing basketball, as the tension increases, they tend to stop breathing when they have the ball. The lack of oxygen does not enhance judgment, and bad things – turnovers and missed shots – tend to accumulate (and exacerbate that nervousness_. It almost looks like they’re playing with plastic bags over their heads or playing underwater without SCUBA: must…get…rid…of…ball…to…restore…air…flow…gasp…gasp.
When other firms, outside of the initial ban, try to be covered by it, too, investors tend to get suspicious of them, too. (It is like being subpoenaed as a witness and asking for immunity.) The natural response by both interested and indifferent parties is that the firm is hiding something, and they tend not to hide good news.
As we have stated repeatedly in other posts during the past several weeks, we think that both elected and unelected federal officials have performed miserably during the recent crisis, and, in fact, have made it worse through their conduct. See almost anything that we have written in the past few weeks, including, Planes, Trains, and Automobiles and Banks and Farms and States…, Shame on Them!, Principles Lost and More, SOX’s Roles in the Financial Crisis of ‘08, and >Out of Their Elements to list just a few.
The Fed’s recent decision to lend directly to firms (via the commercial paper markets) and the SEC’s unwillingness to extend the ban are the only hopeful, sensible actions that we’ve observed are fearful leaders take in quite some time.
When the U.S. Sneezes…
the rest of the world complains.
On Tuesday, we posted The Importance of the Rule of Law, which describes how Russia’s problems are unique from the West’s and, as we see it, are the result of self-destructive policies and desires.
In that entry, without providing additional links to articles, we insinuated that The Wall Street Journal’s reporters seemed to be agreeing with Russian leaders that, of course, Russia was an international victim of the credit crisis in the USA.
In our mind, the only linkage – while large – is the decline in energy prices as the US economy adjusts – by using less – to the higher level of oil and gas prices.
It is nice to see the The Wall Street Journal editorial page criticizing the Russian President for his attack on the U.S in its essay, Dmitry’s Diatribe.
Don’t expect other countries to come to our defense when the US is criticized, however. The recent losses in global equity markets show that the rest of the world still heavily depends upon the USA. Those countries, big and small, fast or slow-growing, suffer at least proportionally when something negative happens in the U.S., and many remain critically dependent upon the US.
It seems that if we don’t buy their stuff, no one does, either, especially their own citizens.
Don’t expect gratitude for keeping the world afloat. Instead expect continued resentment for that dependence upon us; foreign leaders are kind of like teenagers in that respect.
So, while the teenagers of the world will criticize us, the insecure politicians in the US will try to be more like them, when all-the-while, they want to be more like us. (Kind of like Danny and Sandy in Grease.)
Aside: say, doesn’t adopting international accounting standards seem like a great idea right about now? We hear that standards eliminate greed, stupidity, ineffective government policies, and risk concentrations. If we’d followed them, we could be as well of as the rest of the world right now. (And, had we followed them several years ago, Congress would never, ever have pressured Fannie Mae and Freddie Mac to do stupid things, but who knew?)
implied RISK NEUTRAL probability of default, redux
Update: we have newer posts on the topic, too, including Risk Neutral Valuation: There Are at Least Two Expected Values, that describes the difference between real and risk neutral distributions. We also have: Price Implied Default Rates that provides an example more like a risky bond, and a multi-period example: Multi-period Bond Price Implied Default Rates and CDS.
The Wall Street Journal has an article about Iceland’s financial problems in today’s paper: Aftershocks Felt From Iceland. It turns out that the country has more problems than being a small, cold island in the middle of the North Atlantic.
Any way, we’re not writing about its climate, especially since Western PA’s is probably worse and we have no beaches and few tall blonds. No, we’re writing about the graph in the article and the blurb that states, “Trading in the credit default swap market puts the probability of a default by Iceland on its debt at a little over 50%.”
As presented, that statement is highly misleading and nonsense, and the purpose of this post is to explain why.
We’ve written about Implied RISK NEUTRAL probabilities of default a few times. In the aptly titled Implied Risk Neutral Probabilities (of Default) we provided an example that illustrated the difference between the actual probability of default, which is never known in the real world, and the model–implied probability of default, which could be calculated from ANY model–regardless of its validity–that permits at least two outcomes, e.g., survival and failure of the entity. Such a model may or may not assume risk neutrality, but risk neutrality makes the calculation simpler.
Regardless of whether Iceland goes bankrupt or not, we provide several examples that distinguish the risk-neutral, implied default rate from the true default rate.
In our earlier post, Implied Default Probabilities and Risk Neutral Models, we commented on a similar graph in another WSJ article from last June, and mentioned many of the factors that would be involved in such a calculation. Unfortunately, we recently and accidentally deleted a very nice comment about that post, which expanded the analysis to include counterparty credit risk: the risk that the purchaser of a CDS contract would not get paid (the insurance proceeds) in case of bankruptcy because the insurer or CDS writer was also insolvent – kind of like AIG.
In this post, we’ll provide another numerical example with a different assumed, risk-averse, utility function for the insurance buyer.
We’ll again assume a single period, but we will not use the 50% probability of bankruptcy that we did in the earlier post; it would be too confusing. In fact, the 50% probability of default mentioned in the article is likely the cumulative probability of default over the five years. It may or may not be based on equal marginal probabilities of default for each of the five years, regardless the annual marginal probability of default is not 10%; the 50% mentioned for five years was not found by multiplying five years times 10%.
Readers interested in an example of a discrete-time, multi-period survival problem that illustrates these issues should see Good Column, Bad Math. Readers interested in a calculation-intensive, similarly-structured, discrete-time problem, should see our research paper on moral hazard: Deadlines as Management Control Devices, which is based upon our dissertation. In that paper, the game ends with success, rather than failure, but the outcome tree is very similar.
So, will provide a couple examples similar to our square root problem in August.
Case 1: Assume that the person has natural logarithmic utility, which is strictly concave funtion and makes him risk-averse. We’ll also assume that the person has an initial endowment of $75.858, which we choose for convenience as you’ll see below. We’ll ignore time-value-money calculations and interest rates today; they’re inessential.
Assume that a firm will be worth $100 if it survives and $10 if if fails. That makes the loss given default (LGD) $90, and the loss given default rate $90/$100 equal to 90%. In the real world, e don’t know the loss given default until a default occurs, the firm’s assets are liquidated, and the residual cash is paid to the debtholders. LGD rate is always assumed in CDS and other similar calculations and, from our experience, seems to be considered much less than implied default rates.
Assume that the actual probability of default is 12%, i.e., the probability of getting $10 from the investment is 12%. REMEMBER, two items that we never know in real life are the market participants preferences – expressed here as a ln(·) utility function – and the actual probability of default, 12%. It is crucial never to forget this ignorance.
Also, we generally don’t know the person’s entire endowment, specifically his other wealth independent of the gamble. In this first case, we cleverly chose the person’s endowment so that his other wealth, not tied up in this particular investment, is zero. (You’ll that fact below.)
We’ll do what we need to do to calculate the risk-neutral probability of default and then later we’ll change a few assumptions to see how those changes affect the answer.
First, we’ll calculate the person’s expected utility with the investment. Now, with logarithmic utility it is:
10% × ln($10) + 90% × $ln($100) = 4.375 utils.
Now, to get the same 4.375 utils of satisfaction from a certain gamble (involving no risk), the person should be willing to spend up to:
e4.375 = $75.858.
So, that $75.858 is his certainty equivalent, or the most he would pay for the uncertain investment. (That’s why we cleverly set his initial wealth at the same $75.858, so there would be no money left-over after the investment.) With the same hand-waving (about market interactions) that we performed in August, we’ll suppose that the $75.858 is also the price, i.e., competition among similarly-preferenced and endowed buyers drive the price to the break-even point; technically, it is an indifference point but only pedantics like ourselves care.
Now, a risk neutral person could–but need not – be modeled as caring only about expected cash flows on a dollar-for-dollar basis; so, for a risk-neutral person, we could set his utility equal to dollar values and expected dollar values. In other words, he would value $10, $75.858, and $100 as 10 utils, 75.858 utils, and 100 utils, respectively. (We wrote “but need not” above, because we could add a constant and multiply by a positive number without changing the essence of the analysis.)
Remember, in the real world, we don’t know the 12% or the actual market participant’s preferences, which we assumed to be logarithmic here, or his starting wealth, BUT if we assumed that he was risk neutral in our dollar-for-dollar way, then we solve for the corresponding probability of default, i.e., find p such that:
p × 10 + (1 — p) × 100 = 75.858.
Rearranging and solving for p, we get the risk neutral-implied probability of default, p, equals about 26.83% (versus the real probability of default of 12%, which, again, we never know in real life).
So, the WSJ writer or editor is calling that 26.83% the probability of default, when it is, in fact, the implied probability of default assuming that market participants were risk-neutral. (Here, our “model” is so simple as to be innocuous, but in more robust settings – with more details – that’s not the case.)
That risk-neutrality, which provides linearity of preferences, is what allows the analyst to view the price and set it equal to the expected value of the cash flows in the possible outcomes, e.g., survive or fail, for a possible probability, p. In real life, analysts would use different distributions to calculate an implied probability of default based upon their specific model in much the same way that they would calculate a model-implied volatility when using Black-Scholes or a variant. (Provide market variables or guesses about those variables, provide a model, and solve for the last remaining unknown. Notice that there are quite a lot of assumptions in such a process.)
(By the way, for those with a little knowledge of stochastic processes, setting the price equal to the expected value (under risk neutral valuation) is why the phrase Martingale Method is used. That’s what a Martingale is: a process where the value today is equal to the expected value in the future, and it doesn’t really change if we add interest rates and discounting.)
Now please note, unlike in real-life, in this example, we know that the true probability of default is 12%. To an outside observer, without our information to construct the calculations, there is no clear relationship between the 12% and the 26.83%. In other words, knowing only the 26.83% says nothing about the true probability of default, and that is the error that the journalist makes in today’s article.
Because the 50% for Iceland is such a large number, the graph and the blurb seem almost designed to insight hysteria; however, actual – albeit unknown rate – could be substantially lower.
We’re sure that many WSJ readers along with the article’s writer misinterpret that number. We were and continue to be amazed (and shocked) at the number of folks who work or trade in the area who do not understand it. Thus, we view this post as a public service.
It is about 5:00 EDT, and proofread the post like we promised. We’ll add to this post this later today with more examples; so, please check back for updates that show why the price could drop and the implied RISK NEUTRAL probability of default could rise despite the TRUE probability remaining at 12%. (Note: the true default rate has little or nothing to do with the historic default rate. We’ve written a lot about that notion, too. See our essay on uncertainty management for that discussion.)
Case 2: let’s keep everything the same, but make the person “more” risk-averse. In microeconomics, that has a particular, technical meaning having to do with the concavity (the curvedness) of the utility function, but here we’ll avoid the issue by reusing the natural logarthmic function recursively, i.e., our utility function is now ln(ln(·)).
In such a problem, the additional concavity reduces the certainty equivalent of the gamble, and possibly the price. We’ll wave our hands again as a way to stay on course, and assume that the price falls to the new certainty equivalent. To make it work, without trying to hard, we’ll arbitrary assume that as soon as the person purchases the firm, his preferences, via utility function, (and risk aversion) changes to the double-log thing, ie.,
12% × ln(ln($10)) + 88% × ln(ln($100)) = 1.444 utils.
For the changed person to get the same 1.444 utils of satisfaction for sure, he’d be willing to sell it for:
eexp(1.444) = $69.243.
(As his risk aversion increases, the value of a gambles decreases.) Now, in the real world, a decrease in a potential seller’s reservation price doesn’t necessarily change the market price, but we’ll assume that it does. So, immediately, the price is $69.243. We can now find the revised risk-neutral probabilities:
p × 10 + (1 — p) × 100 = 69.243.
Solving for p yields a new, risk-neutral, implied probability of default of 34.175%. So, a change in risk preferences will change the implied probability of default. You may call it the market implied probability of default, but it is really the implied probability of default using the market price and assuming that buyers are risk-neutral, but that gets kind of long. The real probability of default is still 12%.
Case 3: Now, let’s go back to our first case, where we used the natural log, ln, only once, not twice. Let’s assume that right after the purchase, the new owner discovers that the loss given default is really $99 dollars, not the $90 that (it was assumed that) the market knows.
In that case, the new expected utility is 0 + .88 × ln(100) or 4.145 utils. Taking the inverse gives e4.053 = 57.544.
Now, IF everyone knows that the two states are {$1, $100}, then the risk-neutral probability of default satisfies:
p × 1 + (1 — p) × 100 = 57.544,
and equals 42.9%. Remember the actual probability of default is still 12%, but the low outcome is particularly low for a log utility function. So, the implied, risk-neutral probability of default is more than 3.5 times the true probability of default.
Case 4: let’s take Case 3, and assume that the buyer knows that the loss given default has increased from $90 to $99, but a trader or analyst at another firm has not observed that change but has observed the new price of $57.544. In that case, the analyst very likely keep the same LGD assumption and solve for a new implied probability of default of (using the erroneous, but assumed $10, rather than the correct $1:
p × 10 + (1 — p) × 100 = 57.544.
In that case, solving for p gives an model-implied, under the assumption of risk-neutrality probability of default of 47.2%. Of course, once again, the real probability of default is 12%.
The difference between the 47.2% and $42.9% implied default rates is solely attributed to the (incorrect) assumption about the loss given default. In our experience, the LGD is the least-challenged, least-investigated assumption used to price CDS and related products. In real-life, it would be extremely common to maintain that assumption in the face of falling prices.
We’ll probably refine this post in the coming days, but our four simple cases should be sufficient to cast deep suspicion on Iceland’s reported probability of default, when it is really a model-implied, default rate under the assumption of risk neutrality. Remember in all of our cases, the real probability of default is 12%. The models used to calculate that rates involve more variables and more calculations, but apply no more knowledge than do our simple examples here.
If you have any questions or comments, please write.
Copyright © 2008 Spero Consulting.
So Much for the “Hedge” Part of Hedge Funds
From Big Bets Come Back to Bite Fund Managers in today’s Heard on the Street section of The Wall Street Journal:
“To wit, a basket of stocks most popular among hedge funds tumbled 19% in September, more than the 9% drop for the Standard & Poor’s 500, according to Goldman Sachs.”
We doubt that early October has been any kinder.
We don’t want to make too much out of a single month’s or single year’s results or a single fund’s misfortunes, but we are wondering: were gains in past years due to sheer genius or were they due to the (equity) funds being invested in a highly-leveraged manner, in a relatively stable (low volatility) environment, during a period of generally increasing stock prices coupled with a period of very low borrowing costs? (Whether such positions were constructed directly in stocks or options or other derivatives is irrelevant.)
We don’t follow hedge fund marketing very closely, but we doubt that any fund claimed such a strategy, i.e., “we’re going to take your money, leverage it as much as we can, take a bet, and hope for the best.” In which case, it would seem that “hedge” is defined as “speculation.”
We’re also wondering how many wealthy, “sophisticated” investors would have invested were such schemes explained in such an explicit, straight-forward manner rather than via the various selling pitches used to appeal to the pseudo sophisticated.
Neither the (1) frequency of trades, (2) exclusivity of the proprietary algorithms, (3) level of automation, (4) speed of execution, nor (5) even the volume of ‘tude exuded seems to have mattered. At the end of the trading day, it is difficult to not to be either long or short or levered or not, and recent returns provide evidence that despite all the machinations and claims to the contrary, the de facto fund position was long and (highly) levered.
As the chairman asks, aren’t the funds, their managers, and their infrastructures still in place today? Why don’t we see out-sized (positive) returns now?
By the way, regardless of the strategy, we’re not talking about how internal models or investor reports show flatness to the market, etc., we’re talking about real life, which is much more difficult to accurately quantify. (Please see our discussions of nedges and sledges for more on this topic. We’re also in the midst of writing Hedging the Pennywise and Pound-Foolish Way, which discusses the myopic and narrow focus of hedging tactics. Also, please see our essay on uncertainty management for our broader perspective in the area.)
So for all the hyper-frenetic, high frequency trading, etc., many equity funds seem to provide nothing more than a volatile play on the equity market – not exactly our definition of “hedge.”
Then again, many fund managers received HUGE rewards on the upside and faced limited losses on the downside; so, they seem to be much better protected. Oh, we get it! Never mind. We see why they’re called hedge funds. It is for thee, not me.
However, an uncertainty remains: were fund managers trying to fool investors or were they just fooling themselves?
Okay, This Might Work
Now Lend and Shut-up, Mr. Fed Chairman!
Tonight, The Wall Street Journal reports that the Fed Will Lend Directly to Corporations. They mean the Federal Reserve will lend to non-financial corporations.
This is the first sensible action that we’ve seen anyone in the federal government take since the financial crisis began. No, we’re quite serious. The President, Congress, the Treasury, the Fed: all disasters: seemingly nervous and clueless but without the good sense to hide either emotion from each other or from the American people.
We’ve argued that the ridiculous bailout plan will fail. (See almost anything we’ve written in the past several weeks.) We also think that the September panic-speeches of Bernanke and Paulson were equivalent to shouting “Fire” in a theater, and if President Bush had any remaining interest in the country or economy, he would have fired Paulson and asked Bernanke to resign for their shameful behavior.
This evening we just finished writing Even a Perfect Bailout Will Fail. In it and many of other recent posts, we mention that the problem is the banks and the banks, alone. That problem is the general and justifiable lack of confidence in them, including – or should we write especially – their lack of confidence in each other is the problem. Even if all the bad assets were exchanged, would the reader trust the banks and their management’s?
Regular readers will note that for quite some time, we’ve been asking why the losses seem so concentrated? The short answer is that they seem concentrated because they are concentrated. Lax management begat poorly-structured incentives, which begat excessive risk-taking, which begat risk concentration, which begat the massive losses. (Those who would argue that such reasoning is faulty – and there are some – would have to claim that the financial firms are victims of very, very, bad luck, but there doesn’t seem to be much evidence of that.)
As far as we can tell, it is not the rest of the economy – not yet, at least. There are areas of the country that have been overbuilt, and cities like Charlotte and New York will suffer because they rely so heavily on the banks and the financial services industry for income, spending, and taxes, but in many places the economy has been remarkably resilient.
We see the panic-speech and a lack of a clear articulation of (1) the problem, (2) the placement of blame, and (3) the proposed solution and how it would work as the largest problems facing the general economy, and we see it as the reason why the Dow has lost over 1,400 point since the plan was approved. At best we can hope that our politicians and government officials shut-up before they can cause too much harm.
So, we applaud the Fed, the lender of last resort, for fulfilling its mission and acting rather than talking. Banks are the problem, and this latest action avodis them and goes directly towards mitigating the problem. By the way, new readers may be interested in our alternative bailout plan: A Better Solution (than a government takeover).
Even A Perfect Bailout Will Fail
What Hope of Success with Typical Bureaucratic Efficiency?
We have criticized the “$700 billion” federal bailout of banks for the past two weeks and have done so for a variety of reasons. (We used the scare quotes to denote the unreliability of the estimate, which seems to have been grasped from thin air.) We won’t cite all of the reasons for its likely failure, because in this post, we’ll suppose that the “bailout” is perfectly executed.
Would such perfectly executed plan return us to the pre-crisis, halcyon days of early 2007? No! To anything close to it? No.
Suppose that each and every crappy mortgage, mortgage-backed security, and CDO held by a commercial bank is purchased by the government at a fair price, and so, let’s suppose that the banks have $700 billion in cash instead of semi-worthless thingies that they may or may not understand.
Now, under such an incredibly fortunate circumstance, would the dear reader have confidence in those banks? Would he or she have more confidence or less confidence in the bank that sold the most thingies to the Treasury?
This first reason explaining the bailout’s likely ineffectiveness is a “types” argument. They’re lower types than we thought.
We now know that many banks made a tremendous number of very, very costly mistakes and mis-estimations during the past several years. Thus, they now seem substantially less capable they did two years ago. (Does any reader think more highly of the banks today than in, say, 2006?) The capital markets departments, boards, senior managers, traders, risk managers, and treasurers seem less able today than one or two years ago.
Moreover, it is not just the losers. We recall a conversation with a former trader and current risk manager whose bank seems to have avoided many pitfalls that have damaged or destroyed other institutions. When asked why it was so fortunate, he replied, “it wasn’t due to any competence. In fact, it was quite the opposite. They had planned to be just like their peers but were incapable of executing it (the plan).” So, it seems that there are reasons to suspect the non-losers, too.
So, we ask, do you trust the banks with $700 Billion in new cash or do you think they will waste it or take excessive risks? Have they done anything to earn to earn your trust, and is there anything in place, like revised incentives schemes, that would indicate a change in philosophy and an improvement in control?
Secondly, we now know that for many banks, a substantial portion of their pre-2008 earnings were bogus. As those assets were losing value, the banks were recognizing income on them. Much of those earnings have now been reversed via losses, and it is likely that additional losses will be recognized in the next two quarters. (Recall: we’re assuming that the assets trade at a fair price.) So, we know that the banks’ future earnings will not return to pre-2008 levels, and it is unlikely that their equity base and capital levels will permit lending and investing at those past levels. Moreover, where will they invest? In real-estate? In sum, we expect lower earnings for the foreseeable future.
Thirdly, all of these points should be known – at least, collectively – by the surviving banks. As we wrote (tongue-in-cheek) in Financial Projection in a Crisis, if banks project their own abilities onto their peers, they may continue to be suspect of each other thereby keeping the credit markets “frozen.” How much does the dear reader trust them beyond the $100,000 or $250,000 deposit insurance limit?
Fourthly, with the mega-consolidations, and an associated too-big-to-fail mentality, moral hazard becomes an issue that exacerbates these suspicions. Will these mega-banks take outsized risks knowing that the government will cover losses? Will the government cover such losses? So, how long will it takes banks to trust each other, now that there are fewer trading partners? (Will banks trust the debt rating agencies? Do you?)
Finally, does the reader imagine that once the crisis recedes, the federal government will voluntarily give up control of the new portion of the economy that it controls? Generally, to induce the government to shrink requires, if not a literal revolution, at least a figurative one, e.g., the Reagan Revolution. Without such a revolution, what hope does the economy have with more government interference?
Those looking for regulation as a solution should note that investment banks and large commercial banks were already heavily regulated. Most reports to senior management and the board of directors are also sent to the regulators, who may question them. Did the reader not in the industry know that those regulators, maintain permanent offices in each bank’s headquarters and are almost like employees?
Besides reading such reports, the regulators also conduct frequent examinations, and, of course, they did so repeatedly during the past several years. Did they catch anything? Moreover, as we’ve written in the past, do they have the incentive to do so? Or would the discovery of an risky issue merely show that they had missed it in a previous year?
Also, remember that Fannie Mae and Freddie Mac were heavily regulated, too. Many members of Congress, e.g., Barney Frank, et. al., wanted less regulation for those two government sponsored entities. When will faith in such entities be restored? When will Congress have an approval rating above 20%? (Without searching to verify it, as low as Mr. Bush’s approval rating is, we don’t being that Congress’s is even 50% of it: somewhere between one-third and one-half.)
As we understand it, while “Spero” is not an Italian name, the word means “to hope” in Latin. We’re thinking about changing it to something more realistic when we comment on the bailout. Why not try our solution: A Better Solution (than a government takeover)?
We might add to and revise this post through time.
The Importance of the Rule of Law
“You’re riding high in April, shot down in May.”
–Dean Kay Thompson, composer(s), of (Frank Sinatra’s) That’s Life!
Okay, so the line is several months premature, but it reminds us very much of Russia’s August and September. Unfortunately, it’s not “back on top in June,” err, October.
We mentioned Russia twice last month, primarily in It’s Freedom, Baby! Yeah! Mr. Putin.
Today, we read in The Wall Street Journal that its bailout is failing: Russian Investors Want Bailout of Bailout.
Given the circumstances, particularly the unfortunate timing of its recent invasion, we ask rhetorically: how could it not fail?
In August, when Russia invaded Georgia, it was on the top o’ the world, and it once again showed itself to be a less-than-reliable neighbor and partner. When the good times end, that’s not the reputation to have.
See, when times are good and everyone wants your stuff, maybe it doesn’t hurt to remind one’s trading and investing partners of one’s uncooperative past, e.g., the Russian bond crisis of 1998, the czarist bond crisis of 1918, etc. When times turn bad it seems unreasonable to expect positive outcomes from such a stark reminder, and that is the case this autumn.
Like the Russian government, it seems that the WSJ is trying to make the current Russian crisis part of the global financial crisis, but we think it is only tangentially related via the price of oil. Perhaps “only tangentially” is an understatement, but we mean that we view Russia’s problems to be distinct and unique and unrelated to dubious mortgages and mortgage-related securities in the USA.
While we see a distrust of certain asset classes and banks in the West, we think that investors distrust the entire Russian political and financial system, but maybe we’re projecting. (Maybe they’re just ahead of their time.)
That distrust wouldn’t be so harmful if oil were at $150 per barrel, but that’s not the case when oil is at $90.1
As we see it, if oil is around $90 per barrel today, it might well be at $45 or lower by December. Why? Because, these are the times and settings when cartels fail; each member deviates from the publicized and agreed-upon strategy to try to generate the marginal cash flow needed to pay for its commitments.
Many of those commitments could only be supported by high prices and were likely set under the assumption that those high prices would continue from here to eternity. (That has a familiar ring to it, doesn’t it Lehman, WaMu, Wachovia, and friends? Or anyone one that remembers oil prices in the 80s.)
So, dear reader, we ask: if in the past, Russia has defaulted on its debt; tried to squeeze its western neighbors using the supply of natural gas as a vice; nationalized various industries; imprisoned and harassed internal critics; and invaded its southern neighbors – Georgia this time – does the reader think that it would not behave opportunistically within the oil cartel? (Note: excluding movie scripts, there is rarely honor among thieves.) Ergo, our prediction of substantially lower prices in the near future.
See, what our Russian cousins have not learned is that the Rule of Law does not only protect others or only protect only the weak. It also protects one from his or her own self; it protects oneself from being shunned and avoided by others – even the weak. For as weak as they are, the strong may still need them to survive. If those same leaders had learned that lesson and practiced it, we doubt that there would be a new Russian crisis ten years after the last one.
- Oh, look, Dr. Spero’s May 1st prediction in Commodity Bubbles? Yeah, probably, might be turn out to be an incredibly lucky guess. ↩
Justice and Untethered Ferry Rides
Back in June, we wrote Justice and E-mails in part to reply to the chairman’s question about whether financial firms would continue to lose money and in part to criticize the egregious behavior of few former Bear Stearns employees.
At the time, we said that we expected the losses to continue, and offered her a variety of reasons. One of the reasons we gave was not a logical argument related to finance or economics or behavior; instead, it was a “terrestrial justice” observation. (We’ll leave considerations of cosmic justice to higher powers and pray for the best.) We speculated that the extant losses still seemed quite small given the egregiousness of the behavior of many. In fact, they seemed to be smaller by orders of magnitude, and so for that reason alone, we could see the loses continuing.
We have no pretense about our ability to measure and weigh such notions, but despite the massive losses incurred during the past three months, we’re still not sure if an equilibrium has been reached, and that is especially true after the bailout was signed into law.
Now the contentious reader may argue that such a post is silly, and that may be true. But we would argue that such impressions are real and often seem to be shared by believers and atheists alike. Unfortunately, the fact that, say, economists can’t quantify the notion doesn’t mean that it doesn’t exist. (Also note that we have in mind the economic justice of financial losses, not criminal justice or social justice – whatever that it.)
In the current crisis, it seems that members of both the political left and right have performed different reckonings but have reached conclusions similar to ours. In fact, we believe that zeitgeist would be more evident except for the looming Presidential election. (On Friday we did note in What Monster Hath They Wrought? that politicians across the spectrum may be surprised by the level of cynicism that they have unconsciously inculcated into the citizenry, and we hypothesized that it will lead to a resulting fickleness and fecklessness and, therefore, unpredictability of the voting population.)
The fact that the bailout seems to have united both the principled right and left against the expedient middle is quite an achievement, indeed. In fact, for whatever reason, we see the spokesman for both sides as “the carpetbagger” in Clint Eastwood’s 1976 masterpiece, The Outlaw Josey Wales (the Missouri ferry boat scene): “… …No, no, Mr. Josey Wales; there is such a thing in this country called justice!” We don’t think that either side has seen it, yet, and as much as it indirectly hurts our portfolio, we don’t think that we have, either.
Readers interested in more economics-based arguments against the bailout can search on that term above and will find no shortage of prose to occupy their time. In fact, we offered our own tax-based, private capital solution in A Better Solution (than a government takeover) that seemed rather obvious and certainly worth attempting before the massive government takeover.
The End of a Disastrous September
One of America’s largest companies had a disastrous September, and it was touch-and-go there for awhile. A company that some thought too big to fail, failed miserably.
As we have all seen, when a gigantic company on the coast suffers, even from self-inflicted wounds, it can negatively affect all of us in the fly-over.
There were clear warning signs in August. In fact, we wrote about them, but it was too little, too late, and the metaphorical train wreck occurred.
Despite our near-Libertarian stance on economic issues, we were prepared to call for government intervention. Fortunately, it never came to that.
Microsoft seems to have ditched the Jerry Seinfeld advertising campaign.
We initially wrote about Microsoft’s decision to use the former comedian in Seinfeld, a Youthful 54.
After the first ad, we wrote, Seinfeld + Gates = Mac Sales, Or Maybe Not, where we began to suspect that Bill Gates had an ulterior motive and was more clever than the hiring of Seinfeld would indicate.
Until now, we have never mentioned the second ad; it was just too weird and way too creepy and we were trying to repress it. Had we seen it twice we might have had nightmares about those two doing their nails in the older princess’s room.
We’re glad to see the “I’m a PC” commercials, and much prefer the muscular, “tyranny of the masses” approach – where almost everyone in every field uses PCs (hopefully, peer pressure may be enough to get the other 300 people to switch) – to two old men acting like teenage girls. Err, let’s hope they were acting.
In conclusion, we say, good job Mr. Gates! The next time we buy a PC, we promise to also purchase your Windows software.
